What are Foreign Currency Effects?
Foreign currency effects refer to the fluctuations in returns on offshore investments as a result of changes in the value of the investment's denominated currency against that of the domestic currency.
How Do Foreign Currency Effects Work?
Investors who hold securities issued in foreign countries bear the effects of foreign currency fluctuations as manifest in lower or higher returns upon repatriation to the domestic currency. Devaluation in the currency of the investment relative to the domestic currency results in a loss once any returns (e.g. dividends, interest payments, or capital gains) are repatriated.
To illustrate, suppose Bob lives in the United States and holds shares in company XYZ, which is based in Canada. If Bob receives a total dividend of 100 CAD and the CAD-USD exchange rate is 0.9, he will only receive 90 USD (0.9 * 100 CAD) once the CAD-USD account repatriation occurs. Conversely, however, if the exchange rate were to rise from 0.9 to 1.05, Bob would receive 105 USD (1.05 * 100 CAD).
Why Do Foreign Currency Effects Matter?
Foreign currency effects are a dimension of risk built into any offshore investment denominated in a currency different from that of the country in which the investor resides. This means that if the investor's home currency weakens against that of the investment, the investor will receive fewer numeric returns upon repatriation. However, should the investor's home currency weaken against that of the investment, the investor will experience a gain, receiving greater numeric returns upon repatriation.