Currency Risk (Exchange Rate Risk)
So far, the risks we have covered apply primarily to domestic investments. Currency risk introduces a new variable: the value of foreign money relative to the U.S. dollar.
What Is Currency Risk?
- Currency risk (also called exchange rate risk) is the risk that changes in foreign exchange rates will reduce the value of an investment
- Affects any investment denominated in a foreign currency
- Even if the foreign investment performs well in local terms, unfavorable currency movements can erase those gains when converted back to U.S. dollars
How Currency Movements Affect Returns
| Dollar Movement | Effect on Foreign Investments (for U.S. investors) |
|---|---|
| U.S. dollar strengthens | Foreign investment value decreases when converted to USD |
| U.S. dollar weakens | Foreign investment value increases when converted to USD |
Example: You own a European stock fund. The fund gains 8% in euros, but the euro falls 5% against the dollar. Your actual return in USD is closer to 3%.
Which Investments Are Affected?
- ADRs (American Depositary Receipts) - dividends are paid in foreign currency and converted to USD; exchange rate changes affect the dollar amount received
- International mutual funds and ETFs - holdings in foreign securities are affected by currency movements in every country where the fund invests
- Foreign bonds - both interest payments and principal are subject to currency fluctuation
- Emerging market investments - typically face higher currency risk due to less stable currencies
Exam Tip: Gotchas
- A strengthening U.S. dollar hurts foreign holdings. Your foreign investments are worth fewer dollars when converted back. A weakening dollar helps foreign holdings (worth more dollars when converted).
- Strong dollar = bad for U.S. investors abroad. Strong dollar means foreign assets are cheaper in dollar terms, so less value when you bring money home.
Currency risk affects investments across borders. Next, we'll look at a risk that can affect any investment, regardless of location: the ability to sell it when you need to.