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    Currency Exchange Rates: The International Wild Card

    Currency Exchange Rates: The International Wild Card Splash image

    Think you have a hot hand in the international markets because of big gains in your foreign holdings? Think again.

    That explosive growth may have less to do with insightful analysis on your part, and more to do with the falling U.S. dollar relative to many other currencies. Currency exchange rates are the wild card of international investing. You can venture overseas and pick the right stock, bond or mutual fund at the right time and see prices and the market rise—yet watch your U.S. dollar return vanish as the currency exchange rate moves against you. Or more happily, you can make a poor pick with less-than-optimal timing and still receive eye-catching returns if the exchange rate moves in your favor.

    Currency exchange rates are one of the gambles in the world of international investing, whether you invest in international mutual funds or exchange-traded funds, regional or single-country funds, American depositary receipts (ADRs), or directly in foreign stocks or bonds.

    Knowing what factors drive exchange rates, how to calculate the impact of currency changes on return, and what your alternatives are to control or manage exchange rate risk in your foreign investment will make you a more effective international investor.

    What Causes Changes

    Changes in exchange rates occur because of economic, political and speculative forces, all of which are difficult to unravel and monitor. They are highly unpredictable—never mind what the pundits say, because they are rarely right. From an economic viewpoint, common sense dictates that if the demand for a currency exceeds its supply in the short term, the currency will appreciate. So when the goods and services of a country are in demand by foreign purchasers—a net trade balance surplus—the currency has a tendency to appreciate. Conversely, when foreign goods and services are in demand domestically—a net trade deficit—the currency tends to depreciate.

    Inflation, productivity and costs in a country all contribute to trade balances and currency pressures. In addition, fiscal policy that stimulates or depresses economic growth, monetary policy, the money supply and central bank action—all move markets and currency exchange rates.

    There is no precise or direct summary indicator of all these forces. But differences in interest rates between the domestic market and a foreign market or markets can reveal a great deal.

    The differences in real rates of return, nominal return less inflation, probably provide an even better window to currency risk. In order to protect exchange rates, some countries at times maintain relatively high real rates of interest to generate demand for their currency. High real rates of interest, however, take their toll on domestic economic growth, many times forcing countries to devalue their currency or reduce interest rates, adversely affecting foreign investors who hold investments denominated in the currency.

    In the past, currency speculators have also attacked certain currencies by selling them heavily in expectation of a devaluation, or to force a devaluation if a government is unwilling or unable to defend its currency by using foreign currency reserves to buy their own currency.

    How Changes Affect Returns

    Currency risk cuts both ways: An investment denominated in a currency that is appreciating against an investor’s domestic currency will receive a return boost, and an investment denominated in depreciating currency will see returns depressed. Currency terminology can get confusing, but remember: From the perspective of your foreign investment, a weakening dollar relative to the foreign currency of your investment boosts your currency-adjusted total return.

    Why?

    The boost occurs because the currency of your foreign investment buys more dollars, which means that the foreign currency of your investment will translate into more dollars and thus a higher total return after exchanging the investment into U.S. dollars.

    Table 1 provides a good example of how the falling dollar has affected the returns to a U.S. dollar–based investor in a select group of countries. It shows the returns in local currency for several countries (based on MSCI country indexes), and the corresponding return in U.S. dollars over the same period. The dollar has fallen by different rates against various currencies, and this is reflected in the table, with certain returns affected to a much greater degree than others.

    For example, the French market over the last year (through October 12, 2007) returned 8.9%, but the falling dollar boosted this return to 23.1% for a U.S.-based investor. In contrast, Japan’s local currency return of 4.8% received only a slight boost, to 6.6% for U.S. dollar-based investors.

    Remember, however, that currency risk cuts both ways. The dollar won’t fall forever, and a rising dollar could quickly send your positive foreign returns into negative territory because the foreign currency of your investment will translate into less dollars and thus a lower total return after exchanging the investment into U.S. dollars.

    Currency gains can overcome investment losses and magnify gains, or make a bad foreign investment much worse. Table 2 provides a quick reference to judge how currency swings can impact your foreign investments. It shows some significant currency changes, and although unusual over short periods of time, they are not unheard of.

    Table 1. A Foreign Currency Boost for U.S. Investors: Local Currency vs. U.S. $ Returns
      Annualized Returns Through 10/12/2007 (%)
    1 Year 3 Years 5 Years
    Local
    Currency
    US
    $
    Local
    Currency
    US
    $
    Local
    Currency
    US
    $
    France 8.9 23.1 16.6 22.2 14.4 23.0
    Germany 28.7 45.5 24.0 30.0 20.0 29.1
    UK 9.9 20.4 12.9 17.9 11.2 17.3
    Europe 12.7 25.7 17.3 22.5 14.6 22.0
    Australia 29.0 55.4 22.9 31.9 18.5 30.9
    Hong Kong 49.9 50.6 24.7 24.9 24.1 24.2
    Japan 4.8 6.6 15.8 13.2 15.0 16.3
    Canada 24.3 45.0 18.6 29.2 19.6 31.8
    U.S. 15.1 15.1 12.0 12.0 13.6 13.6
    Source: MSCI Barra based on MSCI Barra local market index performance.

    Table 2. Converting Local Returns to U.S. Dollar Returns When Foreign Currencies Change
    Return
    in Local
    Currency
    (%)
    Change in Foreign Currency Relative to US $ (%)
    20% 15% 10% 5% 0% -5% -10% -15% -20%
    Total Return in U.S. Dollars (%):
    20 44 38 32 26 20 14 8 2 -4
    15 38 32 27 21 15 9 3 -2 -8
    10 32 27 21 16 10 4 -1 -6 -12
    5 26 21 16 10 5 0 -5 -11 -16
    0 20 15 10 5 0 -5 -10 -15 -20
    -5 14 9 4 0 -5 -10 -15 -19 -24
    -10 8 3 -1 -5 -10 -15 -19 -24 -28
    -15 2 -2 -6 -11 -15 -19 -24 -28 -32
    -20 -4 -8 -12 -16 -20 -24 -28 -32 -36

    Reducing the Impact

    In general, foreign fixed-income investments have a much higher currency risk than foreign equities. In addition, over very long time periods currency exchange rates tend to reach equilibrium as economies adjust and react to each other. Returns most susceptible to currency changes are those on short-term foreign fixed-income investments; the least impacted would be the longer-term returns of growth-oriented common stock investments.

    If you want to invest internationally but find currency risk too high, what can you do to reduce it? Currency options and futures are too costly and impractical for individual investors, particularly long-term investors. But some choices for the reduction of currency risk are within all investors’ reach:

    • Make investments in foreign countries with stable political and economic environments that also have strong currencies. Avoid countries with extremely high inflation rates that are candidates for currency devaluations.
    • You may want to consider investing in international mutual funds that hedge some portion of currency risk, especially if investing in funds that hold fixed-income investments. Hedging, however, is not free, so you should expect lower returns along with the lowered risk. The prospectus will indicate if hedging currency is part of a fund’s investment approach.
    • Diversify your international investments, relying on the portfolio effect to reduce overall portfolio currency risk. Make sure you are diversified by country, by region, and also by currency. And focus more on the longer-term results.
    • If after having read the currency experts you think you have a good fix on the direction of currencies, slap yourself a few times and come back to your senses. The history of exchange rates is littered with incorrect forecasts that seemed quite plausible when they were made.

       Calculating the Return to a U.S. Investor After Foreign Currency Changes

    How can you calculate how your foreign returns might be affected by currency changes?

    The table below shows the formula, along with an example, using an investment in the common stock of a French firm from the viewpoint of an American investor.

    In the example, the European euro is priced in U.S. dollars. At the beginning of the period, $1.26 bought one euro, while at the end of the period it took $1.42 to buy one euro—the euro appreciated in value against the U.S. dollar and the dollar declined in value against the euro. [Most major newspapers will carry major foreign currency values in U.S. dollars.]

    The euro appreciated in value by 12.7% [($1.26 – $1.42) ÷ $1.26], while the stock fell in value by 9.4% [(€85 – €77 ) ÷ €85].

    What was the return in U.S. dollars for the American investor in this stock?

    The top of the table shows the formula to determine how a U.S. investor would fare in a foreign investment when exchange rates change, which in this instance is a 2.1% gain.

    The Formula:

    *Income includes dividends, interest or distributions.

    An Example for Investment in a French Firm (Priced in Euros):