Currency Appreciation and Depreciation Effects

Introduction

I remember the first time I realized how currency moves could flip an investment’s performance. Years ago, I was backpacking across Europe. The US dollar had dipped, so each euro bought fewer dollars, meaning my bank account shrank a bit faster whenever I converted. It was a real eye-opener on how exchange rates can change your buying power. And that same dynamic applies to portfolio managers who invest globally.

When we invest outside our home country (let’s call it the domestic market), the returns we receive must eventually convert back into domestic currency. If our domestic currency appreciates (becomes stronger), then those foreign returns won’t look as hot once they’re converted. If our currency depreciates (weakens), hey, that can pump up the final returns from foreign investments.

This section delves into why that happens and what we can do about it. We’ll talk about economic theories driving currency values (like purchasing power parity), the pros and cons of hedging currency exposures, and best practices for folding currency outlooks into a global portfolio strategy.

Effects of Currency Movements on Portfolio Returns

It often surprises new investors to learn that positive returns on an international asset in its local market can still translate into losses when converted back home, if the domestic currency has strengthened significantly. Conversely, you might see a modest local return turn into a pleasant surprise once your currency has depreciated relative to the foreign currency.

Basic Example

Suppose you’re a US-based investor buying shares of a European company:

• You invest USD 10,000 when the EUR/USD rate is 1.25.
• That means you exchange USD 10,000 for EUR 8,000 (since 10,000 / 1.25 = 8,000).
• After some time, let’s say your European equity investment grows by 10% in euro terms, so it’s now worth EUR 8,800.
• But the exchange rate also changes. If the EUR/USD rate drops from 1.25 to 1.15 (the USD has strengthened, or the EUR has weakened), when you bring that money back home, you actually end up with 8,800 × 1.15 = USD 10,120. You made a small gain, but nowhere near what you might have expected if the exchange rate had stayed constant at 1.25 (which would have given you USD 11,000).

This simple example highlights how domestic-currency appreciation can erode foreign investment returns. And, as you might guess, the opposite scenario adds a friendly tailwind to your profits if your domestic currency weakens.

Economic Fundamentals Behind Currency Trends

There’s more to exchange rates than random market moves. Over the long haul, economic variables guide currency valuations:

Purchasing Power Parity (PPP)

This principle basically says that in the long run, exchange rates should converge so that identical goods have the same price in different countries. If a burger costs USD 5 in the United States and an equivalent burger costs EUR 4 in Europe, and if the EUR/USD is 1.25, eventually the exchange rate might adjust to maintain consistent prices. Obviously, real markets are more complicated—trade barriers, brand perceptions, shipping costs—but PPP is a helpful concept to anchor your understanding.

Mathematically, PPP can be expressed as:

Though PPP is more of a medium- to long-term anchor, it reminds us that currencies often adjust toward equalizing purchasing power, especially when large discrepancies exist.

Interest Rate Differentials

Countries with higher interest rates often see their currencies strengthen in the short to medium term, as investors seek those higher yields. The interest rate parity relationship suggests that any gain from higher interest rates in one currency should, in theory, be offset by expected changes in the spot–forward exchange rates. Formally:

where:
• \(F\) is the forward exchange rate,
• \(S\) is the current (spot) exchange rate,
• \(i_d\) is the domestic interest rate,
• \(i_f\) is the foreign interest rate.

Trade Balances and Capital Flows

Countries running persistent trade surpluses often see upward pressure on their currency, as foreign buyers need local currency to pay for exports. Conversely, a consistent trade deficit can mean downward pressure on the currency. Meanwhile, strong capital inflows—like foreign direct investment or big bond market purchases—also boost a currency.

Hedged Versus Unhedged Strategies

Global investing often demands a decision: hedge currency exposures or not?

• Unhedged Approach: Your returns fluctuate with currency moves. This can be profitable when your domestic currency is weakening, but it’s a bummer if it’s strengthening.
• Hedged Approach: By locking in an exchange rate or using derivatives (like forwards, futures, or options) to offset currency risk, you stabilize your returns in domestic-currency terms.

Of course, hedging isn’t free. There’s usually a cost, which can be significant if the interest rate differential is large or if implied volatility is high in currency options. And, ironically, you can miss out on gains if your domestic currency depreciates.

Partial Hedging

Some managers hedge only a portion—say 30–70%—of their foreign currency exposures. This approach balances the desire for stable returns with the potential benefit of a favorable currency move. It also helps manage hedging costs.

Example of Hedged Return

Let’s say you’re a Swiss-based investor holding British stocks. You notice that the Swiss franc (CHF) might strengthen against the pound sterling (GBP). If you buy an FX forward contract to lock in the sterling-to-CHF conversion for your expected proceeds, then even if GBP falls 5% relative to CHF, your realized return (in CHF) won’t be impacted as severely by that movement. You’ve basically swapped out that currency risk (though there were some costs and operational complexities to get that hedge in place).

Incorporating Currency Expectations

When building a global or multi-asset portfolio, it’s helpful to forecast currency trends—though precision can be tricky. Some managers rely on:

• Tactical Currency Overlays: Specialists—sometimes external currency managers—actively manage currency risk, seeking alpha from short-term currency moves.
• Strategic Allocation Decisions: Setting a strategic hedging policy (perhaps partial hedges) and revisiting it periodically.

You could have a scenario where you expect your domestic currency to weaken over the next 12 months. In that case, maybe you don’t hedge certain exposures (like foreign equity) so you can potentially reap the additional currency gains. But if your currency starts to strengthen unexpectedly, you might scramble to put on partial hedges.

Practical Mermaid Diagram

Below is a simplified flowchart illustrating how currency appreciation or depreciation impacts returns:

    flowchart LR
	    A["Invest in Foreign <br/>Assets (Local Currency)"] --> B["Value in Foreign <br/>Currency Increases"]
	    B --> C["Convert Foreign <br/>Currency to Domestic"]
	    C --> D{"Domestic Currency <br/>Appreciates or Depreciates?"}
	    D --> E["Appreciation <br/> Domestic Gains -> Lower"]
	    D --> F["Depreciation <br/> Domestic Gains -> Higher"]

This flowchart shows the ultimate step—converting back into domestic currency—where you see the real effect of exchange rate movements.

Real-World Case Study

In early 2015, the Swiss National Bank removed the cap on the CHF relative to the euro. The Swiss franc soared almost instantly against the euro, and for Swiss investors who owned eurozone equities, their returns were suddenly worth fewer francs when converted back. Some Swiss funds faced large revaluation hits on their euro-denominated assets. That abrupt shift illustrated how policy changes can whipsaw currency markets and severely affect portfolio outcomes.

Best Practices and Pitfalls

• Stay Aligned with Objectives: If you need stable returns over short horizons—like paying near-term liabilities—hedging is often advisable.
• Monitor Costs: High hedging costs can eat into returns and potentially erode what you intended to protect in the first place.
• Beware of Overconfidence: Predicting currency moves can be extremely hard. Don’t chase short-term speculative gains without thorough research.
• Regularly Reassess: Global markets, interest rates, and capital flows can shift quickly. A currency strategy that made sense last year might be ill-suited for new macro conditions.

Summary and Exam Tips

• Focus on the Big Picture: For exam scenarios, identify how currency movements affect your final returns and whether hedging is beneficial.
• Quantitative Skills: Practice converting returns under various exchange rates. You might see item sets requiring step-by-step computations.
• Highlight Theories: The CFA exam loves concepts like PPP and interest rate parity. Understand the formulas, but also interpret how they apply to real portfolios.
• Hedging Mechanics: Know the differences between forward- and option-based currency hedges, partial vs. full hedge, and the cost implications.
• Scenario Analysis: Walking through best-case, worst-case, and middle-case currency scenarios is a common approach in exam questions.

In short, to do well on the exam (and in real life), you’ll want a solid grasp on how currency swings can tilt an investment’s fortunes—and how to manage or exploit that volatility.

Glossary

• Purchasing Power Parity (PPP): States that in the long run, exchange rates adjust so that identical goods have the same cost in different countries.
• Currency Overlay: A strategy that manages currency exposures separately from the core portfolio assets, often with the goal of hedging or generating incremental returns.
• Interest Rate Parity: Suggests that the difference in interest rates between two countries is offset by forward exchange rate adjustments in efficient markets.

References and Further Reading

• Abken, P. (1990). “Currency Hedging Strategies for International Portfolios.” Federal Reserve Bank of Atlanta.
• CFA Institute articles on currency management in global portfolios.
• Eiteman, D.K., Stonehill, A.I., & Moffett, M.H. (various editions). Multinational Business Finance.
• For advanced readers, exploring academic research on target-zone models or micro-structure of FX markets can be valuable to broaden understanding.

Test Your Knowledge: Currency Appreciation and Depreciation Quiz