Arguably, one of the most important questions of market participants and investors in Iran is concentrated on the level of interest rates. While the government managed to control inflation over the past few years, the level of benchmark interest rate is around 20%. Given the attractiveness of 20% interest rate, investors tend to deposit their cash into banks to take advantage of risk-free interest rate rather than investing in other risky financial assets such as shares. Contrary to the current level of interest rate in Iran, the interest rate in most of developed countries including United States of America, Canada and Australia is very low. As such, western banks and foreign asset managers may found 20% interest rate in Iran very attractive. However, foreign investors are exposed to one important risk if they manage to deposit their fund in Iranian banks and that it exchange rate risk. The fluctuation of US dollar to Iranian Rial is a key player to realize any return from this.
To further elaborate and highlight the impact of currency risks for foreign investors, we assume 20% interest rate on $1M USD, deposited in one of Iranian banks for a year. Using simple interest rate, the investor will earn around $0.2M over a year, which is a great return for a non-risky asset. However, in our base case, we assume that USD/IRR to remain constant over the course of the year. At the time of writing this article, 1 USD is equal to ~39,000 IRR (free market rate). Figure below illustrates the fluctuation of USD/IRR over the past four years.
However, as illustrated in above chart, USD/IRR is relatively volatile and foreign investors may be worse off by the impact of exchange rate. For example, assuming that Iranian Rial depreciates by around 20% in one year, there would be no profit for foreign investors in that year while the opposite may also be the case. Nevertheless, given the importance of exchange rate, if foreign investors are able to hedge the risk associated with USD/IRR, they could have earned on average 20% return per annum. However, regarding the policy of the government in order to control the inflation and also Purchasing Power Parity(PPP), we do not anticipate depreciation of Rial to be more than 10% annually. The effectiveness of any hedging instrument to protect any currency risk via cross hedging depends on the correlation and price movement of the spot currency prices and the relevant futures contract. As such, futures market is generally used to hedge against currency exchange rate. In the absence of swap contracts for USD/IRR, it would be possible to hedge USD/IRR against other assets with similar price movement. While oil prices have substantial impact on Iran’s economy and oil futures is commonly known as a good indicator of the economy, previous studies show that USD/IRR can be hedged to some extent by gold futures currently traded in Iran’s futures market. According to a study which has been done by number of researchers in Iran, the currency risk can be mitigated up to 50% using gold futures contracts. Figure below illustrates the relative growth in gold futures market and USD/IRR since April 2014.
While using gold futures does not provide a perfect hedge, it will enable foreign investors to gain some advantage of high interest rate in Iran. Overall, it appears that gold futures and USD/IRR have similar price movement.
It is important to note that the content of the article is only a high level introductory to currency exchange rate in Iran. As such, the information shall not be considered as advice or a recommendation to investors.