Currency Risk, sometimes referred to as exchange rate risk, is the possibility that currency depreciation will negatively affect the value of one’s assets, investments, and their related interest and dividend payment streams, especially those securities denominated in foreign currency. The exchange risk arises when there is a risk of significant appreciation of the domestic currency in relation to the denominated currency before the date when the transaction is completed.
Corporations with operations in overseas markets are also exposed to currency risk since their foreign financial results must be consolidated into the company’s home currency. Corporate treasurers and investment managers, particularly with larger multi-national firms where the risk is material, attempt to manage this risk with various hedging techniques where appropriate. Typically, a Treasury Policy exists that states that currency risk must be mitigated where economically justified by using a specified list of financial instruments that may be employed for the purpose. Generally, a combination of forex forwards and options allow the company to fix country risk within acceptable levels as along as premiums are reasonable. These hedging techniques are not consistently effective, but diversification into many major currencies can help limit this risk.
Investors or companies that have assets or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses. Managing currency risk began to capture attention in the 1990s in response to the 1994 Latin American crisis, when many countries in that region held foreign debt that exceeded their earning power and ability to repay, and the 1997 Asian currency crisis, which started with the financial collapse of the Thai baht.
Currency risk can be reduced by hedging, which offsets currency fluctuations. If a U.S. investor holds stocks in Canada, the realized return is affected by both the change in stock prices and the change in value of the Canadian dollar against the U.S. dollar. If a 15% return on Canadian stocks is realized and the Canadian dollar depreciates 15% against the U.S. dollar, the investor breaks even, minus associated trading costs.
To reduce currency risk, investors should consider investing in countries that have strong rising currencies and interest rates. Investors need to review a country’s inflation as high debt typically precedes it. This may result in a loss of economic confidence, which can cause a country’s currency to fall. Rising currencies are associated with a low debt-to-gross domestic product (GDP) ratio. The Swiss franc is an example of a currency that is likely to remain well-supported due to the country’s stable political system and low debt-to-GDP ratio.