Understanding the currency impact of an investment

[TomEdison]

This is generally accepted but is it entirely or even approximately correct?

Yes, it is. Euroland represents about 11.5% of the global economy by purchasing power parity. "Internationa equities" as a class includes companies that sell literally anywhere in the world. Most of the earnings of most of the companies whose shares would be classed as "international equities" are derived in currencies that are not the euro.

If prices rise then corporate revenues also rise,

This contradicts the above statement.

No, I don't think so.

Again, bear in mind that exchange rate risk and inflation risk are not the same thing.

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.

Well, let's think this through.

Not even Chatgpt will hazard a guess as to the percentage of Toyota's revenue's that is derived in the UK, but it does telll me that 1.3% of Toyota's vehicle sales by unit are in the UK. Let's pretend that they also derive 1.3% of their gross revenues from the UK.

Let's also pretend that all the Toyota vehicles sold in the UK are imported. This isn't true, but it will simplify the position so that we can identify what happens when (a) UK inflation shifts, or (b) the sterliing exchange rate shifts.

Lets take those two things in order, first separately and then together.

Inflation: UK prices goes up (but the sterling exchange rate is unchanged)

On the one hand, Toyota has to pay more for its UK inputs — its distribution and sales operation. On the other, it can charge more for its cars (because its competitors are also charging more). So — costs up, revenues up, turnover up. If they all go up by the same percentage, and if profit margins are maintained, Toyota's UK profits are up. All other things being equal, UK earnings now amount to a tiny bit more than 1.3% of Toyota's worldwide earnings. Obviously this isn't going to make a huge difference to the price of Toyota shares, but it will tend to make the price rise rather than fall.

Exchange rate: sterling falls (but UK prices are unchanged)

This has the opposite effect: UK revenues are unchanged (in nominal sterling terms) but when you convert UK revenues to yen they buy less yen, so UK earnings now account for a tiny bit less than 1.3% of Toyota's global earnings. All other things being equal, Toyota's global earnings are a tiny bit less than they used to be, so this tends to cause the price of Toyota shares to fall.

Both of these things happen together

Exhange rates and inflation are not the same thing, but they are not completely unconnected. If the UK suffers a bout of inflation then UK-produced goods become more expensive (in nominal sterling terms). They are less competitive on the world market so fewer people want to buy them so UK exports fall. Because people are importing less from the UK they don't need to buy sterling to pay for UK goods, so demand for sterling falls, so the sterling exchange rate weakens, which of course means UK goods become a bit more competitive again, so more people start to buy them again, so sterling doesn't fall indefinitely; it settles a slightly lower value.

So, the inflationary effect on the Toyota share price of UK car prices going up is offset by the deflationary effect on the Toyota share price of sterling going down. It's unlikely the two will cancel one another out exactly and the net impact on the share price could be either slightly positive or slightly negative. Because UK revenues are only 1.3% of global revenues it hardly matters; whether the net effect of these two factors is slightly positive or slightly negative, it's likely to be swamped by the effect of other, unrelated factors.

It would matter more if we were talking about the US, where Toyota might earn, say, 25% of its global revenues.

 

[Duke of Marmalade]

Again, bear in mind that exchange rate risk and inflation risk are not the same thing.

A high correlation though, certainly in the long term. Toyota with 1.3% UK earnings obviously a bad example. But take Tesco shares. They are almost of themselves a hedge against sterling inflation. To the extent that there is correlation between inflation and exchange rate to hedge the sterling value of your Tesco shares is an over hedge of inflation and therefore increases your € risk.

 

[PMU]

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.

It is. When you invest in an equity priced in say USD, you are taking on two risks: (1) the risk of investing in the enterprise; and (b) the USD/EUR exchange rate risk between the time you buy the equity and the time you sell it.

Fx risk is just one of the many business risks companies manage. In the USA these are exposed in annual reports. For example, the 10-K report (2024) of an American company in which I invest states: “We are exposed to foreign currency exchange risk from our Canadian operations. Fluctuations in the U.S. dollar relative to the Canadian dollar may impact our consolidated financial results. We do not generally hedge this exposure as it is not material compared to our overall business risks.”

So, the fx risk is there; in this case the US company is not hedging it because it is ‘not material’ relative to other business risks. Each company assesses its fx risk uniquely and fx risk is just one of the many business risks a company manages.

As stock exchanges are efficient, investors, in this case in the USA, efficiently price this fx risk together with all the other business risks the enterprise faces, and the market includes this in the price at which the stock trades. You, as an investor, can’t diversify away this business risk; you take it on when you buy the stock, as the fx risk is efficiently priced in to the price at which the stock trades.

Then there is the EUR/USD fx risk, as the exchange rates will change between the time you buy the stock and the time you sell it. I think the average retail investor, and I include myself in this, reduces fx risk by investing for the long term, as volatility, i.e. the standard deviation in returns, scales with the square root of time. It’s like flipping a coin. One flip is unpredictable. Ten flips are more unpredictable, but not ten times more — because some heads and tails balance each other out. That’s why risk grows with time, but not as fast as time itself. So by holding long term, fx risk is there but its not the sum of daily changes in fx rates. It’s lower.
Now, I’ve never done this or met anybody who has, but you could also purchase Micro EUR/USD Futures (via e.g. Interactive Brokers) to hedge your fx risk. Essentially you enter a forward contract (or a set of micro contracts) so your EUR return reflects only the stock’s performance, not the fx swings.

 

[TomEdison]

A high correlation though certainly in the long term.

I wouldn't go so far as to say a "high correlation". Certainly inflation can affect the exchange rate, but many other things can also affect the exhange rate. They don't move in lockstep, and the exchange rate can vary for reasons that have nothing to do with inflation.

But take Tesco shares. They are almost of themselves a hedge against sterling inflation. To the extent that there is correlation between inflation and exchange rate to hedge the sterling value of your Tesco shares is an over hedge and therefore increases your € risk.

Well, hold on. If you're in Ireland, why you you need or want a "hedge against sterling inflation"? You're not buying stuff in sterling-land, or intending to so; why do you care if prices go up in sterling-land? This isn't a risk that you need to hedge against.

In fact, all other things being equal, in fact you would welcome sterling inflation; for the reasona already discussed, a rise in inflation in sterling-land will tend to increase the (sterling) value of your shares in Tesco. (However, as mentioned, this is likely to be at least partly offset by a decline in the sterliing exchange rate.)

It is. When you invest in an equity priced in say USD, you are taking on two risks: (1) the risk of investing in the enterprise; and (b) the USD/EUR exchange rate risk between the time you buy the equity and the time you sell it.

No, I don't think so.

Bear in mind that there are lots of equities that are listed both on a UK or European stock exchange and (in the form of ADRs) in New York. The UK/Euro listing is in quoted in sterling or euros; the NYSE listing is quoted in dollars. You wouldn't suggest, would you, that by investing on the NYSE you are taking an additional FX risk? In both cases the investment is in exactly the same enterprise, and the market has exactly the same information about present and future earnings and about other factors that might affect the valuation to be placed on the company. So you would expect the share prices to be, for all functional purposes, identical in New York and (say) Frankfurt. And indeed they are.

In both cases, what you buy with your investment is a share in the expected future earnings of the business. If you're in euroland then, to the extent that those future earnings will be in US dollars. you're exposed to an exchange rate risk. But that's the same rate regardless of whether you make your investment on the Frankfurt exchange or on the NYSE; there isn't an additional exchange rate risk as a result of investing on the NYSE.

The same holds good for companies that don't have a dual listing. If a company is listed just in the NYSE, what you are buying when you buy a share is a slice of the expected future earnings of the company. Those expected earnings don't depend on where the stock is listed.

Tl;dr; you face an exchange rate risk in relation to the currency in which the business derives its earnings; you do not face an exchange rate risk in relation to the currency in which the shares are quoted.

 

[Duke of Marmalade]

Well, hold on. If you're in Ireland, why you you need or want a "hedge against sterling inflation"

Oh dear! It is getting nerdish and you have misunderstood my point. Let’s for argument sake say that inflation is the only cause of currency movements. Let us say for further argument that Tesco shares align completely with UK inflation plus of course its own economic performance. I am saying that an Irish investor who hedges the exchange rate risk in their Tesco shares has doubled up on the required hedge.
Put another way. You are afraid sterling will fall in value against the euro by 10% over the next 5 years. But if that happens the sterling price of Tesco will rise by 10% based on our two assumptions that Tesco shares mirror sterling inflation and that relative inflation is the only cause of exchange rate movements.
Of course our two assumptions are only partly true but my point is that to 100% hedge the exchange rate is illusory and increases the € risk of holding Tesco shares.

 

[TomEdison]

Oh dear! It is getting nerdish and you have misunderstood my point. Let’s for argument sake say that inflation is the only cause of currency movements. Let us say for further argument that Tesco shares align completely with UK inflation plus of course its own economic performance. I am saying that an Irish investor who hedges the exchange rate risk in their Tesco shares has doubled up on the required hedge.

Oh, right, yes. If inflation is the only cause of foreign exchange movements, and if the tesco share price moves in line with inflation plus its own economic performance, then the sterling exchange rate will move against inflation, balancing out the impact of inflation on the Tesco share price, so an investor in euroland will see the (euro value of) their Tesco shares move only in line with Tesco's own economic performance. So formally hedging the sterling exchange rate would in fact create a risk, not eliminate one.

 

[Duke of Marmalade]

Good. My bad for not explaining the point properly but that is a problem with the medium.
Your point about the same share being quoted in different currency based exchanges highlights very clearly the complexity of hedging the currency aspect of a share price.

 

[Duke of Marmalade]

Of course OP shouldn’t be kicking themselves that they bought this stock in £. It doesn’t matter a jot what currency it was denominated in.

 

[PMU]

Bear in mind that there are lots of equities that are listed both on a UK or European stock exchange and (in the form of ADRs) in New York. The UK/Euro listing is in quoted in sterling or euros; the NYSE listing is quoted in dollars. You wouldn't suggest, would you, that by investing on the NYSE you are taking an additional FX risk? In both cases the investment is in exactly the same enterprise, and the market has exactly the same information about present and future earnings and about other factors that might affect the valuation to be placed on the company. So you would expect the share prices to be, for all functional purposes, identical in New York and (say) Frankfurt. And indeed they are.

Fx risk is embedded in the ADR price. ADRs are denominated in USD, but the price of the ADR is the price of the shares in their home market (e.g. GBP or EUR), converted into USD. With ADRs the American investor buys in USD, his/her functional currency, but the price of the ARD includes the USD/EUR fx exposure. If the price of the share does not change in its home market (let's say euroland) and the dollar weakens relative to the euro the price of the ADR in USD increases to reflect the weakening of the dollar.

Let's say a European company’s shares trade at EUR50 and that price stays constant. Let's also say the fx rate is 1 USD=1 EUR, so 1 ADR will cost 50 USD. If the USD weakens relative to the EUR, e.g. moves from 1.00 EUR to 1.10 EUR, the 50 USD price of the ADR moves to 55 USD, due to the changes in fx rates to reflect the weakening of the dollar. If 1 ADR = 1 ordinary share, the ADR price in USD rises from USD50 to USD55, even though the euro‑denominated share price hasn’t changed.

If the price in euroland remains constant and the USD weakens relative to the EUR, the American investor must pay more for the share as his/her currency is now worth less in euro terms. If the EUR weakens relative to the dollar it's the reverse. So the fx risk is always there.

 

[Duke of Marmalade]

@PMU @TomEdison Obviously you both know your onions and any disagreement is one of communication. @PMU I think your contra demonstration of FX risk is in your description “a European share” you seem to be assuming that that conveys a positive correlation between the share price and €. If the same share had its primary listing in London and in £ the US investor would still be exposed to the €/$ fx rate and not to the £/$ fx rate.

 

[TomEdison]

If the price in euroland remains constant and the USD weakens relative to the EUR, the American investor must pay more for the share as his/her currency is now worth less in euro terms. If the EUR weakens relative to the dollar it's the reverse. So the fx risk is always there.

The FX risk is there for the US investor. But two points about that:

First, we're not US investors, so this is not a risk for us. Therefore we have no reason to hedge against it.

Secondly, the FX risk is there for the US investor regardless of whether he invests in the ADR listed in New York, or in the EU-denominated shares listed in Dublin or Paris or Frankfort or wherever. Which underlines the point; the FX risk has nothing to do with where the securities are listed or what currency they are quoted in.

 

[Tuttlinghorn]

Very interesting if at times confusing ( for some ) thread and topic

I have a question that’s related to the topic, so I hope it’s OK to post it here. ( I doubt I’m the first person to ask this but if a similar question has been posted elsewhere, I can’t find it)


From the perspective of a European investor who wants to invest in a global ETF ( to spread risk) over the medium term eg 8 / 10 years.

And given that a global ETF like Vanguard Total World Stock (VT) still has c. 60% of its value in U.S. shares

If I assume that the current US administration will continue to weaken the dollar

Is there any strategy or method to avoid the investment in that ETF having its gains eaten away over time by the continued weakening of the dollar?

eg I had been wondering if it mattered whether the ETF was purchased in EUR vs USD or domiciled in the EU vs US. From reading this thread I’m pretty sure that is not a factor as currency fluctuations get priced into changes and share prices on whatever exchange and in whatever currency they’re simultaneously listed. Right?

 

[JoeRoberts]

continued weakening of the dollar?

i hear this all the time. What do you believe the fair value rate should be.

 

[Tuttlinghorn]

@JoeRoberts I have zero to contribute on that one. No idea. However I am looking at the trend over the last year whilst trying to plan for an unknown future.

 

[JoeRoberts]

However I am looking at the trend over the last year whilst trying to plan for an unknown future.

Have a look at the trend over the last 25 years. Is the Usd really weak now ?

 

[murphaph1]

I wouldn't even try to hedge for currency fluctuations. It's just way to complicated and most global companies are deriving their earnings globally so if the dollar weakens, those companies based in the US can repatriate more dollars from their earnings in say Europe, which in turn allows them to pay higher dividends. The currency fluctuations can also work in your favour. Nobody knows what way these things will go so for long term investments it makes no sense to hedge for the average person. I have only 2 "active" ETFs though. I'm a lazy but disciplined investor. I have one MSCI ACWI IMI and one for fun (FTSE250) which is my own little gamble on the side that the UK mid-caps will some day benefit hugely from the UK re-joining the EU. I am not brave or stupid enough (depending on who you ask) to even try to pick stocks to beat the global market. I think by the time I have heard about an interesting stock it's already likely to be in the ETF. If stock picking was that easy, fund managers who are professionals would beat the passive funds most of the time and they don't come even close over time. Picking stocks successfully means timing the market and that has been shown not to be possible for the vast majority of people, including me. I think it's just more stress for no gain to be even worrying about currency fluctuations.