What is currency risk and how does it relate to your investments?

Imagine you just booked a well-deserved vacation to the United States three months from now. Whether you’re the type of person who prepares ahead of time and goes to your local bank to purchase US Dollars (USD), or you wait until the last minute choosing to stop at the airport foreign exchange booth, you’ve inherently exposed yourself to currency risk. Within that three month period, you may find that your early preparation was rewarded, or procrastination resulted in a cheaper USD. It’s speculative to know whether or not you made the right decision to buy immediately or wait until the day of the trip-- but that gain or loss incurred in currency value over the three-month period is defined as currency risk. This risk is not only present when you make cross-border purchases, it also impacts your investments.

Because globalization has integrated businesses and economies alike, global investment opportunities have played an integral part in creating a diversified investment portfolio. For most globally diversified investors, this impact of currency risk can be thought of as nothing more than a by-product of investing internationally and not a risk that needs immediate and ongoing attention.

What is the value of currency to an investor?

Investments are made on the basis of assuming a degree of risk and expecting a certain level of return as compensation for this risk. Without assuming volatility, the growth potential of an investment portfolio is limited. When assessing the return potential of an asset, analysts and portfolio managers look to a number of metrics that make an investment attractive with the goal of determining an asset’s fair value by using an objective calculation or financial model.

Factors that are considered in these models are mainly financial considerations of individual companies such as revenue streams, cash flow and dividends. Once an investor has determined the fair value they ascribe to an asset, they can compare it to the market price that it is currently trading for. For example, say an investor determines the fair value of Company X is $30, if the current stock price is $28, the investor would view the stock purchase as “fair and undervalued” and depending on the investor, this might be an attractive purchase.

Because currency as an investment (as opposed to a byproduct) does not share these same financial considerations (like revenue or dividends), it cannot be assessed based on fair value in contrast to its market price. Rather, it shares the speculative nature of investments such as art or collectibles. The fair value that an art or collectibles investor ascribes to a fine piece of art is usually quite personal and based on the value it brings to them from a consumption perspective (such as enjoying a unique piece of art on the wall to share with their friends when they visit) as opposed to the basis of a public market value. Many investors would find it challenging to invest in a rare tapestry with the hopes of achieving their financial goals through a sale down the road and this can also be said for currency given its speculative nature.

Just as the tapestry could be worth 20% less after a short period of time based on trends and preferences of investors, so too could a currency. Most developed market currencies do not experience rapid fluctuation due to the fact that they are relied on for global transactions on a daily basis. However, history has shown us that fluctuations in exchange rates can be material to investors who are not properly diversified.

Currency risk in history

There is no better example of extreme currency fluctuations than that of the infamous 1994 Mexican Peso crisis colloquially labeled the “tequila effect”. On December 20, 1994, the Mexican Central Bank devalued the peso by up to 15%. Due to the weak peso, interest rates at banks were increased in an attempt to maintain investment in the country, but this also resulted in higher-local borrowing costs.

If an investor had speculated on the Peso as a long-term investment, they would have felt this sharp decline instantly. Although this is an extreme example, major currency fluctuations do occur and are influenced by a myriad of factors including interest rates, inflation, commodity prices, government debt levels and overall macroeconomic stress events such as COVID-19.

How does currency risk impact a diversified investment portfolio?

When Canadian investors buy foreign financial assets such as stocks and bonds in their Canadian dollar investment account, their Canadian dollars are exchanged into the local currency of another country to make the purchase. Subsequently, when the foreign assets are sold years later, foreign currency is converted back into Canadian Dollars at the prevailing exchange rate. There is no guarantee that the exchange rate will be the same as when it was purchased, in fact, very rarely will this be the case. However, because the investor is investing in an asset, and not directly in the currency, they still have the opportunity to participate in the capital appreciation of the asset (due to growth of a company), dividends, or interest income.

Let’s say you are a Canadian investor who wants to invest in a Mexican company listed on the Mexican Stock Exchange. You will have to convert your Canadian dollars into Mexican Pesos to purchase the stock. Your portfolio is now exposed to both market risk as well as currency risk. If the company's stock were to appreciate by 5% in one year, but the Peso depreciated 2%, you’d be left with a net 3% return before any potential investment management fees. If this was the only investment in your portfolio, you would notice the impact of currency quite clearly, however, if this Mexican stock was only a small portion of your overall portfolio you probably would not consider the movement in the peso as other market fluctuations and currency impacts would also aggregate into your total return as a “natural hedge”.

How to protect against foreign currency exposure

Hedging

One way currency risk can be mitigated in financial markets is through hedging. Many Albertans will be familiar with the process of hedging without even knowing it because it is a reliable strategy used by farmers around the globe. When a farmer plants a variety of crops similar to a diverse asset mix, some of the crops are more resilient than others to certain weather conditions, no different than diverse asset mixes reacting to challenging market conditions. Weather is outside of a farmer’s control, just like the volatility of financial assets, and the fluctuating valuation of currency are outside an investor’s control so a diverse crop is planted in hopes that losses of one crop can potentially be offset with the success of another.

Diversified crops are not the farmers’ only option to hedge against uncertain weather; they could also buy crop insurance or invest in new machinery to better the crop’s survival chances. Many sophisticated hedging instruments exist in the financial markets to mitigate the impact of foreign currency fluctuations, such as forwards, futures and options—but they too come at a cost similar to the farmer’s expensive equipment or insurance. For the average investor seeking to hedge USD exposure in their portfolio, utilizing these currency hedging instruments is often complex and typically requires the expertise of professional money managers. Which raises the question—does the average investor need to hedge at all? Going back to our farming analogy, over the course of the farmer’s career, or investor’s time horizon, the long-term will surely yield some fantastic crop, or returns, which can be “stored for the future”—balancing out the worst years.

Diversification as a hedge

When we think of a diversified portfolio, we envision a wide array of investments spread across asset classes, such as fixed income, equities and alternative investments, and at a more granular level, across sectors. As an example, let's reference the consumer discretionary and consumer staples sectors in a recessionary period. During this time people are more likely to purchase essentials such as toilet paper (staples) as opposed to buying a brand-new luxury item such as a car or television (discretionary).

Consequently, the positive returns in the consumer staples sector offset the negative returns experienced in the consumer discretionary sector during times of economic hardship, such as during a recession. Consumer staples behave as a “natural hedge” and this concept has important carryover to currency risk. Well-diversified portfolios that have exposure to multiple currencies behave in a similar manner, where the appreciation of one currency tends to offset another. Now this is simplified and might sound routine on paper, but there is a cost and expertise associated with the process of hedging and it is not always a fool-proof strategy.

Bringing it all together

Betting on currencies is highly speculative and it is next to impossible to time out when one currency will appreciate or depreciate. Choosing to hedge can be beneficial under certain circumstances, but generally speaking, a well-diversified portfolio will act as a natural hedge as the interplay of the foreign currency movements offset one another. Additionally, actively managed products such as mutual funds often have experts evaluating currency risk and hedging on behalf of the investor.

Over a long-time horizon, we generally find the impact of foreign currency movements on portfolio return will lessen, as seen below in the chart of the movement of the S&P 500 as of May 31, 2020 over the last 30 years.

As you can see, in the shorter-term horizon there are return differences due to fluctuations in CAD/USD of up to 4%. However, when investing longer-term (20+ year) the annualized performance difference is marginal (<1%).

In the end, an investor is often “rewarded” for their patience and resilience when investing over a long-time horizon and holding a diversified portfolio, whereas, an investor’s attempt to time the market in the short-term exposes themselves to higher-levels of market and currency risk.