Reviewed by Jan 05, 2021| Updated on
Currency risk is also referred to as the exchange rate risk. Currency risk arises due to the variation in the price of one currency up against another. Companies and investors having a business operation or assets spread around the world are more likely to experience currency risk. This risk can go on to creating irregular losses or profits.
Therefore, when there is a currency exchange involved, one must always factor currency risk as there are high chances of being on the receiving end. Most multinational companies (MNCs) run this currency risk, and that is the reason why they generally like to have their businesses expanded to the Asian countries.
Handling currency risk started to get attention sometime in the 1990s as a result of the crisis in Latin America in 1994. Some countries belonging to the South American continent were holding a foreign debt which was way more than their earning power and repayment ability. Also, the Asian currency crisis in 1997 fueled the fire and led to the plummeting of the Thai baht.
Currency risk can be mitigated to some extent through hedging. Hedging is a process that can offset the fluctuations in currency.
If an investor from the United States of America is holding some stocks in Canada, then the returns that he or she may realise be affected by the fluctuations in the stock price and the movements in the Canadian dollar against the United States dollar.
If the investor gets 15% returns on their holding of Canadian stocks, and if the Candian dollar loses 15% against the American dollar, then the investor will go on to break even with additional trading costs.
Currency hedge funds are ETFs and mutual funds that are explicitly designed to bring down the currency risk. These funds are currency hedged and generally use futures and options. The advent of the US dollar has resulted in designing of currency-hedged funds for both emerging and developed markets.