Currency Risk in International Investing — What It Is and How to Manage It

Imagine finding a foreign company with excellent fundamentals — strong earnings growth, a durable competitive advantage, an attractive valuation. You invest, and over the next two years the company's stock price rises 15% in local currency terms. You check your brokerage account expecting a satisfying gain. Instead, you find that your actual return, in US dollars, is closer to 5%. What happened?

Currency risk happened. It is one of the most underappreciated dimensions of international investing, and understanding it is essential before putting money to work in foreign markets.

Disclaimer: This content is for educational purposes only and does not constitute financial or investment advice. International investing involves additional risks including currency, political, and regulatory risk. Always consult a qualified financial advisor before making investment decisions.

What Is Currency Risk?

When a US investor buys shares in a foreign company, the investment is denominated in that country's local currency. A Japanese company's stock is priced in Japanese yen. A German company's stock is priced in euros. A Brazilian company's stock is priced in reais. To invest, your US dollars are effectively converted into the foreign currency. When you eventually sell, the proceeds are converted back into dollars.

This two-way conversion creates exposure to exchange rate fluctuations. The value of your investment in dollar terms depends not only on how the foreign stock performs, but also on how the exchange rate between that currency and the US dollar moves during your holding period.

Here is the key relationship: if the foreign currency strengthens against the US dollar, your returns are enhanced. You collect more dollars when converting back from the now-stronger currency. If the foreign currency weakens against the US dollar, your returns are reduced — sometimes significantly. In the worst cases, currency depreciation can turn a profitable investment in local terms into a loss when measured in dollars.

A Concrete Example

Consider a hypothetical European company whose stock rises 10% in euro terms over a one-year period. If the euro also appreciates 5% against the US dollar over the same period, the US investor's return would be approximately 15% in dollar terms — the stock return plus the currency tailwind.

Now reverse the scenario. The same 10% stock gain in local terms, but this time the euro weakens 8% against the dollar. The US investor's return shrinks to roughly 2% — a far cry from the 10% gain in local currency. The investment was successful in local terms; currency movement mostly erased it in dollar terms.

This dynamic works symmetrically. Currency can be a tailwind or a headwind, and it operates independently of what the underlying business is doing.

Why Currency Moves Matter (and When They Don't)

Currency movements can be particularly dramatic in specific circumstances:

Emerging market currencies tend to be more volatile than the currencies of stable developed economies. Political instability, inflation differentials, commodity price dependence, and capital flow reversals can cause EM currencies to depreciate sharply and quickly. An emerging market currency can lose 20% or 30% of its value against the dollar in a bad year — a headwind strong enough to turn even solid equity performance into a loss.

Periods of US dollar strength are challenging for international investors in general. When global uncertainty rises, capital often flows into the US dollar as a safe haven, causing the dollar to strengthen against most other currencies. This means that periods of market stress — exactly when investors might prefer stability — often come with currency headwinds for international holdings.

That said, currency risk should be kept in perspective over long time horizons. Over extended periods of many years or decades, currency effects often wash out. Exchange rates oscillate around fundamental economic relationships. A decade in which the dollar strengthens significantly against a currency may be followed by a decade in which it gives back those gains. For long-term investors, currency risk is more of a volatility contributor than a permanent return destroyer.

The concern is greatest for shorter holding periods, heavily concentrated single-currency bets, or positions in currencies (like those of less-stable emerging markets) that face structural depreciation pressures.

Currency Hedging: What It Is and What It Costs

Investors who want to own international stocks but want to remove currency exposure from the equation can use a strategy called currency hedging. In practice, this typically means using derivatives contracts (most often currency forwards) to lock in an exchange rate, neutralizing future currency movements.

For individual investors, the most accessible form of currency hedging comes through currency-hedged funds. These are international funds that hold foreign stocks while simultaneously holding positions designed to offset currency movements, delivering returns that more closely reflect the underlying stock performance in local terms — without the currency fluctuation layered on top.

The appeal is straightforward: you get exposure to international equity markets without betting on currency movements you may have no view on.

But currency hedging is not free. It comes with real costs:

Hedging costs money directly. The mechanics of maintaining forward contracts involves ongoing costs that are reflected in a hedged fund's expense ratio or performance drag. These costs fluctuate based on interest rate differentials between countries — when US interest rates are meaningfully higher than foreign rates, hedging international exposure into US dollars becomes more expensive.

Hedging can eliminate tailwinds, too. Currency hedging works symmetrically. It removes the risk of currency depreciation harming your returns — but it also removes the potential benefit if the foreign currency appreciates against the dollar. You are not just removing downside; you are removing upside as well.

Hedging adds complexity. For a buy-and-hold investor with a very long time horizon, the costs and complexity of maintaining currency hedges may outweigh the benefits, especially given that long-run currency effects tend to be modest.

Unhedged vs. Hedged: Which Is Right?

There is no universal answer. The decision depends on your time horizon, the specific currencies involved, your current views (if any) on currency direction, and how much additional volatility you are willing to accept.

A useful framework:

• Long time horizon (10+ years): Currency hedging adds cost and complexity for effects that are likely to diminish over time. Many long-term investors choose to hold unhedged international exposure.
• Medium time horizon (3–7 years): Currency risk is more meaningful over this window. Hedging part of international exposure — particularly in currencies with higher volatility — may be worth considering.
• Short time horizon: Currency risk can dominate equity returns over short periods. Investors with near-term needs should think carefully about unhedged international exposure.
• Emerging market exposure: EM currencies are structurally riskier than major developed market currencies. Many investors accept this as part of the EM risk/reward trade-off rather than hedging it, since EM hedging costs can be prohibitively high.

Managing Currency Risk Without Hedging

Even without formal hedging instruments, investors can manage currency risk in practical ways:

Diversify across currencies. Owning stocks in many countries and currencies means no single currency move dominates your returns. Euro weakness may be partially offset by yen strength or Australian dollar performance.

Invest in globally diversified businesses. Many large international companies earn revenues across multiple currencies. A European company that generates significant revenue in the United States is partially self-hedging against euro weakness.

Size international positions appropriately. Keeping international exposure to a reasonable share of total portfolio value limits the overall impact of adverse currency moves.

Actionable Takeaways

• Understand the basic mechanic. When the foreign currency weakens against the US dollar, your international investment returns in dollar terms are reduced — even if the stock itself performed well in local currency.
• Recognize the time horizon effect. Currency risk is most impactful over shorter periods. Over many years, currency effects tend to wash out as exchange rates fluctuate around long-run fundamentals.
• Evaluate currency-hedged funds thoughtfully. They eliminate currency volatility but add cost and remove potential currency tailwinds. They make the most sense for shorter-to-medium-term horizons or specific high-volatility currency exposures.
• Diversify across currencies. Spreading international exposure across multiple countries and currencies naturally reduces the impact of any single currency move on your portfolio.
• Accept some currency risk as part of international investing. For long-term investors, currency fluctuation is a feature of global markets, not a fatal flaw. Understanding it allows you to size positions appropriately and keep perspective during volatile periods.

Ready to research global stocks? Use the free screener at valueofstock.com/screener to find quality companies worth analyzing.

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Disclaimer: This content is for educational purposes only and does not constitute financial or investment advice. The examples used are for illustrative purposes only.

By Harper Banks