FII currency play behind bounce

De facto shorting of dollars against the rupee through the stock market adds to buoyancy

MUMBAI: Is the relentless bounce in the market due to some deft currency play - or volatility arbitrage — by foreign institutional investors (FIIs)?

Data indicate so. In fact, data on FII stock futures/ cash trading and dollar/rupee trading is telling, if anything. The index futures data show FIIs have been net sellers there, too. In the last three weeks - the recent period when the rupee has seen a very sharp appreciation — FIIs have been net sellers in single-stock futures and net buyers in the cash market.

The FII bet has been that the rupee will do better against the dollar owing to falling metals and crude oil. Over the past one month (since August 21), the rupee has risen 1.03% or by 48 paise, as on September 20, against the dollar.

Now let’s see how they play the currency: Take, for example, an FII having a bullish outlook on the rupee. It cannot obviously sell the dollar (USD) against the rupee (INR) - or short the dollar — because there is no market here. (The only avenue is the non-deliverable forwards market, which is played out of Singapore. Recent NDF data show not much is happening there).

Remember, the local forex market is regulated and unless an FII is registered here to buy equity or debt or any other asset class after taking prior approvals from the Reserve Bank of India (RBI), it cannot trade the pair (USD/INR). The pair is also not listed in any futures exchange for trading.

The best way for the FII, therefore, is to bring in the dollars, convert them into rupees and buy in the cash segment of the equity market in India - and, simultaneously, sell in the futures market at a small premium.

So how does a fund short the USD/INR pair? That is, sell dollars against the rupee?

The FII registered here can trade cash and derivatives. So it buys equities by bringing in dollars — that is, selling the dollars and leaving the position unhedged. To counter the risk of falling prices, the fund shorts single-stock futures.

Take for example, the Reliance Industries share: The fund buys the Reliance share at Rs 1,100 on Thursday and sells September futures (expiry on Sept 28) at Rs 1,105. That’s a cost of carry of around 20% annualised over 8 days. Remember, even a small cost-of-carry covers an FII’s borrowing cost.

Through this process, the FII has now gone short on the USD against INR by buying equities, and has hedged price risk by selling futures and earning a cost-of-carry in the process. The fund earns any depreciation on the USD/INR pair, i.e, falling USD, plus a 20% cost of carry (as in the Reliance example) on the cash futures position.  In turn, the fund pays interest cost at Libor, transaction charges, (including brokerage, custodian charges etc) and the spread quoted on USD/INR by traders, which is very minimal.

Net to net, a leveraged FII, after all costs and assuming a cost-of-carry of say 10% annualised and USD depreciation of 1.03% in the month to September 20, has earned around 10% annualised returns, assuming costs including Libor are at 12% annualised.

Now just exponentially enlarge the Reliance share trade example to guess the money the FIIs must have made in the past couple of weeks — and will make in future as long as the USD keeps weakening against the rupee.  For perspective, FIIs have been net buyers in the cash segment by Rs 4,927 crore (these include IPO subscriptions). On the other hand, they have been net sellers by Rs 2,311 crore in single-stock futures and by 1,193 crore in index futures.

Now here’s a political angle: The US presidential poll is on November 7, 2007. It is in the interest of the G.O.P - or the Grand Old Party - the Republicans - to talk down inflation and crude prices so that the feel-good factor stays. Once the polls are over, a price discovery mechanism in crude oil may occur naturally.  Then the tables may turn here too.