Currency risk, also known as exchange rate risk or FX risk, can be defined as the risk that investors’ assets will be negatively affected by currency depreciation. Since currency rates are constantly changing, investors trading in different currencies should take this into account when making foreign investments. Currency fluctuations can have a significant impact on your returns, both positively and negatively.
If you decide to invest in a product denominated in any foreign currency, whether it is to buy or sell, the transaction will be in that currency. Therefore, a currency conversion will take place. Of course, the current exchange rate or any fluctuations can impact the price you pay as well as the performance of your portfolio.
Exchange rate risk also applies to companies that conduct business internationally. For example, if a company purchases materials overseas and that country’s currency appreciates against the local currency, the company may end up paying more for the materials than it had in the past.
Investors interested in foreign markets may lose or gain from currency exposure. Understanding the reasons why currencies fluctuate can help you when creating your investment plan and deciding how much risk to take. Below are three main reasons why currencies fluctuate:
Countries’ monetary policy: Central banks can influence the demand for currency by adjusting the money supply or changing interest rates.
Countries can influence the value of its currency by buying or selling it. Generally speaking, a country will sell its currency when it wants to decrease its value.
If a country's interest rate increases, this can lead to an appreciation (increase in value) of its currency. High interest rates can attract money to flow into a country, which can strengthen its value. On the contrary, when the interest rate decreases, it can result in depreciation (decrease in value) of the currency.
Inflation: Inflation rate measures how much the average price of a basket of goods increases over a period of time. Typically, countries with higher inflation rates have lower currency values. For example, if inflation rates rise in the UK compared to the Eurozone, this means that the price of UK goods increases more quickly compared to European ones and therefore they can be less competitive. As a result, demand for GBP can decrease and thus its value.
Current political and economic situation: The economic and political conditions of a country have an impact on local currency. Generally speaking, if the country is politically and economically stable, investments in this country are seen to be more stable. As a result, higher demand leads to a higher value of the relevant currency.
On the other hand, global tension, local conflicts or even wars can lead to lower demand of a local currency. This can have a major impact on the level of foreign exchange risk.
There are generally three classifications of currency risk: transaction risk, translation risk and economic risk. As an investor, it is important to understand and consider these risks when investing in foreign financial instruments.
Transaction risk arises when an investor is buying a product from another country and price is denominated in the foreign currency. For example,
if the foreign currency appreciates against your home currency, it means that you will need to pay more in your home currency to make the transaction.
Translation risk is a risk that companies face when they deal with foreign currencies and have foreign assets on their balance sheets. In this case, when companies report their earnings, they typically have to convert the value of foreign assets back to the local currency. When exchange rates fluctuate between countries, the translation value of assets will also fluctuate. Depending on the movement of the exchange rate, a financial gain or loss will be reported.
Economic risk is relevant when the market value is influenced by unexpected currency fluctuations. While unavoidable, this can have a significant impact on a company. Economic risk is also referred to as forecast risk.
Transactions in foreign currency can be handled in two ways; using the AutoFX option or holding foreign funds manually. AutoFX is the default option and we automatically convert the required amount. If you sell a stock, proceeds will also be converted back to your base currency. With Manual currency holding, you have the possibility to manually convert funds and hold foreign currency on your account. If you frequently trade in foreign currencies, the Manual function could be a more cost-effective option. An overview of the fees for both options can be found on our Fees page.
The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.