Currency risk: the unintended consequence of diversification
If you diversify your portfolios across countries, you may introduce unwanted currency risk that can eat into investment gains. Exchange rates always fluctuate, but sometimes movements can be brutal. Be alert to the risk, and aware of how it can be mitigated through hedging.
Whether in turbulent or benign times, currency risk matters. In the natural course of events, currencies continually fluctuate in price against one another. At times of economic and political uncertainty, price swings can be especially large. Investors regularly hedge their portfolios to protect them against such exchange rate movements.
Portfolios are often diversified across different asset classes, regions, sectors and investment styles. Once described as “the only free lunch in finance,” diversification reduces the risk in a portfolio without diminishing potential returns.
Movements in exchange rates – a risk of diversification
Yet diversification across countries introduces a new factor that will affect your portfolio returns – movements in exchange rates. These may make a material difference, especially in countries with relatively undeveloped economies such as emerging markets. Often, the countries with the highest potential returns from equities or bonds are also those with the greatest possible economic risks, including risks from currencies.
Over long periods of time, an investor may be able to tolerate currency risk because it can even out. Currencies go through cycles, just as economies and equities do. In the shorter term, however, currency movements can make a major difference to returns.
Why exchange rates move
A currency’s value against other currencies rises and falls in response to demand on the currency exchanges and for the assets traded in that currency on global markets. Over time, the strength of a national currency tends to mirror the perceived health of an economy and its prospects. If that perception changes, then currency movements can be sudden, swift and sometimes brutal.
At the heart of this perception is ‘fair value’. Also known as purchasing-power parity, this is the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services. The Big Mac index was invented by the Economist magazine in 1986 as a light-hearted guide to whether currencies were at their ‘correct’ level. In this case, differences in local prices for a Big Mac burger are used to suggest what the exchange rate should be.
In the short term, different factors drive financial markets’ perception of the health of an economy and the currency’s value. Rises in inflation, for example, reduce the purchasing power of a country’s currency because consumers get less goods and services for each unit of currency. Central banks may try to curb inflation by raising interest rates. Higher rates typically stimulate demand for a currency as investors in international markets seek out higher yielding currencies. Changes in factors such as these can lead to volatility if they are not expected.
However, political changes can also trigger swift currency movements. A classic example was Britain voting to leave the EU in June 2016. Investors feared that Brexit would weaken the UK economy and the pound fell 20% before making a partial recovery. But such dramatic plunges are exceptional.
The impact on your portfolio
For investors, currency risk can make a big difference to portfolio returns. If, for example, a dollar-based investor holds Japanese stocks priced in yen, the movement in the exchange rate between the US dollar and Japanese yen will influence the portfolio’s returns. While Japanese stocks might rise in value, currency movements will either add to this or diminish it. There would be a boost if the dollar fell against the yen but a fall if it rose. There is a danger that stock price gains can be eroded by currency movements.
For bond investors, currency risk matters even more. Over time, the magnitude of equities’ capital gains and dividends can mitigate the impact of currency movements. But bonds’ coupon income is often not enough to offset adverse movements in underlying currencies.
Investors tend to hedge portfolios of overseas equities and bonds to protect them against unforeseen foreign exchange losses. Doing so makes sure that your portfolio does not forego any profits from equities or bonds due to currency losses.
When hedging portfolios, often your professional portfolio manager will protect your portfolio or fund as a matter of course. There are several ways this can be done. The first of them is a forward contract, which commits two parties to buy or sell a currency at a specific price at a specific date in the future. The flexibility of these contracts makes them especially useful. Options are another way to hedge. They give you the right to buy or sell a currency at a specific price on a specific date – however, there is no obligation to do so.
In practice, there are many reasons why a currency might rise or fall. Geopolitical or political events that are judged to affect a nation’s prosperity often lead to violent price swings. Economic trends such as developments in inflation or productivity might lead to exchange rate movements over time. Whatever the case, currency risk could significantly reduce your portfolio’s gains. Be mindful of currency risk and decide whether to mitigate it through hedging