Level III Core · Swaps, Forwards, and Futures Strategies

Currency Hedging with Forwards and Futures

Updated 9 October 2026

Currency hedging with forwards or futures means taking an offsetting position in the foreign currency, usually selling it forward, so exchange-rate moves do not change your domestic-currency value. Hedge ratio = hedge notional ÷ foreign exposure. Price the forward from interest rates, size the hedge, then plan the cash flows at settlement or roll.

Understand Forwards and Futures for Currency Hedging

A portfolio holding foreign assets has two risks: the asset's return in its own currency, and the change in that currency against your domestic currency. A currency hedge removes the second risk. If you own foreign assets, you hedge by selling the foreign currency forward (or selling a currency future).

Use the quote convention price currency per one unit of base currency, written PC/BC. In USD/EUR = 1.0800, the euro is the base currency and the dollar is the price currency. A foreign-asset holder is long the base currency, so the hedge is a short position in the base currency.

The hedge ratio is the hedge notional divided by the foreign-currency value of the exposure. A ratio of 1 is a full hedge. A ratio below 1 is a partial hedge. A minimum-variance hedge ratio is the slope from regressing the asset's domestic-currency return on the currency return. Use it when the asset's value does not move one-for-one with the currency, or when you hedge with a proxy currency.

The forward price comes from covered interest parity, not from a forecast. The difference between forward and spot is the forward points. If the base currency has the higher interest rate, it trades at a forward discount, and selling it forward costs you roughly that rate gap. If it has the lower rate, it trades at a forward premium and the hedge adds return. So the hedged return is roughly the local asset return plus (domestic rate − foreign rate). The domestic currency is the price currency here.

Most hedges are shorter than the investment horizon, so you roll them: you settle the expiring contract and open a new one. Settlement creates cash flow. If the foreign currency rose, the short forward loses and you must pay cash while your foreign gain is still unrealised. If it fell, you receive cash. Rolling also leaves you exposed to changes in forward points and interest rates. Futures are standardised and marked to market daily, so the cash flows come every day, the contract sizes are fixed (so the hedge is rarely exact), and credit risk is low. Forwards are customised and settle at maturity, but carry counterparty risk.

Key rules to remember

Covered interest parity (forward price): F(PC/BC) = S(PC/BC) × (1 + i_PC × days/360) ÷ (1 + i_BC × days/360); Use the day-count basis given in the question. PC is the price currency, BC the base currency. Rates are for the forward's term.
Forward points: Points = (F − S) × 10,000; Use 100 as the scale for yen pairs. Add points to spot to get the forward when the quote is in points. Positive points mean the base currency is at a forward premium.
Hedge ratio: h = hedge notional (foreign currency) ÷ foreign-currency exposure; h = 1 is a full hedge. Compute on the foreign-currency value, not the domestic value.
Minimum-variance hedge ratio: h* = slope of regression of asset return (domestic currency) on currency return; Equals ρ × σ(asset) ÷ σ(currency). Use when the exposure is not exactly one-for-one.
Approximate hedged return: R_hedged ≈ R_local + (F − S) ÷ S ≈ R_local + (i_PC − i_BC); Hedging swaps currency risk for the interest-rate difference. It adds return when the domestic (price currency) rate is above the foreign (base currency) rate, and costs return when it is below.
Number of futures contracts: N = (h × foreign exposure) ÷ contract size; Round to a whole number. The rounding leaves a small residual exposure.
Short forward gain or loss at maturity: Gain = (F_0 − S_T) × notional (in PC); A short position in the base currency loses when the base currency rises above the forward price.
Mark-to-market value of short forward before maturity: V_t = (F_0 − F_t) × notional ÷ (1 + i_PC × remaining days/360); F_t is the current forward price for the remaining term. Discount at the price-currency rate.

How to solve Forwards and Futures for Currency Hedging questions

Use this order for any forward or futures currency hedging question. It keeps the quote direction, size and cash flows straight.

1Write the quote as PC/BC and identify the base currency. Your foreign asset makes you long the base currency.
2Decide the hedge direction: sell the base currency forward or sell base currency futures. Check whether the question wants a full, partial or minimum-variance hedge.
3Compute the hedge notional: h × foreign-currency exposure. Use the exposure at the current foreign-currency value.
4Find the forward price: add the forward points to spot, or use covered interest parity. Check the sign of the points against the interest rate gap.
5For futures, divide the notional by the contract size and round to a whole number of contracts.
6Calculate the cash flow at settlement or roll: (F_0 − S_T) × notional for a short forward, or the daily price change × size × contracts for futures.
7State the net effect: unhedged currency gain or loss, plus hedge gain or loss, plus the roll yield implied by the points.
8Close with the recommendation or risk: liquidity needed for settlement, hedge drift as asset values change, and basis risk for futures.

Quickest way: Three-line hedge check

When to use it: Use this when the question asks for a hedge size, a cash flow or a net result and you have little time.

Short the base currency. Notional = h × foreign exposure.
Cash on the hedge = (F_0 − S_T) × notional. Negative means you pay.
Net currency result = exposure × (S_T − S_0) + hedge cash. The hedged part reduces to notional × (F_0 − S_0), which is the points you locked in.

Common mistakes in Forwards and Futures for Currency Hedging

Selling the wrong currency, or reversing the quote direction.
Quotes can be read as PC/BC or BC/PC, and students skip identifying the base currency.
Fix: Write PC/BC first. The foreign asset holder is long the base currency and sells it forward. Check that the result has the price currency units.
Thinking a hedge removes all differences from the unhedged return.
Students treat hedging as free and forget the forward points.
Fix: State that the hedged return is about the local return plus (domestic rate − foreign rate). Hedging costs return when the domestic rate is below the foreign rate, because the foreign (base) currency then trades at a forward discount. It adds return when the domestic rate is above the foreign rate.
Ignoring the cash flow when the hedge settles or rolls.
The gain on the foreign asset is in the portfolio value, so the loss on the forward seems offset.
Fix: Show the cash paid or received at each roll. The offsetting gain is unrealised, so the investor may need to sell assets or hold liquid reserves.
Sizing the hedge on the original asset value after it has moved.
Students use the initial exposure, but the foreign asset value changes during the hedge period.
Fix: Use current foreign-currency value when sizing or rebalancing. Say that the hedge drifts as asset values change and needs adjusting.
Using the wrong scale for forward points or the wrong day count.
Points are quoted in pips and conventions vary by currency pair.
Fix: Divide points by 10,000 (100 for yen pairs) before adding to spot. Use the day count in the question.
Assuming futures give a perfect hedge.
Students carry the forward logic over without noticing the contract size and daily settlement.
Fix: Round to whole contracts, name the residual exposure, and mention basis risk and daily variation margin as the differences from forwards.

Worked examples

Example 1

A USD-based investor holds European equities worth EUR 50,000,000. The spot quote is USD/EUR 1.0800 and the three-month forward points are +27. The investor hedges 80% of the exposure with a three-month forward. At maturity, spot is 1.1000. Calculate the hedge notional, the forward price, the cash settled on the forward and the net currency effect on the portfolio.

Show the solution

Quote is USD/EUR, so EUR is the base currency. The investor is long EUR and sells EUR forward.
Hedge notional = 0.80 × EUR 50,000,000 = EUR 40,000,000.
Forward price = 1.0800 + 27 ÷ 10,000 = 1.0827.
Forward settlement = (1.0827 − 1.1000) × 40,000,000 = −0.0173 × 40,000,000 = −USD 692,000. The investor pays USD 692,000.
Currency gain on the full holding = 50,000,000 × (1.1000 − 1.0800) = USD 1,000,000.
Net currency effect = 1,000,000 − 692,000 = USD 308,000.
Check: unhedged EUR 10,000,000 gains USD 200,000. The hedged EUR 40,000,000 earns the locked-in points: 40,000,000 × 0.0027 = USD 108,000. Total = USD 308,000.

Answer: Notional EUR 40,000,000; forward price 1.0827; the investor pays USD 692,000 at settlement; net currency effect is a gain of USD 308,000. The investor needs USD cash (or must sell assets) because the EUR gain is unrealised.

Example 2

A USD-based portfolio has EUR 20,000,000 of foreign-currency exposure. The regression slope of the portfolio's USD return on the EUR currency return is 0.85. The manager hedges with EUR futures of size EUR 125,000 each. Calculate the number of contracts to sell. If the futures price rises by USD 0.0050 per EUR in one day, calculate the variation margin and say who pays it.

Show the solution

Hedge notional = 0.85 × EUR 20,000,000 = EUR 17,000,000.
Number of contracts = 17,000,000 ÷ 125,000 = 136.
The manager sold futures, so a rise in the futures price is a loss.
Daily loss = 136 × 125,000 × 0.0050 = 17,000,000 × 0.0050 = USD 85,000.
The short futures holder pays variation margin through the clearing process that day.

Answer: Sell 136 EUR futures contracts. The manager pays USD 85,000 in variation margin for that day. The offsetting EUR gain on the portfolio is unrealised, so liquidity must be planned.

Exam tips

Write the quote as PC/BC at the start of every currency question. Most lost marks come from a reversed direction.
When a question gives forward points, convert them with the right scale (10,000, or 100 for yen) before adding to spot.
For a 'discuss' or 'recommend' essay item, name the cash flow at settlement, the roll risk from changing forward points, and the hedge drift. These are the usual three scoring points.
For futures versus forwards, list the contrast in pairs: standardised versus customised, daily versus maturity settlement, exchange clearing versus counterparty risk, whole contracts versus exact notional.
A correct number typed on its own earns full credit for a calculation, so keep working brief; only the number of responses asked for is evaluated, in the order given.

Forwards and Futures for Currency Hedging: frequently asked questions

How do I calculate the hedge ratio for a currency forward?

Divide the forward notional by the foreign-currency value of the exposure. A full hedge has a ratio of 1, and 80% hedged has 0.80. If the asset's value does not move one-for-one with the currency, use the regression slope of the asset's domestic return on the currency return as the ratio.

What is the difference between currency forwards and futures for hedging?

Forwards are customised OTC contracts that settle at maturity and carry counterparty risk. Futures are standardised, exchange-traded and marked to market daily, so they involve variation margin and whole-contract sizes. Futures usually leave a small residual exposure because of rounding and basis.

Why is rolling a forward hedge risky?

At each roll you settle gains or losses in cash, and you lock a new forward price. Cash can be needed while the offsetting foreign gain is unrealised. Changes in interest rates and forward points between rolls also change the cost of the hedge.

Does hedging remove the interest rate difference?

No. The forward price reflects the interest rate difference between the two currencies. The hedged return is roughly the local return plus (domestic rate − foreign rate). The hedge costs return when the domestic rate is below the foreign rate and adds return when it is above. You swap currency risk for that known carry.