How Currency Exposure Affects Returns

Now for something less political.

A simple example shows how currency risk affects your returns.

Let’s suppose you’re an American investor and you put $10,000 into a European stock market tracker.

Your investment is not hedged, and so you’re exposed to changes in the exchange rate between the dollar and the euro. That is, you’re exposed to currency risk.

Suppose over 12 months the European market and therefore your tracker goes up 20% in local euro terms:

• If the dollar and the euro is at the same exchange rate after 12 months as when you made your investment, your holding is now worth $12,000. (i.e. $10,000 increased by 20%).

• Say the dollar appreciated by 25% versus the euro over 12 months. Your holding would be worth $9,600 (12,000 / 1.25). i.e. Your euro position now buys fewer dollars.

• Say the dollar depreciated by 25% versus the euro over 12 months. Your holding would be worth $16,000 (12,000 / 0.75). i.e. Your euro position now buys more dollars.

As you can see, currency risk can dramatically affect your returns, ranging from magnifying your gains to turning gains into losses in your own currency