Global and Geopolitical Factors
International economic events significantly impact domestic markets and investment decisions. Advisers must understand how global factors ripple through portfolios.
Currency Valuation and Effective Exchange Rates
- Exchange rate - the price of one currency expressed in terms of another
- Exchange rate fluctuations directly affect the returns on international investments
Currency Effects on Investments
| Foreign Currency Movement | Effect on U.S. Investor Returns |
|---|---|
| Foreign currency appreciates vs. USD | Returns increase when converted back to USD |
| Foreign currency depreciates vs. USD | Returns decrease when converted back to USD |
| USD strengthens (appreciates) | Foreign investment returns decrease in dollar terms |
| USD weakens (depreciates) | Foreign investment returns increase in dollar terms |
- Currency (exchange rate) risk - the risk that changes in exchange rates will reduce the value of foreign investments
- A strong dollar hurts U.S. investors in foreign securities (foreign returns worth less in USD)
- A weak dollar benefits U.S. investors in foreign securities (foreign returns worth more in USD)
- Currency risk is a form of systematic risk - it cannot be diversified away within a single foreign market
Exam Tip: Gotchas
- A strengthening dollar hurts U.S. investors in foreign securities (foreign returns convert to fewer dollars). A weakening dollar helps them (foreign returns convert to more dollars). The exam tests the direction of currency impact on returns.
Sovereign Debt
- Sovereign debt - debt issued by a national government, typically denominated in its own currency
- Sovereign risk - the risk that a foreign government may default on its debt obligations, impose capital controls, or face political instability
- Credit quality varies widely: AAA-rated developed nations to speculative-grade emerging markets
- Sovereign default has no bankruptcy court - recovery depends on negotiation
- Sovereign credit ratings affect the country's borrowing costs and exchange rate
Geopolitical Factors
- Geopolitical risk - the risk that political events, conflicts, or policy changes in a country or region will negatively affect investments
- Examples: wars, trade disputes, sanctions, regime changes, regulatory shifts, nationalization of assets
- Geopolitical events can cause market volatility, currency depreciation, and capital flight
- Affects both equity and fixed income investments in affected regions
- Considered a form of systematic risk for investments in that region