What is Currency Risk?
Currency risk, or exchange rate risk, refers to the exposure faced by investorsInvesting: A Beginner's GuideCFI's Investing for Beginners guide will teach you the basics of investing and how to get started. Learn about different strategies and techniques for trading, and about the different financial markets that you can invest in. or companies that operate across different countries, in regard to unpredictable gains or losses due to changes in the value of one currency in relation to another currency.
To illustrate how exchange rate can affect an investor operating in a foreign marketMarket EconomyMarket economy is defined as a system where the production of goods and services are set according to the changing desires and abilities of the market players. This allows the market to operate freely in accordance with the law of supply and demand, set by individuals and corporations, as opposed to governments., 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%
(1 + rCAN) = (1 + rFM) (1 + rFX)
(1 + rCAN) = (1 + .11) (1 + .9342)
(1 + rCAN) = (1.11) (.9342) = 1.036
rCAN = 3.6%
This is an important matter for investors, as unexpected movements in currency exchange rates might erode otherwise high returns or even result in losses. Exchange rate risk can be mitigated by hedging with currency futures, options, or currency hedge funds if they happen to be available for the market the investor is operating in.
To decide whether or not 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.
Currency Risk related readings
- Forex Trading – How to Trade the Forex MarketForex Trading - How to Trade the Forex MarketForex trading allows users to capitalize on appreciation and depreciation of different currencies. Forex trading involves buying and selling currency pairs based on each currency's relative value to the other currency that makes up the pair.
- Exchange RatioValuationFree valuation guides to learn the most important concepts at your own pace. These articles will teach you business valuation best practices and how to value a company using comparable company analysis, discounted cash flow (DCF) modeling, and precedent transactions, as used in investment banking, equity research,
- Types of Markets – Dealers, Brokers, ExchangesTypes of Markets - Dealers, Brokers, ExchangesMarkets include brokers, dealers, and exchange markets. Each market operates under different trading mechanisms, which affect liquidity and control. The different types of markets allow for different trading characteristics, outlined in this guide
- Investing: A Beginner’s GuideInvesting: A Beginner's GuideCFI's Investing for Beginners guide will teach you the basics of investing and how to get started. Learn about different strategies and techniques for trading, and about the different financial markets that you can invest in.
