An international investment's total return is based on two factors - the investment's return in local currency plus currency fluctuations. For example, suppose you purchase a British stock whose price increases 10% in one year in terms of British pounds. If, during that same year, the British pound increases in value by 5% compared to the U.S. dollar, your total return would be 15% - 10% from the investment's return plus 5% from currency fluctuations. However, if the British pound decreased in value by 5%, your total return would be 5%.
When the U.S. dollar declines compared to the other currency, your investment increases in value since more dollars are then required to purchase the investment. An increase in the U.S. dollar compared to the other currency means your investment decreases in value.
Most countries use a system of managed floating exchange rates. Supply and demand factors set the exchange rates most of the time, as international banks, investors, tourists, consumers, and multinational companies buy and sell foreign currencies and goods. Governments typically only intervene to prevent massive fluctuations in exchange rates.
Demand for a particular currency is determined by many factors, including a country's inflation, interest rates, political and economic outlook, monetary policies, and speculation. The U.S. dollar does not move uniformly against all currencies - it can be rising against one currency while it is declining against another.
In general, a rising dollar makes it less expensive for Americans to travel abroad, to import foreign goods, and to purchase foreign investments. However, U.S. companies may suffer since cheaper imported goods hurt sales of domestic products. When the dollar is declining, it becomes more expensive for Americans to travel abroad and to import foreign goods, but U.S. goods become more competitive in international markets.
When considering international investments, consider these tips about currency fluctuations:
- Foreign bonds are subject to more currency risk than foreign equities.
- Currency fluctuations tend to be more moderate in parts of the world where political and economic factors are stable and the local currency is strong. Avoid areas where inflation rates are extremely high.
- Diversifying your investments by country and region can help reduce the overall effects of currency risk.