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 Explained
Managing currency risk began to capture attention in the 1990s in 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, and the 1997 Asian currency crisis, which started with the financial collapse of the Thai baht.
Currency risk can be reduced by hedging, which offsets currency fluctuations. 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.
Reducing Currency Risk
To reduce currency risk, U.S. investors should consider investing in countries that have strong rising currencies and interest rates. Investors need to review a country’s inflation as high debt typically precedes it. 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 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 lower 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. 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.
Many exchange-traded funds (ETFs) and mutual funds are designed to reduce currency risk by being currency hedged, typically using options and futures. 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-expensive flagship 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.