Currency risk, or exchange rate risk, is the risk that can materialise from fluctuations in the price of one currency against another. Investors that have investments or businesses operating in different countries other than their home are exposed to currency risk. Currency risk might be very damaging as it may cause unpredictable losses (or profits).
Some illustrative examples of currency risk include:
- A U.S. resident whose currency is USD and buys stocks or bonds in other currencies, such as the Japanese Yen (JPY), faces currency risk
- A U.S. investor who holds stocks or bonds in Spain, is affected by both the change in stock prices and change in value of the Euro against the U.S. dollar. If the investor gains 10% return on his Spanish stocks but the Euro depreciates 10% against the U.S. dollar, the investor will be in a break even situation. Of course he will also have to factor in brokerage costs
To mitigate currency risk, investors and companies often adopt hedging strategies which help them limit potential losses in case of significant currencies fluctuations. An example pf this are FX forward contracts.
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