Any adverse movement in the rates can throw your investment planning in a tizzy; however there is a way you can hedge your exposure to currency movements and plan upfront on the returns to your investments.
This can be done through a simple product called Foreign Exchange forward contracts. These products are available with most banks offering NRI services.
What is a Foreign Exchange Forward Contract?
Foreign exchange forward contract is an agreement entered between the NRI Customer and the Bank to fix the rate of exchange of a currency pair which will take place at a future date, TODAY
E.g. Customer invests in a 1 year INR deposit on 1st November 2012 and enters into a forward contract with the bank to convert his maturity proceeds into USD
This means on 31st October 2013 when the NRE deposit matures, the maturity value will be converted into USD at the rate that was fixed on 1st November 2012.
A foreign exchange contract is permissible with Rupee as one leg and any of the FCNR currencies viz USD,GBP, CAD, AUD, EURO etc as the other leg. It is also permitted between the permissible FCNR cross currencies.
What this means is, you may be a US citizen and will be interested in a Dollar return, since that is the primary currency you hold.
The interest rate regime in India is high, for a 1 year NRE deposit, you can earn returns higher than 9%. You invest in an NRE deposit for one year and take a forward contract to convert this into USD a year hence at a predetermined rate.
Spot Rate: The rate at which his currency will be converted today!
e.g., the spot rate for USD to INR for today is 50
Forward Premia: Its the price that the customer has to pay to hedge his deposit.
e.g. 12 month forward premia for today is 2.97
Forward Rate: Spot rate + forward premia
i.e. the rate of exchange the customer has fixed TODAY, for conversion on maturity
i.e. 53.87+2.97 = 56.84
Swap cost: the forward premia as a percentage of the spot rate is called swap cost. It is the cost to swap from INR into USD at a later date
i.e. 2.97/53.87 = 5.52%
Why do you need it?
Lets take an example. Customer has USD 100,000 and wants to invest in an NRE deposit. The rate of exchange today for USD - INR is 50.
The principal amount: Rs. 50,00,000/-,
Rate of Interest for a 1 year deposit : 9.25% p.a.
Deposit is booked on 1st November 2012 and is maturing on 31st October 2013.
The Maturity value of the deposit is INR 54, 78,792/-
Yield in INR : 9.57%
How does a Foreign Exchange Contract Work?
• Customer had USD 100,000, exchange rate for USD - INR is 50.
• The principal amount: Rs. 50,00,000/- , Rate of Interest : 9.25% p.a.
• Deposit is booked on 1st November 2012 and is maturing on 31st October 2013.
• The Maturity value of the deposit is INR 54,78,792/-
• The forward premia is 2.5, and the forward rate 52.5
• The customer enters into a forward contract, and will get USD 104,347
Yield in USD: 4.36% (FCNR deposit rate in USD : 2.78%)
A foreign exchange contract is available for a minimum period of 3 days to a maximum period of 12 months. You can book a contract to hedge an existing deposit with the bank as well as a new deposit with tenure of 12 months.
Cancellation of a Forward Contract
It is important to note that a contract is a legal binding and an obligation on your behalf to accept delivery of the currency at the end of the tenure. In case you wish to pre-terminate the deposit, you will first need to cancel the contract. The contract will be cancelled at the prevailing market rate and as a practise followed by most banks, the gain or loss arising out of the cancellation will have to be borne by you.
It is also important to note, whatever be the market rate, the contracted rate is what you will get. As in the example above if the contracted rate to convert INR into USD is 52.5, and the market rate is 45, you will still get your funds at 52.5 only.
There will be a notional loss or a gain depending on the market scenario vs the rate at which you have entered into a contract. But it is this very uncertainty that you are hedging for!
From a portfolio sense, It is always wiser to hedge your exposure on some part of your portfolio through foreign exchange contracts and keep some amount of exposure to encash favourable movements in currency to your advantage!