Spot the winner: Currency futures or forwards? Economic Times, 25th February 2009

A QUESTION is often posed about whether the currency futures market will someday replace the forwards market. Market-determined rates in all financial segments are intrinsically considered to be superior to those derived in the over-the-counter (OTC) section. Given that the currency futures market is around five-month old, the relation between these rates and the issue of convergence between the two can be analysed. The critical number in this market is the difference between the future and current price. This number is theoretically called the cost of carry. Contrary to one view which treats the forward rate as the expectations of the price, theory defines it as the implicit interest rate. If one were to borrow money and pick up dollars today and hold them for a month and then sell after three months at the forward/futures rate, then the difference between spot and futures would be the cost of carry or interest rate. In the past four months, the terminal points, representing a onemonth period till expiry, have been taken for one month and threemonth futures contracts and reckoned on the RBI reference rate, and the premium has been juxtaposed with that in the forwards market. The NSE Mumbai inter-bank office rate (MIBOR) for the same time span has also been posted to make the necessary comparison, as these are pure market rates for the same tenure. There are three rates (see table) here which are being determined by different sets of players with similar intentions. In case of the futures market, there are players who deal with notional rupees and take calls on the exchange rate movements. They are not buying and selling dollars and hence their calls are speculative in nature. In case of the forwards market, the players have an underlying dollar exposure, as exporters or importers with the banks being the counter-party and this rate looks more like a rate where there is more of a stake in the final product. These are the true hedgers whose perception will vary from those of the investors/speculators. The only difference is that it is still not a market-determined rate. The MIBOR is the inter-bank rate, but ends up being the highest among the three rates. This is the rate at which truly the banks are lending and borrowing amongst themselves. Here, a physical transfer of rupee funds takes place which is only notional in the other two cases. So clearly, there are anomalies in the market which will have to work themselves out with greater volumes of transactions in the futures segment. In fact, efficient markets have to ensure that the futures and forward rates converge, as there will be arbitrage until this equalisation takes place. The next question is as to which rate will tend to be more right: the forwards or the futures? But, for this one needs to know what the right market rate is. Here again, there are anomalies. If one looks at the comparable 91-days’ T-bill rate, it appears that both the futures and forwards rates are actually lower than this rate at all the four points. This is odd because logically one expects a treasury bill to have the lowest rate, considering that it is risk-free. Hence, ideally the implicit interest rate will have to move northwards towards this rate. So, there are two thoughts that come to mind based on these relations. The first is that a mature market should definitely see a convergence of the rates with a difference of no more than 50 bps between these comparable rates. This will also mean that the forex premium will have to move towards the MIBOR/T-bill rate. The other is that there may be some substance to the belief that the future or forward rate could be more than just the cost of carry and could possibly be looked at, under certain conditions.

Trust these numbers: Financial Express: 17th February 2009

The UPA government needs to be applauded for doing the right thing by doing little in the interim budget and letting the new government take the necessary steps later in July.
The most interesting implication of this Budget relates to the expectations of the overall GDP growth rate. Nominal GDP growth rate in FY09 was assumed to be 15.7% which can be broken up into 7.1% real GDP and 8.6% inflation. However, for FY10, the nominal growth rate is taken to be 11.1%. We are either expecting stagnant real GDP growth of 7% with 4% consistent inflation or lower GDP growth with higher inflation. These numbers need some deeper reflection.
There are some other clues that can be taken from the Budget. The first is that the FRBM has been given a go-by and it will probably be so for sometime now. The fiscal deficit ratio of 6% registered for FY09 actually takes us back to 2001-02, when this ratio was 6.2%. The revenue deficit ratio of 4.4% for FY09 goes back to FY03 when a similar level was attained. The deviation of 3.5% of GDP for the revenue and fiscal deficit from the budgeted numbers can actually be termed as the fiscal cost of the global financial crisis for the Indian government. In monetary terms this is around Rs 190,000 crore which would be an equivalent of $ 40 bn. This would be the real cost of the fiscal stimulus programme that the government has incurred to keep the growth process afloat at 7%. The cost is much lower than what the western economies have had to incur in the form of bail-outs of institutions.
Another thought that comes from the budget numbers is that government borrowing is going to be high even next year. For FY08, borrowing was Rs 1,31,768 crore, which rose to Rs 2,61,972 crore in FY09. For FY10, the number is to increase to Rs 3,08,647 cr. This higher number means that there will be much more pressure on the banking system for funds. Deposit growth at 18% (which could be achieved in FY09) would mean an increment of around Rs 6.8 to Rs 7 lakh crore during FY10. If government borrowing is going to be an increment of Rs 3 lakh crore, then the non-government sector would have only Rs 3.8-4 lakh crore left. The credit-deposit ratio will be under pressure and there could be a problemof supply of funds.
Related to the above aspect, is the outlook for interest rates. There would definitely be an increased demand for funds from both the government and private sectors given the large infrastructure projects that have been envisaged. The RBI will have a job on hands in supplying liquidity to the system through CRR cuts, which will be necessary to control the demand for funds. This will put a halt to the regime of lowering interest rates which had started a couple of months back.
Lastly, with demand for funds picking up and investment growing, which is the assumption here, demand-pull inflation which was missing in the last bout of high inflation, could surface. Hence, while the cushion of a good rabi crop and possibly kharif this year, could control cost-push forces in an era of benign oil prices, higher domestic growth can engender these triggers. Hence, inflation will be an issue on hand for the RBI and government. The problems are definitely not going to end anytime soon, and it is going to be a very challenging year again for all, especially the next government.

Price of gold to remain volatile this year’ Interview in Indian Express: 9th February 2009

While other commodities are slowly heading southward, gold is maintaining its upward stride. In January this year, it touched yet another high and is now trading above Rs 14,000 per 10 grams. Suneeti Ahuja spoke with Madan Sabnavis, chief economist, NCDEX, on the future course of the metal and reasons for such high volatility.

How do you explain the heightened volatility in gold?
The price of gold has been volatile for a number of reasons. The demand for physical metal has been fluctuating as it is influenced by the movement of the dollar vis-a-vis the euro. Gold is regarded as a substitute for the dollar and its price rises when the dollar weakens as money moves into the yellow metal. On the supply side, the decision taken by the European central banks to offload gold reserves has varied between induction and reduction of such supplies. Further, the volatile crude Oil market has extended its influence on the price of gold, which bears a long-term relation to the liquid.
•Is the demand pulling the prices artificial or genuine?
The demand is genuine since the dollar strength is real. The physical demand for gold grows at a normal rate or trend rate as there is a tendency for people to demand gold to a certain extent every year, where the price effect is more at the margin. However, the clinching factor here is the relationship with the dollar. The dollar has been quite whimsical last year which has led to erratic demand for the metal.

•Is it a good time to buy gold at its 14,000 rate? Or do you see correction taking place in near term?

In volatile times, one always takes a calculated risk as one does not know how the dollar will behave. Theoretically, a high current account deficit in the US would mean that the dollar will fall and gold will rise. But the actions of the Federal Reserve (Fed) as well as the impact on exchange rate changes the equilibrium constantly, in turn making the price volatile. Last year, the price rose and then suddenly fell as the dollar strengthened amidst the financial crisis. The European Commercial Bank (ECB) has also kept a watch on its interest rates to ensure that the euro does not appreciate too much lest export competitiveness is affected. So, one is not sure of the direction of the movement, let alone a correction.
•What is your outlook for the yellow metal for this year?
It would be difficult to take a directional call here as there would be variations during the year based on the Fed and ECB actions, which in turn will have a bearing on the dollar. In the long run, the dollar has to fall as long as the current account deficit is high at around 4 per cent of GDP. But, in the short run there would be corrections as the present slowdown will tend to reduce imports and push up the dollar. So actually we are taking a call on when the US economy will recover to expand the deficit, which in turn will impact the dollar. The best answer is that gold will be as volatile as last year with no specific direction being conjectured as of now.
•What do you think is better for the retail investor: buying gold ETF or physical gold?
It depends upon two factors: the need to hold on to the metal and risk propensity. In India, gold is held primarily for traditional reasons and the price is not a factor in a traditional household. Typically, we buy gold in terms of quantity during festivals or marriages and it is denoted in grams or tolas and not monetary terms. The individual investor would not really be buying and selling gold per se as it is not convenient to deal with the physical metal. This means that the investor would prefer ETF or futures. ETFs are good for those who do not have to take a personal call and can leave it to the experts to do the trading. Therefore, there will be a different set of investors in each of the two alternatives. The ETF option has, however, not really caught on.
•Do you think the current volatility will affect domestic consumption?
Not really, because the physical demand is more or less fixed and not too responsive to price changes. As far as investors are concerned, volatility should lead to higher trading interest as returns are commensurate with volatility.
What is your view on other commodities? Should retail investors take exposure to commodities?
Investing in commodities is a useful option but one needs to understand the fundamentals otherwise incorrect decisions can be made. Commodity prices are driven by fundamentals and as fundamentals change depending on production conditions, supplies tend to be variable which leads to higher volatility and hence returns. Therefore, one needs to make informed decisions and have adequate knowledge before entering this market as an investor. The market so far has taken care of the interests of hedgers to a certain extent but the retail investor is still a mile away and would have to tread carefully.