How Currency Movements Affect Your Investments
A U.S. investor who bought the MSCI EAFE index (developed international stocks) at the beginning of 2017 and held through the end of 2019 earned a return of approximately 22% in local currency terms. In U.S. dollar terms, the return was approximately 26%. The difference, roughly 4 percentage points over three years, came entirely from currency movements. The euro and other developed-market currencies appreciated against the dollar during that period, boosting returns for dollar-based investors who held foreign assets.
Reverse the currency movement and the outcome flips. From 2021 through 2022, the U.S. dollar strengthened dramatically, driven by Federal Reserve rate hikes and safe-haven demand. The MSCI EAFE index lost approximately 16% in local currency terms during 2022 but fell 14.5% in dollar terms, with the strong dollar converting foreign currency losses into even larger dollar losses. International investors holding unhedged positions experienced the double hit of declining local stock prices and a weakening conversion rate.
Currency impact is not a secondary consideration for globally diversified portfolios. Over short to medium periods, it can account for a larger share of return variation than the underlying stock market performance.
The Mechanics of Currency Exposure
When a U.S.-based investor buys shares of Nestle, the transaction involves two implicit decisions: a bet on Nestle's business and a bet on the Swiss franc relative to the U.S. dollar. If Nestle's stock rises 10% in Swiss francs but the franc weakens 5% against the dollar, the U.S. investor's return is approximately 4.5%, not 10%.
The formula for converting a foreign-currency return to a domestic-currency return is:
Dollar Return = (1 + Local Return) x (1 + Currency Return) - 1
If the local stock return is 10% and the currency depreciates 5% against the dollar: Dollar Return = (1.10) x (0.95) - 1 = 0.045 or 4.5%
If the currency appreciates 5%: Dollar Return = (1.10) x (1.05) - 1 = 0.155 or 15.5%
The currency effect can be larger than the equity effect in certain periods. In 2015, European stocks returned approximately 8% in euro terms. But the euro declined about 10% against the dollar that year. A U.S. investor holding European stocks unhedged lost approximately 3% in dollar terms, despite the underlying stocks performing well in their home market.
Direct and Indirect Currency Exposure
Currency exposure affects portfolios through two channels.
Direct exposure comes from owning foreign-denominated assets. An investor holding the Vanguard FTSE Developed Markets ETF (VEA) owns stocks denominated in euros, yen, pounds, and other currencies. Each position carries explicit currency risk based on the exchange rate between that currency and the dollar.
Indirect exposure comes from the global revenue composition of domestic companies. An investor holding only U.S. stocks is not immune to currency effects. S&P 500 companies derive approximately 40% of revenue from outside the United States. When the dollar strengthens, the dollar value of those foreign revenues declines, reducing reported earnings and, potentially, stock prices. Microsoft, Apple, Procter & Gamble, and Coca-Cola all regularly cite currency headwinds or tailwinds in their earnings reports. The long-term investing guide provides additional perspective on this topic.
In fiscal year 2023, Microsoft reported that a stronger dollar reduced its revenue by approximately $2.3 billion, a direct hit to the income statement caused entirely by exchange rate movements. The underlying business performance in local markets was stronger than the dollar-denominated financial statements showed.
This indirect exposure means that even a portfolio of exclusively U.S.-listed stocks carries meaningful currency sensitivity. It is smaller than the exposure from directly holding foreign stocks, but it is not zero.
Long-Term vs. Short-Term Currency Impact
Over short periods (1 to 5 years), currency movements can dominate investment returns. The U.S. dollar index (DXY) has swung by 30% or more over 3-year periods multiple times since the 1970s. These swings add or subtract entire percentage points from annualized returns on international investments.
Over very long periods (20+ years), currency effects tend to wash out. Exchange rates between major currencies fluctuate around long-term equilibrium values determined by relative inflation rates, interest rate differentials, and trade balances. These fundamentals are mean-reverting over decades. The dollar/euro rate has oscillated between roughly 0.85 and 1.60 since the euro's introduction in 1999, with no persistent trend in either direction.
Research by Dimson, Marsh, and Staunton found that over periods longer than 20 years, currency hedging had minimal impact on the total return of globally diversified equity portfolios. The hedging costs roughly offset the volatility reduction, leaving terminal wealth approximately unchanged. This suggests that for truly long-term investors, currency risk in equity portfolios can largely be accepted without hedging.
The same research found that currency hedging matters more for bonds than for stocks. Bond returns are lower and more stable than equity returns, so currency volatility constitutes a larger proportion of total return variability. An international bond allocation without currency hedging can experience negative returns even when the underlying bonds are generating positive yields, purely due to adverse currency movements.
Purchasing Power Parity
The theory of purchasing power parity (PPP) holds that exchange rates should adjust over time to equalize the price of identical goods across countries. If a basket of goods costs $100 in the U.S. and 90 euros in Europe, PPP suggests the exchange rate should be $1.11 per euro. If the actual exchange rate deviates from this level, the theory predicts it will eventually converge.
In practice, PPP holds over very long periods (decades) but deviates substantially in the medium term. From 2008 to 2014, the euro was persistently overvalued relative to PPP against the dollar. An investor using PPP as a guide would have expected dollar strength, which eventually materialized in 2014 to 2015 when the euro fell from $1.39 to $1.06.
PPP provides a rough anchor for long-term currency expectations but is nearly useless for short-term forecasting. The takeaway for investors is that extreme currency valuations, those that deviate significantly from PPP, tend to correct over time. An investor making a large international allocation when a foreign currency is significantly undervalued relative to PPP may benefit from both equity returns and currency appreciation as the exchange rate reverts.
To Hedge or Not to Hedge
Currency hedging uses financial instruments, primarily forward contracts, to neutralize the exchange rate exposure of foreign investments. A hedged international stock fund delivers returns that approximate the local-currency return, regardless of what happens to the dollar.
The arguments for hedging:
Hedging reduces the volatility of international investments. For a U.S. investor, unhedged international equities have a standard deviation roughly 2 to 3 percentage points higher than hedged equivalents. Over a 1 to 5 year holding period, this additional volatility can significantly impact realized returns.
Hedging provides more predictable returns. An investor who buys European stocks for their equity exposure, not for their currency exposure, may prefer to isolate the equity bet and remove the currency bet. Hedging accomplishes this.
The arguments against hedging:
Hedging has a cost. The cost is the interest rate differential between the domestic and foreign currency. When U.S. rates are higher than foreign rates (as they were from 2022 to 2025, when U.S. rates exceeded European and Japanese rates by 1% to 4%), hedging costs 1% to 4% per year. This cost directly reduces returns.
Hedging removes a diversification benefit. During U.S.-centric economic stress, the dollar often weakens, which boosts the dollar value of foreign assets. This natural hedge partially offsets U.S. stock market declines. Hedging away the currency exposure removes this benefit.
Hedging is unnecessary over very long periods. As noted, currency effects wash out over 20+ years, making the ongoing hedging cost a net drag on long-term returns.
A reasonable middle ground: hedge international bond allocations (where currency volatility is large relative to expected returns) and leave international equity allocations unhedged (where equity returns dominate currency effects over long horizons). For investors with shorter time horizons or lower risk tolerance, hedging 50% of international equity exposure provides partial protection without the full cost.
The Dollar's Special Role
The U.S. dollar occupies a unique position in the global financial system. It is the world's primary reserve currency, used in approximately 60% of global central bank reserves and over 80% of international trade transactions. This reserve status creates persistent demand for dollar-denominated assets, particularly during periods of global financial stress.
During the 2008 crisis, the COVID crash, and the 2022 market selloff, the dollar strengthened as global capital fled to the perceived safety of U.S. Treasury securities. For American investors, this is a double-edged sword: their U.S. assets are insulated from dollar weakness, but their international assets lose value as the dollar rises at precisely the moments when diversification is most needed.
This "dollar smile" pattern, where the dollar strengthens during both very good times (U.S. economic outperformance attracts capital) and very bad times (safe-haven demand), means that international diversification for U.S. investors provides less crisis protection than the equity correlations alone would suggest. The currency effect partially offsets the diversification benefit during stress periods.
Despite this limitation, international diversification remains valuable for U.S. investors. The periods of dollar weakness (often associated with U.S.-specific problems or non-U.S. economic strength) provide returns that a U.S.-only portfolio would miss entirely. From 2002 to 2007, the dollar weakened significantly, and international stocks dramatically outperformed U.S. stocks in dollar terms. Investors who held no international exposure missed that entire cycle.
Practical Takeaways
For long-term equity investors with holding periods exceeding 15 years, currency exposure from international stock allocations can be accepted without hedging. The equity premium dominates currency effects over these horizons, and hedging costs reduce net returns.
For bond investors or those with intermediate time horizons (5 to 15 years), hedging international bond allocations is prudent. Currency volatility is large relative to bond returns and can easily turn a positive-yielding bond allocation into a negative return.
The indirect currency exposure from U.S. multinational companies provides meaningful international diversification without explicit foreign currency risk. An investor who holds no foreign stocks but owns a broad U.S. index already has approximately 40% exposure to global economic conditions through the overseas revenues of S&P 500 companies.
Currency movements are unpredictable in the short term and mean-reverting in the long term. Trying to time currency markets is at least as difficult as timing equity markets and should be avoided. The appropriate strategy is to set a target international allocation, decide whether to hedge based on the asset class and time horizon, and then maintain the allocation through currency cycles without attempting to trade the fluctuations.
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