Currency risk refers to the possibility that movements in foreign exchange rates could affect the value of a business operation or an investment. Whenever an investment or agreement is made based on one currency, movements of that currency against other currencies can have a significant impact on the value or performance for investors or partners using other base currencies. For example, a US investor choosing to invest in German equities could naturally be happy to see the German market rise by 10% in a particular year. However, should the euro fall in value by 12% against the dollar over the period, the investment would actually have fallen in value in dollar terms, despite rising 10% in euro terms. Nevertheless, currency risk can sometimes work in our favor. Using our example, had the euro risen in value against the dollar, the investor’s returns in dollar terms would have benefitted both from the rise in the German stock market but also by favorable currency movements.
Currency risk can be managed by hedging, a strategy which involves a forward-based transaction to essentially lock in an agreed future currency rate. Though the use of a hedge involves some additional costs, these costs are typically small relative to the potential impact of a major adverse currency move.Checklists
- The Foreign Exchange Market: Its Structure and Function
- Hedging Foreign Exchange Risk—Case Studies and Strategies
- Identifying and Managing Exposure to Interest and Exchange Rate Risks
- Understanding and Using Currency Swaps