The term currency risk refers to the relative change in the valuation of two currencies and the impact it has on return on investment. Both investors as well as businesses that own assets in countries with different currencies are exposed to currency risk.
Also known as exchange rate risk, currency risk is the potential for a loss (or a gain) due to the relative change in the value of a foreign currency to an investor's or corporation's domestic currency. Companies oftentimes reduce their exposure to currency risk through hedging.
Currency risk arises from a relative change in the valuation of two currencies. For example, when a foreign currency is converted back into a domestic currency, the relative change in these two valuations over time can significantly affect an individual's return on investment or the profitability of a business. Corporations with significant foreign exchange exposure can control this risk through sophisticated hedging techniques. Individual investors can reduce their exposure to this risk by investing in currency Exchange Traded Funds (ETFs). For example, a decline in the original investment due to a change in exchange rates can be offset with a gain on an ETF.
At the onset of any foreign investment, an individual should understand if the country's currency is rising or falling relative to their domestic currency. They should also understand the foreign country's interest rates, which will reflect their state of inflationary pressures.
An investor purchases foreign bonds and at the time of purchase the investor would receive 100 units of their domestic currency annually, resulting in a 10% return on investment. At the time of purchase, 100 units of domestic currency were worth 50 units of the foreign currency.
Over time, the foreign currency weakens against the investor's domestic currency and now 50 units of the foreign currency are worth 70 units of the domestic currency. Payment on the bond is still fixed at 50 units of foreign currency. However, that currency now provides the investor with only 70 units of their domestic currency. In this example, the investor's return has declined now to 7% from the original 10% RIO.