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 currency other than the principal currency with which a company normally conducts business. A rising domestic currency means foreign investments will result in lower returns when converted back to the domestic currency. The opposite is true for a declining domestic currency.
BREAKING DOWN Foreign Currency Effects
Foreign investments are complicated by currency fluctuation and conversion between countries. A high-quality investment in another country may prove worthless because of a weak domestic currency. Foreign-denominated debt used to purchase domestic assets has led to bankruptcy in several cases due to a fast decline in a domestic currency or a rapid rise in the currency of the foreign-denominated debt.
How Currency Effects Affect Investments
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, while investing in securities denominated in a depreciating currency can trim total returns.
For example, a number of stock indices in Europe reached record highs during the first quarter of 2015, but American investors who had invested in them would have seen their returns hit by the plunging euro. Meanwhile, a comeback in the euro during 2017 helped increase returns in an otherwise meandering Deutsche Borse Dax Index.
Commodities that are priced in U.S. dollars may see greatly decreased global demand when the currency is strong. This lower demand can directly impact earnings for domestic commodity producers, although part of the negative impact would be offset by the weaker foreign currency.
How to Lower the Risk of Currency Effects
When investing in foreign securities, returns are impacted by both the performance of the primary investment itself, as well as the underlying currency.
Ideally, an investor will benefit the most when the value of their international investment goes up and is paired with a rising currency. It's important to remember to factor in the risk from the currency effect on possible returns.
Experienced international investors with significant capital may choose to hedge against these risks from undesired movement in foreign currencies with the use of instruments such as options, forwards, or currency futures. Investors may also leverage currency-based exchange-traded funds (ETFs) to take an opposite position against a single currency they are exposed to in the foreign exchange market.