Have you understood this line about Rupee's Fall

Rupee is falling.

One of the reason cited for this is:

"Low forward premium of USD-INR has made the carry trade less attractive for overseas investors which would lead to their (carry trades) unwinding."

What does it mean?

This line has 3 important points:

1. Low forward premium of USD-INR

2. Carry trade (or currency carry trade)

3. Unwinding of the carry trade

Let's try to get the points one by one:

1. Low forward premium:

You must have heard about the forward contract. If not, it means a contract which would be fulfilled at the future date on terms agreed upon now. The rate and the date of the contract are specified at the time of entry. For e.g. when I agree today to sell you 10 kg of coffee beans at Rs.50 per kg on August 1, this is a forward contract.

Similarly, the forward contract takes place in the forex market wherein the parties agrees on the exchange rate. What is the benefit of doing this? Taking forward the example of coffee beans, suppose you are in japan and I am in India. Now, the rate of exchange of yen and rupee is 1 yen equals to 0.58 rupees. I asked you to pay me in rupees. The total amount of payment is Rs.500 (10 kg*Rs.50).

How much yen you would deposit to get the Rs.500 from Japan's bank? 1 yen equals to 0.58 rupees, then, 500 rupees would be equal to 862 yen (500/0.58). But, the 1 yen=0.58 rupees is today's position. What if this position changes on Aug 1 which is the actual contract date?

If the rupee falls (i.e. more rupee required to get Yen; this also means yen becomes strong as less of it would be deposited to get rupees - if on Aug 1, 1 yen equals to 0.70 rupees, it means now you would only be required to deposit 714.28 yen for 500 rupees) you would get benefitted, but, if the rupee appreciates (i.e. less rupee required to get Yen; this also means yen becomes weak as more of it would be required to be deposited to get rupees - if on Aug 1, 1 yen equals to 0.40 rupees, you would be required to deposit 1250 yen for 500 rupees) you would incur a loss. So, what you can do to get rid of this volatility (i.e. risk of exchange rate changes)? Enter into a forward contract to complete the transaction on specified rate.

Now, there are two rates in forward contract - one is forward exchange rate (rate in the future) and other is spot rate (today's rate which in our case is 0.58).

The excess of forward rate over the spot rate is known as the forward premium. Now, low forward premium means the gap between forward rate and spot rate is less. But how?

The forward rate is calculated as (for USD-INR):

Spot rate* {(1+interest rate in INR)/ (1+interest rate in USD)}

This means any change in interest rates would affect the forward rate which would ultimately increase or decrease the forward premium.

When interest rates are high in India than USA, USD gets premium over INR in forward market. Below e.g. would help in understanding this.

Consider that interest rate in India is 8% and that in USA is 3%. Now, spot rate say is 79. Forward rate is 82.9 (as per formula). On close analysis, if you apply the difference of 5% (8-3) b/w both the interest rates on 79, you would get 82.9. This means, inter alia, forward premium is the difference between interest rates.

Now, when interest rate in India is high, it means gap would be high, and this gap is nothing but forward premium. The more the forward premium, the more would be the forward rate (writing above formula as forward rate = spot rate + forward premium).

It means earlier for 1 dollar 79 rupees were required to be sacrificed but as there is a forward premium, now 82.9 rupees would be required to be sacrificed. Thus, USD is enjoying premium of 5% over INR.

Currently, the interest rate in USA is rising. This rise, inter alia, has narrowed the gap leading to low forward premiums.

2. What is carry trade?

In simple terms, carry trade means I am borrowing in currency which has low interest rate (say USD). Then, I am converting that currency in another currency having higher interest rate (say INR) to make investments in assets in another currency (say bonds in India).

The benefit is the difference of interest rates provided that exchange rate remains the same. If the exchange rate will change, the benefit or profit would also change.

Say, I borrowed 1000 in USD at 3%. Got it converted at 79 and invested that amount in India in bonds having 8% interest rate. If on maturity (say after 1 year), the exchange rate remains the same,

My interest on bond is: 80 (1000*8%)

My interest on borrowing: 30 (1000*3%)

My total return from bond is: 1000+80 = 1080 (principal + interest)

My total borrowing to be repaid is: 1000+30 = 1030

My profit is: 1080-1030 = 50 {5% (8-3) on 1000 as exchange rate is same on maturity}

But exchange rate keeps on changing. If the rate becomes 80, then overseas investor would get less dollars (79000/80 = 987.5). In other ways, I would be required to deposit 80,000 rupees to get 1000 USD. To cover this risk, hedging is done via forward contracts.

Now, you know about forward premium and carry trade.

3. How low forward premium affects carry trade?

We talked about interest rate under both forward premium and carry trade. In USD-INR, low yield USD enjoys premium as I mentioned above. It shows borrowing in low yield currency (USD) essentially means selling currency having forward premium (selling high) (USD) and buying currency not having forward premium (i.e. having forward discount) (buying low) (INR). However, in the current scenario, the forward premiums are getting low which essentially means selling currency with high forward premium is not available. The overseas investors are pulling money out and putting the same in the US where interest rates are rising as gap b/w interest rate is coming down making carry trade less attractive (as benefit is only when interest rates gap is high). The existing investors are also closing their open positions in carry trade (means unwinding of carry trade) because of this reason. Now, by pulling money out, inter alia, there is a less supply of dollar. Basic economics, less supply means value of dollar would appreciate (means rupee will depreciate).