FX Hedging

Using forwards or options to eliminate or reduce currency risk.

FX hedging uses derivatives (usually forward contracts) to lock in exchange rates and eliminate FX risk. A fully hedged position removes all FX exposure — you lock in the asset return in local currency terms. Partial hedging (say, 50%) reduces but doesn't eliminate FX risk. Cost/benefit: Hedging EUR exposure costs ~interest rate differential (if EUR rates are lower than USD, hedging costs you the difference — currently ~0.5-2% annually). Key tradeoff: Hedging eliminates downside FX risk but also upside. Common practice: Many institutional investors hedge 50-100% of developed-market FX and 0-30% of emerging-market FX (EM hedging is expensive and illiquid). The formula F = S × (1 + r_d)/(1 + r_f) shows forward rates embed interest differentials.

Formula

F = S \times \frac{1 + r_d}{1 + r_f}

Related Terms

FX Risk

Risk from exchange rate fluctuations affecting foreign-denominated assets.

Currency Exposure

The fraction of portfolio value exposed to a foreign currency.

FX Volatility

Standard deviation of exchange rate changes — typically 5-15% annually.