What Are Foreign Currency Effects?

Foreign currency effects are gains or losses on foreign investments due to changes in the relative value of assets denominated in a foreign currency. A rising domestic currency means foreign investments will have lower returns when converted back to the local currency. On the other hand, a declining home country currency will increase the domestic currency returns of foreign investments.

KEY TAKEAWAYS

  • Foreign currency effects are gains or losses on foreign investments due to changes in the relative value of assets denominated in a foreign currency.
  • An investor will gain the most when the value of their international investment goes up along with the currency.
  • Foreign currencies can amplify losses as well as gains.
  • Currency-hedged ETFs allow retail investors to take positions in foreign stocks and bonds without having to worry about foreign currency effects.

Understanding Foreign Currency Effects

Foreign investments are complicated by currency fluctuations and conversions between countries. A high-quality investment in another nation may lose money because that country's currency declined. Foreign-denominated debt used to purchase domestic assets has also led to bankruptcies in many emerging market economies.

Movements in currencies can have a substantial impact on the returns from foreign investments. Investing in securities that are denominated in an appreciating currency can boost total returns. However, investing in securities denominated in a depreciating currency can reduce profits.

Commodity markets are also impacted by foreign currency effects, especially the strength of the U.S. dollar. Most commodities are priced in U.S. dollars, so they may see significantly decreased global demand when that currency is strong. This lower demand can directly impact earnings for commodity producers.

When investing in foreign securities, returns are impacted by both the performance of the primary investment itself and the foreign currency. Some investors seek opportunities to align the foreign currency effect with bull markets in stocks. Others, who have less knowledge of currency markets or lower risk tolerance, attempt to reduce the foreign price effect.

Advantages of Foreign Currency Effects

An investor will gain the most when the value of their international investment goes up along with the currency. Although the risk is higher, there is also more potential for profit. During many periods, major stock markets and their currencies have moved in the same direction.

A bullish stock market often attracts foreign investors and strengthens the currency, but the process can go too far. For example, the strength of the Japanese yen and the Nikkei reinforced each other during the 1980s. However, the growing value of the yen undermined the international competitiveness of Japanese companies, and the Nikkei eventually fell. Foreign investors suffered less during the crash because the continuing appreciation of the yen partially offset declines in the Nikkei.

In emerging markets, currency appreciation is often part of the development process. Most developing countries have much higher average incomes in purchasing power parity terms than they do in U.S. dollar terms. That can be an indication of an undervalued currency. The emerging nation usually grows more fiscally responsible and domestic prices become more stable as development proceeds. The developing country's currency gets less risky, so it appreciates. Investors in emerging markets can get a double gain. The first gain is from the growth of emerging stock markets, while the second is from the strengthening of their currencies.

Disadvantages of Foreign Currency Effects

Foreign currencies can amplify losses as well as gains. Between 2010 and 2019, U.S. stocks and the U.S. dollar both tended to outperform in international markets. As a result, Americans investing in foreign markets often had to deal with lower returns from stocks and currency losses at the same time.

International investors may choose to hedge against risks from undesired movements in foreign currencies. They may hedge because they are bullish on a foreign company or stock index and bearish on the country's currency. Some investors believe that while stocks will gain in the long run, foreign currency movements are fundamentally unpredictable. If that belief is true, then currency risk is an uncompensated risk, which is highly undesirable. Finally, the investor may want the benefits of international diversification but lack an understanding of foreign currency price movements.

Investors should not think that currency hedging is only for sophisticated or wealthy investors. Currency-hedged ETFs allow retail investors to take positions in foreign stocks and bonds without having to worry about foreign currency effects. One can buy these exchange-traded funds (ETFs) just as easily as one can purchase shares in a domestic firm.

A Real World Example

For example, the German DAX stock index reached record highs during the first quarter of 2015. However, Americans who invested in the DAX during that time would have seen their profits hit by the plunging euro. A comeback in the euro during 2017 produced good returns for Americans investing in the DAX, even though the index itself was mostly unchanged.