Understanding the currency impact of an investment

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rob oyle

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This won't keep me awake at night but looking at a single share purchase here and I always thought I could understand/explain the currency impact of investing in a foreign currency... what am I missing?

Shares in Coca Cola HBC AG purchased in 2016
Price at the time: £13.05
EUR/GBP rate at the time: 0.761
EUR price at the time: E17.15

Current values
GBP price today: £36.66
EUR/GBP rate today: 0.88
EUR price today: E41.66

In GBP terms, the investment has gained 181%
In EUR terms, the investment has gained 143%
The currency loss is almost 40% based on the weakening of GBP between the two points.
Yet, using the rate for the two periods, sterling has weakened by c.14%.

What is the relationship between the c.40% and the c.14%... I assume the % increase in the base investment magnifies or diminishes the currency movement over time (for this investment) and there is a - simple - mathematical principle underpinning everything here?
 
How much does it cost p.a. these days to hedge the currency risk in an international equity portfolio?
 
JimmyB99 said:
hedge the currency risk in an international equity portfolio?
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If you have an internationally diversified portfolio, you have diversified your currency risk.

If you hedge it all back into euro, then you paying a premium to concentrate the risk.

If 100% of your investment was in a company,100% of whose business was in US$, it might make sense to hedge the currency risk.

But I don't understand why you would pay a premium to increase the risk.
 
In a way it's a moot point for shares in a company that has the majority of its turnover in euro.

If the Euro Sterling rate remained at 76p, then the stg value of turnover and profits would be lower than at the current rate of 88p and the share price would have reflected that.
 
Brendan Burgess said:
If you have an internationally diversified portfolio, you have diversified your currency risk.
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Not sure about that. If you have €100k on deposit you have no currency risk. If you, say, split that 4 ways into €, £, $ and Yen deposits you incur currency risk.
But I agree it could never be cost effective for the ordinary punter to hedge the currency risk of an internationally diversified portfolio.
 
Good point. If you do have deposits they should be for relatively short term liabilities or eventualities and these would probably be € based.
 
Brendan Burgess said:
As a euro resident, should I have all my assets in euro?
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Depends on what you're saving for.

If you're a euroland resident, and your dependants and people you wish to provide for are euroland residents, and all your liablities are denominated in euros, and the things you might want to buy to enhance your life and the lives of those you care about are priced in euros, then if you hold investments in currencies other than the euro, you're exposed to an exchange rate risk. It might be a risk you are happy to run; it might be a risk you want to run. But it is a risk; it;s a mismatch between your assets and your liablities.

But — separate point, but one not to be overlooked — when it comes to investing in equities, the currency in which the security is quoted is not really the currency you are investing in. You're investing in the currency or currencies in which the business concerned derives its earnings, or will likely derive them in the future. For a lot of large-cap international equities, that's a wide portfolio of the currencies, heavily weighted toward the currencies of developed economies.

I agree that deposits should mostly be relatively short-term, and the only reason for having deposits in a foreign currency is because you are reserving the funds concerned to meet a liability denominated in that currency. You're planning to buy a little pied-à-terre for your regular weekends in Marrakesh? By all means keep the deposit in a Dirham account while you scout for likely properties.
 
Brendan Burgess said:
But I don't understand why you would pay a premium to increase the risk.
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My question was about the cost of hedging currently which hasn't been answered. The reason for the question was that, in the past, when I was a pension scheme trustee, Mercer recommended a hedged international Equity Fund for our AVC fund. This was at a time when the cost of hedging was very low.

If the premium was a completely nominal amount, can you explain how this increases the risk please?
 
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JimmyB99 said:
How much does it cost p.a. these days to hedge the currency risk . . . ?
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The cost of hedging a currency risk is basically a function of the difference in interest rates between the two currencies concerned.

Suppose you will want $100k in a year's time. Today, that would cost you about €87k. You want reassurance that you can get it for €87k in a year's time, so you ask a financial institution to hedge the risk for you.

The financial instution reasons as follows: We could take a deposit from a member of the public of €87k for a year. Today, we would offer, say, 2% to attract that deposit, so that would cost us €1,740. If we then converted the €87k to US$ and deposited it, what would that earn us us? The difference between those two figures, plus a margin for the cost of the foreign exchange transaction, is the cost to the us of hedging the risk. They'll add a further margin, because they want to make a turn on the deal. That will determine what they will charge to hedge the risk.

It follows that the cost of hedging an exchange rate risk varies whenever interest rates move in one or other of the currencies concerned. If the two interest rates are very close together, the cost of hedging will be low; the further apart they are, the more the cost will be. (And, of course, the longer the period for which you wish to hedge, the more the cost will be.)
JimmyB99 said:
If the premium was a completely nominal amount, can you explain how this increases the risk please?
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I don't think the suggestion is that hedging increases the risk; it's that investing in currencies that don't match your liabilities increases your risk. You can manage that risk at a cost, by hedging, at least for a time. But you can avoid the risk entirely, at nil cost, by not investing in foreign currency assets in the first place. The suggestion is that you are paying a premium in order to be more comfortable about a risk that you don't have to run at all; why would you pay to ameliorate the risk when you can avoid it entirely for free?
 
JimmyB99 said:
If the premium was a completely nominal amount, can you explain how this increases the risk please?
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If I can put $100k on deposit at 5% in a AAA US bank and someone will hedge that for me at a "completely nominal amount" that is fine.

But it would never be a nominal amount.
 
One could argue that all currency hedging is risky. An asset has intrinsic value. The currency it is denominated in is irrelevant. If you buy that asset in currency A and then hedge that into currency B that is a separate risk which could be largely independent of how the intrinsic value of the asset changes. Even a company which entirely operates in one country will have intrinsic value that to some extent is independent of the country’s currency just as a real estate property would be.
 
TomEdison said:
If you're a euroland resident, and your dependants and people you wish to provide for are euroland residents, and all your liablities are denominated in euros, and the things you might want to buy to enhance your life and the lives of those you care about are priced in euros, then if you hold investments in currencies other than the euro, you're exposed to an exchange rate risk. It might be a risk you are happy to run; it might be a risk you want to run. But it is a risk; it;s a mismatch between your assets and your liablities.
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This is what I am struggling with.

All my liabilities will be in euro.

But what if the euro loses a lot of its value i.e. we get very high inflation in the eurozone. Would it not be worth diversifying into other currencies?

Or if my home and share portfolio are real assets then they will probably rise in line with inflation, so it doesn't matter?

But most of the companies in my share portfolio have significant revenues in non-euro currencies so I am diversified anyway.

Brendan
 
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JimmyB99 said:
It's a bit tricky getting international equity exposure with this approach?
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By definition, yes, since international equities include a lot of companies that derive much of their earnings in currencies other than the euro. You could, by careful stock selection, chose a portfolio of shares in companies who sell mostly in Euroland. They'd be international in the sense that they need not be Irish companies or companies that do much trade in Ireland, but it would be a limited, skewed selection of international equities.

Brendan Burgess said:
All my liabilities will be in euro.

But what if the euro loses a lot of its value i.e. we get very high inflation in the eurozone. Would it not be worth diversifying into other currencies?
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I think we're talking about two separate things here.

When people talk about hedging currency risk, they are talking about the risk of the euro losing its value against other currencies (often the US dollar).

That need not be associated with high inflation in euroland. Inflation risk is a different risk.

The general wisdom is that you hedge against inflation risk by investing in real assets - equities, property. If prices rise then corporate revenues also rise, since they stuff they sell is now being sold for higher prices. Similarly, rents tend to rise when prices in general rise, so property values rise too. And if the risk you want to protect yourself from is inflation in euroland economy, then you protect yourself from that with real assets in euroland.

If you invest in the US — US properties, companies that get most of their revenues in the US — then, if there is inflation in euroland but not in the US (and if the euro/dollar exchange rate is unchanged) you will lose out, because euroland real assets will go up in price but US real assets will not (unless coincidentally). On the other hand, if there's inflation in the US but not in euroland (and, again, if the euro/dollar exchange rate is unchanged) you'll do very nicely. (A mismatch between your assets and liablities can work out well for you — there's upside risk as well as downside risk.)
 
TomEdison said:
By definition, yes, since international equities include a lot of companies that derive much of their earnings in currencies other than the euro.
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This is generally accepted but is it entirely or even approximately correct?
TomEdison said:
If prices rise then corporate revenues also rise, since they stuff they sell is now being sold for higher prices.
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This contradicts the above statement. Let's take Toyota. They will have significant revenues in the UK. But does that mean they are vulnerable to the £? Only second order; the price of a Corolla (apologies @Corola and @Corolla) will flex with the currency.
 
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