Question

Discuss different policies of currency valuation and strategies for mitigating exchange risk.

Answer 1

Most individual investors take advantage of the international benefits investment in foreign assets, but, unless investment in foreign securities is issued in U.S. dollars, the portfolio will gain an element of current risk. Currency risk is the risk that one currency moves against another currency, negatively affecting overall return. A few strategies can be helpful to mitigate currency risk or eliminate it completely.

Specialized Exchange-Traded funds (ETFs): ETFs focus on providing long and short exposures to many different currencies and they specialize in long or short currency exposure to match the actual performance of the currencies on which they are focussed.

Forward Contracts: A forward contract is an agreement between two parties to buy or sell a specific asset on a future date, at a specified price. These contract can be utilized for speculation or hedging, and for hedging purposes, they enable an investor to lock in a specific currency exchange rate. These contracts require a deposit amount with the currency broker.

Currency Options: They are very similar to future contracts, but the investor is not forced to engage in the transaction when the contract’s expiration arrives. If the option’s exchange rate is more advantageous than the current spot rate market, then the investor would utilize the option and benefit from the contract. In contrast, if the spot market rate is more favourable, the investor would let the option expire worthless, and conduct the foreign exchange trade in the spot market. The option can be quite an expensive way to hedge currency risk and this flexibility does not come free.

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