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Summary
- The variations in price of one currency compared to another is known as currency risk or exchange-rate risk.
- The changes in global exchange rates bear a significant impact on value of investments.
- The changes in prices of currencies may result in unpredictable gains or losses for businesses or investors.
The changes in global exchange rates bear a significant impact on value of investments. The variations in price of one currency compared to another is known as currency risk or exchange-rate risk.
The companies with business operations spread across different economies and investors with substantial exposure to foreign assets are exposed to such risks. The changes in prices of currencies may result in unpredictable gains or losses for businesses and investors.
Suppose a Japanese company sells cars in US, France, and Britain. It would do so in US dollars in US, euros in France and pounds in Britain. The company would receive its sales payments in the respective currencies of these countries.
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It would have to convert the currencies back to its domestic currency, i.e., yen. In such a case, changing exchange rates impact the value of the currency that the company receives when converted back to yen.
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Similarly, investing in debt may expose investors to currency risk as they have smaller profits to counter risks posed by currency fluctuations.
How do exchange rate changes impact stock prices?
The fluctuations in currency prices also tend to impact a company’s stock prices. Hence, majority of investors witness a knock-on effect of these currency changes via stocks.
Generally, there are three general correlations between stock price performance and exchange rate fluctuations:
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Zero correlation
As the name suggests, zero correlation is when stock prices are not influenced by variations in exchange rates. For instance, it may happen that Japanese carmaker Toyota’s share price doesn’t change while yen falls 2% in value.
Negative correlation
It happens when the share price of a company rises as the domestic currency depreciates. An example of negative correlation can be if the stock price of US tech firm Apple Inc rises with a depreciation of US dollar.
Positive correlation
It occurs when stock prices fall while the domestic currency depreciates. For example, if the stock price of Apple Inc were to fall with a depreciation of US dollar, it would be a case of positive correlation.
Commodity prices
Another important factor that investors should consider while currency exposure analysis is the impact of the US dollar exchange rate on all assets. There are several raw materials such as crude oil which are priced in US dollars. A fall in the value of US dollar generally results in a rise in the prices of commodities and vice versa.
How can investors reduce currency risks?
There are several exchange traded funds (ETFs) and mutual funds designed to lower currency risk. They do so by being hedged, typically using forex, options, or futures. However, one shortcoming of these currency-hedged funds is that they can lower investors’ gains. They are also more expensive than funds that aren't currency-hedged.
Thus, investors could be in a better position to analyse the currency exposure of their investment portfolio by comprehending the impact of exchange rate fluctuations on individual companies and assets.
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