A deep dive into foreign exchangeA deep dive into foreign exchange

Why foreign exchange matters

Foreign exchange matters because it can affect your investment returns. 

Generally, when you invest overseas, you need to use the local currency of the country you’re investing in. So if you’re buying US shares, you need to first change your AU dollars (AUD) into US dollars (USD), then spend those US dollars on US shares. 

But just like shares, the value of currencies change all the time. For example, let’s say you change $100 AUD into USD and receive $77 USD. You do the same exchange a few months later and receive $66 USD—$11 less! As a result, you end up buying fewer US shares (if those shares are worth the same amount of US dollars). 

How foreign exchange affects your investment 

Let’s say you buy US shares using USD you’ve just converted from AUD. Later, you might decide to sell those shares, and convert the USD back to AUD. If you convert when the US dollar is worth less than it was when you bought the shares, any AUD returns will be reduced. 

The opposite can also happen. If you do that same conversion when the US dollar has become more valuable, then any AUD returns will be increased by foreign exchange.

There are four different ways that the exchange rate can affect your investment. When you sell US shares, and convert the USD to AUD:

• If your investment has gained value, and the US dollar has gained value, you get a higher return! 

• If your investment has gained value, and the US dollar has lost value, you lose some of your return due to the change in exchange rate.

• If your investment has lost value, and the US dollar has gained value, you lose less than what you would have otherwise lost if the exchange rate hadn’t changed.

• If your investment has lost value, and the US dollar has also lost value, you make even more of a loss than what you would have if the exchange rate hadn’t changed.

On the one hand, foreign exchange can amplify your returns—both positive and negative. This means it can make gains higher, but it can also make your losses even greater. 

Why currency prices change

Currency and shares have some common features. Both are traded on markets, and both have their prices set when buyers and sellers agree on a price, and make a trade. 

This means that the price of currencies change based on supply and demand. If lots of people want a specific currency, and there aren’t many people selling that currency, then the price is likely to go up. And the reverse is also true. If few people want a currency, and lots of people are trying to sell it, then the price is likely to go down. 

How much people want a currency (and how much they’ll pay for it) is driven by all kinds of things. 

Interest rates

If one country has high interest rates, while another country has low interest rates, then some people may want to borrow money from the low interest rate country and put it in a bank account in the high interest rate country. This increases demand for the second country’s currency, and generally makes it more valuable. (In fact, it can balance out the difference in interest rates pretty quickly.) 

Economic prospects

If a country has a booming economy, people from around the world may want to invest in that economy. To do so, they need to buy local currency—and when they all compete for local currency, the price of that currency is likely to go up. 

Demand for exports

If a country exports a lot more than it imports, then those exporters need to turn their foreign currency back into local currency in order to spend it on things. This increases demand for the country’s currency, and puts upwards pressure on its price. In other words, it can be a factor in the currency’s price going up. But the opposite can also happen, if a country’s exports become less valuable, then it can put downwards pressure on the currency’s price. 

Money supply

The more money there is in the economy, the easier it is to get a hold of. So a country that is printing lots of money may sometimes have a lower exchange rate than a country that is not printing very much money. 

Inflation expectations

Inflation is when currency becomes less valuable. If people expect inflation to be high, and for a currency to lose value in the future, then they won’t want that currency today—which may in turn cause it to lose value. 

How to manage foreign exchange risk

Every investment has risks, and exchange rates are just another risk to understand and manage. Just like shares, you can manage the risk of exchange rates moving around by diversifying, having a long time horizon, and dollar-cost averaging.

Diversify

Diversifying in the context of foreign exchange is just a matter of owning investments in both foreign currencies and in Australian dollars. That way, your foreign exchange risk is spread across different currencies. However, it's important to remember local and foreign investments can still perform poorly independent of any shift in exchange rates.

Use dollar-cost averaging

Finally, dollar-cost averaging (where you invest on a regular basis, rather than all at once), may help protect you from minor swings in foreign exchange rates. If you invest every week or month, you might get stung by a low exchange rate sometimes, but may also get the benefits of a high exchange rate at other times. 

Also, if you’re investing in ETFs, you may want to look at ETFs that are hedged against foreign currency fluctuations. These ETFs use tools like forward exchange contracts, which are an agreement to buy foreign currency at a certain rate in the future. This effectively ‘locks in’ an exchange rate. By repeatedly doing this, the ETF can reduce the volatility of exchange rate movements. 

To wrap up

Foreign exchange can amplify gains and losses, so it’s worth considering when you’re investing overseas. But, like all risks, it’s a risk that you can manage (but not eliminate) over time. So it’s important to keep foreign exchange in mind, and there are strategies that you might consider to help you manage it, but don’t let it stop you from investing!