A deep dive into foreign exchangeA deep dive into foreign exchange

Foreign exchange—the concept of buying and selling foreign currency—is a major factor when you’re investing overseas.

Let’s look at how foreign exchange factors into investing, and some of the things that can influence foreign exchange.

Why foreign exchange matters

Foreign exchange matters because it can affect your investment returns. 

Generally, when you invest overseas, you need to use the local currency of the country you’re investing in. So if you’re buying US shares, you need to first change your NZ dollars (NZD) into US dollars (USD), then spend those US dollars on US shares. 

But just like shares, the value of currencies change all the time. For example, let’s say you change $100 NZD into USD and receive $77 USD. You do the same exchange a few months later and receive $66 USD—$11 less! As a result, you end up buying fewer US shares (if those shares are worth the same amount of US dollars).

How foreign exchange affects your investment 

Let’s say you buy US shares using USD you’ve just converted from NZD. Later, you might decide to sell those shares, and convert the USD back to NZD. If you convert when the US dollar is worth less than it was when you bought the shares, your NZD returns will be reduced. 

The opposite can also happen. If you do that same conversion when the US dollar has become more valuable, then any NZD returns will be increased by foreign exchange.

There are four different ways that the exchange rate can affect your investment. When you sell US shares, and convert the USD to NZD:

• If your investment has gained value, and the US dollar has gained value, you get a higher return! 

• If your investment has gained value, and the US dollar has lost value, you lose some of your return. 

• If your investment has lost value, and the US dollar has gained value, you lose less than what you would have otherwise lost. 

• If your investment has lost value, and the US dollar has also lost value, you make even more of a loss than what you would have if the exchange rate hadn’t changed.

On the one hand, foreign exchange can amplify your returns - both positive and negative. This means it can make gains higher, but it can also make your losses even greater. 

Why currency prices change

Currency and shares have some common features. Both are traded on markets, and both have their prices set when buyers and sellers agree on a price, and make a trade. 

This means that currencies change their price based on supply and demand. If lots of people want a currency, and there aren’t many people selling that currency, then the price will go up. And the reverse is also true. If few people want a currency, and lots of people are trying to sell it, then the price will go down. 

How much people want a currency (and how much they’ll pay for it) is driven by all kinds of things. 

Interest rates

If one country has high interest rates, while another country has low interest rates, then some people may want to borrow money from the low interest rate country and put it in a bank account in the high interest rate country. This increases demand for the second country’s currency, and generally makes it more valuable. (In fact, it can balance out the difference in interest rates pretty quickly). 

Economic prospects

If a country has a booming economy, people from around the world will want to invest in that economy. To do so, they need to buy local currency—and when they all compete for local currency, the price of that currency goes up. 

Demand for exports

If a country exports a lot more than it imports, then those exporters need to turn their foreign currency back into local currency in order to spend it on things. This increases demand for the country’s currency, and pushes its price up (this happens in NZ, as we export lots of stuff). But the opposite can also happen, and a currency can become less valuable if a country’s exports become less valuable. 

Money supply

The more money there is in the economy, the easier it is to get a hold of. So a country that is printing lots of money will sometimes have a lower exchange rate than a country that is not printing very much money. 

Inflation expectations

Inflation is when currency becomes less valuable. The fact that a fizzy drink costs more than double what it did about 20 years ago is an example of inflation. If people expect inflation to be high, and for a currency to lose value in the future, then they won’t want that currency today—which will in turn cause it to lose value. 

How to manage foreign exchange risk

Every investment has risks, and exchange rates are just another risk to understand and manage. Just like shares, the three best ways to manage the risk of exchange rates moving around is to diversify, have a long time horizon, and dollar-cost average. 

Diversify

Diversifying is just a matter of owning investments in both foreign currencies and in NZ dollars. That way, shifts in relative exchange rates generally get balanced out. If you own NZ, US, and Australian shares, and the exchange rates move, then some of your currencies may gain value while others lose value. 

Have a long time horizon

The other way you can manage foreign exchange risk is by having a long time horizon. Foreign currencies tend to move around a lot day to day and week to week, but also tend to be reasonably stable over five years, ten years, or more. 

Use dollar-cost averaging

Finally, dollar-cost averaging (where you invest on a regular basis, rather than all at once), protects you from the swings in foreign exchange rates. If you invest every week or month, you might get stung by a low exchange rate sometimes, but also get the benefits of a high exchange rate at other times. Combine with diversification and a long time horizon, and it balances out. 

To wrap up

Foreign exchange can amplify gains and losses, so it’s worth considering when you’re investing overseas. But, like all risks, it’s a risk that you can manage (but not eliminate) over time. So bear it in mind, and think about how you’re going to manage it, but don’t let it stop you from investing!