As world economies become increasingly connected, more and more investors are investing abroad, but doing so raises a new risk. International investments are purchased in international currencies, and that can create what’s commonly called “currency risk.”
Currency risk stems from the change in the price of one currency relative to another. To illustrate, let’s say you buy $10,000 worth of shares in a Japanese company. To do so, you’ll need to convert your U.S. dollars to Japanese yen. At the time, one yen equals two dollars, so you end up with 5,000 yen invested in shares of the Japanese company.
Now, let’s say a few months later you want to sell your shares, which have neither increased nor decreased in market price. To do so, you’ll have to convert them back into U.S. dollars. If the exchange rate stays the same – one yen equals two dollars – you’ll get $10,000 back. But, let’s say the exchange rate changes so that one yen equals one dollar. In this case, your investment, for which you paid $10,000, will be worth only $5,000. The share value didn’t change; the exchange rate did.
When you invest in international mutual funds that follow indices which measure global equity performance, such as the MSCI EAFE, you take on currency risk. This may be beneficial during periods of a weakening U.S. dollar, but if the U.S. dollar strengthens against the international currency you’re invested in, you could lose money.
You don’t have to take on currency risk, however. If you prefer to avoid it, you can seek out a currency-hedged investment.
Investorwords.com defines currency hedging as “a particular hedging strategy used to reduce risks in the foreign exchange market.” It’s fairly complicated, but professional fund managers do it well. So, if you’d like to invest internationally but avoid currency risk, ask your advisor about currency-hedged products.