How To Reduce Currency Risk

A common area of concern for nearly every international professional, regardless of nationality, personal resources, or background, is the question “what currency should savings be held in”. Looking beyond a foreign currency deposit in your bank account, you will also at some point need to ask yourself: in what currency should my investments be denominated? The interplay between somebodies “home currency” and any second currency is formally referred to as foreign currency risk; also known as FX risk, currency risk, or exchange risk.

Foreign currency risk – a financial risk that exists when a transaction is denominated in a currency which is different from the base currency of the company or individual

For example: placing savings into a deposit account or investment denominated in a currency entirely separate from the base currency in which you live and pay for basic cost of living expenses. This creates an extra layer of uncertainty, and as such an extra layer of gain or loss on top of the performance of the investment, should you decide to convert it back to your base currency later on.

Japan is not famous for having very high interest rates. In fact, at the time of publishing this article, Japan is experiencing negative interest rates. Although these negative rates have not yet been passed on to the consumer, deposits at the banks attract next to nothing in the form of interest. As such, foreign currency deposits are a popular product pushed by the retail banks, onto their customers. A foreign currency deposit involves allowing the bank to convert from JPY into some other currency; be it USD, AUD, NZD, EUR, etc.; and then receive a market interest rate in the foreign currency; usually ranging from a 1 or 2% to as much as 5% or more depending on the currency and market conditions. While this seems attractive when compared with 0.01%; it comes with its own set of risks. For starters, the bank is usually going to charge around a 1% fee just to exchange into the foreign currency, and another 1% to change back into JPY when the deposit matures. So, for example, if it is a 3% annual deposit, you’ve only made 1% profit. And in exchange for the 1% profit over the normal Japanese rate, you have exposed yourself to a full year of currency risk. If history has taught us anything, it’s that currencies can move much more than 1% in one year, whether it be up or down.

Simply put, if the purpose is to receive a slightly higher interest rate on your JPY savings than 0.01%; we would argue a mere few % marginal benefit is not sufficient compensation for taking on the foreign currency risk. The popular retort of “if the exchange goes against me, I can always wait for it to come back” is also flawed, as currencies do not always “come back”, and even if they do, sometimes it can take decades.

A recent example of foreign currency risk manifesting itself would be the “Brexit” situation. While the political and macroeconomic debates surrounding this topic are beyond the scope of this article; conceptually it still poses a strong example of how quickly the currency markets can take a strong turn for, or against investors.

One type of investment that can spell fortune or financial ruin at the hands of currency market movements is the dual-currency loan. This typically involves , for example, working in Japan earning JPY, and wishing to purchase a piece of investment property overseas. From time to time, banks will offer the opportunity to borrow JPY against a foreign asset; the enticement usually being a slightly lower annual interest rate than those offered overseas.

For simplicity’s sake, assume in this example you are buying a property worth 1 million USD and the exchange rate is 100 yen to the dollar; and the bank requires a 20% down payment.

 

Asset Value: 1,000,000 USD (100,000,000 JPY at the time)

Down Payment: 20,000,000 JPY

Outstanding Loan: 80,000,000 JPY

Equity (Asset – Loan Balance): 20,000,000 JPY

Now let’s take a look at what happens a couple of years later if the currency market turns against the investor; and the JPY strengthens by 20%

Asset value: 1,000,000 USD (80,000,000 JPY now)

Outstanding Loan: 77,000,000 JPY

Equity (Asset – Loan Balance): 3,000,000 JPY

 

As you can see, the currency movement wiped out practically all of the equity, as the cash that the investor deposited for the down payment has been completely erased, leaving only what little equity has been built up by paying the mortgage for a couple of years. This is the good news. The bad news is that this is potentially only half of the story. As they say: “the toast always falls butter-side down”. If there is a large macroeconomic event that could cause currency markets to dramatically shift (a recession, a war, geo-political turmoil, etc.), it is possible that those same macroeconomic events could also cause the secondary market value of the property to decrease….

 

Asset Value: 850,000 USD (68,000,000 JPY now)

Outstanding Loan: 77,000,000 JPY

Equity (Asset – Loan Balance): -9,000,000 JPY

 

If the bank was not already calling with draconian demands in the second example, they definitely are now. Not only has the 20 Million in savings that constituted the down payment been completely wiped out, this investor is now underwater an additional 9 Million JPY.

This is of course not limited to USD and the US property market; dual-currency loans can be found in various different countries and as many currencies. It should be mentioned however, that this example could go the exact opposite direction as well. The USD could possibly appreciate versus the JPY, along with a rise in the US property market; creating an immense equity gain for the investor. Such is the nature of a highly leveraged investments, compounded by currency speculation. Fortune is possible, but an investor should understand and accept that ruin is also on the menu.

In a sense, the question of currency can be one of the most difficult questions to answer, as it involves multiple moving parts which are difficult or impossible to accurately predict. For example, international professionals often have multiple currencies to begin with. Although they are living in Japan, sometimes their salary is paid in the base currency of their employer’s base country; be it USD, EUR, CHF, GBP, HKD, etc. This alone can add a layer of complexity to paying the bills here in Japan. Add to that the fact that many people cannot say for certain precisely where they will be living 5, 10 or 20 years from now; and as such in what currency they will be spending. This uncertainty creates more risk that must be properly managed in order to avoid unexpected losses or financial difficulties.

Taking it a step further, proper financial planning and investment decisions should revolve around a fundamental goal-oriented plan. For example, if you live in Japan and earn in JPY; and are planning on sending your children to European universities in 8 years time; then it would make good sense to begin constructing a savings and investment strategy heavily weighted towards acquiring and accumulating Euros to prepare for that liability. If the goal is a bit more open-ended, such as planning for long term financial security, then it would make good sense to make use of international diversification. Spreading risk across asset classes and geographic regions will typically also involve spreading risk across a basket of currencies. This would be an example of balanced approach at accumulating and receiving your share of the global total market returns; being overweight or underweight particular positions where appropriate. As you gain clarity as to where and when you foresee making large or regular withdrawals from your savings, and in what currency these expenditures are anticipated to be in, you can begin re-balancing your asset base to reflect investments that would provide the relevant currency income.

[Sources]

– Exposure to Currency Risk: Definition and Measurement, Michael Adler and Bernard Dumas, Financial Management Association International Vol. 13 No. 2

– Offshore Markets for the Domestic Currency: Monetary and Financial Stability Issues, Bank for International Settlements Paper No. 320

– Regulation of Foreign Currency Mortgage Loans, Simon Walley, Financial & Private Sector Development, World Bank

Latest Insights

Summary
How To Reduce Currency Risk
Article Name
How To Reduce Currency Risk
Description
How to quantify and reduce currency risk. Tips for exapts looking to reduce forex risk.
Author
Back to Top
Close