Hedging Surge Prompts India Central Bank Inquiry on Rupee Moves

India’s central bank, concerned about the fastest growth in currency derivatives trading in more than three years, is asking overseas funds to prove they aren’t speculating on the rupee.

Futures and options trading involving the currency rose 47 percent to a daily average of 387.7 billion rupees ($6.4 billion) in June on the National Stock Exchange of India Ltd., the biggest jump since January 2010. Exchange-rate volatility jumped the most in almost two years during the last quarter as the rupee slid 8.6 percent, Asia’s worst performance. The spot rate plunged to an unprecedented 61.2125 per dollar today.

The Reserve Bank of India on June 26 asked overseas funds for proof that individual accounts were seeking to limit currency risk on securities by using derivatives. The central bank has also enquired about foreign lenders’ open positions involving the rupee. Global investors can only use rupee futures and options to protect their holdings of Indian shares and debt.

“There is increased participation from speculators as currency markets are very volatile,” Supreeth S.M., chief executive officer at Quant First Asset Advisors India Ltd. in Bangalore, which manages about $100 million in options, said in a July 3 telephone interview. “Companies having external debt payments and those hedging are actively accessing the market.”

RBI spokeswoman Alpana Killawala did not immediately respond to an e-mail sent outside of business hours in Mumbai.

Downward Spiral

While the central bank has no direct oversight of exchange trading, the authority is concerned the speculative nature of the contracts will lead to a downward spiral in the spot exchange rate, according to J. Moses Harding, who resigned as executive vice president at IndusInd Bank Ltd. in Mumbai last week.

The surge in transactions in exchange-traded currency derivatives is partly due to the central bank’s curbs on trading in forwards and over-the-counter futures, which are under its purview, according to Kanji Pitamber & Co.

The RBI said in May 2012 futures and options positions on exchanges can’t be netted, or offset, by those in the OTC market, following measures in December 2011 that banned rebooking of canceled forward contracts. Forwards are agreements to buy or sell assets at a set price and date.

Lowering the limit on net open positions “cuts market liquidity and makes the rupee more volatile,” Unnati Parekh, head of currency derivatives at Kanji Pitamber, a 78-year-old brokerage, said in a July 2 interview in Mumbai. “By reducing liquidity in the market you can control, you are just encouraging movement into the non-deliverable forwards market.”

NDF Transactions

NDFs, which are settled in dollars, evolved for currencies such as India’s rupee and China’s yuan, which aren’t fully convertible. Spot transactions involving the rupee equaled $30 billion in 2010, while NDF volumes were more than $40 billion, according to a December report from the London School of Economics & Political Science, citing a 2010 survey by the Bank for International Settlements.

Investors with overseas offices can buy dollars in the onshore derivatives market and sell them in the NDF market to benefit from the difference in prices, Naveen Raghuvanshi, a trader at Development Credit Bank Ltd. in Mumbai, said in a July 3 telephone interview.

The one-month futures contract on the National Stock Exchange in Mumbai closed at 59.85 per dollar on June 26, while a similar-maturity NDF was at 61.06, data compiled by Bloomberg show. The spread between the futures and NDF contracts widened to a five-year high of 121 pips that day before collapsing to 13 on June 27, a day after the RBI’s latest directive. A pip is the smallest unit of a currency’s price, which in U.S. dollar terms equals one-hundredth of a cent.

Derivatives Usage

Few Indian companies use currency derivatives and the boards of a “very large number” prohibit using them for hedging, according to a July 3 report by KPMG.

In a KPMG survey of treasurers and chief financial officers across 100 Indian companies, 79 percent said they use forward contracts for hedging. Twenty-one percent covered at the spot rate, 45 percent favored plain vanilla options and while 3 percent used exotic options, according to the report.

Last month’s surge in derivatives trading outstripped equity contracts, which rose 2 percent. The value of commodity derivatives deals fell 14 percent in the two weeks through June 15 from the previous period, latest data from the Forward Markets Commission show.

The surge in currency derivatives trading reflects the rupee’s relatively large swings, Chetan Jain, an analyst at Anand Rathi Financial Services Ltd. in Mumbai, wrote in a July 3 e-mail. Arbitragers also have more scope to “optimize returns,” he said.

One-month implied volatility in the rupee, a gauge of expected moves in the exchange rate used to price options, rose 452 basis points last quarter, the most since September 2011.

“The latest RBI notification looks to cut down speculation and allow only actual hedging,” said Parekh from Kanji Pitamber. “So we have to see how this will play out on the futures and options volumes.”

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