Hedged and unhedged

Chapter 2 showed the currency leg can be larger than the asset leg. The obvious response is to remove it. This chapter is about what that costs and when it is worth paying.

What a forward rate must be

A forward contract fixes today the rate at which you will exchange currencies on a future date. Its price is not a forecast — it is set by arbitrage, exactly as option prices were in the Option pricing subject.

The argument. Suppose you have one rupee and a year. Two routes to having foreign currency in a year:

Route A. Lend the rupee in India at $i_{\text{INR}}$, then convert at whatever rate prevails.

Route B. Convert now at the spot rate $S$, lend abroad at $i_{\text{for}}$, and sell the proceeds forward at $F$ agreed today.

Route B has no uncertainty. So Route A, made certain by also selling forward, must deliver the same amount — otherwise there is riskless profit. Setting them equal:

$F = S \times \frac{1 + i_{\text{INR}}}{1 + i_{\text{for}}}$

This is covered interest parity, and it is an arbitrage relation rather than a theory. The Option pricing subject's put-call parity has the identical logical structure: two portfolios with identical certain outcomes must cost the same.

So hedging costs the rate differential

Rearranging, the forward premium is

$\frac{F}{S} - 1 = \frac{1 + i_{\text{INR}}}{1 + i_{\text{for}}} - 1 \approx i_{\text{INR}} - i_{\text{for}}$

The currency of the higher-interest economy trades at a forward discount. India's policy repo rate is 5.50%. Where the foreign rate is lower, the rupee is priced to be weaker forward — and locking in that forward rate means accepting the weaker rate.

And you do not have to estimate it, because it is published. The RBI reports forward premia on the US dollar against the rupee. For the week ended 2 October 2026:

Tenor	Forward premium on the US dollar
1 month	4.07%
3 months	4.31%
6 months	3.75%

(RBI weekly series, week ended 2 October 2026, with the INR-USD spot rate at 95.99.)

That is the cost of hedging, directly observed — roughly four percentage points a year. It is not a small frictional charge; it is larger than many investors' entire expected real return.

And it tells you what the market thinks the rate differential is. Inverting covered interest parity against an Indian money-market rate near 5.50% implies a dollar rate somewhere around 1.1% to 1.7% — which is the arithmetic working, not a coincidence.

Read the direction carefully, because it is counter-intuitive. An Indian investor hedging a foreign currency pays when Indian rates are higher. You are giving up the forward depreciation of the rupee — which chapter 2 identified as the long-run tailwind on foreign holdings.

So the two halves of chapter 2 are the same fact. The rupee's tendency to depreciate is the currency gain on an unhedged holding, and it is also exactly what a hedge costs. The market has priced the tailwind. You can have the protection or the drift, and the price of the first is the second.

And whether it is even available

Before deciding, note that an Indian individual largely cannot do this personally.

The Overseas Investment rules exclude derivatives from OPI "unless otherwise permitted by Reserve Bank", and chapter 3's LRS prohibition on margin remittances closes the other route. So an individual is not, in the ordinary case, going to put on a currency forward against a personal foreign holding.

The decision is therefore usually a product choice rather than a transaction: whether to buy a hedged or unhedged fund. Indian international funds are commonly unhedged, and where a hedged variant exists the cost above is inside its returns rather than on a statement.

Which means the practical question is not "should I hedge?" but "do I understand which one I am holding?" — and the answer for most people, most of the time, is that they hold an unhedged fund without having considered it.

The argument for not hedging

For an Indian investor buying foreign equities, this is usually the right answer, and the reason is chapter 2's correlation point.

The purpose of the holding is diversification away from India. Indian equities and the rupee tend to fall together, because the same episode — capital outflow — drives both. An unhedged foreign holding therefore rises in rupee terms exactly when the Indian portion of the portfolio is falling.

Hedging removes precisely that property. A hedged foreign equity fund gives you foreign equity risk with the diversification benefit stripped out, and you pay the rate differential for the privilege.

Two supporting arguments.

Over long horizons the currency's contribution to risk is proportionally smaller. Equity volatility compounds with the square root of time and so does currency volatility, but equity volatility is much the larger — so over twenty years the asset dominates the outcome, while over one year the currency can dominate, as chapter 2's table showed.

And the cost is certain while the benefit is not. The rate differential is paid every year with certainty. The protection pays off only if the rupee strengthens.

The argument for hedging

It is a narrower case and a real one.

Hedge a liability, not an investment. This is the rule worth carrying out of the chapter.

If you have a known foreign-currency obligation — university fees of USD 60,000 due in September, a property purchase, a planned emigration — then you have a short position in that currency whether you acknowledge it or not. A rupee saver facing dollar fees loses when the rupee falls.

Matching the currency of an asset to the currency of a liability is not speculation; it is removing a mismatch. The family in chapter 3's problem, paying overseas fees, has a genuine reason to hold dollars that has nothing to do with investment returns.

The other cases are shorter and narrower:

A short horizon. Money needed in a year, where the currency can plausibly be the whole result.

An asset whose returns are themselves currency-driven, where the exposure doubles up rather than diversifies.

And a position large enough that the currency alone would breach your risk tolerance — the Risk subject's capacity-and-tolerance question applied to one leg of one holding.

Working the problem

India at 5.50%, foreign at 4%.

Step 1 — the forward premium.

$\frac{F}{S} - 1 = \frac{1.055}{1.04} - 1 = +1.44\%$

The foreign currency trades 1.44% higher forward than spot, which is the same statement as the rupee being priced 1.44% weaker.

Step 2 — what it costs and who pays. An Indian investor hedging a year of foreign exposure sells that currency forward at a rate 1.44% above spot — which sounds like a gain and is not, because they are also giving up the spot-to-forward move. The hedged investor's expected return is lower by about 1.44 points a year than the unhedged one's, assuming the spot rate drifts towards the forward.

The rupee investor pays, because Indian rates are higher. An American investor hedging rupee exposure would be on the other side and would receive roughly the same 1.44%.

Now check that against what the market actually charges. The RBI's published forward premia for the week ended 2 October 2026 were 4.07% at one month, 4.31% at three and 3.75% at six — far above the 1.44% the 4% assumption produces. The assumption was too generous, and reading the observed premium is better than deriving one from policy rates, because the forward market prices the money-market rates a hedger can actually transact at rather than the central bank's corridor. Take the real number: hedging a dollar exposure has been costing roughly four points a year.

Step 3 — should a twenty-year holder of US equities hedge? No, for four reasons in descending order of weight.

It removes the reason for the holding. The diversification value of foreign equity to an Indian portfolio comes substantially from the currency moving against Indian assets. Hedging deletes that and keeps the foreign equity risk.

The cost is certain and compounds, and at observed premia it is enormous. At the 6-month premium of 3.75% a year, $1.0375^{20} = 2.09$ — so over twenty years a hedged holding ends at about 48% of the unhedged one, if the spot rate simply tracks the forward. Hedging would cost roughly half the ending wealth. At the 1-month premium of 4.07% it is 45%. That is not a frictional cost; it is most of the outcome.

The horizon works against the hedge. Over twenty years, equity returns dominate currency returns in the decomposition. The leg being hedged is the one that matters least over this holding period.

And it is largely unavailable anyway — an individual cannot easily put on the forward, so the choice is between products, and the hedged variant carries the cost inside its returns.

When I would change that answer. If the money is earmarked for a dollar liability — a child's education abroad in six years, a planned move — then the holding is no longer an investment with a currency attached. It is a matched asset, and matching is right. The question to ask is not "will the rupee fall?" but "what currency will I spend this in?", and that question has a definite answer where the first does not.

The point

A forward rate is fixed by arbitrage at $S(1+i_{\text{INR}})/(1+i_{\text{for}})$, so hedging costs approximately the interest rate differential — and the RBI publishes it directly, at 4.07% for one month, 4.31% for three and 3.75% for six in the week ended 2 October 2026. Roughly four points a year, which compounds to about half the ending wealth over twenty years. That cost is exactly the rupee's expected depreciation, so the long-run currency tailwind on foreign holdings and the cost of removing it are the same number, priced. Indian individuals mostly cannot transact the hedge themselves, since OPI excludes derivatives and LRS forbids margin remittances, so the choice is between hedged and unhedged products. For a long-horizon Indian holder of foreign equities, unhedged is usually right, because the currency's tendency to move against Indian assets is the diversification being bought. Hedge a known foreign liability, not an investment.