What Is Currency Exposure?
Currency exposure refers to the vulnerability of an investment based on the exchange rate between two currencies. It can affect anyone who has assets priced in another country’s currency. The value of the money can depreciate suddenly, and that can lead to the depreciation of investments. People who invest in multiple currencies can see the value of their assets fall if even one of these currencies depreciates unexpectedly.
The number of currencies involved in an investment can impact its depreciation over time. Investors who account for currency exposure in their foreign assets are well-equipped to guard against this risk.
3 Types of Currency Exposure
As with any industry, understanding the basics of currency exposure can go a long way in making sure you’re creating a sound investment strategy that will be as lucrative as possible in the future. There are three types of currency exposure any investor should guard against:
1. Transaction exposure
Transaction exposure occurs when exchange rate fluctuations affect a company’s obligations to make or receive payments in a foreign currency.
2. Translation exposure
Translation exposure occurs due to currency fluctuations on a company’s consolidated financial statements with foreign subsidiaries.
3. Economic exposure
Economic exposure occurs due to unexpected currency fluctuations in a company’s future cash flows and market value.
There is no telling when any of these risks could impact your investments. Investors who develop and implement risk mitigation strategies can protect against all three types of currency exposure.
Currency Exposure Risk Mitigation Strategies
There are several strategies for mitigating the risk of currency exposure in an investment. Here are three of the best ways to protect yourself:
1. Hedging Risk With Exchange-Traded Funds (ETFs)
ETFs contain multiple securities or investments that include currency valuation gains or losses based on exchange rates. Some ETFs provide long (buy) and short (sell) exposures to currencies to hedge against current rate changes. They are designed to match the performance of coins included in the funds.
2. Forward Contracts
A currency forward contract serves as an agreement in which two parties buy or sell a currency at a specified exchange rate and future date. It enables an investor to lock in at a country’s current exchange rate to hedge against the risk of depreciation.
3. Currency Options
A currency option lets an investor buy or sell a currency at a specific rate on or before a particular date. The option requires the investor to pay an upfront premium, but it does not need the investor to engage in a transaction when the option’s expiration date arrives.
These strategies deliver varying results, depending on the investment and the currencies involved. Investors can also do several things to guard against currency exposure, regardless of which method they use.
7 Ways to Minimize the Risk of Currency Exposure
Currency exposure must be accounted for in any investment strategy that involves foreign currencies. Some of the best ways to minimize this risk in an investment strategy include:
1. Evaluate the Global Market
Look at countries’ debt and inflation levels. The currencies of countries with low debt tend to be more profitable than those with high debt. There is often a direct correlation between countries with high inflation and declining currency valuations as well.
2. Analyze the Risks of Foreign Bonds
Bonds have low gains to offset currency losses and are increasingly susceptible to currency exposure. Some foreign bonds have currency fluctuations at plus or minus 10%, making these investments exceedingly risky. Investors in the market for bonds may benefit most from ones issued in U.S. dollars, which can be more stable than foreign options.
3. Prioritize Currency-Hedged ETFs
Currency-hedged ETFs tend to be less volatile than traditional ETFs. They can be found nearly anywhere in the world and limit the risk of losses.
4. Establish a Diverse Portfolio
Make investments in foreign securities in multiple regions rather than focusing exclusively on investments in one section of the globe. A diverse investment portfolio can help you consistently hedge against currency volatility.
5. Move Beyond Foreign Markets
Resist the urge to put all of your investments into foreign markets. It often helps to start slow and build up your foreign investments to guard against currency exposure.
6. Watch the Foreign Markets Closely
Know your investments and keep an eye on the foreign markets associated with them. You can watch for market patterns and update your portfolio as needed based on currency exposure dangers.