How to manage currency risk

Many of my clients earn and save in more than one currency. I often get asked the following:

• Should I keep large deposits in different currencies?
• When should I exchange one currency to the other?
• How often should I exchange?

Before we answer those questions, it’s helpful to look at the currency market through the long-term lens and short-term lens separately.

 

Long-term Currency Risk

Below are the charts of EUR, GBP and JPY against USD in the last 20 years.

 

 

While the changes to exchange rates are not entirely random, you can see that there isn’t a particular pattern or range the rates exhibit over a long period of time. If your needs related to the currency happens regularly over many years, doing the exchange in intervals usually allows you to spread out the risk.

For example, if you earn in EUR but buy investments in USD, exchanging in regular interval allows you smooth out short-term volatility. It’s the equivalent of contributing to your US 401(k) regularly regardless of market performance. You may buy low or high sometimes, but overtime you average out the purchase price.

This means that keeping large deposits in different currencies for multi-year regular expenses is generally not necessary. You can exchange at regular interval as needs require, while consider the costs associated with the transfer.

 

Short-term Currency Risk

Now looking at only one year of history, we can feel the currency risk more.

 

 

USD became stronger in 2022 due to relative higher interest rates and better economic conditions than other major countries that back their own currencies. Given USD is still the dominant global trade currency, and the US Federal Reserve has hiked interest rates aggressively to tame inflation, demand for USD has gone up and raised its price.

With hindsight, we know that the currency imbalance eventually reversed course when the other countries began raising interest rates. Nevertheless, if you happened to need a large amount of USD when the exchange rates do not favor you, knowing that the exchange rates stabilize in the long-term doesn’t help!

This is the main currency risk that we focus on – when we have a known need in the near future for a different currency that is large and irregular.

For example, you may need to make a house down payment, pay college tuition or even large tax bill in a different currency from what your most of your income or saving is denominated in. You may have expected a certain foreign currency is enough six months ago. But in the current environment, suddenly it won’t give you the same amount of USD as you had planned.

 

How to manage short-term currency risk

Now we are more acutely aware that this risk exists, how should we plan for it?

First, a mindset shift. Just like we don’t invest our emergency fund in volatile stock markets, we don’t keep the funds we know are needed in the short-term for an expense in a different currency. Don’t invest your immediate cash needs in the volatile currency market!

For instance, if you need to pay for USD 100,000 in six months, and some of that is still in EUR, even though EUR is still dropping, you should exchange that into USD now to make sure you have USD 100,000 in six months.

You may feel like you lose money this way and believe exchange rate will get better within six months. In reality, you lose money only relative to your expectation, and you can’t be sure EUR will not drop further.

On the flip side, you may be the lucky person who only needed 100,000 EUR in six months but now have more EUR because you didn’t exchange earlier. You should also exchange enough now to make sure you can meet your short-term need. Don’t try your luck further!

Under either of the two scenarios, you are “giving up” something. You are giving up the potential for gaining some through currency exchange for the guarantee that you have enough to fund the expense you would not be able to do otherwise.

Think about it as insurance. You are paying a premium, a cost of not getting a better exchange rate, to guarantee that you can fund your purchase.

 

Simulating Futures Contract

In fact, this is the same concept that companies apply to manage currency risk with international trade. It’s just that they use instruments such as futures contract instead.

A company may be earning a non-US currency from its local product sales, but need to pay its foreign suppliers in USD, the dominant currency in international contracts. To manage the risk of not having enough USD due to exchange rate risk, companies will purchase futures contract to lock in the exchange rate that they can use to guarantee their profits in local currency.

Note the key words – purchase, and lock in. To purchase a futures contract, there is a cost. To lock in an exchange rate, there is a loss of potential better exchange rate.

To mitigate the downside, you must be willing to give up the upside.

For most individuals, the need for foreign currency isn’t generally at the scale where purchasing futures contracts makes sense. However, the same principal applies. At some point, you need to lock in the exchange rate needed for you to fund the purchase. The further away the purchase, the more volatility you can endure and smooth out by regular exchanges. For near-term needs, don’t try to “time the market” for a gain that may never come with a downside that you cannot weather.

 

Currency Devaluation and Crypto

One caveat as I close. Devaluation of certain currencies is also a real risk, but it’s out of scope of our discussion. (See TRY and LKR.) In this discussion, we view currencies as means of exchange (purchase and sell). As you probably agree, we don’t keep all our assets in cash! The currency risk we discussed only exists when we exchange assets into cash in the form of different currencies to spend, or when we purchase assets with different currencies to save. People whose livelihood is intricately connected to an ill-managed currency need to invest in assets that are a store of value to manage currency devaluation risk.

At this point, you might be thinking, isn’t Crypto currency supposed to be the perfect solution to currency devaluation risk? Well, only if it is stable (which is now still tied to USD) and safe from custodian collapse. Alas, the fate of a currency is still tied to the entity that controls it. A truly decentralized and stable value currency simply doesn’t exist.