Understand currency risk in foreign investments
Published 9:38 pm Thursday, May 16, 2013
By Arie J. Korving
There is an increasing amount of interest by American investors in investing overseas. Those investors should remember the return they will receive from overseas investments depends not just on the performance of the stocks or bonds in other countries, but also on the exchange-rate changes between foreign currencies and the U.S. dollar.
The number of U.S. dollars it takes to buy one Euro, for example, changes not just by the day but by the minute. And those changes can have a meaningful affect on how well your foreign investments perform. Unless the foreign currency is “pegged” to the American dollar you face what is referred to as “currency risk.”
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Currency risk can work for you or against you, increasing your returns or reducing them, depending on the direction of the U.S. dollar versus the foreign currency. This is of critical importance to large multinational corporations doing business around the globe. They often use “hedges” to minimize that risk. For the average investor, the cost and/or complexity of hedging is often impractical.
However, it’s useful to understand currency risk and how it can affect your investments in foreign investments.
Suppose you’re an American investor and you put $10,000 into a European stock market index fund. When you do this, you are exposed to the exchange rate between the U.S. dollar and the Euro.
Assume that over the next year the European stock fund goes up 20 percent in local Euro terms. How will that affect the return you receive as an American investor?
- If the dollar and the Euro have the same exchange rate after a year, your fund is now worth $12,000 ($10,000 increased by 20 percent).
- If the dollar has increased in value by 25 percent versus the Euro (or stated another way, the Euro declined 25 percent versus the dollar) at the end of the year, you would actually have lost money. Your holding would be worth $9,600 (that is: $10,000 increased by 20 percent and then divided by 1.25). Two things are at play. First, the fund went up 20 percent. However, you have to take into account exchange rates, which in this scenario resulted in a 25-percent increase in the dollar versus the Euro. To put it in simpler terms, your Euro fund would buy fewer dollars.
- The opposite can happen, too. Let’s assume the dollar decreased by 25 percent versus the Euro over 12 months. Now your fund would be worth $16,000 ($10,000 increased 20 percent and then divided by 0.75). Again in simpler terms, your Euro fund would buy more dollars.
It is important to keep currency risk in mind when making investments in securities that are denominated in foreign currencies. The changes in exchange rates can have a dramatic impact on your returns. The Japanese Yen went from approximately 80 to one dollar in November of 2012 to approximately 100 to the dollar today. That means that simply due to changes in exchange rates, investments denominated in Yen declined by about 25 percent in less than six months.
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.
Arie Korving is a life-long financial advisor and the founding principal of Korving & Company, Suffolk, VA. For more information, visit www.korvingco.com or call 757-638-5494.