Currency Risk and Diversification

Managing currency risk in investments
Currency risk—uncertainty of returns associated with changes in exchange rates—is an inevitable companion of international investments. Understanding the nature of this risk and strategies for managing it is critically important for building global portfolios.

Sources of currency risk
For an investor holding foreign assets, the return in the home currency consists of the return of the asset in the local currency and the change in the exchange rate:
$r = r^* + \Delta e$ (approximately), where $r$ is the return in the home currency, $r^*$ is the return in the foreign currency, and $\Delta e$ is the percentage change in the exchange rate.
Currency volatility can significantly increase the volatility of international investments. For developed markets, currency volatility is comparable to bond volatility and constitutes a significant portion of overall risk. For emerging markets, currency volatility is often even higher.
The correlation between asset returns and the currency affects overall risk. If the asset declines simultaneously with the currency (positive correlation), currency risk amplifies losses. If the asset and currency move in opposite directions, the currency can partially hedge the asset's risk.

Currency risk hedging
Hedging eliminates or reduces currency risk using derivative instruments. Forward contracts and currency swaps allow one to fix a future exchange rate. The cost of hedging is determined by the difference in interest rates (covered parity).
The decision to hedge depends on several factors.

Investment horizon: short-term investors are more likely to hedge; for long-term investors, currency fluctuations average out.
Asset class: hedging bonds is usually recommended due to the low volatility of the underlying asset; for equities, opinions differ.
Hedging cost: with a large interest rate differential, hedging may be expensive.

Currency diversification
Holding assets in different currencies provides diversification. If currencies are not fully correlated, some currency movements are averaged out.
For a global portfolio, holding assets in many currencies reduces currency risk relative to concentration in a single currency.

Income currency vs. expense currency: investors with future liabilities in a certain currency (for example, pension expenses) should take this into account when selecting the currency structure of assets.

Strategic considerations
The US dollar plays a special role as the world's reserve currency. During crises, the dollar often strengthens ("safe haven"), which increases losses for American investors from falling foreign assets. For non-American investors, dollar strengthening can partially offset declines in dollar-denominated assets.
Emerging market currencies are more volatile and prone to crises. Investing in EM requires heightened attention to currency risk.

Choice of debt currency: companies and countries make decisions about the currency of borrowings. Debt in foreign currency is cheaper when rates abroad are low, but creates currency risk. Crises are often exacerbated by the currency mismatch of assets and liabilities.

Application for investors
Full hedging eliminates currency risk, but also possible benefits from currency diversification. Partial hedging is a compromise.
The optimal degree of hedging depends on risk preferences, horizon, cost.

Active currency management can add returns through currency selection, timing, and carry trade. However, this requires skill and creates additional risks.

Taking currency effects into account for companies: exporters benefit from a weak currency, importers—from a strong one. This affects sectoral analysis and stock selection in the international context.