Authored by Nish Bhatt
A very common risk for HNIs or overseas investors is currency risk. Currency risk has the potential to convert a profit-making bet into losses and vice-versa, it may end up eroding a significant chunk of gains made in a given trade if not factored in or steps taken to protect the slide.
For example, an India-based investor investing overseas first needs to convert his rupee to dollar, that is, Rs 76 is worth $1 (at current value) on winding up his position/cashing out from his investment the $1 may be worth 78 which is a currency gain of Rs 2 or it may be worth 74 which is a currency loss of Rs 2 all this is due to constant currency fluctuation.
So, any overseas investor needs to keep in mind the currency risk over and above the actual investment which can be a Real estate unit, Gold, Equity, or government bonds. Currency risk is more so with real estate as it an immovable asset, other things can be moved to a different country like antique, vintage cars, expensive paintings. Also, the holding period in real estate is a few years at least if one has to reap the benefits of the hefty investment made.
Not only in investing, but there is also a currency risk in Import-Export business, while signing a service contract with an overseas client i.e. many Indian I.T. firms sign contracts with U.S. firms, and it too faces currency risk in the event of undesirable fluctuation.
While the movement of currency is out of an investor’s control, there are certain steps that can be taken to protect an investment from currency risk.
Hedging with currency swaps and futures
Currency swaps are an instrument to protect an investment against undesirable/unplanned movement of currency. Under this arrangement, two parties enter an agreement to exchange currency for a fixed tenure, at the end of the tenure the currency is returned at a pre-determined exchange rate. Companies/investors use this route as a hedge, this route may incur an opportunity to gain or lose depending on the prevailing exchange rate. A currency swap involves an interest payment by both parties to each other which is normally on a quarterly basis.
A forward contract is a derivative agreement entered at a current rate for a fixed, predetermined rate at a future date. An investor is shielded in case of any adverse movement of stock, the benefit is low cost and fixed-rate guaranteed at a later date.
A mechanism wherein an investor can exchange currencies at a pre-fixed rate & tenure is called a currency option. It is of two types a call and a put option. Depending upon the prevailing situation an investor can opt for a Put or call option. While a put option is for investors looking to sell in a particular currency, a call option is to buy a currency anticipating an appreciation.
Invest in currency-hedged funds
Another way of hedging your currency is currency-hedged funds, as exchange-traded funds diversify your risk by investing in a basket of currencies. An investor can accordingly benefit by reducing risk due to diversification. The fee charged for these funds is very low. Based on the risk appetite, an investor can choose to invest in an individual currency fund or a fund that invests in a basket of currencies.
Short an overvalued currency
Investors anticipating a fall in a particular currency due to over-valuation or any other reason can short that currency or the corresponding ETFs and buy at a later date. Movement of a particular currency is linked to the economic growth or trade balance/deficit it maintains.
Buy undervalued currencies
Buying undervalued currencies is also a way to hedge, an investor can look at currencies where the valuation is below the benchmark, countries with high inflation, large debt, fiscal & trade deficit usually have to deal with undervalued currency.
Trading in currency is very volatile and can lead to considerable losses, it is recommended that a dummy account be set up until you have sufficient proficiency to trade with real money.
Nish Bhatt is Founder & CEO at Millwood Kane International. Views are personal