Making sense of currency risk

P

Pwipp

New member
Hello all,

I am new to investing and am trying to wrap my head around currency risk when, as a Swiss investor, I invest in a foreign currency like USD. I know that there have already been several posts regarding this topic on this forum and on others like r/swisspersonalfinance, but to me it's still not exactly clear, and I want to get all the details right. Let me go through a few examples to illustrate what I understand so far. I would love to get some comments/corrections to further improve my understanding.

Example 1:​

Let's imagine a simple scenario in which 1 USD = 1 CHF = 1 gold coin. Let's consider the Dow Jones ETF DJI and for this example DJI = 1 USD. Now let's say that the USD depreciates so that now 1.2 USD = 1 CHF = 1 gold coin. I'll come back to it later but for now let's assume that the companies inside the DJI are not affected by the depreciation of the USD, so they still have the same value as before.

Now we have that DJI = 1.2 USD = 1 CHF = 1 gold coin. The price in USD of the DJI increases as there is now an interesting opportunity: these companies are still worth 1 gold coin like before; if the price of the DJI stayed at 1USD, then we could sell CHF and gold to buy the DJI for a cheap price below its true value.

After the currency depreciation the Swiss investors lost no money, nothing happened. The American investors got a 20% nominal gain, which might actually translate to them being a bit richer inside the US as prices probably won't fully adjust to the currency fluctuation. Even so, this will not make them richer in other countries like Switzerland.

Example 2:​

Of course, in practice, companies could be affected by the weaker dollar which might in turn decrease their value. However, this could also happen to companies in the SMI like Nestlé. Trading them in CHF won't prevent this. We can make an example which takes this into account. Let's again assume that the USD depreciates like before but this time the companies value is also affected negatively due to lower revenues.

1.2 USD = 1 CHF = 1 gold coin and DJI = 1.1 USD = 0.92CHF = 0.92 gold coins

This time the ETF is worth less but this affects everyone. Again US based investors might make some purchasing power gain in terms of local US prices but they are not richer than the Swiss when they go to Switzerland.

Example 3 (ThePoorSwiss blog):​


There was a similar example in this blog post: Should you use currency hedging in your portfolio?

For example, you are investing in the S&P 500 index in USD, and your base currency is CHF. If the index gains 10%, but the USD loses 10% of its value against CHF, you will be left with no returns. On the other hand, if the USD gains 10% over CHF during the same period, you will have 21% returns!
Click to expand...
In this example, it is not clear to me what causes the index value to change. Does it gain 10% just to compensate, like in my first example, because the actual value of the companies remained unaffected?

In the second case, we assume that the USD gains 10% over the CHF, and implicitly that the index rises by 21%. The index tracks the value of the companies so that means their values increased by 21%. However, if for some reason their value would have remained unaffected by the stronger dollar, then the index's value should have decreased by 10% to reflect the fact that they are still worth as much (gold for example) as before right? As a result, Swiss investors and US investors would have made no gains, but the US investors might be affected more negatively because the prices in the economy, like before, might not adjust perfectly to the currency fluctuation.

Overall, it seems to me that you will get all the real returns as a foreign investor, but you might miss out on some US specific nominal returns, which can translate to a very real purchasing power increase due to sticky prices in the economy.

Thanks for your time, I would love to hear your thoughts!

As a side note, thanks a lot for the content in the blog! I find it very useful!
 
Last edited:
Welcome to the forum!

Pwipp said:
Now we have that DJI = 1.2 USD = 1 CHF = 1 gold coin. The price in USD of the DJI increases as there is now an interesting opportunity: these companies are still worth 1 gold coin like before; if the price of the DJI stayed at 1USD, then we could sell CHF and gold to buy the DJI for a cheap price below its true value.
Click to expand...
I don't see how your first example works.

If DJI does not move and the price of USD goes down from, 1 = 1 to 1.2 = 1, DJI is not equal to 1.2 USD = 1 CHF
Instead, DJI = 1 USD remains true since the index itself has not changed. What has changed is the value in CHF, not in USD.
So, after this event, DJI = 0.833 CHF. Therefore, investors in CHF have lost money but investors in USD have not lost not gained anything.

The only advantage for the Swiss investor is that its purchasing power in USD is higher (it's cheaper to buy more DJI). And the USD investor now has less purchasing in CHF.
 
Thanks a lot for taking the time to reply!

I completely agree with what you wrote in the short term. However, since in my example I was assuming that the companies were unaffected by the currency fluctuation (meaning they still own the same assets, make the same profits etc...), my intuition was that their value sould still be at 1 CHF. Additionally, as you state, the DJI now has become cheaper to buy for anyone not holding US dollars. Therefore, I was thinking that in the medium run, the price should go back to 1 CHF = 1.2 USD to match the underlying value of the asset. Otherwise, there would be a persisent opportunity/inefficiency in the market.

When I say the companies make the same profits as before we can imagine they make all their profits in currencies excluding the USD or they make more profits in USD after the currency depreciation (for example because they make more sales).
 
I am realizing that my phrasing might not have been very good. Instead of "if the price of the DJI stayed at 1USD" it should have been "if the price of the DJI were to stay at 1 USD" in the text that you quote.
 
I think what you are describing is some kind of currency arbitrage. But it does not work like that at scale. This would negate currency risk, no? Are you saying there is no currency risk?

Even ignoring the impact on companies, there is a currency risk.
 
I don't think this is currency arbitrage, or at least that is not what I had in mind. As far as I understand, if it truly works like I described it would kind of negate currency risk yes. However, I don't have any strong opinion on the existence of currency risk as I am just trying to understand the concept and how exactly it manifests. So far it is not clear to me why in my example the price would not go back up to 1 CHF if the companies values are not impacted. You mention that it does not work like that at scale, so maybe that is what I am missing?
 
For me, currency works in the same way as shopping across countries. When CHF is strong, it's interesting to shop in other countries because we can buy more EUR with our CHF. So, if a company in valued in USD, we can buy more of it when the USD is weak, but our existing shares are worth less in CHF.
 
Yes I completely agree. Continuing with that logic, market participants in the entire world can now sell their currencies (excluding USD) and assets to buy the ETF for a cheap price. All the banks and professional traders will surely not miss the opportunity. Because of this, the price should rise. As of now, I don't understand why it would not rise to match the previous price, which assuming the market was efficient at that time, reflected the underlying value of the assets.

You mention the following which I completely agree with:
if a company in valued in USD, we can buy more of it when the USD is weak, but our existing shares are worth less in CHF
Click to expand...
We can make the statement more general: if a company is undervalued, we can buy more shares but our shares will be worth less. This does not stop people from buying undervalued companies (which will usually drive the price up until the company is no longer undervalued).
 
I just don't see how it would work, and it does not work that way. You can look at history, prices don't rise because currency are falling.

Of course, if the USD loses, other participants have more USD and can invest more and this may make prices rise. However, for this to negate the price difference, we would need massive volume. Most of the trades are done in USD, not in foreign currencies.
 
Looking at historical values is a good idea so thank you for bringing it into the conversation. Looking just at asset prices and currency depreciation, how do you know that the companies value did not go down as a result form the currency depreciation? To me the distinction seems highly important, as holding the same asset(s) in CHF will not protect you against a companies value going down in reaction to a weaker USD.

I agree with the fact that massive volume would be needed and honestly do not know how this would play out in the market. However, I do not understand this:
Most of the trades are done in USD, not in foreign currencies.
Click to expand...
Since the ETF/company in our discussion sells in USD, then of course the trades will all be in USD right? People sell whatever assets (CHF) to buy USD and then buy the ETF/company in USD.
 
You must log in or register to reply here.
Back
Top