What is Currency Risk
Foreign exchange rate fluctuations can greatly influence the return of your foreign investment. Why? Because you will need to convert the foreign currency holding in your foreign investment back into your domestic currency. Currency risk is when the change in exchange rates negatively impacts the returns you will get on an investment. From an investor’s perspective, a rising domestic currency will lower returns whereas a weakening domestic currency will increase returns.
Danielle, a Canadian, owns a share of a U.S company worth 10 USD. If the current exchange rate between U.S and Canada is 1 USD/CAD (1 USD per 1 CAD), Danielle will have an investment worth 10 CAD when she converts her investment to CAD.
- If the Canadian dollar gets stronger - 2 USD/CAD (2 USD per 1 CAD). Danielle’s share in the U.S company is still worth 10 USD, but if she were to cash out and convert the returns to CAD, she will only receive 5 CAD. She would lose money just due to a change in the currency.
- If the Canadian dollar gets weaker - 0.5 USD/CAD (0.5 USD per 1 CAD). The same Danielle’s share is worth 10 USD, would become 20 CAD if she converts her returns to CAD. She has profited off of the currency movement.
Currency Hedging
Hedged, or currency neutral, equity funds and ETFs are supposed to give you the return of a foreign stock index or portfolio of stocks without being affected by a change in the exchange rate. However, hedging is not a perfectly precise process which means it may not completely protect you from currency movements. As well, hedged funds require more work and usually more fees are charged, which would lower your returns.
- Non-hedged funds are generally recommended if you invest:
- for the long term: changes in currency values will usually level out so as to not affect your returns greatly
- in multiple countries: hedging reduces the benefits of diversification - Hedged funds could offer some protection from the losses caused by the change in exchange rate if the domestic currency is about to rise in value.
