What are the risks?

Today, investors are increasingly turning to global markets to find opportunities for profit, giving urgency to the issue of protecting returns from foreign exchange risk. While there are many excellent investment opportunities to be found all over the world, volatility in the currency markets can and does affect the profitability of these investments. An understanding of how currency rate movements can affect profits can help investors protect their bottom line from this uncertainty.

A vivid example of how currency volatility can impact profits occurred in 2004. When the US stock market rallied, investors from Europe converted their euros into dollars and sent them to America to take advantage of these opportunities. Even though there was a 30% gain in the US stock market that year, it was accompanied by a 22% decline in the value of the dollar. Although the European investors had earned substantial returns on their stock investments, their profits were reduced considerably when converted back into euros because of the decline in the dollar.

Investors in other markets are also exposed to currency rate risk. When interest rates increased in the UK, many investors sent capital from all over the world to profit from these higher returns. However, at the same time, the price of the US dollar versus the pound sterling was subject to great volatility -as much as 11% in 2004! Because of this, the amount those American investors took home varied greatly depending on when they chose to convert their profits back into dollars.

Exchange rate risk can be a threat to your profitability when investing abroad. While it is impossible to predict exactly where the markets will go, you can protect yourself from this kind of volatility. Read on to learn how easy it is to hedge against currency exchange risk by taking a position in the spot foreign exchange market.

How to protect your profits

Protecting your investment profits by hedging in the spot currency market is simple and inexpensive, and completely protects your account against currency market volatility. Hedging entails taking a position in the market so that the effects of foreign exchange movements are neutralized, and gives you the peace of knowing that your profits are not vulnerable to movements in the currency market.

The principle of a hedge is simple. An investor who has invested his funds abroad wants to make sure that he is protected if the currency of the country he has invested in depreciates. Depreciation in the value of the foreign currency would mean that he gets less of his home currency when he converts his profits. The simplest way for an investor to avoid a loss like this is to sell the currency of the country where he has invested in the spot currency market. If it depreciates in value, he will profit from his spot position.

In an example taken from go currency.com someone from the UK who is investing 300,000 pounds in the US wants to make sure that when he takes his profits home, he is protected if the dollar gets weaker. To do this, he would sell dollars in his trading account so that he profits if it does get weaker. When he converts his investment funds back to pounds, his gains in the currency market will cancel out any losses caused by exchange rate volatility.

All hedging takes is a little foresight and a trading account. The total transaction cost of a hedge is minimal-only $150 in the example above. Any losses of investment capital are completely offset by gains in a currency trading account, making hedging an inexpensive and very efficient way to protect against substantial risk.