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Currency Risks and International Investing
How Currency Fluctuations Affect International Investments
Currency Risk Management
As the globalization of investment portfolios continues, an important risk factor investors have to take into consideration when investing overseas is currency fluctuation. A U.S. investor's foreign investment returns depend on both the foreign assets' market value in terms of the local currency, as well as the currency's exchange rate against the U.S. dollar, since the foreign assets will be converted into dollars at some future date.
How Currency Fluctuations Affect International Investments
For a U.S. investor, a currency gain arises when the value of the dollar falls against the currency in which a foreign security is denominated. An appreciation of the dollar against the foreign currency could result in a loss regardless of how well the foreign security performed. For example, assume stocks of a German company traded in Frankfurt gained 10% in market value from January 1997 to December 1998. Your return in terms of dollars for this period was only 2.3%, however, because the U.S. dollar appreciated about 7.6% against the deutsche mark during this period of time.
Because the impact of currency fluctuations on a portfolio is not a one-way street, currency fluctuations are not necessarily a negative factor. The prolonged depreciation of the U.S. dollar has made overseas investing particularly attractive to U.S. investors (past performance doesn't guarantee future results). As opposed to the 2.3% return from 1997 to 1998, had you bought the German stock in early 1985 and sold it at the end of 1998, while the stock price increased 100% during this period, your return in dollar terms would be 280%! That is because the dollar has depreciated about 53% against the deutsche mark since its peak in 1985.
In addition to direct impacts of currency fluctuations, there are also indirect impacts. Various economic factors often interact with each other and result in adverse movements of exchange rates and equity prices. For example, a surging U.S. dollar against the Japanese yen would cut demand for some American products and increase demand for some Japanese products. This would help increase the competitiveness of some Japanese companies, particularly those export-oriented companies. This would soon be reflected in these companies' stocks; and the rise in stock prices could offset currency losses incurred from the conversion of the yen into the dollar. On the other hand, a weakening of the dollar against the yen could negatively impact some export-driven Japanese companies, especially those with a large presence in the American marketplace. These Japanese companies' stock prices might be depressed, but there would be gains arising from the conversion of the U.S. dollar into the yen.
New developments in the currency world can also affect currency fluctuations in new and unpredicted ways. For example, the long-awaited introduction in 1999 of a single "euro" currency -- shared by 11 european nations -- could have unanticipated consequences for other currencies worldwide. As one-time rival nations unite under the euro to help strengthen the overall financial health of participating nations, it remains to be seen how these countries will put their potential strength to work in currency and other markets.
Values given represent a hypothetical investment made on Jan. 1 and its value when converted after a change in exchange rates.
Currency Risk Management
There are different strategies for managing a portfolio's foreign currency exposure, which fall into three broad categories of using hedging tools to protect against currency losses.
The simplest approach adopted by international portfolio managers and investors is not to hedge the currency risks at all. Some argue that there is a correlation between the performance of a foreign equity market and strength of the foreign currency: "If I like the market, ultimately I like the currency." Others believe that currency fluctuations tend to wash out over an extended period of time. Neither of these arguments, however, can be proven conclusively, although there is practical evidence to support each of them. Another argument supporting the non-hedging approach is that foreign currency exposure helps diversify a portfolio.
The exercise below will help you calculate a foreign investment's return adjusted for exchange rate fluctuations.
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Example
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Your
Return
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1. Return on foreign security.
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9%
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___________
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2. Change in exchange rate.
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-3%
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___________
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3. Add 1 to Line 1.
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1 + .09
= 1.09
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___________
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4. Add 1 to Line 2.
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1 + -.03
= .97
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___________
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5. Multiply Line 2 by Line 3.
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1.09 x
.97 = 1.0573
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___________
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6. Subtract 1 from Line 5 and multiply by 100.
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(1.0573
- 1) x 100 = 5.73%
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___________
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In contrast to the non-hedging approach, some international fund managers go to the other extreme and hedge 100% of their currency exposures. This group believes that foreign exchange rates are highly unpredictable and that currency risks in non-dollar securities should always be fully hedged. In theory, an international investment portfolio would become a pure equity or fixed-income play, free of currency risk, if the foreign currency exposures of the portfolio were fully hedged.
The key argument for hedging is that it reduces a portfolio's volatility resulting from currency fluctuation. But hedging costs, tending to reduce overall returns over time compared to an unhedged portfolio.
Balancing the pros and cons of hedging, the third strategy falls somewhere between the two extremes. Fund managers who use an actively managed hedging approach hedge selectively: sometimes no hedge, sometimes a partial hedge, and sometimes a full hedge. The selective approach is gaining in popularity. Most investment firms now offer some kind of currency service, and some firms with substantial international investments even appoint a separate manager to handle currency as a distinct asset class.
Summary
Currency risk is an essential element of international investing and is only one risk of international investing. Others include possible increased taxation as well as political uncertainties. For investors seeking higher returns from overseas markets, it is important to understand how currency risk could affect returns.
Points to Remember
1. As more and more investors invest overseas, currency risk is becoming a major factor to consider. For a U.S. investor, a currency gain or loss stems from a fall or rise in the value of the dollar against the currency in which the investment is made.
2. The impact of currency fluctuation is not necessarily a negative factor. Currency fluctuations can increase or lower your overall return.
3. There are three basic ways to manage currency risks. The first approach is not to hedge at all, assuming that currency fluctuations will wash out over a period of time; the second approach is to hedge fully, which may reduce the volatility of the portfolio. The third approach is to actively manage hedging, choosing when and how much to hedge. This approach is gaining popularity with most investment firms.
4. Currency risk is an essential element of international investing and it is important to understand how currency fluctuations can affect returns.
Copyright 1999 The McGraw-Hill Companies, Inc.
Standard & Poor's including its subsidiary corporations ("S&P") is a division of the McGraw-Hill Companies, Inc. Reproduction of Standard & Poor's articles in any form is prohibited except with the written permission of S&P. Because of the possibility of human or mechanical error by S&P's sources, S&P or others, S&P does not guarantee the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information.
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