Managing volatility tricky with NDF market

Written by Aparna Iyer | Mumbai | Updated: Jun 12 2013, 21:37pm hrs
At a time when the Indian rupee has been thrashed down to record lows, the task of managing volatility in the currency markets is being complicated by a thriving offshore speculative market where the rupee is traded.

The non-deliverable forwards (NDF) market, which allows FIIs to punt on dollar-rupee, has once again seen a pick up in turnover as arbitrage opportunities have increased. This increased activity has added to volatility in the domestic rupee market.

The one-month NDF dollar/rupee rate is currently trading at R59.17 compared to the forward premium in domestic markets of R59.09 a spread of almost 10 paise. In the last one month, the NDF rate has been 20 paise higher than the onshore rate on average, creating an arbitrage opportunity for traders.

The offshore USD/INR rate is quite elevated as the dollar demand offshore has been very strong, said Paul Mackel, who heads the Asian currency research at HSBC.

NDF trades in Singapore and Hong Kong are already predicting the rupees fall to 59/$ and beyond ahead of the onshore rates. On Tuesday, the rupee hit a fresh lifetime low of 58.98/$. In particular, as FIIs look to exit Indian debt right now, the gap between the NDF and the onshore forward rate has created a fertile ground for arbitrage.

Once an FII buys a rupee bond or shares, the position is hedged in the offshore NDF, usually in the one-month segment. The hedge is taken early in the morning before the RBIs reference rate is released.

This position is unwound later in the day and the bond or the shares sold back here, the difference between the onshore rate and the NDF rate fetches the FII a high return. In many cases, the arbitrage return on the currency, helps increase the return on the sale of the underlying asset in India or buffer any likely losses

Much of the earnings from NDF contracts depends on the RBIs reference rate fixing. The central bank releases daily reference rate for the dollar/rupee around 12 noon.

On Tuesday, the reference rate was 58.9255/$ while the domestic spot rupee ended at 58.39/$. The offshore one-month NDF rate was last quoted around 59.17/$.

The NDF markets influence on the onshore market is certainly reduced. But arbitrage opportunities are always taken advantage of, said a currency dealer at a foreign bank. Since the RBI frowns at banks participating in the NDF market, no Indian bank openly confirms its participation in the NDF market.

The speculative trading in the NDF market often tends to create volatility in the Indian spot rupee market and hence has always miffed the RBI. The central bank recently allowed FIIs to participate in the domestic exchange traded futures market in the hope that it would take volumes away from the NDF market. Guidelines for this have still not been released.

However, forex experts said instead of trying to clamp down on the NDF market due to fears of volatility, the RBI should instead try and gauge the size and the impact of the market.

Because we have shut our eyes to the NDF market, we do not have enough information or data on it, said forex expert AV Rajwade.

China is encouraging offshore yuan market, but we have shut our eyes to it, Rajwade added.