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25 Nov 2016

USD/INR Forwards Crash – What Does this Indicate?

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The USD/INR forward premia has come off sharply in recent weeks.

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Ketan Verma

The USD/INR forward premia has come off sharply in recent weeks. The 3-month, 6-month and 12-month forward premia came off by 299 bps, 219 bps and 151 bps from 5.41%, 5.38% and 5.23% respectively as of 27th Oct 2016 to 2.43%, 3.19%, 3.73% as of 25th Nov 2016 respectively. Forward premia has come off even as the INR fell to record lows against the USD on 24th November.

Falling forward premia is due to three factors 1) Sharp fall in money market yields on the back of demonetisation  2) Falling risk premia on the INR and 3) Maturity of FCNR B deposits. One and five year OIS yields have fallen by 40bps and 30bps respectively from the time Demonetisation was announced on the 8th of November.Fall in money market yields lowers the cost of carry of forwards. The risk premia on the INR is down as the INR has witnessed a fall of close to 4% since Trump victory on the 8th of November that has led to a sharp rally in the USD. Markets now believe that INR has fallen enough and are unwilling to take forward bets on further sharp falls.FCNR B deposits of around USD 20 billion have matured this month and RBI’s outstanding forward purchase/sale contracts would have wound down and this could have lead to demand for USD/INR forwards coming off sharply leading to fall in the premia.

The downside of INR against USD is seen limited despite global bond sell off and strong USD.

USD/INR Forward Premia

The calendar spread between 3-month and 12-month contract has come down sharply to 130  bps as on 25th November 2016 from September 2013 when the spread was at 228 bps. The calendar spread between contracts indicates the short term and long term outlook for the USD/INR currency pair. The 3-month forward contract as on September 2013 was at around 10% while 12-month contract was trading in the range of 7.5% – 8%, giving spreads of more than 200 bps. The premia rose during September 2013, largely driven by the worries that U.S. Fed was on its way to taper its six-year long quantitative easing program and market participants were not sure about the repercussion of the taper, which made global financial markets nervous, driving up the demand for safe haven assets and providing broad strength to the USD.

Currency Forwards

Forward markets are significant in determining foreign currency prices through the interaction of fundamentals that are interest rates, inflationary expectations, balance of payments and other macro-economic factors. The forward rate could be in premium or discount, based on the interest rate differential in currencies that are fully convertible. In the case of partially-convertible currencies, forward rates are determined purely on the basis of demand and supply. If a currency pair is available at a cheaper rate in the spot market than in the forward market, it implies that it is quoted at ‘premium’. On the other hand, if the currency pair is costlier in the spot market than in the forward market, it is quoted at ‘discount’. If spot and forward rates are equal, the currency is said to be at ‘par’.

Countries that have fully-convertible currencies, the forward premium is deduced from their interest rate differentials. The premium/discount is measured in points, which represent the interest rate differential of the countries to which the currencies belong, for the period of maturity.

 

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