Currency risks & international investing
Key Points
- Currency Fluctuations Affect International Investments
- Effects of Currency Fluctuations on Investments
- Calculating Your Return
- Currency Risk Management
- Summary
- Points to remember
As the globalization of investment portfolios continues, an important risk factor investors have to take into consideration when investing overseas is currency fluctuation. A U.S. investor's foreign investment returns depend on both the foreign assets' market value in terms of the local currency, as well as the currency's exchange rate against the U.S. dollar, since the foreign assets will be converted into dollars at some future date.
How Currency Fluctuations Affect International Investments
For a U.S. investor, a currency gain arises when the value of the dollar falls against the currency in which a foreign security is denominated. An appreciation of the dollar against the foreign currency could result in a loss regardless of how well the foreign security performed. For example, assume stocks of a particular foreign company gained 10% in market value in a given year, but that the U.S. dollar appreciated 8% against this foreign currency during this time period. Your return in terms of dollars for this period would be only 2%.
But currency fluctuations are not necessarily a negative factor. Depreciation of the U.S. dollar can make overseas investing more attractive to U.S. investors. For instance, the dollar depreciated 36%, from the end of 2001 to the end of 2008 against the euro, making an investment denominated in that currency 56% more valuable once it was converted back to dollars and that's before counting any appreciation of the underlying investment. In addition to direct impacts of currency fluctuations, there are also indirect impacts. Various economic factors often interact with each other and result in adverse movements of exchange rates and equity prices. For example, a surging U.S. dollar against the Japanese yen would cut demand for some American products and increase demand for some Japanese products. This would help increase the competitiveness of some Japanese companies, particularly those export-oriented companies. This would soon be reflected in these companies' stocks; and the rise in stock prices could offset currency losses incurred from the conversion of the yen into the dollar. On the other hand, a weakening of the dollar against the yen could negatively impact some export-driven Japanese companies, especially those with a large presence in the American marketplace. These Japanese companies' stock prices might be depressed, but there would be gains arising from the conversion of the U.S. dollar into the yen.
New developments in the currency world can also affect currency fluctuations in new and unpredicted ways. For example, the long-awaited introduction in 1999 of a single euro currency shared by many European nations was greeted by projections that the currency would strengthen. After initially being weaker than the U.S. dollar, by the close of 2008, the euro was 39% above par with the dollar.
Effects of Currency Fluctuations on Investments
Invest $1,000 in the Toyko Stock Market with an Exchange Rate of 100 Yen per U.S. Dollar.*
| U.S. Dollars | Exchange Rate | Ending Value |
|---|---|---|
| $1,000 | 80 Yen | $1,200 |
| $1,000 | 100 Yen | $1,000 |
| $1,000 | 120 Yen | $800 |
*Values given represent a hypothetical $1,000 invesment made and its ending value when converted after a change in exchange rates.
Calculating Your Return1
The example below will help you calculate a foreign investment's return adjusted for exchange rate fluctuations.
| Example | |
| 1. Return on foreign security | 9% |
| 2. Change in exchange rate | -3% |
| 3. Add 1 to Line 1 | 1 + 0.09 = 1.09 |
| 4. Add 1 to Line 2 | 1 + -0.03 = 0.97 |
| 5. Multiply Line 2 by Line 3 | 1.09 x 0.97 = 1.0573 |
| 6. Subtract 1 from Line 5 and multiply by 100 | (1.0573 - 1) x 100 = 5.73% |
Currency Risk Management
There are different strategies for managing a portfolio's foreign currency exposure, which fall into three broad categories of using hedging tools to protect against currency losses.
The simplest approach adopted by international portfolio managers and investors is not to hedge the currency risks at all. Some argue that there is a correlation between the performance of a foreign equity market and strength of the foreign currency. Others believe that currency fluctuations tend to wash out over an extended period of time. Neither of these arguments, however, can be proven conclusively, although there is practical evidence to support each of them. Another argument supporting the nonhedging approach is that foreign currency exposure helps diversify a portfolio.
In contrast to the nonhedging approach, some international investment managers go to the other extreme and hedge 100% of their currency exposures. This group believes that foreign exchange rates are highly unpredictable and that currency risks in non-dollar securities should always be fully hedged. In theory, an international investment portfolio would become a pure equity or fixed-income play, free of currency risk, if the foreign currency exposures of the portfolio were fully hedged.
The key argument for hedging is that it reduces a portfolio's volatility resulting from currency fluctuation. But hedging costs tend to reduce overall returns over time, compared with an unhedged portfolio.
Balancing the pros and cons of hedging, the third strategy falls somewhere between the two extremes. Fund managers who use an actively managed hedging approach hedge selectively: sometimes no hedge, sometimes a partial hedge, and sometimes a full hedge. The selective approach is gaining in popularity. Most investment firms now offer some kind of currency service, and some firms with substantial international investments even appoint a separate manager to handle currency as a distinct asset class.
Summary
Currency risk is an essential element of international investing and is only one risk of investing across borders. Others include possible increased taxation as well as political uncertainties. For investors seeking higher returns from overseas markets, it is important to understand how currency risk could affect returns.
Points to Remember
- As more and more investors invest overseas, currency risk is becoming a major factor to consider. For a U.S. investor, a currency gain or loss stems from a fall or rise in the value of the dollar against the currency in which the investment is made.
- The impact of currency fluctuation is not necessarily a negative factor.
- Currency fluctuations can increase or lower your overall return.
- There are three basic ways to manage currency risks. The first approach is not to hedge at all, assuming that currency fluctuations will wash out over a period of time. The second approach is to hedge fully, which may reduce the volatility of the portfolio. The third approach is to actively manage hedging, choosing when and how much to hedge. This approach is gaining popularity with most investment firms.
- Currency risk is an essential element of international investing, and it is important to understand how currency fluctuations can affect returns.
1This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rate of return does not reflect the inherent cost of investing.