Understanding Currency Risk & Hedging for Stock Investments

What is Currency Risk in International Stock Investing?

When you invest in stocks denominated in a foreign currency, your final return in your local currency is affected by two main factors:

1. The performance of the stock itself in its local (foreign) currency.
2. The change in the exchange rate between the foreign currency and your local currency from the time you buy the stock to the time you sell it and convert the proceeds back.

If the foreign currency weakens against your local currency, your returns will be lower when converted back. Conversely, if the foreign currency strengthens, your returns will be higher.

How Exchange Rate Changes Impact Returns:

This tool helps illustrate this by calculating:

• Profit/Loss from Stock Price Change (in Foreign Currency): The direct gain or loss from the stock's performance.
• Gain/Loss from Currency Movement: The additional profit or loss incurred when converting the foreign currency proceeds (initial investment + stock profit/loss) back to your local currency at the new exchange rate.

What is Currency Hedging?

Currency hedging is a strategy used to reduce or eliminate the risk associated with adverse movements in exchange rates. The goal is to "lock in" an exchange rate for a future transaction or to protect the value of foreign currency denominated assets.

Common (simplified) ways to think about hedging effects, which this tool models via a "Net Cost/Gain from Hedge %":

• Forward Contracts: You agree to exchange a specific amount of one currency for another at a predetermined rate (the forward rate) on a future date. This effectively locks in your conversion rate for the hedged portion of your investment. The difference between the forward rate and the future spot rate determines the gain or loss on the hedge itself.
• Currency Options: Give the right, but not the obligation, to buy or sell a currency at a specific rate on or before a future date. Options have an upfront cost (premium).

How This Tool Estimates Hedge Impact:

This calculator uses a simplified approach for the "Hedged Scenario":

• You specify what **percentage of your initial foreign currency investment value** you hypothetically hedged.
• You input a **"Net Cost (-) or Gain (+) from Hedge as % of Hedged Amount."** This single percentage is meant to represent the overall net effect of your chosen hedging strategy over the investment period.
  • A **negative value** (e.g., -0.5%) implies the hedge had a net cost (like an option premium paid, or forward points that were unfavorable relative to the initial spot rate).
  • A **positive value** (e.g., 0.2%) implies the hedge resulted in a net gain (e.g., forward points were favorable, or an option paid off more than its premium relative to a simple conversion at purchase rate).

The tool then applies this net cost/gain percentage to the local currency equivalent of the hedged portion of your initial investment to estimate its final value. The unhedged portion is converted at the sale date exchange rate.

Important Considerations:

• Hedging is Not Free: There are usually costs associated with hedging (e.g., transaction fees, bid-ask spreads on forward contracts, option premiums).
• Hedging Can Limit Upside: While hedging protects against adverse currency movements, it can also limit potential gains if the foreign currency appreciates significantly more than anticipated or beyond what the hedge covers.
• Complexity: Real-world hedging strategies can be complex to implement and manage.

This tool provides simplified estimations based on your inputs. It is for informational and educational purposes only and is not financial advice. Actual hedging outcomes can vary. Consult with financial professionals for specific hedging advice.