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Currency risk

Currency risk arises from the potential change in price of one currency with another.

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.

Suppose you’re an American investor and you put $10,000 into a European stock market tracker fund. The fund 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.

Let’s say that over the next 12 months the European stock 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 first made your investment, your holding is now worth $12,000. (i.e. The $10,000 investment 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.
  • What if the dollar depreciated by 25% versus the euro over 12 months? Your holding would now 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, 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 operates across different territories that use different currencies will face currency risk. 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 you’re based in the UK, your main market is America – but you also use lots of raw materials priced in dollars? Here you will still benefit if your local currency depreciates versus the dollar, but some or all of the gains will be wiped out because of the extra cost of buying raw materials with more expensive dollars.
  • A multinational firm operating in lots of different countries may find these exchange rate moves broadly cancel 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 deal with currency risk. The theory is they should concentrate on their proper business, rather than have a side business in currency trading.

However hedging does cost money, and a poor call can make a big dent in profits.

Dealing with currency risk when investing

So much for business, what about the likes of us one-man investing bands?

Opinion is divided as to whether currency risk is a good thing for us. There is some academic evidence that exposure to currency risk does not reward investors with higher returns. Others argue it increases diversification and so reduces risk, on top of the usual benefits of investing overseas.

Hedging away the currency risk – which comes built into some funds and ETFs – has its own snags. It costs money, whether born separately by you as an investor, or in the shape of higher costs via a hedged fund. You also give up potential rewards, which is always the unarguable price of hedging but still annoying when it happens.

Some notable investors believe currency risks can be ignored if investing in overseas equities for long periods. Sir John Templeton, the grandfather of far-flung investing, believed currency movements were neutral over the long-term when investing in equities.

Overseas bond funds are usually best hedged though – 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 danger for you as a U.S. investor is that the pound may fall versus the dollar after you’ve made your investment.

Let’s say you buy $1,000 worth of Astra shares at an exchange rate of $2 to £1. You have £500 in Astra shares.

Now suppose that after some years the pound falls to parity with the dollar, so £1 is worth $1.

If the AstraZeneca share price stayed the same over the period, you’d have only $500 when you sold up and brought your pound sterling 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 if the exchange rate changed like this, 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 to the UK.

Astra’s earnings and profits would thus rise in pound terms purely from this exchange rate change, and its share price would almost certainly rise too.

For US investors, such a rise in the share price could potentially cancel out for U.S. investors the loss from the exchange rate change!

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{ 12 comments… add one }
  • 1 Steve Mac July 4, 2013, 1:28 pm

    So, I want to invest in emerging markets because those countries are growing, while this happens I expect their share prices to increase.

    If those countries are doing better than my country (hence the reason for investing there), can I expect their currency to strengthen against my home currency. Does this create a double whammy for returns; once from the rising share prices and once from the strengthening foreign currency?

  • 2 The Investor July 4, 2013, 4:36 pm

    @Steve — If your rising securities are denominated in a strengthening currency, then yes, that would give you a double whammy of returns, all things being equal. Be wary of investing in emerging markets solely because you think their economies are going to grow better, however. There’s little evidence that higher GDP leads to higher stock returns, and some evidence to the contrary — perhaps because investors overpay for that expected growth, for example, or perhaps because some share of it is ‘captured’ by local workers, governments, etc.

    There are other reasons to invest in emerging markets of course, such as the fact they look fairly cheap compared to their historical averages at present.

  • 3 ermine July 4, 2013, 10:52 pm

    Currency risk also helps you against the thieving barstewards of one’s own government who are devaluing the currency. Step forward one Mervyn King, who is responsible for most of the nominal gain in my pension AVCs, which were invested in a FTSE100:Global 50:50 fund

    I chose the global mix specifically to try and soften some of the hit of that devaluation. Indeed, w.r.t. the UK I’d say academic studies be damned, we are a special case already. The UK will reduce its debts by devaluing the money even more, as our handsome new rock star at the BoE has intimated.

    If you’re holding over decades I guess there’s some case to be made that these things come out in the wash to be neutral.

  • 4 dearieme July 4, 2013, 10:53 pm

    Index-linked gilts give lousy returns because (i) interest rates are low, and (ii) the rules pretty much require pension funds to buy large amounts, forcing up prices and therefore lowering yields.

    So might it not be worth considering trying to offset UK inflation by buying currencies that you expect to rise against the pound while the pound loses value because of the UK inflation rate? You’d have to guess a few currencies to diversify across, of course, but I wonder whether it would be easy to beat the return on short duration ILGs.

  • 5 The Investor July 4, 2013, 11:21 pm

    Currency markets are among the deepest, most efficient and most liquid markets in the world. Also the most humbling. “Easy” isn’t a word to use lightly in this context! 😉

  • 6 Jon July 5, 2013, 2:03 am

    As you approach retirement and live in the UK I think you need to be careful that your portfolio is not too biased towards currency risk. Makes sense to have your core assets denominated in sterling. You need hard earned £ to spend in ole’ blighty.

  • 7 Neverland July 5, 2013, 9:59 am

    If you’re trying to minimise costs hedging doesn’t make sense

    Philisophically (sp?) I don’t bother with hedging for the reasons already outlined by Ermine and Steve Mac

    Most of my equity investments are outside the UK because the rest of my personal economic situation is very much tied to the UK and I want to diversify my risk

    Exposure to the strength or weakness of overseas currencies is just part of that diversification

    In passing I’ll say we face an interesting medium term future for sterling as BoE (and the ECB) seem to have decided to fight the Fed in keeping monetary policy loose when the Fed is moving to a tightening stance

    I can only see two outcomes that are possible really, which aren’t mutually exclusive: UK gilt rates rise anyway; or the pound falls more against the dollar

  • 8 Roger July 5, 2013, 11:22 am

    It is for this very reason that i have my eye on South Africa. On present forex rates it is a buy but may become cheaper in the future.

  • 9 John July 5, 2013, 12:43 pm

    Agree with Jon above – in the UK you need sterling

  • 10 dearieme July 5, 2013, 9:32 pm

    Then how to protect yourself from inflation?

  • 11 The Investor July 5, 2013, 10:45 pm

    @dearieme — Personally I think your suggestion to diversify overseas to reduce the risk of inflation hitting your net worth in Sterling terms is fine for some of one’s money.

    So I’d happily put say 20% of even a spending-mode Sterling-orientated retirement portfolio overseas in equities in various different currencies, to protect against the worst fears of the inflationists.

    It’s when people start talking in their Doomsday way about “get all your money out of here” or “put it all into gold” or suggesting there’s an easy one-shot (or even two or three-shot 😉 ) solutions that my “hang on a minute!” radar goes up.

    In my view, there’s no secret — one has to diversify against all outcomes, especially when not earning anymore and relying on saving. Currency is part of that but so is assets, duration, even legal and tax diversification (e.g. the ISA and SIPP discussion we’re having on the other thread).

    Any single silver bullet is going to be to a greater or less extent a gamble. When I’m into wealth preservation mode, I’ll do what the wealthy family houses do, and spread it about.

  • 12 Mark July 9, 2013, 3:30 pm

    I have been considering expanding into trading within the US, and your article has explained a lot of monetary queries that I had. Another well-considered and concise article – thank you. Now just to hope to avoid further “roller coaster” fluctuations in the near future. Ah, one can dream.

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