Currency Risk

Currency risk, also called exchange-rate risk, is the risk that movements in the exchange rate between two currencies change the value, measured in an investor's home currency, of an asset or cash flow denominated in a foreign currency. For a U.S. investor who owns European or Japanese stocks, the return in dollars has two moving parts: how the investment does in its local currency, and how that currency moves against the dollar. A gain in the local market can be amplified, reduced, or entirely erased by the currency move, and a local loss can likewise be softened or deepened. Currency risk is separate from the performance of the underlying asset; it is a layer added on top by the act of investing across a currency boundary.

Any cross-border investment carries currency risk because its value must eventually be converted back into the investor's home currency to be spent. An unhedged international stock fund, for example, passes both the local-market return and the currency movement straight through to the U.S. investor's dollar return. Over short periods currency swings can dominate the local investment return entirely; over long periods they tend to be a smaller, though never negligible, part of the picture. Currency risk cuts both ways: a falling home currency raises the value of foreign holdings, while a rising one erodes them, so it is a source of two-directional variability rather than a guaranteed cost. Investors who want the foreign asset exposure without the currency exposure can use currency-hedged funds or share classes, which use forward contracts or similar instruments to neutralize exchange-rate movements. Hedging removes the currency swing but introduces its own costs and can itself lose money when currencies move favorably, so it is a trade-off rather than a free improvement. Currency risk is one reason a globally diversified portfolio behaves differently from a purely domestic one, and it interacts with the tendency many investors have to overweight their own country, known as home-country bias. There is also a modest tax dimension: foreign investments can generate foreign income and foreign taxes withheld at the source, which a U.S. investor may be able to offset with the foreign tax credit, though that is a separate matter from the currency movement itself.

The home-currency return on a foreign investment combines the local return with the change in the exchange rate.

A hypothetical example. A U.S. investor buys a European stock when the euro is worth $1.10.

• The investor converts $11,000 into 10,000 euros and buys the stock.
• Over the year the stock rises 10 percent in local terms, to 11,000 euros.
• If the euro has fallen to $1.00, the position is worth $11,000, a 0 percent dollar return despite the 10 percent local gain: the currency move exactly offset it.
• If instead the euro had risen to $1.20, the 11,000 euros would convert to $13,200, a 20 percent dollar gain, as the currency move added to the local gain.

The stock did the same thing in Europe in both cases. The difference in the investor's outcome came entirely from the exchange rate, which is currency risk in action.

Pros (of accepting unhedged currency exposure)

• Currency movements can add to returns, and holding foreign currencies provides genuine diversification away from a single home currency.
• Leaving exposure unhedged avoids the ongoing cost and complexity of hedging.

Cons

• It adds a layer of variability that has nothing to do with how the underlying investment performs, and it can erase an otherwise good local return.
• Currency moves are notoriously hard to forecast, so the exposure is close to unpredictable in the short run.
• Hedging it away is possible but not free, carrying its own costs and the chance of losing money when currencies move favorably.