13 March 2006

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With rupee volatility hovering around 6% for most of 2006 so far, managing USD/INR risk is becoming more and more challenging, particularly with 10 to 15 paise inter-day moves not uncommon. Our market stability indicator, which is designed to signal when volatility is likely to move sharply, has remained in the stable band for over six months now, indicating that we can expect these current volatility levels to continue for another month, and probably much longer.

Many companies, who are still wedded to the "I want the best rate in the market" benchmark, are finding this Aladdin's lamp getting dustier by the day, and more and more companies are looking for some approach whereby they could protect their downside, while still staying in the market to take advantage of positive moves. Clearly, the options market has come of age, with several companies having recognized that paying an up-front premium is often the best way to go.

The table below shows how buying a plain vanilla at-the-money call (or put) has worked out, relative to either hedging everything on Day 1 or staying open. [We have also built in a mid-way benchmark, representing a 50% hedge on Day 1 and the balance staying open].
The study was run from June 2004 to February 2006, during which period the spot moved in quite a diverse pattern - see chart. For each tenor, we compared the forward rate on the start date (zero risk) with the spot rate on the due date (fully open), with an approach that was 50% open, and with the final value of a plain vanilla at-the-money option (incidentally, also zero risk). For each tenor, we did the comparison with positions beginning on June 1, July 1, August 1 and so on till January 1, 2006. The entries in the table show the average gain for the three strategies (compared with hedging on Day 1).

The results show that over this test period buying at-the-money options for 1, 2 and 3 months was an excellent strategy. As the table shows, this strategy produced results that were not materially different from buying forward for puts and were substantially better for calls.

Of course, the results depend on how the market moved during the period studied, and it is certain that there will be market scenarios where puts will perform much better than calls. Again, the cost of the premium, which is directly linked both to the tenor of the option and to the volatility of spot, would also be a determining factor in whether or not to go for options. This may explain why the longer-term options showed bad results (when the market moved adversely to the option). We also looked at the correlation between the volatility of spot and the gain/loss on using an option and the correlations were always negative - i.e., when volatilities were high, it was likely that the option would be too expensive (and lose money). However, this relationship was only really strong beyond 3 months. Again, this suggests prima facie that options beyond 3 months are not generally recommended, certainly at the prevailing volatility levels.

Many companies have begun to recognize that options can truly offer value, despite the natural tendency to avoid paying an upfront cost - market reports that liquidity in plain vanilla options has been increasing dramatically over the past few months. Of course, as with any new product, it is important to understand pricing and ensure that you are paying a fair premium. [From this week onwards, we will be providing indicative option prices in our daily rate sheet.]

It is also possible to combine option protection with a market view by, under appropriate circumstances, buying out-of-the money options (where the strike price is worse than the forward rate), and complex structures, (like seagulls, participating forwards, and, of course, for the real punters, leveraged forwards). In-the-money options (where the strike price is better than the forward rate) are usually very expensive and have limited utility.
In combining options with a market view, a good rule of thumb is that if you believe the market will move against you, buy a forward, but if you believe the market could move in your favor, options are the way to go.

So, get your checkbooks out - plain vanilla options are ready, willing and able.

CURRENCY MARKETS VIEW: RUPEE AND MAJORS

INR

Fortnightly movement: O-44.3800 H-44.5800 L-44.2900 C-44.5000.

Sentiment: range bound with a negative bias

Expected range for 1 Month: 44.25-45.25

Expected range for 3 Months: 44.00-45.50

The domestic unit was quite volatile during the past fortnight with liquidity pressure creating dollar sales and continuous flows into the buoyant stock markets providing dollar supply. Nationalized banks were seen buying at various levels, probably on behalf of oil companies and, perhaps, also for the central bank who could have been looking to absorb flows to aid liquidity in the domestic money markets. It is significant that in the first week of the fortnight reserves rose by over USD 1 bn for the first time since December. Dollar strength against the crosses especially Yen further dampened the rupee. The domestic unit ended the fortnight at 44.49/50 largely on gains posted by dollar overseas.

With the central bank protecting exporters interest and the dollar holding firm against the crosses suggests that we may not see too much appreciation in the rupee in the near term. On the other hand, liquidity pressure that is likely to continue ahead of financial year closing and advance tax outflows could prevent any significant depreciation, although we could see the premiums continue firm.

EUR

Fortnightly movement: O-1.1834 H- 1.2092 L-1.1826 C-1.1915

Sentiment - neutral but may worsen

Expected range for 1 Month: 1.1600 -1.2150

Expected range for 3 Months: 1.1300 -1.2150

The euro's range of about 270 pips last fortnight was wider than the 125 points range in the fortnight before last but it finished just marginally above 1.19. Early on the euro rose to about 1.2090 on some disappointing US data and the ECB President's hawkish tone at the press conference following the widely expected rate hike. However, the euro then shed almost all its gains and slid to 1.1860 following uncertainty about ECB rate hike next month, good US data and comments by Fed officials that further rate hikes are likely in view of the strength of the US economy.

Towards the end of last week, the euro's inability to capitalise on a record US trade deficit in January seems as surprising as the euro's resilience in the face of better-than-expected US non-farm payrolls. Some clarity and resolution can be hoped for this fortnight after the US TICS report and other data.

However, the charts seem to point to a resumption of the euro's medium term downtrend so long as the euro is unable to rise decisively over 1.21. A decisive break below 1.18 will most likely confirm the onset of the downtrend.

GBP

Fortnightly movement: O-1.7399 H- 1.7622 L-1.7230 C-1.7272

Sentiment: negative and may worsen

Expected range for 1 Month: 1.7000 -1.7500

Expected range for 3 Months: 1.6500 -1.7500

Sterling rose in tandem with the euro and rallied to about 1.7620 before sliding sharply by about 400 points to as low as 1.7230. Although Bank of England's MPC again voted to leave rates unchanged, a weak CBI retail sales survey and UK inflation having undershot the 2% target for 2 months in a row are probably prompting the market to expect a slimmer majority at the last meeting, a rate cut sooner than later and in any event no rate hike in the near future. Moreover, with the widely expected Fed rate hike on March 28, the Fed funds rate now at 4.5% will, after a long time, again rise above BoE's benchmark rate.
Sterling charts appear even more bearish than those of the euro. Sterling is likely to be capped under 1.75 for a strong test and likely break of 1.70 enroute to 1.65 and lower.

JPY

Fortnightly movement: O-117.05 H- 119.13 L-115.44 C-118.94

Sentiment: negative (for yen) and may worsen near term

Expected range for 1 Month: 117.00 -122.00

Expected range for 3 Months: 113.00 -122.00

The Japanese yen did strengthen early last fortnight with the comments of Japanese government officials appearing to show a semblance of consensus between the Japanese government and Bank of Japan. The dollar fell just under 115.50 yen but then began to stage a remarkable recovery after a caution from the Japanese FM against hasty action by the BoJ. Last Thursday, in an apparent show of independence, BoJ announced an end of its ultra-loose monetary policy but said that in deference to the wishes of the government it had not decided on any immediate reduction of the excess money supply. Consequently, the dollar closed on a bullish note just under 119 yen.

From a technical perspective, the dollar could dip to the 117.50-117.00 yen before a strong test and likely break over 119.50 enroute to 121 plus. By that time, speculation will probably start about BoJ decision at the next month's policy setting meeting. If Japan's annual core CPI due early next month again turns out be positive for the 4th consecutive month, the BoJ will likely begin to drain excess money market liquidity which may then trigger another bout of yen strength towards 113. If US economy also begins to weaken in the next 2-3 months and signal a peak in the Fed funds rate, the dollar could fall much lower.

DR RISK’S PRESCRIPTION

Euro seems to have gone back into hibernation just when it seemed ready for a rally. Or was the rally to 1.2090 last Monday just a correction of the 1.2325-1.1825 decline and has the medium term decline resumed in right earnest? That is difficult to say with the euro appearing oversold and US employment report due later today?

At the beginning of this fortnight, the euro dipped to about 1.1825 on continued euro/yen selling. The euro then recovered and staged a smart rally all the way to about 1.2090 on some disappointing US data viz. new and existing home sales, consumer confidence and Chicago PMI and hawkish comments by the ECB President in the press conference following the ECB's widely expected 25-bp rate hike on March 2. It was the dollar's turn thereafter to strengthen in response to comments by FOMC members that in view of the strength of the US economy further rate hikes were very likely. On the other hand, comments from ECB officials didn't point to a certain April rate hike. In consequence the euro has shed almost all its gains to slide down to about 1.1865 ahead of today's US employment report. It is trading around 1.19 at 10 a.m.

In our view medium term view last fortnight, we had urged you to stay put, if you had the choice, unless the euro made a decisive break out of the earlier 1.1850-1.1975 range. The euro did rise to 1.2090 only to slump sharply. False breaks are an integral and inevitable part of forex gyrations. It seems increasingly likely that the euro's medium term decline has begun but from a short term perspective it may be hasty to throw in the towel right now. The euro may still rise to about 1.2130 before turning down sharply. Only a decisive rise above 1.2130 may lead to further gains to 1.23 plus and probably 1.25. However, if the euro turns down from current levels and falls speedily below 1.1825 or rallies a bit on bad US data and then turns down sharply - like the move on January 27 after the release of the very poor US Q4 GDP data i.e. a small, short-lived rally followed by a sudden and swift reversal - the euro is quite likely on its way to 1.1640 enroute to 1.13 and perhaps even lower!

Now let's wait and see what happens after the US payrolls data later today.

The Japanese yen strengthened against both the dollar and the euro early last fortnight with Japanese government officials apparently supporting independent Bank of Japan action. Disappointing US data also aided the dollar's decline against the yen. The dollar fell as far as about 115.45 yen and was then hovering around the 116 yen level last week. However, the dollar began to recover after hawkish comments by Fed officials this week. Furthermore, although Bank of Japan decided yesterday to end its quantitative easing monetary policy, BoJ Gov Fukui said the BoJ left the amount of liquidity target reserves at 30 trln after facing government opposition against making an immediate shift. The bank also added that it will take a few months to reduce that target. Consequently, the dollar has already risen as high as about 118.70 yen. Unless today's US employment report is very disappointing, the dollar could well rise to 119.50 by early next week. A decisive break over 119.50 will likely be very bullish for the dollar. Otherwise, the dollar could move in a broad 115.50-119.50 range till the market has more fodder to digest and a roadmap from the BoJ on liquidity reduction.
[Dr. Risk was quite confused right after the dollar failed to rally significantly after the employment figures last Friday; however, having no doubt enjoyed a glorious weekend, he awoke on Monday morning with the following comment: "After sounding like a die-hard dollar bear for some time, a look at the latest weekly candlestick charts, has prompted me to turn into a cautious dollar bull."]