USDINR Forward Premium: Steady Decline a game changer!

Owing to its huge dependence on crude oil, India’s macro-economic factors are majorly depend upon crude prices. Indian rupee is no exception in this regard, so when global crude prices slump in second half of 2014, Rupee entered into a great period of low volatility. Indian rupee joined the top 5 performing EM currencies from fragile five in 2013.

Surge in Volatility: A Reality!

Weekly Realized Volatility of USDINR

As above chart shows weekly realized volatility of USDINR pair. For calculating realized volatility weekly return on closing basis considered and standard deviation from 12 week moving average is considered. A closer look to above chart, shows rupee had been in a period of low volatility from Jan-14 to Aug-18. During this period volatility remained kept 1% level and at times fell to 0.4% also.

Weekly Range of USDINR

To compare volatility in recent past, Weekly range, difference of high and low, of USDINR pair is compared. During FY-15 to FY18 there has been 5 instances of more than 2% weekly range, same as in FY-19. The below chart shows, % of weeks with more than 1% weekly range. While FY-15, FY-16 witnessed 45% weeks with more than 1% weekly range and FY-17, FY-18 witnessed 25% weeks with more than 1% weekly range. But FY-19 is a clear outlier as nearly 75% of weeks witnessed more than 1% weekly range.   

This long period of low volatility can also be attributed to RBI’s management during this period. Dr. Raghuram Rajan believed India need to have a ‘Bullet Proof’ balance to manage global turmoil’, hence RBI’s forex reserve grew substantially from USD 277.1 Bn in September 2013 to USD 400 Bn August 2018. RBI regularly intervened in FX markets to absorb foreign inflows, keeping large gains in Rupee at bay. Though, RBI was net buyer during the period, but it was actively intervening both sides keeping volatility artificially low. It is note-worthy that RBI was cautious about imported inflation thus kept sudden depreciation of rupee under check.

Due to relatively stable USD/INR move and high forward premiums have induced a passive hedging in market participants. While receiving premiums, exporter tends to hedge long-term in expectation of stable rupee and Importers tends to delay long-term hedge as they have to pay high forward premium. For importers the decision to hedge or not depend a lot on its residual maturity.

USDINR Forward Premium: Steady Decline a game changer!

As shown in the figure below, 1 Year forward premium in USD/INR has seen steady declined owing to change in interest rates in both economies, India and US. 1 Year annualized forward premium declined from 6.50% in October-15 to 4.00% in Dec-2018. Going forward, USDINR forward premium might decline further amid expectation of interest cut in India in the next fiscal.

Fig: 1 Year Annualized Forward Premium of USDINR

The decline in forward premium and a surge in volatility in USD/INR should ideally nudge market participant towards more active hedging policies. To ascertain the point the further, ratio of Weekly movement and 1 year forward premium is analyzed.

Ratio: Mod(% Weekly movement)/ 1 Year annualized premium

The modulus of weekly movement is taken to keep ratio positive, so this ratio only compare weekly movement vs 1 year forward premium.

Fig: Ratio of Weekly Movement to 1 Year Forward Premium

As above chart suggest, Up-until end FY-18  ratio remained relatively low b/w 0.05-0.2, which means every week movement is just 20% of 1 year forward premium. But due to recent increase in volatatlity and declining forward premium, the ratio has seen a significant jump. The ratio has even spiked to above 0.5 levels, which mean weekly movement is as high as 6 month forward premium.

With steady decline in forward premium and recent surge in volatility, it is safer to argue that now forward premiums should have little say in USDINR forward hedging strategies. The decision of hedging currency risk should not be affected by it residual maturity.