Currency risk is often the riskiest part of any investment portfolio, and yet it is frequently overlooked by investors.
Currency risk, also referred to as exchange-rate risk, arises from the change in the price of one currency with another.
Any portfolio that holds investments denominated in international currencies is subject to currency risks, particularly if the portfolio is not hedged.
“Currency risk, also referred to as exchange-rate risk, arises from the change in the price of one currency with another”
So a typical portfolio, which holds 60% global equities and 40% global bonds,
the greatest risk is currency risk
Currency risk is rated at 4.55% which is above stock risk at 3.36%, then comes interest rate risk at 0.44%. The least risky part of a typical portfolio is spread risk at 0.44%.
A 60/40 Global Portfolio has a total risk of 8.40% with currency risk representing more than half of the total portfolio’s risk
Moreover, when factoring in geopolitical considerations and black swan events currency risk can wreak havoc on investment portfolios heavily exposed to currencies affected.
“A 60/40 Global Portfolio has a total risk of 8.40% with currency risk representing more than half of the total portfolio’s risk”
The impact of Brexit on GBP comes to mind
In the lead-up to the EU Referendum in June 2016, and afterward, GBP has decoupled from its stereotypical trading patterns. Brexit’s impact on GBP was so noticeable that the Bank of England Governor, Mark Carney was compelled to make the following statement. ”Sterling volatility, as you would know, is an emerging market level and has decoupled from other advanced economy pairs” Mark Carney, Bank of England (September 2019).
“Sterling volatility, as you would know, is an emerging market level and has decoupled from other advanced economy pairs” – Mark Carney, Bank of England
Emerging market currencies typically expose investors to greater currency risk than developed economies with relatively stable democracies, also known as the G-7 (Group of Seven). So in a risk-off environment emerging markets tend to underperform.
Concerning GBP, Brexit ebbs and flows have created wide fluctuations in what used to be called stable pairs such as EUR/GBP or USD/GBP. Many believe that volatility in these stable pairs is likely to continue in 2020.
The current US-China trade war going viral (no pun intended) is a black swan event, which is creating currency risk
Europe is the new front of Trump’s trade war. The EU’s carbon emission to combat climate change will put US companies at a disadvantage. The EU says it is championing climate change and will not make special concessions for US industries to the disadvantage of their industries. So the US is drafting up a plan to impose 25% tariffs on agricultural goods,European aircraft and possibly autos.
What can investors do to mitigate the adverse effects of currency risk?
Hedging is a strategy often used by investors to reduce losses associated with currency risk.
Diversification is a type of hedging. For example, investors could buy Exchange Traded Funds (ETF). But equally, investors may want to ride the currency risk wave to profits.
So investing in an ETF fund is not a solution for all investors, particularly speculators who bet with conviction and make or lose money from currency risk volatility.