Quick Answer
Currency risk, also called exchange rate risk, is the chance changes in foreign exchange rates reduce an investment's value. A stronger dollar hurts foreign holdings, while a weaker dollar helps them. American Depositary Receipts and bonds denominated in a foreign currency face this risk, since their value depends on currency conversion back to dollars.
The risks covered so far, such as interest rate risk and credit risk, can hit foreign and domestic bonds alike. Currency risk is different: it applies only when an investment is tied to a foreign currency, because it depends on the value of that currency relative to the U.S. dollar.
What Is Currency Risk?
- Currency risk (also called exchange rate risk) is the risk that changes in foreign exchange rates will reduce the value of an investment
- Affects any investment denominated in a foreign currency
- Even if the foreign investment performs well in local terms, unfavorable currency movements can erase those gains when converted back to U.S. dollars
How Currency Movements Affect Returns
| Dollar Movement | Effect on Foreign Investments (for U.S. investors) |
|---|---|
| U.S. dollar strengthens | Foreign investment value decreases when converted to USD |
| U.S. dollar weakens | Foreign investment value increases when converted to USD |
Example: You own a European stock fund. The fund gains 8% in euros, but the euro falls 5% against the dollar. Your actual return in USD is closer to 3%.
Which Investments Are Affected?
- ADRs (American Depositary Receipts): dividends are paid in foreign currency and converted to USD; exchange rate changes affect the dollar amount received
- International mutual funds and ETFs: holdings in foreign securities are affected by currency movements in every country where the fund invests
- Foreign-currency-denominated bonds: both interest payments and principal are subject to currency fluctuation. A foreign issuer's bond issued in U.S. dollars does not carry this risk for a U.S. investor
- Emerging market investments: typically face higher currency risk due to less stable currencies
Exam Tip: Gotchas
- A strengthening U.S. dollar hurts foreign holdings. Your foreign investments are worth fewer dollars when converted back. A weakening dollar helps foreign holdings (worth more dollars when converted).
- A domestic dollar bond carries no currency risk. Interest rate risk, credit risk, and political risk can affect both foreign and domestic debt.
- Strong dollar = bad for U.S. investors abroad. Strong dollar means foreign assets are cheaper in dollar terms, so less value when you bring money home.
Currency risk affects investments across borders. Next, we'll look at a risk that can affect any investment, regardless of location: the ability to sell it when you need to.
What Should You Check on Exam Day?
- Can you explain why a stronger dollar hurts the value of foreign investments for investors?
- Do you know which investments, like American Depositary Receipts and foreign-currency bonds, carry currency risk, and why a domestic dollar bond does not?
- Can you state why gains from a strong foreign fund can still shrink when converted to dollars?
- Do you know why emerging market investments typically carry higher currency risk?