Currency and Interest Rate Risk

Currency Risk

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. Many institutional investors, such as hedge funds and mutual funds, and multinational corporations use forex, futures, options contracts, or other derivatives to hedge the risk.

Currency Risk, sometimes referred to as exchange rate risk, is the possibility that currency depreciation will negatively affect the value of one’s assets, investments, and their related interest and dividend payment streams, especially those securities denominated in foreign currency. Corporations with operations in overseas markets are also exposed to currency risk since their foreign financial results must be consolidated into the company’s home currency. Corporate treasurers and investment managers, particularly with larger multi-national firms where the risk is material, attempt to manage this risk with various hedging techniques where appropriate. Typically, a Treasury Policy exists that states that currency risk must be mitigated where economically justified by using a specified list of financial instruments that may be employed for the purpose. Generally, a combination of forex forwards and options allow the company to fix country risk within acceptable levels as along as premiums are reasonable. These hedging techniques are not consistently effective, but diversification into many major currencies can help limit this risk.

Examples of Currency Risk

To reduce currency risk, investors can consider investing in countries that have strong rising currencies and interest rates. Investors need to review a country’s inflation, however, as high debt typically precedes inflation. 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.

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. 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 sometimes outperform during periods of U.S. dollar weakness, which typically occurs when interest rates in the United States are lower than other countries.

Investing in bonds may expose investors to currency risk as they have smaller profits to offset losses caused by currency fluctuations. Currency fluctuations in a foreign bond index are often double a bond’s return. Investing in U.S. dollar-denominated bonds produces more consistent returns as currency risk is avoided. Meanwhile, investing globally is a prudent strategy for mitigating currency risk, as having a portfolio that is diversified by geographic regions provides a hedge for fluctuating currencies. Investors may consider investing in countries that have their currency pegged to the U.S. dollar, such as China. This is not without risk, however, as central banks may adjust the pegging relationship, which would be likely to affect investment returns.

Interest Rate Risk

Interest rate risk is the risk that arises for bond owners from fluctuating interest rates. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market. The sensitivity depends on two things, the bond’s time to maturity, and the coupon rate of the bond.

Interest-rate risk is the risk, taken by bond investors, that interest rates will rise after they buy. Stated another way, it is the risk that a bond’s yield will rise (as its price falls) after it has been purchased.

All bonds involve interest-rate risk, but some involve more than others. The more interest-rate risk a bond involves, the more its price will fall as its yield rises. Duration quantifies the amount of interest-rate risk a bond involves.

Interest rate risk in a bond or a bond portfolio arises on account of the vulnerability of the value of the bond or the portfolio to the changes in interest rates.

When interest rates change, it has an impact on new and existing bonds. New bonds will now pay a coupon rate that reflects the prevailing interest rates, while existing fixed-rate bonds will not see a change in their coupon rates. However, the price of the bond will adjust so that the yield will reflect the new levels of interest rates.

If interest rates go up, existing bonds that pay a lower coupon will see a decline in the prices so that the yield from them will adjust upwards to the current market rates.

How to Mitigate Interest Rate Risk?

Similar to other types of risks, the interest rate risk can be mitigated. The most common tools for interest rate mitigation include:

1. Diversification

If a bondholder is afraid of interest rate risk that can negatively affect the value of his portfolio, he can diversify his existing portfolio by adding securities whose value is less prone to the interest rate fluctuations (e.g., equity). If the investor has a “bonds only” portfolio, he can diversify the portfolio by including a mix of short-term and long-term bonds.

2. Hedging

The interest rate risk can also be mitigated through various hedging strategies. These strategies generally include the purchase of different types of derivatives. The most common examples include interest rate swaps, options, futures, and forward rate agreements (FRAs).