Asset Allocation: Global Asset Management : Currency Risks

Having discussed the various advantages of a global investment strategy, we now need to consider one of the major potential drawbacks, namely, currency risk.

An international investor’s total returns can be significantly affected by the exchange rate between their home/reference currency and the currency in which foreign assets they have invested in are denominated.

Consider an investor working in US dollars (USD) and another working in Swiss francs (CHF). Both buy a share in the same company traded on the Swiss stock exchange at CHF100. (As investment returns in this example will be in CHF, we will express the exchange rate as CHF/USD i.e. ‘how many dollars does a Swiss franc buy’).

Opening exchange rate	Opening stock price (CHF)	Opening stock price (USD)
CHF/USD 0.50	CHF100	USD50

Let's now assume that a year later our stock is trading at CHF120, a 20% return in local currency terms. But that won’t necessarily be the return in USD terms. To see why, let's also assume that the exchange rate has fallen to CHF/USD 0.40 - in other words the Swiss franc now only buys USD 0.4 instead of USD0.5.

Closing exchange rate	Closing stock price (CHF)	Closing stock price (USD)
CHF/USD 0.40	CHF120	USD48.00

So the USD investor’s return over the year was actually -4%, compared to the local currency return of +20%. Highly favourable local market returns have been sabotaged by the CHF’s poor performance against the USD.

Of course, FX movement can have a positive effect on foreign currency asset returns too. Our example would simply have needed the CHF to have appreciated against the USD - so the asset would have bought more dollars, increasing real returns in reference (USD) currency terms.

The currency movement...	In reference currency terms	In investment currency terms
...increases total returns	a depreciation	an appreciation
...decreases total returns	an appreciation	a depreciation

So investments in assets denominated in non-reference currencies create two separate investment risk/return elements - local market value changes and currency market value changes.