Updated August 2018
Currency risk (or exchange-rate risk), as applied to investment, is the extra layer of risk you take by owning an asset in a foreign currency.
Say you are a UK-based investor and you buy an S&P 500 tracker, which is denominated in US dollars. The US stockmarket stays flat, but the pound falls in value against the dollar. As a result, your S&P 500 holding would gain value in sterling terms, even though the market has stayed flat.
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In the same situation, if the dollar had weakened against the pound, then your holding would have lost value in sterling terms. So, currency risk represents a further factor that can affect your returns, either positively or negatively.
One way to try to tackle currency risk is by hedging. Put simply, this involves using derivatives to neutralise movements in exchange rates, leaving the investor exposed only to the underlying asset class. However, this is not a cut- and-dried decision, as we discuss above.
One factor to consider is that exposure to foreign currencies can be a useful feature of global portfolio diversification, rather than an irritating side-effect. As the slide in sterling after the Brexit vote demonstrated, owning overseas assets when your home currency is on the way down is a nice way to diversify away some geopolitical risks.
Also, remember that most major stockmarkets contain many multinationals, all of which are exposed to currency risk. For example, almost half the revenues generated by S&P 500 companies come from outside the US and the figure is more than two- thirds for the FTSE 100. So even if you invest solely in Britain's "headline" index, you are still taking currency risk it's just not as obvious.
Finally, if you decide you prefer to hedge your currency risks, do so consistently. If you chop and change your approach, you are effectively betting on currency movements and that's a recipe for disaster.
See Tim Bennett's video tutorial: Depository receipts: An easy way to invest in foreign firms.
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