Guide to Foreign Exchange Risk Management
There are several ways to address currency risk, whether you invest directly or through funds. Discover more on Fineco Newsroom.
IN A FEW WORDS
Currency riskForeign exchange riskExchange rate riskCurrency fluctuationFX riskExchange rate fluctuations
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How to navigate currency risk
It’s important to be aware of foreign exchange risk, even if you only invest in the UK market. Your investment can still be subject to currency fluctuations. There are several ways to address FX risk, whether you invest directly or through funds. International investing can bring real advantages. It allows access to a range of sectors and emerging countries that won’t be represented in your home market. A globally diversified portfolio may be more robust, with exposure to a broader range of economies. However, investors need to be aware of currency risk when building a portfolio of international companies and funds.
Foreign exchange risk (FX risk) is difficult to avoid
Even if you only invest in the UK market, your portfolio can be subject to currency fluctuations. UK companies may draw their revenues from across the world and as such, their profitability can be impacted by differences in exchange rates. A good example of this was in the wake of the UK voting in 2016 to leave the European Union. Contrary to expectations, the FTSE 100 rallied. This was because the UK’s largest companies draw around two-thirds of their revenue from abroad, so the decline in sterling flattered their revenues.
In this instance, the currency fluctuations worked to the advantage of UK investors, but it can work against them as well. If sterling appreciates significantly against the home currency of the company in which you’re investing, it will dent your returns.
For example, the MSCI All Countries World Index has risen by more than 12% over the past five years in USD terms. In sterling terms, that dips to around 10%.
Alternatively, currency fluctuations can present an opportunity. UK investors in the large US technology giants have done particularly well in recent years, benefiting both from the rise in the share prices of the companies themselves and the rise in the dollar.
Exchange rate fluctuations can be particularly acute when investing in emerging markets
Against the UK pound, over the past 10 years, the South African rand has been as high as 23 and as low as 12. For investors in the country’s gold mining companies, or its financial services giants, this has significantly affected the returns. That said, it’s worth noting that many emerging market countries have built up substantial foreign exchange reserves in recent years to try and reduce currency fluctuation. This has largely worked, except in extreme cases such as the Russian crisis.
Hedging is one route to managing foreign exchange risk
Currency risk is complex and, for individual companies, can be difficult to disentangle. Some companies will hedge their currency risk, which will change their exposure. Collective investment funds will usually make it clear whether they do so and investors can choose hedged or non-hedged versions. For investors who don’t want to deal with currency fluctuations, this can be a good option.
If you are investing directly in individual companies, it is worth factoring FX risk into your decision-making. This is particularly important if a company is listed in a more difficult or obscure market. You need to look at good and bad scenarios and whether you want to hedge against volatility. It’s also worth considering any events that may affect the currency. It was well understood that Brexit would affect sterling, for example, so many investors either hedged their positions or avoided the UK market altogether.
Hedging can take several forms. A relatively straightforward and cheap option is to look at currency ETFs. You can buy long dollar ETFs, for example, if you believe the dollar is likely to rise, or short dollar ETFs if you believe it is likely to fall. There are also leveraged options for those that want to take a bigger bet. You can also trade directly in currency, but this may take more experience.
A low maintenance approach can work for some over the long term
Many fund managers take the view that currency fluctuations even out over time and doing nothing saves a lot of time and money. This is a reasonable view. Trying to anticipate the highs and lows of volatile currency markets is not easy and may not add a lot of value. Your decision is likely to come down to whether you can tolerate the short-term fluctuations that shifting exchange rates can inflict on your portfolio. If you’re a long-term investor, you may find movements cancel each other out.
Exchanging currencies at the true exchange rate can give you greater control over how you manage your currency exposure. If you’re serious about trading on the international level, Fineco offers direct investment in more than 20 local currencies. You can upgrade your investment experience with a single multi-currency account.
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