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.
Many institutional investors, such as hedge funds and mutual funds, and multinational corporations use forex, futures, options contracts, or other derivatives to hedge the risk.
Key Takeaways
- Currency risk is the possibility of losing money due to unfavorable moves in exchange rates.
- Firms and individuals that operate in overseas markets are exposed to currency risk.
- Institutional investors, such as hedge funds and mutual funds, as well as major multinational corporations, hedge currency risk in the forex market, and with derivatives like futures and options.
Currency Risk Explained
Managing currency risk began to capture attention in the 1990sin response to the 1994 Latin American crisis when many countries in that region held foreign debt that exceeded their earning power and ability to repay. The 1997 Asian currency crisis, which started with the financial collapse of the Thai baht, kept the focus on exchange-rate risk in the years that followed.
Currency risk can be reduced by hedging, which offsets currency fluctuations. If a U.S. investor holds stocks in Canada, for example, the realized return is affected by both the change in stock prices and the change in the 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.
$2.4 quadrillion
The total value of the global foreign exchange market, as of 2020.
Examples of Currency Risk
To reduce currency risk, U.S. investors can consider investing in countries that have strong rising currencies and interest rates. Investors need to review a country’s inflation, however, as high debt typically precedes inflation. This may result in a loss of economic confidence, which can cause a country’s currency to fall. Rising currencies are associated with a low debt-to-gross domestic product (GDP) ratio.
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. The New Zealand dollar is likely to remain robust due to stable exports from its agriculture and dairy industry which may contribute to the possibility of interest rate rises. Foreign stocks sometimes outperform during periods of U.S. dollar weakness, which typically occurs when interest rates in the United States are lower than in 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 a foreign bond index often double a bond’s return. U.S. investors can expect more consistent returns from U.S. dollar-denominated bonds because these instruments have lower currency risk.
Meanwhile, investing globally is a prudent strategy for mitigating currency risk, as having a portfolio that is diversified by geographic regions 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.
Special Considerations
Many exchange traded funds (ETFs) and mutual funds are designed to reduce currency risk by being hedged, typically using forex, options, or futures. In fact, 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 that they can reduce gains and are more expensive than funds that aren't currency-hedged.
BlackRock's iShares, for example, has its own line of currency-hedged ETFs as an alternative to its less-expensiveflagship international funds. In early 2016, investors began reducing their exposure to currency-hedged ETFs in response to a weakening U.S. dollar, a trend that's since continued and has led to the closures of a number of such funds.
What Is the Safest Currency?
The Swiss Franc (CHF) is considered one of the safest currencies in the world and is frequently used as a safe-haven asset. The Australian dollar, U.S. dollar, and Norwegian Krone are also considered reliable forex investments.
What Causes Currency Values to Change?
Currency prices change in response to shifting demand for a country's goods and products.If a country's goods are in high demand in the world market, the value of that country's currency will increase as traders import those goods. Conversely, if a country experiences falling demand for its exports, the value of its currency will weaken.
How Do Businesses Protect Against Currency Risk?
Businesses engaged in cross-border trade may expose themselves to currency risk. This risk can be alleviated by specifying local currency as their transaction currency, or by using forward contracts to set an exchange rate for future transactions.
The Bottom Line
In international trade, currency risk is the risk that traders assume by making transactions in foreign currency. Exchange rates tend to fluctuate over time, and businesses can lose value if they hold a weakening currency. Certain hedging strategies can help alleviate this risk.
