How to cope with exchange-rate risk

Many people only think about exchange rates when they're about to go on holiday or when they hear something on thenews about the pound versus the dollar.

But exchange rates between currenciesare very important for investors andcan have a big impact on the value ofyour portfolio.

Exchange rates can affect the prices of items in the shops, a company's annual profits, and the value of your investments. Understanding the impact of exchange rates can help you to control your risks. You may even be able to profit from changes in exchange rates.

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How exchange rates are determined

The value of one currency against another depends on lots of different factors, including the strength of the two countries' economies, interest rates, economic policies and internal politics.

Recent jitters about the outcome of the Scottish referendum illustrate how important politics can be. That said, in the end it all boils down to supply and demand. More demand for a currency pushes its value up. Lots of people selling a currency pushes the value down.

Say, for example, that a British company wants to build a new factory in America. It will need to pay for the new factory in dollars, so it will have to exchange pounds for dollars.

The extra demand for the dollar may push its value up, while the value of the pound may fall depending on what's going on elsewhere. Once the factory is built, it starts making profits in dollars. But the company pays dividends in pounds, so it has to sell dollars andbuy pounds.

The risk from exchange rates comes when there are big swings in value. At the moment, the pound/dollar exchange rate is $1.625. This means that £1 buys $1.625 or you need $1.625 to buy £1.

However, if the exchange rate makes a significant move up or down, it can have a big impact on how much the British company pays for its investment in America and how big its profits are when they are converted back into pounds.

Let's say the factory will cost $500m to build and fit out. At the current exchange rate, that will cost £307.6m, but if the value of the pound was to fall to, say, $1.45, that would push the bill up to £344.8m. This is known as transactional foreign-exchange risk. You'll see a similar impact on sales.

At the current exchange rate, an American has to pay $1.625 for a British product that costs a pound. However, if the exchange rate fell to$1.45, the British company's product would become cheaper in America, which should lead to higher sales.

Profits in pounds can also fall if the exchange rate changes. This is known as translational risk. For example, $100m of profits at £=$1.625 would equate to £61.5m. At $1.45 the British company would make profits of £69m.

The company can earn fewer dollars to make the same £1 of profit. But if the pound rises in value, overseas profits fall.Lots of British companies have been hitby this recently.

Exchange-rate risk andindividual shares

Whenever you consider investing in a company, it's a good idea to look in the notes to the financial statements in the annual report and see where the company makes the bulk of its revenues and profits. Does it have large overseas businesses, or sell a lot of its products in overseas markets? If it does, ask yourself if you want to expose yourself to the exchange-rate risk.

Also, is the company reliant on a source of raw materials from abroad? Does it hedge' this risk by buying financial insurance against a falling pound? You should also look at the currency or currencies the company borrows in.

Are they matched with the currency of the assets the loans are financing? Any mismatch here can be very risky. If the value of the loan currency rises, the value of the foreign debt also goes up and shareholders' equity falls.

If you think the value of the pound is going to fall, then buying the shares of exporters or thosewith large overseas earnings can be a profitable strategy.On the other hand, you may want to avoid these shares if the pound is rising.

Diversify risk

Many investors have cottoned on to the benefits of having some foreign investments. It can be a good way to diversify your portfolio and tap into some potentially lucrative investments. But it does expose you to considerable exchange-rate risk.

Foreign shares may perform very well in their local currency, but you may receive less or more than the local return, depending on what happens to the exchange rate. A falling pound will boost your sterling return from foreign investments. A rising pound will have the opposite effect.

A good example of this was the Japanese Nikkei 225 index, which went up by 52.4% in 2013. However, the pound appreciated by 22.5% against the yen that year. That meant that UK investors' gains were reduced to 24.4% when their money was converted back into pounds.

When the pound is falling, you don't need to hedge your exchange-rate risk. Just sit back and enjoy the increasing value of your foreign investments. If the pound is rising though, you can buy funds or exchange-traded funds (ETFs) that can protect the value of the currency for you. One example is the iShares MSCI Japan GBP Hedged UCITS ETF (LSE: IJPH).

If you invest in this ETF, and the Japanese stockmarket goes up, you'll make money regardless of what happens to the pound/yen exchange rate.

Another alternative is to buy a currency ETF such as ETFS Securities Bull GBP vs G10 Currency Basket Securities (LSE: LGBB), which should increase in value if the value of the pound increases. This can be used to offset some of the damage done to the value of your overseas investments by a rising pound.