Article first seen on Investment Frontier
When investing in foreign markets, it is important to consider currency risk, a topic that Investment Frontier has covered many times before. Calculating the USD-adjusted returns is not as simple as adding the stock and currency returns together, here is a guide on how to do it:
Calculating Currency’s Impact On Returns
This is the formula:
USD Currency Adjusted Return (%) =
(1 + Return in Local Currency) x (1 + Return on Local Currency vs USD) – 1
Currency has a multiplicative, rather than additive, effect on returns. This is because it affects not only the initial amount invested, but also the subsequent profit/loss that is in local currency. This means that if a currency has appreciated during the holding time, the currency adjusted profit/loss will be larger than if you added the two returns together, and smaller if the currency has depreciated.
Massive returns on equities will always be overshadowed by large moves in the currency. This is why 250% returns in Venezuela are largely meaningless when the currency has depreciated by 95% (you net return about 2.4% for your troubles in this case).
Example #1: Profit in Both Equities and Currency
A Canada-based investor has invested on the Cyprus Stock Exchange. Their portfolio of stocks, denominated in Euros (EUR), has returned 30% on the year. The Euro has also appreciated vs the Canadian dollar by 5%.
To calculate their CAD-adjusted returns for the year, multiply (1 + 0.3) x (1 + 0.05) – 1 = 36.5% CAD-adjusted returns.
To work this back, the investor made 30% on their equity, made 5% on the currency for the initial investment, and made 5% of 30% = 1.5% because returns were denominated in EUR. This equals to 30% + 5% + 1.5% = 36.5% total CAD-adjusted returns.
Example #2: Profit in Equities, But Loss on Currency
An US-based investor has invested on the Vietnamese Stock Exchange. Their portfolio of Vietnamese stocks (denominated in the local currency, VND), has returned 20% on the year. However, the Vietnamese Dong (VND) has depreciated vs the USD by 10% on the year.
To calculate their USD-adjusted return for the year, multiply (1 + 0.20) x (1 – 0.10) -1 = 8% returns in USD.
To work this back, the investor made 20% on their equity, lost 10% on the currency, then lost 10% of 20% = 2% from the profit which was held in VND. This is how we get 20% – 10% -2% = 8% USD adjusted returns.
Example #3: Loss in Both Equities and Currency
A US-based investor has invested on the Egyptian Stock Exchange. Their portfolio of Egyptian stocks (denominated in the local currency, EGP), has lost 10% on the year. The Egyptian Pound has also depreciated by 30% on the year.
To calculate their USD-adjusted return for the year, multiply (1 – 0.10) * (1 – 0.30) – 1 = -37% returns in USD.
To work this back, the investor lost 10% on their equity, lost 30% on the currency, but the loss was in local currency, so they actually lost less in USD terms, or 30% of 10% to be exact. This is how we get (-10%) + (-30%) + 3% = -37% USD adjusted returns.
Conclusion
For investors with portfolios in foreign currency, the impact of the currency may be more than you would initially expect. Local currency returns only matter to locals, so make sure you calculate your true home currency adjusted returns when managing your portfolios.
Author: Shalifay Investments
