Wednesday, March 28, 2012

Know your options

Foreign exchange transactions are entered into either for hedging a risk or to trade / speculate.  If it is hedging, treasury (based on budgeted rate or FX target rate) decides the timing of transaction.  If it is one of speculative trading, then it is dependent on internal view.  I came across (what appears to be) a simple structure which left me confused as to what could be the objective of entering into a transaction such as this.  Let me take you through an example before we go further.

Indicative market quotes
USD/INR spot        - 51.00
1 month forward    -  51.50

Option strategy / structure
Buy USD put    @ 51.50 (A)
Sell USD call   @ 51.50 (B)
Sell USD put    @ 51.00 (C)

Maturity              1 month
cost                     zero

The strategy under discussion is a combination of options A, B and C.  This structure hedges export exposures (dollar receivable). Option A and B together is nothing but a synthetic forward, (i.e) if USD/INR at maturity is below 51.50 option A gets exercised and and if USD/INR is above 51.50 then option B gets exercised; whichever way, the effective rate would be 51.50 making it work like a forward.  This strategy also has a third leg (option C).  Below is a comparison of  this strategy with a simple forward contract (51.50) under two scenarios:

(1) if market at maturity is <51,
  • this strategy is 50 paise better than spot (at maturity) 
  • whereas a forward contract will be better than spot (at maturity) and above structure.  For instance, if  USD/INR spot, at maturity is 45, forward contract is Rs.6.5 better than market  whereas the above strategy is Rs.0.50 better than the market (spot at maturity)
(2) If market at maturity is > 51, then the above structure works just like a forward

This strategy CAPS YOUR GAIN AT 50 PAISE BUT YOU COULD LOSE A WHOLE LOT.  An option which has a limited upside and a substantial risk - Beats the purpose?

Going back to where we began, why would a corporate enter into this transaction?  I wouldn't think it's for hedging as this does not protect any particular level. If it is speculation, what is the view?  If the view is one of rupee depreciation, this strategy doesn't work; if  it is otherwise, forward is a better bet. Or it's the "zero cost" temptation? Beats me! 

 "Zero cost options" have been around for a long time and could turnout to be most expensive in hindsight.  It is important for corporates to check (1) if the offered strategy meets their hedging needs and / or confirms to their view and (2) scenario analysis before closing the trade.  

So are options bad?  Not if you know what you are getting into.  As cliched disclaimer goes  "please read the offer document carefully before investing". 

Wednesday, March 21, 2012

Non Deliverable Forwards

Indian Rupee is once again on a downward spiral; while oil importers' dollar demand is one key factor, what has been adding to rupee volatility is the offshore rupee market.  Popularly known as NDF (non deliverable forward) market , has been gaining volume and momentum over the last few years and a major price determinant of USD / INR.  This week's market talk is an attempt  at  exploring the how, why and what of NDF market.

NDF is an instrument to hedge foreign currencies which are not traded internationally and which do not have forward markets outside their countries.  This instrument only trades outside the country of the currency. NDF is typically a short term, cash settled, currency forwards between two counterparties. On the contracted settlement date, the profit or loss is settled  between the two, based on the difference between the contracted rate and a fixing (benchmark) rate. Fixing rate for rupee is RBI reference rate.  As the name suggests, there is no physical delivery of currencies and profit / loss is cash settled. NDFs are quoted from one month to one year.

NDF evolved as a result of restrictions in local forward markets.  It was mainly used to hedge currencies which could not be delivered offshore or unhedgeable in the corresponding countries.  Rupee is not fully convertible, there are capital restrictions and NDF market helps circumvent the issue.
Some of the Asian currencies which have active NDF markets are: Chinese Renminbi, Indian Rupee, South Korean Won, Malaysian Ringgit and Indonesian Rupiah. The main trading locations for NDFs are Singapore, Hongkong, Korea, Taiwan, New York, London and Tokyo.  

Offshore forward market now serves more as a platform to speculate and take advantage of arbitrage that exists between onshore and offshore currency forwards.  Offshore INR market is trading 24 * 7 moving from one financial center to another and reflects the views of international investors / speculators. Also as Indian market is not fully evolved  (due to capital restrictions), there are interest arbitrage and currency arbitrage that exists from time to time.  For instance, an Indian company which borrows in US Dollar (USD) and hedges forward may have an all-in borrowing cost that is lower than if it borrowed in rupees as rupee forwards is not function of interest differential between USD and  INR. 

This arbitrage opportunities exist between offshore (NDF) and onshore rupee forwards.  Many Indian companies with operations overseas, take advantage of this arbitrage by simultaneously entering in forward contracts onshore and offshore.  For instance if one month forward rate is 51.10 in India and the same is 51.20 in offshore NDF market, the offshore arm of the Indian company simply sells and the onshore (India) parent contracts to buy, making a neat 10 paise risk free profit.  On the settlement date, wherever the fixing rate is, this 10 paise (per dollar) profit is assured.  The more number of time this deal is churned, the more profitable it gets.  This has pushed up the volume of NDFs considerably.   

While the arbitragers come in only when there is a window of opportunity, speculators take more risk based on their view.  If global investors have a weak outlook of rupee, they sell the currency in the offshore market , arbitragers close the difference between offshore and onshore rupee exchange rate; this moves the rupee onshore (India) to reflect the view of global investors.  This in itself is not bad.  However an Indian entity with an actual exposure to currency risk, can do nothing about overnight rupee swings offshore and in a trending market it could prove detrimental as the currency may open with a huge gap the next morning in India.  

So NDF market has largely been determining the direction of rupee and rupee is now globally traded currency albeit non deliverable.  Why not open up the market and make it more efficient?  

Friday, March 16, 2012

Credibility is key!

It is a lackluster budget but is being perceived as one that hinges on credibility, pragmatism and reality.  Given the political, economic and global environment, an aggressive budget would have been a non starter.  

Highlights of union budget:
  • No change in corporate tax structure, however the indirect taxes, both excise and service tax have been moved up to 12% from 10%. Also service tax now covers a wider spectrum.  These two have been aligned as a preparatory step towards GST. 
  • Very modest change in personal income tax where exemption limit has been moved up to 2 lac from existing 1.8 lac and highest income tax rate made applicable for income above 10 lacs
  • Agriculture, power, civil aviation and infrastructure sectors have received attention. Proposed measures are ECBs for working capital and to replace rupee debt, reduction in withholding tax on ECB and tax free infrastructure bond has been doubled and part of it would be allocated to (Venture capital) to MSMEs through SIDBI
  • Large cars duty raised raised from 22% to 27%
  • Government borrowing program is aggressive; with no clear cut direction on fiscal consolidation, interest rate easing would be slow paced, cost of fund and liquidity would be under pressure
  • Import duty on refined gold has been doubled - this is a good move as investment could now move to more productive avenues and would also help current account deficit considering our gold import is substantial
  • Fiscal deficit is pegged at 5.1% for FY 2012-13 which is lower than where we are likely to end this year (5.9%) but higher than what was projected for the current year (4.6%) in last budget
  • GDP for FY 2012-13 is estimated at 7.6%
  • There is no direction or timeline on FDI, deregulation on diesel, GST or DTC

It is a credibility building exercise after Government has floundered about in its projections (growth and fiscal deficit) for the current year, recent election results, not-so-cooperative coalition and other challenges.

 It is a realistic budget, all right.  Let us hope our Government delivers in line with it's proposal if not more! 

Wednesday, March 7, 2012

Buyer beware and sellers too!

USD / INR reached well over 50 (50.75 intraday high) yet again.  Stock market slump, oil demand, a bit of panic and RBI intervention - just the same old story. Rupee staged a smart recovery on the back of investment flows earlier this year.  However fundamentally little has changed explaining Rupee's nosedive. 

Recent data showed the Euro Zone shrank 0.3% in the last quarter of 2011 worsening recession fears.  Despite second bailout package concerns remain whether Greece would manage to meet its deadline for debt restructuring.  

Crude continues to soar putting huge pressure on India's balance of payment. There seems to be no respite.

US data though increasingly encouraging, the recent testimony of Federal Reserve chairman continues to reflect skepticism - the pace of expansion has been modest and uneven and long term unemployment is near record high.  Given the restrained growth, the fed rates are likely to remain near zero for considerably long time.

At home, economic and political situation remain as challenging as it was yesterday or last week or last month.  Added to existing woes, the poll results seem to set an anti-incumbency trend raising further concerns on fate of policy decisions going forward.  

Volatility in Rupee is likely to remain high see-sawing between hot money chasing Indian shores and internal inability to retain investments.  Views and projections make an interesting conversation at a cocktail party; but decisions based on views may not bode well for business.  

Base your hedge decisions on exchange rate budgets and be extra cautious in setting budget rates for the coming financial year.  As the old adage goes, it is better to be safe than sorry!