Why Should the Investor Worry About Exchange Rate Risk?
Businesses are taking on an increasingly global perspective. An investment in stocks in an American company on the New York Stock Exchange (NYSE) no longer means that the American investor has no exchange rate risk. This is because the company may purchase from overseas in different currencies, or indeed have customers overseas who wish to purchase products in currencies other thanthe US dollar. The same methodology can be applied to other investors around the world, such as the British investor on the London Stock Exchange.
In short to make an informed decision on an investment, the investor needs to have a solid appreciation of the exchange risks within a particular investment.
How is Exchange Rate Risk Defined?
Exchange rate risk could be defined as:
Exchange Rate Risk = The risk (gain or loss) in the value of an investment that is a consequence of changes in the various global exchange rates
What Does the Exchange Rate Risk Mean to the Investor?
Investors will look at the relative size of the Exchange Rate Risk. In terms of risk and reward the investor will demand higher returns from an investment with a perceived higher exchange rate risk. For example some currencies are considered relatively stable by many, such as the US dollar or the Euro, however this has been tested by recent events. There are however obviously currencies which are substantially riskier, the market often perceives currencies such as those in Latin America or Asia to be riskier. The investor would therefore need to consider this when making portfolio investment decisions.
What are the Key Problems with Exchange Rate Risk for the Investor?
Some perceived exchange rate risks to the investor are:
- Any operational profits made by a company in a country which has a different currency to the company’s reporting currency may be wiped out by large movements in that currency.
- A product’s price competitiveness could be affected if the competition’s currency weakens (thus making its exports cheaper to the purchaser). Depending on the price elasticity of the product, this could substantially affect the company’s performance, which is likely to impact the value of the share price and the value of dividends.
How the Investor Can Minimise Exchange Rate Risk in Their Investment Portfolio
Simply try to invest in companies that purchase all of their goods and sell all of their products in the same currency as you wish to invest. This will make a less risky investment, thus may give a less attractive return. However, in a global market place this type of company is also difficult to find.