Currency Risk: What Is It?
Many U.S. investors never consider the impact that changes in foreign exchange rates can have on their investments. Currency risk refers to the potential for gains or losses resulting from the fluctuations between various currencies. It's the possibility of losing money due to unfavorable moves in exchange rates.
Currencies tend to have free-floating exchange rates set by market forces, though in some cases, they can be tied to a currency where the price is close to that of another country.
The two main systems used to determine a currency's exchange rate are floating currency and pegged (fixed) currency. The market determines a floating exchange rate based on supply and demand, which is in turn driven by foreign investment, import/export ratios, inflation, and a host of other economic factors. A currency is worth whatever buyers are willing to pay for it.
In the 1930s, the U.S. set the value of the dollar at the value of 1 ounce of gold, which was worth $35. This was known as the gold standard. Eventually, due to inflation and other factors, the value of the U.S. dollar was officially reduced so that 1 ounce of gold was now worth $70. The dollar's value was cut in half.
For investors, currency risk commonly arises from the ownership of foreign stocks in one's portfolio. If an investor who holds a U.S. brokerage account that owns foreign stock, sees a sudden decline in that country's currency, those stocks will suddenly decline in value in U.S. Dollar.
The most obvious sort of currency risk is from foreign exchange losses. This happens when a company sells in a foreign market and then the value of the local currency there declines, or when a company buys in a foreign market and then the value of the local currency there rises.
To reduce currency risk, investors can consider investing in countries that have strong rising currencies and interest rates. In addition, there are currency-hedged exchange-traded funds which can take currency risk out of the equation.
Currency markets represent one of the oldest forms of financial transactions and foreign exchange rate risk is just something you have to deal with in a global economy. But, there are measures you can take to reduce the risks involved and make it easier to handle any risk that remains.
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