Why the forex market is worried about dollar term premiums

The Indian rupee has depreciated sharply since the Reserve Bank of India (RBI) pledged to buy 1 trillion government bonds. While increasing rupee liquidity invariably puts pressure on the exchange rate, that’s not all.

What is also worrying the forex market is the term premium, especially since the central bank is sitting on a huge stack of dollar long positions.

What happens to the rupee in the futures market also affects the spot exchange rate, and vice versa.

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Satish Kumar / Mint

The central bank’s net forward position in the market stood at $ 47.38 billion in January and is expected to increase further in February. RBI is releasing details of its foreign exchange trading with a two-month lag, and February details are not available at this time.

What the January figure indicates is that the central bank will buy dollars on various future dates through futures contracts.

In the parlance of the market, the Reserve Bank is long on the dollar. This means that the counterparty, which in this case are authorized brokers or banks, will have to provide those dollars to the central bank on those future dates.

What’s also remarkable is that the central bank built this long dollar position over a very short three-month period. The attached chart shows that RBI’s dollar futures position jumped $ 33.82 billion between October and January.

Another important thing to note is that most of these contracts last between three and 12 months. This means that some of those contracts will start shipping this month.

What RBI does in terms of a dollar futures position will impact the rupee in the future. The central bank has the option of unwinding these contracts or taking delivery of dollars or rolling them over by entering into new, longer-term contracts.

Historically, RBI has renewed itself to avoid disruption in the market.

Abhishek Goenka, founder and CEO of IFA Global Ltd, believes the central bank would renew them this time around as well.

“The RBI has the option of unwinding its positions or renewing contracts. We believe that, in all likelihood, the regulator can roll over its futures contracts that are delivered, ”he noted.

Either way, the rupee is likely to come under pressure in the coming weeks. If RBI renews its forward contracts, forward premiums are expected to remain high.

This would encourage market participants to buy dollars in the spot market to avoid a high premium. One-year term premiums on an implied return basis have jumped about 100 basis points since October. A steep forward premium curve indicates that the dollar remains at a premium for longer.

“The forward premium curve is very distorted because of the position of the RBI. The rupee will come under additional pressure if the RBI does not renew the contracts, ”said a forex trader, requesting anonymity.

If the central bank takes delivery, it will buy dollars in the market, which will put pressure on the rupee.

With the second wave of covid infections, the poor economic outlook and a central bank with a significant share in the market, the rupee has little incentive to appreciate.

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