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How to Estimate What Hedging Currency Costs
Manesh Jayawardhana
CIO & Co-founder
A supplier contract commits you to paying 500,000 in a foreign currency in six months. Someone asks what it would cost to fix the rate now, and the instinctive answer is that it depends on where the currency goes.
It does not. The cost of a forward contract is set by the interest rate differential between the two currencies, and it is knowable today.
Why the cost is arithmetic
Covered interest rate parity is the principle underneath it. If a forward rate were priced differently from what the interest rate differential implies, you could borrow in one currency, convert, lend in the other, and lock in a risk-free profit.
Markets remove that opportunity, so the forward rate settles at:
forward = spot × (1 + r_quote × t) ÷ (1 + r_base × t)
The gap between spot and forward is the forward points, and it is entirely determined by the two interest rates and the tenor. No view about the currency’s direction enters the calculation.
At a 2.5 percentage point differential over six months, that is roughly 1.25% — about 6,250 on a 500,000 exposure.
Hedging can pay you
The direction depends on which currency has the higher rate.
Hedging into a higher-yielding currency costs — you pay the differential.
Hedging into a lower-yielding currency earns — the forward points are in your favour.
Neither is a gain or a loss in any meaningful sense. It is the mirror of the interest you would earn or forgo holding the currency instead, which is exactly the point of parity. Treating positive forward points as free money misreads what they are.
| Situation | Forward points | What it reflects |
|---|---|---|
| Hedge into higher-rate currency | Cost | Interest forgone |
| Hedge into lower-rate currency | Gain | Interest earned |
| Rates equal | Near zero | No differential |
The dealer spread is the negotiable part
Forward points are theoretical. What you actually pay includes the bank’s margin, and that varies with amount, tenor, relationship and how much competition they think they have.
On a large exposure the spread is a small fraction of the total. On a smaller one it can exceed the forward points themselves, which means the quoted “cost of hedging” is mostly the bank’s margin rather than market pricing.
Two things follow. Get more than one quote, and know the theoretical points before you ask — a quote you can compare against parity is a quote you can negotiate.
What hedging is actually for
It is worth being clear that hedging does not make you money. It removes variance.
A business that hedges its foreign currency payables knows its costs. A business that does not is running an unintended currency position alongside its actual operations, and occasionally that position is larger than the operating margin it is attached to.
The question is not whether hedging beats not hedging on average — over time it roughly does not, by construction. It is whether the variance is one you can absorb.
Decide the hedge ratio
Hedging is not all or nothing, and treating it that way is a decision by default.
A full hedge removes currency variance entirely and locks in the rate, including locking out any favourable movement.
A partial hedge — covering half or three quarters of a known exposure — reduces variance while retaining some exposure. This is common where the exposure is a forecast rather than a contracted amount, since over-hedging a forecast that does not materialise creates a speculative position.
Layering — hedging progressively as the exposure becomes more certain — is the usual approach for rolling exposures, and it averages the rate across several points rather than betting on one.
The right ratio depends on how certain the exposure is and how much variance the business can absorb, which is a policy decision rather than a market view.
Common mistakes to avoid
- Treating hedging cost as a prediction about the currency.
- Comparing a dealer quote against spot rather than against the theoretical forward.
- Accepting a single quote on a small exposure, where the spread is proportionally largest.
- Hedging a forecast exposure that does not materialise, which turns a hedge into a speculative position.
- Ignoring the differential’s direction and assuming hedging always costs.
How to do it with Currency Hedging Cost Estimator
The Currency Hedging Cost Estimator computes the forward points from the rates you supply.
- Enter the exposure, the two currencies’ rates for your tenor, and the period.
- Read the forward points, which follow from parity rather than from any forecast.
- Compare a dealer’s quote against that figure — the difference is the spread.
- Get a second quote before committing on anything small enough for the spread to dominate.
Other finance tools are in the tools directory.
Frequently asked questions
Why does hedging cost anything?
Because of the interest rate differential, not a forecast. Forward rates are set so that borrowing in one currency and lending in the other yields no free profit, which makes the cost arithmetic.
Can hedging earn money?
The forward points can be positive when hedging into a lower-yielding currency. That is not a profit — it mirrors the interest differential and comes with the corresponding funding position.
Does this include the bank’s margin?
No. Forward points are the theoretical figure. Dealers add a spread that varies with size and tenor, and on a small exposure it can exceed the points themselves.
Final thought
Work out the theoretical points before you ask for a quote. The difference between the two is the spread, and it is the only part of the price that is negotiable.