Currency risk is part of investing internationally and should not be scary. We discuss what currency risk is, whether we should hedge it, and the costs involved in doing so.
- What is Currency Risk?
- How Currency Risk affects us
- How Currency Risk is Hedged
- Costs of Hedging Currency Risk
- Currency Risk by Asset Class
- Should we Hedge our Currency Risk?
1) What is Currency Risk?
Whenever we own assets denominated in a currency other than our domestic currency, we are exposed to currency risk. For example, if we live in the United Kingdom, the Pound is our currency. Therefore, if we invest in US, Japanese or European stocks, we will be exposed to currency risk.
It is a risk worth taking in most situations, thanks to the potential returns and diversification possibilities offered by foreign markets. If we could only invest in assets in our own country, our choices would be severely limited, and the outcome would be much worse.
2) How Currency Risk affects us
Currency risk can affect us both negatively and positively. Every time the exchange rate between our domestic currency and the currency of our investments moves, we are exposed to potential gains and losses.
A European investor with money invested in the US’s S&P 500 index is exposed to the exchange rate between the euro and the US dollar. If the European currency strengthens against the dollar, that investor will experience a loss. Conversely, if the euro weakens against the dollar, those investments in the United States will now be worth more in euros.
Exchange rates can be quite volatile. It is not uncommon to see movements of 10% or more in a matter of a few months. And that is something we must understand and accept, especially if we want to be in control of our emotions. Imagine, as a European investor, buying a US stock, seeing it rise 5%, while at the same experiencing a 10% loss in the exchange rate.
Someone who invests in many global markets will be exposed to a multitude of currencies. With an ETF tracking the MSCI World or MSCI Emerging Markets indices, for example, which contain stocks from tens of countries, we will own assets from all over the world and denominated in various currencies.
Although global indices tend to be denominated in US dollars, the actual currency exposures are a lot more varied. The MSCI World contains stocks denominated in Japanese Yen, Pounds Sterling, Euros, Swiss Francs, etc. In the case of the MSCI Emerging Markets, we will encounter stocks denominated in Chinese Yuan, Indian Rupees, Brazilian Reais, etc.
With multiple currencies in our portfolio, our P&L will be moving constantly, even if some of those stocks are not trading. But this should discourage us from investing abroad.
3) How Currency Risk is Hedged
Currency risk can be hedged with financial derivatives. In most cases, the currency hedge is carried out with an FX forward. An FX forward is a financial contract that allows us to exchange money in the future at an agreed exchange rate.
If the exchange rate between the euro and the US dollar (EUR/USD) is 1.15, it means one euro is worth 1.15 US dollars. This would be the exchange rate for a transaction today today. But we can also buy US dollars in the future. For example, the 6-month exchange rate can be $1.16 per euro. Therefore, we could agree with a counterparty to buy US dollars 6 months from now at an exchange rate of $1.16.
The possibility of fixing the exchange rate for some of our investments means that we can reduce our currency risk. This is likely to reduce the volatility of our investment portfolio.
These derivative contracts are used by institutional investors and fund manager. They are not usually available to retail investors. But it is critical for everyone to understand how they work.
For retail investors interested in hedging their currency risk, the solution is to invest in a fund that automatically hedges the currency risk. There are many fund management companies that offer the same funds in different versions, both hedged and unhedged.
For example, we could invest in the MSCI World in an unhedged fashion, or in the MSCI World with all currency risk hedged for an investor whose domestic currency is the Euro.
As you can imagine, if an investment fund invests in assets denominated in multiple currencies and hedges all that currency risk, the management fees will be slightly higher.
4) Costs of Hedging Currency Risk
Now that we have seen how currency risk is hedged, let us discuss the cost of hedging for investors. There are three types of costs that we must assume:
4.1) Forward Exchange Rate
As we have seen in the previous section, financial derivatives allow us to exchange currencies in the future by fixing the exchange rate today. But the exchange rate for a future date will rarely be the same as for today. And it is essential to understand how future exchange rates, known as forward exchange rates, are set.
Forward exchange rates are set based on the interest rate differential between the two currencies. If interest rates were exactly the same, the forward exchange rate would be the same as the spot rate. The spot rate is the exchange rate for exchanging money today.
When it comes to setting forward exchange rates, the currency with lower interest rates will be more expensive for forward rates than for spot rates. The currency with higher interest rates will become gradually cheaper.
In the case of the euro and the US dollar, the European currency tends to have lower interest rates. Therefore, the EUR/USD forward exchange rate will be higher than the spot exchange rate. For example, if the spot rate is $1.10, the forward rate for exchanging money in 12 months might be $1.12.
I know this can be unintuitive. How can it be that the currency with lower interest rates will be more expensive in the future? The reason why it has to be like this is that, otherwise, investors would be able to make risk-free money.
Let me explain to you how forward rates are fixed with a simple example. I made the numbers to illustrate the mechanics of forward rates:
- EUR/USD spot exchange rate: 1.15
- Interest rates in euros: 2%
- Interest rates in US dollars: 4%
- If we invest €100 today, we will have €102 in one year (interest of 2%)
- If we invest $115 today (equivalent to €100), we will have $119.6 (interest of 4%)
- So that we cannot take advantage of the market, buying US dollars today and buying US dollars a year from now fixing the exchange rate today, should be equivalent.
- For that reason, €102 in one year should be the same as $119.60.
- The exchange rate today to exchange currencies in one year should be 119.60/102= $1.1725
That does not mean that is going to be the spot rate one year from now. The spot exchange rate fluctuates constantly. And so do interest rates. Based on the movements of the spot rate and interest rates in both currencies, forward exchange rates are also constantly fluctuating. Nevertheless, once we have entered into an FX forward transaction, the forward rate will be fixed.
What does the calculation of forward rates tell us?
If our currency has lower interest rates than other currencies, hedging currency risk will be expensive. Why? Because, as we have just seen, the cost of buying our currency at a forward exchange rate will be more expensive than doing so at the spot exchange rate.
Consequently, for investors whose domestic currency is the Euro, the Japanese Yen or the Swiss Franc, all currencies that tend to have low interest rates, hedging currency risk from investments denominated in US dollars will cost them money.
The opposite would be the case for US investors with investments in Europe or Japan. They could lock in more favorable forward exchange rates than the spot rate.
4.2) Management Costs
At the same time, if we invest in funds that hedge currency risk, management costs are likely to be a bit higher. This is because fund managers must carry out an additional activity.
Hedging currency risk makes it necessary for someone to monitor and execute the necessary financial derivatives transactions. That additional cost will translate with slightly more expensive fees.
4.3) Lower Potential Returns
Finally, we must emphasize that hedging currency risk also has an opportunity cost. If the future exchange rate has been fixed, you will no longer be able to benefit from movements that go in your favor.
Think about the following situation. You are a European or Japanese investors with assets in the United States. Since you were afraid that the US dollar could fall in value, you have decided to hedge your currency risk. But it turns out that the US dollar is up 10% against your currency. Unfortunately, you will not be able to benefit from it.
Owning assets denominated in foreign currency is also a source of diversification for your investment portfolio. Hedging currency risk also means we are giving up that benefit.
5) Currency Risk by Asset Class
Regardless of the asset classes in which we invest, we will be exposed to currency risk whenever we own assets denominated in foreign currencies. However, it must be clarified that currency risk does not affect all asset classes equally:
It is very popular to own stocks from all over the world. Everyone likes to invest in the best companies. And these can be in the United States, Switzerland, Germany, Japan or any other country. For that reason, being exposed to currency risk is something natural for most equity investors.
We will illustrate the currency risk in stocks by using Apple as example. Apple is one of the largest companies in the world by market capitalization. It is an American company, listed in the United States, and selling its products all over the world.
Apple’s stock is denominated in US dollars. That means that, if we are in Europe or Japan, we will suffer a loss if the US dollar weakens against the Euro or the Yen, since the stock price in euros or yen will be lower.
Nonetheless, if the US dollar weakens, the profits that Apple makes overseas will now be worth more in US dollars. Consequently, the company will report an increase in profits. That will help push the stock price higher, offsetting the loss we experience due to the exchange rate.
Similarly, if the US dollar strengthened a lot, we would experience a gain, since those Apple shares would now be worth more in Euros or Yen. However, a stronger US dollar also means that Apple’s profits overseas will now be worth less in US dollars. This will negatively affect its bottom line and put downward pressure on the stock price.
As you can see, for companies that sell their products internationally, the exchange rate is relatively unimportant when it comes to investing in their stock. It is true that, in the short term, the currency can play an important role. But in the long run things return to their equilibrium. The important thing is not the currency in which a stock is denominated, but whether the company is able to make profits and grow.
The exception to this rule would be companies that sell their products and services (almost) exclusively in a single country. These domestic stocks would expose us to greater currency risk, since a drop in the value of their currency would not be offset by an increase in profits overseas.
5.2) Government Bonds
In this section, we will focus on government bonds issued in the currency controlled by that country. These bonds have no risk of default since, in an extreme situation, the government would be able to use the central bank to print the money and avoid declaring bankruptcy.
Leaving aside bonds issued by emerging countries in their own currencies, which tend to have greater potential but also much more risk, government bonds of developed countries tend to be negatively correlated with their currencies.
That means that when the currency falls, bonds go up in price, and vice versa. Consequently, the currency risk in this case is generally lower.
This negative correlation between the strength of the currency and bond prices can be explained by interest rates. Higher interest rates tend to be good for the value of a currency. If interest rates go up, the currency will strengthen, but bond prices will drop, since bond prices and interest rates are negatively correlated.
5.3) Corporate Bonds
Corporate bonds are quite different from sovereign bonds. They are exposed to default risk. After all, companies, unlike governments, do not have a central bank that can print money.
Business failures tend to increase when there is an economic downturn. That means corporate bond prices are likely to go down if there is a recession. At the same time, a recession is usually negative for the country’s currency.
For this reason, corporate bond prices and the value of the currency tend to be positively correlated. If we own foreign corporate bonds and want to hedge the risk of a worst-case scenario, it can make sense to hedge our currency risk. We do not want the price of our corporate bonds go down at the same time that the currency in which they are denominated is dropping in value.
5.4) Commodities and Gold
Commodities (natural resources) and gold are generally quoted and traded in US dollars. However, they can be considered global assets. Their value is not really tied to the US dollar. It is all about the value of our currency relative to that asset. Let us analyze that for both oil and gold:
In the case of oil, it is an energy source produced and consumed all over the world. The US dollar is just the currency in which transactions take place.
In July 2008, oil reached an all-time high of $147 per barrel. That extreme price spike occurred while the US dollar was at a very weak level. If we were to look at the price of oil in Euros or Yen, the price increase would not have been as dramatic as the media portrayed it:
Regarding gold, we can refer to it as another currency. In fact, gold has been money for more than 5,000 years. Therefore, even though gold is generally quoted in US dollars, the only exchange that matters is between gold and your domestic currency.
A higher gold price means less confidence in a national currency, since more investors prefer to own the safe haven asset.
6) Should we Hedge our Currency Risk?
In my opinion, it is best not to hedge our currency risk in most situations, since the cost of hedging is likely to outweigh the benefits of doing so. However, there are situations in which it can make sense. That is why I will distinguish between the short and the long term.
If we are investing for the short term, hedging our currency risk can make sense. This is because short-term foreign exchange rate fluctuations may take time to be reflected in stock prices.
We have already seen that a fall in the US dollar can be positive for Apple’s share price in US dollars, as that makes its profits abroad more valuable when translated into US dollars. However, that is something that does not usually happen immediately.
For this reason, if we want to reduce the risk of our short-term investments, doing so by hedging currency risk can be a good option.
In the long term, I think hedging currency risk is of little value. This is because, if you invest in a diversified way, the gross return of those hedges should average 0. Therefore, the net result is likely to be negative since hedging currency risk is not free.
If you really invest for the long term, choose the markets you want to invest in and be patient. For example, if you want to own global stocks, you can invest in ETFs tracking the MSCI World and MSCI Emerging Markets indexes. You immediately own stocks from almost a hundred currencies. Do not worry too much about currency risk from then on.
I hope you will now be able to identify what currency risk is, how it can affect you in the short term, and what its effect is in the long term. This will allow you to take better investment decisions to optimize the returns of your portfolio and, potentially, lower the risk.
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