What Is Currency Risk?
Currency risk is commonly referred to as exchange-rate risk. It 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 multinational corporations and institutional investors such as hedge funds and mutual funds 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 as well as major multinational corporations hedge currency risk in the forex market and with derivatives like futures and options.
- Investing globally is a solid strategy for mitigating currency risk.
Understanding Currency Risk
The possibility of managing currency risk began to capture attention in the 1990sin response to the 1994 Latin American crisis. Many countries in that region held foreign debt that exceeded their earning power and ability to repay.
The 1997 Asian currency crisis that began 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, 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. The investor breaks even minus associated trading costs if a 15% return on Canadian stocks is realized and the Canadian dollar depreciates 15% against the U.S. dollar.
$805 billion
The global foreign exchange market size as of 2023.
Examples of Currency Risk
U.S. investors can consider investing in countries that have strong rising currencies and interest rates to reduce currency risk. They should review a country’s inflation, however, because high debt typically precedes inflation. This can result in a loss of economic confidence that 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's 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. This typically occurs when interest rates in the United States are lower than in other countries.
Investing in bonds can expose investors to currency risk because bonds 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.
Investing globally is a prudent strategy for mitigating currency risk because a portfolio that's diversified by geographic regions provides a hedge for fluctuating currencies. Investors might consider investing in countries that have their currency pegged to the U.S. dollar, such as China. This isn't without risk, however, because central banks may adjust the pegging relationship. This would be likely to affect investment returns.
Special Considerations
Many exchange-traded funds (ETFs) and mutual funds are designed to reduce currency risk because they're hedged. This is typically accomplished by using forex, options, or futures. The rise in the U.S. dollar has prompted numerous currency-hedged funds that have been introduced for developed and emerging markets including Germany, Japan, and China. The downside of currency-hedged funds is that they can reduce gains and they're more expensive than funds that aren't currency-hedged.
BlackRock's iShares offers a line of currency-hedged ETFs as an alternative to its less-expensiveflagship international funds. Investors began reducing their exposure to currency-hedged ETFs in response to a weakening U.S. dollar in 2016. The trend has continued and has led to the closures of several such funds.
What Is the Safest Currency?
The Swiss Franc (CHF) is considered to be one of the safest currencies in the world. It's frequently used as a safe-haven asset. The Australian dollar, the U.S. dollar, and the Norwegian Krone are also thought to be reliable forex investments.
What Causes Currency Values to Change?
Currency prices change in response to shifting demand for a country's goods and products. The value of a country's currency will increase if its goods are in high demand in the world market and traders import those goods. Conversely, the value of its currency will weaken if a country experiences falling demand for its exports.
How Do Businesses Protect Against Currency Risk?
Businesses engaged in cross-border trade may expose themselves to currency risk. This 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
Currency risk in international trade is the risk traders assume when they make 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.
