Currency Risk in International Investing: How Exchange Rates Affect Your Returns

Published: March 15, 2026 | Category: International Investing | Reading time: 6 min

When US investors buy international stocks, they sign up for two separate bets whether they realize it or not: one on the foreign company's performance, and one on the direction of the exchange rate. The interaction between these two is currency risk, and it's one of the most misunderstood elements of international investing. You can be right about a company's fundamentals and still lose money if the currency moves against you. And you can be wrong about a company and still come out ahead if the currency bails you out. Understanding this dynamic is essential to making sense of your international portfolio's actual performance.

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Disclaimer: This article is for informational and educational purposes only. Nothing here constitutes financial advice, investment advice, or a recommendation to buy or sell any security. All investing involves risk, including the possible loss of principal. Past performance is not indicative of future results. Consult a qualified financial professional before making investment decisions.

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The Two-Part Return on Any Foreign Investment

Here's the fundamental relationship that governs every international investment for a US dollar-based investor:

Total return (in USD) = Local currency return + Currency return

These two components can work together or against each other. If you invest in a Japanese stock that rises 12% in yen terms, and the yen also strengthens 5% against the dollar during your holding period, your total return in USD is approximately 17% — the currency effect amplified your gains. But if that same 12% yen-denominated gain coincides with a 10% depreciation of the yen against the dollar, your USD return shrinks to around 2%. The investment performed well locally. You barely made money.

This isn't hypothetical. It happens regularly. During periods when the US dollar strengthens significantly — as it did in 2014-2015 and again sharply in 2022 — international equity returns for US investors were substantially dragged down by currency headwinds, even when local market performance was reasonable.

What Drives Exchange Rate Movements?

Currency movements are notoriously difficult to forecast. Even professional currency traders get them wrong most of the time. But understanding the key drivers helps frame the risk.

Interest rate differentials are among the most powerful short-to-medium-term drivers. When the US Federal Reserve raises rates faster than other central banks, the US dollar typically strengthens because higher US rates attract capital seeking yield. This is one reason the 2022 rate hike cycle hit international portfolios hard from a currency perspective.

Economic growth differentials also matter. If the US economy is growing faster than Europe or Japan, investment flows tend to favor USD-denominated assets, pushing the dollar higher.

Trade balances and capital flows create longer-term currency pressures. Countries running persistent current account deficits may see their currencies weaken over time.

Risk sentiment drives short-term flows powerfully. During global financial stress, investors flock to perceived safe-haven currencies — the US dollar, Swiss franc, and Japanese yen tend to strengthen during crises, while emerging market currencies often sell off sharply.

For the individual investor, the takeaway isn't to become a currency forecaster — it's to understand that exchange rate movements are a real and separate source of return variance in your international portfolio.

When the Strong Dollar Hurts

The US dollar is the world's reserve currency, and it has periods of significant strength. When the dollar is strong, international returns look worse to American investors — not because foreign stocks performed poorly, but because those foreign-currency gains are worth fewer dollars when converted back.

Consider a European equity fund that tracks the MSCI EAFE index. If European stocks rise 8% in euro terms over a year, but the dollar strengthens 10% against the euro, your USD return on that fund would be roughly negative 2%. You owned appreciating assets and still lost money in dollar terms. This is not a theoretical edge case — it has materialized in real portfolios, real years, and real investor statements.

Conversely, when the dollar weakens — as it did during much of 2017 and parts of the early 2000s — currency effects boost international returns for US investors. The same European fund returning 8% in local terms, combined with a 10% dollar depreciation (equivalent to a 10% strengthening of the euro), would deliver roughly 18% in USD terms. The currency worked in your favor.

Over very long periods, many economists and investment researchers argue that currency effects tend to wash out. Major currencies don't persistently trend in one direction forever — they cycle. But "very long periods" can mean 10, 15, or even 20 years. That's a long time to wait for mean reversion, especially in retirement.

Currency-Hedged vs. Unhedged ETFs

The investment industry has responded to currency risk with a product solution: currency-hedged ETFs. These funds use forward contracts to neutralize the currency exposure, giving you the local market return without the exchange rate component.

The most prominent example is DBEF (Xtrackers MSCI EAFE Hedged Equity ETF), which provides MSCI EAFE exposure with the currency effects hedged away. Compare it to an unhedged EAFE fund like EFA and you can observe directly how currency moves affect returns in different market environments.

The appeal of hedging is obvious: you eliminate an unpredictable variable and isolate your bet on the foreign equity markets themselves. But hedging isn't free. Forward currency contracts cost money, and the cost depends on interest rate differentials between countries. When US rates are significantly higher than foreign rates, hedging international exposure back to dollars can cost 1–2% per year or more. That's a real drag on returns.

The historical evidence on whether to hedge is genuinely mixed. Over long periods, studies have found that the costs and benefits of currency hedging have been roughly equal — which means neither approach has dramatically outperformed the other when measured across full market cycles. Hedging reduces short-term volatility but doesn't reliably improve long-term returns after accounting for its cost.

The practical implication: unhedged exposure is reasonable for long-term investors who can stomach short-term currency volatility. Hedged exposure may be preferable for shorter-term allocations, for investors nearing retirement, or for those with genuine conviction that the dollar will strengthen over their investment horizon.

Currency Risk in Emerging Markets

Currency dynamics in emerging markets deserve special attention. EM currencies tend to be more volatile and more susceptible to sharp depreciations than developed market currencies. During periods of global risk aversion or US dollar strength, EM currencies can fall dramatically — sometimes 20–30% or more in a single year.

This amplifies both the upside and the downside of EM investing. A strong local market return can be wiped out by a collapsing currency. And currency crises in countries like Turkey, Argentina, Brazil, and others have inflicted serious damage on EM investors even when the underlying companies were operationally sound.

This is part of why the recommended EM allocation is kept moderate (10–15% of equity holdings) and why understanding which currencies your EM exposure is denominated in matters. Currency-hedged EM ETFs exist but are less common and more expensive to hedge than developed market equivalents.

Putting It Together for Value Investors

Currency risk doesn't change the core value investing discipline — it adds an additional layer of analysis. When evaluating an international investment, factor in the currency environment as part of your margin of safety. If you're buying a European company at what looks like a deep discount, but the euro is near multi-decade highs versus the dollar, part of that "cheapness" may be explained by the currency premium — and it could reverse.

The Value of Stock Screener can help you identify foreign equities trading at valuation discounts so you can begin your fundamental research with currency dynamics in mind.

Actionable Takeaways

• Your international return = local return + currency return. Both components matter and must be tracked separately to understand performance.
• USD strength is a headwind for international investors. When the dollar rises, foreign currency earnings convert to fewer dollars, dragging returns down.
• Currency-hedged ETFs like DBEF remove currency exposure but carry a hedging cost — historically, hedging and not hedging have produced roughly equivalent long-term outcomes.
• Emerging market currencies are more volatile than developed market currencies and can cause severe return drag in risk-off environments; keep EM allocations sized accordingly.
• Think of currency as a margin of safety factor. Buying an international position when the foreign currency appears undervalued adds a potential tailwind; buying when it's overvalued reduces your margin of safety.

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This article is for educational purposes only and does not constitute financial or investment advice. Currency exchange rates can fluctuate significantly and unpredictably, which can result in losses on international investments even when the underlying securities perform well in local currency terms. Consult a qualified financial professional before making investment decisions.

— Harper Banks, financial writer covering value investing and personal finance.