Currency Conundrum

The Bureau of Economic Affairs breaks down changes in foreign stock holdings between price changes, the effect of currency translation, and cash flows. During 2002, the value of foreign equity holdings fell to $1.34 trillion. The $267 billion drop comprised $399 billion in price declines offset by $114 billion in currency gains and $18 billion of new investment, an inflow that occurred as investors withdrew $27 billion from US equity mutual funds.

Currency movements complicate the proper calculation of return on a foreign investment. Sometimes you must include a currency translation effect to get the true return, while in other cases the price of a security incorporates the currency movement. A foreign investment program is not likely to succeed unless you compute returns correctly.

CHOOSING A BASE CURRENCY

First you must determine your base currency, the unit in which you keep score. US investors use the US dollar, while most Europeans use the euro (€). The return on a security for a fixed period is not the same when calculated in different base currencies, because the exchange rates for those currencies change. In the simplest example, assume that a US investor places €100 on deposit in a non-interest bearing bank account, and the exchange rate starts at $0.93. One year later, assume the exchange rate is $0.98 and the investor converts the money back into US dollars. The investor has made a gain of 5.38% in his base currency. During the same period, a European investor counting in euros has made nothing at all. (See Figure 1.)

Figure 1: Base currency. A US investor investing euros would have gained 5.3%, whereas a European investor would not have gained anything.

Reversing the example, assume a European investor places $100 on deposit at the same time and converts back to euros a year later. The initial amount of €107.53 falls to €102.04 for a loss of 5.11%. A US investor has neither gain nor loss because he still has $100 at the end of the period. (See Figure 2.)

Figure 2: Base currency. A European investor converting dollars back to euros would have lost 5.11%.

Once you determine the base currency, you must measure the returns on all foreign investments in that currency. If the European investor in our example does not convert back into euros and counts the return on his $100 deposit as 0%, he is deluding himself by ignoring the unrealized currency loss.

CALCULATING RETURNS

Interest earned on deposited money complicates the calculation, but the investor still needs to figure in the base currency. The total return has two components: the return on the investment in local currency and the effect of currency translation. If one-year deposits return 2% in US dollars and 3% in euros, a European investor holding dollars would exchange $102 at the $0.98 rate for a 3.21% loss instead of a 3% gain on a deposit in euros. A US investor holding euros would exchange €103 at the $0.98 rate for an 8.54% gain instead of a 2% gain on a dollar deposit. (See Figure 3.)

Figure 3: Calculating returns. Your choice of base currency will make a difference in your overall profits and gains.

FOREIGN EQUITIES

The base currency concept applies to every foreign investment, including equities and mutual funds. Sometimes you can invest in the same underlying stock or fund in different ways, and the currency implications can become even more confusing.

US investors can buy some foreign stocks in the form of American Depository Receipts. Under this mechanism, a US bank acts as depository to hold the underlying foreign shares and issues ADRs, which then trade through the normal US settlement system. Investors thus avoid settling trades in foreign currencies because ADR prices are quoted in US dollars. ADRs are nothing more than a dealing facility; although they are denominated in dollars, the investor still bears the risk of currency fluctuations. The US dollar ADR price reflects movements in both the underlying share price and the foreign exchange rate. If a British share price does not change over a period when sterling rises in value against the dollar, a US investor enjoys a gain equal to the currency movement, whether he buys an ADR quoted in dollars or the underlying share traded in British pounds. (See Figure 4.)

Figure 4: Investing in foreign equities. Take advantage of the movements in the underlying share price and the exchange rates.

If a US investor buys the underlying shares, he must translate the ending value in sterling back into dollars at the ending exchange rate, whereas the ADR price quoted in dollars already captures the currency translation effect. If a British investor buys an ADR, the currency loss on converting the proceeds back to British pounds at the $1.60 exchange rate exactly offsets the 10.34% gain in dollars. The return in British pounds is still zero. You cannot escape currency exposure by buying an instrument quoted in dollars if the underlying shares trade in a different currency.

FOREIGN MUTUAL FUNDS

Mutual funds often sell shares denominated in the local currency where the shares are sold, even if the fund's assets are invested elsewhere. Some funds offer share classes denominated in different currencies but representing an equal interest in the underlying portfolio. The return on the portfolio is fixed, but the return for the different share classes is not the same, because currency movements affect the calculation.

Figure 5 illustrates the returns for a fund with three classes of shares (in British pounds, dollars, and euros). Assume that the return in British pounds is 0%, while the pound and euro both rise in value relative to the dollar by different amounts.

Figure 5: Investing in foreign mutual funds. Currency movements affect returns for different share classes.

The results reported in each currency are different, but the return to an investor in a particular base currency is identical, no matter which class of shares he buys. A US investor buying the euro shares will make not only 4.71% for the euro class, but also the increase in the value of the euro (from $0.93 to $0.98) for an additional 5.38% return. Compounding the two components produces the total return: 1.0471 x 1.0538 = 1.1034 or 10.34%, precisely equal to the return on the dollar share class.

The currency of the underlying portfolio assets does not change the calculation. Whether it was a single currency or several, including or excluding any of the three in which shares are denominated, the return in a particular base currency does not change. If the combined movements of local prices and currency exchange rates produced a 0% return in British pounds, the return was 4.71% in euros and 10.34% in dollars.

CONCLUSION

Foreign investment is an exciting and potentially rewarding opportunity, but unrealized currency gains and losses complicate total return calculations. You must translate both foreign security prices and reported mutual fund net asset values denominated in foreign currencies at end-point exchange rates to find the return in your base currency. Keeping proper score is critical to your success.

Neil A. O'Hara is a freelance writer who worked in the financial services industry for almost 30 years. He was a hedge fund manager and portfolio manager for various funds and focused on foreign merger arbitrage.

REFERENCES

Investment Company Institute Mutual Fund Yearbook: http://www.ici.org/stats/mf/2003_factbook.pdf

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.