Three Strategies to Mitigate Currency Risk (EUFX)

Investing in foreign assets has proven the merits of diversification, and most individual investors take advantage of the benefits of international assets. However, unless you invest in foreign securities issued in U.S. dollars, your portfolio will gain an element of currency risk. Currency risk is the risk that one currency moves against another currency, negatively affecting your overall return. Investors can accept this risk and hope for the best, or they can mitigate it or eliminate it completely. Below are three different strategies to lower or remove a portfolio's currency risk.

There are many exchange-traded funds (ETFs) that focus on providing long and short exposures to many different currencies. For example, the ProShares Short Euro Fund (NYSEARCA: EUFX) seeks to provide returns that are the inverse of the daily performance of the euro. A fund like this can be used to mitigate a portfolio's exposure to the performance of the euro.

If an investor purchased an asset that is based in Europe and denominated in the euro, the daily price swings of the U.S. dollar versus the euro will affect the asset's overall return. The investor would be going "long" with the euro in this case. By also purchasing a fund like the ProShares Short Euro Fund, which would effectively "short" the euro, the investor would cancel out the currency risk associated with the initial asset. Of course, the investor must make sure to purchase an appropriate amount of the ETF to be certain that the long and short euro exposures match 1-to-1.

ETFs that specialize in long or short currency exposure aim to match the actual performance of the currencies on which they are focused. However, the actual performance often diverges due to the mechanics of the funds. As a result, not all of the currency risk would be eliminated, but a vast majority can be. 

Currency forward contracts are another option to mitigate currency risk. A forward contract is an agreement between two parties to buy or sell a specific asset on a specific future date, at a specific price. These contracts can be used for speculation or hedging. For hedging purposes, they enable an investor to lock in a specific currency exchange rate. Typically, these contracts require a deposit amount with the currency broker. The following is a brief example of how these contracts work.

Let's assume one U.S. dollar equaled 111.97 Japanese yen. If a person is invested in Japanese assets, has exposure to the yen and plans on converting that yen back to U.S. dollars in six months, he can enter into a six-month forward contract. Imagine that the broker gives the investor a quote to buy U.S. dollars and sell Japanese yen at a rate of 112, roughly equivalent to the current rate. Six months from now, two scenarios are possible: The exchange rate can be more favorable for the investor, or it can be worse. Suppose the exchange rate is worse, at 125. It now takes more yen to buy 1 dollar, but the investor would be locked into the 112 rate and would exchange the predetermined amount of yen into dollars at that rate, benefiting from the contract. However, if the rate had become more favorable, such as 105, the investor would not get this extra benefit because he would be forced to conduct the transaction at 112.

Currency options give the investor the right, but not the obligation, to buy or sell a currency at a specific rate on or before a specific date. They are similar to forward contracts, but the investor is not forced to engage in the transaction when the contract's expiration date arrives. In this sense, if the option's exchange rate is more favorable than the current spot market rate, the investor would exercise the option and benefit from the contract. If the spot market rate was less favorable, then the investor would let the option expire worthless and conduct the foreign exchange trade in the spot market. This flexibility is not free, and the options can represent expensive ways to hedge currency risk.