What is currency risk?

Currency risk — also called exchange-rate risk or FX risk — is the risk that changes in exchange rates alter the value of investments held in foreign currencies. For a euro investor, a US stock can rise 10% in dollars and still lose value in euros if the dollar falls far enough against the euro. Every investment outside the euro area carries this second source of gains and losses on top of its own performance.

How it arises

The return of a foreign investment in euros combines the investment's return in its own currency with the change in the exchange rate:

1 + R_{\text{EUR}} = (1 + R_{\text{local}}) \times (1 + R_{\text{FX}})

where $R_{\text{local}}$ is the return in the investment's own currency and $R_{\text{FX}}$ the change in the value of that currency against the euro. For small moves, the euro return is roughly the sum of the two.

A simple illustration

A US stock rises 10% in dollars over a year. During the same year, the dollar loses 8% of its value against the euro:

1 + R_{\text{EUR}} = 1.10 \times 0.92 = 1.012

The euro investor gains only 1.2%. Had the dollar risen 8% instead, the gain would have been 18.8%.

How it is measured

Currency exposure: the share of the portfolio's value in each currency, based on the currency of the underlying assets — not the currency in which a fund happens to be traded.
Volatility: exchange rates between major currencies typically fluctuate with a volatility of around 6–10% a year. That adds to the volatility of the investments themselves, and sometimes partly offsets it.

How large it is in typical portfolios

A euro investor in a world equity ETF has most of the investment in foreign currencies: in an MSCI World fund, around 70% in US dollars and less than a tenth in euros. Buying the fund in euros does not change that; a euro-listed ETF of global stocks still carries the currency risk of its holdings.

How much it matters

For stocks, currency moves add noticeably to short-term swings, but over long periods they have tended to matter less than the stocks' own returns. Many investors accept them.
For bonds, currency swings can be as large as the bonds' own returns, so foreign bonds are often held in currency-hedged form.
As diversification, foreign currencies sometimes rise when the home market falls, which can soften losses.

Currency hedging removes most of the currency effect, at a cost that depends on the difference between the interest rates of the two currencies.

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