How do currency exchange rates affect your investments?

When you invest in an investment fund, surely there are several factors that you look at first: profitability, commissions, and what it invests in… But have you thought about how currency exchange affects your investments? Or do you think that it has nothing to do with the final return of a stock, an ETF or a mutual fund? 

The reality is that they do influence and a lot. This happens due to the so-called exchange rate, which is the one that compares currency pairs ( euro against the dollar, pound against the euro …). As an investor, you will notice it more in the short term, when the currency effect becomes more intense, and in periods of greater volatility.

Movements in the foreign exchange market depend mainly on expectations about interest rates in two countries or regions. Forex traders seek returns by selling currency from countries where they expect rates to remain low…and buying where they anticipate rates to be higher

Also read: How to know the value of a foreign currency

Exchange rate: why does it affect me?

One of the most common references here in Europe is the euro-dollar exchange rate. This 2022 they have become almost on par, but for the last few years, the euro has been the stronger currency of the two. In fact, about a year ago they gave you 1.2 dollars in exchange for 1 euro. Now, on the other hand, they are almost equal, it is what is known as parity.

For this reason, when you go to a foreign exchange house at the destination airport, let’s say in New York, with €100 you would receive just over $100 (after deducting the exchange house commission).  

Well, the same thing happens in investments: investing in euros is not the same as investing in dollars, hiring an investment fund denominated in euros, dollars or pounds. 

And, in addition, the effect of the currency on investments has an extra difficulty: it is a continuous market, which does not close, unlike the Stock Market. This makes it more difficult to measure its impact.

A quick summary can be this: what you pay in dollars will be more expensive than a year ago. Entrepreneurs, for example, import products from the United States at a higher price than in the past. The opposite effect happens for entrepreneurs who export to the US: a weaker euro helps them.

The effect of exchange rates on investments: quick example

This explanation of the business world has a mirror in investments. Investing in euros or dollars has effects on our capital. 

Suppose you contract a fund from Spain or buy US shares with a broker. You will usually do it in euros because you do it from the point of view of a European investor.  Let’s say you invest 10,000 euros. You have two options:

1. Invest assuming the exchange rate risk. If you hire a US technology fund, not only the price of the companies in which the fund invests will influence. The rise or fall of the dollar against the euro also influences. Example: those who invested like this in 2022 are succeeding. The dollar’s rise against the euro has partially offset the declines in US stocks.
2. Invest without assuming that currency risk. This is possible in the world of mutual funds because most often offer a hedged currency class. They hire a kind of insurance by which the evolution of one currency against the other is canceled (it stops affecting the value). That risk is assumed by the investor who “sells” you the insurance. Actually, it consists of an operation in which you do nothing, it is carried out by the fund manager. 

Let’s see it with numbers: 

Imagine that, after 1 year, the €10,000 invested becomes €11,100 already discounting commissions (a net profit of €100 in our example). 

During that time, you have won €1,000. A return of 10%. Nothing bad.

Sure, but all this is assuming that exchange rates do not change. Suppose the euro, when you bought your fund, was trading at $1.2. And after that year, it depreciates and reaches parity (that is, each euro trades at one dollar).

If you invested without the hedged currency, then you bought $12,000 worth of fund shares instead, because the euro was at $1.2 (remember: your investment was actually €10,000). 

So when you withdraw the money, what happens? Let’s imagine that the value of the fund has not moved in this time, it has been flat, and it has only been affected by the movement of the dollar.

You would still have 12,000 dollars in the fund, which when converted to euros, as it is now at parity, would be 12,000 euros. That is, your initial 10,000 euros would have become 12,000 euros when you withdraw the investment and convert the dollars to euros.

If you had invested with the hedged currency, with the “insurance” that protects you from what happens in the foreign exchange market, those initial 10,000 euros when you recover the investment would also be 10,000 euros… less the cost of the insurance.

A ruinous operation? After all, yes, but if the dollar had fallen against the euro, you would have come out ahead.

Also read: Factors that affect the value of money over time

Hedges: the lifeline against currency changes 

To prevent the exchange rate from ruining the returns of the funds, the managers create different classes of the same fund in different currencies, following what is called “hedging strategies”, to cover this effect of exchange rates. about your investments. That is, the funds have different classes depending on the market in which they are listed.

With these “hedges” investments are protected from strong fluctuations thanks to a term contract or a derivative product (financial instruments whose value derives from the prices of another asset called underlying ). 

Hedge investment funds: hedging currency risk

When we choose an investment fund that invests in the US, most funds, especially those of international managers, offer us, different classes, to be able to make the investment in one way or another.

One such class is called a hedge. Covered currency in Spanish. This class allows you to eliminate the effect of the exchange rate or currency effect on the evolution of your investment portfolio. How is it possible? Because the managers of the investment fund change the currency at the close of the market to avoid the impact on the price of the assets that the fund holds in its portfolio. 

That is, if, for example, they invest in dollars and are listed in euros, these funds are covered against increases and decreases in the dollar with respect to the euro. In this way, what the fund is worth will depend only on how much its financial assets rise or fall, but in local currency.

Let’s take the dollar as an example. It is a currency that this 2022 has functioned as a refuge asset. Investors have flocked to it to hedge against falling markets. Thus, the dollar has been the big winner in its crossing with the euro and also with the pound.

In one of our last consultations, we asked a financial advisor if it now makes sense to invest in dollars or euros and if he had us cover the currency in case the dollar continued to rise. He answered us this:

.