How do exchange rates affect investment returns?

When an investment is priced in a foreign currency, its return for a euro investor has two parts: how the investment performed in its own currency, and how that currency moved against the euro. The second part — the exchange-rate effect — can add to the return or take away from it, and in some years it is larger than the investment's own performance.

The formula

The return in euros is the product of the two effects:

1 + R_{\text{EUR}} = (1 + R_{\text{local}}) \times (1 + R_{\text{FX}})

where $R_{\text{local}}$ is the return in the investment's own currency and $R_{\text{FX}}$ the change in the value of that currency against the euro. With the EUR/USD rate quoted in dollars per euro, the dollar's change against the euro is:

R_{\text{FX}} = \frac{\text{EUR/USD}_{\text{start}}}{\text{EUR/USD}_{\text{end}}} - 1

A rising EUR/USD rate means a stronger euro and a weaker dollar, which reduces the return of US investments for a euro investor.

A simple illustration

A US stock fund returns 12% in dollars over a year, while the EUR/USD rate moves from 1.08 to 1.15:

R_{\text{FX}} = \frac{1.08}{1.15} - 1 \approx -6.1\%

1 + R_{\text{EUR}} = 1.12 \times 0.939 \approx 1.052

The euro investor earns about 5.2%, less than half the fund's return in dollars.

Separating the effects

Breaking a foreign investment's euro return into its two parts shows what actually drove the result:

Local return: how the investment itself did — 12% in the example.
Currency effect: the rest of the euro return, $(1 + R_{\text{local}}) \times R_{\text{FX}}$ — about −6.8 points in the example, including the small cross term from multiplying the two.

A fund that "did badly" in euros may have done well locally in a year of a strong euro, and the other way round.

What drives exchange rates

Interest rate differences: higher rates tend to attract capital and support a currency.
Inflation and growth: over long periods, the currencies of high-inflation countries tend to weaken.
Risk sentiment: in global crises, investors often seek the US dollar, the Swiss franc or the Japanese yen.

Exchange rates are notoriously hard to predict. Over long horizons their effect on stock returns has tended to be smaller than in any single year, but it rarely disappears entirely.

A worked example

Worked through on a sample portfolio. The figures below are that portfolio’s, not yours.

How does EUR/USD affect my portfolio?

EUR/USD changes the euro value of the parts of your portfolio that are held in USD or other foreign currencies. Your portfolio is 138.999,45 €.

Key numbers

Euros: 74.017,59 € (53,25%) — these are already in EUR and do not change with EUR/USD moves.
US dollar exposure: 19.751,80 € (14,21%) — this portion moves with EUR/USD. A +1% move in EUR vs USD typically lowers the EUR value of USD holdings by about +1% (and a -1% EUR move raises their EUR value by about 1%).
Foreign vs home split: 33,91% is outside your home-currency exposure; currency coverage of the breakdown is 87,18% (so the listed breakdown reflects the part we can classify).

What that means in practice

If EUR strengthens against USD, the EUR value of your USD holdings (listed above) will fall roughly in proportion to the EUR move. If EUR weakens, their EUR value will rise roughly in proportion.
The net portfolio impact equals the USD exposure multiplied by the % move in EUR/USD, ignoring transaction effects, dividends, and no buying/selling.

If you want, I can show the exact holdings that carry USD risk or run a simple +5% / -5% EUR/USD scenario to translate the effect into euros.

See these numbers for your own portfolio

Floreo works out every figure on this page from your own holdings — returns, risk, allocation, currencies — and the assistant explains them the way this page does. Import from your broker, or try it on the sample portfolio first.

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