What is Currency risk?
Currency risk, commonly referred to as exchange-rate risk, arises from the change in price of one currency in relation to another. Investors or companies that have assets or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses. Currency risk can be reduced by hedging, which offsets currency fluctuations.
Currency risk is the potential risk of loss from fluctuating foreign exchange rates when an investor has exposure to foreign currency or in foreign-currency-traded investments.
Currency risk refers to a risk form arising from the changes price of one currency as compared to another currency. Whenever companies or investors possess assets or business operations across national boundaries, they experience currency risk if their positions are not prevaricated. Currency risk is also referred as exchange rate risk. Putting it simple, currency risk can be defined as the possibility that currency depreciation will show negative effect on the value of assets, investments, and their related interest and dividend payment streams, specifically those securities denominated in foreign currency.
How it works (example)
If a U.S. investor holds stocks in Canada, the realized return is affected by both the change in stock prices and the change in value of the Canadian dollar against the U.S. dollar. If a 15% return on Canadian stocks is realized and the Canadian dollar depreciates 15% against the U.S. dollar, the investor breaks even, minus associated trading costs. Managing currency risk began to capture attention in the 1990s. This was in response to the 1994 Latin American crisis and the 1997 Asian currency crisis.
Currency risk is important to understand because foreign currency exchange rates can drastically change an investor’s total return on a foreign investment, despite how well the investment performed.
Currency risk can also create an opportunity for investors when the interest rates between two countries reflect the expected changes in their exchange rates. For example, if interest rates are higher in Canada, the U.S. dollar will probably drop in value relative to the Canadian dollar. (This is because when interest rates increase in a particular country, international currencies flow into that country to take advantage of the higher yields. This pushes the value of that country’s currency higher.) Currency risk also means that foreign bond investors can increase their exposure to foreign-exchange markets.
Types of Currency risk
Generally, there are three basic types of currency risk:
- Economic risk. The source of economic risk is the change in the competitive strength of imports and exports. For example, if a company is exporting (let’s say from the UK to a eurozone country) and the euro weakens from say €/£1.1 to €/£1.3 (getting more euros per pound sterling implies that the euro is less valuable, so weaker) any exports from the UK will be more expensive when priced in euros. So goods where the UK price is £100 will cost €130 instead of €110, making those goods less competitive in the European market. Similarly, goods imported from Europe will be cheaper in sterling than they had been, so those goods will have become more competitive in the UK market. Note that a company can, therefore, experience economic risk even if it has no overt dealings with overseas countries. If competing imports could become cheaper you are suffering risk arising from currency rate movements.
- Transaction risk. This type of risk is the one related to an unfavorable change in the exchange rate over a certain time period. This arises when a company is importing or exporting. If the exchange rate moves between agreeing the contract in a foreign currency and paying or receiving the cash, the amount of home currency paid or received will alter, making those future cash flows uncertain.
- Translation risk. This risk type is an accounting concept. It is relative to the amount of assets held in foreign currencies. Alterations in exchange rate over a certain period will provide an inaccurate report, and thus the assets are generally balanced by borrowings in the specific currency.
Consequences of Currency risk
Currency risk has been demonstrated to be predominantly significant and damaging for very large, rarity investment projects, generally referred as ‘megaprojects’. This is for the reason that such projects are generally financed by huge debts nominated in currencies distinctive from the currency of the home country of the debt owner. These type of megaprojects have been demonstrated as prone to ending up as what is commonly known as ‘debt trap’ resulting from currency risk, i.e. unexpected changes in the exchange rates.
Reducing Currency Risk
U.S. investors should consider investing in countries that have strong rising currencies and interest rates, as well as to reduce currency risk. Investors need to review a country’s inflation as high debt typically precedes it. This may result in a loss of economic confidence causing a country’s currency to fall. Rising currencies are associated with a low debt-to-gross domestic product (GDP) ratio. As of 2016, the Swiss franc is an example of a currency that is likely to remain well supported due to the country’s stable political system and low debt-to-GDP ratio of 34.40. The New Zealand dollar is likely to remain robust due to stable exports from its agriculture and dairy industry that may contribute to the possibility of interest rate rises. Foreign stocks are also likely to outperform during periods of U.S. dollar weakness. This typically occurs when interest rates in the United States are less than other countries.
Investing in bonds may expose investors to currency risk as they have smaller profits to offset losses caused by currency fluctuations. Currency fluctuations in the foreign bond index are often double a bond’s return. Investing in U.S. dollar-denominated bonds produces more consistent returns as currency risk is avoided.
Currency Hedged Funds
Many exchange-traded funds (ETFs) and mutual funds are currency hedged, typically using options and futures, which reduces currency risk. The rise in the U.S. dollar has seen a plethora of currency-hedged funds introduced for both developed and emerging markets such as Germany, Japan and China. The downside of currency-hedged funds is they can reduce gains and are more expensive than currency-hedged funds. Investors reduced their exposure to currency-hedged ETFs in response to a weakening U.S. dollar in early 2016.
Investing globally is a prudent strategy for mitigating currency risk. Having a portfolio that is diversified by geographic regions effectively provides a hedge for fluctuating currencies. Investors may consider investing in countries that have their currency pegged to the U.S. dollar such as China. This is not without risk, however, as central banks may adjust the pegging relationship, which would be likely to affect investment returns.