Definition
Currency risk affects any investment denominated in a foreign currency. A U.S. investor holding European stocks gains when EUR appreciates and loses when it depreciates, regardless of the stocks' local performance. Currency risk can be hedged using forwards, options, or currency ETFs, but hedging has costs and removes the potential for favorable currency movements.
lightbulb Example
A U.S. investor buys a European stock that rises 10% in EUR terms. But EUR/USD drops from 1.10 to 1.03 (-6.4%). USD return = (1.10 × 1.10) / (1.03) - 1 ≈ 3.2%, versus 10% in local terms. Currency drag reduced returns by ~6.8 percentage points.
verified_user Key Points
- Affects all foreign-currency investments
- Can be hedged with forwards, options, or currency ETFs
- Hedging has cost and removes upside potential
- Long-term impact can be significant (positive or negative)