Consider a simple currency transaction. An institution sells rupees and buy US dollars at the current rate of say, 62.5. Then it invests in zero-risk US government debt. For example, it may buy dollar treasury bills at a yield of 0.11 per cent. A year later, when the treasury bills are redeemed, it converts dollar back into rupee.
In the meantime, the institution which sold the dollar and received the rupee invests in Indian government instruments. It buys GoI treasury bills, which yield 8.7 per cent and then converts rupee back into dollar.
If the exchange rate has not changed, the rupee investments gain due to the higher yield offered. Parity is maintained if the dollar strengthens to a level where the dollar plus the US yield is equal to the rupee plus GoI yield. If dollar strengthens beyond that level, the dollar investor makes a profit. If either investor can hedge one year forward at a favourable rate, it makes a profit.
There will be a tendency for the currency rate to change in favour of the dollar, given yield differences. Or else, investors will enter rupee instruments in such high volumes that they will drive rupee yields down, creating parity at some other level.
But while markets are good at arbitrage, they are not perfect. Rates will never adjust to perfect parity. Somebody will always make a profit in transaction such as the one described above. Most currencies offer interest rates at varying risk-levels and various tenures. If the currency is freely convertible, or partially convertible, with forward hedging mechanisms, there will always be chances of profits, if you pick the right instruments and currency pairs.
Currency speculators look for opportunities of this nature. Their actions in turn, influences currency rates and interest rates, giving rise to a very complex market with incredibly high volumes. There are open markets for currency futures and options, and interest rate options and futures across multiple currencies.
Apart from open markets, financial institutions deal directly with other institutions in what is known as the OTC (over-the-counter) market. They may create more exotic instruments with complicated conditionals.
A simple swap for instance, involves for example, an dollar-rupee exchange on a given date at a given exchange rate. There will be an agreement to take the reverse swap on an agreed date, at the same initial exchange rate, with interest components thrown in. For example, the swappers may take the London Interbank offered Rate (LIBOR) and Mumbai Interbank offered Rate (MIBOR) as benchmarks. Then, changes in LIBOR-MIBOR and in currency rates would mean somebody gains.
Such deals are very common. Pricing such instruments is difficult and there are much more complicated instruments available. Indian institutions and corporates have dabbled in these but not with very exposures yet.
India's trade component (imports and exports) is now over 40 per cent of GDP. Given increasing trade exposure, and a large and growing number of Indian businesses invested overseas, more currency exposure is inevitable.
Understanding the possible impact on balance sheets, or even realising that dangerous exposures exist is difficult. The details will rarely be available and even if those details are known, it will take a lot of work to understand the potential for gain or loss.
There have been many spectacular blow ups where treasury operations have gone wrong and wiped out apparently healthy businesses. There have also been cases where companies have deliberately obfuscated dangerous exposures and hidden potential losses.
In theory, India's accounting standards should be able to handle this. In practice, accountants, auditors and investors will need to learn how these things work. Historical experience suggests that this learning process is painful. There will be blow-ups before people figure out the pitfalls. It is highly probable that there are corporates with dangerous unrecognised exposures out there.
The July-Sept quarter saw a lot of currency fluctuation. The rupee plummeted and then made a partial recovery. The currency situation is still not stable and it's likely that the volatility will continue. Every exporter and every importer will need to deal with this. So will the financial sector which services their needs. In addition, global interest rates are in flux.
Look out for corporates with abnormally high treasury and forex gains or losses in Q2, when the results start coming in. They are the ones likely to be at most risk. Going forward, learning how to read the pertinent schedules in the balance sheet should become a mandatory due diligence exercise for every investor.