Currency risk, also known as exchange rate risk, refers to the potential for investment losses due to fluctuations in foreign exchange rates affecting the value of international investments.
Currency Risk is the financial risk that arises from changes in the exchange rate between two currencies. When investors or family offices hold assets denominated in foreign currencies, the value of these assets in their home currency may vary as exchange rates fluctuate. This volatility can lead to gains or losses independent of the underlying asset's performance. Currency risk is particularly relevant for portfolios with international equity, bond, real estate, or alternative investments. In finance and wealth management, currency risk affects the measurement of returns, asset valuation, and risk assessment for multi-currency portfolios. It is managed either by accepting the risk as part of international investing or by employing hedging strategies such as forwards, futures, swaps, or options to mitigate adverse currency movements. Understanding currency risk helps advisors and family offices align investment strategy with risk tolerance and objectives.
Currency risk impacts investment strategy by influencing asset allocation decisions toward or away from international assets. Unhedged exposure may offer diversification benefits but also introduces volatility that can affect overall portfolio performance and risk profile. Accurate reporting requires currency translation of foreign asset values, which can distort performance metrics if exchange rates move significantly. Tax planning and governance considerations also come into play, as currency gains or losses might be taxable or influence reporting requirements. Family offices must balance currency risk reduction with cost and complexity of hedging, tailoring approaches to long-term wealth preservation and growth objectives while considering operational and compliance factors.
A family office holds €1,000,000 in European equities. If the EUR/USD exchange rate moves from 1.10 to 1.00 during the year, the USD value of that investment drops from $1,100,000 to $1,000,000, effectively causing a $100,000 currency loss, even if the equity value in euros remains the same. Hedging with currency forwards could have locked in the exchange rate to protect against this loss.
Foreign Exchange
Foreign Exchange (Forex) is the global marketplace for trading currencies, where exchange rates are determined. Managing currency risk involves understanding foreign exchange markets since price movements in currency pairs drive the gains or losses associated with currency risk.
What is the main cause of currency risk in international investing?
Currency risk is primarily caused by fluctuations in exchange rates between the investor's domestic currency and the foreign currency in which an asset is denominated. These rate changes affect the asset’s value when converted back to the home currency.
How can currency risk be managed or mitigated?
Currency risk can be managed by hedging strategies such as using currency forwards, futures, swaps, or options to lock in exchange rates. Alternatively, investors can opt for unhedged exposure or diversify currency exposures to reduce overall risk.
Does currency risk affect investment returns directly or indirectly?
Currency risk affects investment returns indirectly by altering the home-currency value of foreign investments. Even if the foreign asset performs well, adverse currency movements can reduce or negate gains when converted to the investor's currency.
