Foreign exchange affects net return on foreign assets

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currency
A picture illustration of crumpled kuna, dollar and euro banknotes, taken in Zagreb, Jan. 18, 2011.

A modern investor is knowledgeable of many global factors that affect decisions regarding the management of one's portfolio. One of the most fluid markets would be non-US assets, where one of the major influences would be the fluctuation of currencies and its effect on global markets.

The basic question is, how does currencies affect global markets? This is based on the concept of total return which is the combined effect of the increase in value of an asset together with the dividend it pays out. This happens onshore, meaning in the US. When one does offshore investments, then the increase or decrease of the value of the asset includes the dividend paid out and the foreign currency exchange rate between the currency of the investment and the US dollar. 

Currency hedging is particularly important for asset classes such as fixed income and property, which are generally purchased for their defensive characteristics. This is due to income rather than capital being the major driver of expected returns. As currency changes can increase portfolio volatility, it is common to fully hedge these asset classes in order to remove exchange rate risk.

This is best shown through an example. When one invests in say, the Philippines in say, shares of stock, the total return on the investment is the appreciation of the stock's value plus the dividend paid out and the difference in the foreign exchange between the Philippine peso and the US dollar. 

Do remember when the foreign currency falls as against the dollar, it means your investment increases in value, as it takes less amount of dollars to purchase more of the asset. 

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