Markets

How RBI-government rift moved currency traders

MUMBAI: The perceived rift between Indias central bank and the government has led a section of concerned currency traders to cover their rupee exposure in the options market as they expect volatility in the local monetary unit to continue.

The one-month implied volatility index (Bloomberg), a measure of stability in the currencys outlook, climbed about 75 basis points since November 12, reflecting an increase in hedging. Options are used to cover currency exposures. The gauge ended at 8.54% on Monday after hitting a high of 8.74%.

To be sure, the month-long verbal duel between the Reserve Bank of India (RBI) and New Delhi seemed to be put to rest late Monday with the decision to set up a panel that would decide on the quantum of surplus transfer to the government.

Liberalising the terms for banks under the Prompt Corrective Action to enable credit flow would be studied by the RBIs Board for Financial Supervision, and banks would get a breather in meeting the capital norms under the Basel norms, the central bank said in a late-evening statement after a marathon meeting of its board.

Usually, traders and hedgers buy the options to protect themselves against event-led volatility, such as the bickering between the central bank and the government.

"Traders have rushed for cover in options as they expect volatility amid domestic uncertainties," said Anindya Banerjee, currency analyst at Kotak Securities. "We are seeing increased demand for such options from hedgers and traders. Any significant policy amendments by the authorities will impact the exchange rate.”

When demand for such derivative contract rises, they become expensive. Another way to capture how expensive options have become is to look at the implied volatility. When demand for options rises, implied volatility of the option rises.

While importers are buying option contracts expecting the rupee to fall further, exporters are doing the same anticipating a rupee rise.

“Coprorates are trying various hedging instruments now," said K N Dey, founder of forex advisory firm United Financial Consultant. "Options market enables them to pay upfront premium for a wide range of exchange rate movements. This works well when the rupee is expected to trade amid uncertainties."

The premium an options contract buyer must pay is in-built in the option rates unlike in the forwards market where chances of losses or gains are equally higher.

However, the option contract buyer has the right to exit the contract without the obligation of executing the contract. Hence, his/her losses are only restricted to the premium, which needs to be paid.

The rupee gained for a fifth day, the longest run of gains in more than a year as markets expected easing of regulatory rules in coming days, according to Bloomberg. The local unit gained 0.38% to close at 71.65 a dollar Monday.

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