1.3.3 Foreign Exchange and International Investing
When making a foreign investment, it’s important to understand that unless currency hedging is employed, returns will depend not only on the performance of the investment but also on the currency exchange rate.
For example, if a U.S. investor buys shares in an international bond fund, the investor may expect the fund to mirror the performance of the foreign bonds in which the fund has invested. But that may not be the case because exchange rates play a large role in the actual returns that an investor will see. If the dollar strengthens against foreign currencies, returns will be reduced for the U.S. investor. That’s because any returns will need to be converted back to dollars, and since the dollar has appreciated, the returns will buy fewer dollars, thus reducing U.S. investor returns. Conversely, if the dollar weakens against foreign currencies, returns will be higher for the U.S. investor. That’s because any returns will need to be converted back to dollars, and since the dollar has depreciated, the returns will buy more dollars, thus increasing U.S. investor returns.
To protect against currency risk, many international bond funds hedge by using forward contracts or derivatives on the