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Currency Risk
Risk associated with foreign exchange rate fluctuations
What is Currency Risk?
Currency risk, or exchange rate risk, refers to the exposure faced by investors or companies that operate across different countries, regarding unpredictable gains or losses due to changes in the value of one currency in relation to another.
Formula
To illustrate how the exchange rate can affect an investor operating in a foreign market, consider the following example using the formula:
(1 + rCAN) = (1 + rFM) (1 + rFX)
Where:
- rCAN = Return on the foreign investment in Canadian Dollars
- rFM = Return on the foreign market in local currency
- rFX = Return on the foreign exchange
Example: Foreign Investment Return in Canadian Dollars
- Initial Investment: $35,000
- Initial Exchange Rate: $2.13 / Pound Sterling
- Final Exchange Rate: $1.99 / Pounds Sterling
- Return on British Security Investment (rFM): 11%
Sample Calculation
(1 + rCAN) = (1 + rFM) (1 + rFX)
(1 + rCAN) = (1 + .11) (1 + .9342)
(1 + rCAN) = (1.11) (.9342) = 1.036
rCAN = 3.6%
Key Takeaways
Exchange rate risk is a crucial matter for investors, as unexpected movements in currency exchange rates may erode otherwise high returns or even result in losses. Such a risk can be mitigated by hedging with currency futures, options, or currency hedge funds, if they are available in the market where the investor operates.
To determine whether hedging currency risk is necessary or worthwhile, a few preliminary questions can be asked. For example, an investor might want to evaluate whether or not the costs of hedging are too high, the holding period required for the hedge investment, and the current risk of a decline in a given currency’s relative value, which, in turn, might involve assessing interest rate forecasts between countries.
Additional Resources
Thank you for reading CFI’s guide on Currency Risk. To learn more about career paths and how to break into banking, please see these additional resources:
