Investing in foreign assets has proven the merits of diversification, and most individual investors take advantage of the benefits of international assets. However, unless the foreign securities have been issued in U.S. dollars, the portfolio will experience 澳洲幸运5开奖号码历史查询:currency risk. Three ways to mitigate this risk include hedging with ETFs, entering int🌟o forward contracts, and entering into opti🌠ons contracts.

Understanding Currency Risk

If a U.S. investor purchased an investment in Europe that's denominated in euros, the price swings in the U.S. dollar versus the euro exchange rate (EUR/USD) would affect the investment's overall return. Since the investment was purchased in euros, the investor would be considered long the eu🐽ro (or owner of euros) since the investor would've converted dollars into euros to initiate the investment purchase. The initial investment would have been converted at the prevailing EUR/USD exchange rate atꦰ the time of the purchase.

When the investor wants to sell the investment and bring the money back to the U.S., the investment's value 澳洲幸运5开奖号码历史查询:denominated in euros w💜ould need to🍌 be converted back into dollars. At the time of the investment sale, the euros would be converted into dollars at the prevailing EUR/USD exchange rate.

The difference between the EUR/USD exchange rate at the time of the initial investment purchase and the rate at the time when the investment was sold would result in a gain or loss. Regardless of the return on the investment, the difference between the two 澳洲幸运5开奖号码历史查询:exchange rates would be realized. The risk that the exchange rate could move against the investor while the investment is tied up in euros is called currency exchange risk.

Hedging Currency Risk𝐆 With Exchange-Traded Funds๊ (ETFs)

There are many 澳洲幸运5开奖号码历史查询:exchange-traded funds (ETFs) that focus on providing long (buy) and short (sell) exposures to many currencies. ETFs are funds that hold a basket of securities or investments that can include currency positions that experience gains or losses on moves in the underlying currency's exchange rate.

The ProShares Ultra Short Euro (EUO) seeks to give investors two times the inverse daily exposure to the EUR/USD currency pair. This means it offers investors twice "the daily performance of the price of the euro versus the U.S. dollar." As such, it is meant for investors who want to benefit from a weaker euro against the U.S. dollar.

Example of an ETF Hedge

If an investor purchased an asset🅺 in Europe for 100,000 euros and at the EUR/USD exchange rate of $1.10, the dollar cost would equal $110,000. If the EUR/USD rate depreciated to $1.05, when the investor converts the euros back into dollars, the dollar equivalent would only be $105,000 (not including any gains or losses on t🅘he investment).

So an investor who holds the EUO ETF would gain by twꦡo times on the move lower in the EUR/USD exchange rate offsetting the loss from the currency conversion associated with the asset purchase and sale.

Benefits and Costs of an ETF Hedge

The ProShares Short Ultra Short Euro Fund would effectively cancel out the currency risk associated with the initial asset. Of course, the investor must make sure to purchase an appropriate amount of the ETF to be certain that the long and short exposures match.

ETFs that specialize in long or short 澳洲幸运5开奖号码历史查询:currency exposure aim to match the actual performance of the currencies on which they are focused. However, the actual performance often diverges due to the mechanics of the funds. As a result, not all of the currency risk would be eliminated. Also, currency-based ETFs can be expensive and typically charge a 1% fee.

Forward Contracts

Currency forward contracts are another option to mitigate currency risk. A forward contract is an agr🌸eement between two parties to buy or sell a currency at a preset exchange rate and a predetermined future date. Forwards can be customized by amoun🌱t and date as long as the settlement date is a working business day in both countries.

Forward contracts can be used for hedging purposes and enable an investor to 澳洲幸运5开奖号码𒉰历史查询:lock in a specific curren💃cy's exchange rate. Typically, these contracts require a deposit amount with the currency broker.

Example of a Forward Contract

Let's assume that one U.S. dollar equaled 112.00 澳洲幸运5开奖号码历史查询:Japanese yen (USD/JPY). A person is invested in Japanese assets, meaning they have exposure to the yen and plan on converting that yen back into U.S. dollars in six months. The investor can enter into a six-month forward contract i⭕n which the yen would be converted back into dollars six months from now at a predetermined exchange rate.

The currency broker quotes the investor an exchange rate of 112.00 to buy U.S. dollars and sell Japanese yen in six months. Regardless 🤪of how the USD/JPY exchange moves in six months, the investor can convert the yen-denominated assets back into dollars at the preset rate of 112.00.

Six months from now, two scenarios are possible: The exchange rate can be more favorable for the investor, or it can be worse. Suppose that the exchange rate is worse and is trading at 125.00. It now takes more yen to buy 1 dollar. Let's say the investment was worth 10 million yen. The investor would convert 10 million yen at the forward contract rate of 112.00 and receive $89,286 (10,000,000 ÷ 112.00).

However, had the investor not initiated the forward contract, the 10 million yen wo🥂uld have been converted at the prevailing rate of 125.00. As a result, the investor would have only received $80,000 (10,000,000 ÷ 125.00).

Benefits and Costs of Forward Contracts

By locking in the forward contract, the investor saved more than $9,000. However, had the rate become more favorable, such as 105.00, the investor would not have benefited from the favorable exchange rate move. In other words, the investor would have had to convert the 10 million yen at the contract rate of 112.00 even though the prev🍎ailing rate was 105.00.

Although forwards provide a rate lock, protecting investors from adverse moves in an exchange rate, that protection comes at a cost since forwards don't allow investors to benefit from a favorable exchange rate move.

Currency Options

Currency options give the investor the right, but not the obligation, to buy or sell a currency at a specific rate (called a strike price) on or before a specific date (called the expiration date). Unlike forward contracts, options don't force the investor to engage in the transaction when the contract's 澳洲幸运5开奖号码历史查询:expiration date arrives. However, there's a cost for that flexibility in the form of an upfront fee called a premium.

Example of a Currency Option Hedge

Using our example of the investor buying as Japanese asset, the investor decides to buy an option contract to convert the 10 million yen in six months back into U.S. dollars. The option contract's strike price or exchange rate is 112.00.

In six months, the following scဣenarios 🎀could play out:

• Scenario 1: The USD/JPY exchange rate is trading at 120.00, which is above 112.00. The option's strike is more favorable than the current market rate. The investor would exercise the option, and the yen would be converted to dollars at the strike rate of 112.00. The U.S. dollar equivalent would be credited to the investor's account equaling $89,286.00 (10 million yen ÷ 112.00).
• Scenario 2: The USD/JPY exchange rate is trading at 108.00, which is below 112.00. The prevailing rate is more favorable than the option's strike. The investor could allow the option to expire worthless and convert the yen to dollars at the prevailing rate of 108.00 and benefit from the exchange rate gain. The U.S. dollar equivalent would be credited to the investor's account equaling $92,593.00 (10 million yen ÷ 108.00).

By buying the option, the investor made an additional $3,307 in scenario #2 since the USD/JPY rate moved favorably. Had the investor bought the forward contract at a rate of 112.00, 🗹which was highlighted earlier, the investor would have missed out on a $3,307 g🦩ain.

Option Premiums

The flexibility provided by options can be quite costly. If the investor decides to pay the premium for an option, the exchange rate must move favorably by enough to cover the cost of the premium. Otherwise, the investor would lose money on the conversion.

For example, let's say that the above 112.00 yen option cost $5,000 upfront. The favorable move in the yen rate to 108.00 (in scenario two) would not be enough to cover the cost of the premium. If you recall, the original USD/JPY rate for the 10,000,000 yen investment was 112.00 for a dollar cost of $89,286.00.

As a result of the premium, the investor would need to get back $94,286 from the currency conversion ($89,286 + $5,000 fee). As a result, the yen rate would have to move to 106.06 for the investor to break even and cover the cost of the premium (10,000,000 / 106.06 = $94,286.00).

Although options provide flexibility, the cost of the option premium needs to be considered. Investors need to get two things right when buying an option to hedge an overseas investment. The investor needs to make a good initial investment in which it earns a gain. However, the investor must also be able to forecast the currency exchange rate so that it'll move favorably enough to cover the option premium. Although forwards don't provide the flexibility of walking away like options, they reduce the risk of a currency exchange loss and investors don't have to play the currency forecasting game.

Other Currency Risk Mitigation Strategies

Let's quickly touch on several other potential risk mitigation strategies for currency risk. They include but aren't limited to:

• Futures Contracts: Currency futures are standardized contracts that obligate you to exchange currencies at a future date at a predetermined price. Unlike forward contracts, futures are traded on exchanges, requiring margin deposits and daily settlements.
• Natural Hedging: Natural hedging involves matching revenue and costs in the same currency to offset currency exposure. For example, a business with operations abroad can use local suppliers and production, so currency fluctuations have minimal impact on the bottom line.
• Currency Swaps: A currency swap is an agreement between two parties to exchange cash flows in different currencies over a set period.
• Multicurrency Accounts: These types of bank accounts allow businesses or individuals to hold funds in multiple currencies, reducing the need for frequent conversions.
• Operational Diversification: A company can diversify business operations across multiple currencies by transacting in different countries. By doing so, it can spread (but not eliminate) currency risk.

The Bottom Line

Investors can experience currency risk when an investment's return is negatively affected by fluctuations in exchange rates—when one currency moves against another. Investors can hedge their bets against currency risk by using the three strategies highlighted above. As with anything else, it's important to do your due diligence by doing your research or speaking with a financial professional to make sure any investment you make aligns with your financial strategy.