Investing in foreign assets has proven the merits of diversification, and most individual investors make the most of the advantages of international assets. Nevertheless, unless the foreign securities have been issued in U.S. dollars, the portfolio will experience currency risk. Currency risk is the chance that one currency moves against one other currency, negatively affecting an investment’s overall return. In other words, the exchange rate between the 2 currencies can move adversely and erode the returns of a foreign investment. Investors can accept currency risk and hope for the very best, or they’ll employ hedging strategies to mitigate or eliminate the chance.

Currency Risk with International Investing

If a U.S. investor purchased an investment in Europe that is denominated in euros, the value swings within the U.S. dollar versus the euro exchange rate (EUR/USD) would affect the investment’s overall return. Because the investment was purchased in euros, the investor could be considered “long” the euro (or owner of euros) because the investor would’ve converted dollars into euros as a way to initiate the investment purchase. The initial investment would have been converted on the prevailing EUR/USD exchange rate on the time of the acquisition.

When the investor desires to sell the investment and convey the a refund to the U.S., the investment’s value denominated in euros would have to be converted back into dollars. On the time of the investment sale, the euros could be converted into dollars on the prevailing EUR/USD exchange rate.

The difference between the EUR/USD exchange rate on the time of the initial investment purchase and the speed on the time when the investment was sold would end in a gain or loss. Whatever the return on the investment, the difference between the 2 exchange rates could be realized. The danger that the exchange rate could move against the investor while the investment is tied up in euros known as currency exchange risk.

Hedging Currency Risk With Exchange-Traded Funds

There are a lot of exchange-traded funds (ETFs) that give attention to providing long (buy) and short (sell) exposures to many currencies. ETFs are funds that hold a basket of securities or investments that may include currency positions that have gains or losses on moves within the underlying currency’s exchange rate.

For instance, the ProShares Short Euro Fund (NYSEArca: EUFX) seeks to offer returns which can be the inverse of the day by day performance of the euro. In other words, when the EUR/USD exchange rate moves, the fund moves in the wrong way. A fund like this may be used to mitigate a portfolio’s exposure to the performance of the euro.

Example of an ETF Hedge

For instance, if an investor purchased an asset in Europe for 100,000 euros and on the EUR/USD exchange rate of $1.10, the dollar cost would equal $110,000. If the EUR/USD rate depreciated to $1.05, when the investor converts the euros back into dollars, the dollar equivalent would only be $105,000 (not including any gains or losses on the investment). The EUFX ETF would gain on the move lower within the EUR/USD exchange rate offsetting the loss from the currency conversion related to the asset purchase and sale.

Advantages and Costs of an ETF Hedge

The ProShares Short Euro Fund would effectively cancel out the currency risk related to the initial asset. In fact, the investor must be sure to buy an appropriate amount of the ETF to make sure that the long and short euro exposures match 1-to-1.

ETFs that concentrate on long or short currency exposure aim to match the actual performance of the currencies on which they’re focused. Nevertheless, the actual performance often diverges as a result of the mechanics of the funds. Consequently, not the entire currency risk could be eliminated. Also, currency-based ETFs may be expensive and typically charge a 1% fee.

Forward Contracts

Currency forward contracts are an alternative choice to mitigate currency risk. A forward contract is an agreement between two parties to purchase or sell a currency at a preset exchange rate and a predetermined future date. Forwards may be customized by amount and date so long as the settlement date is a working business day in each countries.

Forward contracts may be used for hedging purposes and enable an investor to lock in a particular currency’s exchange rate. Typically, these contracts require a deposit amount with the currency broker.

Example of a Forward Contract

For instance, let’s assume that one U.S. dollar equaled 112.00 Japanese yen (USD/JPY). An individual is invested in Japanese assets, meaning they’ve exposure to the yen and plan on converting that yen back into U.S. dollars in six months. The investor can enter right into a six-month forward contract by which the yen could be converted back into dollars six months from now at a predetermined exchange rate.

The currency broker quotes the investor an exchange rate of 112.00 to purchase U.S. dollars and sell Japanese yen in six months. No matter how the USD/JPY exchange moves in six months, the investor can convert the yen-denominated assets back into dollars on the preset rate of 112.00.

Six months from now, two scenarios are possible: The exchange rate may be more favorable for the investor, or it may be worse. Suppose that the exchange rate is worse and is trading at 125.00. It now takes more yen to purchase 1 dollar. For example the investment was price 10 million yen. The investor would convert 10 million yen on the forward contract rate of 112.00 and receive $89,286 (10,000,000 / 112.00).

Nevertheless, had the investor not initiated the forward contract, the ten million yen would have been converted on the prevailing rate of 125.00. Consequently, the investor would have only received $80,000 (10,000,000 / 125.00).

Advantages and Costs of Forward Contracts

By locking within the forward contract, the investor saved greater than $9,000. Nevertheless, had the speed grow to be more favorable, corresponding to 105.00, the investor wouldn’t have benefited from the favorable exchange rate move. In other words, the investor would have needed to convert the ten million yen on the contract rate of 112.00 despite the fact that the prevailing rate was 105.00.

Although forwards provide a rate lock, protecting investors from adversarial moves in an exchange rate, that protection comes at a value since forwards don’t allow investors to profit from a positive exchange rate move.

Currency Options

Currency options give the investor the fitting, but not the duty, to purchase or sell a currency at a particular rate (called a strike price) on or before a particular date (called the expiration date). Unlike forward contracts, options don’t force the investor to interact within the transaction when the contract’s expiration date arrives. Nevertheless, there’s a value for that flexibility in the shape of an upfront fee called a premium.

Example of a Currency Option Hedge

Using our example of the investor buying as Japanese asset, the investor decides to purchase an option contract to convert the ten million yen in six months back into U.S. dollars. The choice contract’s strike price or exchange rate is 112.00.

In six months, the next scenarios could play out:

Scenario 1

The USD/JPY exchange rate is trading at 120.00, which is above 112.00. The choice’s strike is more favorable than the present market rate. The investor would exercise the choice, and the yen could be converted to dollars on the strike rate of 112.00. The U.S. dollar equivalent could be credited to the investor’s account equaling $89,286.00 (10 million yen / 112.00).

Scenario 2

The USD/JPY exchange rate is trading at 108.00, which is below 112.00. The prevailing rate is more favorable than the choice’s strike. The investor could allow the choice to run out worthless and convert the yen to dollars on the prevailing rate of 108.00 and profit from the exchange rate gain. The U.S. dollar equivalent could be credited to the investor’s account equaling $92,593.00 (10 million yen / 108.00).

By buying the choice, the investor made a further $3,307 in scenario #2 because the USD/JPY rate moved favorably. Had the investor bought the forward contract at a rate of 112.00, which was highlighted earlier, the investor would have missed out on a $3,307 gain.

Option Premiums

Unfortunately, the pliability provided by options may be quite costly. If the investor decides to pay the premium for an option, the exchange rate must move favorably by enough to cover the fee of the premium. Otherwise, the investor would lose money on the conversion.

For instance, for example that the above 112.00 yen option cost $5,000 upfront. The favorable move within the yen rate to 108.00 (in scenario two) wouldn’t be enough to cover the fee of the premium. In case you recall, the unique USD/JPY rate for the ten,000,000 yen investment was 112.00 for a dollar cost of $89,286.00.

Consequently of the premium, the investor would want to get back $94,286 from the currency conversion ($89,286 + $5,000 fee). Consequently, the yen rate would must move to 106.06 for the investor to interrupt even and canopy the fee of the premium (10,000,000 / 106.06 = $94,286.00).

Although options provide flexibility, the fee of the choice premium must be considered. Investors must get two things right when buying an choice to hedge an overseas investment. The investor must make a superb initial investment by which it earns a gain. Nevertheless, the investor must also find a way to forecast the currency exchange rate so that it will move favorably enough to cover the choice premium. Although forwards don’t provide the pliability of walking away like options, they reduce the chance of a currency exchange loss and investors do not have to play the currency forecasting game.