In today’s global economy, currency risk is an important concern for companies conducting business internationally and individuals planning to send or receive money from abroad.
Since the early days of the pandemic, most currencies have been on a roller coaster ride with the U.S. dollar. The euro lost over 22% from May 2021 to September 2022 and rallied almost 15% since. The British pound lost 25% before rallying 15% during the same time span. Likewise, the Japanese yen lost almost one-third of its value in 18 months, only to claw back half of its losses since October.
This massive currency volatility adds a great deal of uncertainty to the process of buying or selling a foreign asset. As an example, the U.S. dollar value of a €500,000 apartment in France has oscillated between $480,000 and $610,000 during the last 2 years, a substantial difference of $130,000.
Paying in U.S. dollars is sometimes cited as one way of avoiding currency risk. However, using the dollar for international transactions has its own pitfalls. Foreign sellers will add a spread to their price in dollars to avoid losing money on the currency conversion and/or adjust their price upwards, therefore making the asset more expensive for the U.S. buyer. On the other hand, in most cases, they will not reduce their price in dollars if the U.S. currency appreciates.
If you transact internationally, you are therefore – directly or indirectly – exposed to currency risk, and if you use the U.S. dollar, you are generally impacted only by the negative side of currency volatility.
To hedge or not to hedge? That is the question.
Hedging can be defined as the implementation of a financial strategy that aims to reduce or eliminate the risk of an adverse price movement in an underlying asset or index that has the potential to cause financial loss. This is generally achieved through financial products that either lock-in the foreign exchange rate in advance or reduce the range of possible outcomes (mostly via forwards and options). Accordingly, not hedging could be described as de facto embracing currency risk, which begs the question: Why would anyone willingly decide to remain exposed to currency volatility? There are three reasons that could explain this apparently irrational behavior:
- Investors expect that the exchange rate will evolve favorably and might miss out on potential gains if a hedging strategy is implemented.
- What mathematician Benoit Mandelbrot labeled “the false assumption that what had been seen before would, more or less, persist into the future.” In other words, investors tend to underestimate the likelihood of extreme outcomes (the belief that potential losses, if any, would not be significant)
- Additional considerations that render hedging through financial products unnecessary (i.e., if there are other parts of the investor’s business that are positively impacted by an unfavorable evolution of the currency, like having invoices and revenues in the same currency).
Excluding the last reason, an investor’s decision to abstain from hedging can therefore be characterized as the most aggressive risk management strategy. Not hedging is tantamount to “hope for the best.”
In our hypothetical case of an investment in a French property, the final cost in U.S. dollars will depend on the currency rate at the time of the purchase, creating a considerable amount of financial uncertainty for the buyer.
Of course, refraining from hedging could be a valid strategy, but it is important to understand that it is an implicit decision to embrace foreign currency risk. Ultimately, there is another word for “hope for the best:” speculating.
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