Currency Fluctuations and International Investing

Posted on June 7, 2020

The majority of people will only consider exchange rates between currencies when planning a holiday abroad. However exchange rates are often a major consideration when investing.

If you hold investments (whether directly or via an ISA or pension fund wrapper) then you should be aware that currency exchange rates can have a major impact on both the returns and cash value of your portfolio. In fact, you would be surprised how often a gain or loss was not due to the performance of the equity or other asset, but instead down to currency fluctuations.

Foreign Exchange Risk – what is it?

In today’s global markets many investment funds are exposed to what is commonly called ‘foreign exchange risk’. Investors and brokers regularly trade in foreign markets where an exchange takes place from the inward ‘buy’ currency to the outward ‘sell’ currency. Even investments in domestic companies may still be exposed to foreign exchange risk if the company imports, exports, or has overseas offices.

What are the drivers of FX Risk?

Fluctuations in currencies (even ones like Bitcoin, which is not tied to a particular country) most commonly derive from changing interest rates, predicted interest rate changes, and the prevailing economic climate. Higher interest rates in a country’s economy will tend to have a positive effect on its currency, and assets held in that currency and any yields returned will have more value. The reverse is true for low rates.

Foreign exchange risk derives from movements in either currency involved in the exchange and, depending on the type of business or transaction, any significant change could be cause for either concern or celebration. A stronger currency can impact export markets; a weaker currency can affect the domestic and international tourist markets if people decide not to holiday abroad. These are just two examples, and there are many more.

Major political or social events can impact currency exchange rates, and the 2016 EU Membership Referendum held in the UK is a particularly good recent example.

When the London currency markets closed for dollar trading in the evening of Thursday 23rd June that year, one pound would have bought you almost a dollar and fifty cents. That was because the consensus among the markets was (as, indeed, it was almost everywhere else) that the ‘Remain’ campaign would be triumphant. The shock ‘Leave’ result created international concern about the strength of the UK economy and made the UK a less attractive proposition for overseas investors who had included EU membership as a factor in their decision to invest in the UK. By the time markets opened in the UK on the morning of Monday 27th June, sixteen cents had been knocked off the value of every pound traded: a pound was worth a dollar and thirty four cents.

By early 2020 one pound was worth a dollar and twenty nine cents. This is due mainly to the almost perfect storm of political uncertainty around the exact form that Brexit would take. Early concerns that a lack of confidence in the UK and the resulting lessening of inward investment and economic growth had become cold hard truth, and a growing number of large manufacturers and financial institutions had decided to relocate to a country certain to remain in the EU for the foreseeable future. But that is not necessarily bad news for investors, and we’ll return to this below.

Forex Risk Management

When it comes to overseas investments, there are three main risk factors to bear in mind:

  • the political environment;
  • local tax laws; and
  • exchange rates.

Political risk

The drastic changes seen recently to USD / GBP conversion rates are, thankfully, rare. But, in all countries, new legislation, changes in government or other political upheaval can have direct impact on different parts of the economy and different business sectors.

The best way to minimise this type of risk is to hold investments in many different countries and economies. This strategy is called ‘diversification’, and we have more information about it here.

Local taxation risk

Foreign investments are usually subject to two sets of tax laws. Any returns on the investment will be initially subject to tax within the overseas jurisdiction; UK tax is then also applicable to profits transferred to or withdrawn within the UK.

Currency exchange risk

Of the three factors, this is perhaps the most important: returns are almost always ultimately converted back to pounds sterling.

Let’s imagine a US investment returning 100 dollars, and perform two calculations using the USD/GBP exchange rates above. With an exchange rate of USD 1.50 to GBP 1.00, a $100 return would be worth £66.67, but the recent rate of USD 1.29 to GBP 1.00 sees that $100 worth £77.40.

Of course, we’re not factoring in any taxes applicable, but we hope this demonstrates that it can be an ill wind that blows no-one any good. Currently, any UK portfolio that receives revenue from abroad paid in dollars (or euros) will be experiencing an increased value on those assets once they are converted back to sterling.

Minimising currency exchange risk using derivatives

We mentioned that thorough diversification can offer some protection against political risk. Taxation risk can be anticipated because rates are a matter of public record and announced in advance. When it comes to foreign exchange risk, what can be done?

Most people will be familiar with the phrase ‘hedging your bets’, where the risk of one asset is hedged by buying another asset that behaves in the opposite way. Many funds attempt to negate the effects of currency movements on the value of its primary assets in this way.

FX (Foreign Exchange) Hedging

A hedged fund aiming to minimise foreign exchange risk would hold currency derivatives relevant to its primary assets, with the idea that currency fluctuations which change the value of the primary assets will be offset by equal opposite changes in the value of the secondary assets (the derivatives).

Needless to say, hedging is not guaranteed to be effective. Furthermore, the principle of hedging means that currency movements that might work in your favour on the primary assets are likely to be negated by virtue of the derivatives. Finally, a currency-hedged fund will incur a second set of costs arising from the various additional currency transactions made.

What is the solution for investors?

First, do not attempt to forecast changing currency values – foreign or domestic.

Second, remember that this is just another demonstration that:

  • investment is long term activity;
  • it is impossible to eliminate risk;
  • there is no asset class guaranteed to provide returns; and
  • every asset class is affected by multiple factors.

The best general way to protect your investments is to ensure that they are sufficiently diversified (by asset class, by sector, and by country), and to review your portfolio regularly to see if adjustments are necessary. In the long term, currency movements will generally even out. The more patient you are, the less you are likely to be affected by them.

INFORMATION IS BASED ON OUR CURRENT UNDERSTANDING OF TAXATION LEGISLATION AND REGULATIONS. ANY LEVELS AND BASES OF, AND RELIEFS FROM, TAXATION ARE SUBJECT TO CHANGE.

THE VALUE OF INVESTMENTS AND INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED. PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE.

No guarantee can be given that the information provided is accurate in the present or the future. It is not intended to constitute either a statement of applicable law or financial advice, and responsibility cannot be accepted for any subsequent loss following activity or inactivity by any individual or organisation. Indeed, such information should NOT be acted upon without first receiving appropriate and specific professional advice.