Currency Risk arises when the currency denomination of portfolio assets differs from the currency in which the fund's NAV or investor return is measured. Changes in exchange rates can therefore increase or decrease portfolio value even when the local-currency prices of the underlying investments remain unchanged.
The size of the exposure depends on both the amount invested in each currency and the extent to which those exposures are hedged. Currency movements may represent an intentional source of return for some strategies, while in other portfolios they are an incidental exposure that the manager attempts to neutralize.
Currency hedging is commonly implemented using forward contracts or other foreign-exchange derivatives. A hedge can reduce the effect of exchange-rate movements, but its effectiveness depends on the hedge ratio, contract maturity, frequency of adjustment and changes in the value of the underlying positions. A hedge established against an earlier portfolio value may become incomplete as asset prices and allocations change.
Currency exposure can also be less obvious in multi-asset or multi-manager portfolios. An investment may be denominated in one currency while its underlying economic exposures are linked to several others. Similarly, an underlying fund may operate its own currency-hedging program, making the effective exposure different from that implied by the denomination of the investment alone.
Due diligence should therefore examine the manager's currency-hedging policy, the currencies and positions covered, hedge ratios, contract maturities and the process used to adjust hedges as exposures change. The objective is to determine whether currency risk is intentional, controlled and consistent with the investment strategy rather than an unintended source of portfolio volatility.