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Dividend Yield

By: Punam Sharma

Inflation proofing your income and income proofing your assets . ReWISE tells you why investing for dividend yield investing is a great investing style.

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Is there a correlation between policy actions and yields?
 

  • RBI uses three types of monetary policy actions
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  • Repo rate which impact interest rates.
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  • Cash reserve ratio (CRR) and statutory liquidity ratio (SLR) impacts liquidity conditions in the market.
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  • RBI policy actions mainly include changing repo rate and CRR. SLR is not changed often and used very rarely by RBI as a policy action.
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  • We know that Gsec yields are affected by changes in interest rates.
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  • Interest rates are managed by RBI through its monetary policy by increasing or decreasing or not changing the Repo rates.
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  • RBI by changing CRR, impacts the liquidity condition in the market which will impact Gsec yields too.
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  • However the policy actions by RBI affect short term yields and long term yields differently.
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  • Long-term rates are determined by market forces and are a function of the effect investors believe current short-term rates will have on future levels of inflation and economy.
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  • Therefore long term rates are largely influenced by market expectations than policy actions.
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  • On the other hand, short term rates are directly influenced by RBI via its policy actions.
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  • Therefore short term rates are more correlated with policy actions.
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  • Chart below shows the movement of 3 month &10 year Gsec yield and Repo rate and CRR during different RBI policies.
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Gsec Yield

 

  • From the above chart, we can see 3 month Gsec yield moves more in line with policy action than 10 year Gsec yield.
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  • Policy changes do have an effect on yields of all maturities; however the effects reduce with increase in maturities.
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  • To know the correlation between short term rates, long term rates and policy actions, we have calculated correlation between policy actions and Gsec yields having different maturities.
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  • To calculate correlation, we have calculated policy rate and Gsec yields changes at date of the policy change from the previous policy. For same, monetary policy dates have been considered from April 2001 till May 2013.
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  • Table below shows the correlation between policy action and Gsec yields having different maturities.
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  • From the above table, we can see that short term rates have higher correlation than long term rates with policy action.
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  • A 3 month Gsec yield changes by 52% while 10 year Gsec yield changes by around 26% when there is policy action.
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  • Charts below shows yield curve during various dates when repo rate was hiked and cut.
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Yield curve when repo rate hiked

 

  • From both charts above, we can see that when repo rate changes, short term yields reflect the change than long term yields.
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  • When repo rate is hiked, we generally have upward sloping curve. This is clearly reflected with short term yields. Long term yields do depict but not consistent during all dates mentioned.
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  • Similarly, with repo rate cut, we observe inverse yield curve. This again is observed for short term yields while long term yields have risen rather than falling.
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  • Policy changes does influence short term yields while long term yields are marginally influenced by policy changes.

 

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Yield Spread

By: Punam Sharma

What is a yield spread?
 

  • Yield spread is the difference in the yield between two bonds of the same maturity.
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  • Commonly, yield spread is the difference in the yield of any bond (PSU, corporate or banks) and Government bonds having the same maturity.
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  • Suppose AAA 10 year corporate bond yield is 8.6% and 10 year Gsec yield is 7.46% then, the yield spread is 114 bps (1.14%).
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  • Spread is generally expressed in basis point (bps) where 1 percent is equal to 100bps.
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  • Yield spread can also be the difference in the yield between different maturities of a same bond.
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  • For example, spread between 1 year Gsec bond having yield 7.40% and 10 year Gsec bond having yield 7.46% is 6 bps (0.06%).
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Why there is a spread between bond yields?
 

  • Government bonds are free from credit risk i.e. risk arising from the issuer of the bond to default in making the payment of the principal amount and interest.
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  • Government bonds being default free i.e. government won’t default in making payment, Gsec yields are taken as a benchmark against which other bond yields are compared.
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  • This enables the investors to get an idea of the credit risk associated in investing in bonds other than government bonds.
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  • Investors to be compensated for investing in less safer bonds than the government bonds demand higher yield than Gsec resulting in the differences in the bond yields.
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  • Yield spread reflects the extra compensation investors receive for bearing credit risk.
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  • Higher the credit risk, higher is the yield spread as investors need to be paid in order to take the additional risk.
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  • Besides credit risk, investors can also face liquidity risk.
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  • Liquidity risk is when the bond cannot be traded easily in the market.
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  • Investors will therefore demand higher yield to compensate for the risk arising from illiquidity increasing its yield spread.
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  • Chart below shows yield of different types of bonds having different credit risk as on 3rdJan 2013.
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Yields of different type of bonds

 

  • From the above chart, we can observe higher the credit risk higher is the bond yield.
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  • Gsec yield being benchmark, all other bonds are benchmarked against Gsec yield. However their yields vary as per their credit risk.
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  • Corporate AAA bond having highest credit rating has lowest spread. As on above mentioned date, spread between 10 year AAA corporate bond and 10 year government bond was 120bps.
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  • Corporate AA bond having lower credit rating which means higher credit risk has higher spread of 150bps for the 10 year maturity.
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  • Corporate A bond has the lowest rating and highest risk among the three bonds and has highest spread of 240bps for the 10 year maturity.
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What causes changes in yield spread?
 

  • Yield spread can increase i.e. widen or decrease i.e. narrows.
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  • Widening yield spread means yield difference between other type of bonds and government bonds is increasing.
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  • Narrowing yield spread means yield difference between other type of bonds and government bonds is decreasing.
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  • Changes in the yield spread is due to changes in the interest rates, supply and demand of bonds, risk associated with the bond and economic conditions.
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  • Any change in interest rates1 causes yield on government bonds to change. Since other types of bonds are benchmarked against Gsec yield, any change in Gsec yield will cause other bond yields to change.
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  • When there is economic slowdown, company performances are impacted which increase their credit risk. This causes yields on corporate bonds (or PSU, bank bonds) to increase to compensate investors for the additional risk involved, thereby widening yield spread.
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  • Also during deteriorating economic environment with credit risk of companies increasing, investors chooses to invest in safer bonds i.e. government bonds rather than riskier corporate bonds. This leads to fall in Gsec yields as demand increases causing bond price to rise and yields to fall.
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  • As yields on corporate bonds are rising and Gsec yields are falling, resulting yield spread to widen.
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  • Conversely, when economy is booming, company profitability increases improving their performance lowering their credit risk. This causes investors to view investments in corporate bonds favorable causing yields to fall, thereby narrowing yield spread.
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  • Also during booming economy with lower credit risk, investors invest in corporate bonds rather than government bonds. Since demand for government bond falls, causing their yields to rise.
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  • As yields on corporate bonds are falling and Gsec yields are rising, yield spread narrows.
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  • Charts below shows widening and narrowing of yield spread between corporate AAA bond and government bond during different economic conditions2.
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Yield spread graphs

 

  • From above both charts, it’s clearly seen when there has been economic slowdown, yield spreads have widened depicting increase in corporate AAA bond yield to compensate for additional risk it carries.
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  • Spread for 10 year corporate AAA bond and 10 year government bond was 400bps.
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  • Similarly, when economy was booming the spread narrowed and was 110bps for 10 year maturity.
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Yield Curve

By: Punam Sharma

What is yield curve?
 

  • Yield refers to the interest earned on a bond till it matures
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  • Yield curve is a graphical presentation showing relationship between a bond’s yield and
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  • It’s maturity.
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  • A yield curve describes relation between yield on short term bond (referred to as short end of the yield) and long term bond (referred to as long end of the yield).
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  • It shows investor’s expectations on future interest rates.
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  • Yield curve is also used as a leading economy indicator.
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Types of yield curve
 

  • There are four types of yield curve – normal, inverted flat and humped.
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  • Normally the yield curve is upward sloping (normal yield curve) where bond with longer maturity pay higher yield. Yield on long term bond is higher than yield on short term bond.
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  • An upwardly sloping steep yield curve is when gap between yield on long term bond and short term bond widens which makes the curve look steeper. Yield on long term bond is rising faster than yield on short term bond or yield on short term bond is falling faster than rising yield on long term bond.
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  • Inverted yield curve is a downward sloping curve where yield on long term bond is lower than yield on short term bond.
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  • Flat yield curve is almost like a straight-line curve where yield on long term bond and short term are almost similar.
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  • Humped yield curve is when yield on long term and short term bond are almost similar and yield on medium term bond is high forming a hump shape.
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  • Chart below uses hypothetical yield to show the types of yield curves.
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Yield Curves

 
What causes yield curve to be normal, flat or inverted and its indication?
 

  • Factors like monetary policy (also investor’s expectation on future interest rates), inflation and economic conditions causes the yield curve to change shape.
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  • Before, we understand how the above factors cause changes to the yield curve; one must understand relation between short term interest rate and long term interest rate along with relationship between interest rate, yield and bond price.
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  • While short-term interest rates are managed by RBI, long-term interest rates are determined by market forces. Long-term interest rates are a function of the effect investors believe current short-term interest rates will have on future levels of inflation and economy.
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  • When interest rates rise, bond price falls, raising yield of older bonds to be at par with the newer bonds issued with higher coupons.
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  • When interest rates falls, bond price rises, lowering yield of older bonds to be at par with the newer bonds issued with lower coupons.
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  • Typically a yield curve is upward sloping (normal) or a steep yield curve as investors need to be compensated for risks associated with holding a bond with longer maturity.
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  • This happens when investors expect interest rates to rise on back of high inflation or excess liquidity in the market as RBI might increase interest rates to lower inflation or absorb liquidity.
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  • Upward sloping steep yield curve generally indicates economic growth as a growing economy will result in increase demand for money (Increase in borrowing for investments) resulting interest rates to rise.
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  • Chart below shows India Government securities yield curve as on 30 April 2006 depicting a normal yield curve.
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Normal Yield Curve

 

  • During the above mentioned period of time, India was facing high inflation and repo rates were increased from 6.5% to 7.5% (2006-07).
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  • As upward sloping curve indicates growing economy, that year India GDP (2006-07) was 9.5%.
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  • Flat yield curve signals economic slowdown.
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  • Yield curve flattens when RBI to curb effects of rapidly growing economy raises interest rate causing yield on short term bond to increase.
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  • At the same time on the expectation of falling inflation investors don’t demand risk premium for holding long term bond causing yield on long term bond to fall causing flattening of yield curve.
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  • Chart below shows India Government securities yield curve as on 9 June 2011 depicting a flat yield curve.
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Flat Yield Curve

 

  • During the above mentioned period of time, India experienced rising interest rates of around 100 bps and though inflation was high it declined to 7.69% by March 2012.
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  • Flattening yield curve indicator of slowing economy; India GDP fell to 6.2% (2011-12).
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  • On the above mentioned date, yield for 3 month T-bill was at 8.15% and on a 10 year Gsec bond was at 8.26% leading to a flatter yield curve.
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  • When investors expect interest rates to fall on back of lower inflation or tight liquidity conditions, investors do not demand compensation in form high yield on long term bond as they expect rates to fall further. This cause’s yield curve to invert as yield on short term bond is higher than yield on long term bond.
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  • Inverted yield curve indicates economic recession as investors expect demand of money to decrease and interest rates to fall to stimulate growth, therefore not investing for longer period.
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  • Chart below shows India Government securities yield curve as on 30 June 2008 depicting a partial inverted yield curve.
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Inverted Yield Curve

 

  • From the chart above we can see a partially inverted yield curve.
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  • During that period of time, India witnessed falling inflation from 10.89% in June 2008 to 1.48% in March 2009 and Repo rate was cut by 350 bps around the same time.
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  • Inverted yield curve indicates economic recession; India GDP for 2008-09 fell from 9.3% to 6.7%.

 

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What is rupee appreciation & depreciation?
 

  • Exchange rate is the price of foreign currency (USD, Yen, Euro, Pound etc) in terms of domestic currency (rupee) i.e. amount of domestic currency needed to buy one unit of foreign currency.
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  • Currently price of 1$ = Rs. 53.74, which means 1$ can be purchased in exchange of Rs. 54.
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  • Exchange rate tells us the value of domestic currency in relation to one unit of foreign currency. 1$ is worth Rs. 53.74.
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  • Rupee prices keep fluctuating all the time. Sometimes we need more rupees to buy one unit of foreign currency and sometimes we need fewer rupees to buy one unit of foreign currency.
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  • This change in rupee price is known as rupee appreciation or depreciation.
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  • Rupee appreciation is when value of rupee increases (becomes expensive) and fewer rupees can buy one unit of foreign currency. This is also known as strengthening of rupee as now INR is worth more than foreign currency.
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  • Suppose exchange rate changes to 1$ = Rs. 50, we say rupee has appreciated as 1$ can buy fewer INR.
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  • Rupee depreciation is when rupee value decreases (becomes less expensive) and more rupees can buy one unit of foreign currency. This is also known as weakening of rupee as now INR worth is less than foreign currency.
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  • If exchange rate changes to 1$ = Rs. 55, we say rupee has depreciated as 1$ can buy more INR.
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  • Currency price is always stated in relation to another currency. So when one currency appreciates the other currency depreciates.
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  • Chart below shows daily exchange rates of rupee per unit of various foreign currencies like USD, Pound, Euro, and Yen*.
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The exchange rate for Japanese Yen is in Rupees per 100 Yen

What is rupee appreciation & depreciation?
 

  • Like any commodity whose price is determined by its demand and supply, currency price is also determined by demand and supply of that currency in the international market.
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  • When supply of a country’s currency increases, value of currency falls as more currency is required to purchase another currency causing currency to depreciate. Reverse holds true when demand for a currency increases.
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  • Demand for a country’s currency comes from its export of goods and services and foreign investment in the country.
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  • Supply for a country’s currency comes from its imports of goods and services and its investments in other countries.
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  • Major factors which cause currency to appreciate or depreciate are current account deficit/surplus, capital account flows, interest rate and inflation.
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  • Current account deficit is when imports are higher than exports. When a country imports more, it needs to pay in foreign currency, causing the country’s currency to depreciate as demand of its currency decreases. Reverse holds true in case of current account surplus.
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  • Chart below shows India’s current account quarterly data and rupee movement from 2000 till December 2012.
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Chart of India’s Rupee Movement From 2000 to December 2012

 

  • From above chart, we can see that rupee has depreciated with increase in current account deficit.
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  • During 2002-2004, when India saw current account surplus, rupee has appreciated from Rs. 48.8 to Rs. 43.58.
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  • From 2011 with increasing deficit, rupee has depreciated from Rs. 49 to Rs. 54.7(as on December 2012).
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  • Capital account flows- Current account deficit is funded by capital flows and current account surplus generate capital outflows (invest in other countries). When there is capital inflows in the country, demand for the currency increases leading to currency appreciation. Capital outflow causes the country’s currency to depreciate as supply of its currency decreases and demand for foreign currency increases.
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  • Chart below shows India’s quarterly capital account flows and rupee movement from March 2000 to December 2012.
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Chart of India’s quarterly capital account flows and rupee movement from Mar 2000 to Dec 2012

 

  • From above chart, we can see with increase in capital flow, rupee has appreciated.
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  • Interest Rate- A country with high interest rate attracts foreign investors to take advantage of the arbitrage opportunity arising from low interest rates in their country. Thus demand for the country’s currency increases, resulting in appreciation in the value of the currency.
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  • Chart below shows movement between repo rate and rupee.
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Chart of movement between repo rate and rupee

 

  • Inflation- High inflation in a country impacts the country’s exports as goods become expensive for other countries resulting decreased demand for the currency and hence depreciating currency value.
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  • Chart below shows monthly inflation and rupee price change1 from April 2006 till March 2013.
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Chart of monthly inflation and rupee price change from Apr 2006 till Mar 2013

 

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