Hedge funds active in currency arbitrage

Some hedge funds seem to resorting to currency arbitrage under the pretext of equity investments, if the FII inflows of $1.2 billion in a mere three days are anything to go by.

Hedge funds - known for their high-risk, high-return short-term investment plays - are taking bets on the upward and downward movement of the rupee against the dollar under the pretext of investing in equities.

Hedge funds do not register with the Securities Exchange Board of India (SEBI), but take the participatory note (P-note) route to dabble in the stock markets. The foreign institutional investor (FII) norms are thus not applicable to them.

Overseas funds cannot take naked positions, but only hedge their risks in Indian forex market. As on July 31, 2007, 28 FIIs issued P-notes whose cumulative outstanding notional value stood at $86.26 billion. This is nearly 40 per cent of the value of foreign portfolio investments in India.

The Reserve Bank of India (RBI) rules do not permit the hedge funds to take a call on the Indian forex market. So when they expect the Indian currency to appreciate, they invest or park funds in equities, and book profits when the targeted forex rates are achieved.

They also take a call on currency depreciation, but in such cases they invest only if they can hedge their currency risks at a reasonable cost. This is because when currency depreciates, it becomes expensive to take money out of the market.

Last June and early July, most analysts said the rupee could not continue appreciating and the RBI would intervene to ensure that the rupee corrects a bit. This view was shared by many foreign brokerage houses as well.

The RBI did intervene, but only to stop the rupee from appreciating further. The hedge funds also believed that the rupee would fall against the US dollar.

They entered the market some time in early July when the US dollar traded at Rs 40.40/40.60. At that time, the dollar was available at a discount in the forward market, thereby making hedging cheaper.

Some banks issued dollar call options to the hedge funds at a premium of 20 paise a dollar. When the rupee depreciated in August due to the sub-prime crisis and exodus of FIIs from India, the dollar was trading around Rs 41.40/41.20.

The hedge funds thus made currency gains of 1.5 to 2 percentage points. Their gains from stocks would, however, depend on the level at which they sold their investments. Some of the funds betting on the currency movement might have made losses, as well.

In the last week of August, the Indian markets found support close to their 200-day moving average, the dollar was quoting between Rs 41.50 and Rs 41.20 and most were of the opinion that the US sub-prime crisis would have a limited impact on India.

The hedge funds invested at this time, making gains in both equities and currencies, according to market sources closely tracking their strategies.

Such funds also opt for arbitrage between the Indian markets and NDF (non-deliverable forward) markets to take advantage of differences in the rates.

"Such activity (arbitrage) happens when market is steady. It is less likely to happen in choppy markets," said Indian head of an FII having a big share in hedge fund investments.

Numbers are hard to come by, and so are the identities of the hedge funds. The fact, however, is that hedge funds come with the intention of making money in currencies and the returns in equities are a bonus, according to analysts.

"Besides attractive returns on investments in the equity markets, the Indian currency market has offered international investors a hedge against a persistently depreciating US dollar. Moreover many investors, especially from the US, believed that the Indian currency was grossly undervalued in terms of dollar. Nevertheless, investors had the option to hedge and de-hedge the currency risks whenever the currency pair underwent a technical correction, said N Subramanian, senior consultant, Basixfx, a forex consultancy firm.

"Since March 2007, the increased volatility provided tremendous opportunity for hedge funds to punt on the currency markets. The hedge funds might have tested the depth of both the domestic equity and foreign exchange market and found it quite deep." Subramanian added.