Currency Risk

Currency Risk (also known as Foreign Exchange Risk) is the potential for an investment's value to decrease due to changes in the relative value of two currencies. Think of it as a sneaky financial thief. You might wisely invest in a fantastic French company, watch its stock price soar in euros, and still end up losing money simply because the euro weakened against your home currency (e.g., the US dollar) by the time you sell. This risk affects anyone who invests across borders, from buying foreign stocks and bonds to holding cash in a foreign bank account. The performance of the underlying asset is only half the story; the other half is the exchange rate dance between the currency you invested in and the currency you live on. For international investors, ignoring currency risk is like sailing a ship while ignoring the tides—you might be a great captain with a sturdy vessel, but a strong current can still pull you off course.

Let's imagine you're an American investor named Jane. You've done your homework and found a wonderful British car manufacturer, “Regal Motors,” trading on the London Stock Exchange. You decide to invest $1,300. At the time, the exchange rate is $1.30 for every £1.00.

1. Your investment: $1,300 / 1.30 = £1,000.
2. Regal Motors shares cost £10 each, so you buy 100 shares.

A year later, your analysis proves correct! Regal Motors has had a brilliant year, and its share price has risen by 20% to £12. Your investment is now worth £1,200 (100 shares x £12). But wait, before you celebrate, you must consider the exchange rate.

The British pound has weakened against the US dollar. The new exchange rate is $1.20 for every £1.00. When you sell your shares and convert your £1,200 back into dollars:

1. Your return: £1,200 x 1.20 = $1,440.

Your stock gained 20%, but your actual profit in US dollars is only 10.8% ($1,440 is 10.8% more than your initial $1,300). The weak pound “stole” nearly half of your stock's gains.

The British pound has strengthened against the US dollar. The new exchange rate is $1.40 for every £1.00. Now, when you convert your £1,200 back home:

1. Your return: £1,200 x 1.40 = $1,680.

In this case, you got a double win! Your stock gained 20%, and the currency move gave you an extra boost, resulting in a total gain of 30% on your original $1,300. This tailwind is the pleasant flip side of currency risk.

For a dedicated Value Investor, the long-term view is paramount. How does currency risk fit into this philosophy?

Legendary investors like Warren Buffett and Charlie Munger have often characterized short-term currency fluctuations as “noise.” Their argument is that over very long periods (think decades), these exchange rate movements tend to even out. The real driver of long-term returns is not the currency's daily wiggle but the underlying business's ability to generate cash and increase its Intrinsic Value. Furthermore, many of the world's best businesses are global behemoths. A company like Nestlé (Swiss) or Coca-Cola (American) earns revenue in dozens of currencies. This global footprint acts as a natural hedge. If the US dollar weakens, Coca-Cola's foreign earnings become more valuable when converted back to dollars. A truly great business is resilient and can thrive regardless of what any single currency is doing.

While it might be long-term noise, you shouldn't ignore currency risk entirely. It becomes more significant in specific situations:

• Short Time Horizon: If you plan to hold an investment for only a year or two, a sharp currency swing can completely wipe out your gains or deepen your losses.
• Concentrated Bets: If your international portfolio consists of just one or two stocks in a single emerging market with a historically volatile currency, your exposure is much higher.
• Extreme Currency Valuations: If a country's currency is at a multi-decade high against your own, it might be a sign of trouble. Metrics like Purchasing Power Parity (PPP) can help gauge if a currency is significantly over or undervalued. Buying into a business when its currency is at a peak adds an extra, often unnecessary, layer of risk.

So, what's a prudent investor to do? You have several options, from the simple to the complex.

For the patient, long-term investor focused on high-quality, global businesses, this is often the best strategy. The logic is simple: the costs and complexity of actively managing currency risk can outweigh the benefits. You trust that the superior business performance will dwarf the currency fluctuations over time.

Don't put all your international eggs in one basket. By owning great companies in different economic zones—Europe, Japan, Canada, the UK—you diversify your currency exposure. A weak Euro might be offset by a strong Yen, smoothing out your overall returns.

Actively seek out multinational corporations that are, in themselves, geographically diversified. These companies have operations, sales, and costs spread across the globe, making them less vulnerable to a downturn in any single currency.

If you're particularly worried about currency moves, you can invest in currency-hedged Exchange-Traded Funds (ETFs). These funds use financial instruments called Derivatives, such as Forward Contracts, to lock in an exchange rate and neutralize the impact of currency fluctuations.

• The Upside: Your return will closely match the local-market return of the stocks in the fund, without the currency volatility.
• The Downside: This hedging isn't free; it adds to the fund's expense ratio. More importantly, it works both ways. If the foreign currency strengthens, you will miss out on those extra gains.