Exchange rate movements impact returns when a change in the value of one currency against another currency leads to a rise or fall in the value of an asset. When an investor buys a domestic asset, the only variable is whether that asset increases in value. But if they invest abroad, they will have to consider the impact of an exchange rate too. The basic function of this is relatively simple: when a local currency depreciates, it can buy less of a foreign currency, decreasing its purchasing power. And when a local currency appreciates, it can buy more of a foreign currency, increasing its purchasing power.
For example, let’s say you want to invest in a (fictitious) French clothing company, Paris Prints. Shares of the company are trading at €50 – so at the current EUR/GBP exchange rate of 0.9004, you’d be paying £45.02 (50 x 0.9004) for the stock. If you bought 100 shares, your initial outlay would be £4502.
Although the value of the asset has not changed, the local currency has depreciated, so foreign investments are more expensive to purchase. This dynamic means whenever an exposure exists to a foreign currency denominated asset, currency risk exists and needs to be managed.
Discover what the best instrument for hedging is
An important consideration to make when managing currency risk is that by opening forex positions to balance foreign exchange exposure, you’re taking on the risk of these additional positions. There will be different requirements for hedging forex positions themselves.
While less conventional, one way to hedge foreign exchange risk is by investing in a specialised currency exchange traded fund (ETF). In principle, a currency ETF functions just like any other ETF, but rather than holding stocks or bonds, it holds currency cash deposits or derivative instruments tied to an underlying currency, which mirror its movements. For example, the ProShares UltraShort Euro ETF or the Invesco DB US Dollar Index Bullish Fund.
A trader can go long or short on these ETFs, depending on the required hedge, to protect the value of an investment or cash flow from a currency’s (or multiple currencies’) volatility.
A contract for difference (CFD) is a derivative that can be used to hedge foreign exchange risk – to open a CFD position, the trader is not required to own the underlying currency. A CFD hedge works because you are agreeing to exchange the difference in price of an asset – in this case currency – from when the position is opened, to when it is closed. If the market moves in the direction the trader predicted, they would profit and if it moved against them, they would lose.
A CFD position can be used to offset the currency exposure of the asset being hedged. Because CFDs are a leveraged product, only a small amount of capital is required to enter the hedge. Furthermore, the hedge can be closed via cash settlement, limiting the potential financial outlay of the trade.
A forward exchange contract (FEC) is a derivative that enables an individual to lock in an exchange rate in the present for a predetermined date in the future. The benefit of a forward is that it can protect an individual’s assets from exchange rate movements by locking in a precise value now. The cost or benefit of buying a forward is known at its purchase, with the forward exchange rate calculated by discounting the spot rate using interest rate differentials.
An option gives the right, but not the obligation, to exchange currencies at a pre-determined rate on a pre-determined date. There are two types of options: puts and calls. A put option protects an option buyer from a fall in a currency, while a call option protects an option from a rally in the currency. The benefit of such a strategy is that, for a premium, an individual can protect themselves from adverse movements.
Currency risk can rapidly erode profits, especially in times of high volatility. As a result, when exposing oneself to overseas markets, whether that be through a traditional investment, a sale of a property, a commercial purchase, or receiving income, a view needs to be taken about currency risk. Some may feel comfortable with the risk of exchange rate volatility, and wish to try to take advantage of it. Others would prefer not to have such uncertainty. In any event, the risks associated with foreign exchange ought to be considered to ensure one’s personal objectives are not compromised.
To start hedging currency risks, there are a few steps every trader should follow. These are: