This week, India’s first ever currency futures market will open for business at the National Stock Exchange, 36 years after these financial contracts made their debut at the Chicago Mercantile Exchange.
Businesses can now protect themselves against the risk that come from gyrations in exchange rates. But there are larger possibilities as well. Once a vibrant market for currency futures is in place—and it will take time—India can also begin thinking of truly market-determined exchange rates, rather than the current one that is dominated by heavy interventions from the Reserve Bank of India, or RBI, in the forex market.
How do currency futures help? Say you export paintings to the Netherlands. The rupee-euro exchange rate in January was 50; unfortunately, by March, when the paintings are ready, the rupee appreciates to 25. Your Dutch partner is not willing to pay more euros, and you end up with half as many rupees compared with what was expected at the time of investment.
A currency future is a contract promising to trade certain currencies at a specified price at a future date, of course at a premium for hedging risk. In essence, you can in January enter into a futures contract to be paid a certain amount of rupees at a rate of 50 per euro in March, regardless of any appreciation.
The Indian rupee officially floats in the foreign exchange market. RBI’s official position is that it does not take a view on what level the rupee should trade against the dollar and other major currencies. The central bank only tries to dampen any excess volatility in the forex market.
In reality, the central bank has tried to intervene in the market and nudge the rupee along a path decided by it. Depending on conditions, RBI has bought dollars to prevent the rupee from appreciating and sold dollars to moderate rupee depreciation. That is why the official forex reserves rise and fall.
India will have to make the eventual transition to free pricing of its currency. The risk of currency gyrations should be borne by firms and individuals, rather than the central bank. A modern currency futures market removes yet another institutional barrier to such a transition.
Who should hedge exchange rate risks: businesses or RBI? Write to us at email@example.com