Exchange rate and foreign currency risk

By making some assessments between inviting investments denominated in foreign currency and in particular on the US dollar, certainly, at some point in your reasoning, you will certainly have thought, "Well interesting. However, the problem of exchange risk remains. What if the US dollar weakens against the Euro? If you are reading this guide, customers find the optimal choice with respect to managing their financial and non-financial assets. There are some characteristics that we must take into account, and in particular, we must enter the order of ideas to evaluate investment with long-term characteristics and, therefore, not hit and run operations. The second aspect is that precisely because we are considering an investment in foreign currency, the time horizon cannot be short, and we will understand in a little while why.

Exchange rate risk: what to consider in investments?

To ensure that the exchange rate risk is significantly reduced, we must focus on investments whose yield is interesting or which have the ability to generate an important interest rate in the order of 9% -10% on an annual basis. You are certainly wondering if they exist and what these investments are. The answer is that they exist both in the financial and non-financial fields. In the financial sphere today, the market does not offer many opportunities. If we search among the listed instruments, we find that there are some long-term bonds that offer these returns. Of course, as you well know, there are no free meals in finance. Therefore, you must take on a risk of insolvency or bankruptcy of the issuer, which is not negligible, exchange rate risk. 

You do not care? Do you think that we went crazy? Absolutely no! And we fully agree with you. You cannot take exposure on those securities as a single private saver, different matter if they are contained within a mutual fund or an ETF. Are there any safer alternatives? Another possibility is provided by some bonds listed on the LUXEMBOURG market, which have a short duration of just 18 months. With this tool, we go to financial companies operating in the field of consumer credit in Russia who made 100 the loan granted to the applicant cover themselves with a 130% of guarantees provided by the same. The company has a very low default rate of around 4% on an annual low. However, this type of investment has two characteristics i.e., a minimum denomination of 125 000 dollars (about 110,000 euros). 

It is not possible to sell it before its natural expiration, although it is only 18 months. So let's say it's a better alternative to the government bonds of Venezuela and Argentina with which to reduce the exchange rate risk, but it has characteristics that are not for everyone. As a last resort, we'll talk to you about the one offered by the American real estate market. For example, it is possible to buy a property in North Carolina with a fairly modest figure or $ 70,000, which at the time of writing corresponds to € 62,500, which offers a rental rate of 9.3%. You are probably wondering, yes, you like this option more, but who manages the property, how the rent is perceived, etc. Sacred questions, but it is much simpler than you think without having to make any kind of move. Trust this for the time being, not the subject of this post. So, in summary, we take for granted the fact that there are financial and non-financial investments with a yield of 9% -10% on an annual basis.

Why isn't an exchange rate risk a problem?

Of course, when dealing with investments in foreign currency, it is obvious that we are exposed to exchange rate risk. The size of this risk must be framed in the right way. To fully understand the context in which we are moving, it is necessary first of all to frame the situation from a macroeconomic point of view. The US dollar is currently the base currency for the marketing of all commodities (gold, copper, silver, oil, gas, etc.). The historical reason why the quotation of various instruments and commodities takes place in dollars is a consequence of the fact that the USA basically won the Second World War. The main advantage that the US derives from this is that they are not exposed to exchange rate risk. On the other hand, Europeans have the Euro, the currency representing the economy of the old continent. Currently, the Euro and the US dollar undoubtedly represent the main currencies of the world economy. 

The exchange ratio between the two currencies has economic implications for the American and European economies. For example, a strong dollar represents an advantage for European exports since American citizens will pay less for goods imported from the old continent. Therefore they will consume more imported goods obviously to the detriment of their internal economy; if it becomes cheaper to buy a European car, they will obviously be purchased, less American cars. A strong euro or a weak dollar will cause the exact opposite to happen, and in particular, Europeans will consume more imported goods or, in any case, expressed in dollars and less domestic production goods. 

The consequences of these dynamics that we have described in a simple way obviously have an impact on the value of the GDP of the various nations. Therefore it can provoke growth on the one hand and recession to use a strong term on the other. As nobody wants the recession, the exchange ratio between the two currencies is also subject to the decisions of the various central banks, in particular the FED (American central bank) and the ECB (European central bank), which through monetary policy maneuvers. For example, an increase or decrease in interest rates has consequences on the exchange rate between the Euro and the US dollar.

Exchange rate risk: how to hedge it

Money as a commodity

It is necessary to start from the basic concept that currencies are treated on the markets as if they were commodities, although they have peculiar characteristics. So they can be bought or sold exactly like other types of goods. When you have to go on vacation to the United States, you likely to go to the bank; buy dollars by paying with the euros you have in your account. But how much are the dollars’ worth in this case? Currencies are associated in your country; if the pair is formed by the dollar plus another currency, it is called the exchange rate; if it is formed by two currencies other than the dollar, it is called the cross.

Since the relationship between two currencies reflects the relationship between the economies of the two countries to which the currencies belong. This relationship is carefully monitored and, in some cases, regulated by the relations of economic strength between nations.

The relationship between the two currencies is called the " exchange rate, "and its value varies continuously, exactly like the price of a share or a derivative, as determined by the demand, supply, and monetary policies of governments.

In addition, each currency is associated with an interest rate, negative or positive, which is given to holders by central banks.

Currency trading and exchange rate risk

When an investor or trader negotiates an instrument listed in foreign currency, its value is transposed into the quote currency on the basis of the exchange rate of that moment, considering that each financial intermediary can apply slightly different rates, the one from the other.

For example, if you buy a US share worth ten dollars since the exchange rate is 0.8852 euros for 1 dollar (i.e., 1.1297 dollars for 1 euro), you will pay 8.8552 euros for the share. However, and here the exchange rate risk takes over, the stock always remains quoted in dollars, because it was your euros that were converted into the US currency. So when the exchange rate between the dollar and the Euro will change, this will also change the value of my operation, which will be highlighted when the order is closed.

How to hedge currency risk

Staying at the mercy of the case is not a valid choice for any trader. The choice to operate on currency instruments should first of all be part of a portfolio diversification strategy that also takes account of currency and geographical exposure, and not only of the instrument itself.

Any investment you undertake, then, it is always mandatory to have an exit strategy that takes into account at least the worst case and the best case that can occur. And to better manage the worst case, that is, the loss of strength of our currency compared to the currency of the security on which we invested, it is possible to hedge the exchange rate risk. How?

A first hypothesis is that, suitable for expert traders, to hedge directly by trading on the currencies, with a symmetrical operation (short or downward) on the exchange rate in question. In this case, the opportunity to exploit the exchange rate trend in favor is lost, as the exchange rate is completely sterilized.

Then there are ETCs or euro hedge mutual funds that eliminate this risk but above all future exchange standards, which offer the possibility, at the given expiration date, to receive a certain amount in one currency against payment in the other.

Finally, among the many possibilities offered by the market, it is possible to diversify its operations by simultaneously focusing on geographic areas, currencies, and instruments with the inverse correlation coefficient. When a part of the portfolio is in difficulty, the other could at least partially compensate for the deficit.

The impact of exchange rate risk on foreign currency investments

With all the above premises, let's see the impact that exchange rate risk can have on a potential investment. To make the reasoning as likely as possible to reality, you can use simplifications while starting from objective data. In particular, the hypotheses on which you can develop the reasoning are the following:

1) The investment, for example on the property in the USA, has a duration of 10 years with a yield of 10%

2) The value of the property in these ten years does not undergo any devaluation and not even a revaluation

3) The constant flow of rental income

4) Development of two extreme hypotheses using the two maximum and minimum values ​​reached in the last 20 years.

Hypothesis A (strong Euro)

We have identified a property of our interest, costing $ 70,000, which at the current exchange rate corresponds to approximately € 62,500. The yield of our property is 10% per annum or rental flows of $ 7,000 per year are collected, which at the end of the tenth year amount to $ 70,000. Suppose, at the end of the tenth year, the exchange rate euro / USD is equal to 1.60 dollars for each Euro, therefore, an extremely unfavorable situation for us Europeans in terms of investment made today. We, therefore, decide to get rid of the property that we hypothesized not to have undergone any devaluation or a revaluation. At the end of the tenth year, you will end up with:

- $ 70,000 value of all rental fees

- $ 70,000 value of the property

- Total $ 140,000.

If at maturity, we hypothesize an exchange ratio of 1.6 dollars for each Euro, it means that the 140.000 $ will be equal to 87.500 € against the 62.500 € invested today. It translates into a return, in the worst-case scenario, equal to 40 % in 10 years, about 4% per year.

Hypothesis B (strong dollar)

We have identified the property of our interest, costing $ 70,000, which at the current exchange rate corresponds to approximately € 62,500. The yield of our property is 10% per annum or rental flows of $ 7,000 per year are collected, which at the end of the tenth year amount to $ 70,000. Suppose that at the end of the tenth year, the exchange rate euro / USD is equal to $ 0.85 for each Euro, an extremely favorable situation for those who make the investment today. We decide to get rid of the property that we hypothesized not to have undergone any devaluation or a revaluation. At the end of the tenth year, we will end up with:

- $ 70,000 value of all rental fees

- $ 70,000 property value

- Total $ 140,000.

If on maturity, we hypothesize an exchange ratio of $ 0.85 for each Euro, it means that the $ 140,000 will be equal to € 164,700 against the € 62,500 invested today, which translates into a yield, at best, of 163 % in 10 years.

Final considerations

Both hypotheses A and hypothesis B represent extreme scenarios that are difficult to reach. Someone said that between two extremes, the truth lies in the middle. So we assume that at maturity, the exchange ratio is equal to $ 1.22 for each Euro or equal to the average between the maximum and minimum value historically reached by the exchange ratio. In this situation, our $ 140,000 would become € 114,700, which is almost double the amount we have available to use on this investment.

The moral of the story is the exchange rate risk but, although exasperating reality with the data available to date, it translates into a more or less significant gain, as we explained in the examples above. However, the principle of diversification between financial assets, real estate assets, and currency assets remains valid but also examines geographical diversification. 

Author: Vicki Lezama