How Currency Exposure Affects Returns

There is an ever increasing amount of interest by Americans in investing overseas.  When doing so it must be kept in mind that the return that one receives from overseas investments depends not just on the performance of the stocks or bonds of the firms in other countries, but also on the change in exchange rates between foreign currencies and the US dollar.

The following is an example from Monevater:

A simple example shows how currency risk affects your returns.

Let’s suppose you’re an American investor and you put $10,000 into a European stock market tracker.

Your investment is not hedged, and so you’re exposed to changes in the exchange rate between the dollar and the euro. That is, you’re exposed to currency risk.

Suppose over 12 months the European market and therefore your tracker goes up 20% in local euro terms:

  • If the dollar and the euro is at the same exchange rate after 12 months as when you made your investment, your holding is now worth $12,000. (i.e. $10,000 increased by 20%).
  • Say the dollar appreciated by 25% versus the euro over 12 months. Your holding would be worth $9,600 (12,000 / 1.25). i.e. Your euro position now buys fewer dollars.
  • Say the dollar depreciated by 25% versus the euro over 12 months. Your holding would be worth $16,000 (12,000 / 0.75). i.e. Your euro position now buys more dollars.

As you can see, currency risk can dramatically affect your returns, ranging from magnifying your gains to turning gains into losses in your own currency. The basic rule is:

  • When the foreign currency strengthens versus your own currency, your overall return goes up

  • When the foreign currency weakens versus your own currency, your overall return goes down

The bottom line is this: foreign investing is popular and can be profitable, but when doing so there is an added element of risk that investing in US securities does not have.  Leave it to the professionals.

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