Foreign funds may get to hedge foreign exchange in stock exchange derivatives

Foreign portfolio investors, or FPIs, the largest investors in Indian stocks, who largely cover their currency risk in overseas markets, will now be able to hedge their risk of a falling dollar in currency derivatives segment of stock exchanges such as NSE, BSE and MCX-SX.

A year-old proposal of the government to open up the currency futures market to FPIs will be implemented shortly, with Sebi set to issue a circular that will allow these investors to hedge their currency risk to the extent of their rupee exposure in the stock market, a person aware of the development told ET.

"A stable currency is the reason why the decision may be expedited soon," said the person. The rupee has appreciated by 14.5% to above 59 since hitting a low in August last year. The move is expected to deepen the six-year-old currency derivatives market launched by NSE, MCX-SX and United Stock Exchange and more recently BSE, where most trades in currency are speculative as the joint regulators of currency derivatives — Sebi and RBI — do not mandate underlying exposure to do a trade. Also, currently only resident Indian individuals and corporates can trade on the currency derivatives segment. According to Motilal Oswal, chairman of the eponymous brokerage, turnover could jump "multifold" from the daily combined $3 billion if FPIs, whom he terms "serious players" begin participating in the market.

FPIs, according to brokers, largely cover their currency risk on the offshore, unregulated currency market called non-deliverable forwards (NDF), where settlement of all currencies takes place in dollar. Brokers such as Oswal feel that once the exchange-traded market is opened to FPIs, they would shift trades from the NDF market to the former.

"The fundamentals of electronic trading are far more efficient than when trading is done over a phone as FIIs currently do (for currency trades)," he said."It's a good move and makes sense."

Though the size of the NDF market cannot be ascertained as it is unregulated, experts such as Madan Sabnavis, chief economist, Care Ratings, said in the past when the rupee was buffeted by a stronger dollar, the volumes on NDF were two-to-three fold that on the domestic over-the-counter (OTC) market dominated by banks and corporates. In March, the turnover on the OTC currency market was $67 billion. A currency futures is similar to a stock or a commodity futures contract. A person with a bullish view on the dollar a month from now buys a dollar-rupee futures contract at say, 58. If a month from now, the dollar appreciates to 59, the trader gains Re 1 per every contract he buys. If it declines, he loses. The settlement takes place in rupee.

FPIs who buy shares here typically go long the dollar as they have to convert rupees into dollars while repatriating funds from here. Their risk is a falling rupee which reduces their dollar returns.

They thus short the rupee and buy the dollar on the NDF market. If the rupee falls, the long dollar bet on NDF offsets the fall. If the rupee rises, the gain while converting rupee to dollar on the spot market offsets the NDF loss.

However, brokers also added that just opening up the market to FPIs would not guarantee their participation. They said position limits would have to be raised from the current $10 million for a client as this was too low for FPIs who pumped $20 billion in Indian stocks last year and $7.6 billion so far this year. Apart from this, the liquidity in the exchange-traded market is restricted to the front and the next month despite 12 monthly contracts being available for trade.

"Raising position limits is a must for FPIs to find this market attractive," said Suresh Nair, director, Admisi Forex India, part of investment brokerage company Admisi UK.

Also, dollar-rupee contracts traded on the exchanges enjoy liquidity over one or two months despite monthly contracts being available up to a year ahead. For instance, on NSE, the May month dollar futures contract accounts for almost 90% of the Rs 6,664 crore daily turnover. The June month contract has a share of 8%.

While the fine print for allowing FPIs access to the currency futures market is being worked on, the regulators may raise the position limits to encourage the new class of investors to participate, said the person cited earlier. Hemal Doshi, chief currency strategist of Geojit Comtrade, said, "If foreign portfolio investors are allowed, the volume, depth and liquidity of the currency derivatives segment will increase significantly.

But before that the current position limits needs to be revised upwards. Our markets mirror the NDF markets, if FPIs come in there will also be a shift in volume from the offshore markets to Indian exchanges.

This article taken from Economic Times :