Forward premiums drop to record low and why?

Imported inflation, driven in particular by demand for motor fuel and gadgets, is likely to soften as forward premiums on the currency have crashed up to 60 basis points in just over a week, benefiting importers hedging risks at lower costs.

One basis point is 0.01%.

The Reserve Bank of India’s (RBI) market intervention strategy, coupled with the expectation of narrowing the rate differential between US and Indian bonds, triggered a drop in forward premiums across maturities.

The one-month forwards premium plunged to its lowest since 2010, show Bloomberg data. The Onshore Implied yield was at 2.96 per cent Wednesday. This segment is billed as the most popular, even for RBI’s intervention in the currency market.

“While the RBI’s intervention strategy pulled the premium down, traders expect a narrowing rate differential between US and India after Washington reported record-high inflation,” said Kunal Sodhani, AVP at Shinhan Bank.

The differential between the two-year government bond yields of India and the US was at about 352 basis points. The US Federal Reserve was expected to announce a rate increase, sharper than expected, Wednesday night. This will help narrow the gap.

At the same time, the RBI raised the policy repo rate by 90 basis points on May 4. The pace of further rate increases is expected to be moderate with the retail consumer prices rising at a slower pace in May in comparison with April.

“Falling forwards premium is an incentive for importers to cover their unhedged positions and lower their import cost in the backdrop of elevated volatility in global financial markets,” said Vivek Kumar, an economist at QuantEco Research. “Locking in lower hedging costs may also help reduce inflation pressures,” he said.

The noise over US consumer price rises gained momentum during the period with the gauge hitting a 40-year high in the world’s most developed country.

Between June 6 and 15, the forward premiums have tanked about 40-60 basis points across one-month, three-month, six-month and 12-month maturities.

“Lower forward premium helps lower importers’ costs, which should cushion rising inflation,” said Anindya Banerjee, currency analyst at Kotak Securities. “Also, a perceived dollar shortage on the back of Quantitative Tightening by the US Fed is weighing on forward premiums,” he said.

The central bank has been intervening in the currency market via two legs. While select banks were seen selling dollars in the spot, they are backing it up via buy-sell swaps. The move protects forex reserves and helps maintain rupee liquidity in the system checking any abrupt fall.

The rupee on Wednesday was down 0.09 per cent at 78.07, an all-time record closing level. A large Mumbai-based bank was seen selling dollars to stem the rupee’s loss against the dollar.

Under buy-sell swap deals, banks sell long-term forwards contracts at a spread, often called the swap premium.

There is no exchange rate risk to banks since both purchase and sale happen in a single transaction with two legs.

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