What is Currency Risk?
Currency risk, or exchange rate risk, refers to the exposure faced by investors 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 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%
(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.
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