Recently, we got a question on the blog about how currency impacts international investing. It’s a great question because exposure to foreign currency fluctuations may provide potential for enhanced returns as well as opportunities for diversification to reduce risk.
The impact of currency exposure on returns in US dollars is tied to the relationship between foreign local equity returns and the change in value of the local currency relative to the US dollar. An appreciating foreign currency combined with rising local market returns will generate positive US dollar returns. At the same time, an appreciating local currency can help offset declining local market returns. Likewise, a depreciating local currency can reduce or even cause negative returns.
Four key determinants drive currency exchange rates:
1. Purchasing power parity: This economic theory says that an exchange rate can adjust in order to keep the relative price of a basket of goods and services constant in two different countries.
2. Interest rate differentials: The gap in interest rates between two interest-bearing assets dictates prices of foreign exchange contracts. Investors take advantage of differences in interest rates with a strategy known as the carry trade, which is simultaneously selling a currency with a relatively low interest rate while buying a currency yielding a higher interest rate.
3. Capital flows: The movement of money between countries–in the form of investments, trade and business transactions–affects the supply and demand for different currencies, moving exchange rates.
4. Sentiment: Investor attitudes can influence exchange rates. Increased appetite for risk drives demand for cyclical currencies, like the euro, or currencies with high interest rates, such as the Australian dollar. Risk aversion motivates people to seek out currencies perceived to be safer, such as the Swiss franc and Japanese yen.
Since foreign currencies fluctuate considerably over time, so too can their impact on returns in US dollars. In seven of the years since 1970, currency exposure has had a greater impact on the US dollar return than on the performance of foreign local currencies. However, over the long term, the currency effect has usually smoothed out.
In our own analysis of countries, we look at currencies through the prism of how they may impact growth and corporate profits, rather than the exchange rate per se. However, we do take exchange rates into account when they appear at a significant discount or premium to their fair value. There’s no question that exchange rate movements strongly influence portfolio risk and return. Investors in US dollar-denominated international funds are exposed to fluctuations in both local equity and currency returns. A thorough understanding of this relationship can help investors more efficiently capture the return and diversification opportunities available beyond US borders.