What Exactly Is Currency Risk?

Currency risk, also known as currency exchange-rate risk, originates from a change in the value of one currency in comparison to another. Currency risk exposes investors and firms with assets or commercial activities across national boundaries to unpredictable earnings and losses. To hedge risk, many investment banks, such as mutual funds and hedge funds, as well as multinational organizations, utilize options contracts, futures, forex, or other derivatives.

Currency Risk Described

Currency risk management gained prominence in the 1990s as a result of the Latin American crisis in 1994, when several nations in the area had foreign loans that exceeded their earning capacity and ability to repay. The Asian currency crisis of 1997, which began with the economic meltdown of the Thai baht, placed currency exchange-rate risk front and center in the years that followed.

Hedging, which counters currency changes, can help to decrease currency risk. If a US investor holds Canadian equities, for example, the realized return is impacted both by the changes in stock markets and the valuation of the Canadian currency relative to the US dollar. If Canadian equities earn a 15% return and the Canadian dollar remains stable.

While investing in foreign equities is beneficial to your long-term portfolio, it continues to bring new risks to investors. As more people diversify their investment portfolios by adding overseas bonds and equities, they should accept the risk of currency changes.

Currency fluctuations, whether in the country’s currency or even the foreign exchange, can either increase or decrease the profits on international investments. Currency is important in investing; keep reading to learn about various techniques for mitigating its impacts.

Assume your international investment portfolio had a 12% return rate last year, but your local currency loses 10% of its value. In this situation, converting your gains to US dollars will increase your net return since a falling currency makes overseas investments more appealing. However, if a foreign stock falls but the worth of the country’s currency rises significantly, the gains on the foreign position are further dampened.

Currency Risk Examples

To mitigate currency risk, US investors could consider investing in nations with rapidly increasing currency and interest rates. However, investors should consider a country’s inflation because excessive debt usually precedes inflation. This can lead to a loss of traction, causing a country’s currency to plummet. Rising currencies are connected with a low debt-to-GDP ratio.

Because of the nation’s stable political structure and low debt-to-GDP ratio, the Swiss franc is an example of a currency that is expected to stay well supported. The New Zealand currency is projected to continue strong due to solid agricultural and dairy exports, which may add to the potential for interest rate hikes. Occasionally, foreign equities outperform during moments of U.S.

Despite the perceived risks of international investment, an investor can limit the risk of loss from currency changes by offsetting with currency futures. Simply put, hedging is the act of taking one risk to offset another. Futures contracts are orders to sell or purchase an asset—in this example, a currency—in advance. An investor who expects to receive cash flows in a foreign currency at some point in the future can lock in the present exchange rate by taking an offsetting currency futures position.

Speculators in exchange rates purchase and sell currency exchange futures contracts in order to profit from fluctuations in exchange rates. According to how they feel the currency will perform, investors may make long or short bets on it. As an example, if a speculator feels the euro will climb against the US dollar, they will enter into an agreement to purchase the euro at a future date. This is known as a long posture. On the other hand, you could claim that the exact same speculator has gone short on the US currency.

This hedging method has two possible outcomes.

If the speculation is accurate and the euro appreciates versus the dollar, the contract’s value will climb as well, and the speculators will benefit. 

Nevertheless, if the euro falls against the dollar, the contract’s value falls. So, for example, you may purchase a fund that trades nearly entirely in Japanese or European companies, and it then hedges on your behalf the exposure. 

WisdomTree, for example, provides the Europe Hedged Equity Fund (HEDJ), which invests in dividend-paying Eurozone businesses that are often exporters. Then it uses its own hedges to reduce its euro currency risk. It also has a Japan-focused fund (DXJ) as well as other options. Under the iShares brand, wealth manager BlackRock also provides comparable hedged equity funds.

When you sell or buy a futures contract, the price of the item (in this case, currency) is determined presently, but payment is delayed until later. Investors that trade currency futures are required to put up cash margin, and the contracts get marked to market on a daily basis, so losses and gains on these contracts are computed daily. 

Hedging of currencies can also be done by another method. Rather than setting up a value transfer for a future date, you can purchase the currency at the current price right away. In both cases, you end up spending the same amount of money, but in one case, you don’t really pay for the item up front.

Bond investing may subject investors to currency risk since bonds have lower earnings to cover losses due to currency volatility. Currency swings in an international bond index can quadruple the return on a bond. Investing in bonds denominated in US dollars generates more consistent profits since currency risk is eliminated. Meanwhile, investing abroad is a wise method for avoiding currency risk, since having a profile that is geographically diverse offers a hedge against currency fluctuations. Investors may want to explore investing in nations whose currencies are tied to the US dollar, such as China. This is not without danger, since central banks may modify the peg relationship, thereby affecting investor results.

Investment in exchange-traded funds is another strategy to reduce currency risk. The Standard & Poor 500 index is a compilation of hundreds of America’s biggest firms, but it’s also a strategy to diversify your currency risk exposure. While these firms are American, they earn a large share of their profits and revenue outside of the country, implying that they balance their major emphasis on American sales with a large amount of overseas sales. Many of these firms additionally hedge part or all of their positions.

This geographic balance, although imperfect, serves as a natural buffer against currency risk. It’s also relatively simple and affordable to invest in an index fund based on the Standard and Poor’s 500.

Many ETFs focus on offering short (sell) and long (buy) exposure to various currencies. ETFs are funds that maintain a portfolio of assets or investments, which may include currency holdings that profit or lose based on changes in the existing currency’s exchange rate.

In other words, the fund moves in the reverse direction of the EUR/USD exchange rate. This type of fund can be used to reduce a portfolio’s susceptibility to the performance of the euro.

Many ETFs and unit trusts are designed to mitigate currency risk by hedging with FX, options, or futures contracts. Indeed, the growth of the US dollar has resulted in the introduction of a slew of currency-hedged funds for both emerging and developed economies, such as China, Japan, and Germany. The disadvantage of currency hedged funds is that they can diminish earnings while being more expensive than non-currency hedged funds.

As an alternative to its less costly flagship foreign funds, BlackRock’s iShares has its own series of currency-hedged ETFs. In reaction to a sinking US dollar, investors began decreasing their investment in ETFs that are currency hedged in early 2016, a trend that has since persisted and resulted in the closure of a variety of such funds.

An ETF Hedge Example

For instance, if an investor pays 100,000 euros for an item in Europe, the dollar cost will be $110,000 at a EUR/USD conversion rate of $1.10. When the investor transfers the € back into dollars if the EUR/USD currency falls to $1.05, the dollar equivalent is only $105,000. The move downward in the USD/EUR currency exchange rate would benefit the EUFX ETF, compensating the losses from the currency exchange linked with the asset acquisition.

The Advantages and Drawbacks of ETF Hedge

The currency value associated with the first asset would be effectively cancelled out by the ProShares Short Euro Fund. Obviously, the investor must acquire a suitable quantity of the ETF to ensure that the short and long euro exposures are equal.

ETFs that concentrate in short or long currency exposure seek to replicate the performance outcome of the currency on which they focus. However, real performance frequently differs owing to funding mechanisms. As a consequence, not all currency risks would be eliminated. Furthermore, monetary system ETFs can be costly, with a usual 1% fee.

Conclusion

Investing in foreign equities has a definite advantage when it comes to portfolio creation. Foreign equities, on the other hand, have distinct risk characteristics that US-based stocks do not. As investors extend their foreign interests, they may choose to employ certain hedging measures to protect themselves against continued currency changes. There’s no shortage of investing options available today to assist you in effortlessly achieving your goal.

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