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.