When looking at all of the opportunities associated with investing in international opportunities, it is important for personal investors to remember how it is that these potential returns come in hand with a variety of additional risks that are exclusive to that kind of position. Between the currency, interest rate risks between the two countries alone, a personal investor needs to be aware of which products can be used in conjunction with their foreign investments, so as to fortify the position over the longer term.
By far the largest risk associated with foreign investment stems from the fluctuations that occur between the different currencies involved in the transaction. For example, an American investor may realize a 9% nominal gain by holding funds in an Indian Certified Deposit, which is a reasonably safe investment in that country, and provides an extremely high comparative rate of return.
However, because of the way in which the inflation rate on the Indian Rupiah tends to exceed 10%/year against the US Dollar, the investor will actually lose money against the currency exchange rate, and walk away worse off as a result of the investment. Alternatively, if the investor has placed their money into a shared deposit in a country with an appreciating currency, such as the Czech Republic, the investor could walk away with an even greater return on the exchange rate.
Regardless of the movements, the volatility of currency changes can be unsettling for a personal investor that would rather take on direction exposure to a foreign company. As such, an investor can benefit by taking on an ETF or mutual fund position that counter-acts the risks of the currency fluctuations, or the interest rate changes that underlie those rate shifts, which will leave the investor with only exposure to the fundamental risks of the investment itself. Alternatively, investors can take out currency swap agreements with their banks, which allow them to insure themselves against the risks of currency fluctuations over a defined period of time
The second major risk of investing into an international equity stems from the sheer liquidity of that particular country. Because of the way in which many of these foreign investments are made in markets that are still developing, there will not usually be enough of an established market to support the market price of the investment over the short term. This means that, in the short term, there would be no reasonable way to liquidate an investment position without taking a loss, because there is nobody that is really interested in the position.
However, while a long-term outlook is by far the most effective strategy for mitigating this sort of risk, there are a number of options available for investors to take a tangible stand against the liquidity risks themselves. Firstly, an investor may choose to use options and derivatives to hedge their entry and exit prices for the position, and to also provide a ‘volatility cushion’ from the premiums received by the options sold against the security itself.
This strategy is effective in the way that it provides investors with a reduced effective purchase price, which then reduces the risks of price fluctuations. However, it also reduces the amount of control that an investor has over their position, as it becomes subject to execution risks associated with a counter-party. Before entering into such a position, we must therefore first decide upon how it is that we feel as though the counter-party risks of execution measure up against the premiums (and therefore the level of protection) that we will receive from the options themselves.