Understanding the Shift to FX Options
Indian importers are increasingly looking at foreign exchange (FX) options to manage currency-related risks. This shift comes as the Indian rupee shows limited volatility, making traditional hedging methods like outright forwards less attractive due to rising costs.
Outright forwards are agreements to exchange currency at a future date at a predetermined rate. However, with the Federal Reserve planning a potential rate cut, the interest rate differences between the US and India have widened, causing forward premiums to climb.
Why FX Options?
FX options provide flexibility and cost savings for importers. Unlike forwards, which have become more expensive, options can be structured to mitigate costs significantly. For example, a capped forward, which is a variation of a traditional forward contract, can be 55%-65% cheaper. It allows importers to protect against unfavorable currency moves while benefiting from favorable ones up to a cap, say at a dollar/rupee rate of 85.
"With forward premiums up significantly, we are recommending importers consider option structures," said Samir Lodha, Managing Director at QuantArt Market Solutions. The company suggests options as a way to hedge at a lower cost, especially with the rupee's relative stability.
The Impact of Low Volatility
The Reserve Bank of India (RBI) has been actively managing the currency market, contributing to the rupee's stability and low volatility. As a result, importers now favor options like seagulls, knockouts, and range forwards.
For example, a knockout option allows importers to buy dollars at a more favorable rate compared to the forward market, unless the rupee depreciates beyond a set limit.
Cost-Effective Hedging
Ashhish Vaidya of DBS Bank India highlights that both implied and realized volatility metrics are low, which benefits importers seeking better payoffs through option structures in the current market environment. An FX salesperson at a bank added, "Higher premiums are a deterrent in the forward market, prompting increased interest in cost-effective option strategies."
In summary, as the rupee remains one of Asia's least volatile currencies, Indian importers are prudently opting for FX options to hedge against currency risk efficiently.
