Exchange Rate Risk (Currency Risk)
Exchange rate risk is the potential for loss when the value of investments fluctuates due to changes in currency exchange rates between countries.
🎬 Video Explanation
Exam Tip
Dollar strengthens = hurts foreign investment returns. Dollar weakens = helps foreign investment returns.
What is Exchange Rate Risk?
Exchange rate risk (also called currency risk or foreign exchange risk) is the possibility that changes in currency values will affect the value of international investments or transactions.
How It Affects Investments
When you invest in foreign securities:
- You convert dollars to foreign currency
- Investment gains or loses value in local currency
- You convert back to dollars
- Currency changes add to or subtract from total return
Example
| Event | Impact |
|---|---|
| Foreign investment gains 10% | Good! |
| Foreign currency loses 5% vs. dollar | Reduces your gain |
| Net return | Approximately 5% |
Types of Currency Risk
| Type | Description |
|---|---|
| Transaction Risk | Affecting individual transactions |
| Translation Risk | Converting financial statements |
| Economic Risk | Long-term competitive effects |
Hedging Strategies
| Strategy | Method |
|---|---|
| Currency Futures | Lock in exchange rate |
| Currency Options | Right to exchange at set rate |
| Currency ETFs | Hedge with inverse currency funds |
| ADRs/Hedged Funds | Some funds hedge currency exposure |
Impact on Returns
| Scenario | Effect on US Investor |
|---|---|
| Dollar Strengthens | Reduces foreign returns |
| Dollar Weakens | Increases foreign returns |
Study This Term In
Related Terms
ADR (American Depositary Receipt)
An ADR is a certificate issued by a U.S. bank representing shares in a foreign company, allowing American investors to buy foreign stocks on U.S. exchanges in U.S. dollars without dealing with foreign exchanges or currencies.
Diversification
Diversification is an investment strategy that spreads investments across various assets, sectors, or geographic regions to reduce risk without necessarily sacrificing returns.