Forex rate movements-Interest rate differentiel

Forex rates movement-Classical Interest rate differentiel theory

Let me start with a warning note, reason for Forex movements, that is movements between currencies and the premia or discount that one currency commands over a period depend on various factors.Just to list a few, the reasons range from Interest rates,short term availaibility and requirement of the currency, Balance of payments of trade movement in the short term between two countries ,and of course the most important , Government regulations and restrictions .

Discussion is on forex movements and not on the base rate itself. The base currency rate between two or more currencies depend on factors starting from Purchase power parity , Balance of payments of trde as of a certain date and various other factors which is possibly a subject for discussion for another day.

This piece is only on movement of Forex rates .

While the actual reason is quite complex and is driven by various factors which affect the market including imperfect market, restriction on currency movements, restrictions on trade and short term imbalances between supply and demand for currencies, the one compelling theory and what could be termed as a classical one on forex movement is the one with reference to Interest rate differentiel between currencies. This is the simplest , most logical and something which should work if the market is perfect and there are no restrictions on currency movement, investment or borrowing in the currencies under study.

Let us do a simple one between USD and INR. Let us assume a base rate of INR 40 to a 1 USD. Let us assume prevailing interest rates of 10 % PA in the case of INR and 5% PA in the case of USD. For the sake of simplicity we will have to assume no interest rate differentiel between borrowing and Investing .This is to make the example easier . INR 40 at the end of one year will be equivalent to INR 44 and the in the case of USD, $ 1 at the end of one year at an interest rate of 5% be $1.05. Equilibrium forward rate of USD to INR for one year period should be 44/1.05 , that is INR 41.9048 to1 USD. If the rate is anything other than this , there arises an opportunity to make riskless profit.

Normally the currency on which interest rate is lower will be at a premium and the one whose interest rate is higher will be at a discount.

Let us assume that at the interest levels specified, the actual forward rate quoted at the end of one year is at INR 40 to a USD.

Easy way to make profit is

- borrow in USD,
- convert to INR immediately,
- deposit in INR ,
- simultaneously take a forward cover to buy USD at INR 40.


Let us calcuate the flows .

Since you have borrowed in USD , you will have to pay $ 1.05 with interest at the end of one year.

USD converted to INR 40 and deposited would become INR 44 at the end of one year since INR deposit attracts 10 % interest.

Since a forward cover has been taken , you would be in a position to buy USD of 1.05 for a total outflow of INR 1.05*40= 42. This leaves you Rs 2 as riskless profit.

In the same case, if at the same interest rates, INR forward rate had been 46 to USD, we will be doing the borrowing in INR, depositing in USD, forward cover to sell USD .

Let us work out the simple math in this sequence.
You had borrowed INR 40 at the end of one year , to be returned is Rs 44 .
INR borrowed was converted to USD at the beginning has been deposited as USD deposit .At the end of one year we get USD 1.05.
Since we had a cover to sell USD at the rate of INR 46 to a USD, we will sell the $ 1.05 at INR 46 to a USD and get on hand INR 48.03. We pay off the INR 44 and left with INR 4.03 rsikless

We have assumed no difference in interest rates between borrowing and investing and also no difference between buying and selling of currency. Margins between these two will make a slight difference in the calculations but the theory holds good.

As a thumb rule,arbitrage opportunity will arise when the currency forward rate is different from the interest rate differentiel. Normally in such situations the demand/supply for the currencies adjusts in such a way that the interest rates move and nullify the advantage. If this kind of anamoly were to persist , every one will be doing this set of transaction and the interest rates and the demand for the currency will drastically undergo a change till such time equilibrium is attained.
This is theory and will continue to be theory till such time, we have free currency movements and unrestricted deposit and borrowings in any currency in any country or atleast in the countries of the currencies in question/discussion.

Impact of interest rates on Share prices

What kind of an impact does interest rate have on stock prices ? What factors influence interest is a discussion for another day. It is a lot more complex .Let us get back to the subject of Interest and Stock prices.

In simple terms, prevailing riskless interest earning, as they term it, is the first point to start ( let us say from investment in RBI(Reserve Bank of India bonds or an equivalent sovereign guranteed bond, where there is no risk at all) . This could be , say Rs 5 for every Rs 100 invested. Any investment involving slightly higher risk would make the depositor/lender expect better return, that is higher interest rate. This is what the classical Finance theorists call the risk -return matrix. Shares, being a lot riskier, expectations would be for a higher return.

In the current context where ,say the , prevailing riskless interest rate is 5%, expectations from shares could be may be around 8-10%. That being the case, other things being equal , in the case of a Company which has a earnings per share of Rs 5, the price could be anything between Rs 62.5 ( 8% return ) and Rs 50 (10% return). This could further get affected by other factors , like degree of certainty in the EPS ( Earnings per share) , past growth in EPS demonstrated by the Company etc.

Other things being equal, higher prevailing riskless interest rate means lower share prices for a given EPS and lower riskless interest rates mean higher share prices for a given EPS. In the above example , if the riskless interest rate was 10 %, expectations of return on shares would be closer to 12-15 % and the share prices of a Company with EPS of Rs 5 would be between Rs 41.67 (12% return) and Rs 33.33 (15% return )

Market Yo Yo

What is the latest ?
Experts advise investors to keep 50 % cash and expect further fall. Experts see better value but are apprehensive of a downside .Panic grips the market.
Index of Industrial production showing weakness ( don't remember the exact figure )
Just watch this space may be 6-12 months from now, the same people may do a turnaround
Physically we evolved from and are close to Apes , mentally I think we evolved from Goats . We move together , get influenced by others. Psycholgists have to necessarily go through a crash course ( pun intended )in stock markets and human behaviour if they want to get a good understanding of people. I am talking about 90 % of the popluation who are materialistic to some extent or other and are never averse to some money, easier the better.

In fact the latest is Behavioural economics.

Stockastics

Stockastics

To those who hold in awe the experts who make frequent appearances on CNBC and who keep dropping words of wisdom, what follows may not make a great read .

In fact , I had typed in a quite a long piece post the boom and subsequent semi bust of the infotech stocks some 4/5 years back. I lost the piece somewhere down the line ( change of desktops at home…)

The central theme is , that there are not too many real and genuine experts , of course there are some ,but most are followers . There have been very instances of one of these high finance experts who have predicted something huge or a major trend .Most of them start mumbling when they see the signs of a trend, then half way through it gets louder. They feed on each other and feed on their own rhetoric and keep pushing the prices up.

You see a typical case of cause and effect played out exactly in the reverse order. You see the effect and start filling in the most plausible theories as to the reasons.

Few for reference

Replacement cost theory

This was started by our great Harshad mehta. What was the theory ? In simple terms, cost of replacement of some of assets of some of the Companies was much more than the market capitalisation. Simple and plain inflation added credence to the theory.You hold on to machineries long enough and at the end of it all, may be 15 years, you have a pot of gold.Good for a laugh. What was conveniently forgotten was the fact that the machineries built later and with more modern functions had the inherent capability to ensure production at lower cost. Still everyone fell for Harshad Mehta’s theory, long enough for most of the retail investors to loose their shirt , pant and in some cases still more.

PEG,price earnings growth.

There was this new theory that PE ( Price earnings is a post mortem ) is based on past results and PEG (Price earnings growth) is more tuned to factor in the future. This has a growth multiple added in. On paper , a good theory, but the excesses played out in the market with this theory was for all to see. Wipro, no doubt a good company, was selling at a market capitalisation of INR 1000,000 Mio when the profit was something close to Rs 5000 Mio. It was an enormous show of faith that people predicted Wipro to continue to grow , god knows at may be 50 % for the next several decades. The price anyway would not have been justified if the underlying assumption of growth had been just for a few years.

To restate a basic economic principle ,.... when you have super profits, the business attracts more people till you get in to normal profits period...... May be unlike commodities and industries which have linkgaes to commodities, get to that stage earlier and Tech Companies do and have in fact maintained leadership position for longer periods,but it can not be forever. People who are the cutting edge of such "Technology Companies" can and in fact moved, taking out that edge.

Some of the so called advantages that we had, Labour cost arbitrage , Currency advantage etc have all diminshed significantly

Cost advantages in Export market,in the fields of IT and textiles post MFA scrapping

First one , IT Industry is still okay, the latter one, textile never really took off . China stole a march. Government machinery kept talking of a brigh future and the potentiel etc in this Industry , but never really prepared themselves in terms of modernising and providing the support structure to the Industry ( Subsidised loans from Textile fund was a small feed for the huge hunger )
Of course this MFA was not overplayed by the Experts. An exception which proves the rule.

Invest in Domestic driven Industries

Volte face , export focus to Domestic market. What was a problem ( Population ) few years back has suddenly become a virtue, demographic dividend they call it.This will continue to play out for sometime.

Asset play

With increased disposable income, you have the real estate prices skyroceting and Companies mismanaged for years and holding on to lands in prime locations, suddenly became darlings. Pure luck. People who caught this slightly earlier made tons of money.Why is it that this was never brought out 3-4 years back, is it that no one predicted the real estate boom ?

People have made money and have made good recommendations but the genuinely great ones are very few.Most of the money is by people who are in the market , who get inside information and these people make money at the cost of gullible investors who are old timers and who have been holding on for sometime and who sell out at the first sign of a rally. They don’t have inside information.

More to follow

Tamilnadu newsprint analysis of financials

I have been trying to track this Company. Generally one is against this kind of State run Companies, but this one is an exception. It is very well run . There is also an inherent asset play. Broad financials are as follows

EPS Rs 18 approx for 2007-08
Book value Rs 100 per share by end of the year
Paper capacity 220 k mt and going up to 400 in 1.5 years
Power generation capacity 63 mw going up to 86 mw soon
Has a 63 acres land in the outskirts of Chennai which it proposes to convert in to an IT Park
Is setting up a cement clinker unit with 400 tpd capacity to use the flyash from the paper mill.

Well run company, makes mid course corrections. Started as newsprint manufacturer , but shifted tracks to other forms of paper when newsprint prices came down .
Has poineered cooperaive effort with farmers for land development for trees
Increasing pulp capacity

If one is looking for a steady 20-25 % return in the next 3 years with a potentiel upside of 50 % and with very little downside, this is it
Genuine solid value proposition at the current market rate of Rs 106 and will continue to be so till Rs 140

PS: This is just my view . People are at liberty to have a look , take the recommendation but check up with other sources or do your own due diligence before taking the plunge. I have knowleldge but do not claim great predictive capabilities especially stock prices. Success /gain is a function of your focus and the time frame on top of the Company performance

Dance of the bourses

This is great. I mean starting to put some nonsense in to the wide and far reaching webworld. Now let me get cracking.
If you are looking at how consistent and constant human beings are , you don't have to go too far ,all that you need to do is to look at the stock markets. As fickle as an exposed candle light on wildly windy day is.Burns but never gives the confidence that it will survive.

Few months back, India was the ultimate darling, the ultimate growth story , now suddenly getting pushed in to pariahdom

All the self proclaimed experts, have retreated . If somebodty has the patience to chronolgically list out the utterances of the bulls ( mostly bullshit), you can see the consistency." At PE ( Price earnings of 16-18), a growth market like India is a steal. India is not dependent on US. Sub prime has no impact on India, in fact if anything , it may have a beneficial impact.........Markets may touch 25 k in a few months.............. "

Next scene, the same folks

"........market valuations are rich, considering the fact that there have been some interlinkages in the Borrowings , risk swaps etc ( ICICI writing off something ), there is a possibility of the market touching 12k
Growth is stuttering, markets overbought,heated up,retail investors advised to stay out,.................................... "

I have been watching the the Forex markets for quite sometime . Most of the experts start commenting after the trend is truly in to its mid stage.They see the graph and start shouting. I remember when the Dollar was appreciating , they all did some semi intelligent extrapolation and said it would appreciate further. Nobody predicted ( or very few did ) the reversal, the moment it started and lasted for a few months, our experts were all over the channels uttering words of wisdom expressing exactky opposite views.

To be continued