The stock exchanges that are readying to launch currency futures for the first time in India are gung-ho about the benefits that the individual investor will get from these products. As resident Indians are permitted to trade in currency futures, financial advisors also will soon come out with the benefits of
investing in derivative products with the Indian rupee as the underlying asset. What they won?t probably tell you are the pitfalls lying ahead, arguably the most destructive-and the most lucrative-investment avenue that once brought one of the world’s largest hedge funds, LTCM, to bankruptcy in 1998, with worldwide economic ramifications.
The individual investor has to remember that the strategies that are ideal for companies looking to hedge their risks may not bode well for him. Some of the important factors that may work against the individual investor are described below.
Favourable asset movement
One may take an exposure in currency derivatives, expecting the rupee to depreciate in four months’ time, when he plans to go to the US for medical treatment. In case the rupee appreciates in four months, which is actually favourable for him, he stands to lose. But in the case of companies, a different dynamics works and they many not be at as much a loss as an individual investor in currency derivatives.
Take, for example, the case of an ice-cream company, which fears a not-so-hot summer will dent its sales. The company takes a derivatives position. In case of a surprise hot summer, the ice-cream manufacturer may lose out on his derivative position, but he will more than make up the loss with the booming sales due to that hot summer. In the case of an individual who wants to finance his son’s study in the US, or a senior citizen who lives off his son’s remittance from Canada, none of these balancing avenues are available.
Demand and supply
Those who go to the over-the-counter market for currency hedging at the banks, usually big conglomerates, need not bother about either the liquidity of the product they buy, or the demand-supply equation that will determine the cost of such products. In the case of exchange-traded derivative products, you can buy a contract if and only when a counter-party is willing to sell that contract. In other words, the buy orders and the sell orders have to match. Therefore, currency futures are at the mercy of the market forces operating in the exchange, and these forces may not always operate in the direction of your investment purpose.
Cost
The objective of an individual in taking a position in currency futures is to reduce the outgo from his pocket. But there are various costs involved in purchasing or selling a derivative product such as brokerage, margin, etc. If the cost far outweighs the benefit accruing from a futures position, then you’d better not hedge at all.
Administered exchange rate
In an ideal free market, only the interest rate differential will decide the comparative price of two currencies. That is when full convertibility of rupee on the capital and current account of India becomes a reality. Despite the government rhetoric, Indian currency is still regulated. In fact, one can almost expect what step the Reserve Bank of India will take next in order to curb unbridled dollar inflow, or burgeoning inflation. Due to the managed exchange-rate regime, the entire effort of taking a position in currency futures may sometimes turn out to be a non-event for the individual investor.
If one guards against such pitfalls on the way to investing in currency futures, then he has a fortune to make when the National Stock Exchange launches currency futures for the first time in India on August 29.