Understanding Currency Exposure On Your Investments

For the investor, globalization allows him or her to take on opportunities across the world. However, it has its disadvantages and one of them is foreign exchange risk.

The world has become smaller. Thanks to advancements in technology and communication, an individual is no longer solely restricted to his or her community, country, or continent. There is no doubt that this has come with its impeccable advantages and opportunities.

For the investor, globalization allows him or her to take on opportunities across the world. However, it has its disadvantages and one of them is foreign exchange risk.

Foreign exchange risk, also known as FX risk or currency risk, refers to the risk that comes with international financial transactions. It typically exists where a financial transaction is denominated in a different currency and it refers to the losses that could arise as a result of the changes in the value of the associated currencies.

There are many reasons for currency volatility or movements. Just like the stock market, the inherent strength of the economies involved plays a major role in determining its level of volatility. However, extraneous factors like unpredictable political events can also affect it.

There are two different ways by which the investor gets exposed to currency risks. The first comes with investing directly in another currency where the investor or his or her fund manager invests in foreign stock or bond markets.

For example, If you invest N100,000 in stocks in an American company and a few months down the line, the value of the dollar increases by 10% against the Naira, by the time you convert it back to Naira your investment would be worth 10% more even if there was no growth on the investment at all. The losses are the other way round.

The other way comes with investing in international companies or multinationals that have part of their operations in other countries. Ordinarily, when you invest in the Nigerian stock market, you are investing in Nigerian-based companies that are Naira denominated.

However, thanks to how operations for many companies no longer exist in a vacuum, movements in FX would most probably affect a form of operation or the other in a big company. Many companies having inventory are known to export abroad, with large percentages of their sales coming from foreign nations.

Investing in a business that produces its stock in one country and sell in others, is a prime example of a security that is exposed to currency risk. Beyond changes attributed to stock, investors can also have currency exposure when they invest in companies that have financial obligations like debt/interest repayment on foreign loans.

In both cases, it is not only the value of the investment that would be affected. Many companies are known to pay dividends in other currency denominations and as such, dividends could also be affected.

It is for these very reasons that changes in FX could have an effect on investments that investors need to be aware of it. Since it might not always be possible to invest in companies that have no relation with the foreign market at all in terms of finance or its trade, currency risk is hardly a good enough reason to back off from a security anyway.

Rather, it is one of the general factors that affect the volatility of the share price of the investment in the first place. The first step is to determine the correlation of the stock price of any investment of your choice and exchange rate fluctuations to determine if there is a zero correlation, negative correlation, or a positive correlation.

This is what would help you carry out relevant assessments. Investors, thus, need to carry out deeper analysis to know the extent of the exposure of stocks having diverse international operations to FX changes and make relevant assertions.

There is no gainsaying the fact that a diversified portfolio that cuts across currencies would ultimately lead to the eventual success of a portfolio. However, investors need to fully grasp their level of exposure to FX before investing accordingly so as to leverage possible gains and reduce the effect of possible losses.

Written by Lawretta Egba.