What is currency risk in foreign currency investments? Factors behind exchange rate fluctuations and the pros and cons of currency hedging you should know to avoid mistakes
With the current depreciation of the Yen (Weak Yen), attention to investing in foreign currency-denominated assets is increasing.
However, many people may hesitate to take the first step due to concerns about "Currency Risk" (Exchange Rate Risk).
To give the conclusion first: Currency risk is unavoidable in foreign currency investment.
However, if you understand the factors of exchange rate fluctuations and the key points of risk avoidance, it is possible to minimize damage or even turn it into a positive.
In this article, I will explain currency risk in foreign currency investment through the following points:
• What is Currency Risk?
• What factors cause exchange rates to fluctuate?
• What methods are available to avoid risks?
What is Currency Risk?
Currency risk refers to the fluctuation in the Yen valuation of foreign currency-denominated assets due to changes in exchange rates.
When investing in foreign stocks or bonds, you basically invest in that country's currency (e.g., US Dollars for US stocks).
However, investors based in Japan are affected by exchange rates because they convert the amount into Japanese Yen when investing or cashing out.
In other words, even if the price of the stock or bond itself does not change, its value when converted to Yen changes depending on the exchange rate fluctuation.
• Example 1: If you buy US stocks when $1 = 140 JPY, and the Yen depreciates to $1 = 150 JPY, the Yen value increases.
• Example 2: If the Yen appreciates to $1 = 130 JPY, the Yen value decreases, resulting in a loss.
Basically, currency risk means that investment profit and loss are influenced by currency movements.
Let's take the popular "All Country" (All-Country World Index / eMAXIS Slim All Country) as an example.
Since "All Country" funds mainly invest in US dollar-denominated assets, there is a risk that the valuation will drop if the Yen appreciates. This is currency risk.
Conversely, the price of "All Country" is calculated by multiplying its underlying stock index (MSCI ACWI) by the USD/JPY rate, so if the Yen depreciates, the Yen-based net asset value rises.
Furthermore, stock prices tend to rise when the Yen is weak. For foreign currency assets like "All Country," a weak Yen works positively as a foreign exchange gain, so returns tend to accelerate in combination with rising stock prices.
In short, while there is currency risk, the benefits of currency movements can also be significant.
(Note: As an exception, stock price increases can cancel out currency losses.
Even if the Yen appreciates, if the stock price rises more than the currency loss, the overall price will not fall. For example, from the end of 2023 to the beginning of 2024, the Yen appreciated slightly against the Dollar, but the price of "All Country" funds actually rose because the underlying index rose even more.)
Main Factors of Exchange Rate Fluctuations
Exchange rates are basically determined by the balance of supply and demand.
Funds flowing into a country raise the exchange rate, while funds flowing out lower it.
The five main fluctuation factors are:
1. Interest Rate Differentials
2. Economic Indicators
3. Actual Demand (Real Demand)
4. Speculators
5. International Affairs / Geopolitical Risks
Let's explain each one.
1. Interest Rate Differentials
Generally, since managing funds in high-interest currencies is expected to yield more interest income, the exchange rates of countries/regions with high interest rates tend to rise, while those with low interest rates tend to fall.
For example, if US interest rates are higher than Japan's, funds flow to the US in search of better-yielding dollar assets,
leading to selling Yen and buying Dollars, resulting in a weaker Yen and stronger Dollar.
Therefore, the movements and statements of central banks (such as the FRB and BOJ) and governments can be material for exchange rate fluctuations.
2. Economic Indicators
Economic conditions indicated by various national statistics also affect exchange rates.
In particular, the Consumer Price Index (CPI) and Employment Statistics (Jobs Reports) are directly linked to central bank "monetary policy," making them high-attention indicators.
For example, strong US employment statistics often lead to a stronger Dollar.
For example, strong US employment statistics often lead to a stronger Dollar.
This strengthens expectations that dollar interest rates will remain high, potentially promoting dollar buying.
3. Actual Demand (Real Demand)
Exchange rates can sometimes move against the backdrop of supply and demand transactions associated with economic activity.
Changes in the flow of funds to and from abroad in the current account, such as the trade balance, and in the capital account, such as investments, affect exchange rates.
• Current Account Balance (Trade Balance, etc.):
If exports exceed imports, payments from foreign countries increase, leading to Yen buying (Strong Yen factor).
Conversely, excess imports lead to Yen selling (Weak Yen factor). Recently, Japan has been purchasing large amounts of cloud services and digital subscriptions (Netflix, AWS, iPhone cloud, etc.) from overseas companies.
Since these payments are in foreign currencies, the movement to sell Yen and buy Dollars is strengthening.
This is pointed out as the "Digital Deficit," a factor increasing pressure for a weaker Yen.
• Capital Account Balance (Investments, etc.):）
When Japanese companies and investors invest overseas, they sell yen to buy foreign currency, which contributes to yen depreciation.
Conversely, if investment from overseas to Japan increases, it would be a factor in strengthening the yen.
Due to the demand for yen selling in response to the increase in investment in foreign currency-denominated assets such as Orkan in the new NISA, foreign securities investment has become a factor in the depreciation of the yen.
4. Speculators
Many transactions in the foreign exchange market are speculative transactions aiming for short-term price movements, unrelated to actual demand.
• Hedge Funds and FX Transactions:
To check the trends of speculative positions, "IMM Speculative Position Data" is often used. This data is based on the "COT Report" released by the CFTC every Friday.
• Foreign Exchange Intervention by Central Banks:
Intervention by the government and the Bank of Japan has been used as an important means to change rapid market trends.
In particular, in recent cases, there have been the following movements.
■Intervention from April to July 2024
☑April 29 and May 1
About 9.8 trillion Yen buying intervention
The purpose of suppressing the dollar-yen exchange rate that has broken through the 160 yen level
☑July 11th and 12th
Yen buying intervention of about 5.5 trillion yen
Conducted in line with the downside of the US CPI,
causing the Dollar/Yen to plummet from 161 Yen to the 157 Yen level.
5. International Affairs / Geopolitical Risks
Political events like regime changes or economic sanctions affect currency credit risk. Also, when conflicts or wars occur, the Swiss Franc and Yen have traditionally been bought as "Safe Assets" (Safe-haven Yen buying).
However, with recent tensions in the Middle East, the movement to buy Yen in emergencies has weakened, and sometimes Yen depreciation proceeds instead.
Using "Currency Hedging" is Effective for Avoiding Currency Risk
One way to avoid exchange rate risk is to use currency hedging.
Exchange rate hedging is a method of avoiding gains and losses in yen terms due to exchange rate fluctuations such as yen appreciation and depreciation.
Hedge literally translates to 'to avoid,' but it is used in the sense of avoiding or mitigating risk.
By implementing a currency hedge, it is possible to reduce the risk of exchange rate fluctuations.
Many investment trusts invest in foreign assets.
Some allow you to choose between "Hedged" (Currency Hedge ON) and "Unhedged" (Currency Hedge OFF).
The advantages and disadvantages of currency hedging are as follows.
◉Advantages
☑ Can avoid exchange losses due to the strong yen
◉ Disadvantages
☑ You can't gain foreign exchange profit from a weak yen
☑ Using currency hedging incurs hedge costs
What is Hedging Cost? The cost generally corresponds to the difference in short-term government bond yields between the two countries/regions.
Hedging costs are basically higher when the interest rate difference between two countries or regions is large, and lower when it is small.
Basically, the larger the interest rate difference between the two countries, the higher the cost. Since hedging costs are deducted from the trust assets, you must recognize that they become a negative factor for investment performance.
Summary
When choosing currency hedging, you must consider:
1. Can you tolerate currency risk?
2. Which way will the exchange rate move (Strong Yen or Weak Yen)?
3. What is the level of hedging cost?
For example, as an individual, I hold US Treasury Bond ETFs (over 20 years) with Currency Hedging.
In the current state where the short-term interest rate gap between Japan and the US is wide, there is a cost disadvantage. However, I think it is not bad because I receive dividends (passive income) four times a year without worrying about currency risk. At the time of my entry, I felt the Yen depreciation had gone too far, so I opted for a hedged operation.
From 2024 onwards, costs may tend to decrease due to the narrowing interest rate gap against the backdrop of the US pivot to rate cuts and Japan's gradual rate hikes.
However, no one knows how interest rates and exchange rates will move in the future.
It is naturally acceptable to accept currency risk and expect performance from a medium- to long-term perspective.
The choice of currency hedging and the pros and cons of investing in foreign currency-denominated assets depend on individual judgment and are case-by-case. (Text by Julius)
About the Author Kenji Kamioka
CEO, Julius Inc. / FIRE Practitioner
Kenji Kamioka is a former IT executive who spent 30 years in the corporate world, with over 10 years working across Asia. His life changed when he read Rich Dad Poor Dad.
Realizing the trap of the "rat race," he started building assets in real estate and stocks while still working. It took him 10 years, but he successfully achieved Financial Freedom and graduated from the salaryman life.
He established his own asset management company to optimize tax efficiency and now dedicates his time to teaching others how to escape the corporate cage.
His advice is not theoretical but based on the gritty reality of achieving FIRE.Credentials: AFP (Affiliated Financial Planner), Certified Real Estate Transaction Agent.
Book
❶『令和のサラリーマンの為のFIREのススメ』(Amazon電子書籍）
❷『FIRE Recommendation for Office Employee』(Amazon Kindle）
