Considering that there seems a general consensus regarding the source of the currency rally in Indian equity markets, one would wonder how sustainable it is. Further quantitative easing in US may push things even further up. What can one do to hedge against an FII outflow driven market correction in Indian equity?
Today's business standard has an interesting article on a related topic. It contains an interesting idea. One can short Rupee in the currency futures markets to hedge against a sharp pullout of FIIs from Indian markets. Of course the cost of this is that the gains driven by FII inflows will get dampened somewhat by the losses on the futures side since Rupee will continue to appreciate in that case. However, considering potential RBI intervention in forex markets to keep Rupee from appreciating too much may work in favor of this strategy. On the other hand a sudden pullout by FIIs will certainly push Rupee down. The gains from that will partially offset the losses in the equity portfolio.
Why not simply buy a put on the index? For one it would be costlier. For two, it does not address the specific issue of volatility of FII inflows. A dollar rupee futures contract does just that. One can even use an option - out of the money call on Rupee (or put of Dollar) - as an alternative. In this case the upside from further FII inflows remains fully untouched in return for the option premium. This is best done in one or two month one off cases. For a regular hedge futures are likely to be more effective.
A multi-asset portfolio can also benefit from the above. Bonds are affected by the FII flows as well - albeit to a lesser extent. Gold of course is an entirely different topic. More on that later!