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C. Shivkumar

Some of the forwards, up to three months were at a discount, as a result of the FII taking cover.

Bangalore , Nov. 24

FOREIGN institutional investors (FIIs) have begun taking forward cover for inward remittances into the country from next year onwards in anticipation of further strengthening of the rupee against the US dollar.

Traders said here that some of the FIIs had left their positions open during the year. As a result, these foreign funds had incurred losses in exchange rate depreciation.

Most of them had anticipated the rupee to strengthen against the US dollar. Instead, during the last quarter of the year, between October 9 and November 24, the rupee has dropped from Rs 45.30 to Rs 45.87 to a dollar. Typically, most FIIs prefer entry when the exchange rate is most favourable, or when they get more rupees for the dollars and exit when the rupee appreciates against the dollar.

Traders said that this was not the first time that FII funds were taking forward cover in the markets. Funds normally take forward cover for repatriation purpose, with a preference for locking into the most favourable exchange rate. This would be at the point when the rupee is strongest against the dollar. This is because it allowed the funds to earn maximum possible dollars at the time of conversion from domestic rupees.

This was, however, the first time that funds were taking cover for their inward remittances and none of them was prepared to forego the exchange rate advantage available now at the current exchange rates. Accordingly, some of the funds have now begun taking forward cover for their post-budget investments in the domestic equity markets.

This was one of the major reasons for the forward premiums remaining in the sub 0.5 per cent zone for up to six months, they said. In fact, some of the forwards, up to three months were at a discount, as a result of the FII takings cover.

Traders said that most of these funds expected the rupee to appreciate from the current levels. The expectation is partly reinforced by some subtle hints of greater foreign currency inflows into the country. To facilitate some of the investment, major legislative changes were expected, sources said. These include permitting foreign insurers a majority stake in their domestic joint ventures. Further, traders said the foreign exchange reserves were likely to top $100 billion, driven by the current account flows and some debt capital flows.

Traders said that along with FIIs taking the cover, what was compounding the situation was the shortage of cash dollars. The shortage of cash dollars has come about in view of the rush for prepayments, by sourcing dollars from the spot markets. Besides, oil companies were also sourcing foreign currency from the spot markets, bankers said.

This shortage was pushing more banks to resort to forward to spot swaps, selling forward and buying spot, to meet the dollar demand. Such swaps are, however, prompting the forward premiums to narrow further from the current levels.

This trend also contradicts some fundamental trends where interest rate differentials or yield differentials determine the forward premiums.

Ideally, the rupee should be at a discount to the US dollar in view of the interest/ yield differential. This difference between 10-year domestic gilts security and US treasuries is about 1 per cent.

Ten-year yields for government securities is about 5.11 per cent, whereas for a similar maturity US treasury security it is about 4.11 per cent.

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