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If USDINR forward premium is higher than interest differential, does that signify INR depreciation?

Forward premium is a function of difference between two countries interest rate and normally have nothing to do with the spot rate outlook. For example if Indian interest rate is 6.00% and US interest rate is 2.00% then forward premium will be approximately 4.00%. Approximate because day count convention and same currency adjustments to be done.

 If forward premium is any different than 4.00% then there will be arbitrage and arbitrages do not exist in market for long. Let’s take an example –

From the table it is clear that anomaly in forward premium cannot exist and it should follow interest rate differential. However some anomaly exists for USDINR forward premium since there is no full capital account convertibility in India. No Arbitrage theory requires free movement of capital to take advantage of the arbitrage. However regulations in India do not permit such unlimited flows but allows large enough flows. Hence USDINR forward broadly represents interest rate differential but not exactly like you will see for EURUSD or USDJPY.

So Forward premiums are interest rate differential and has not much to do with spot outlook.  However for USDINR, the gap between interest rate differential and forward premiums signifying interests of counter parties. For example if interest rate differential is 4.00% but forward premium is 3.90% that is a scenario when either exporters are selling heavily or significant FII inflows are coming in. However if the same forward premium changes to 4.10% that signifies change in interest and possibly importers or FIIs are hedging more.

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