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Difficulty: HardSystematic and Market Risks

A U.S.-based investor holding a selection of European equities denominated in euros (EUR\text{EUR}) decides to double the number of stocks in the portfolio from 15 to 30 companies across various Eurozone market sectors to protect against exchange rate losses. During the year, the euro depreciates significantly against the U.S. dollar (USD\text{USD}), reducing the investor's total return upon conversion back to U.S. dollars. Which of the following best explains why expanding the portfolio's equity holdings failed to protect the investor from foreign exchange losses?

  1. Currency risk is a systematic risk for foreign holdings that affects all assets denominated in that currency and cannot be eliminated through asset diversification.Answer
  2. B
    Adding additional individual equities within the same monetary zone eliminates currency volatility once the portfolio expands beyond 25 distinct security positions.
  3. C
    Equity prices automatically rise in direct proportion to foreign currency devaluation to maintain constant yield curve parity with domestic bonds.
  4. D
    Currency risk represents an issuer-specific credit default hazard that applies exclusively to fixed-income instruments rather than equity shares.

Answer

Currency risk is a systematic risk for foreign holdings that affects all assets denominated in that currency and cannot be eliminated through asset diversification.
Currency risk is a form of systematic (market) risk that affects all investments priced in a foreign currency. Because all 30 equities are denominated in euros, a drop in the euro's value relative to the U.S. dollar reduces converted returns across the entire portfolio. Adding more individual company holdings reduces business-specific risk but cannot eliminate systemic exchange rate exposure.

Step-by-Step Solution

1
Identify the risk factor described in the scenario
The investor is exposed to currency (exchange rate) risk, which occurs when a foreign currency depreciates relative to the investor's home currency (USD\text{USD}), diminishing converted returns.
Understanding the specific risk category is essential to evaluating risk mitigation strategies.
2
Distinguish between systematic and non-systematic risk
Systematic risks (such as market, interest rate, inflation, and currency risks) impact the broader market or an entire asset category and cannot be diversified away. Non-systematic risks are company-specific and can be reduced by adding more holdings.
Diversification across more companies within the Eurozone reduces stock-specific risk but leaves the portfolio fully exposed to euro currency shifts.
3
Evaluate the effect of portfolio expansion
Doubling the number of Eurozone stocks from 15 to 30 distributes capital across more issuers, but all holdings remain denominated in euros (EUR\text{EUR}). As the euro declines against the U.S. dollar, every position incurs exchange rate drag.
To hedge currency risk, investors must use specific hedging instruments (such as currency options or futures) rather than domestic/regional equity diversification.

Key Concept

Currency Risk as a Systematic Risk
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Topics

Systematic and Market Risks

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