What Is Exchange Rate Risk?
Exchange rate risk, or foreign exchange (forex) risk, is an unavoidable risk of foreign investment, but it can be mitigated considerably through hedging techniques. To eliminate forex risk, an investor would have to avoid investing in overseas assets altogether. However, exchange rate risk can be mitigated with currency forwards or futures.
- The exchange rate risk is caused by fluctuations in the investor’s local currency compared to the foreign-investment currency.
- These risks can be mitigated through the use of a hedged exchange-traded fund or by the individual investor using various investment instruments, such as currency forwards or futures, or options.
- Exchange rate risk isn’t completely avoidable but it can be mitigated.
How Exchange Rate Risk Works
For the U.S. investor, hedging exchange rate risk is particularly important when the U.S. dollar is surging since the risk can erode returns from overseas investments. For overseas investors, the reverse is true, particularly when U.S. investments are performing. This is because the depreciation of the local currency against the USD can provide an additional boost to returns. In such situations, since the exchange rate movement is working in the investor's favor, the appropriate course of action is to go unhedged.
The rule-of-thumb, with regard to foreign investments, is to leave the exchange rate risk unhedged when the local currency is depreciating against the foreign-investment currency but to hedge this risk when the local currency is appreciating against the foreign-investment currency.
Here are two ways to mitigate forex risk:
- Invest in hedged assets: The easiest solution is to invest in hedged overseas assets, such as hedged exchange-traded funds (ETFs). ETFs are available for a wide range of underlying assets traded in most major markets. Many ETF providers offer hedged and unhedged versions of their funds that track popular investment benchmarks or indexes. Although the hedged fund will generally have a slightly higher expense ratio than its unhedged counterpart due to the cost of hedging, large ETFs can hedge currency risk at a fraction of the hedging cost incurred by an individual investor. For example, for the MSCI EAFE index—the primary benchmark for U.S. investors to measure international equity performance—the expense ratio for the iShares MSCI EAFE ETF (EFA) is 0.31%. The expense ratio for the iShares Currency Hedged MSCI EAFE ETF (HEFA) is 0.69.
- Hedge exchange rate risk yourself: Investors most likely have some forex exposure if their portfolio contains foreign-currency stocks or bonds or American depositary receipts (ADRs). A common misconception is that their currency risk is hedged, but that is not the case.
You can hedge currency risk using one or more of the following instruments:
- Currency forwards: Currency forwards can be effectively used to hedge currency risk. For example, assume a U.S. investor has a euro-denominated bond maturing in a year's time and is concerned about the risk of the euro declining against the U.S. dollar in that time frame. The investor can enter into a forward contract to sell euros (in an amount equal to the maturity value of the bond) and buy U.S. dollars at the one-year forward rate. While the advantage of forward contracts is that they can be customized to specific amounts and maturities, a major drawback is that they are not readily accessible to individual investors. An alternative way to hedge currency risk is to construct a synthetic forward contract using the money market hedge.
- Currency futures: Currency futures are used to hedge exchange rate risk because they trade on an exchange and need only a small amount of upfront margin. The disadvantages are that they cannot be customized and are only available for fixed dates.
- Currency ETFs: The availability of ETFs that have a specific currency as the underlying asset means that currency ETFs can be used to hedge exchange rate risk. This is probably not the most effective way to hedge exchange risk for larger amounts. However, for individual investors, their ability to be used for small amounts and the fact that they are margin-eligible and can be traded on the long or short side leads them to provide major benefits.
- Currency Options: Currency options offer another feasible alternative to hedging exchange rate risk. Currency options give an investor or trader the right to buy or sell a specific currency in a specified amount on or before the expiration date at the strike price. For example, currency options traded on the Nasdaq are available in denominations of EUR 10,000, GBP 10,000, CAD 10,000 or JPY 1,000,000, making them well-suited for the individual investor.
Exchange rate risk cannot be avoided altogether when investing overseas, but it can be mitigated considerably through the use of hedging techniques. The easiest solution is to invest in hedged investments such as hedged ETFs.
The fund manager of a hedged ETF can hedge forex risk at a relatively lower cost. However, an investor who holds foreign-currency stocks or bonds, or even American depository receipts (ADRs) should consider hedging exchange rate risk using one of the many avenues available such as currency forwards, futures, ETFs or options.