If you are a Euro based investor, you need to be aware of how the movement of other currencies in which you invest will appreciate and depreciate against the Euro. Most of the world’s stock markets are denominated in other currencies such as the US Dollar, Pound Sterling and increasingly, Emerging Markets currencies are becoming more important. Currencies are very volatile and can rise and fall sharply and regularly and without warning.
Euro based equity investors need to invest in many of these other markets in order to properly diversify their equity portfolios and also to seek better growth opportunities than what is available in the Eurozone. By purchasing equities an investor is taking on investment risk which is the price of the shares will rise or fall. However, when that investor purchases equities denominated in another currency, they are taking on not just the investment risk, but also the much more uncertain currency risk.
An example of how currency movement has affected investors can be found by comparing the relative returns of Euro investors and US Dollar investors in the MSCI World Index in 2015. The US Dollar investor saw the value of their investment show no growth for the year, whereas the Euro investor saw their investment appreciate by 10%. It may seem strange that such a difference could occur when both investors held the exact same stocks. The answer is in the currency movement, over the year the US Dollar appreciated against the Euro. So, while the US Dollar investor saw no growth on their assets, the Euro investor was better off because the value of the assets increased in Euro terms.
It is possible to protect your equity portfolio against currency movements by taking out an ‘insurance policy’ called currency hedging. This means purchasing financial derivative instruments for the purposes of hedging. However, hedging can be quite expensive and will reduce the growth you will get. For that reason, it is mainly institutional fund managers who seek to protect their funds from currency risks. Private retail investors tend not to hedge their investments.