Buy Exotic, Not Vanilla, Rupee Options, Barclays Says

By Anil Varma

Sept. 17 (Bloomberg) -- Overseas investors should buy so- called exotic rupee options that offer limited protection at a lower price to guard against the Indian currency's steepest slide in 17 years, according to Barclays Plc.

Traders should avoid the costlier and more common ``vanilla'' options because the rupee's rising volatility is raising derivative prices, said Peter Redward, head of research for emerging Asia at the U.K.'s third-biggest bank. Money managers should buy partial defense against rupee weakness as India stems the currency's slide, he said. The currency plunged 1.9 percent yesterday, the most in a decade, and jumped as much as 1.4 percent today.

``The balance of risks tilts toward more rupee losses,'' Singapore-based Redward said in an interview. ``It's much better to use structured options to hedge than simple vanilla contracts, which are too expensive.''

India's rupee is headed for its biggest slide since 1991, when a balance-of-payments crisis forced the nation to pawn its gold with the International Monetary Fund to pay for imports. It is poised for the first annual loss since 2005 as overseas investors pulled out a record $8.1 billion from local stocks this year.

The rupee has slumped 15 percent this year, the second- worst among Asia's 10 most-active currencies outside Japan. It traded at 46.37 at 5 p.m. in Mumbai, after falling to a two-year low of 46.975 yesterday, according to data compiled by Bloomberg.

Reverse Knock-Out

Implied volatility on one-month dollar-rupee options rose today to 16 percent, the most in at least nine years, Bloomberg data show. Traders quote implied volatility, a gauge of expected swings in exchange rates, as part of option prices.

Options are derivative contracts that give the holder the right to buy or sell an asset without the obligation to do so. Exotic options have features that allow investors to cut costs and brace for more probabilities than one. India doesn't allow local trading in exotic options. The strike price is the rate at which an option holder may buy or sell a currency.

Investors should buy so-called reverse knock-out rupee put options due in a month, which grant the right to sell the currency against the dollar as long as its losses don't exceed a set limit, Redward said. The option ceases to exist, or gets ``knocked out,'' should the rupee fall past the limit, or trigger, within a month. An ordinary put option allows sales of the currency without setting any limits.

Barclays recommends a strike price of 47.15, equal to the price of one-month rupee-dollar contracts in the overseas non- deliverable forward market, and a knock-out trigger of 49. The option would cost less than a tenth of a contract that doesn't limit rupee losses, Redward said, using prices before the market opened today.

Reducing Costs

``Vanilla options are extremely costly due to strong demand and high volatility in the rupee,'' he said. ``Paying so much doesn't look viable, particularly because the central bank may curb currency losses. One can express a bearish rupee view more comfortably using structured options.''

Redward also recommends buying a rupee put option with a strike price of 47.15 and selling another one at 49 to partly offset the price of the first contract. The trade, called a rupee put spread, reduces the cost of protection against a rupee slide by a third, compared with an ordinary option, he said.

The Reserve Bank of India said yesterday it will sell dollars and increase interest rates on foreign-currency deposits held by local banks to bolster the rupee. The bank said it will sell dollars through its agent banks or directly to meet the demand-supply gap.

India's foreign-exchange reserves have declined by more than $27 billion from a record high of $316.2 billion reached in May, indicating it sold dollars.

To contact the reporters on this story: Anil Varma in Mumbai at avarma3@bloomberg.net.