5.1.5 Currency Hedging

What currency hedging actually does

A hedged international fund uses financial instruments specifically designed to substantially offset the effect of currency movement, aiming to deliver a return closer to the foreign market's own local-currency performance, largely stripped of the additional currency effect. An unhedged fund makes no such attempt, meaning the investor's actual rupee return combines both the foreign market's own performance and whatever currency movement happened to occur over the same period.

Currency hedging is the practice of neutralising the effect of exchange rate movements on an international investment. When an Indian investor buys a US equity fund, the return has two components: the dollar return of the underlying stocks and the rupee-dollar exchange rate movement. Currency hedging removes the second component, locking in the return in rupee terms regardless of how the exchange rate moves.

The trade-off inherent in each choice

Hedging generally reduces the added volatility that comes specifically from currency movement, but it also carries its own ongoing cost, and it can occasionally forgo a favourable currency movement that would otherwise have added meaningfully to returns. Leaving currency exposure unhedged accepts additional variability in exchange for potentially benefiting from favourable currency moves, while equally being exposed to unfavourable ones.

The cost of hedging is determined by the interest rate differential between the two currencies. Indian interest rates have historically run above US rates, though the size of that gap varies considerably over time, from around 1.5-2% in some periods to 4-5% in others. Hedging the rupee-dollar exposure costs roughly this differential, because the hedge involves borrowing in the higher-rate currency (rupee) and lending in the lower-rate currency (dollar). This means hedging an international equity position effectively converts it into a rupee-denominated position, but at an annual cost equal to whatever that differential happens to be.

For long-term investors, this cost is significant and, given the rupee's historical depreciation trend, likely unnecessary. If the rupee tends to depreciate over time against the dollar, the unhedged investor captures this as additional return. Paying the differential to hedge away an exposure that has historically been beneficial is economically unattractive over long horizons. Hedging makes more sense for short-term international positions or for investors who need to protect a specific rupee value at a specific date.

There is no universally correct default here

Whether hedging is worthwhile depends on an investor's own view of likely currency direction over their relevant time horizon, and on how much of that added currency-driven variability they are comfortable accepting on top of the underlying foreign market's own return. Most retail international funds available in India are, in practice, unhedged, which is simply a fact worth being aware of rather than something to be surprised by later.