Understanding Asset Management [Part 15] Basics of Foreign Currency Assets and Exchange Rate Risk: Building a Portfolio That Can Withstand Yen Depreciation and Inflation

An era has arrived where simply keeping yen in a Japanese bank account leads to a real-term erosion of your assets. When the yen depreciated significantly from “1 dollar = 100 yen” to “1 dollar = 150 yen,” many people likely felt the rise in living costs as the prices of food and energy, which rely on imports from overseas, soared.

Concentrating assets solely in the Japanese currency, the “yen,” actually carries significant risk. To protect your assets and increase them efficiently, it is essential to incorporate “foreign currency assets,” such as the US dollar, into your portfolio (a combination of assets).

In this installment, we will explain the basics of foreign currency assets, the mechanism of “exchange rate risk” which cannot be avoided, and the key points for selecting specific products in an easy-to-understand manner.

1. Why are “foreign currency assets” necessary now?

Foreign currency assets refer to “assets traded in foreign currencies other than the Japanese yen,” such as the US dollar, euro, or Australian dollar.

For those of us who live in Japan, receive salaries in yen, and shop in yen, why are foreign currency assets necessary? There are three main reasons.

① Preventing the “erosion of asset value” due to yen depreciation and inflation

Many of the items we consume daily, such as groceries, crude oil, smartphones, and home appliances, are imported from overseas. As the yen depreciates, import costs rise, leading to domestic price increases (inflation).

If all your assets were in “Japanese yen cash or deposits,” even if the balance in your account did not decrease, the amount of goods you could buy would decrease, meaning your real asset value would decline. If you hold foreign currency assets, their yen-denominated value increases when the yen depreciates, serving as a powerful hedge against inflation.

② Capturing overseas growth

Japan is facing a super-aging society and continues to experience low economic growth. On the other hand, looking at the world as a whole, there are many countries and regions that maintain strong economic growth against the backdrop of population growth and technological evolution. Holding foreign currency assets is a means to enjoy returns from global economic growth rather than being limited to Japan.

③ Enjoying higher yields

Japan has continued its ultra-low interest rate policy for many years, and the yields on yen-denominated ordinary deposits and government bonds are at very low levels. On the other hand, major countries, including the United States, maintain appropriate interest rate levels, and there are many opportunities to obtain higher yields (interest rates) than in Japan, even with bonds and deposits.

2. Types and characteristics of foreign currency assets

While we use the term “foreign currency assets,” there are various products depending on the investment target and the degree of risk. Let’s look at six representative products.

Product Type Characteristics/Overview Merits Cautions/RisksForeign Currency DepositsExchanging yen for foreign currency and depositing it in a foreign bank or a Japanese foreign currency deposit account. The mechanism is simple and intuitively easy to understand. Exchange fees are relatively high. Not covered by the deposit insurance system (pay-off).Foreign StocksPurchasing stocks of overseas companies, including US stocks. Can obtain growth and dividend returns from giant global companies. Bears double risk: stock price fluctuation risk and exchange rate risk.Foreign BondsBuying bonds issued by foreign governments or overseas companies, such as US Treasury bonds. Regular interest income (income gain) can be expected. Credit risk (default) of the issuer and interest rate fluctuation risk.Overseas ETFs / Investment TrustsPackage products that diversify investments into stocks and bonds around the world. Easy to diversify investments globally with a single product. Trust fees (holding costs) are incurred.Foreign Currency InsuranceProducts where insurance premiums are paid and insurance benefits are received in foreign currency. Can manage assets in foreign currency while obtaining insurance coverage. Beware of principal loss risk upon early cancellation and high fee settings.FX (Foreign Exchange Margin Trading)Trading exchange rates by depositing margin. Speculative trading. Can utilize leverage to conduct large transactions from small amounts. Highly speculative, with the risk of large losses due to sudden fluctuations.

For beginners, we recommend starting with “overseas investment trusts” or “overseas ETFs (exchange-traded funds),” which allow for easy diversification into assets around the world from small amounts, or with proven “US stocks/foreign bonds.”

3. The mechanism of “exchange rate risk” you must know

When investing in foreign currency assets, the most important concept is “exchange rate risk (foreign exchange fluctuation risk)”. Exchange rate risk does not just refer to the “risk of losing money,” but means the “uncertainty that the asset value in yen terms will fluctuate up or down due to changes in the exchange rate.”

Depending on fluctuations in the exchange rate, investment results change significantly as follows.

“Exchange Gain” (Benefit) from Yen Depreciation

When the yen weakens compared to when you purchased, the yen-denominated value of foreign currency assets increases.

• Example: Purchased $1,000 (worth 100,000 yen) in foreign assets when 1 dollar = 100 yen

• Afterward, the yen weakens and 1 dollar = 150 yen occurs

• The value of $1,000 rises to 150,000 yen (+50,000 yen profit = exchange gain)

“Exchange Loss” (Risk) from Yen Appreciation

When the yen strengthens compared to when you purchased, the yen-denominated value of foreign currency assets decreases.

• Example: Purchased $1,000 (worth 150,000 yen) in foreign assets when 1 dollar = 150 yen

• Afterward, the yen strengthens and 1 dollar = 100 yen occurs

• The value of $1,000 falls to 100,000 yen (-50,000 yen loss = exchange loss)

In this way, the performance of foreign currency assets is determined by the multiplication of the “value fluctuation of the investment target itself (such as stock prices or bond prices)” and the “fluctuation of the exchange rate.” It is important to note that even if the stock price of a U.S. stock you invested in rises by 10%, if the yen strengthens more significantly than that, the valuation in yen terms can become negative.

4. Exchange Fees and the Concept of “Currency Hedging”

When dealing with foreign currency assets, there are two practical points to check in addition to exchange rate risk.

① Exchange Fee (Spread) Costs

When exchanging yen for foreign currency, or converting foreign currency back to yen, you pay an exchange fee to the financial institution. It is collected in a form such as “25 sen per dollar.” If you use a financial institution with excessively high exchange fees (some brick-and-mortar banks or major securities firms), it will erode your investment returns. The golden rule for keeping fees low is to utilize online securities firms and online banks.

② Currency Hedged vs. Currency Unhedged

When purchasing investment trusts, you may see “Currency Hedged” or “Currency Unhedged” in their names.

• Currency Hedged: A mechanism that uses futures trading or similar methods to minimize the impact of exchange rate fluctuations.

  • Benefit: Asset value is less likely to drop even if the yen strengthens.

  • Drawback: You cannot obtain exchange gains even if the yen weakens. Hedging costs (expenses resulting from interest rate differentials between countries) are incurred continuously.

• Unhedged: A mechanism that directly reflects fluctuations in exchange rates in the value of assets.

  • Pros: You can earn exchange gains when the yen depreciates. There are no hedging costs.

  • Cons: You may face significant temporary unrealized losses during periods of rapid yen appreciation.

When investing with a long-term perspective for the purpose of “hedging against yen depreciation and inflation” or “geographic diversification of your portfolio,” it is generally standard to choose “unhedged.”

5. Three Strategies for Smart Management of Foreign Currency Assets

Here are practical techniques for safely managing foreign currency assets while controlling exchange rate risk.

1. Use “Dollar-Cost Averaging” to spread out purchase timing

Predicting exchange rates accurately is nearly impossible, even for professional investors. If you start trying to time the market by thinking, “Isn’t the yen too weak right now?” or “I want to buy after the yen gets stronger,” you will never be able to start investing.

This is where “dollar-cost averaging” (systematic investment), which involves continuing to purchase a fixed amount (in yen) every month, becomes effective. Because you buy more foreign currency when the yen is strong and less when the yen is weak, you can smooth out the average purchase price and significantly reduce the risk of buying at a high.

2. Utilize “Yen-denominated foreign asset investment trusts” available domestically

For those who feel that “holding and managing foreign currency directly seems difficult…”, I recommend Japanese investment trusts (such as All Country or S&P 500 index funds).

These funds are purchased by us in “Japanese yen” from Japanese brokerage accounts, but within the fund, they are effectively used to purchase and manage overseas stocks and bonds. Therefore, while you manage them in yen on your end, you can achieve the same diversification effect as holding foreign currency assets.

3. Be conscious of the currency balance across your entire portfolio

You do not need to put 100% of your assets into foreign currency. It is important to adjust the currency ratio (currency allocation) of your total assets according to your lifestyle and spending plans.

• Youth to Asset Accumulation Phase: Prioritize growth and inflation protection, setting a higher foreign currency ratio of about 50% to 70%.

• Retirement to Withdrawal Phase: Prioritize safety by increasing the ratio of yen-denominated assets (deposits, Japanese government bonds, etc.) to prepare for daily living expenses (in yen).

Summary: Start “Currency Diversification” that doesn’t rely solely on the yen

Investing in foreign currency assets is not simply “high-risk investment aimed at making a profit.” Rather, it is a sound risk management method to avoid the risk of “only holding Japanese yen.”.

Instead of being swayed by fluctuations in exchange rates, let’s use methods like systematic investment to diversify investments into growth and assets around the world from a long-term perspective.

In the next installment [Part 16], we will explain the “positioning of crypto assets (virtual currencies),” which have been attracting attention as a new option for portfolios in recent years. We will delve into the differences from traditional assets (stocks and bonds) and points to note when incorporating them into your portfolio.