Understanding USD-INR forward dynamics: How you can create arbitrage opportunities

Abhishek Goenka

Post the announcement of the Reserve Bank of India (RBI) buy-sell swap, USD/INR forwards have been the focus of much discussion. It is unusual for the forwards to be this volatile and create headlines.

This is because the forward points represent the interest rate differential between the two currencies, which is usually quite stable. The difference between the spot and the forward rate is also referred to as the basis/cost of carry/premium or discount.

For example, if the 1-year interest rate in the US is 2 percent and that in India is 6 percent, the USD would trade at a 4 percent premium against the Rupee i.e. if USD/INR spot rate is 70, the 1-year forward rate would be 72.80. (Rs 2.80 is the interest on 70 INR placed at 4 percent for 1-year). 72.80 is referred to as the no-arbitrage forward price. If the 1-year forward trades at any rate other than 72.80, it would present an arbitrage opportunity.

If it trades higher than 72.80, let’s say 73.00, then, one can exploit the arbitrage opportunity by borrowing in INR at 6 percent, converting Rupee into USD at 70, entering into a forward contract to sell USD after 1-year at 73 and lending the USD (investing USD at 2 percent).

This is known as cash and carry arbitrage. The transaction would result in an arbitrage profit of 0.28 percent (Since the interest of Rs 3 on Rs 70 for 1-year is equivalent to 4.28 percent).

Arbitrage Profit (0.28 percent) = -6 percent (cost of borrowing in INR) + 4.28 percent (implied rate in the Buy USD today, Sell USD forward transaction*) + 2 percent (rate earned by investing/lending in USD).

If it trades lower than 72.80, let’s say at 72.50, then, one can exploit the arbitrage opportunity by borrowing in USD at 2 percent, converting USD into INR at 70 today, entering into a forward contract to Buy USD 1-year forward and lending the INR at 6 percent. This is known as reverse cash and carry transaction. The transaction would result in an arbitrage profit of 0.43 percent.

Arbitrage Profit (0.43 percent) = -2 percent (cost of borrowing USD) -3.57 percent (cost of Selling USD today and buying USD 1-year forward*) + 6 percent (rate earned by lending/investing in INR).

Therefore, whenever the 1-year forward price deviates from 72.80, arbitrage forces would cause it to converge to 72.80.

However, there are instances when the forward points can be dislocated from the no-arbitrage price when a certain section of the market cannot capitalize on the arbitrage opportunity because of regulatory constraints.

Besides interest rate differential, supply and demand of USD and INR also influence forwards. The abundance of USD or Shortage of INR in the banking system or both tends to result in forwards getting paid.

Shortage of USD or Excess INR liquidity or both tends to result in forwards getting received. In extreme cases of USD shortage, we may even see the forward premium flip into a discount for near tenors.

The term structure of the annualized forward premia in India up to 1-year is downward sloping. This is because, in the near months, the demand and supply are roughly balanced as a result of exporter receiving interest and importer paying interest.

However, at the far end exporters do have to receive interest but importers are reluctant to pay a higher premium and therefore forward points tend to be depressed.

As far as exporters are concerned, whenever the term structure flattens out it is better to receive farther out i.e. book forwards with longer maturities and whenever the term structure is steep, it is advantageous to receive near term and keep rolling over.

Disclaimer: The author is Founder and CEO of IFA Global. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.