Currency Risk

When an investor or business deals in a currency other than its own, exchange rate movements can increase or decrease the value of those amounts when converted back.

For example, a European investor converts 10,000 euros into US dollars at a rate of 1.10, receiving 11,000 dollars, and buys US shares. A year later, the shares are still worth 11,000 dollars, but the euro has strengthened to 1.20 dollars. Converting back gives only about 9,167 euros, a loss of about 8%, even though the shares did not fall in value.

Currency movements can also work in the investor's favour. If the euro had weakened instead, the investor would have gained on the conversion.

Businesses face currency risk when they import, export or operate abroad. An exporter that receives payment in a foreign currency may receive less in its home currency if that foreign currency weakens before payment arrives.

Currency risk can be reduced through hedging, using financial contracts such as forwards to lock in exchange rates. Some international funds hedge their currency exposure, while others leave it unhedged. Over long periods, some investors accept currency risk as part of global diversification.