Investing in foreign assets can be a good way to diversify your investment portfolio. But you must first understand the risks involved before diving in head-first.
You can make more money by investing in foreign assets, but you could also lose big if the values of the foreign currencies go down. And given that fluctuations in currency values can occur overnight, it’s important to know just how much risk you’re prepared to take on.
In this article, we are going to look at some of the potential risks around investing in foreign assets and how you can deal with those risks.
What are foreign currency risks
Currency risk arises when there is a change in the exchange rate between one currency and another. This can be either an appreciation or depreciation of the other currencies (known as foreign currency) or your domestic currency (known as home or domestic currency).
When you invest in overseas assets, you are exposing yourself to three different types of foreign currency risk. These are:
Transaction risk
Transaction risk comes from buying or selling a foreign currency. To buy a foreign investment, you have to first convert your domestic currency into other currencies. If you do this through an intermediary, such as a bank, there may be exchange rate costs and/or fees involved.
Translation risk
Translation risk occurs when the value of the foreign investment is translated into your home currency for reporting or taxation purposes. To do this, you need to know how much the investment is worth in your home currency at a given time. For example, if you have an investment that is denominated in Japanese yen and needs to be converted to Australian dollars, then there is a risk that the value you report for taxation purposes may be different from the actual value.
Economic Risk
Even if the value of a foreign currency is not changing, economic events such as inflation, or deflation can cause changes to its purchasing power. For example, if you invest all your money in Japanese yen and that country experiences deflation for several years, then you would expect the yen to increase in value due to the reduced cost of goods and services. However, your investment returns are likely to be lower than expected because the value of the yen would have fallen.
How to manage foreign currency risks
To manage foreign currency risks well you need a strategy. We look at how you can do this below.
Be mindful of which countries hold importance for your investments
Risk management is as much about knowing which areas to avoid as it is knowing those with potential. Different countries have different levels of exposure to various economic risks, such as deflation, inflation, interest rates changes, political risks like war and government changes, or natural disasters like tsunamis and earthquakes.
Be mindful of your tolerance to risk
For example, if you need the money back in 1 year then you should not invest in long-term assets such as property or shares. This is because their value can fluctuate dramatically over short periods and this may affect what you can get back.
Invest in some form of international diversification
For example, if you had all your money in shares of companies based only in the United States, then your investment would be very exposed to fluctuations in US dollar currency. Just as you can diversify by country of origin or investments of choice, you can diversify by currency. This means that if the value of one currency drops against another, then you are protected to some degree because the investment returns, although in a different currency, are still positive.
Use forward exchange contracts
If you want to exchange your money for another currency at a later point in time and the risk of fluctuations between now and then is too great, then you can use ways to lock in today’s rate. This is done through the forward market. It helps you to buy foreign currency at a certain price on a future date.
Practice Hedging
You can reduce the risk of changes in currency rates by using hedging strategies where you lock in today’s rate (or better) on future transactions or investments. Hedging is when you agree with someone else to sell at a particular price in the future. This limits your potential loss from a favorable movement in the exchange rate, but it will also reduce your profit if there is a significant rise in that rate. You can use derivatives to hedge your foreign currency exposure or you can “hedge” through spot transactions using forward contracts.
Conclusion
Investing in foreign assets can be very rewarding but it comes with risks. If you are not careful, this can lead to significant losses. By being aware of the main types of risks that are involved and by making sure your investments are diversified, you can manage these risks well.
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Read excerpts from columns that appeared in April, May and June 2024 in FP Comment. This in the second instalment in a series
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