What Is Exchange Rate Risk?
Exchange rate risk is the uncertainty of returns to an investor who acquires securities denominated in a currency different from his or her own. The likelihood of incurring this risk is becoming greater as investors buy and sell assets around the world, as opposed to only assets within their own countries.
A U.S. investor who buys Japanese stock denominated in yen must consider not only the uncertainty of the return in yen but also any change in the exchange value of the yen relative to the U.S. dollar. That is, in addition to the foreign firm’s business and financial risk and the security’s liquidity risk, the investor must consider the additional uncertainty of the return on this Japanese stock when it is converted from yen to U.S. dollars.
As an example of exchange rate risk, assume that you buy 100 shares of Mitsubishi Electric at 1,050 yen when the exchange rate is 115 yen to the dollar. The dollar cost of this investment would be about $9.13 per share (1,050/115). A year later you sell the 100 shares at 1,200 yen when the exchange rate is 130 yen to the dollar.
When you calculate the HPY in yen, you find the stock has increased in value by about 14 percent (1,200/1,050), but this is the HPY for a Japanese investor. A U.S. investor receives a much lower rate of return, because during this period the yen has weakened relative to the dollar by about 13 percent (that is, it requires more yen to buy a dollar—130 versus 115).
At the new exchange rate, the stock is worth $9.23 per share (1,200/130). Therefore, the return to you as a U.S. investor would be only about 1 percent ($9.23/$9.13) versus 14 percent for the Japanese investor.
The difference in return for the Japanese investor and U.S. investor is caused by the decline in the value of the yen relative to the dollar. Clearly, the exchange rate could have gone in the other direction, the dollar weakening against the yen.
In this case, as a U.S. investor, you would have experienced the 14 percent return measured in yen, as well as a gain from the exchange rate change. The more volatile the exchange rate between two countries, the less certain you would be regarding the exchange rate, the greater the exchange rate risk, and the larger the exchange rate risk premium you would require.
There can also be exchange rate risk for a U.S. firm that is extensively multinational in terms of sales and components (costs). In this case, the firm’s foreign earnings can be affected by changes in the exchange rate. As will be discussed, this risk can generally be hedged at a cost.
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