Currency risk definition: Its the risk that currency depreciation will affect the value, worth or profit of one’s revenue streams, investments or assets, in a negative way.
Currency risk is a term used in forex trading but also commonly used for businesses that have their operations in different countries. In fact, the currency risk term was coined around 1988-1992 due to a lot of countries having foreign debt that vastly exceeded their earning capabilities. Simply explained. When you are dealing with two different currencies it creates a risk of unpredictable profits and losses (PNL). The two different currencies will develop unrelated to each other.
An example: A business based in Europe is commonly using Euro, the same business might have operations in the US, where they are paid in USD. The currency risk here is that a very strong or weak Euro in relation to a very strong or weak Dollar.
In today’s society we are all being exposed to currency risk so having knowledge of what exactly currency risk is and how to handle problems that might arise due to currency risk can be very useful. A few useful methods of managing currency risk would include:
- Investing in strong currencies only
- Invest in EFTs that are commonly protected by options of futures.
- Hedging currency risk (Foreign exchange hedge)
Currency risk management
Having a few tricks up your sleeve to for currency risk management can be useful regardless if you are trying to master forex trading or if you are the CEO of Facebook. A few useful methods of currency risk management:
Hedging currency risk – Foreign exchange hedge – Forex Hedge
Hedging currency risk refers to a method which is used to hedge and eliminate currency risk. When you are hedging currency risk you managing the risk with either forward contracts or options. A forward contract is simply a contract that uses the current exchange rates for any deal or agreement made. In other words, you lock today’s exchange rate and this exchange rate will be used going forward independent on how the different currencies develop in the future. An option sets an exchange rate at which the company may choose to exchange currencies. If the current exchange rate is more favorable, then the company will not exercise this option. An option lets a company set an exchange rate and leaves it as optional and if the current exchange rate is more beneficial the company will most likely not choose the previous option (exchange rate) that was agreed upon.
Only invest in strong currencies
If you are a forex trader then another way to manage currency risk is to only invest in currencies that have a strong foundation and development. By doing this you are decreasing the currency risk, or exchange rate risk. If you invest in volatile currencies, you will do the opposite and increase the currency risk.
Invest in Currency hedged Funds
It’s quite common that EFTs (exchange-traded funds) are protected against currency risk by options or futures (see above for explanation). In other words, if you invest in EFTs, and they are currency hedged, you minimize the currency risk.
As we gain knowledge it will become easier to avoid currency risk, and that knowledge is literally at your fingertips, below, you can find a few interesting articles that you may find useful.
- What is forex trading?
- Best forex brokers
- Best Forex trading strategies
- Plus500 Review, 24Option Review & IQ option Review.