Currency risk
What is Currency risk?
Currency risk is the possibility that exchange-rate movements change an investment's return when measured in the investor's base currency.
Why currency risk matters
An asset can rise in its local market but lose value for a foreign investor if its currency weakens enough. Currency also affects company revenues, costs, liabilities, and competitiveness, creating indirect exposure beyond the denomination of a security. Global portfolios therefore need to distinguish asset performance, currency translation, and economic currency sensitivity.
How it is measured
Direct exposure begins with market value by currency, adjusted for cash, forwards, and other hedges. Return attribution separates local-currency return from the exchange-rate effect and their interaction. Scenario analysis applies single and correlated currency shocks. For companies and funds, look-through revenue, cost, and underlying asset exposures may differ from listing or reporting currency.
Example
A Japanese equity gains 8% in yen while the yen falls 10% against the investor's base currency. The base-currency return is approximately negative 2.8%, because the two returns compound rather than simply subtract. A currency hedge could reduce the exchange-rate effect but would add forward pricing, transaction costs, collateral, and basis differences.
How to interpret it
Clarify the base currency and whether figures are hedged, unhedged, or partially hedged. A currency position can diversify some portfolios and amplify others. Evaluate exposure with asset and liability currencies together. Strategic currency policy should be separated from active currency views so performance and risk can be attributed to the correct decision.
Limitations
Currency sensitivity changes with company behavior, derivative positions, and market correlations. A hedge may not match the asset's changing value and can create cash requirements when forwards settle. Political controls or market disruption can limit execution. Historical currency volatility alone does not capture devaluation, convertibility, or settlement risk.
Practical checklist
Aggregate direct and look-through exposures by currency, identify the base currency for each objective, and document hedge ratios and permitted ranges. Model asset and hedge cash flows under large moves. Separate translation from security return in reporting. Review hedge costs, counterparties, collateral, roll schedule, tax treatment, and whether the policy comprehensively addresses both invested assets and future liabilities.
Also known as: foreign-exchange risk, FX risk