April 2 (Bloomberg) -- Volatility in the Indian rupee will rise after the Reserve Bank of India meets on April 29 to decide on interest rates, according to Morgan Stanley.

Implied volatility on one-month rupee options fell to 7.8 percent from a five-month high of 9.85 percent on March 17, when the currency touched a six-month low against the dollar as stocks slumped. Investors should buy options that profit from larger fluctuations after the RBI meeting, Morgan Stanley wrote in a research note. Thomas Gade, a Hong Kong-based analyst who helped write the report, confirmed its contents yesterday.

Governor Yaga Venugopal Reddy, whose board has kept the benchmark interest rate unchanged at 7.75 percent since March 2007, is seeking to slow inflation from a 13-month high, while supporting the economy as global demand slows.

``Diverging forces on the rupee will likely leave limited movements for the currency in the weeks leading up to RBI's policy meeting on April 29,'' the March 31 note said. ``The RBI's reaction to inflation will be revealed at the April meeting and will determine the rupee's road.''

The currency has retreated 1.1 percent this year to 40.1250 per dollar as the benchmark stock index slumped 24 percent.

Investors should sell a three-week dollar-rupee at-the- money straddle option and buy a similar six-week contract, Morgan Stanley said. At-the-money means the option can be exercised at a strike price close to the current market level. A straddle is a call and put option with the same strike price and duration.

Inflation Threat

The volatility on the three-week at-the-money rupee option today is 5.744 percent, according to data compiled by Bloomberg. Volatility on the six-week at-the-money rupee option is 8.257 percent. Traders quote implied volatility, a gauge of expected swings in exchange rates, as part of pricing options.

Asia's third-biggest economy expanded 9.6 percent in the financial year ended March 2007. The government estimates growth at 8.7 percent in the year ended March 31 as export expansion slows. The current account deficit widened to 5.4 billion dollars in the fourth quarter from 4.7 billion dollars the previous quarter, the central bank reported on March 31.

Inflation is ``unacceptably high'' and the Reserve Bank of India is ready to take steps to contain it, Reddy said on March 31, after wholesale prices unexpectedly rose 6.68 percent in the second week of March.

``If there is no tightening, it is seen as a sign that the RBI is putting growth before inflation, a trigger for rupee to head downhill,'' the note said. ``If RBI shows its inflation fighting credentials, then the rupee could head uphill.''

To contact the reporter on this story: Patricia Lui in Singapore at plui4@bloomberg.net

Last Updated: April 1, 2008 22:29 EDT