If USDINR forward premium is higher than interest differential, does that signify INR depreciation?
Forex Hedging |
Updated on: 1st November 2021
Forward premium is a function of the difference between two countries’ interest rates and normally has nothing to do with the spot rate outlook. For example, if the Indian interest rate is 4.00% and the US interest rate is 0.25%, then the forward premium will be approximately 3.75%. Approximate because day count convention and same currency adjustments are to be done. If the forward premium is any different than 3.75%, then there will be arbitrage. And arbitrages do not exist in the market for long. Let’s take an example –
If the forward premium is any different than 3.75%, then there will be arbitrage. And arbitrages do not exist in the market for long. Let’s take an example –
| Sl No | INR interest | USD interest | Forward Premium | Arbitrage for large banks |
|---|---|---|---|---|
| 1 | 4.00% | 0.25% | 5.00% | Borrow in INR at 4.00%, invest in USD at 0.25% and book forward at 5.00% and make arbitrage gain of (5.00%+0.25%-4.00%)=1.25% |
| 2 | 4.00% | 0.25% | 3.00% | Borrow in USD at 0.25%, invest in INR at 4.00%, hedge using forward 3.00% make an arbitrage gain of (4.00%-0.25%-3.00%)=0.75% |
| 3 | 4.00% | 0.25% | 3.75% | No Arbitrage |
From the table, it is clear that an anomaly in forward premiums cannot exist and it should follow the interest rate differential. However, some anomaly exists for USDINR forward premium since there is no full capital account convertibility in India. Arbitrage theory requires the free movement of capital to take advantage of the arbitrage. However, regulations in India do not permit such unlimited flows but allow large enough flows. Hence USDINR forward broadly represents interest rate differential but not exactly as you will see for EURUSD or USDJPY.
So forward premiums are interest rate differential and have not much to do with spot outlook. However for USDINR, the gap between interest rate differential and forward premiums signifying the interests of counterparties. For example, if the interest rate differential is 3.75% but the forward premium is 3.65% that is a scenario when either exporters are selling heavily or significant FII inflows are coming in. However if the same forward premium changes to 3.85%, that signifies a change in interest and possibly that importers or FIIs are hedging more.