Exchange rate risk

Exchange rate risk is simply the risk to which investors are exposed because changes in exchange rates may have an effect on investments that they have made.

The most obvious exchange rate risks are those that result from buying foreign currency denominated investments. The commonest of these are shares listed in another country or foreign currency bonds.

Investors in companies that have operations in another country, or that export, are also exposed to exchange rate risk. A company with operations abroad will find the value in domestic currency of its overseas profits changes with exchange rates.

Similarly an exporter is likely to find that an appreciation in its domestic currency will mean that either sales fall (because its prices rise in terms of its customers currency) or that its gross margin shrinks, or both. A depreciation of its domestic currency would have the opposite effect.

However the two risks can often hedge each other. Suppose an investor in the US buys shares in a British company. There will be a risk that the value of the investment in dollar terms may decline if the pound falls against the dollar.

Now suppose that the British company makes a substantial proportion of its sales in the US and most of the rest of its sales are dollar denominated exports. This situation is not uncommon in sectors like pharmaceuticals or IT, or any which sell into truly global product markets.

In these circumstances a fall in the value of sterling is likely to reduce the value of the shares of the British company in dollar terms, for a given share price in sterling terms. However if the pound depreciates, the share price is likely to rise as the value in pounds of its dollar denominated sales rises.

The end result is that the two types of exchange rate risk neatly hedge each other.

This type of offsetting of risks can also be important when dealing with investments in emerging markets (especially small emerging markets) that often combine a volatile currency with high dependence on imports and exports. Small economies tend to be particularly open to the global economy because an economy that lacks technology must import many things or do without, and because an economy that produces a small range of goods or service in quantities that far exceed domestic demand (at reasonable prices), must depend on exporting them.