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4 ways to protect yourself from foreign-currency risk

On March 31, Janet Yellen gave a speech to which every U.S. investor with foreign holdings should have been listening—on whether or not the Fed plans to raise interest rates anytime soon.

During her talk, which she gave at a community investment conference, the new Federal Reserve chairperson mentioned that the decision would be based on a number of factors, including inflation and labor market conditions, but she believes that the economy and jobs are still too weak to start increasing rates.

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Why is this important? Because interest-rate movements impact the most liquid market in the world: foreign currency.

Any investor who holds stocks outside the U.S. will have some exposure to foreign currency, and where the greenback goes will have an effect on these people's portfolios. For instance, a strengthening dollar could negatively impact foreign stock market returns.

Interest rates are critical, because when a country's rate rises, in many cases, so does its currency, said Shahab Jalinoos, managing director of foreign-exchange strategy at UBS.

Up until recently, this wasn't much of a worry for American investors. Rates were low, the U.S. dollar was weak, and people made money by investing in foreign assets.

While Yellen's recent comments have assuaged some people's fears that a rate increase was coming before the economy could handle it, most experts think that at some point over the next two years, interest rates will rise.

"The theme in the last few years has been dollar weakness," said Jalinoos. "That will change as the interest rates increase in the U.S."

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Investors need to take currency into account when they invest, said Ed Boyle, vice president and portfolio manager of global fixed income for American Century Investments, a large New York City-based asset-management firm.

To some that will mean finding undervalued currencies in order to make money off the eventual price appreciation. To others that will mean finding ways to protect their portfolio from forex ups and downs.

So what's an investor to do? Here are four ways people should approach currency today.

1. Hedge your bets

With the U.S. dollar rising, many experts suggest that average investors remove as much of their currency risk as they can, said Boyle.

By hedging foreign assets in your portfolio, you won't lose any money if the currency your investment is in falls. Of course, you won't gain anything if that currency appreciates.

Hedging against movements in the Japanese yen would have been a wise decision over the last year and a half, said Boyle. Since January 1, 2013, the Nikkei Index has climbed 45 percent, but the yen is down 13 percent.

"You could have outperformed the S&P 500 if you hedged," said Boyle. "But most people probably didn't."

There are two ways to hedge: Buy a currency-hedged mutual fund, or invest in an exchange-traded fund. These funds remove the risk for you, so you only have to worry about stock market returns.

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2. Short an overvalued currency

Another way is to short the currency you're exposed to. Someone wanting exposure to Canada would buy the iShares MSCI Canada ETF(EWC) and then short the FXC, a Canadian currency ETF. If the Canadian dollar falls against the U.S. dollar, you'll make up those gains from shorting that currency ETF, said Boyle.

More adventurous investors can simply short currencies they think will fall in value, said Dean Popplewell, the Toronto-based chief currency strategist at OANDA, a company that offers a forex trading platform to investors.

Investors who use this strategy will sell a currency for a predetermined price on a specific date in the future. Every currency trades in pairs, though, so you also have to buy another currency for this transaction to work.

Essentially, you're exchanging one currency for another. If you think the euro is going to depreciate, you'd sell that currency and buy U.S. dollars.

After the euro falls, you buy it back at the lower rate, and the difference between the selling price and the buying price is your profit.

"It's like going long or short on stocks," said Popplewell. "You go long on anything you think will go up and short something that will underperform."

He thinks that most currencies will continue to struggle against the U.S. dollar, but it's the euro that could fall hardest. It's up 4.6 percent since January 2013, but it's only a matter of time until that reverses, he said. Europe's economy is still in a recovery mode, and Popplewell thinks consumption could remain low for some time.

Typically, when an economy is doing well—as America's is today, at least compared to other developing nations—the dollar does well, too.

"Europe is still being supported by Germany, it's still struggling, and there will be a much greater gravitation toward U.S. assets from Europe," Popplewell said.

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3. Look for high interest rates

Buy the currency of a country that has a higher interest rate than America's. Australia used to be a good place to store cash, said Boyle, because you could make about 4 percent annually just by holding the country's dollar in a bank account or buy owning government bonds.

Many people held money in Brazilian real, too. In 2008 its interest rate was close to 14 percent.

While this can be a good strategy, it's also a risky one. Brazil's interest rate took a nosedive in 2009, falling to about 9 percent. It's been up and down since.

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"Eventually, it can come back to bite you," said Boyle. "Eventually, prices got overstretched compared to the U.S. because of the high interest-rate differential, and it whipsawed back."

Only people who can stomach risk should take this approach. With the U.S. dollar expected to rise, the interest-rate differentials between America and other countries will narrow.

Plus, a lot of countries have lowered their rates since the recession in order to spur growth, and that's made the differential between U.S. and foreign rates less attractive. Australia's benchmark interest rate, for instance, has fallen from about 4.75 percent in 2011 to 2.5 percent today.

Still, there are places where rates are higher. China's interest rate is at 6 percent, Russia's is at 7 percent, and Turkey is at 10 percent.

If you believe that a country's rate can be sustained at its current level, then you could make a handsome profit without much effort, said Boyle.

4. Buy undervalued currencies

Just like you would buy undervalued stocks, so, too, can you buy undervalued currencies, said Jalinoos.

The first place to start is by looking at a country's current account deficit—the different between what a country imports versus exports. If the deficit is large, it could be that the currency has become uncompetitive, which would then suggest that it may be overvalued and will fall, said Jalinoos.

He also looks at inflation differentials. If one country has a high inflation relative to another, the country with the higher rate will lose its competitiveness over time. That tends to put downward pressure on the currency.

Certain market dynamics could also have an affect on currency valuations. Australia's currency appreciated because of its strong commodity markets, yet its trade picture was poor, said Jalinoos.

Many people think that the U.S. currency is one of the most undervalued, so that means other currencies, by comparison, are overvalued.

However, there are some currencies that look attractive. The South Korean won, Mexican peso and Indian rupee could all appreciate in value over the next several months, said Jalinoos.

Mexico is undergoing structural changes that could give the peso a "one-off boost," while India, which "never looks good in terms of its currency account position," he said, could see its currency rise after its election for prime minister in May. It's expected that Narendra Modi, a more market-friendly candidate, is going to win.

Whether you're an average investor who wants to mitigate currency risk or a more sophisticated one who wants to take advantage of currency fluctuations, the forex world isn't for the faint of heart.

It can be hard to understand, but it's also something that can't be ignored. Unless you only invest in the U.S., you have to pay attention where the world's money is headed.

"Investors are more globally oriented and have more overseas exposure than ever before," said Jalinoos. "That guarantees that there's a need for people to take more interest in this topic."

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