Appreciating Rupee: Changing Paradigm?

This paper discusses the volatility behaviour of the rupee dollar movement. Analysing data on the forward premium in the rupee dollar forward market from 1997 to 2002, the authors attempt to understand the dynamics of the forward market and also, how optimal hedging works. This analysis shows that contrary to what an efficient markets perspective would predict, the forward premia systematically exceeds rupee depreciation, implying that there is an asymmetric advantage to sellers of dollar forwards.
AJIT RANADE, GAURAV KAPUR

I Introduction

uring the year 2002, the Indian rupee appreciated by 1 per cent in nominal terms against the US dollar, and almost 2 per cent from its lowest point in May, to its peak at the end of the year. In many ways this was an unprecedented year for the rupee and Indias external sector. Firstly, it was the most sustained appreciation so far, and the appreciation is expected to continue well into 2003. In fact 2002 was the first year in which rupee finished at a level higher than its level at the beginning of the year. There were two other episodes of rupee appreciation in the past 12 years. The last two episodes of rupee appreciation date back to 1992 and 1996. In 1992 the rupee appreciated from April to October from a monthly average value of 30.93 to 30.05, which was a more than 2 per cent appreciation. However during February to April in 1996, the rupee gained by almost 6 per cent when it went from 36.63 to 34.24 per dollar. But clearly, the 2002 episode is much more sustained. Otherwise the rupee dollar movement over the past decade has been mostly unidirectional, with the rupee depreciating annually by an amount roughly equal to the inflation differential between the two economies (Table A). The current sustained rupee appreciation was mainly on account of the dollars global weakness. A large current account deficit, poor equities market sentiment and a weak economy, led the US dollar to its biggest annual fall in 15 years. During 2002, the dollar lost 9.6 per cent of its value in real trade-weighted terms against a basket of other major currencies. Trade weighted fall in 2002 was the steepest

since its 16.9 per cent drop in 1987, the year in which the US stock markets witnessed a big crash. In nominal terms during 2002, the US dollar lost 14 per cent against the euro and the Indonesian rupiah, 10 per cent against the yen, pound and the Korean won, 2 per cent against the Thai baht, 6 per cent against the Singapore dollar (Figure 1). This was despite the fact that the GDP growth of the US outpaced all other large economies in 2002, growing an estimated 2.4 per cent compared with 0.8 per cent in the eurozone and a fall of 0.3 per cent in Japan. Apart from rupee appreciation, the second remarkable development on the external front, was that for the first time since 1977, India recorded a current account surplus in the fiscal year which ended in April 2002. This situation is also likely to continue in the current fiscal year. During April to September 2002, the current account registered a surplus of $ 1.7 billion. The surplus registered in 1976-77 was an anomalous situation, due to a sudden compression of imports. Hence the recent current account surplus is a historic first. The third remarkable development relates to inflows of foreign exchange via export earnings, remittances and through the capital account. It was only during the last fiscal year (2001-02), that all quantitative controls on imports were finally removed, although import duties remain, which too have reduced considerably since the early 1990s. On the capital account, the accounts of non-resident Indians were made almost completely repatriable. Some capital barriers have been progressively removed even for resident Indians who can now buy limited assets abroad. In the olden days such bold opening was resisted for fear of massive capital flight out of the

country. But during 2002, the opening up was accompanied by an increased surge of inflows (total $ 21 billion). A fourth remarkable feature relates to volatility of the rupee dollar exchange rate, which is the focus of this article. In recent years, the volatility of the rupee dollar movement (measured as standard deviation, of daily, weekly or monthly returns) has been declining steadily (Figure 2). Among all currencies worldwide, which are not on a nominal peg, and certainly among all emerging market economies, the rupee dollar relationship has been a very stable one, perhaps too stable. A big part of this stability is due to the central banks frequent intervention in the currency markets (the so called managed float) and also due to the various restrictions placed on participants. In fact the behaviour of participants is conditioned by the expected intervention of the central
Table A: History of Rupee Dollar Rate
Year Rs/US$ Year FY86 FY87 FY88 FY89 FY90 FY91 FY92 FY93 FY94** FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 Rs/US$ 12.24 12.79 12.97 14.48 16.66 17.95 24.52 26.41 31.36 31.4 33.46 35.5 37.16 42.06 43.33 45.69 47.69

Till June 1966 4.76 June 6, 1966 to mid-December 1971 7.5 Mid Dec 71 to end-June 1972 7.28 FY72 7.44 FY73 7.71 FY74 7.79 FY75 7.98 FY76 8.65 FY77 8.94 FY78 8.56 FY79 8.21 FY80 8.08 FY81 7.89 FY81 8.93 FY83 9.63 FY84 10.31 FY85 11.89

Note: ** From FY94, the rates are market determined. Source: IMF.

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Figure 1: Movement of USD against EUR, JPY, GBP and INR during 2002
(All rates normalised to January 2, 2002 = 100) 105

100

95 GBP/USD GBP/USD EUR/USD EUR/USD INR/USD INR/USD JPY/USD JPY/USD

90

85 January 2, 2002 Source: Reserve Bank of India. December 31, 2002

bank, which in turn affects the pricing in spot and forward markets. But more about the phenomenon of forward premium later in this article. This article has two parts. The first part discusses the volatility behaviour of the rupee dollar movement. In the second part, we analyse data on the forward premium in the rupee dollar forward market, from the period 1997 to 2002. The forward premium (usually a positive amount) is paid in excess of the current spot rate so as to hedge against unforeseen currency fluctuations. In the period when the rupee was (steadily) depreciating, the forward premium ensured that the hedger was protected against excessive depreciation of the rupee. Our purpose is to understand the dynamics of the forward market, and also how optimal hedging works. Our analysis shows that contrary to what an efficient markets perspective would predict, the forward premia systematically exceed rupee depreciation, implying that there is an asymmetric advantage to sellers of dollar forwards.

by banks. The Turkish lira too had a precipitous fall. In February 2001, when the Turkish government made the lira fully convertible, the currency crashed by 28 per cent against the US dollar, on a single day!

The demise of Argentinas peso peg last year, is by now well known. If we go back farther to the east Asian financial crisis of 1997-98, the stories of the fall of the Thai baht and the Indonesian rupiah are also reminders of currency gyrations. And it must be noted that currency movements can be in both directions. Thus when Turkey got a rating upgrade, owing to an IMF mandated austerity programme, which brought inflation down from 100 per cent to almost single digits, and also enabled Turkey to meet her monetary and fiscal targets, her currency started to appreciate. By contrast, the rupees journey during much of the 1990s was quite sedate, except for a couple of sharp devaluations the most famous being the one of 1991. Until recently the movement of the rupee was unidirectional, i e, downward with respect to the US dollar. The annual depreciation of the rupee was roughly equal to the inflation differential between India and the US. In the last few years, the volatility of the rupee has been steadily declining. From April 1993 to February 2002, the coefficient of variation in the rupee was 100 per cent. But measured over April 2001 to December 2002, it was as low as

Table 1: Monthly Average 30-day Moving Volatility

(Exchange Rate against the Dollar) Month Mar-00 Apr-00 May-00 Jun-00 Jul-00 Aug-00 Sep-00 Oct-00 Nov-00 Dec-00 Jan-01 Feb-01 Mar-01 Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 Sep-02 Oct-02 Nov-02 Dec-02 Yen 12.3 14.0 11.7 11.0 9.0 7.8 7.6 7.0 6.8 8.1 9.6 11.3 10.4 12.5 12.1 10.9 8.8 10.0 11.0 10.4 7.0 6.7 7.2 9.8 11.9 10.5 7.9 9.3 9.2 11.4 10.5 9.2 6.8 9.4 Euro 12.0 10.6 12.9 13.8 11.1 10.3 11.9 12.7 12.4 13.2 16.0 14.7 13.3 13.2 11.1 9.8 11.4 9.9 12.1 11.7 8.5 8.5 9.9 9.1 7.8 6.6 8.6 8.9 9.5 13.1 10.8 9.2 7.5 6.3 Brazilian Indonesian Philippines Mexican Polish Hungarian Thai Indian Real Rupiah Peso Peso Zolty Froint Baht Rupee 7.4 8.0 8.9 7.8 6.8 5.5 5.6 6.9 10.9 12.5 8.1 5.8 9.7 15.1 18.4 15.0 24.0 23.4 12.4 12.4 16.9 20.1 17.7 12.2 11.3 10.8 10.6 19.9 26.1 30.6 23.3 37.7 30.0 21.9 12.9 12.1 15.1 16.6 19.0 21.8 19.8 15.7 14.7 13.7 14.8 10.4 19.1 27.5 25.8 20.6 16.1 30.2 26.1 19.7 17.7 14.8 10.1 6.1 6.4 10.8 9.4 16.5 17.3 15.2 7.4 9.2 10.6 6.8 2.8 1.8 2.5 5.7 5.0 5.4 3.4 6.1 19.2 13.8 16.3 30.0 11.5 6.9 8.0 8.8 8.1 8.0 6.7 2.7 2.3 3.7 6.4 4.0 3.8 3.4 4.6 7.0 5.9 5.4 4.6 4.0 4.3 4.2 12.3 9.1 7.4 8.5 15.0 11.4 7.6 7.4 6.7 6.1 7.4 7.7 6.1 7.9 10.2 9.2 8.1 8.9 6.9 9.1 6.0 5.3 6.4 6.8 6.7 5.5 5.6 6.6 8.7 9.6 8.7 9.0 7.8 7.3 9.6 9.5 18.6 17.6 9.8 9.0 9.4 10.6 9.0 7.7 11.8 10.8 12.1 13.3 10.3 6.3 15.4 14.6 7.7 7.7 6.5 7.0 9.3 11.5 8.6 5.8 7.5 8.0 10.5 12.0 7.7 7.0 8.7 9.2 11.4 11.2 14.8 14.4 10.8 11.7 10.9 11.5 12.4 14.7 13.1 13.3 13.5 13.7 13.0 12.7 16.6 16.5 15.6 14.3 9.0 9.6 11.0 11.2 11.7 8.6 8.5 9.4 10.5 13.0 10.8 10.0 9.7 7.4 5.0 3.8 4.6 5.2 4.1 8.1 6.8 7.7 8.3 7.5 8.8 6.8 5.3 7.3 6.3 3.6 2.3 3.3 5.0 4.2 2.9 2.7 3.4 3.6 3.5 3.7 2.9 3.4 4.9 9.9 6.2 5.5 4.3 3.5 0.4 0.3 2.5 2.9 1.8 3.7 3.7 3.3 2.5 1.4 1.0 1.4 1.3 1.8 1.6 0.9 1.0 0.6 1.7 2.2 1.2 1.3 1.7 1.4 1.1 0.8 0.9 1.0 0.9 1.0 1.0 0.8 0.9 1.0

Declining Volatility
In emerging and developing economies, the tales of volatile currencies are quite common. There are many examples of volatility even from recent times. In late 2001, the South African rand fell by 37 per cent in a matter of just three months, which had prompted a presidential investigation into possible market manipulation

Source: Moneyline Telerate, authors calculations.

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Figure 2: Trade Weighted Major Currency Index of the US Dollar

(Base: 1973 M3 = 100) 140

130

120

110

100

90

80

70 January, 1985 Source: Federal Reserve Bank of St Louis.

December, 2002

Figure 3: India/US Inflation Differential

18 16 14 12 10 8 6 4 2 0 April, 1991 Source: Ministry of Commerce, Federal Reserve Bank of St Louis. India USA (rhs) 18 16 14 12 10

India

USA(rhs)

8 6 4 2 0 November, 2002

of purchases kept the rupee sliding at about 10 to12 paise a month. September 11, 2001 triggered first a one-off sharp drop in the rupee, followed by strong dollar inflows, which compelled the RBI to undertake much heavier dollar buying to engineer the continuing steady slide in the rupee. By the start of 2002, it took (on average) a billion dollars of buying to push the rupee lower by 10 paise. The continued stocking up on forex assets by the RBI is attributed to various factors, such as volatile oil prices and repayments due on account of the Resurgent India Bonds and the India Millennium Deposits. But an equally important reason for reserves accumulation could be to keep the rupee steadily depreciating. This helps contain the volatility of the rupee and also helps exports. A weaker rupee has also got the support of an alliance of exporters and domestic manufacturers who feel the threat of cheap imports. In a WTO mandated world, domestic industry has lost the protection of high import tariffs and quantitative restrictions. Similarly exporters are likely to lose the advantage of export subsidies. For both these categories, a weak rupee is a welcome source of support. But more important than a depreciating rupee, is a stable rupee. The stability, or low volatility is a confidence building measure for importers, exporters and investors, be the investment be in the form of portfolio flows or direct investment. Volatility management of the currency is under the purview of the central bank. A central bank can choose to emphasise one out of three targets, which are inflation, currency and interest rates. Only in
Table 2: Volatility of Monthly Rupee Dollar Rate
Monthly Re/$ (yoy Percentage Change) Apr-93 to Dec-02 Std Dev Mean cv Std Dev Mean cv 4.77 4.94 1.0 1.77 3.62 0.5

50 per cent. (The coefficient of variation is defined as standard deviation divided by the mean.). Table 2 illustrates the growing stability of the rupee. So it does appear that rupee volatility has been steadily falling. The annual depreciation (and now more recently appreciation) in the rupee has become somewhat more predictable, due to this stability. A thumb rule to estimate currency depreciation is to use the inflation differential between the two economies of the US and India. This is a direct evidence of the rupee being a managed float. The following is a longish trend data comparing the differentials between the US and Indian inflation rates. From this trend it is evident that the in-

flation differential has also been narrowing. This may be partly because the decade of the 1990s has been a disinflation decade for most emerging market economies (Figure 3). Declining rupee volatility has been made possible by a heavy exchange rate management by Reserve Bank of India (RBI), given its objective of maintaining a stable exchange rate. During 2002, RBI added $ 21 billion to its foreign exchange reserves to stem the rupee from appreciating. From April to September 2001, market liquidity and sentiment was such that the RBI could keep the rupee moving gradually lower with relatively modest dollar buying. Roughly $ 400 million a month

Apr-01 to Dec-02

Source: Reserve Bank of India, authors calculations.

Table 3: Annual Volatility

(Per cent) Currency Pairs INR/USD USD/EUR JPY/USD INR/EUR 2000 2.4 12.4 10.0 13.6 2001 2.1 11.9 10.4 12.5 2002 1.6 9.1 9.9 9.7

Source: Reserve Bank of India, Authors calculations

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the extreme case of a fixed currency peg (as in pre-1997 Thai Baht, or the present Chinese Yuan), will the other two targets become irrelevant. In all other cases, the three variables can be managed simultaneously, although not independently. But there will be trade-offs. The more the emphasis on the management and control of one variable, the lesser its volatility. But that would mean that the other two variables may exhibit higher volatility. Thus,

an indirect way of deducing the current focus of RBIs policy is to look at which variable exhibits the lowest volatility. If the rupee is exhibiting low volatility, then one can conclude that it must be higher on the RBIs current priority. In that case interest rates and inflation may fluctuate more than expected. Of course, it is possible that despite RBIs neglect, the other two variables might exhibit low volatility due to other macroeconomic factors.

Volatility and Forex Accumulation

One question worth examining is whether the declining volatility is at the expense of increased volatility of forex stock. Or in other words, is there a correlation between monthly rupee fluctuation and forex stock fluctuation? Some correlation seems to be evident from a scatter plot (Figure 4), which shows the monthly variation in the Re/$ measured as a year-on-year (y-o-y) percentage against similar variation in the monthly stock of forex, from April 1993 onwards. It is tempting to assert that downward movement of the rupee has been positively and significantly correlated with reserve accumulation. But that may not be the case, accompanying scatter plot notwithstanding. The statistical correlation is negative, and almost insignificant. The graph (Figure 5) shows the monthly variation in forex stock and the absolute value of rupees per dollar (inverted scale on the right hand axis). It can be seen that for the past 50 months, the y-o-y monthly growth rate of forex stock has been continuously positive. Which means that the currently noticeable RBI action of reserve accumulation is not as recent as it seems. The related relevant question is, what is the cost of maintaining a low (but non-zero) rupee volatility via reserve management. Clearly the opportunity cost of maintaining high (and perhaps volatile) reserves, includes the cost of not-pre-paying foreign debt, and also foregoing profitable trading and investment opportunities. The benefit includes the increased stability and improved
Table 4: Annualised Gains
(In per cent) Tenor Average Minimum Maximum Std Gain Deviation (1) (2) (3) 1.271 1.227 1.261 1.271 1.315 1.467 1.629 1.731 1.776 1.806 1.814 2.050 -43.60 -30.79 -21.43 -16.06 -11.16 -11.68 -9.69 -8.28 -7.12 -5.68 -4.54 -4.14 25.37 15.09 10.94 11.25 11.05 9.97 11.21 9.89 10.07 8.88 8.83 8.50 11.33 8.74 7.27 6.27 5.65 5.19 4.78 4.40 4.06 3.81 3.59 3.43

Box 1: Development of Foreign Exchange market in India In 1978, RBI allowed banks to undertake intra-day trading in foreign exchange and, the stipulation of maintaining square or near square position was to be complied with only at the close of business hours each day. This marked the beginning of forex market in India. During 1975-92, the exchange rate regime was characterised by daily announcement by the RBI of its buying and selling rates to Authorised Dealers for merchant transactions. Given the then prevalent RBIs obligation to buy and sell unlimited amounts of the intervention currency arising from the banks merchant purchases, its quotes for buying/selling effectively became the fulcrum around which the market was operated. The growing depth of the Indian forex market after 1992 reflects essentially the result of the implementation of a number of recommendations of three important committees (a) the High Level Committee on Balance of Payments (chairman: C Rangarajan) (b) the Report of the Expert Group on Foreign Exchange Markets in India (chairman: O P Sodhani) (c) the Committee on Capital Account Convertibility (Chairman: S S Tarapore) In March 1992, the Liberalised Exchange Rate Management System involving dual exchange rate system was instituted. This was followed by the convergence of the dual rates effective from March 1, 1993. This was the beginning of the market determined exchange rate regime of rupee, based on demand and supply in the forex market. Current account convertibility, was achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the International Monetary Fund. Since the unification of the exchange rate in March 1993, several measures were introduced to widen and deepen the forex market. Banks were given the freedom to (i) fix net overnight position limits and gap limits (with the Reserve Bank formally approving the limits), (ii) borrow or invest funds in the overseas markets (up to 15 per cent of Tier I Capital unless otherwise approved); (iii) determine the interest rates of NRI deposits (subject to a ceiling) and maturity period (not exceeding 3 years) (iv) use derivative products for asset-liability management Inter-bank borrowings were exempted from statutory pre-emptions. Authorised Dealers were allowed to borrow abroad. Their external borrowings were related to their capital base. Corporates were permitted to hedge anticipated exposures. EEFC account eligibility was increased and the permissible end-uses widened. Freedom was given to cancel and rebook forward contracts (rebooking was disallowed for sometime after the Asian currency crisis, but the facility was restored effective March 26, 2002). Crosscurrency options on back-to-back basis and hedging of external commercial borrowing exposures were allowed subject to prudential requirements. Corporates were also allowed to access swaps with rupee as one of the currencies to hedge longer term exposures. More recently, Multinational companies have been allowed to take forward cover in respect of their India exposure through the FDI route without any RBI approval. RBI also has allowed to banks to invest as much as they want in the overseas money markets and debt instruments. Source: Reserve Bank of India, Various reports

1-month 2-months 3-months 4- months 5- months 6- months 7- months 8- months 9- months 10- months 11- months 12- months

Notes: 1 Minimum gives the maximum loss that can be incurred. 2 Maximum gives the maximum gain that can be made. 3 Standard Deviation shows the variability of returns. Source: Authors calculation.

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Figure 4: Re/$ Variation in Per Cent (y-axis) versus Forex Stock Variation in Per Cent (x-axis)
20

15

10

5 15

15

30

45

60

75

90

105

Source: Reserve Bank of India, authors calculation.

Figure 5: Change in Reserves vs Change in Rupee Dollar Rate

110 100 90 80 70 60 50 40 30 20 10 0 10 20 1993 M4 yoy percentage variation in Reserves (lhs) Source: Reserve Bank of India.

yoy% variation in R eserves (lhs) R e/$ rate

30

35

40

premia systematically exceed rupee depreciation to the benefit of sellers of dollar forwards. Our findings are particularly significant in light of the recent appreciation in the rupee. Traditionally importers would tend to buy dollar forwards, so as to insulate themselves from the risk of excessive depreciation of the rupee. Of their total expected dollar requirement, it was customary for the importers to buy a forward cover for 70 per cent of their requirement. Conversely, exporters expecting dollar inflows at a future date did not feel inclined to cover their positions since unexpected excess depreciation of the rupee works to their advantage. So almost half of their exposures remained unhedged. In light of the appreciation of the rupee, exporters are now resorting to selling all of their dollar forwards, at whatever premium the market is willing to pay them. In all of the above it must be mentioned that gains or losses arising from leaving exposures unhedged by any forward contract, are really in the nature of windfall gains and losses and not related to the underlying business.

45

Brief Theoretical Background on Forward Exchange Rates

Determination of forward exchange rates (or forward premia and discounts) can be understood from the interest rate parity relationship. Interest rate parity is
Tablea 6: Gains from Selling $1m Forward

50 2002 M12 Re/$ rate

investment climate, both rather difficult to quantify. The building up of foreign exchange reserves is also seen as an insurance mechanism. It also sends positive signals to rating agencies. It is nevertheless true that in a managed float such as the rupee, forex reserves offer a powerful tool of cushioning volatility of the currency. And declining rupee volatility should at least partly manifest as higher volatility in the stock of reserves, unless other economy characteristics are causing rupee stability. The volatility absorption via reserve management does have an opportunity cost. Thus lower volatility has to be purchased at a price.

seller promises to deliver the goods to the buyer for a fixed price (decided today) on a future date. In the foreign exchange market the seller of the currency is also the buyer of the opposite currency. If the dollar is expected to become more expensive in the future, the seller of dollar forwards will command a premium over the spot rate. This is the forward premium. The objective is to establish whether any asymmetric advantage exists in selling dollar forwards and understand how optimal hedging works. Our analysis shows that forward

Tenor 1-month 2-months 3-months 4- months 5- months 6- months 7- months 8- months 9- months 10- months 11- months 12- months

Average Annualised Gain (in $)* 12707 12269 12610 12707 13150 14671 16286 17311 17757 18059 18142 20502

Source: Authors calculation. * Computed over the data.

Table 5: No of Data Points with Positive Gains Over Various Tenors

1 2 3 4 5 6 7 8 9 10 11 12 month months months months months months months months months months months months 1998 1999 2000 2001 2002 8 7 6 7 11 9 10 4 7 10 9 10 4 8 9 8 11 4 8 8 7 11 5 8 7 7 10 5 7 6 7 10 5 7 5 10 10 5 8 4 10 10 5 8 3 10 9 5 9 2 10 9 5 10 1 11 7 5 10

II Rupee Dollar Forward Market

In this section we examine long term data on rupee dollar forward premia and the spot rates. In a forward contract the

Source: Authors calculation

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Figure 6: Distribution of Gains

(Tenor: 1 Month) .2

.15

.1

.05

0 6 4 2 Percentage gain 0 2

a relationship that holds between interest rates, current exchange rates and forward exchange rates. Two theorems, popularly known as covered interest parity (CIP) and uncovered interest parity (UIP) are used to understand the relationship between currencies. The CIP theorem states that the covered interest differential between two similar assets denominated in different currencies should be zero. Thus foreign exchange risk is eliminated by the use of forward markets. For UIP, an investor does not participate in the forward exchange market at all. The UIP theorem states that differences between interest rates across countries can be explained by expected changes in currencies. The UIP is thus about expected spot rates in the future, whereas CIP is about the forward rate. Both these theorems are illustrated in the equations in Box 2. The CIP principle also implies that, if nominal interest rate on one currency is higher, then the future price of that currency should be lower than the spot rate. UIP says that this should also hold for expected future spot rate as well. In practice however, the CIP principle holds true, whereas the UIP generally fails. The failure of UIP is one of the most puzzling feature of currency prices. Thus contrary to UIP, we often find that high interest rate currencies have a tendency to appreciate, even though the UIP condition suggests the reverse. Unlike UIP, the CIP theorem is generally valid under conditions of free capital mobility across borders, zero transaction costs and no trade restrictions.

In some cases even the CIP has failed to hold true.

differentials between the US and India. But this is not true, as our analysis below shows. The following additional features are specific to Indian conditions: (a) The preference of RBI towards a stable and weakening rupee, even if that means excessive accumulation of reserves. This in turn implies that the rupee depreciation is typically lower than that implied by forward premia. (b) Foreign banks are the dominant player in spot and forward currency markets. Since they do not have an extensive branch network, they tend to depend on other sources for rupee funding. Recent restrictions on call borrowing has meant that these banks are securing their rupee funds by funding rupee purchases through selling spot and buying dollar forwards. This asymmetry has increased the advantage of sellers of dollar forwards.

Fraction

Empirical Analysis and Findings Some India Specific Factors

Since the Indian rupee is not totally convertible, we cannot expect CIP to hold true completely. Moreover there are several other constraints on inward and outward flow of currencies which add to the transaction costs. Thus it is not the case that interest rate differentials alone are the driving factor for the rupee dollar forward premium. In the spot market, it is usually the demand and supply for currency by importers and exporters that largely determines the rupee dollar (Re/$) rate. The forward rate is also partly affected by mismatches in supply and demand in the spot market. Under CIP we should have expected the forward rate to be determined purely by interest rate We look at fortnightly data compiled over 1997 to 2002 on forward premia. Our objective is to discern any pattern in the behaviour of the premia. We examine whether the forward premia systematically overstate the extent of rupee depreciation. Market participants in the past, have come to expect the rupee to depreciate by 3 to 5 per cent per annum. But premia might overstate the extent of this depreciation. If such is the case, it presents the sellers of dollar forwards with an opportunity, in that by selling forward dollars, they can gain, because rupee does not depreciate to the extent implied by the forward premia. If the advantage persists with the seller of forwards always (and thus negating CIP), it could be because of

Box 2: Interest Rate Parity Conditions Covered rRe = r$ + (f e) e Uncovered rRe = r$ + (e * e) e rRe = rate of interest on Rupee denominated security for any tenor. r$ = rate of interest on US dollar ($) denominated security for equivalent tenor as of the rupee security. e = spot Re/$ rate e* = expected Re/$ rate. f = forward Re/$ rate.

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Figure 7: Re/$: Premium vs Depreciation

(In per cent) 14 12 10 8 6 4 2 0 2 6 month forward premium 6 mth forward premium 6 mth depreciation 6 month depreciat

with forward sellers declined a bit. For the year 2002, all the data points across all tenors were positive.

An Illustrative Hedging Strategy

On the basis of the analysis and findings of the previous section we present an example of gains to be made by selling dollar forwards. Table 6 presents gains that would have been made by selling $1m forward, over various tenors and rolling such gains for a year. As can be seen the annualised gains for maturity tenors of two and three months are lower than that for one month, but higher from five to 12 month maturity tenor. This implies that, the best strategy seems to be to sell dollar forwards of duration five months or longer. However, positive gains to be made from all tenors. This conclusion holds irrespective of whether one sells end of the month or at mid-month. The gain to seller of dollar forwards will depend on three parameters: (a) the forward rate of the day (b) the tenor he chooses; (c) the spot rate that would prevail on the day the forward contract terminates. Based on our analysis, the optimal strategy for an exporter would be to sell exports forward for tenors ranging from five months to 12 months. However, this decision would also depend on the risk appetite of the exporter. That is because the variance in gains is higher for shorter tenors. In case, an exporter is unwilling to take a long-term view on the movement of the forward premia, selling for shorter tenors, i e, one month to 6 months would also be beneficial (Figure 6). For importers, the optimal strategy is to seek short-term covers, and remain unhedged for longer tenors. With rupee appreciation, the divergence between depreciation implied by forward rates and actual depreciation will be greater. Thus selling dollar forwards will be even more profitable. EPW
Address for correspondence: ajit.ranade@abnamro.com

Note: Except for the period of May to December 2000 the rupee depreciation has mostly been less than that implied by the forward premium. Source: Reserve Bank of India, Moneyline Telerate, Authors calculations.

December 2000

India specific factors, which we have listed above. For our analysis we followed the following methodology: Data on month-end forward premia, for tenors of 1 to 12 months and spanning over 60 months beginning December 31, 1997, was used as the sample of our analysis. The data was obtained from Dow Jones Telerate and data gaps were filled by inputs from foreign exchange brokers. The forward premium, for tenors, 1 month to 12 months, were used to arrive at the respective outright Re/$ rate. Outright Re/$ rate for any tenor, is the Re/$ rate implied by forward premium (on any particular date) at the end of that tenor. The outright Re/$ rate for all tenors, was calculated at the end of every month, over the sample period. The outright rate was compared with the prevailing spot Re/$ rate on maturity to calculate the divergence between the two rates. Positive divergences between the two rates (i e, when spot rate is lower than the outright rate), would translate into a gain for an exporter selling dollars via a forward contract and vice versa for negative divergences. The divergence data, was normalised with respect to the spot rate, by calculating divergences as per cent of the Re/$ spot rate. Normalised divergences were averaged, for all tenors from 1 month to 12 months. The average divergences were then annualised.

From our analysis the following are some important observations: (1) Table 4 presents the average annualised gain over various tenors along with the standard deviation calculated from the sample data. As can be seen from Table 4, the average gain across various tenors, is positive. But more importantly, the magnitude of the mean gain, is lower for tenors from two up to five months, as compared to the gain on one month. From six months onwards, though the gain is monotonically rising. Also, the annualised variability of gains, as measured by the standard deviation, falls with an increase in the tenor. That is, for longer tenors, one is more sure of booking a profit. (2) We also observe that the distribution of percentage gain for any tenor, tends to be non-normal. (see graph (Figure 6) which shows data alongside an ideal normal distribution curve.) The distribution is positively skewed, which means that the frequency of positive gains is higher than that of the negative gains. (3) Outright Re/$ rate for any tenor, as implied by the forward premium, tends to overstate the extent of depreciation in the rupee or in other words the actual spot Re/$ rate turns out to be lower than the outright rate. (4) Table 5 gives data on the number of data points, over various tenors and years, when gains from selling dollar forwards were positive. Between 1998 and 2001, only for the year 2000, the number of data points during which the advantage rested

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