- INR down 5.5% year-to-date, hurt by elevated oil prices and portfolio outflows
- Policy measures have steadied spot INR but forwards, options reflect investor anxiety
- Risk reversals show investors willing to pay more for protection against weaker INR
MUMBAI, Nov 3 (Reuters) - The Indian rupee's recent rally and relative stability contrast with signals from options and forward markets, where pricing suggests investors remain wary of further weakness and are seeking protection against fresh declines.
The divergence is particularly evident in the forward market, where premiums have climbed well above levels implied by the India-US interest-rate differential.
While forward premiums can move away from interest-rate differentials due to dollar demand and supply, the unusually wide gap suggests investors remain unconvinced by the rupee's central bank-led recovery, bankers said.
The Reserve Bank of India has sought to ease pressure on the spot market by allowing state-run oil firms to buy dollars directly from it, removing an estimated $10 billion to $12 billion in monthly demand from the open market.
It has also imposed reserve requirements on large hedges, raising costs and curbing activity.
The measures initially lifted the rupee to a roughly six-week high in the spot market but also triggered unusually high volatility in the forwards market.
When spot demand is squeezed, forwards "reflexively take the strain", said Madhavi Arora, chief economist at Emkay Global Financial Services, adding that forward premiums are "severely dislocated".
TAIL CAN WAG THE DOG
Trading volumes in the onshore forward market have thinned since the RBI's measures, reducing liquidity and amplifying price swings.
Volatility has also spread to the offshore non-deliverable forward (NDF) market, where forward points have swung sharply between premiums and discounts to onshore levels.
Forward points reflect the cost of hedging future currency exposure, driven mainly by interest-rate differentials and dollar demand and supply.
"Forwards can begin to price expectations of currency movements rather than interest rates," said Tanay Dalal, an economist at Axis Bank.
"In effect, the tail can wag the dog, with evidence suggesting that elevated forward premiums are now influencing interest rate pricing beyond what underlying fundamentals would imply."
Interest rate swaps are currently pricing about 100 basis points of rate hikes by the Indian central bank over the next 12 months.
The swings in forward premiums also underscore the uncertainty over the rupee's outlook and a lack of clear direction in pricing across markets, bankers and analysts said.
The options market also signals growing caution, with investors favouring bets on further rupee weakness over a recovery, data shows.
Risk reversals across tenors from one month to one year have risen over the past three weeks, indicating that investors are willing to pay more for protection against further rupee weakness.
Meanwhile, implied volatility across one-month to one-year tenors remains relatively subdued, hovering around year-to-date averages and below peaks seen earlier this year. This suggests that concerns are centered more on the rupee's direction than on expectations of heightened currency volatility.
Reporting by Jaspreet Kalra, Nimesh Vora; Editing by Nivedita Bhattacharjee
Source: Reuters