When you buy shares priced in another currency, your return has two parts. The first is how the share price moves in its own currency. The second is how that currency moves against yours. The two can point in opposite directions, and the second part is often larger than people expect. A share can rise 20 percent in its own currency and still lose money for you, if that currency falls by more than 20 percent against your own.
This guide explains how currency risk arises, how to work out the combined return, what the costs of converting add, and how investors decide whether to hedge. It is general information, not financial advice.
Two returns, one holding
Your total return in your own currency is approximately the share's return in its own currency, combined with the change in the exchange rate. If the share rises 10 percent and the currency rises 5 percent against yours, your gain is larger than 10 percent. If the share rises 10 percent and the currency falls 8 percent, your gain is smaller, and it may be negative after conversion costs.
Total return ≈ (1 + share return) × (1 + currency return) − 1
Use the exact formula when the numbers are large, because the approximation of adding the two returns is least accurate when either move is big.
A worked example
Suppose you convert 10,000 of your own currency into a foreign currency at a rate that gives you 1,000,000 units of it. You buy shares worth all of it. A year later, the share has risen 15 percent in the foreign currency, to 1,150,000 units. Meanwhile the foreign currency has fallen 10 percent against your currency.
Your total return is (1.15 × 0.90) − 1, which is 0.035, or 3.5 percent before conversion costs. The 15 percent share gain has shrunk to 3.5 percent, because the currency fell. The result would have been very different if the currency had risen 10 percent instead: then the total return would have been (1.15 × 1.10) − 1, or 26.5 percent.
| Scenario | Share return | Currency move | Total return in your currency |
|---|---|---|---|
| Currency rises | +15% | +10% | +26.5% |
| Currency flat | +15% | 0% | +15% |
| Currency falls | +15% | −10% | +3.5% |
Currency moves can be large
Exchange rates can move a lot in a year, especially for currencies that are less widely traded or that are managed by governments with capital controls. A currency that loses a quarter of its value in a year is not unusual in some markets, and a currency move can dominate the result of a share investment for a year or more.
This is why many investors find that the currency decides whether a foreign investment works, more than the company does. A good company can produce a poor outcome if the currency falls, and a weak company can look better than it is when the currency rises.
The costs of converting
Each conversion carries costs. There is usually a spread, which is the difference between the buying and selling price of the currency, and there may be fees and transfer charges. You convert twice, once to buy and once to sell, so the costs are paid on both sides. On a small investment these costs can be a meaningful share of the return.
Compare the total cost of converting across the providers you could use. Banks, specialist transfer services and brokers all charge differently, and the rate you see on a screen is not always the rate you get. Check the all-in cost before you convert.
Measuring your exposure
Before you invest, decide how much of your overall wealth is in a currency other than your own. A simple measure is the share of your investments held in each currency. A large share in one foreign currency concentrates the currency risk, even if the shares themselves are spread across many companies.
Consider also your spending. If you will spend the money in your own currency, a currency move adds a second risk: the value of the proceeds when you need them. Matching the currency of your investments to the currency of your spending reduces this mismatch.
Hedging
Hedging means taking a position that offsets the currency move, so the currency does not affect your return as much. Investors can hedge through forward contracts, currency funds or products that hold foreign assets with a currency hedge built in. Hedging has a cost, which is usually the difference in interest rates between the two currencies, and it may not match your exposure exactly.
Whether to hedge depends on your time horizon, your spending currency and how much currency movement you can tolerate. Many long-term investors choose not to hedge, because the currency tends to move in both directions over long periods, though that is not guaranteed. Short-term investors and those who need the money in their own currency may find hedging more valuable. Take advice from a qualified adviser before using hedging products, because they can be complex.
Currency risk in emerging markets
Currencies of many emerging markets have historically been more volatile than those of developed markets. They can be affected by inflation, interest-rate decisions, political events and limits on moving money out of the country. A currency that falls sharply can take much of the value of a foreign investment with it, even when the company performs well in its own currency.
If you invest in such a market, plan for the currency to move a great deal, and decide in advance how large the position should be. The guide on emerging vs developed markets covers the broader picture.
A simple currency check
Before any foreign purchase, write down three numbers: the return you expect in the share's own currency, the currency move you could tolerate, and the total cost of converting in both directions. Combine them using the formula above. If the combined result still makes sense after the worst currency move you could accept, the exposure is one you can live with. If it does not, the investment is too large, or the currency is too volatile for the amount.
Common mistakes
Judging a foreign investment by its share price alone. The currency can change the result completely.
Ignoring conversion costs. They are paid on both the buy and the sell.
Holding a large foreign position without a plan. Decide the currency exposure before you invest.
Assuming a currency always recovers. Some currencies have fallen for many years.
Hedging without understanding the cost. A hedge has a price, and it can be complex.
Checklist
- Calculate the total return in your own currency, not only the share's return in its own currency.
- Find the all-in conversion cost, both ways.
- Measure how much of your wealth is in each currency.
- Match the currency of your investments to the currency of your spending where you can.
- Decide whether to hedge, and take advice before using hedging products.
- Set a size for any position in a volatile currency that you could hold through a large move.
Key takeaways
A foreign share's return in your own currency combines the share's return with the change in the exchange rate. Currency moves can add to or cut the return, and in some markets they dominate it. Conversion costs are paid on both sides, and they matter on small investments. Measure your currency exposure, match currencies to your spending where possible, and decide whether to hedge with proper advice, because hedging has its own cost and complexity.
This guide is for general information, not financial advice. See the disclaimer.