Q: How do exchange rates impact international stock returns?
A: Currency exchange rates change constantly, causing an increase or decrease in the US dollar value of foreign investments. This fluctuation occurs even if the price of the asset in its local currency remains the same. When US investors receive dividends or sell shares of an international investment, the cash they receive is converted into US dollars. If the US dollar strengthens against a foreign currency, that currency will buy fewer dollars. This results in a lower US dollar return for investors. Conversely, if the dollar weakens, the foreign currency will buy more dollars and thus increase a US-based investor’s return.
Currency fluctuations, and their impact on investor returns, can be quite dramatic. Take the calendar year returns in 2005 and 2007, for example. In 2005, international stocks returned nearly 30% in their respective local currencies. The US dollar, however, grew stronger that year, resulting in a lower return to US-based investors.
In 2007, the opposite occurred. Returns in international markets were much weaker in local currencies. The value of the US dollar, however, fell against those foreign currencies. This provided a boost to US investors, lifting international stock returns to nearly 12% in US dollar terms.
While some investors may wonder why they should subject themselves to these currency fluctuations, it’s important to note currency fluctuations do not occur at the same time, or in the same amount, as the fluctuations of stock markets. More simply, currency returns don’t move in lock step with stock returns. At modest levels, exposure to currency fluctuation can help diversify a stock portfolio and lower overall portfolio risk.
