International stock markets can be exciting places to trade. Investing in one or more global markets also helps diversify your portfolios. As more investors add international stocks and funds, it’s important to understand the potential impact of currency risk.
Currency plays a major part in today’s global economy and the size of currency market dwarfs the global equity market. One 2014 estimate sees average daily forex volume of $4 trillion versus $84 billion for global stocks. Governments, central banks, corporations, and investors of all types are active participants in the global forex market. Even if you primarily trade stocks, failure to consider the impact of currency risk in your stock trading can be a major oversight. Note that there are many unregulated forex brokers out there so make sure you carefully compare forex brokers before trying forex trading.
Currency Risk in Foreign Stocks
Currency risk is most apparent when you buy a stock in a currency other than that of your home country. It’s possible to have a profitable trade in the local currency, yet lose money overall due to currency risk. There is a video with an illustrative example of a USD investor buying a GBP denominated stock. Despite a 2 pound gain (in local currency), the trader lost money overall due to the decline in the value of the pound versus the dollar below.
Currency Risk in Domestic Currency Securities
So I’m only exposed to currency risk if I buy stocks denominated in currencies other than my home currency, correct? Not so. Currency risk may also be present in assets which are denominated in your home currency.
American Depository Receipts (ADRs)
One good example of this is ADRs. ADRs were created to provide an easier way for Americans to own foreign stocks. Without ADRs, US investors might need to open trading accounts abroad and exchange currency in order to purchase shares in those foreign companies.
ADRs are US exchange listed securities issued by banks that represent an ownership interest in a foreign stock. They trade on US exchanges during US trading hours and meet US regulatory standards. Although the underlying foreign stock is often denominated and pays dividends in a foreign currency, the ADR is denominated and makes dividend payments in USD. As you can see, there is a mismatch in the currency denomination of the assets and liabilities of the ADR, which makes ADR owners subject to currency risk.
An example of an ADR is Japan-based company, Toyota Motor Company (NYSE: TM) for which the performance of the ADR is linked to the price of the yen denominated shares and the JPY USD exchange rate. Between Dec 2012 and Oct 2014, the price of Toyota’s Yen shares increased 74.6%, however, the ADR only appreciated 33.7%. This is because there was a 24% depreciation in the value of the Yen versus USD over this time period.
Many multi-national companies have substantial operations in more than one currency zone. These companies will accumulate foreign currency from overseas sales and incur foreign currency expenses from overseas operations. However, a 2013 study found that close to half of non-financial US companies do not actively manage their foreign exchange risk. This means that a multi-national company’s earnings may be driven by both their global business operations as well as unmanaged currency volatility. This can have a positive or negative impact on company earnings depending on forex markets.
Managing Currency Risk
So what’s a trader to do? Do I need to stick to small domestic stocks if I don’t want to deal with currency risk? Not so. There many time tested methods and instruments to deal with foreign currency risk.
Currency Hedged Instruments
One possibility is to trade currency hedged ETFs or invest in currency hedged funds. There are close to 100 currency hedged ETFs available these days from providers like Deutsche Bank, Blackrock, Wisdom Tree, Invesco, Proshares, etc…
One example, the WisdomTree Europe Hedged Equity Fund (Ticker: HEDJ) tracks an index of dividend paying eurozone companies but removes the EUR / USD exposure via hedging. This might be good fund to trade if you are long term bullish on European companies but afraid to trade because of the potential currency risk emerging from the recent Brexit vote.
Another option is to measure and monitor the currency exposure in your portfolio and actively manage such risk by currently trading. One effective and efficient way to go about this would be via the use instruments like contracts for differences (CFDs). Forex CFDs are over-the-counter financial derivatives (not traded on an exchange). They allow you to speculate on the changes in the value of currencies without actually owning them.
As we’ve often see when we travel abroad, currency exchanges at international airports have substantially different buy and sell rates. This means you can lose a lot of just by exchanging physical currency even if they don’t charge commission. CFD brokers allow you to make similar trades with a fraction of the cost, often only a spread of a few “pips.” Note that you can also trade CFDs on individual stocks and stock indicies with these brokers. So it’s possible to do your stock and currency trading under a single platform.