Currency risk arises from exchange rate moves between pairs of currencies. If you have investments or assets in a foreign country with a different currency, you face currency risk, unless the foreign currency is pegged to your domestic currency or your exposure is hedged.
A simple example shows how currency risk affects your returns.
Let’s suppose you’re an American investor and you put $10,000 into a European stock market tracker.
Your investment is not hedged, and so you’re exposed to changes in the exchange rate between the dollar and the euro. That is, you’re exposed to currency risk.
Suppose over 12 months the European market and therefore your tracker goes up 20% in local euro terms:
- If the dollar and the euro is at the same exchange rate after 12 months as when you made your investment, your holding is now worth $12,000. (i.e. $10,000 increased by 20%).
- Say the dollar appreciated by 25% versus the euro over 12 months. Your holding would be worth $9,600 (12,000 / 1.25). i.e. Your euro position now buys fewer dollars.
- Say the dollar depreciated by 25% versus the euro over 12 months. Your holding would be worth $16,000 (12,000 / 0.75). i.e. Your euro position now buys more dollars.
As you can see, currency risk can dramatically affect your returns, ranging from magnifying your gains to turning gains into losses in your own currency. The basic rule is:
- When the foreign currency strengthens versus your own currency, your overall return goes up
- When the foreign currency weakens versus your own currency, your overall return goes down
Currency risk and businesses
Any business that operate across territories using different currencies faces currency risk. Different businesses will be hurt and helped in different ways from exchange rate moves.
Some examples:
- If you’re a British manufacturer and your main market is Europe, you will benefit when the pound weakens. The euros you receive in return for your goods will be worth more pounds so profits increase, and/or your goods become more competitive due to their lower price in euro terms. The opposite happens when the pound strengthens.
- What if instead your main market is America – but you also use lots of raw materials that are priced in dollars? You will still benefit as above if your local currency depreciates versus the dollar, but some or all of the gains will be wiped out by the extra cost of buying raw materials with more expensive dollars.
- An international company operating in lots of different currency regions may find these exchange rate moves broadly roughly each other out.
- Companies sometimes hold debts in foreign currencies. An unhedged move in the exchange rate can greatly increase their debt burden if they service the debt via a different currency.
Companies often hedge exchange rate exposure to try to remove currency risk. The theory is they should concentrate on the actual business they’re good at, rather than have a side business in currency trading.
However hedging does cost money, and the wrong call can reduce a company’s profits.
Dealing with currency risk when investing
Opinion is divided as to whether currency risk is a good thing. There is some academic evidence that exposure to currency risk does not reward investors with higher returns.
Hedging away the currency risk has its own problems, however. For a start, it costs money, whether born by you as an investor or company, or in the shape of higher costs if investing via a fund.
Moreover some notable investors believe that currency risks can be ignored if investing in overseas equities for long periods. Sir John Templeton, the grandfather of investing in overseas markets, believed currency movements were neutral over the long-term when investing in equities.
Overseas bond funds are usually hedged though, because the shorter life of bonds reduces the time for currency affects to even out.
Not all foreign investments expose you to currency risk, especially if you’re an American investor. Many emerging market countries have currencies pegged to the dollar. This means their currencies rise and fall with the dollar, so currency risk can be ignored by U.S. investors putting money there.
Hedging as a side product of an investment
Some investments are inherently hedged. Suppose you’re a U.S. investor, and you buy shares in AstraZeneca, the UK-listed drugs giant.
The value of your investment is determined by: a) the performance of the AstraZeneca share price, and b) currency risk.
The currency-related danger for you as a U.S. investor is that the pound falls versus the dollar after you’ve made your investment.
Suppose you buy $1,000 worth of Astra shares at an exchange rate of $2 to £1. You’d have £500 in Astra shares.
Now imagine after some years the pound falls to parity with the dollar, so £1 is worth $1. If the Astra share price stayed the same over the period, you’d have only $500 when you sold up and brought your money back into dollars. You’d have lost $500 due to the change in the exchange rate.
However the Astra share price would be very unlikely to stay the same, because Astra does most of its business in dollars. As the dollar strengthened towards parity with the pound, the dollars that Astra made overseas would be worth more pounds when repatriated back home.
Astra’s earnings and profits would thus rise in pound terms purely from this exchange rate change, and the share price would rise accordingly, potentially canceling out for U.S. investors the loss from the exchange rate change.
