Currency Risk
Have you ever thought about investing in a foreign country? If so, here’s something you should know.
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Have you ever thought about investing in a foreign country? If so, here’s something you should know.
Anytime you buy a foreign asset for investment purposes—whether it be real estate, stocks or bonds— there is a special type of risk you need to be aware of: currency risk.
When you buy a foreign asset, you’re exposed to all the typical risks associated with that investment— market and company-specific risks in the case of stocks; credit and interest rate risk in the case of bonds, etc.
The asset’s price can go up and its price can go down, just like any other investment you might buy.
But currency risk is unique type of risk you’re exposed to with foreign assets. Here’s how it works.
In most cases, when you buy a foreign asset, you purchase it in the currency associated with the country in which that asset exists.
So if you’re an American and you buy British stocks, you’re buying stocks denominated in British pounds. You might not do it yourself— especially if you buy British stocks through an ETF or mutual fund—but at some point, your dollars have to be exchanged for pounds in order for you to buy British stocks.
And when that happens, you are exposed to the fluctuations in the exchange rate of the U.S. dollar versus the British pound.
In fact, you can think of yourself as being long both British stocks and the pound versus the dollar. What that means is that if the pound goes up against the dollar, you make money because once you convert those pounds back into dollars, you’ll have more dollars than you started with.
The opposite is true as well. If the pound drops against the dollar, you’ll have fewer dollars than you started with.
We can clearly see this phenomenon in the performance of the iShares MSCI United Kingdom ETF (EWU), an ETF that holds U.K. stocks but trades in the U.S.
The stocks that EWU holds are up 6.6% this year, but the ETF is down by 3.6% because the British pound has fallen 10% versus the dollar.
Exceptions
Currency risk usually comes into play when you buy a foreign asset, but there are exceptional cases when it doesn’t. For example, that can happen when you buy bonds issued by emerging market governments or companies.
Many times, those bonds are denominated in dollars because it’s much easier for those governments and companies to raise money when they offer to make their payments in dollars rather than their local currencies.
If you’re an American and you buy dollar-denominated emerging market bonds, you aren’t exposed to the direct currency risk discussed above.
On the other hand, you’ve probably exchanged that currency risk for higher credit risk because now the issuer of the bonds must get its hands on dollars to pay you, which is usually harder than earning domestic currency. At the same time, the currency risk hasn’t gone away—it’s just been transferred to the issuer of the bond.
If the government of Turkey issues a dollar-denominated bond, it has to come up with dollars even though most of its revenues are in Turkish lira. So while you aren’t exposed to the lira/dollar exchange rate, the Turkish government is.