Why Currency Risk Can Be Genuinely Painful
October 7, 2022 Updated July 14, 2023
Currency risk is often associated with companies who trade in different foreign markets. Unfortunately as many investors and traders have found over the years, this risk also applies to them. This can come from a direction you do not expect but is no less powerful. To combat this eventually we have given examples to prepare you for the unexpected. This can ensure when the worst happens you are already a step ahead.
Takeaways
Understand how currency risk can evolve
Find out which countries have manipulated their currencies
Learn from real life examples
Why is currency an issue for investors?
Because it can create a risk of loss. Imagine you identify a fantastic opportunity in a foreign listed stock. You sell the currency your account is based in, and then buy this stock in it's own currency. The stock promptly increases by 20%.
The problem is, in the meantime the currency has lost 20% in value. For all your hard work, your have gained nothing. This is currency risk.
Frankenshock
Currency risk is also a risk for Forex traders because you can loose everything. Your Forex broker could go bankrupt. What became known as Frankenshock is an example of this.
In 2015, the Swiss central bank removed its peg against the Euro. This caused the Swiss Franc to skyrocket 20% in a heartbeat. Few were ready for it, as such volatility in between two important currencies is unheard of.
Sometimes currency risk can come from the most unexpected areas. In the Autumn of 2022, the UK government decided for political reasons to cut taxes. This was in the hope of appealing to the conservative base which supported them. The government also believed these tax cuts would stimulate growth.
To achieve these tax cuts, meant borrowing large amounts of money from public markets. When public markets realised the sums required, they balked. This concern led to indiscriminate selling of GBP versus USD as can be seen below.
At the centre of this is the New York Federal reserve who are desperate to stop the rise in inflation and indeed lower it. As a result they have increased the Fed fund rate a cool 0.75% in 3 successive Federal Open Markets Committee meetings in 2022 (at the time of writing).
This is a lot. The new NY Fed governor has openly said that some pain may be needed to achieve the aim of reducing inflation. This creates increased currency risk for those short the US dollar.
Currency risk through central bank manipulation
The currency risk that king dollar creates, has led to other currencies being weakened. At times, this has been considered unacceptable. An example is what is currently happening in Japan.
The Japanese Yen has dropped so much versus the dollar that The Bank Of Japan has 'rate checked' the market. This phenomenon is when Forex dealers at the Bank of Japan ring round major broking houses asking what is the prevailing exchange rate in their view. This has two effects.
One, it informs the person doing the asking. (Although they can find this out through market information feeds). Secondly, and arguably the reason for rate checking in the first place, is that it creates an expectation in the Forex market that they are going to intervene in the defence of the Japanese Yen (by selling dollar and buying Yen).
This is important. No central bank can defend its currency against the Forex market if it believes a currencies's valuation is unsustainable (Kwasi Kwarteng please take note).
By 'rate-checking' a central bank can see what the immediate reaction is. A change in the momentum of the currency, means the market supports your actions. As a result, you know that Forex market participants will support your intervention by trading in the same direction, creating the desired momentum.
If your currency keeps losing value after you have rate-checked the market then you know there is no point in intervening. (you can save a lot of money in the process as successful interventions are rare). Although I am not implying this is what the Bank of Japan is up to, just the notion of rate checking can create market volatility and therefore risk for you.
Conclusion
Fundamentally currency risk comes from the same place as a trading opportunity: Business and politics. Whether we like it or not, the two are inter-twined. Having an understanding of what could happen in the Forex market as a result of a change in policy means you can plan this into your risk management strategy.
It also means you can use occasions where currency risk appears, by taking advantage of the opportunities to profit that are presented to you.
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