Currency risk impacts positions in foreign companies. Find out the different ways you can protect your portfolio, including using CFDs to hedge FX.
What is currency risk?
Currency risk – also known as foreign exchange risk – is the negative impact that fluctuating exchange rates can have on a portfolio. When investing in foreign assets, the currency movements of your domestic country and the target country will increase or decrease the return on the asset itself.
How does currency risk impact a stock portfolio?
Currency risk can diminish the value of a stock portfolio both at the point of buying new shares or selling an existing holding.
When you either convert your domestic capital into the foreign denomination to make the investment or convert the foreign returns into your domestic currency, it’s possible your capital could be worth more or less.
Currency risk example
Say you want to invest $1,000 into a UK company. At the time you first think about the purchase, the exchange rate is 1.2, so each UK pound is the equivalent of 1.2 US dollars. This means your investment would buy £833 worth of shares.
But you decide to wait a week. Although you still want to invest $1,000, the exchange rate has changed to 1.24. This means that the same capital would now only be worth £806.
How to manage currency risk
Some traders and investors might try to avoid currency risk by only investing in domestic assets, but a diversified portfolio is an important hedging technique because spreading assets out can improve the odds that a fall in one market or asset class can be offset by better performances in others.
Avoiding currency risk isn’t necessarily good practice. So, market participants need to learn how to manage their currency risk, ensuring they’re comfortable with the possibilities before putting their capital into overseas assets.
Here are a couple of techniques.
Currency hedging involves opening a new position that offsets the risk to an existing trade.
A common type of hedge is a forward agreement, which is an agreement to swap a certain amount of currency at today's exchange rate on a given date in the future. These are usually carried out by firms and large-scale commodity investors.
For example, a UK manufacturer is contracted to deliver £10 billion worth of products to an Australian company two years from today.
The customer has agreed to pay 18 billion Australian dollars for the products, rather than UK pounds. This means that if the Australian dollar depreciates by the time the contract is fulfilled, the UK manufacturer would be given less than anticipated.
To hedge the risk, the UK manufacturer contacts a bank and agrees to swap those 18 billion AUD for 10 billion GBP two years from now. This type of swap will usually cost a fee.
There are several ways individuals can employ hedging strategies too, such as via CFDs, options and futures. All of these derivatives enable traders to speculate on the future value of a market – whether it will rise or fall.
But it’s always important to remember that as hedging involves opening multiple new trades, often with leveraged instruments, you are opening yourself up to different types of market risk. For example, when trading CFDs, although leverage can magnify your profits, it can magnify your losses too.
Another means of hedging against currency risk is currency-focused ETFs. Exchange traded funds (ETFs) trade on an exchange like a stock. But currency-hedged ETFs hold foreign stocks or bonds alongside currency-forward contracts to mitigate the risk of fluctuations.
These ETFs won’t cancel out currency risk completely, as there’s always the risk that both the instruments and the hedges lose money. Another downside of using currency ETFs is that you might have to pay more to trade them, as they typically have a higher expense ratio than other types of ETFs.
Currency risk sharing
Currency risk sharing is an agreement between two parties to mutually hedge against the risk of exchange-rate fluctuations. They’d enter a contract to adjust the price of their transaction if the exchange rate fluctuates outside of a chosen range.
If the transaction is settled outside of that band, the two parties would split the profit or loss. This creates a situation in which neither party in the transaction benefits at the expense of the other.
These agreements are not standardised like other types of contracts, so they’re very much dependent on the counterparties’ terms. Normally these counterparties are companies or institutions, rather than individual investors.