How do exchange rates affect currency returns?
Exchange rate movements impact returns when a change in the value of one currency against another currency leads to a rise or fall in the value of an asset. When an investor buys a domestic asset, the only variable is whether that asset increases in value. But if they invest abroad, they will have to consider the impact of an exchange rate too. The basic function of this is relatively simple: when a local currency depreciates, it can buy less of a foreign currency, decreasing its purchasing power. And when a local currency appreciates, it can buy more of a foreign currency, increasing its purchasing power.
For example, let’s say you want to invest in a (fictitious) French clothing company, Paris Prints. Shares of the company are trading at €50 – so at the current EUR/GBP exchange rate of 0.9004, you’d be paying £45.02 (50 x 0.9004) for the stock. If you bought 100 shares, your initial outlay would be £4502.
However, you don’t execute your order for two days. Although the share price of Paris Prints has remained the same, a Brexit announcement caused the pound to depreciate against the euro. So, at the new exchange rate of 0.9250, you’d be buying the shares at a higher price of £46.25, giving you an outlay of £4625.