Daily Gains Letter

Why Knowing the Currency Risk Can Pay Off

By for Daily Gains Letter |

Knowing the Currency RiskPortfolio management is the key to growing savings over time. The implication behind this is that if an investor manages their portfolio regularly, adjusting asset classes based on market and economic conditions, they can reduce their risk and earn a decent rate of return, as well as peace of mind.

That said, investors need to look out for many different types of risks. To name a few, investors need to protect their portfolio from market fluctuations, reduce industry-specific risks, and keep in mind the rate of inflation.

While these risks may be known to investors—and they are very often quoted in the financial media—sometimes they may be exposed to currency fluctuation in hindsight. This type of risk is often referred to as “currency risk.”

Simply stated, currency risk is how the portfolio will react to the fluctuations in the exchange rates of currencies.

To say the very least, it can affect the rate of return investors earn on their portfolio, and without a doubt, investors need to be aware of this phenomenon.

For example, if an investor buys shares of a company that trades on a Canadian stock exchange, and their broker’s account is valued in U.S. dollars, upon buying the Canadian stock, investors will need to convert their U.S. dollars into Canadian dollars and buy the shares.

Now, let’s say if the stock goes up by five percent over a month and investors want to sell their position. But assume that, as the stock price appreciated, the value of the Canadian dollar went down by two percent compared to the U.S. dollar. As a result, investors’ actual gains would be smaller than they appear.

Investors need to know that they aren’t the only ones affected by currency risk. Big-cap companies have to deal with this risk, as well.

Consider Encana Corporation (NYSE/ECA, TSX/ECA), the biggest natural gas producers in Canada. In the first quarter of 2013, the company registered a loss of $431 million, compared to net income of $12.0 million in the same period a year earlier. One of the major contributors to this loss was Encana losing more than $100 million due to currency fluctuation. (Source: “Encana Sees Earnings Erased on Foreign-Currency Losses, Hedging,” Bloomberg, April 23, 2013.)

To avoid losses due to currency fluctuations, big-cap companies use hedging strategies; for example, they may set the prices of goods they will deliver in advance, so even if the currency value fluctuates, it doesn’t affect them in any manner.

Investors, on the other hand, can’t really do this, since they are not producing any goods. To protect their portfolio from exchange rate fluctuation, investors may want to look into buying an exchange-traded fund (ETF) that lets investors profit if a certain currency rises or falls in value, or an ETF that is hedged against currency fluctuation.

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