Currency risk

As you diversify to protect your investments against nonsystematic risk, you may want to consider putting a portion of your portfolio into international stocks or bonds or into mutual funds that invest in those securities. It can be a way to benefit from gains overseas and to offset potential losses at home.

In addition to the risks that you may encounter by investing internationally — such as dealing with tax policies, varying requirements for corporate disclosure, different attitudes toward government oversight, and the economic consequences of potential political instability — currency risk is the one that may have the greatest recurring impact.

Currency risk describes the consequences of changes in the value of the U.S. dollar in relation to the currencies of the various countries where you invest or, in the case of countries in the European Monetary Union, the euro.

Up is down

When the dollar gains strength against another currency, the return on investments issued in that currency are worth less to you than they were before the dollar strengthened. Conversely, if the dollar loses ground against that currency, the same return is worth more to you. For example, if the euro is worth 5% more than the dollar, a dividend of € 1 is worth $1.05. But if the situation is reversed and the dollar is 5% stronger, the € 1 dividend is worth only 95 cents.

Finding a resolution

Since currency values change regularly, you are likely to realize both gains and losses over time. There’s not much that you, as an individual investor, can do to protect yourself from the downside. That’s one reason some investors choose mutual funds that hedge potential currency losses with derivative products known as interest rate swaps. Other funds don’t hedge, using the argument that currency risk is something you factor into a diversified portfolio.