Currency Risk – What it is, Samples & How to Manage it

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Currency risk impacts companies and investors alike. It can create unpredictable profits and losses out of the control of involved parties. To mitigate currency risk, two parties may enter a currency risk-sharing agreement, or an investor may seek to compensate for added risk in foreign investments, with a currency risk premium. Market participants exposed to currency risk can mitigate it with derivative contracts, like futures and options, or with Forex.

Understanding the definition of currency risk can help in the deployment of risk management strategies to mitigate exposure. All investors, but particularly those with international exposure must prioritize the mitigation of currency risk when making investment decisions. This is especially true when buying and selling bonds, since gains are significantly smaller for bond investments, which magnifies the impact of currency risk.

Currency risk arises from currency fluctuations and impacts businesses and investors when they convert a foreign currency to their domestic currency. Examples include bond investors receiving coupon payments in a foreign currency or domestic companies with foreign earnings reporting them in their domestic currency.

  • Economic risk: This refers primarily to inflation, GDP, and the debt-to-GDP ratio, which often precedes inflationary pressures and results in notable currency fluctuations
  • Monetary policy risk: This relates to economic and inflationary changes or instances when a foreign currency remains pegged to another currency
  • Transaction risk – This refers to the risk companies face when buying and selling across jurisdictions that have different currencies, and they are paying with their domestic currency
  • Translation risk – This applies to domestic companies with sales in foreign countries who must report earnings in their domestic currency, or international bond investors who receive coupon payments in a foreign currency and convert them to their domestic currency

Currency risk gained momentum during the 1994 Mexican Peso Crisis, where the Mexican government aggressively devalued the Mexican Peso against the US Dollar. The Latin American debt crisis of the 1980s served as a precursor. Most economies carried excessive debt and could not repay it, depressing economic activity, spiking unemployment, and causing a drop in wages and spending power. This resulted in massive currency devaluations and losses for foreign investors related to currency risk.

The 1997 Asian Financial Crisis, sparked by the collapse of the Thai Baht, resulted in a contagion event across Asia except for China. This contagion intensified the focus on currency risk as the global economy became more integrated, creating interdependencies, and the decentralized 24/5 OTC Forex market evolved as a result.

The below currency risk calculation for a British investor buying Canadian securities will illustrate the currency risk definition and actual return.

Assume the following:

  • Initial investment of £10,000
  • GBP/CAD exchange rate at purchase of 1.5500
  • Duration of three years
  • GBP/CAD exchange rate at the end of investment of 1.7500
  • Return on Investment of 12.00%

Therefore:

  • £10,000 (initial investment) x 1.5500 (GBP/CAD exchange rate) = C$15,500 (value of investment in Canadian Dollars)
  • C$15,500 + 12% (ROI) = C$17,360 (value of investment after three years in Canadian Dollars)
  • C$17,360 x 0.5714 (the reciprocal rate, or inverse exchange rate of the GBP/CAD of 1.7500, the rate at the end of investment, calculated as follows: 1 / 1.7500 = 0.5714 CAD/GBP) = £9,920

Conclusion:

  • The ROI in Canadian Dollars was 12.00%
  • Currency risk – in this case, translation risk – resulted in a 0.80% loss for the British investor, as the currency fluctuation was 12.90% versus the 12.00 ROI

Currency risk can cause unexpected losses or profits and remains out of the control of market participants. Understanding the definition of currency risk will allow those involved in cross-currency transactions to deploy currency risk management, demand a currency risk premium, or negotiate a currency risk-sharing agreement.

Bond investors face more significant currency risk exposure, as the ROI remains minimal, while currency fluctuations often exceed returns.

It is equally important to assess the positive opportunities of currency risk, which can improve the final ROI if the investor has analyzed market conditions accurately. 

Businesses and investors can lower currency risk by hedging their exposure to currency fluctuations, diversifying cross-currency portfolios, or limiting cross-currency investments.

  • Evaluating interest rates in both countries is critical, as higher interest rates attract foreign capital, pushing the currency higher
  • Considering inflation and how it may impact monetary policy is important as it has an immediate impact on a currency
  • Analyzing portfolio hedging needs and associated costs is essential for determining if and how much of the investment requires a hedge. Hedging instruments usually consist of options, futures, and Forex, depending on the individual requirements
  • Avoiding investments in countries with volatile currencies due to economic instability and political risk is advisable for risk-averse investors
  • Investing in domestic securities, especially fixed-income, will eliminate currency risk, making diversification essential

Currency risk arises from currency fluctuations and can result in unexpected losses in cross-currency transactions. Market participants must analyze exposure to deploy appropriate currency risk management strategies. Currency risk can turn a profitable return on investment into a realized loss if the currency fluctuation exceeds the ROI. It also impacts operating costs and revenues for multi-national companies.

What are the types of currency risk?

The four primary currency risks are economic risk, or the weakening and strengthening of an economy; monetary policy risk, changes by a central bank; transaction risk, payment across jurisdictions with different currencies, and translation risk, referring to a domestic company conducting business in a foreign country but reporting financial statements in their domestic currency.

How do you determine currency risk?

Some of the most- popular measures to determine currency risk involve evaluating economic indicators, focusing on debt and the debt-to-GDP ratio, inflation and central bank policy, and the stability of the political system.

How does currency risk affect businesses?

Currency risk poses a significant risk as it can negatively impact a business even when the company is executing its business plan and expanding operations. Multi-national companies face transaction and translation risks, while domestic companies that source raw materials globally also face material currency risks.

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