What is Exchange Rate Risk?
Exchange rate risk (also called currency risk) arises when you invest in assets denominated in a foreign currency. A Japanese investor buying US stocks faces the risk that the yen strengthens against the dollar. If the S&P 500 returns 10% but the yen appreciates from 150 to 135 per dollar (a 10% move), the return in yen terms drops to roughly 0%. The USD/JPY rate has fluctuated between 100 and 160 over the past decade, demonstrating how significant this risk can be.
Managing Currency Risk
Currency hedging uses forward contracts or options to lock in exchange rates, eliminating currency fluctuations. Hedged international funds are available but typically cost 0.1-0.5% annually in hedging fees. For long-term investors with horizons of 10+ years, currency movements tend to average out, making hedging less necessary. A practical approach is to hedge bond investments (where currency volatility can overwhelm small bond returns) but leave equity investments unhedged.
Key Considerations
Currency diversification itself can be a benefit. Holding assets in multiple currencies reduces dependence on any single economy. Japanese investors with 100% yen-denominated assets face concentration risk if Japan's economy weakens. A portfolio split across yen, dollars, and euros provides natural diversification. However, retirees who spend primarily in yen should consider hedging a larger portion of foreign investments to stabilize income.