In the first part of the article I contextualize the exchange rate, explaining how it develops in current economies and how it affects the world of investments, in the second part I explain the impact of the exchange rate on an investment denominated in foreign currency (for example a investment in stocks or bonds of another country), what appreciation and depreciation mean, how the exchange rate is calculated.
Understanding the foreign exchange risk (or currency risk) of foreign investments is essential to correctly assess the risk / profit ratio. Let’s start from the basics and make an example to understand what the exchange rate is.
Let’s imagine two countries, Italy (or another country in the Euro Area) and the United States: both are characterized by an open economy, i.e. an economy based on trade to sell their products abroad (exports) and buying foreign products by bringing them in their respective markets (imports). As we know, these two states have different currencies: the euro for Italy and the dollar for the United States. What happens in the exchange operations?
The Italian company Alfa Spa decides to purchase software from Beta Ltd, an American IT company: consequently the executives of Alfa, to purchase Beta’s products in US dollars, will “offer” the equivalent in euros. In the opposite case, to buy Alfa’s products sold in euros, Beta executives will offer the equivalent in dollars. It is clear that it was necessary to exchange one currency (euro) with another currency (dollar) to complete the exchange: the rate at which this operation is possible is precisely the nominal exchange rate.
Furthermore, the flexible exchange rate (which can change over time) reflects the macroeconomic dynamics of the two countries, both in terms of the overall economic performance and in terms of monetary policy choices.
The exchange rate is mainly determined by the quantity of money demanded and offered: so it is the subjects who operate on the market who determine its final value.
Now let’s focus on the importance of the exchange rate when investing.
Why is the exchange rate important in investing?
In the world of investments, exchange rate analysis plays a primary role in decision making (when building the investment portfolio) and in the evaluation field, in order to analyze the performance of the portfolio. In fact, by exploiting the different dynamics underlying currencies, it is possible to carry out an internal diversification of the portfolio not only at a geographical or sectoral level, but also at a currency level.
From the previous explanation of what the exchange rate is, it is clear how a flexible exchange rate is influenced by different variables, whose single trend can cause rate volatility, which is the measure of its riskiness: the greater the volatility, the greater the variability of the rate and, consequently, the risks incurred through the currency exposure present in the investment.
The graph below shows the annualized volatility of some exchange rates: note the stability of the euro / dollar rate compared to the rates relating to the currencies of emerging countries.
It is important to make a comparison, as an example, between two investments with the same underlying (emerging market equities), but one of which provides an exchange risk hedging service: hedged ETFs take exposure on a specific external market without being affected by fluctuations in its currency, therefore without exchange rate risk.
In this case, the ETF exposed to exchange rate fluctuations suffered more significant losses than the one with hedged exchange rate risk. Other times, the opposite can happen, of course.
As always in the investment world, it is important to know the dynamics of the exchange rate in order to be aware of both the opportunities and the risks deriving from exposure to the currency world.
How to measure the exchange rate in investments?
Imagine an American investor who invests 10,000 euros for three years in a bond of a German company that pays an annual coupon (always reinvested) of 10%: after three years the investor will have a capital of 13,310 euros. At this point the investor will have to “change” the revenue into US dollars. We observe in the graph how the possible investment income changes according to different levels of the dollar / euro exchange rate.
In the event of a parity of the exchange rate, obviously the revenue would correspond to 13,310 dollars. Assuming a EUR / USD exchange rate of 1.105 dollar for each euro, the investment income would be $ 14,708. The calculation is simple: € 13,310 x $ 1,1051 / € = $ 14,708.
On the other hand, if the exchange rate increased to 1.20 dollar for each euro, ie the dollar loses strength, the gain would be $ 15,972 because, with the same amount of euro, more dollars can be “bought”, thanks to the appreciation of the euro (and the symmetrical depreciation of the dollar, which becomes “weaker”). The calculation is: € 13,310 x $ 1.20 / € = $ 15,972.
Finally, in the case of euro depreciation (0.90 $ / €) and therefore of symmetrical dollar appreciation, the final gain would be limited to 11,979 dollars. The calculation is: € 13,310 x $ 0.90 / € = $ 11,979.
As you may have noticed, I started talking about appreciation and depreciation of a currency, observing the effects on the final result of the investment. What are we talking about? Let’s look together at the trend of the euro/dollar exchange rate in the period 2011-2019:
At first glance, the “decline” of the exchange rate in recent years is evident: a fall that highlights how the euro has progressively depreciated against the US currency, which has appreciated, thus becoming “more expensive” for the markets foreign countries, with all the consequences that this entails (difficulties in exports for the USA, for example).
If we want to calculate how many dollars corresponds to some amount of euros, just do € multiplied by the EUR/USD exchange rate. Having the value of the euro/dollar exchange rate (the one commonly used and reported), to have the reciprocal dollar/euro the formula 1 divided by EUR/USD exchange rate must be used.
In an increasingly financially globalized world, the need to know how to correctly evaluate and read the information provided by the exchange rate allows us to evaluate, from a new point of view, the investment opportunities offered by the national market, and beyond.