Trades have occurred between nations around the world for a very long time, despite their different currencies. Therefore, countries found a way to judge the value of their currency in relation to another, establishing a standard exchange rate in the process. This standard and other terms related to it are referred to as currency risk. In addition, currency risk has for long affected businesses and activities of investors, causing unexpected losses or profit accordingly.
What is currency risk?
Currency risk is simply the risk surrounding the change in the price of a currency with respect to another. Also, it is known as exchange rate risk (signifying the changes in the value of each currency at exchange). In addition, currency risk majorly affects foreign investments, especially when the origin country does not share the same currency with the country it invested in. Therefore, more often than not, this leads to unexpected losses or profit depending on the rise or fall in currency values.
As a result of the nature of currency risk, most investors tend to make use of buffers like options contracts, forex, futures to hedge the risk. Examples of these investors include hedge funds, multinational corporations, and mutual funds. In all, currency risk is simply the tendency of losing money as a result of sudden movements in exchange rates.
How do you hedge currency risk?
There are four major ways through which investors manage and mitigate currency risks. They are:
investors can simply manage currency risk by investing in international countries with rising currency. For example, if an investor from the US purchases a bond predominated in Euros, he has to convert USD to EUR at the current exchange rate. Therefore, during the period of investment, the bond value stays as Euros and appreciates or depreciated accordingly.
Finally, when it’s time to sell off the bond, the investor converts EUR back to USD at the current exchange price. In essence, whichever way it goes, he would realize the difference between the different exchange rates. However, this could still result in a loss or gain.
Hedging currency risk with ETFs:
the exchange-traded funds function more or less like international investing. Therefore, the ETFs focuses on providing short (sell) and long (buy) exposures to several currencies. In doing so, the currency could experience losses or gains depending on the exchange rate.
this is simply an agreement to buy or sell a currency at a certain exchange rate in the future. Therefore, this means that changes in currency exchange value would not lead to more cost on the investors’ part, as they keep the previous agreement. Also, forward contracts can be customized to include specific amounts and date. Furthermore, the settlement date is usually a working business day in both countries.
lastly, currency options simply provide investors with the right to purchase or sell a currency at a particular rate. However, they are not obligated to, and they have to make a choice on or before a specific date. In addition, the agreement mostly comes with a cost for such flexibility in form of an upfront fee that the investor pays. This fee is called a premium.
As an investor, you have to be wise and intentional about hedging currency risks in order to avoid losses. However, it is left to you to choose the means that best fits. Also, keep in mind that currency risks can cause significant losses when neglected.