When investing in foreign markets, you need to familiarize yourself with all the currency fluctuation risks on your investments. That’s because currency movements play a vital role in your return on investments. It would help if you learned how to manage the risks.
Currency fluctuations occur as a result of the movements in floating exchange rates. It’s no doubt that major economies use floating exchange rates, including Canada and the U.S. Some factors that influence exchange rates are interest rates and inflation rates.
This guide unveils the impacts of currency fluctuations on foreign investments, including a few examples to help you understand better. You will also learn how to protect your foreign investments from the negative effects of currency fluctuation risks.
That said, let’s get started!
International investments are different from domestic investments in several ways. However, the most significant difference is the effect of currency fluctuation. The fluctuation of currency is a result of exchange rate movements in foreign countries.
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Fluctuations in currency values, whether foreign currency or home currency, can either increase or lower the returns on your foreign investments. Notably, the currency risk impacts can affect the investments directly or indirectly. For instance:
Pro Tip: Currency fluctuation risks can sometimes work in your favor or result in losses.
Here is an example of how currency fluctuation can affect your foreign investments.
Let’s say that your last year’s return on foreign investment portfolio was 12 percent, but your home currency (CAD) depreciated by 10 percent. In that case, your net return will increase when you convert the gains to Canadian dollars.
The declining Canadian dollar makes foreign investments more attractive to Canadians. However, if the foreign stocks decline but your home currency strengthens significantly, it will further lower the returns on your foreign investment portfolio and result in losses.
Other than currency fluctuation risks, local tax implications and political risks can also affect the performance of your foreign investment portfolio. Understanding all the risks will help you safeguard your investments in another country.
Political risks such as instability in a foreign country can affect your foreign investments. Instabilities could arise due to changes in government laws, legislative bodies, military control, and other foreign policies. These can cause losses.
Risks such as political decisions can also influence your foreign investments. Some include government spending, taxes, regulations, trade tariffs, and labor laws.
Other complicated risks that could affect your foreign investment portfolio are tax risks. Like foreign investors with Canadian securities are subject to Canadian taxes, Canadians with foreign investments may also have to pay taxes in foreign countries.
The country holding your assets or securities will typically withhold taxes on the foreign investments before investors can earn any gains. Profits will then get taxed when the investors repatriate their funds. Notably, taxation risks vary by country.
As a foreign investor, you need to protect your investments from the negative impacts of currency fluctuations. You can achieve that by making informed decisions. For example, when investing in foreign stock, you are making two investment decisions.
With a foreign stock, you bet on the currency itself and the company’s performance. The most exciting part of this type of investment is when the foreign currency strengthens against your local currency and the stock price rises. As a result, you’ll get more profits.
The worst-case scenario when investing in a foreign stock is when the stock price goes down and the foreign currency weakens relative to the Canadian dollar. In some instances, you will have mixed results. The bottom line is that you’ll never escape currency effects.
Despite the exchange rate risks, investing in foreign currencies can help you diversify your investment portfolio. Since diversification is a reduced correlation between assets, investing in foreign currencies will increase the diversification of a Canadian portfolio.
Now that you know the impacts of currency fluctuations, how can you minimize their adverse effects? Here are some of the strategies to consider.
If you have several investments in foreign assets and securities, ensure that you diversify the investments in different geographic areas. For example, you can invest in Europe and North America.
Some investment experts recommend investing in regions with currencies relatively stronger than your home currency. You can also invest in countries that have pegged their currencies to stable and stronger currencies, such as the Euro and U.S. Dollar.
Generally, currency volatility is often very low in developed nations, despite the rising geopolitical risks. An excellent example is the United States. Currencies in such countries are usually a haven for foreign investments.
Another way to protect your international investments from currency fluctuations is by investing in currency-hedged ETFs. Such funds often use sophisticated assets such as options and futures to hedge against currency risks of bonds or equities.
Hedged ETFs seek to offset the impacts of currency movements. The good news is that many financial institutions have introduced ETFs that hedge currencies. For that reason, currency-hedged ETFs are now available in most regions of the world.
While currency-hedged ETFs help to lower losses, they can also cut into your returns. They are slightly more costly than non-hedged ETFs. The good thing about them is that they are less volatile than non-hedged options. So it’s better to select the hedged ones.
When you invest in countries with strong and stable currencies, your foreign investment will less likely get affected by currency fluctuations. So, pick an economically sound country with a stable currency, then stick to it. That way, you will secure your funds.
Some of the factors that can influence the strength of a country’s currency are debt and inflation rates. For example, high debts usually come before inflation, and when inflation rises, currencies tend to decrease in value as foreign investors lose confidence in them.
Countries with a lower debt-to-GDP ratio tend to have rising currencies, making them more attractive to foreign investors. The big problem is that most strong and safe currencies tend to offer fewer rewards.
Investing in foreign securities is one of the most reliable and profitable ways to diversify your investment portfolio. However, you need to be aware of all the factors affecting your foreign investments, including currency fluctuations. Thankfully, there are many ways to safeguard your investment portfolio from currency fluctuation risks.
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