In a detailed post last week (see post Why Currency Hedging is Necessary), reader Avon explained how foreign stocks are much riskier when one considers the effect of exchange rate fluctuations. He argued that even when exchange rate fluctuations wash out over the long term, the added volatility of these fluctuations increase the risk of holding foreign stocks. Therefore, he suggested that currency hedging is worthwhile even if the costs of hedging run close to 2% per year.
I turned to Triumph of the Optimists, an excellent book on 101 years of investment returns from sixteen countries around the world by Elroy Dimson, Paul Marsh and Mike Staunton to find out how currency fluctuations have affected investment returns in the past. The first point that should be made is that currency values have fluctuated considerably in the past. Most currencies depreciated against the U.S. dollar and the volatilities were quite large. The Italian Lira, for instance, depreciated at an annual rate of 5.7% against the U.S. dollar with a standard deviation of 17.4. As an aside, if the Canadian dollar depreciated at a similar rate, $100 will be worth just 37 cents after 101 years. Fortunately, compared to most other currencies, the Canadian dollar was very stable (depreciation of just 0.4%) and exhibited the lowest volatility — a standard deviation of just 4.3. Even in the era of floating exchange rates, the Canadian dollar exhibited low volatility: a standard deviation of just 4.7% in the 1972-2000 period.
Despite the volatility in currency rates, currency risk did not add greatly to investor risk. Dimson et al. note: “The total dollar risk was generally less than the sum of the local market and currency risks because the correlation between the two returns was such that they often offset one another”. For instance, an U.S. investor in Canadian stocks would have experienced real returns with a standard deviation of 16.8% in local currency, 4.6% in exchange rate and 18.4% in U.S. dollar terms. In some markets such as Netherlands, Denmark and Sweden, the exchange risk offset local market risk so much that dollar risk was lower than local market risk.
The authors conclude:
International investors, can, of course, choose to hedge currency risk. We have seen, however, that even for single country investments, exchange risk does not greatly increase portfolio risk, and its impact is even smaller in the context of internationally diversified portfolios. Indeed, unhedged international portfolios might even have lower long-term variability than their hedged equivalents when measured in real terms.
