How to Mitigate Foreign Exchange Rate Risk

Many U.S. investors never consider the impact that changes in foreign exchange rates can have on their investments, especially if they tend to buy shares of U.S.-based companies. Yet as we've seen in recent years, foreign exchange fluctuations can have a huge impact on your portfolio, directly and indirectly. Below, we'll talk about some ways you can identify and mitigate foreign exchange risk.

How foreign exchange rates affect youAs an investor, there are several ways that the foreign exchange markets can change the value of your investments. If you invest in international stocks, then fluctuations in the U.S. dollar against the foreign countries in question can increase or reduce their share prices in dollar terms. Even if stocks keep their prices stable in local-currency terms, a rise in the U.S. dollar can make their share prices fall in dollar terms. Conversely, a falling dollar can make international stocks more valuable in dollar terms even if they stay flat when measured in the local currency.

However, even if you invest only in U.S. companies, the fact that the companies do business globally still makes foreign exchange rates relevant to you. If a multinational company does business abroad and the dollar rises, then the sales and profits it earns abroad will be worth fewer dollars, and that will reduce growth rates and often lead to poor financial results. If the dollar falls, then the foreign exchange that multinationals bring in will be worth more in dollar terms, and that will enhance and accelerate growth rates.

Dealing with foreign exchange rate riskIf you want to take steps to mitigate your foreign exchange rate risk, there are a number of things you can do. By focusing on domestic companies that don't do business outside the U.S., you can minimize your exposure to foreign currencies. However, you still have to be careful if a domestic company faces competition from global players, as currency impacts can help foreign rivals and hurt the domestic company's prospects.

In addition, there are now currency-hedged exchange-traded funds you can use to take currency risk out of the equation. These investment vehicles use a variety of futures contracts and derivatives to offset the impact of shifting foreign exchange rates. By doing so, they try to isolate the fundamental strength or weakness of the businesses whose shares they own from the positive or negative impact they get from the dollar's strength or weakness.

Finally, look to see how the companies handle foreign exchange rate risk. Some companies use futures or forward contracts to offset adverse movements in foreign exchange. These methods can be imperfect, but they nevertheless often have some positive influence.

Overall, foreign exchange rate risk is just something you have to deal with in a global economy. Still, there are some measures you can take to reduce the risks involved and make it easier to handle any risk that remains.

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