MC Explains | Here’s all you need to know why the dollar-rupee onshore forward premiums are falling again

MC Explains | Here’s all you need to know why the dollar-rupee onshore forward premiums are falling again

The dollar-rupee onshore forward premiums have seen a steady fall in the last one month as the interest rate differential between the US and India have narrowed, dealers said.

The premium on the one-year dollar/rupee contract was 183.97 paise or 2.1527 percent on annual basis on April 19, against 206.54 paise or 2.4814 percent on annual basis on March 20, as per Bloomberg data.

If you have read this news development and want to understand how forward premium rates work, read on to find out.

First, what are forward points?   

A forward point is the interest rate differential between two countries. These points are added or subtracted to the spot rate. A spot rate is the price quoted for immediate settlement of a currency trade. An addition of forward points to the spot rate is called a forward premium and a subtraction of forward points is called a forward discount.

For instance, if the one-year treasury bill (T-bill) in India is at 6.97 percent and the one-year US treasury yield is 4.84 percent, the difference between the two is 2.13 percentage points, and the one-year forward premium should be around that level.

Also read: Forward premium rates trend lower in April as interest rate differential narrows

Why are forward premiums falling?

One of the reasons is that the interest rate differential between the US and India is shrinking as a consequence of the US Federal Reserve (Fed) tightening its monetary policy at a faster pace than the Reserve Bank of India (RBI), resulting in low forward points.

Kunal Sodhani, Vice President at Shinhan Bank (Global Trading Centre, FX and Rates Treasury) said, with Consumer Price Index (CPI)-based inflation expectations remaining below 6 percent, the market is not expecting any further rate-hike from RBI. On the contrary, the Fed is expected to hike rate by 25 bps at its May 2-3 policy meet.

Further he said, Fed Fund Futures are pricing in the same with 85 percent probability. This scenario suggests that the interest rate differential between the US and India will narrow further, pushing forward premiums lower.

What happens when forward premiums fall?

Typically, higher premiums will attract carry traders (OR IS IT “trades”?) and lower premiums will lead to an unwinding of carry trades. A carry trade is a trading strategy in which investors borrow at a low interest rate and invest in an asset that gives a higher rate of return.

“Rupee tends to underperform as it loses its attractiveness as a higher-yielding currency. This keeps carry traders away from the market and since forward premiums are lower, importers tend to hedge longer-term payables as they are cheaper to buy and hedge,” said Vikrant Sharma, Founder and Fund Manager of Kushak Capital Management.

When premiums are low, the incentive to take on such trades is low. In such a situation, investors will prefer to unwind these positions. Thus, the demand for dollars will increase, leading to a shortage of the greenback. This, in turn, will further weaken the rupee.

Swap points are the difference in interest rates between transaction currencies.

Also read: Sovereign gold bonds – should you buy them this Akshaya Tritiya 2023?

Who benefits from low forward premiums?

Falling forward premiums benefit importers, who take money out of India and demand dollars. Hence, when premiums are low, importers can cover their unhedged exposures at a lower cost. Unhedged exposures can incur significant losses due to exchange rate fluctuations, and lower premiums provide an opportunity for these investors to hedge their positions.

What is the outlook?

Forex dealers are of the view that till the time the US Fed continues its rate-hike cycle, there will be pressure on the forward premium due to expectations of rate pause by the RBI.

However, the pressure is unlikely to remain unchanged as there is also expectation that the Fed may hike the rate for the last time in the May policy, and then pause, forex dealers said.

“Going forward, the rate-hike trajectory may pause, and possibly by next year beginning it may start to reverse as well. Considering that, we don't see one-year forwards falling below 1.78 percent,” Sodhani added.

(This story has been updated after forward premium started falling again in April. The original story was published on June 24, 2022.)