The top ten stock exchanges in the world account for 65% of global stock exchanges by market capitalisation. They span the US, London, Germany, Japan, Hong Kong, Canada, Spain and Brazil.
In contrast, the entire Australian share market only counts for 2% of global share markets.
Consequently, anyone considering trading stock indices or shares who doesn’t come from one of the larger markets will probably consider trading internationally. However, although international trading opens opportunities across a wider range of markets, it also makes your portfolio vulnerable to currency risk.
What is currency risk?
Currency risk is the risk of the exchange rate turning against you. For example, if you were an Australian trader who wanted to go long on the FTSE100, not only would you be taking on the risk that the FTSE100 would fall instead of rising, but you would also take on the risk that the AUD/GBP forex pair would move against you.
Let’s say you bought a mini-contract on the FTSE 100 on August 25, 2010 when it was at 5100 points. A mini contract is worth GBP2 per point movement so, as this is a short trade, you will make a GBP2 profit for every point the index falls, and a GBP2 loss for every point the index rises (these figures exclude the dealing spread and any other charges).
On September 30 you closed your trade at 5600 points, making a profit of GBP1,000.
On September 30 the GBP/AUD exchange rate was 1.6300. So your GBP1,000 profit would have been a profit of AUD1,630 when converted into Australian dollars.
However, the exchange rate on August 25 was 1.7435. If you had made your profit then, it would have been AUD1,743.50. Consequently, you lost a potential AUD100 in profit.
An AUD100 loss of potential profit isn’t that bad – you still made nearly AUD1,750 in actual profits.
Currency risk gets more serious when you are in a losing trade, and the exchange rate also moves against you.
Let’s say that you decided to go long on 1,000 Barclays shares on July 29, when they were priced at GBP220 each. On August 10, they hit a low of GBP162.50, losing you GBP57.50 per share, or GBP5750 in total.
On July 29, when the GBP/AUD was at 1.4811, this would have been a loss of AUD8,516.32. On August 10, when the exchange rate was 1.6056, this loss was AUD9,232.20.
Hedging with forex trading
The most common way to hedge currency risk is to take a position on the forex pair concerned in your other trade.
The trades above both involved the GBP/AUD. In the first trade the pair fell, and in the second, it rose. If you had predicted the direction the pair would move, you could have made a trade on the pair to offset any losses incurred as a result of the changing exchange rate.
Locally-denominated assets
However, the difficulty in hedging by trading forex is that you will need to be able to make judgements about the expected movements of a currency pair, as well as the expected movements of your shares.
A simpler way is to trade in locally-denominated assets.
In the conventional share market, it can be difficult to access international shares, as few are often listed on domestic exchanges. Consequently, international shares are often traded through derivative products, like CFDs.
A CFD is a contract that allows you to trade on an underlying asset without actually owning it – instead you just make a profit or loss as its price moves. Good CFD providers offer CFDs on a range of markets, like forex, options and commodities, as well as international shares and stock indices.
And, one additional benefit is that a number of CFD providers are now offering CFDs denominated in the local currency. This allows you to trade on a number of global markets, without worrying about currency risk.
IG Markets, for example, has a number of mini-contracts available on global stock indices, which are valued at AUD1 per point movement. By contrast, the internationally-denominated mini-contracts have varying values per point movement, in AUD, USD, GBP, EUR, HKD, CHF and more, which makes it more difficult to calculate your potential profits and losses.
Conclusion
Currency risk is the risk of the exchange rate turning against you when you trade in international markets. As trading shares and indices already carries the risk of adverse price movements, many traders choose to avoid international markets and the additional foreign exchange risk. However, this can be managed, either by trading forex, or by using a broker who offers locally-denominated international assets.
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