International Stock Investing: Understanding Currency Risk

International Stock Investing: Understanding Currency Risk

When you invest in international stocks, you are making two bets at once: one on the stock and one on the currency. A foreign stock might gain 15% in local terms, but if the foreign currency weakens 10% against your home currency, your actual return is closer to 5%. This double-edged sword is currency risk, and understanding it is essential for any global investor.

How Currency Risk Works in Practice

Suppose you are a US-based investor who buys shares of a German company trading on the Frankfurt Stock Exchange at EUR 100 per share when EUR/USD is 1.10. You invest $11,000 to buy 100 shares.

Scenario A: Stock up, currency stable

• Stock rises to EUR 120 (+20%)
• EUR/USD stays at 1.10
• Your value: 100 x 120 x 1.10 = $13,200
• Total return: +20%

Scenario B: Stock up, currency down

• Stock rises to EUR 120 (+20%)
• EUR/USD falls to 1.00 (EUR weakens 9.1%)
• Your value: 100 x 120 x 1.00 = $12,000
• Total return: +9.1% (almost half eaten by currency)

Scenario C: Stock up, currency way down

• Stock rises to EUR 120 (+20%)
• EUR/USD falls to 0.90 (EUR weakens 18.2%)
• Your value: 100 x 120 x 0.90 = $10,800
• Total return: -1.8% (a loss despite the stock gaining 20%)

This is not a hypothetical exercise. Between 2014 and 2015, the euro fell roughly 20% against the US dollar. European stocks gained in euro terms but many US investors saw flat or negative returns.

The Math: Decomposing International Returns

Your total return from a foreign investment can be approximated as:

Total Return ≈ Local Stock Return + Currency Return + (Local Return x Currency Return)

The third term is small for modest moves but becomes significant during volatile periods.

Component	Example
Local stock return	+12%
Currency return	-8%
Cross term	12% x (-8%) = -0.96%
Total return	+3.04%

Over the long term (10+ years), currency effects tend to average out for diversified portfolios. But over shorter horizons (1–5 years), currency movements can dominate your returns.

Measuring Your Currency Exposure

Before deciding how to manage currency risk, quantify your exposure:

Portfolio Allocation	Currency Exposure
100% domestic stocks	Near zero (indirect exposure through corporate earnings)
70% domestic / 30% international	30% direct FX exposure
50% domestic / 50% international	50% direct FX exposure
100% international	100% direct FX exposure

Remember that even "domestic" companies often have significant international revenue. A US investor holding the S&P 500 has roughly 40% of earnings coming from overseas, creating indirect currency exposure.

Hedged vs. Unhedged International ETFs

One of the most practical tools for managing currency risk is choosing between hedged and unhedged ETFs.

Unhedged ETFs (Standard)

These ETFs hold foreign stocks and make no effort to neutralize currency effects. Your returns include both stock performance and currency movements.

Examples:

• Vanguard FTSE Developed Markets ETF (VEA) — Expense ratio: 0.05%
• iShares MSCI EAFE ETF (EFA) — Expense ratio: 0.32%
• Vanguard FTSE Emerging Markets ETF (VWO) — Expense ratio: 0.08%

Hedged ETFs

These ETFs use forward contracts to neutralize currency movements, delivering returns that closely match the local stock market performance.

Examples:

• iShares Currency Hedged MSCI EAFE ETF (HEFA) — Expense ratio: 0.35%
• WisdomTree International Hedged Quality Dividend Growth Fund (IHDG) — Expense ratio: 0.58%
• Xtrackers MSCI EAFE Hedged Equity ETF (DBEF) — Expense ratio: 0.35%

Performance Comparison

Period	MSCI EAFE (Unhedged)	MSCI EAFE (Hedged)	Difference
2014	-4.9%	+5.7%	+10.6% (hedged won)
2017	+25.0%	+16.8%	-8.2% (unhedged won)
2020	+7.8%	+2.5%	-5.3% (unhedged won)
2022	-14.5%	-7.2%	+7.3% (hedged won)

The winner alternates depending on currency trends. When the dollar strengthens, hedged funds outperform. When the dollar weakens, unhedged funds win.

Cost of Hedging

Hedging is not free. The cost depends on the interest rate differential between the two currencies.

Currency Pair	Rate Differential (2024)	Approximate Annual Hedge Cost
USD vs EUR	+1.5%	~1.5%
USD vs JPY	+4.5%	~4.5%
USD vs GBP	+0.5%	~0.5%
USD vs CHF	+3.0%	~3.0%

For Japanese yen-denominated investments, the cost of hedging back to USD is particularly steep due to the large interest rate gap between the US and Japan.

Timing Your Currency Exposure

While timing currencies perfectly is as difficult as timing stocks, there are evidence-based frameworks that can inform your decisions.

Purchasing Power Parity (PPP)

PPP suggests that exchange rates should eventually adjust so that identical goods cost the same in different countries. The Big Mac Index and OECD PPP data provide rough measures of currency over/undervaluation.

As of early 2025:

• Japanese yen: approximately 40% undervalued vs. USD on PPP basis
• British pound: approximately 10% undervalued vs. USD
• Swiss franc: approximately 15% overvalued vs. USD
• Euro: approximately 20% undervalued vs. USD

Currencies that are significantly undervalued on PPP tend to appreciate over very long periods (5–10 years), though short-term movements can go in either direction.

Interest Rate Differentials

When one country has significantly higher interest rates, its currency often strengthens in the near term as capital flows in, but may weaken over the longer term as higher rates reflect higher expected inflation.

Current Account Balances

Countries with persistent current account surpluses (like Japan and Germany) tend to see their currencies appreciate over time, while deficit countries (like the US and UK) tend to see depreciation.

Strategies for Managing Currency Risk

Strategy 1: Do Nothing (Accept the Risk)

For long-term investors (10+ years) with diversified international exposure, currency effects tend to wash out over time. Academic research by Vanguard and others suggests that for very long horizons, hedging adds cost without meaningfully reducing risk.

Best for: Long-term, buy-and-hold investors with 10+ year horizons.

Strategy 2: Full Hedge

Eliminate all currency risk by using fully hedged ETFs. Your returns will closely match local stock market performance.

Best for: Investors with shorter time horizons (1–3 years) or those who want pure equity exposure without currency noise.

Strategy 3: Partial Hedge (50/50)

Split your international allocation between hedged and unhedged ETFs. This reduces currency impact by half while keeping costs moderate.

Best for: Most investors. This provides a balanced approach that reduces extreme outcomes in either direction.

Strategy 4: Dynamic Hedging

Adjust your hedge ratio based on currency valuation signals. Increase hedging when your home currency is weak (foreign currencies are expensive) and decrease hedging when your home currency is strong.

Best for: Active, knowledgeable investors willing to monitor and adjust positions.

Tax Considerations

Currency gains and losses on international investments create tax complexity:

• Embedded FX gains: When you sell a foreign stock, the currency component is embedded in your capital gain or loss. No separate reporting is needed for most individual investors.
• Hedged ETF distributions: Currency hedging gains inside ETFs are distributed as short-term capital gains, which are taxed at ordinary income rates (up to 37% in the US).
• Foreign tax credits: Dividends from foreign stocks may be subject to withholding tax in the source country. You can typically claim a foreign tax credit to offset this.

Building a Currency-Aware Portfolio

Here is a sample allocation for a US-based investor with $500,000:

Allocation	Amount	Hedging	Annual FX Exposure
US stocks	$300,000 (60%)	N/A	~$0 direct
Developed international (unhedged)	$75,000 (15%)	None	$75,000
Developed international (hedged)	$75,000 (15%)	Full	~$0
Emerging markets (unhedged)	$50,000 (10%)	None	$50,000
Total FX exposure			$125,000 (25%)

This portfolio has 40% international exposure but only 25% direct currency risk, a balanced approach that captures diversification benefits while limiting currency-driven volatility.

Key Takeaways

1. Currency risk is real and can significantly impact international investment returns over 1–5 year periods.
2. Over very long periods (10+ years), currency effects tend to mean-revert for diversified portfolios.
3. Hedged ETFs eliminate currency risk but add cost, especially for high-rate-differential currencies like JPY.
4. A 50/50 split between hedged and unhedged international ETFs is a sensible default for most investors.
5. Always consider the tax implications of hedging, particularly the short-term capital gains generated by hedged ETFs.

Stay informed about the exchange rates that affect your international portfolio by checking real-time rates at hwanyul.com.