In our last blog post on the performance of Indian equities, we showed them reaching all-time highs.1 This fact may surprise U.S. investors, as certain indexes of India’s equities are down over 30% cumulatively since 2007, a result of the Indian rupee’s decline by approximately 36% over the same period.2
An Obvious Case for Hedging… or Not?
Now seems like a perfect time to use currency-hedged strategies in India as protection against these declines in the rupee. But the currency-hedging story in India is not as straightforward as it is in Europe or Japan today. Why? It would be too expensive to hedge the Indian rupee now, with the cost eroding the protection from loss in the currency’s value against the U.S. dollar.
Developed Market Currency Hedging Is Different Than Currency Hedging in India
One reason we advocate currency hedging in Europe and Japan is because it is relatively inexpensive to hedge. The primary cost of currency hedging is based on short-term interest rate differentials between the foreign market and the home market. The difference between Japanese or European interest rates and U.S. interest rates is currently so low that hedging their currencies is essentially a free option for U.S. investors. At some point, if short-term interest rates in the U.S. normalize and become higher than those similar interest rates in Japan or Europe, one might actually get paid the higher interest rate differential to hedge the yen or the euro.
But in India the situation is very different. Interest rates are high, making the cost to hedge the rupee high for U.S. investors. The sizable short-term interest rate differential between India and the U.S. represents a “hurdle rate” for how much the rupee has to depreciate before U.S. investors can break even on the cost of that hedge. Given these high hurdle rates we think it’s difficult to make a case that the hedge adds long-term value, specifically given the extraordinarily low U.S. short-term interest rates. Right now, the spread between implied yields for 1-month rupee forwards and 1-month London Interbank Bid (LIBID) rates is 7.53%.3 Consequently, in neutralizing rupee exposure, investors face a 7%-plus annual headwind or—in other words—can expect to lose about 65 basis points a month. If one is convinced the rupee could depreciate more than that over the investment horizon, then it would make sense to hedge.
Our Strategic Approach to India’s Currency
We would argue that strategic investors would rather be on the opposite end of that trade, with the potential to collect the higher interest rate in India’s local markets. That is why we created the WisdomTree Indian Rupee Strategy Fund (ICN), which benefits from high short-term interest rates available to investors in India.
This Fund takes the opposite side in the same instruments—non-deliverable forward contracts—to collect the interest rate premium, instead of paying it, as one would need to do to hedge the exposure. The forward contracts in the Fund are also collateralized by U.S. cash investments. The combination of interest from the U.S. cash instruments with the interest rate premium approximates the local money market rates in India, which is how the strategy seeks to accomplish its objective.
The differential in the exchange rate performance of the rupee and the return of this Fund over its life provides a simple estimate for how much it would have cost to hedge the rupee over nearly five years of live performance history.
Illustrating the Impact of India’s Higher Short-Term Interest Rate
For definitions of terms in the chart, please visit our Glossary.
Average Annual Returns (as of December 31, 2013)