Question

Explain ‘currency’ and ‘Interest Rate Risk Management’ in International financial Management.

Answer 1

Currency risk, commonly referred to as exchange-rate risk, arises from the change in price of one currency in relation to another. Investors or companies that have assets or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses.

BREAKING DOWN Currency Risk

Managing currency risk began to capture attention in the 1990s in response to the 1994 Latin American crisis, when many countries in that region held foreign debt that exceeded their earning power and ability to repay, and the 1997 Asian currency crisis, which started with the financial collapse of the Thai baht.

Currency risk can be reduced by hedging, which offsets currency fluctuations. If a U.S. investor holds stocks in Canada, the realized return is affected by both the change in stock prices and the change in value of the Canadian dollar against the U.S. dollar. If a 15% return on Canadian stocks is realized and the Canadian dollar depreciates 15% against the U.S. dollar, the investor breaks even, minus associated trading costs.

Reducing Currency Risk

To reduce currency risk, U.S. investors should consider investing in countries that have strong rising currencies and interest rates. Investors need to review a country’s inflation as high debt typically precedes it. This may result in a loss of economic confidence, which can cause a country’s currency to fall. Rising currencies are associated with a low debt-to-gross domestic product (GDP) ratio. As of December 2016, the Swiss franc is an example of a currency that is likely to remain well-supported due to the country's stable political system and low debt-to-GDP ratio of 32.60. The New Zealand dollar is likely to remain robust due to stable exports from its agriculture and dairy industry that may contribute to the possibility of interest rate rises. Foreign stocks are also likely to outperform during periods of U.S. dollar weakness. This typically occurs when interest rates in the United States are lower than other countries.