Currencies and Foreign Exchange: How FX Works for Investors

Direct Answer

Foreign exchange (FX) is the global market where currencies are bought and sold. For investors, it matters primarily because currency movements add a second layer of return and risk to any investment denominated in a foreign currency. A portfolio of international stocks can earn a positive local-currency return while producing a negative return in the home currency if the foreign currency weakens significantly. Understanding how exchange rates work, what drives them, and how currency risk can be managed is essential for any investor with cross-border exposure.

Key Takeaways

• Every international investment has two return components: the local-currency performance of the asset and the change in the exchange rate between the foreign currency and the investor's home currency.
• Currency markets are the largest and most liquid financial markets in the world, with daily trading volume exceeding trillion, yet they remain difficult to predict reliably in the short term.
• Purchasing power parity (PPP) provides a long-run anchor for exchange rates based on relative price levels, but currencies can deviate substantially from PPP for years.
• FX hedging reduces currency volatility but adds cost and eliminates the potential benefit when the foreign currency strengthens.
• Carry trades, which involve borrowing in low-rate currencies to invest in high-rate currencies, can earn consistent income but are subject to sudden, sharp reversals when risk sentiment shifts.

How exchange rates work

An exchange rate is the price of one currency expressed in units of another. Exchange rates are quoted in two ways: direct quotes express the number of home-currency units per unit of foreign currency; indirect quotes express the number of foreign-currency units per unit of home currency.

The bid price is what a dealer will pay to buy the base currency; the ask price is what a dealer charges to sell it. The difference between bid and ask is the spread, representing the dealer's profit margin. Spot rates apply to transactions settled within two business days. Forward rates are agreed today for settlement at a specified future date, locking in an exchange rate for a future transaction.

What moves exchange rates

Exchange rates are determined by the relative supply and demand for currencies across global markets. The key drivers include:

• Interest rate differentials: currencies in countries with higher interest rates tend to attract capital and strengthen, holding other factors constant (the basis of carry trade logic).
• Inflation differentials: countries with higher inflation see their currencies weaken over time as purchasing power erodes, which is the core mechanism behind PPP.
• Current account balances: persistent trade surpluses generate demand for the surplus country's currency; deficits generate supply of it.
• Capital flows: large cross-border investment flows, including direct investment and portfolio investment, can dominate trade-flow effects in the short to medium term.
• Risk sentiment: during periods of global risk aversion, investors tend to move toward safe-haven currencies such as the US dollar, Japanese yen, and Swiss franc, even when those countries' fundamentals do not obviously justify the move.

Purchasing power parity: the long-run anchor

Purchasing power parity (PPP) is the theory that exchange rates should, over the long run, equalize the price of a comparable basket of goods across countries. If a basket of goods costs in the United States and 90 euros in Germany, PPP implies the exchange rate should settle near 0.90 euros per dollar.

Empirically, PPP provides a reasonable long-run anchor but a poor short-run predictor. Currencies can deviate from their PPP-implied values for years or decades due to capital flows, structural differences in productivity, differences in the composition of economic output, and speculative pressures. The concept is more useful for identifying broad long-run misalignments than for timing currency movements.

Currency risk in international investing

When a US investor purchases shares of a European company, the investment involves two distinct risk components: the performance of the company's stock in euros and the performance of the euro against the US dollar. The investor's total return in dollars is the combination of both.

If the stock rises 10% in euro terms but the euro weakens 8% against the dollar over the same period, the dollar-denominated return is approximately 2%, not 10%. If the stock falls 5% in euro terms and the euro strengthens 8% against the dollar, the dollar-denominated return is approximately 3% positive despite the local market loss. Currency exposure can enhance or erode returns independently of the underlying investment's performance.

FX hedging: cost, benefit, and trade-offs

Currency hedging uses financial instruments, typically forward contracts or options, to lock in an exchange rate for a future period, reducing the uncertainty of the currency component of an international investment. A currency-hedged international equity fund removes most of the exchange rate effect and delivers returns closer to the underlying local-market performance.

Hedging is not free. The cost of hedging is approximately the interest rate differential between the two currencies. When the home currency has lower interest rates than the foreign currency, hedging is expensive and reduces expected return. When the home currency has higher rates, hedging can add return. Hedging also eliminates the benefit when the foreign currency strengthens, which is a gain the unhedged investor would have received.

Carry trades and their risks

A carry trade borrows in a low-interest-rate currency and invests the proceeds in a high-interest-rate currency, earning the interest rate differential (the carry). During periods of stable risk sentiment and low volatility, carry trades can generate consistent positive returns. The risk is asymmetric: gains accumulate slowly over time and can reverse suddenly.

Carry trade unwinds occur when risk appetite deteriorates and investors rapidly exit their positions simultaneously. The resulting demand for the low-rate funding currency can cause it to strengthen sharply against the high-rate investment currency, sometimes reversing months of accumulated carry in a single day.

Reserve currencies and the US dollar's role

A reserve currency is one that other central banks hold in large quantities as part of their foreign exchange reserves, primarily for conducting international trade and providing a store of value. The US dollar is the dominant global reserve currency, meaning a large proportion of international trade, commodity prices, and financial transactions are denominated in dollars.

The dollar's reserve currency status creates persistent global demand for dollar-denominated assets and allows the United States to run persistent current account deficits without the currency depreciation that would typically accompany such imbalances. It also means that global risk-off episodes tend to strengthen the dollar, even when the United States itself is a source of the stress.

FX and emerging markets

Emerging market currencies typically exhibit higher volatility than developed-market currencies, reflecting greater political risk, shallower capital markets, and more variable economic performance. Some emerging markets maintain capital controls that limit the free flow of currency in or out of the country, creating additional risks for foreign investors who may not be able to repatriate investments freely in all conditions.

Currency crises, in which a country exhausts its foreign exchange reserves while defending an exchange rate peg and is forced into a sharp devaluation, have historically been among the most damaging events for emerging market investors, as they simultaneously affect the value of assets and the exchange rate that determines the home-currency value of those assets.

Where to go next

• International Investing: the broader framework for cross-border investment decisions.
• Macro and Market Regimes: how macroeconomic forces affect financial markets.
• Fixed Income and Bonds: including international bond markets and currency-hedged bond investing.
• Forex and FX Trading: the mechanics of actively trading currencies.

FAQ

References

• Bank for International Settlements: Triennial Central Bank Survey of Foreign Exchange Markets
• Federal Reserve: The Federal Reserve in the International Sphere
• SEC Investor.gov: Introduction to International Investing
• Swoopr Investment: International Investing
• Swoopr Investment: Macro and Market Regimes