Currency risk in international investing: how FX exposure affects portfolio returns

Currency risk is the risk that an exchange rate movement will reduce the value of an international investment when measured in the investor's home currency. For an investor based in euros holding US equities, the total return in euros has two components: the return of US equities in dollars and the change in the EUR/USD exchange rate. In any given year, the FX component can easily be larger than the equity component—currency risk in international investing is not a minor consideration.

What currency risk is

When an investor holds an asset denominated in a foreign currency, they hold two exposures simultaneously: the economic risk of the underlying asset and the translation risk of converting returns back to their home currency. Translation risk refers to the mechanical effect of exchange rate movements on the home-currency value of a foreign asset: a 10% appreciation of the foreign currency against the home currency adds 10% to the home-currency return of any asset denominated in that foreign currency, regardless of how the asset itself performed.

Beyond translation risk, international investors also face economic exposure: the possibility that exchange rate movements affect the underlying value of their investments, not just the translation of that value. Multinational corporations earn revenues and incur costs in multiple currencies; a depreciation of their domestic currency relative to export markets boosts competitiveness and reported earnings, while appreciation does the reverse. Investors in internationally exposed equities therefore hold FX risk not only at the portfolio level but also embedded in the earnings and valuations of the companies they own.

How FX affects portfolio returns

The magnitude of FX effects on international equity returns is well documented. For a USD-based investor holding global equities excluding the US, studies covering the period 1990–2020 found that the annualised volatility of the currency return component was approximately 8–10%—comparable to, and sometimes larger than, the volatility of the underlying equity returns in local currency. In years of significant currency movement, FX effects can turn a positive local-currency equity return into a negative home-currency return, or amplify an already strong equity return further.

Over shorter horizons, FX dominates. Over longer horizons—ten years or more—currencies tend to mean-revert toward purchasing power parity, and the contribution of FX to long-run total returns is smaller. This mean reversion is imperfect and slow, but it reduces the long-run case for systematic hedging compared to the short-run case.

The direction of FX effects also depends on the investor's home currency and the diversification properties of the foreign currency held. Some currency pairs exhibit negative correlation with equity markets—the Japanese yen and Swiss franc, for example, have historically appreciated against most currencies during global risk-off episodes, providing a partial hedge against equity drawdowns for investors who hold yen or franc exposure. Others, such as emerging market currencies, tend to depreciate precisely when global equity markets fall, amplifying portfolio drawdowns.

What the evidence shows

Research on the impact of currency hedging on international equity portfolio returns has produced mixed conclusions, and the results are sensitive to the measurement period and the investor's home currency. Studies covering 1988–2018 by Perold and Schulman (1988) and subsequent researchers have found that for most developed-market investors, hedging roughly 50–100% of international equity currency exposure reduced portfolio volatility by 1–3 percentage points per year without a systematic effect on average returns over long periods—consistent with the view that currencies contribute risk without a reliable long-run return premium for most investors.

The exception is investors whose home currency is itself highly volatile or subject to systematic depreciation. For such investors, holding assets in stable foreign currencies provides genuine long-run diversification and return benefits that may outweigh the short-term volatility of unhedged exposure.

Limitations and trade-offs

Hedging currency risk carries a cost equal to the interest rate differential between the home currency and the foreign currency. When the foreign currency has a higher interest rate—as the US dollar has had relative to the euro for much of the post-2015 period—hedging costs money. For euro-based investors hedging US equity exposure, the hedge cost has been as high as 2.5% per year, which must be weighed against the volatility reduction it provides.

Partial hedging is an alternative to either full hedging or no hedging. Some investors hedge approximately 50% of their international equity currency exposure on the grounds that this reduces volatility without incurring the full cost of a 100% hedge. The optimal hedge ratio depends on the correlation between the currency and the underlying equity market, which varies over time and across currency pairs.

Active currency management—attempting to add return by taking deliberate FX positions—is a distinct proposition from hedging, which aims only to reduce risk. Evidence on the long-run after-cost alpha of active currency management is mixed; most investors are better served by thinking of currency as a risk to manage rather than a return to pursue.

Currency risk in pfolio

pfolio portfolios include both hedged and unhedged ETFs, and currency exposure is tracked across all positions. The asset class classification in pfolio explicitly distinguishes currency exposure taken as a deliberate return driver from the incidental currency risk embedded in international equity and fixed income ETFs. Currency exposure and its impact on portfolio volatility are visible in pfolio Insights. Portfolio construction methodology, including how asset selection handles multi-currency exposure, is described in how we build portfolios.

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