The following blog post is sourced from Lakeside’s Financial Knowledge Centre
Written and accurate as at: Feb 01, 2014
The exchange rate (known also as the Forex rate or foreign-exchange rate) between two currencies is the rate at which one currency can be exchanged for another. For example, at the time of writing this article, $1 Australian dollar (AUD) will buy $0.90 US Dollars (USD).
Over the past decade, the Australian dollar (AUD) has appreciated strongly against the US dollar (USD), rising from less than US $0.50 in 2001 to a peak of over US $1.10 in
2011. It came close to this high again in 2013. While the rise is attributed to a number of factors, the key driver of appreciation over this period is largely attributed to Australia’s mining boom.
Put simply, the higher a nation’s currency the more expensive its goods and services will be for people overseas. So typically a high AUD will impact Australian businesses such as tourism, manufacturers and exporters, because it will be more expensive for people to travel here and the selling price of our goods and services will be higher than previously putting price pressures on business and trade opportunities.
There are a number of factors that impact the Australian Dollar (AUD). Some of these include interest rates movements and the RBA cash rate decisions, inflation, the strength of our economy, our terms of trade and Australia’s level of Government debt.
Shareholders of international shares or international bond funds have foreign-currency exposure. What this means is when a fund manager buys international shares or bonds, they usually buy these shares in the “local market,” or the market where they are issued. This means the manager must buy the security in the local currency, which requires the exchange of AUD into that currency.
The associated risk due to the exchange of currency is called currency risk.
As the value of the dollar is always shifting relative to the value of overseas currencies, a change in the value of the relationship between the AUD and the currency in which the asset or security is purchased can impact the value of the investment. A strong AUD will have a negative impact on the performance of international funds (since the value of the foreign currencies are falling) while a weak AUD will have a positive impact on performance (since the value of the foreign currencies are rising).
To manage currency risk, some fund managers may decide to hedge their currency exposure. The best way to understand hedging is to think of it as a type of insurance.
In the context of international share and bond funds, currency hedging is the decision by the fund manager to reduce or eliminate the fund’s exposure to the movement of foreign currencies. This is typically achieved by buying futures contracts or options that will move in the opposite direction of the currencies that the fund holds its investments in.
Let’s use an example to explain how this works. A fund manager decides to invest $100,000 Australian dollars in shares issued in the United Kingdom but they are concerned about the outlook for the British Pound. The manager decides to buy the shares, then “hedge” the currency by buying an investment that moves in the opposite direction of the British Pound. If the British Pound falls 5%, the hedge gains 5% and the net effect is zero. On the other hand, if the British Pound gains 5% the value of the hedge will fall by 5%. Either way, the impact of the currency position is neutral.
Theoretically, an investor can choose from either hedged or unhedged versions of international share and bond funds. Hedged International funds will generally have higher ongoing management fees due to the cost to implement their currency hedging strategy. Currencies can make large moves in a relatively short period of time, so there can be a reasonable difference between the performance of hedged and non-hedged portfolios in any given month, quarter or year. On a longer-term basis however, the difference may not be as significant since developed-market currencies don’t tend to provide long-term appreciation. However, international emerging-markets (or developing markets) may be more volatile and provide some level or appreciation (and possibly depreciation).
As is the case with all prospective investment decisions, it pays to do your research to ensure you know exactly what you’re investing into. Whether an international fund employs currency hedging strategies is only one of many considerations for selecting an investment. How each investment stands on its own merits as well as how it relates to the other components of your portfolio must be considered, along with the suitability of these two factors given your personal situation.
We trust this article has provided further insight into the effect of currency on investing, however, this is a technical area and we highly recommend seeking personal advice especially when it comes to currency risk and international investing.