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.
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:
- Unclear objectives for risk management
- Lack of performance benchmarks
- Making investment decisions based solely on foreign market forecasts
- Use of complex derivatives for hedging
- Ignoring hedging opportunities and other risk-reduction options
- Confusion surrounding currency of denomination and currency of determination
- 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.