Learn · How markets are plumbed
Currencies and exchange rates
The price of one money in terms of another. It quietly changes the return on everything you own abroad.
An exchange rate is a price like any other, set by supply and demand. What makes it confusing is that it is a ratio — every quote describes two currencies at once, and “the dollar rose” always means it rose against something.
What tends to move them
- Interest rate differences. Money tends to flow towards higher returns, raising demand for that currency.
- Inflation differences. A currency losing purchasing power domestically tends to weaken internationally over time.
- Trade and investment flows. Buying foreign goods or assets requires buying the foreign currency.
- Safety. In stress, money moves towards currencies perceived as safe, often regardless of the fundamentals.
Fact
Currency movements are notoriously resistant to forecasting
Over short horizons, exchange rate changes are close to unpredictable, and the record of professional forecasters is poor. This is one of the few areas where the honest description of the state of knowledge is simply that nobody reliably knows.
Over short horizons, exchange rate changes are close to unpredictable, and the record of professional forecasters is poor. This is one of the few areas where the honest description of the state of knowledge is simply that nobody reliably knows.
Why it matters to an investor who never travels
Because owning a foreign asset means owning two exposures: the asset and the currency it is priced in. A foreign market can rise while your return in home currency is negative, purely because the currency moved.
Wealth Signal calculation
An illustration
A foreign index rises 10%. Its currency falls 12% against yours. Your return in home-currency terms is negative, despite the market having gone up. The two effects combine multiplicatively, not by addition — these figures are invented to show the direction of the effect.
A foreign index rises 10%. Its currency falls 12% against yours. Your return in home-currency terms is negative, despite the market having gone up. The two effects combine multiplicatively, not by addition — these figures are invented to show the direction of the effect.
Hedged share classes
Some funds offer a hedged version that attempts to remove the currency effect using derivatives. It costs a little, it is never perfect, and it converts an uncertain exposure into a smaller certain cost.
Interpretation
Neither hedging nor not hedging is the default correct answer
For a short horizon and a large foreign allocation, currency noise can swamp the investment thesis, which argues for hedging. Over decades, currency effects have historically been less dominant than asset returns, which argues against paying to remove them permanently.
For a short horizon and a large foreign allocation, currency noise can swamp the investment thesis, which argues for hedging. Over decades, currency effects have historically been less dominant than asset returns, which argues against paying to remove them permanently.
Check whether a fund you hold is hedged. It is usually in the share class name, and it materially changes what you own.
Education, not advice. These lessons explain how things work. They do not tell you what
to buy, and Wealth Signal does not publish recommendations. Full disclaimer.