Currency Exposure: What It Is and How to Guard Against It

How can the exchange rate between two currencies affect your investments? Global currency values are volatile, and if you’re not careful, fluctuating exchange rates can take chunks out of your overseas holdings. This is currency exposure, and you need to protect yourself against depreciation caused by the constantly fluctuating global exchange market. The last thing you want is to see your investment lose money, not due to poor performance but an unlucky turn of international exchange rates.

This guide will help make sure you know everything you need to about currency exposure, including what it is, three ways it can affect your investments, and strategies to minimize your risk.

What Is Currency Exposure?

Currency exposure refers to the vulnerability of an investment based on the exchange rate between two currencies. It can affect anyone who has investments priced in another country’s currency. The value of currency can depreciate suddenly, and that can lead to the depreciation of investments. People who invest in multiple currencies can see the value of their investments fall if even one of these currencies depreciates unexpectedly.

The number of currencies involved in an investment can impact its depreciation over time. Investors who account for currency exposure in their foreign investments are well-equipped to guard against this risk.

3 Types of Currency Exposure

As with any industry, understanding the basics of currency exposure can go a long way in making sure you’re creating a sound investment strategy that will be as lucrative as possible going forward. There are three types of currency exposure any investor should guard against:

1. Transaction exposure

Transaction exposure occurs when exchange rate fluctuations affect a company’s obligations to make or receive payments in a foreign currency.

2. Translation exposure

Translation exposure occurs due to currency fluctuations on a company’s consolidated financial statements when it has foreign subsidiaries.

3. Economic exposure

Economic exposure occurs as a result of unexpected currency fluctuations on a company’s future cash flows and market value.

There is no telling when any of these risks could impact your investments. Investors who develop and implement risk mitigation strategies can protect against all three types of currency exposure.

Currency Exposure Risk Mitigation Strategies

There are several strategies for mitigating the risk of currency exposure in an investment. Here are three of the best ways to protect yourself:

1. Hedging Risk With Exchange-Traded Funds (ETFs)

ETFs contain multiple securities or investments that include currency valuation gains or losses based on exchange rates. Some ETFs provide long (buy) and short (sell) exposures to currencies to hedge against current rate changes. They are designed to match the performance of currencies included in the funds.

2. Forward Contracts

A currency forward contract serves as an agreement in which two parties buy or sell a currency at a specified exchange rate and future date. It enables an investor to lock in at a country’s current exchange rate to hedge against the risk of depreciation.

3. Currency Options

A currency option lets an investor buy or sell a currency at a specific rate on or before a specific date. The option requires the investor to pay an upfront premium, but it does not require the investor to engage in a transaction when the option’s expiration date arrives.

These strategies deliver varying results, depending on the investment and the currencies involved. There are also several things investors can do to guard against currency exposure, regardless of which strategy they use.

foreign currency to avoid currency exposure

What is Currency Risk?

Currency risk, also known as exchange rate risk or foreign exchange (FX) risk, is the potential for losses that may arise from fluctuations in the foreign exchange rate. Currency exposure can occur when an investor or business holds assets or liabilities denominated in a currency other than their domestic currency.

When the value of one currency rises against another, those who hold assets in the weaker currency could suffer losses while those holding assets in the stronger currency would experience gains. Therefore, investors and businesses that have substantial international activities should be aware of this inherent volatility and take steps to manage their exposure to it. Here are some key points to consider:

• Currency exposure involves potential losses and gains due to changes in foreign exchange rates.

• It affects investors and businesses with international activities, particularly those dealing with multiple currencies simultaneously.

• These risks can be managed through hedging strategies such as forward contracts, options contracts or futures contracts; diversifying investments; or by entering into long-term contracts with counterparties denominated in a single foreign currency.

• In addition to these strategies, investors and businesses should review their financial statements regularly and monitor changes in economic conditions that might affect their exposure to FX risk.

• Understanding the nature of FX risk is essential for successful international investing and doing business abroad.

7 Ways to Minimize the Risk of Currency Exposure

Currency exposure must be accounted for in any investment strategy that involves foreign currencies. Some of the best ways to minimize this risk in an investment strategy include:

1. Evaluate the Global Market

Look at countries’ debt and inflation levels. The currencies of countries with low debt tend to be more profitable than those with high debt. There is often a direct correlation between countries with high inflation and declining currency valuations as well.

2. Analyze the Risks of Foreign Bonds

Bonds have low gains to offset currency losses and are increasingly susceptible to currency exposure. Some foreign bonds have currency fluctuations at plus or minus 10%, making these investments exceedingly risky. Investors in the market for bonds may benefit most from ones issued in U.S. dollars, which can be more stable than foreign options.

3. Prioritize Currency-Hedged ETFs

Currency-hedged ETFs tend to be less volatile than traditional ETFs. They can be found nearly anywhere in the world and limit the risk of losses.

4. Establish a Diverse Portfolio

Make investments in foreign securities in multiple regions rather than focusing exclusively on investments in one section of the globe. A diverse investment portfolio can help you consistently hedge against currency volatility.

5. Move Beyond Foreign Markets

Resist the urge to put all of your investments into foreign markets. It often helps to start slow and build up your foreign investments to guard against currency exposure.

6. Watch the Foreign Markets Closely

Know your investments and keep an eye on the foreign markets associated with them. You can watch for market patterns and update your portfolio as needed based on currency exposure dangers.

7. Partner With a Wealth Management Specialist

Choose a wealth management specialist that provides custom-tailored financial planning solutions. This specialist can teach you about currency exposure and help you find ways to get the most value out of your foreign investments.

The aforementioned tips can help you protect your foreign investments. They can also help you develop an effective foreign exchange risk management strategy.

7 Pitfalls of a Poor Foreign Exchange Risk Management Strategy

There is risk with any investment, particularly those that involve foreign currencies. You must understand foreign exchange risk management before you select foreign investments. This ensures you can avoid the pitfalls of a poorly developed and executed foreign exchange risk management strategy. These pitfalls can include:

  1. Unclear objectives for risk management
  2. Lack of performance benchmarks
  3. Making investment decisions based solely on foreign market forecasts
  4. Use of complex derivatives for hedging
  5. Ignoring hedging opportunities and other risk-reduction options
  6. Confusion surrounding currency of denomination and currency of determination
  7. Failure to account for market volatility due to the coronavirus (COVID-19) pandemic or other global crises

Currency exposure can be problematic, especially for investors who lack foreign investment expertise. Choosing an experienced wealth management specialist can make a world of difference in managing these risks to your foreign investments.

Contact an Expert for Answers to All Your Currency Exposure Questions

A wealth management specialist can review your short- and long-term financial goals and offer a personalized plan to mitigate currency exposure risks in your portfolio. This type of specialist will also share their knowledge and insights regarding foreign investments, so you can make an informed decision.

Bogart Wealth can teach you about currency exposure and the dangers associated with it. We also provide custom strategies to help guard against currency exposure and similar issues for all of our clients. Contact Bogart Wealth today to reduce your exposure.

Please remember that past performance is no guarantee of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Bogart Wealth, LLC [“Bogart Wealth”]), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Bogart Wealth. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Bogart Wealth is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Bogart Wealth’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request or at www.bogartwealth.com
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