Investment in Foreign Exchanges: Risks Involved

International investment offers potential for higher return but at the same time bears additional risk than investing in domestic securities. The risk associated with international investing are described below:

Political Risk

Investors in developed countries have to be aware of potential political risk. The political risk arises from an unstable government. In the country of investment. Many parts of the world are ongoing immense changes, including the Middle East, parts of Asia, and Latin America. Some countries within these regions are not only new to capitalism but also new to democracy and the rights of workers as well as investors. An emerging nation might be a safe and stable place to invest until a new regime is voted into power. Practically overnight, a nation can change from a conducive place for outside investors to a destabilized country. Investors also bear the risk of civil unrest and war, which can greatly affect the value of their investments. Political instability and other political calamities can bring down returns, and, in extreme cases, can make it entirely impossible to withdraw investors’ capital.

Regulatory Risk

The second factor is that majority of the global markets are less regulated than developed markets, increasing the risk of manipulation or fraud. Some foreign countries do not have the same level of regulatory and financial oversight over companies doing business within their borders as the developed world does. Accounting rules might be more lenient in some countries than others, which might increase the chances of fraud. Therefore, it is always a good idea to check before investing whether a foreign country has filed regulatory reports. Investors can obtain information on international securities regulation from the sources like International Organization of Securities Commissions.

Tax Risk

The taxation of foreign investments is a complicated area. First, most foreign countries tax corporate profits and dividends paid to investors. Those tax rates might be higher or lower. Furthermore, the tax due by foreign governments is usually taken or withheld from any money due to investors, such as dividends. For example, if an ADR pays a $1 per share dividend, investors might receive only 90 percent after 10 cents per share withholding is subtracted. The institution that creates the ADR might also charge a fee to pay the taxes to the foreign government. The domestic government might also tax investors’ gains from international investments. And for many taxpayers, the domestic tax rate charged on dividends received by foreign companies will be higher than the tax charged for dividends paid by domestic stocks.

Information Risk

There is also risk due to inadequate reliable information available about various international markets. This can limit the investor’s precision of market movement. Even in cases where adequate information is available, the right interpretation of it can be challenging for an outside investor. Foreign countries have different views on the flow of news and information. The accounting practices and reporting requirements of overseas nations just are not the same as those in the home country. Crucial information can be difficult to acquire. In many cases, such information may not be available at all. Even if an investor can get such information. s/he can never be sure that the information is completely accurate.

Liquidity Risk

Liquidity risk is also a common risk in international investing. Some foreign markets trade at much lower volumes compared to the major exchanges. There could be fewer investment options, and the markets may not be open during all traditional business hours. Investors may also pay a higher price to purchase foreign securities, and when they are ready to sell the securities, they could experience trouble locating a buyer. These factors increase the liquidity risk in international investing.

Currency Exchange Risk

On top of these, the risk of fluctuation in the exchange rate is the most important. The exchange rate between the currencies of countries changes frequently. An increase in the value of one currency relative to another currency is known as appreciation and a decrease in the value of one currency relative to another currency is known as depreciation. For example, let us consider the exchange rates between the US dollar (USD) and Nepalese rupee (NPR) in the given table:

You can just see the fluctuation in the exchange rates and guess the impact of investing in USD vis-a-vis NPR or vice-versa. Let us take two dates 01 Jan 2020 and 01 March 2020. You could buy 1 USD by paying Rs. 106.18 NPR on 01 Jan 2020; the value of NPR depreciated relative to USD. Alternatively, we can say the value of USD appreciated on that day. Again take two dates – 01 March 2020 and 01 May 2020. You notice NPR appreciated against USD or we can say USD depreciated against NPR. Such fluctuations in the value of currencies are regular phenomena in the foreign exchange market and the risk posed by such fluctuations is known as currency exchange risk.

Currency fluctuations may offer both advantages and disadvantages to investors. For example, when you sell the investment or get dividends, you receive money in foreign currency. But you cannot buy food or pay the rent with foreign currency. You need to turn those dividends and payments back into domestic currency. To get the domestic currency back, you must use the foreign currency to buy the domestic currency. If the foreign currency rises in value compared to the domestic currency, you can buy more domestic currencies, which boosts your return. Unfortunately, the opposite may happen, too. If the foreign currency declines in value, your returns declines when you buy domestic currency. Thus, investing overseas requires investors to closely follow news and trends from various regions and keep a keen eye on potential currency fluctuations.

Overall, foreign securities offer a great opportunity, given the benefit of geographical diversification and exposure to multiple growing economies. Thus, most financial experts and advisors recommend the inclusion of foreign securities to investors’ portfolios.