Currency risks are risks that arise from changes in the relative valuation of currencies. These changes can lead to unexpected gains and losses when converting profits or investment earnings from a foreign currency to U.S. dollars. Investors can mitigate currency risks by using hedging and other techniques designed to offset any gains or losses related to currencies.
How to Manage Currency Risks
International investors have several options when it comes to managing currency risks, including using instruments such as currency futures, forwards, options, or currency-related hedge funds. However, these tools can often be costly and complicated for individual investors to use. A simple and flexible alternative for hedging against currency risk is currency-focused exchange-traded funds (ETFs).
Determining Whether Hedging is Necessary
Creating a hedge against currency risks can be quite expensive. By definition, investors need to offset every unit of foreign currency with U.S. dollars to be fully protected. Some of these costs can be reduced by using stock options instead of equity capital, but the cost may still be prohibitive for individual investors with small investments. Accordingly, investors should review whether hedging is even necessary. Here are some common questions to consider before hedging:
- Does the cost of the hedge represent an excessive percentage of the total investment? In other words, does the cost exceed the negative currency risk?
- How long will you hold the foreign security? In the short term, currencies tend to fluctuate relatively little, meaning the cost of hedging may not be worth the marginal benefit.
- Do you think there is a significant risk of currency depreciation? During stable economic times, currencies tend to trade with relatively low volatility, making hedging somewhat unnecessary.
Creating a Hedge Against Currency Risks
If hedging seems reasonable, the next step is to find a suitable exchange-traded fund to use. A complete list of currency-related ETFs can be found on CurrencyShares and/or WisdomTree websites. Meanwhile, several other companies may offer specialized exchange-traded funds that may or may not be suitable, depending on the investor’s situation. Here are some common currency ETFs:
- CurrencyShares Canadian Dollar Trust (NYSE: FXC)
- CurrencyShares Australian Dollar Trust (NYSE: FXA)
- WisdomTree Chinese Yuan Fund (NYSE: CYB)
Here are the steps to hedge against currency risks using an ETF:
- Identify an ETF. Start by searching CurrencyShares and WisdomTree and other ETF providers for an ETF that aligns with the foreign investment. If multiple options are available, investors should look for ETFs with the lowest costs and fees.
- Determine the direction. Hedging always takes the opposite direction to the foreign investment. Therefore, if the investor holds a long position in a Canadian stock, they should have a short position in a Canadian dollar ETF. Conversely, if the investor holds a short position in a Chinese stock, they should have a long position in a Chinese yuan ETF.
- Calculate the amount. Investors can partially or fully hedge their foreign investments against currency risks. For a full hedge, investors must buy the same dollar amount in the currency fund. Alternatively, they can purchase options with rights for the same dollar amount.
- Manage the trade. Once the trade is executed, investors should monitor the situation closely throughout the duration of the trade. If the currency becomes more stable, it may be wise to sell a portion of the hedge, while an unstable situation may call for additional protection.
Source:
https://www.thebalancemoney.com/what-is-currency-risk-1978927
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