SmartAsset and Yahoo Finance LLC may earn commission or income through links in the content below.
Exchange rate risk, or currency riskcould potentially occur when the value of one currency fluctuates relative to another. For investors and companies operating in global markets, this volatility can affect profitability and return on investment. Fortunately, there are many strategies and tools available to hedge currency risk. AND financial advisor could work with you to manage it effectively. Here’s what you should know.
Currency risk can occur when the value of a currency potentially changes between the time a transaction is initiated and the time it is settled. This can affect cost of goodsinvestment value or profitability of international business.
For example, an American company importing goods from Europe could experience an increase in costs if the euro strengthens against the dollar, as more dollars will be needed to pay for the same amount of goods.
A number of factors affect currency risk, including interest ratesgeopolitical events, trade policy and market sentiment.
Currency markets operate 24 hours a day, 7 days a week, and exchange rates can change rapidly due to the release of economic data or unexpected global events. These fluctuations create uncertainty for investors and businesses involved in cross-border transactions.
Let’s say you’re a US-based investor and you own shares in a European company valued in euros. If the value of the euro falls against the dollar, the value of the investment in dollars will decrease, even if the share price remains the same in euros. This currency risk can reduce profits or increase losses. A stronger euro, on the other hand, could boost returns when converted back into dollars.
Currency risk can take several forms. Here are four to consider:
A busy, focused young adult male freelancer sits at a desk and rests his head on his hand while working on a project on his laptop.
Risk protection involves the use of financial instruments or strategies to offset potential losses caused by currency fluctuations. Below are five common methods of hedging currency risk.
AND forward contract allows you to lock the exchange rate for a specific future date. These contracts are negotiated directly with the financial institution and are tailored to your specific needs. A forward contract allows you to lock in the exchange rate, so you know exactly how much you will pay or receive in your base currency.
For example, suppose an American company needs to pay a European supplier 100,000 euros in three months. If the current exchange rate is 1 EUR = 1.10 USD, the company can enter into a forward contract to lock in that exchange rate.
Regardless of whether the euro strengthens to 1 EUR = 1.15 USD or weakens to 1 EUR = 1.05 USD, the company will still exchange €100,000 at the agreed rate of 1.10 USD, avoiding any adverse exchange rate movements.
Forward contracts are particularly useful for companies and investors with predictable foreign currencies needs, such as recurring international payments or settlements.
Currency of the future are standardized contracts traded on exchanges, allowing you to buy or sell a specified amount of currency at a predetermined exchange rate on a specified date in the future. Unlike futures contracts, which are private contracts, futures are regulated and provide greater liquidity and transparency.
For example, suppose you own foreign assets and expect to convert those assets into your home currency in six months. You can use a currency futures contract to lock in the exchange rate, reducing the risk of loss.
If the market rate moves against your position, gains or losses on the futures contract offset changes in the value of your foreign assets.
Currency futures are useful if you value flexibility and transparency because you can easily buy or sell contracts on exchanges.
Option contracts give you the right, but not the obligation, to exchange the currency at a specified rate before or on the expiry date. This flexibility allows you to take advantage of favorable exchange rate movements while limiting downside risk. The options involve paying the premium up front, which is a trade-off for the protection they provide.
For example, consider a Canadian importer who expects to pay USD for goods in three months. If the Canadian dollar weakens against the US dollar during that time, their CAD payment amount would increase.
By purchasing a currency option, the importer can secure the right to exchange CAD for USD at a favorable exchange rate. If the CAD strengthens, the importer may choose not to exercise the option and take advantage of the improved exchange rate.
Options are particularly useful for hedgers who want to maintain some flexibility, as they allow you to capitalize on favorable currency movements while protecting you from losses.
Natural hedging involves managing currency exposure by matching income and expenses in the same foreign currency. This strategy eliminates the need for currency conversions, reducing the risk of exchange rate fluctuations. It is a cost-effective method that does not require additional financial instruments.
For example, an American exporter that earns revenues in euros might choose to pay its European suppliers in euros as well. In this way, the company reconciles its currency inflows and outflows, avoiding the need to exchange euros for dollars.
Natural hedging works best for companies with balanced cash flows in foreign currencies. Although it requires careful planning, it is an effective way to reduce currency risk at no additional cost.
Multi-currency accounts allow companies and investors to hold funds in different currencies. By maintaining balances in foreign currencies, you can avoid the risks and costs associated with frequent currency conversions. These accounts also provide the flexibility to manage payments and receipts in multiple currencies.
For example, if you have assets in the UK and the Eurozone, you can use a multi-currency account to hold both GBP and EUR. When you need to pay expenses or transfer funds, you can do so directly from the currency in question without converting to your home currency.
Multi-currency accounts are particularly useful for global companies and investors who frequently work with multiple currencies. They simplify currency management and at the same time reduce exchange rate risk.
Any individual or company that is exposed foreign currenciessuch as importers, exporters and investors in foreign assets should consider hedging to protect themselves against potential losses.
Hedging strategies involve costs, such as option premiums or futures contract fees. However, these costs can be worthwhile compared to the potential losses from unhedged currency exposure.
Although hedging significantly reduces currency risk, it does not eliminate it completely. Fluctuations in other financial factors, such as interest rates or market volatilitymay still affect protected transactions.
A couple reviews their investment goals.
Currency risk is a challenge for both investors and businesses, but you can manage it effectively with the right strategies. Futures and maturities can help you lock in exchange rates for future transactions, while options offer the flexibility to take advantage of favorable exchange rate movements. Natural hedges match income and expenses in the same currency to avoid conversions, and multi-currency accounts allow you to hold funds in different currencies, which could reduce your exposure to exchange rate changes.
AND financial advisor can help you analyze investments and manage risk for your portfolio. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three trusted financial advisors serving your area, and you can have a free introductory conversation with your advisors to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you want to know how much your investments could grow over time, SmartAsset’s investment calculator can help get an estimate.
