A detailed exploration of how currency fluctuations impact returns, hedging strategies, and portfolio construction for CFA Level II candidates.
I’ll never forget the day I first discovered how a “winning” investment can turn sour once you factor in the exchange rate. I’d invested in a Japanese equity that shot up 20% in yen terms—fantastic, right? Well, by the time I converted my proceeds back to my own base currency, the yen had depreciated so much that I ended up with barely any gain at all. That one experience taught me more about currency risk than a hundred textbooks could!
In cross-border investing, you’re not just dealing with the usual ups and downs of equity or bond markets; you’re also at the mercy of exchange rate fluctuations. And guess what? Those fluctuations can sometimes be far bigger and faster-moving than the underlying asset’s change in value. Understanding currency-adjusted returns is a critical element of making savvy portfolio choices, especially for CFA Level II candidates who are learning to integrate macroeconomics into real investment decisions.
Below, we’ll explore key issues that arise when your base currency differs from that of your investments. We’ll look at how interest rate differentials and forward markets guide hedging decisions, how to include currency views in asset valuations, and what to do when you face real-world frictions like bid–ask spreads and correlation shifts. By the end, you’ll have a more robust sense of how currency risk permeates nearly every corner of the global investing playbook—and you’ll be better prepared to handle it.
An investor’s “local currency return” is simply the return you observe in the currency where the asset is traded. However, from your perspective—wherever you call home or whichever currency you use to measure your wealth—that local return might mean very little until you convert it back into your base currency.
Let’s say you’re based in the United States, and your home currency is USD. You purchase shares of a European company in euros (EUR). The stock goes from €100 to €110—a 10% return in local currency. During the same period, however, the EUR/USD exchange rate drops from 1.20 to 1.10. Let’s see what that implies in your base currency:
• Before: – Stock price in EUR: 100 – EUR/USD: 1.20 – Stock price in USD: 100 × 1.20 = 120 USD
• After: – Stock price in EUR: 110 – EUR/USD: 1.10 – Stock price in USD: 110 × 1.10 = 121 USD
In local currency (EUR), you see a 10% jump (from 100 to 110). In USD, you’re up from 120 to 121, which is only about a 0.83% increase. The 10% local return is very quickly eroded by the EUR’s depreciation: that is the currency effect coming into play.
Mathematically, you could measure your base currency return as:
(1 + R_local) × (1 + R_fx) − 1
where:
• R_local is the local currency return (in the above example, 10% or 0.10),
• R_fx is the return arising from currency movement (in the above example, –8.33% or –0.0833, given how EUR/USD changed).
If you’re unlucky, currency movements might more than wipe out your gains. Alternatively, if the foreign currency appreciates, you can turbocharge your returns. This interplay can become quite complicated in multi-currency portfolios—hence the importance of carefully monitoring exchange rate shifts.
One of the big questions faced by cross-border investors is whether to hedge the currency exposure. Often, the decision hinges on interest rate differentials and forward currency market prices. If the forward or expected future exchange rate is unattractive (for instance, if the currency you’re investing in is expected to depreciate), you might decide to hedge that exposure using forward contracts or other derivatives. But if you believe the foreign currency will appreciate, leaving it unhedged could deliver a performance boost.
These decisions are usually analyzed within the framework of covered and uncovered interest rate parity (CIRP and UIRP).
Under covered interest rate parity (CIRP), the forward exchange rate should adjust such that you can’t earn a risk-free arbitrage profit by borrowing in one currency, investing in another, and locking in the forward rate. Formally:
where
• \( F \) is the forward exchange rate (domestic currency per foreign currency),
• \( S \) is the current spot exchange rate,
• \( i_d \) is the domestic interest rate,
• \( i_f \) is the foreign interest rate,
• \( T \) is the time period in years or fraction thereof (e.g., 0.5 for 6 months).
Under uncovered interest rate parity (UIRP), the expected change in the currency’s spot rate should reflect the interest rate differential, but it’s not specifically locked in by a forward contract. Instead, it’s assumed, in theory, that any “excess” yield in one currency is offset by an expected depreciation of that currency. The formula can be expressed as:
Of course, real-world data frequently deviate from UIRP, and that’s where currency speculation (or “leaving your exposure open”) can lead to gains and losses.
If you want to push beyond simply deciding whether or not to hedge, you can incorporate explicit currency forecasts into your valuation of foreign assets. This approach involves two key steps:
• Convert all cash flows into a common reference currency.
• Adjust the discount rate to reflect currency-specific risks.
Imagine you’re analyzing a foreign bond that pays coupons in euros. If you want to run a discounted cash flow (DCF) analysis in USD (your base currency), you’d need to forecast the EUR/USD rate at each coupon date. The simplest approach is to multiply the foreign-currency cash flow by your exchange rate forecast to determine each period’s dollar-based cash flow. However, forecasting exchange rates is notoriously complex, so many analysts rely on forward rates implied by interest rate differentials, or they incorporate short-term macro signals for an estimate.
It’s also possible to keep your projections in the foreign currency and adjust the discount rate to reflect the local currency’s risk-free rate plus any risk premium. Once you arrive at a value in foreign-currency terms, you then multiply by the current spot rate. Either method should (in theory) yield the same result, assuming consistent assumptions about exchange rates, interest rates, and risk. In practice, you want to be mindful of transaction costs, taxes, and the liquidity of the hedging instruments.
So, how do we protect ourselves against unwelcome currency moves? Three primary tools come to mind: forward contracts, currency options, and currency overlays.
A forward contract locks in a future exchange rate for a specified notional amount of currency. By entering a forward, you eliminate uncertainty about the ultimate settlement rate at some point in the future. Of course, “removing uncertainty” also means giving up any potential windfall if the currency moves in your favor. A key driver of the forward rate is the interest rate differential (as illustrated in the CIRP equation).
Shifting or rolling forward contracts can be tricky. You might have to close out an old forward and open a new one if your investment horizon changes or if the contract expires. Mark-to-market gains or losses periodically occur, so pay attention to the impact on cash flow management—especially if you’re managing collateral or margin accounts.
Options on currencies (calls and puts) allow you some flexibility. A currency call option gives you the right (but not the obligation) to buy a certain currency at a specified strike price; conversely, a put option is the right to sell a currency. Options can be expensive, particularly if the implied volatility of the currency is high, but they let you preserve some upside if the currency moves favorably.
This might sound ideal compared to forwards (since you can still profit from a favorable currency move), but you pay for that luxury in the form of the option premium. And if you’re transacting in illiquid currency markets (less common pairs), that premium might be steep.
Sometimes you might prefer to delegate the entire currency decision to a specialist manager—this is known as a currency overlay. You keep your underlying assets (like stocks or bonds) in place, but a separate overlay manager is responsible for the currency hedging strategies. They might utilize a systematic approach, fundamental analysis, or a combination of both to manage your currency risks. Overlay can be an efficient way for large institutions to handle multi-currency exposures when internal resources are limited or when a dedicated manager can exploit mispricings across multiple currency pairs.
Let’s be honest: the theoretical results of interest parity conditions rarely hold perfectly in practice. A few real-world frictions that can disrupt or complicate currency hedging and returns:
Transaction Costs and Bid–Ask Spreads
Buying or selling currency forward, rolling positions, using options—each step can eat into your returns via bid–ask spreads and broker fees. These costs can be especially significant in emerging market or less liquid currencies.
Market Liquidity
Some currencies are pegged (officially or unofficially), some are subject to capital controls, and others are just plain expensive to trade in large volumes. During times of market stress, liquidity can dry up fast, making it hard to roll forward contracts or exit positions at favorable prices.
Margin Requirements and Financing Costs
Hedging instruments might require posting collateral, which means you have to think about cash flow and the opportunity cost of holding collateral. If interest rates are high, the cost of carry might be a factor.
Multiple Currency Exposures
In a global portfolio, you could easily have exposures in five, six, or even a dozen currencies. Managing each pair’s forward, option, or overlay strategy becomes more complex. Correlations among currencies can shift rapidly, so adopting a holistic approach is key.
From a performance measurement standpoint, you want to separate out how much of your total return is attributable to:
In fact, many portfolio managers break down performance attribution reports to highlight currency effects in each region. This can be eye-opening. A portfolio that looks like a superstar in local currency terms might just have a large foreign-currency tailwind. On the other hand, a manager who “only” posted modest returns might actually be generating strong alpha if they were hedging away harmful currency moves.
When you look at multi-country or regional funds, always consider how currency exposures are being managed and reported. Are they passively hedged? Are they actively taking currency bets to generate alpha? The overall risk-return profile can differ drastically between these two approaches.
Now, here’s a twist: the correlation between currency returns and asset returns can suddenly change under stress conditions, like a financial crisis or a geopolitical shock. Often, you’ll see a “flight to safety,” in which investors pile into currencies such as the U.S. dollar or the Swiss franc. If you were counting on historical correlations to remain stable, you might be in for a nasty surprise.
For instance, suppose you have a portfolio that historically displays negative correlation between currency movements and local equity returns—great for diversification, right? Well, if a crisis hits and everything starts moving in the same direction, your hedge might fail exactly when you need it most. This phenomenon underscores the importance of stress-testing your currency exposures and not relying purely on historical correlation data.
Given all these moving parts—local vs. base returns, forward rates, interest differentials, hedging costs, correlation shifts—how do you actually manage currency in your portfolio effectively? A few practical tips:
• Decide whether you want a strategic hedge ratio. Some institutions pick a “neutral” hedge ratio (like 50% or 100%) on their foreign currency exposures, adjusting only occasionally.
• If you have a strong view that a currency is undervalued or overvalued, consider adjusting your hedge ratio or using currency options for a partial hedge.
• Continuously monitor transaction costs and reevaluate your approach if they become prohibitively high.
• Keep an eye on interest rate differentials. Hedging might be cheaper or more expensive depending on forward spreads.
• Stress-test your currency exposures under various “worst-case” correlation scenarios.
And, of course, for exam success, practice evaluating vignettes where you see multiple currencies, forward quotes, interest rate data, and cost structures. The item set might ask you to calculate currency-adjusted returns or determine the best hedging approach given certain forecasts on interest rates. As always in the CFA context, the correct answer often hinges on properly interpreting the numbers and applying the right conceptual framework.
flowchart LR
A["Initial Investment in Base Currency"] --> B["Convert to Foreign Currency <br/>and Purchase Foreign Asset"]
B --> C["Foreign Asset Performance in Local Currency"]
C --> D["Convert Back to Base Currency <br/>at Prevailing FX Rate"]
D --> E["Realized Return in Base Currency"]
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