Why Hedging the Rupee Doesn’t Make Business Sense

The turbulence and the risks of Equity investments attract unsolicited risks to hedge fund managers across the world, it’s no surprise thus that Currency Hedging has been the most talked about topic amongst investment firms who venture across borders in search of that extra buck. In the first world countries Currency fluctuations often pose uncompensated risks and there is no reason to believe that the Euro or the Yen would always appreciate against the US Dollar. The move opens up fresh avenues for arbitrageurs and exposes global economies to instinctive speculation.

Negative Cost of Funds

In recent times the ECB’s lending rates stand at negative 40 basis points while the Federal Reserve has a positive interest rate of close to 30 basis points. Therefore, by skillful use of the forward contract an investor can earn the interest differentials and avoid additional risks that his portfolio is exposed to. However the same rules don’t quite apply with the Indian Rupee and the risks associated with Fund Exposed in the Indian equity markets.

Higher Borrowing Costs in India 

Lending rates in India are much higher compared to the United States or the Euro Zone, thus investors end up paying the interest rate differential when using the Currency Hedging tool. The RBI’s current repo rates stand at 6.5% while the Federal Reserve’s lending rates stand at 0.30%. The interest differential between the two countries therefore is a whopping 6.2%. The wide gap between the interest differential thus leaves the American investor in the lurch. The one question that makes the equation even more complex which in time leads to speculative avenues is “can the Rupee depreciate by more than 6% in a year?” Believe it or not, that is how much the currency has to fall for the investor to break even on the cost to hedge the Equity risk by means of Currency Hedging.

The Alternative Bet 

Over a period of 10 years, the cumulative spot return for the Indian Rupee stood at a negative 31.8%, however a total return for being long in the forward Rupee contract was a positive 53.6%. The stark contrast was caused by the interest differentials of 7% per year on an average which more than compensated for the decline in the Indian Rupee’s value. Statistics suggest that an investor may have the opportunity to collect the higher interest rate in the local Indian markets.

Interesting Ways to Earn Interests 

If an investor goes long in the Rupee forward contract to collect the interest rate premium instead of paying it by locking on to a Rupee Hedge strategy. The forward contracts in the funds are also collateralize by cash investments. This combination of interests from the American cash instrument clubbed with the interest rate premium approximates the local money market rates in India. This in fact turns out to be a better bet than Hedging the Rupee to protect Equity exposures in the Indian subcontinent.