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.
BREAKING DOWN 'Currency Risk'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.
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.