3 Strategies for Mitigating Currency Risk with International Investments

While investing in international assets provides great diversification for your portfolio, it also comes with risks, from country risk to currency risk. While some foreign securities may be issued in your native currency, the likelihood that all are is low. As long as some assets in your portfolio are issued in a foreign currency, you are exposed to currency risk. This is the risk associated with the value of currencies relative to each other. The exchange rate may change in such a way that your foreign assets are suddenly worth more, or the shift could sharply limit the returns from your investment. Many investors simply accept currency risk and hope that their returns are not negatively affected. However, there are also ways to mitigate this risk.

1. Using Exchange-Traded Funds to Hedge Currency Risk

One strategy for hedging currency risk involves exchange-traded funds (ETFs). You will find ETFs that offer both long and short exposures to most currencies. The funds are a basket of investments that include currency positions which will gain or lose according to changes in the exchange rate. You can use these funds to balance the position you have with your existing investments. For example, if you invest in a security issued in euros, you could also purchase an ETF that works inversely to the value of the euro relative to your currency. In other words, if you invest in something that will lose money if the euro loses value, then you could also invest in an ETF that gains when the euro loses value. However, this hedge could also reduce any gains you would see if the euro ended up increasing in value.

There are several limitations to trying to hedge in this way. First, you need to find an ETF with the appropriate exposure that has investments you feel comfortable with. Then, you need to be able to invest in that ETF in a way that matches your exposure to the foreign currency 1 to 1. Also, you must know that the mechanics of the fund may not make it operate as intended all the time, which means that some risk remains. Furthermore, ETFs based on currency tend to be among the most expensive and can charge high fees, which eats into your gains.

2. Using Currency Forward Contracts to Mitigate Currency Risk

You can also consider currency forward contracts to mitigate currency risk. These contracts are essentially an agreement to buy or sell a currency at a certain exchange rate and a specific time in the future. With a forward, you can lock into a specific exchange rate for a currency. In general, you will need to put a deposit down with a currency broker to purchase a forward contract. This makes the most sense when you plan to hold foreign assets for a specific amount of time. You can purchase a forward to lock in your conversion rate at the time you expect to sell, which reduces the risk you face in this situation. Of course, this can always work against you if the exchange rate moves in such a way that you would actually gain through the conversion since you are locked into a different conversion rate. 

The above scenario is the biggest risk with currency forward contracts. In general, you should only lock into this contract if you expect that the conversion rate will move in a way that does not favor you or if you need to eliminate this variability from the equation. You will also need to find another party willing to enter the forward contract with you. Depending on the current political situation, this could be quite difficult, and you may need to accept a different exchange rate than you wanted to get the contract. 

3. Using Currency Options to Reduce Currency Risk

The third option you have for controlling currency risk is a currency option. An option gives you the right but not the obligation to sell a currency at a specific rate on a predetermined date. These contracts do not force a sale like forward contracts. 

However, you will need to pay a premium for this convenience. The premium is an upfront fee for the contract. With an option, you can choose not to do the exchange if the conversion rate changes in such a way that you gain value. Remember that this deal is only worth it if the premium is less than the amount that you gain with the change in conversion rate. The premium is lost money, so an option only makes sense if you think that the conversion rate could change enough to make it worth it.

Of all the strategies listed, options are the riskiest since they require you to make an international investment that earns a gain, and you can forecast the exchange rates to the point that it covers the premium. In certain situations, options can earn you an incredible amount of money. However, if you misjudge, you could also lose out on considerable money depending on the price of the premium. Since these premiums can easily be thousands of dollars, it is important to balance risk when purchasing a currency option. 

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