Exchange rate risk of or foreign exchange risk is an unavoidable risk of foreign investing, but it can be mitigated substantially through hedging techniques. To get rid of forex risk, you would have to avoid investing in overseas assets altogether.
However, this may not be the best alternative from the perspective of portfolio diversification since numerous studies have shown that foreign investing improves portfolio return while minimizing risks.
How to Hedge Risks
There are two general ways if you want to hedge risks:
Invest in hedged assets
The easiest way is to invest in hedged overseas assets, such as hedged exchanged-traded funds (ETFs). ETFs are available for a wide range of underlying asset traded in most major markets.
Many ETF providers offer hedged and unhedged versions of the funds they have that track popular investment benchmarks or indexes.
Although the hedged fund will generally have a slightly higher expense ratio than its unhedged counterpart due to the cost of hedging, big ETFs can hedge currency risk at a fraction of the hedging cost incurred by an investor.
Hedge Exchange Rate Risk Yourself
You most probably have some forex exposure if your portfolio contains foreign-currency stocks or bonds or American depository receipts (ADR).
Instrument for Hedging Currency Risk
Currency forwards can be effectively used to hedge currency risk. For example, suppose a US investor has a bond that’s denominated in euro and that’s maturing in a year’s time and concerned over the risk of the euro plunging against the US dollar in that time frame.
The investor can enter into a forward contract to sell euros in an amount that’s equal to the maturity value of the bond and buy US dollar at the one-year forward rate.
While the benefit of the forward contracts is that they can be customized to certain amounts and maturities, a big disadvantage is that they are not immediately accessible to individual investors.
An alternative way to hedge currency risk is to build synthetic forward contract using the money market hedge.
Currency futures are used to hedge exchange rate risk because they are trading on an exchange and they need only a small amount of upfront margin. The pitfall is that they cannot be customized and are only available for fixed rates.
The availability of ETFs that have a specific currency as the underlying asset means that the currency ETFs can be used to hedge exchange rate risk.
This is likely the most effective way to hedge exchange risk for larger amounts. On the other hand, for individual investors, their ability to be used for small amounts and the fact that they are margin-eligible and can be traded on the long or short side leads them to provide major benefits.
Currency options provide another possible alternative to hedging exchange rate risk. Currency options provide an investor or trader the right to buy or sell a specific currency in a specified amount on or before the expiration date at the strike price.