Login with Facebook

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 assetsforeign currency risk, and currency assets remains valid but also examines geographical diversification. 


Comments




Send Comment

Need a custom
essay?

We will write it for you.
Order now

Free Essay Examples

Free essays:

Analysis of Consumption and Investment
Analysis of Business Cycles
Analysis of Fiscal and Monetary Policies
An Overview Of Economic Studies
Biosensors for cancer diagnosis
Business Analysis: Pricing strategies and Demand Curve
Broadcasting: How to Be Good In Front of the Camera
Bioconjugates for the Drugs Delivery
Cells of Immune system
Challenges that IT Managers are facing
Cochlear implant: what it is and how it works
Current challenges to the health of women
Doppler ultrasound or simply eco Doppler
DNA extraction
Dynamic Systems Modeling with Machine Learning
Digital Imaging: What Is It?
Economy analysis: Business Cycle and Economic Trends
Exchange rate and foreign currency risk
Economic Factors Affecting Decision Making In A Business
Economy Analysis: Inflation, Unemployment And Policies
Factors Influencing Interest and Exchange Rates
Fiscal and Monetary Policies in Response to 2008/2009
Fermentation: how it works and what it is used for
Financial Markets and Functions
Genetic regulation networks: modeling in biology
How does the economics of war affect society?
How can immigrants blend in the American society?
How to make your business survive at economic crisis
Importance of corporate sustainability
Interaction of Consumer and Firm Choices in Markets
Introduction to Microeconomics
Introduction of Microfabrication techniques
Journalism: What is News?
Journalism: Broadcast media and Television Presenters
Journalism: Sources of News
Journalism and Law
Key Determinants of National Income
Key Factors That Affect Pricing Decisions
Kinetic models in biology and Related fields
Know about the different forms of traditional African dances
Latest technology trends
Latest dance trends
Methods of labeling of nucleic acid that enable their detection
Macroeconomics: International Economic Issues
Neuromuscular disorders
National Economies, Fluctuation, and Responses to Fluctuations
Neurotransmitters: what they are and different types
Nanomedicines to target tumors
Overcoming Hiring Challenges for Nonprofit Organization
Principles of Microeconomics - Producer Theory
Principles of Microeconomics - Consumer Theory
Principles of Economics
Role of media in wartime.
Role of technology in the modern business environment
Role of Homeostasis in Human Physiology
Role of a digital artist
Skills in Journalism: Effective Interview
Systems biology - An understanding the functioning of biological systems
Self-assembly for biological systems
School of American Ballet
Types of corporate responsibility
The Role of Government Policy in Improving Economic Outcomes
Types of bioreactors and their applications
Technological perspectives and reflections of neural engineering
Understanding Perfect and Imperfect Competition
Ultrasound: physical principles and image formation
Understanding social entrepreneurship
Understand the importance of investigative journalism
Various theoretical perspectives of sociology
Virtual reality, what it is and how it works
What is MBA with Concentrations
What are the Causes of financial instability?
4 Facts about Origin of Mathematics!
5 techniques to create an animation
10 strategies to maximize corporate profits
13 Best colleges for political science in the world
6 Medical Technologies that revolutionized the healthcare in 2020
All you need to know about the ACA Code of ethics
Architecture and Democracy: An Introduction
Architecture and Democracy: Democratic Values
Architecture and Democracy: Democratic Procedures
All You Need to Know About a Synthesis Essay
An essential guide to understanding Film Theory
Application of Artificial Intelligence in Cyber Security
Applications of electrical engineering
Augmented reality: what it is, how it works, examples
Advantages And Disadvantages Of Social Networking
All you need to know about Cryptography
Applications of astrophysical science
All you need to know about architecture engineering
Applications of geological engineering
Artificial intelligence and medicine: an increasingly close relationship
An insight into Computational Biology
ACA code of conduct
A Rose for Emily
Applications of Mathematics in daily life
Architecture mistakes to avoid
All you need to know about Toxicology
All you need to know about Holistic Medicine
All you need to know about linguistics
An introduction to Linguistics and its subfields
All you need to know about Anxiety disorder
All you need to know about Drones
A Brief Insight into Political Science
Assumptions related to feminism
All you need to know about Byzantine emperors
All you need to know about labour economics
An insight into xenobots -the first-ever robots
An ultimate guide about Biomaterials
A Comprehensive Introduction to the Mona Lisa
Analysis methods of Transport through biological membranes
An ultimate guide about biochemical reactions
Analysis of brain signals
Artificial Gene Synthesis
Application to synthetic biology of CAD methods
All you need to know about metabolic pathways
Applications of BIOMEMS
All you need to know about the epidemiology
Asian vs. western leadership styles
All you need to know about Smart prosthesis
Analysis of Economy: Output of Goods and Services (GNP), and GDP on Economic success
A Guide to Pricing Strategies
An Overview Of Economic Studies
Analysis of Fiscal and Monetary Policies
Analysis of Business Cycles
Analysis of Consumption and Investment
How to Write a Personal Essay
Housing Needs in America
How to Write a Description Essay
How to Create an Excellent Scholarship Essay?
How to write a cause and effect essay
How to Hire the Best Essay Writing Service Provider?
How to Write a College Application Essay?
How to get the most out of your English lectures
How to write Expository Essay
How to succeed in your psychology class?
How to Write an Academic Essay in the Shortest Time?
History of Journalism
How Different Sectors are Using Artificial intelligence (AI)
How to write an informative essay
How to deliver persuasive essays?
How to Give a Convincing Presentation
How to write an essay on leadership?
Historical Art Still Around Today
Humanoid robot: what it is, how it works and price
History of Chemistry
Healthcare Advanced Computer Power: Robotics, Medical Imaging, and More
Healthcare AI: Game Changers for Medical Decision-Making and Remote Patient Monitoring
How to understand different types of English
How to Cope with Chronic Pain
How African American choreographers and dancers have influenced American dance
How mobile robot can do in logistics or in production
How To Become a Successful Entrepreneur
History of the Philosophy of Feminism
How is the climate changing?
How to Track Your Content Marketing ROI
How to Gun control In the USA?
Historical and contemporary role of labour in the modern world
How breast cancers are classified?
How the cells of our body communicate?
How the Lymphatic System Works?
How Digestive System Works
How to complete your capstone projects effectively?
How to write a research project
Healthcare technologies that help patients with better self-management
How to choose the topic of the senior capstone project
How to make your business survive at economic crisis
How can immigrants blend in the American society?
How does the economics of war affect society?
The Looming Energy Crisis in America
Top benefits of performance-based engineering
The More Languages You Know, The More Times You Are a Man
Things to consider while writing an Argumentative Essay
Top Ways to Improve Your Academic Writing Skills
Tips to Excel in Creative Writing
The origins of films in the early 19th century
Top career options in Architecture
The Elevator Pitch
Top finance trends 2020
The basic Structure and functionality of robots
The Way to Success
The election system of the President in the United States of America
Two-party System in United States of America
Top trends in urban design
The history and theory of African American filmmaking
Top benefits of creative writing
Tinnitus Guide: Common Symptoms and Treatment Options
The language of dance
The digital image processing management
Top famous politicians of the World
Top methods of political science!
The history of the feminist movement
The blood flow in cardiovascular system - Biofluid Mechanics
The best of Leonardo Da Vinci
The Structure and Function of Macromolecules
The structure of cell: a research on the bricks of the human body!
Tissue and organ construction: Adhesion and recognition between cells
The kinetics of the transformation processes
The Modeling of Biological Systems
Tips for writing a great thesis statement
The Defense mechanisms against infections
The impact of the technological innovations in medicine
Top journalism trends to know about
The relation between mass media & politics
Theranostics: Diagnosis and Care through Nanoparticles
The practical Applications of X-rays
The applications of Ultrasound in medicine
Transfer mechanisms of genetic information in Bacteria
The regulation of cellular metabolism in the diagnosis
The Principles of MRI Contrast agents
The technical basis of optical coherence imaging
The New Media: Emerging Trends
The Structure of Interest Rates and the Yield Curve
Technological perspectives and reflections of neural engineering
Types of bioreactors and their applications
The Role of Government Policy in Improving Economic Outcomes
Types of corporate responsibility
What is a Definition Essay?
What are diagnostic essays?
What is the relation between art structural engineering?
What is a Narrative Essay
What are robotics and intelligence systems?
What are the benefits of studying health sciences?
What is artificial intelligence and why it matters?
What is comparative Literature?
Why study neuroscience
What is Wi-Fi and how does it works
What is French history famous for?
What are Humanistic Studies?
What is covered in Biophysics?
What is modern journalism?
What is Virtualization? Benefits & Applications
What are modern public relations?
What is plasma physics?
What is teacher preparation?
What is rapid prototyping for 3D printing?
What is contemporary European Politics?
Why should you learn American Ballet?
What is engineering physics?
What is the purpose of African American Literature?
Ways to learn the Rhythm
What is digital art used for?
What are Enzymes and how do they work
Who is the father of political science?
Why Study Political Science - Job?
What is the Philosophy of Feminism?
What is a quantum computer?
Ways B2B Startups Streamline Their Conversion Strategies
Why do biomedical signals need processing?
What are the long term effects of climate change?
Why study labour relations
What is Holoprosencephaly?
What is antisocial disorder?
What are the important principles of evolution?
What is the cytoplasm and its function?
What is biopolymers?
What Makes a Good Leader
Women empowerment in modern generation
What is the history of political thought?
What is Gene recombination
What is synthetic biology
What is business cost analysis?
What is Inflation
What are the consequences of unemployment?
What is lithotripsy and its types?
What is transition elastography?
What is the purpose of deep brain stimulation?
What is a Brain-Computer Interface (BCI)
What is neuroethics?
What is Market and Supply and Demand
What is optogenetics?
What are the techniques to record brain activity?
What happens if the interest rate increases?
What is immunotherapy?
What is the economic role of the financial market?
What are the factors behind illegal immigration?
What is the lymphocyte activation?
What is financial market and its types?
What is the structure of financial markets?
What are the methods of measuring business performance?
What is the Credit market?
What is business ethics and code of ethics
What are the Causes of financial instability?
What is MBA with Concentrations