The current hype over the non-deliverable forwards (NDF) market influencing the onshore dollar-rupee market is baseless.

A high degree of statistical correlation between the two is confused with causality. This is because it is not understood how arbitrage actually occurs.

Arbitrage between two differing prices of an asset in two different markets requires taking simultaneous long and short positions to benefit from, and eventually align, the differing prices.

Tautologically, this arbitrage is risk-free, in that the loss on one position is offset by a matching gain on the other.

But restrictions on who, and how, one can take positions in the onshore and NDF dollar-rupee market come in the way of agents engaging in risk-free arbitrage. Therefore, in the context of the NDF and onshore markets, it is hard to establish that one is influenced by the other. To elaborate, domestic entities — whether banks or businesses/individuals — are not permitted to engage in transactions in the NDF market.

But banks are permitted to take open positions in the onshore OTC (over the counter) forward market, subject to the RBI-monitored and supervised limits.

FEMA RULES Businesses/individuals are permitted to engage in the onshore OTC forward market subject strictly to the actual underlying exposure requirements, and not otherwise. In other words, a forward seller (exporter) must have actual underlying export and a forward buyer (importer/foreign currency borrower) must have an actual underlying import or foreign currency loan.

Therefore, if FEMA regulations are not breached, arbitrage between the two markets is impossible because the net position will always be open and not zero, which is the hallmark of any arbitrage.

Specifically, if forward premium is higher in the NDF market relative to the one in the onshore forward market, an arbitrageur will typically sell forward in the NDF market and buy forward in the onshore market. But a domestic entity cannot do this because of FEMA regulations which require an actual underlying exposure, that is, either an import order or foreign currency loan.

And if there indeed is such an actual underlying exposure then the net position is not zero — a sine qua non for a typical arbitrage — but actually net short. This is because the actual underlying short position of import/ foreign currency loan is offset by the on-shore long forward position, leaving the NDF short position open, and thus exposing the entity to the risk that the US dollar may appreciate which may potentially more than wipe out the entire arbitrage profit!

Of course, if only there is no underlying actual exposure in the way of import, or foreign currency loan, will a typical arbitrage be possible with the on-shore long forward position exactly offsetting the NDF short forward position. But this will not be possible if FEMA regulations are strictly monitored and actually enforced. In other words, only in breach and violation alone of FEMA regulations will arbitrage be possible.

THE OTHER SITUATION The same holds when the opposite is the case, namely, the forward premium is higher in the domestic onshore market relative to the one in the NDF market, in which case an arbitrageur will typically sell forward in the domestic on-shore market and buy forward in the NDF market.

But, again, a domestic entity cannot do this because of FEMA regulations, which require an actual underlying exposure — export order.

And, therefore, as before, if there indeed is such an actual underlying exposure, then the net position is not zero — a sine qua non for a typical arbitrage — but actually net long because the actual long position of export is offset by the on-shore short forward position, leaving the NDF long position open and thus exposing the entity to the risk that the US dollar may depreciate which, as stated before, may potentially more than wipe out the entire arbitrage profit!

Of course, only if there is no actual underlying exposure in the way of export will a typical arbitrage be possible with the on-shore short forward position exactly offsetting the NDF long forward position. But, as before, this will not be possible if FEMA regulations are strictly monitored and actually enforced.

This conclusively proves that the NDF market influencing the onshore dollar-rupee market is a non-sequitur .

As regards statistically establishing causality, this can be credibly and effectively done by recourse to the so-called Granger Causality Test. But it is very important that the dollar-rupee data points be taken as frequently as feasible for the Granger causality conclusions to be robust and reliable.

Ideally, such data points can be taken at five to one minute intervals when both the markets are active. Since the NDF market is almost a 24- hour market, the data points can overlap the market timings of the on-shore market. The Granger Causality Test would not be reliable.

(The author is former, ED, RBI.)

Related Topics