The Impact of Currency Fluctuations on International Investments

Currency can have either a positive or negative impact on returns, but it always adds a layer of potential volatility. This new perspective explains currency risk and the impact it has on international companies and investor returns.

  • September 2018

Risk is part of every investment. But, some risks are more obvious and better understood than others. Take international securities for example. Investing in international securities requires investors to accept not only equity or bond risk, but currency risk as well.

Currency can have either a positive or negative impact on returns, but it always adds a layer of potential volatility. Here is what investors need to know:

What Is Currency Risk?

Currency risk, also known as foreign exchange risk, is the risk that the value of one currency will change in relation to another. When investing internationally, U.S. Dollars are changed into local currency—and vice versa when an investment is sold. These exchanges can affect the value of and, ultimately, return on an investment.

What Forces Affect Currencies?

Currencies can be affected by many forces including government actions, inflation, interest rates, speculation and more.

These forces impact the relative value of currencies in ways that are often unpredictable, increasing the volatility of international investments.

For illustrative purposes only.
Source: “Six Factors That Influence Exchange Rates”, Visual Capital.

How Does Currency Impact Companies?

Currency risk can change the costs a company pays for supplies, the prices at which they can sell their products, and ultimately, the profits they make. Imported supplies from overseas that cost $100 today may cost $120 (or $80) tomorrow.

Currency differences can also change supply and demand for products or services. For example, in an export-driven economy, the cheaper the currency, the more attractive the products may become to international buyers. And, as buyers flock to buy the now-cheaper products, the companies may make more profits and equity prices may rise.

How Does Currency Impact Investment Returns?

Because currency fluctuations impact companies and countries, it follows that these same fluctuations are a key ingredient in international returns. To put it simply:

International return = [equity return] + [currency return]

It is important to note that currencies and financial assets do not always move in the same direction. For example:

  • Sometimes currencies may have positive correlation to equities or bonds, so they both move up at the same time
  • At other times, currencies and markets move in different directions, so when equities or bonds are up, the currency may be down and vice versa

 

This means currency can be the tailwind that helps to push an investment’s return higher or the headwind that drags the returns down.

How Does Currency Impact Investors?

Currency risks can impact investors in the same way—eroding returns or enhancing them. Imagine, for example, that you invest in a Japanese company today. Six months later, the stock has increased 20%, but the Yen decreases by 20% in relation to the Dollar. Did you make any money? In this example, you broke even.

[20% equity return] + [-20% currency loss] = 0% international return

Of course, this can work the other way as well. Let us say you invest in a European company that invents a new life-saving medication. The company’s stock rises 40%, while the Euro also happens to increase 10% relative to the dollar. In this instance, you earned a 50% return.

[40% equity return] + [10% currency increase] = 50% international return

Conclusion

International investments are a smart way to diversify and should be a part of every portfolio. It is important, however, to understand that these investments come with additional risks, making it critical for investors to select managers with deep experience navigating international markets.

Diversification does not guarantee a profit or protect against a loss in declining markets.

Investments in international securities are subject to certain risks of overseas investing including currency fluctuations and changes in political and economic conditions, which could result in significant market fluctuations. These risks are magnified in emerging markets.

Investing involves risk, including possible loss of principal.

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