The Cost of Hedging and Forward Point Drag

A US investor holding foreign bonds can hedge away the currency risk by selling the foreign currency forward. This removes the exchange-rate gamble, but it is not costless: the forward rate embeds the interest-rate gap between the two currencies, so the hedge itself either drags on returns or adds to them depending on which currency yields more. That steady cost or benefit is forward point drag, and over long holding periods it can matter as much as the yield on the underlying asset.

Where the drag comes from

Covered interest parity ties the forward rate to the two interest rates, so selling a high-yield currency forward locks in a worse exchange rate than spot by roughly that rate gap. A US investor hedging euro-denominated bonds when euro rates are lower than dollar rates actually earns a small pickup from the hedge, since the drag runs in their favor; the reverse happens when the foreign currency yields more than the dollar.

Worked example

A US investor holds $10 million of euro bonds yielding 3.5%. Dollar short-term rates are 5.0%, euro short-term rates are 3.0% — a 2 percentage-point gap. Hedging the euro exposure with a rolling 3-month forward costs roughly that 2% gap per year in forward points, since dollars are the higher-yielding currency and the hedge effectively forces the investor to give up dollar-rate income. Net hedged return is roughly 3.5% (bond yield) − 2.0% (hedging drag) = 1.5%, well below the 3.5% headline yield the bond alone appeared to offer.