Currency Risk

Currency risk arises from a change in the value of one currency relative to another. It is an important consideration for swing traders, with the potential to impact profit and loss. In this guide, we explain how currency risk works with examples. We also outline useful risk management strategies for forex swing traders.

Currency Risk Explained

Foreign exchange risk originates from a change in the price of one currency, such as the USD, in comparison to another, such as the EUR. It becomes even more important in international trade as it can impact the price of assets, goods and services. It can also expose retail investors, resulting in the unpredictability of earnings and losses.

Example

Assume you wish to make an investment in a European firm, so you buy 100 EUR worth of stock. The exchange rate at the time of purchase was 1.13 EUR to 1 USD. You spent 88 USD. If you sell the stock for the same amount, but the FX rate has changed to 1.2 EUR, you now have 83 USD. However, if the currency were to change to 1 EUR, you would have 100 USD. So even small fluctuations can impact the profit you stand to make.

Types of Currency Risk

There are three key categories to understand:

• Transaction risk – this is the risk that an organisation is exposed to when purchasing a specific product or service in another country. When the exchange rate changes between entering the deal in a foreign currency and paying or receiving the money, the amount of base currency paid or received fluctuates. Let’s consider an example of currency risk in China that could be encountered by a US company. A company in the United States with operations in China is looking to purchase a product valued at CNY 100. If the currency rate at the time of the sale was 1 USD for 6 CNY, and it drops to 1 USD for 7 CNY before payment, the US company will pay 14 USD rather than 16 USD. If the rate were to rise to 5 CNY, the US company would be required to pay 20 USD.
• Translation risk – if a company has a subsidiary in another country, the subsidiary’s financial data, which will be written in that country’s currency, may need to be translated into the main company’s currency. Losses from currency swings might occur.
• Economic risk – known as forecast risk. This type of currency risk occurs when a company’s market value is influenced by inevitable exposure to forex swings. This can have several adverse impacts, including a loss of confidence in the company among retail swing traders.

Pros & Cons

Currency risk is dangerous because it could reduce the profits you make on your investments. And unfortunately, unless you are able to invest only in your country’s securities, you cannot totally avoid currency risks. Of course, when the exchange rate fluctuates in your favour, you are able to rake in more profits. But when it drops, you may incur losses.

Capitalising on fluctuations in currency values caused by interest rate movements can also lead to investment opportunities.

Currency Risk Management

ETF Hedging

One possibility for currency risk mitigation is using Exchange-traded funds. ETFs, like equities, are traded on a stock exchange. Currency-hedged ETFs use, for example, futures or options as part of their risk hedging strategies. They usually include currency positions that give a diversified exposure to many currencies.

For example, a fund that reduces a portfolio’s exposure to GBP performance might provide more steady returns during periods of geopolitical uncertainty. This happens because profits from other assets are used to offset losses.

Importantly, currency focused EFTs seek to replicate the results of the currencies on which they are based. They are costly, and performance may vary due to the nature and composition of such funds. Fees are usually priced at 0.5 – 1.5%.

Forward Contracts

Another way to hedge against currency risk is using forex forward contracts. A forward contract is an understanding between two parties to buy or sell an asset at a specified future time and price.

Thankfully, forward contracts can be great buffers against currency risk. For example, an investor from Australia locks in 100 CAD worth of Canadian assets for a period of three months. At the start of the contract, the exchange rate for the Australian investor was 0.9 CAD for 1 AUD. In three months, when the forward contract ends, the CAD assets will be converted back into AUD at the agreed exchange rate.

If the agreed exchange rate is 0.9 CAD, the broker will have to honour the contract regardless of how the exchange rate moves. The investor will be able to convert their assets back to AUD at the agreed rate no matter if the exchange rate has gone up or down, therefore mitigating the currency risk for the investor.

This is advantageous to swing traders as it mitigates losses. However, if the exchange rate moves in the investor’s favour, they aren’t able to lock in the profits because of the agreement they have with their broker and counter-party.

Let’s assume that at the beginning of the contract, an investor spent 111 AUD to buy 100 CAD worth of assets. If the CAD moves to 0.8 in three months, the investor will still receive 111 AUD at the agreed-upon exchange rate of 0.9 CAD. If the investor hadn’t locked his assets in a forward contract, they could have received 125 AUD. This is a fortunate example when currency risk would have worked out in the investor’s favour. Of course, the forward contract prevents this from happening because of the agreed price.

Options

Foreign exchange options (FX options for short), are financial derivates that grant the right but not the obligation to exchange currencies at a pre-agreed rate (strike price) before or at a defined date (expiration date). They are a good option for hedging against currency risk.

Let’s say a US investor decides to buy an option contract worth 100 NZD with an expiration date of six months. Let’s also assume the strike price is 1 USD for 1.5 NZD. The trader spends 66 USD.

In six months, the exchange rate is 1.6 NZD, which is above the strike price. If the investor would exchange at this rate they would have 62 USD, incurring a loss of 4 USD. However, because the strike price was agreed at 1.5 NZD, the investor can end the contract favourably and is protected against any currency risk.

If the exchange rate moves to 1.4 NZD in the six month period, which is above the strike price of 1.5 NZD, the investor could exercise their right to leave the option without claiming it and take advantage of this fluctuation. Instead of 66 USD, the investor could now claim 71 USD.

Options may sound like the perfect solution to mitigate currency risk, but investors should be aware of the high cost of options premiums, which must be paid regardless of the exchange rate. In such a scenario, the investor could lose money, even if the exchange rate moves favourably. Fees and premiums must always be part of your trading calculations.

Diversification

Currency risk diversification can be achieved by owning different global assets such as stocks, index funds and commodities. This provides exposure to strong economies such as the US, UK, European countries and China.

With this kind of diversification, you are increasing your access to the world’s most stable economies and reducing the impact of a single investment moving against you.

Final Thoughts

In this guide, we’ve explained how currency risk can have a significant effect on returns. Swing traders should understand the basics before forex trading and can use the strategies outlined above to protect investments and capitalise on opportunities.

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