20 Sep How to Address Currency Risks on Foreign Investments
Currency risk results from changes in the relative currency valuations. The changes can bring along unpredictable gains or losses once dividends or profits are converted into U.S. dollars from a foreign currency. An example of this is a U.S. based citizen who invests 100 euros in the German stock, and later having the exchange rates fall from 1.5 to 1.3 euros per U.S. dollar. In such a case, the investor will make a 13% loss once his profits are converted.
Luckily, there are available techniques designed to offset currency-related losses, one of them being the use of hedges. In the above example, an investor could have saved himself from the loss by hedging his position, which could entail simultaneously short-selling the euro. Let’s have a look at how investors can manage currency risks and protect their portfolio as they enhance risk-adjusted returns.
How Can One Manage Currency Risk?
Any international investor has several options for managing currency risk. This includes the use of tools such as currency features, currency-hedged funds, and forwards & options. These instruments are however quite expensive and complicated for an investor to use. Exchange-traded funds (ETFs) is one simple, liquid, and flexible alternative to hedge against currency risks.
A number of financial institutions provide different currency types focused on ETFs covering many world currencies, including those of emerging investment destinations such as Brazil and China. An investor can simply purchase put options against EFTs so as to profit from any currency value declines, and offset him or her of losses once currency conversions are made.
How can you determine if a hedge is crucial?
Hedging against a currency risk can be quite costly. For an investor to be fully hedged, he ought to offset each currency unit with a U.S. dollar. Some of the costs can be reduced by using stock options that are in lieu of equity. However, the cost could be prohibitive for someone who has small investments. It is hence important that any investor first assesses all factors to know if the hedge is necessary. Below are some things to do before hedging.
- Assess the chances of currencies declining – In stable economic times, there is a low volatility, and thus makes hedging unnecessary.
- Know whether the cost of the hedge is a representation of a disproportionate amount of the entire investment.
- Be keen to see if the cost of hedging outweighs the downside risk of the currency.
How to Hedge Against Currency Risk
Once you deduce that hedging is reasonable, the next thing to do should be finding out the right EFT to use. There are several currency EFTs to choose from. Steps to take are identifying the ETF and determining the direction to ensure that the hedge you choose does not take the opposite direction. You also need to assess the risk and determine whether you should hedge your investment partially, or completely. After doing this, manage your trade prudently.
Hedging your stock investment is surely one of the best measures to take against currency risk. Smart trading entails equipping oneself with the right information and making informed decisions. You can get more of this from reliable stock market newsletters or the readily available online investment blog articles.