3.4 Inflation & Currency Risk

Inflation Risk & Currency Risk

Both inflation risk and currency risk are systematic risks that affect investment returns. Investment advisers must understand how these risks impact different asset classes and how to protect client portfolios.

Inflation Risk (Purchasing Power Risk)

Inflation risk is the risk that the purchasing power of investment returns will be eroded by rising prices.

The Real Impact of Inflation

Inflation doesn't just affect prices - it affects the real value of every dollar you earn:

Savings account: Nominal Return 1%; Inflation 3%; Real Return -2%

Corporate bond: Nominal Return 5%; Inflation 3%; Real Return +2%

Stock portfolio: Nominal Return 10%; Inflation 3%; Real Return +7%

Real Return Formula:

Real Return = Nominal Return - Inflation Rate

Who Is Most Affected?

Most Vulnerable to Inflation Risk:

- Retirees on fixed income

- Bondholders with fixed coupon payments

- Cash savers

- Anyone with long-term fixed annuities

Less Vulnerable:

- Equity investors (companies may pass on costs)

- Real asset owners (real estate, commodities)

- TIPS investors

Inflation Protection by Investment Type

Fixed-rate bonds: Poor. Why: Fixed payments lose purchasing power

TIPS: Excellent. Why: Principal adjusts with CPI

Common stocks: Moderate. Why: Companies can raise prices, but not guaranteed

Real estate: Good. Why: Hard asset; rents and values tend to rise

Commodities: Good. Why: Prices directly reflect inflation

Gold/Precious metals: Good. Why: Traditional inflation hedge

Cash/Money market: Poor. Why: Returns typically lag inflation

Floating-rate notes: Moderate. Why: Coupon adjusts with rates

Treasury Inflation-Protected Securities (TIPS)

TIPS are designed specifically to protect against inflation:

Principal adjustment: Par value increases with CPI (Consumer Price Index)

Coupon rate: Fixed rate applied to adjusted principal

Adjustment frequency: Principal adjusts with the CPI (TreasuryDirect publishes daily index ratios); interest is paid every 6 months on the adjusted principal

Deflation protection: Cannot receive less than original par at maturity

Taxation: Phantom income - taxed on principal increase even though not received

TIPS Example:

- Buy TIPS at $1,000 par with 2% coupon

- Annual inflation is 3%

- After 6 months: Principal adjusts to $1,015

- Interest payment: 2% divided by 2 x $1,015 = $10.15 (vs. $10 originally)

Currency Risk (Exchange Rate Risk)

Currency risk is the risk that changes in foreign exchange rates will affect the value of international investments.

How Currency Risk Works

For a U.S. investor holding foreign securities:

Foreign currency strengthens: Positive - investment worth more in dollars

Foreign currency weakens: Negative - investment worth less in dollars

Detailed Example

A U.S. investor buys 10,000 euros of German stocks when 1 euro = $1.10:

Initial Investment: 10,000 euros x $1.10 = $11,000

Scenario A: Stock rises 10%, euro strengthens to 1 euro = $1.20

- Stock value: 11,000 euros x $1.20 = $13,200

- Total return: 20% (10% stock + approx. 9% currency)

Scenario B: Stock rises 10%, euro weakens to 1 euro = $1.00

- Stock value: 11,000 euros x $1.00 = $11,000

- Total return: 0% (10% stock gain offset by currency loss)

Scenario C: Stock rises 10%, euro weakens to 1 euro = $0.90

- Stock value: 11,000 euros x $0.90 = $9,900

- Total return: -10% (currency loss exceeds stock gain)

Managing Currency Risk

Hedging: Use currency forwards, futures, or options. Considerations: Costs money; may reduce returns

Diversification: Spread across multiple currencies. Considerations: Currencies may move together

Accepting risk: Don't hedge. Considerations: Long-term investors may accept volatility

Domestic focus: Avoid international investments. Considerations: Misses diversification benefits

ADRs: Buy foreign stocks via U.S.-traded ADRs. Considerations: Still has currency risk (underlying shares in foreign currency)

Hedged vs. Unhedged International Funds

Unhedged: Currency Risk - Full exposure. Best When: Dollar expected to weaken

Currency-hedged: Currency Risk - Minimal exposure. Best When: Dollar expected to strengthen

Interaction Between Inflation and Currency

Currency movements and inflation are related:

Higher inflation in U.S. than abroad: Dollar tends to weaken

Lower inflation in U.S. than abroad: Dollar tends to strengthen

Higher interest rates: Currency often strengthens (attracts capital)

In Practice: How Investment Advisers Apply This

Managing inflation risk:

- Include TIPS in portfolios for explicit inflation protection

- Consider real assets (real estate, commodities)

- Recognize that stocks provide some long-term inflation protection

- Discuss real returns, not just nominal returns, with clients

Managing currency risk:

- Decide whether to hedge based on client time horizon

- Longer horizons may accept currency volatility

- Short-term needs should minimize currency exposure

- Consider currency-hedged international funds for conservative clients

Client communication:

- Explain that inflation is a "hidden tax" on savings

- Help clients understand why international diversification creates currency risk

- Discuss the trade-offs of hedging (cost vs. protection)

On the Exam

The Series 65 exam tests your understanding of:

1. Inflation risk definition and which investments are most vulnerable

2. Real vs. nominal returns and the formula

3. TIPS and how they protect against inflation

4. Currency risk and how exchange rate changes affect returns

5. Strong dollar vs. weak dollar impact on U.S. investors

Common formats include identifying which investment provides the best inflation protection and understanding currency risk impact.

Key Takeaways

- Inflation risk erodes purchasing power; fixed-income investors are most vulnerable

- Real Return = Nominal Return - Inflation

- TIPS provide direct inflation protection (principal adjusts with CPI)

- Common stocks and real assets provide moderate inflation protection

- Currency risk affects international investments

- Weak foreign currency = negative for U.S. investors

- Currency hedging eliminates exchange rate risk but has costs

- Long-term investors may accept currency volatility for diversification benefits