Investors can reduce their currency risk by hedging with currency futures. Investing offshore helps to spread risk because not all markets around the world move in the same direction at the same time.
Diversification between markets offers the opportunity to reduce risk and improve return, however, along with this opportunity comes the risk associated with fluctuations in exchange rates.
These fluctuations have a direct effect on the value of investments. If you have investments in Australia which are producing a good return and the value of the New Zealand dollar increases with respect to the Australian dollar, then the value of your Australian investments, when converted to New Zealand dollars, will fall, thus reducing the total return on your investment.
Of course, the opposite can also be true and returns can be enhanced if the New Zealand dollar falls in value.
Predicting exchange rates in the short term is by no means an easy feat because there are so many variables at play.
Investors can reduce their currency risk by hedging with currency futures. Futures contracts are advance orders to buy or sell an asset, in this case a currency.
An investor expecting to be repaid funds in a foreign currency at a future date can lock in the current exchange rate by entering into an offsetting currency futures position. It makes sense to do this when you are expecting a change in exchange rates that will have a significant adverse effect.
If your offshore investments are in a managed fund, it pays to find out what the fund's hedging policy is.
Some funds are hedged and some are not. Of those which are hedged, some may be fully hedged and some may be hedged at the discretion of the fund manager, usually within certain limits.
The impact of currency risk should not be overlooked when investing offshore.
* Liz Koh is an authorised financial adviser. The advice given here is general and does not constitute specific advice to any person. A disclosure statement can be obtained free by calling 0800 273 847. For free e-books see moneymax.co.nz and moneymaxcoach.com