Banks and large corporate treasuries routinely use movements in interest rates and forward premiums (which are really interest rates in themselves) to capture arbitrage-type gains for both their trading and hedging books. While these are not strictly arbitrage gains (like those obtained by, say, selling non-deliverable forwards and buying onshore, or between the over-the-counter and futures markets), they are quite easily visible and, often, appear there for the taking.
For instance, in recent months (and, I expect, for at least some months to come), the difficult domestic liquidity situation has resulted in the near-term forwards being higher than the farther forwards. For example, on April 9, the one-month premium was 35 paise (8.3 per cent annualised), while the six-month premium was 180 paise (7.0 per cent annualised). Thus, a company that had decided to sell its exports forward for six months could get a better rate if it sold forward only to a single month, and then rolled the hedge forward on a month-to-month basis, provided, of course, that the month-to-month premiums did not fall in the interim.
Indeed, the potential returns can be significant. If a company had followed this approach – selling a month forward and rolling it over month-to-month – every day from April to September 2011, it would have made an average gain of 62 paise (not including the increased transaction costs) as compared to simply selling six months forward. Building in transaction costs of, say, two paise per rollover would still have provided a gain of 52 paise, or one per cent. (The best gain during this period was a huge 1.82 per dollar, more than three per cent even after transaction costs; the worst case would have been a loss of 11 paise, which would work out to about -0.5 per cent, again, after factoring in transaction costs.)
Building in some decision-making ideas would have provided even better results. If, for instance, the company only entered the trade if the annualised one-month premium was a certain percentage higher than the annualised six-month premium, the average gain (after costs) would have been 1.30 — that’s 2.5 per cent, or Rs 2.5 crore on exports of Rs 100 crore. Better yet, the trade never lost money — in the worst case it would have made about 0.5 per cent. Of course, this sort of win-win doesn’t show up every day – the model we used would have provided a signal only once every six days.
Attractive as all this sounds, there are caveats. First of all, in general, there’s no gain without risk, and this approach carries the risk that if the forwards fall below current levels, the company’s export realisations would be worse than if it had simply hedged six-months forward on day one.
Thus, to play this tactical game, the company should have a well-developed risk management system, monitoring the balance-period premium to make sure that the overall mark-to-market of the transaction did not fall below the six-month forward rate at the start of the transaction minus some “risk margin”. As things happen, the volatility of the premiums was relatively low during the April to September period — the overnight risk on the five-month premium was only 0.16 to a 99 per cent confidence. This means that there was a 99 per cent probability that the five-month premium would move adversely by less than 16 paise on any given day. Thus, if the company could allocate a risk limit of, say, 0.25 from the six-month forward rate, it would be a good bet to take.
Again, the company would have to manage possible cash outflows on each rollover. And, importantly, it would need to have very strong transaction capabilities to ensure that transaction costs did not eat away too much of the gain.
Unfortunately, in today’s still-narrow regulatory environment, most SMEs would be locked out of this opportunity, which can really only be enjoyed by large companies that are able to negotiate fine rates, paying bank margins of less than 0.025 per cent for each transaction. SMEs, in general, pay more than 20 times that.
The Reserve Bank of India needs to make the company-bank interface much more efficient by doing away with myriad old-generation rules and regulations. Even while know-your-customer and underlying transaction norms need to be maintained, SMEs and mid-sized companies should be able to buy or sell foreign exchange (FX) at the best price the market will offer them, unconstrained by various diktats like banks only being permitted to transact FX with constituent borrowers, a need for no-objection letters, etc.
These “enabling” changes, to quote Kaushik Basu’s term from a couple of economic surveys ago, would not in any way conflict with the current level of deregulation, and would help SMEs (and mid-sized companies) substantially improve their use of the FX market, giving a big boost to their competitiveness.