Currency risk arises from exchange rate moves between pairs of currencies.

If you have investments or assets in a foreign country with a different currency, you face currency risk, unless the foreign currency is pegged to your domestic currency or your exposure is hedged.

A simple example shows how currency risk affects your returns.

Suppose you’re an American investor and you put $10,000 into a European stock market tracker fund. The fund is not hedged, and so you’re exposed to changes in the exchange rate between the dollar and the euro. That is, you’re exposed to currency risk.

Let’s say that over the next 12 months the European stock market and therefore your tracker goes up 20% in local euro terms:

• If the dollar and the euro is at the same exchange rate after 12 months as when you first made your investment, your holding is now worth $12,000. (i.e. The $10,000 investment increased by 20%).

• Say the dollar appreciated by 25% versus the euro over 12 months. Your holding would be worth $9,600 (12,000 / 1.25). i.e. Your euro position now buys fewer dollars.

• What if the dollar depreciated by 25% versus the euro over 12 months? Your holding would now be worth $16,000 (12,000 / 0.75). i.e. Your euro position now buys more dollars.

As you can see, currency risk can dramatically affect your returns, from magnifying your gains to turning gains into losses in your own currency.

The basic rule is:

• When the foreign currency strengthens versus your own currency, your overall return goes up.

• When the foreign currency weakens versus your own currency, your overall return goes down.

Currency risk and businesses

Any business that operates across different territories that use different currencies will face currency risk. Businesses will be hurt and helped in different ways from exchange rate moves.

Some examples:

• If you’re a British manufacturer and your main market is Europe, you will benefit when the pound weakens. The euros you receive in return for your goods will be worth more pounds, so profits increase and/or your goods become more competitive due to their lower price in euro terms. The opposite happens when the pound strengthens.

• What if instead you’re based in the UK, your main market is America – but you also use lots of raw materials priced in dollars? Here you will still benefit if your local currency depreciates versus the dollar, but some or all of the gains will be wiped out because of the extra cost of buying raw materials with more expensive dollars.

• A multinational firm operating in lots of different countries may find these exchange rate moves broadly cancel each other out.

• Companies sometimes hold debts in foreign currencies. An unhedged move in the exchange rate can greatly increase their debt burden if they service the debt via a different currency.

Companies often hedge exchange rate exposure to try to deal with currency risk. The theory is they should concentrate on their proper business, rather than have a side business in currency trading.

However hedging does cost money, and a poor call can make a big dent in profits.

Dealing with currency risk when investing

So much for business, what about the likes of us one-man investing bands?

Opinion is divided as to whether currency risk is a good thing for us. There is some academic evidence that exposure to currency risk does not reward investors with higher returns. Others argue it increases diversification and so reduces risk, on top of the usual benefits of investing overseas.

Hedging away the currency risk – which comes built into some funds and ETFs – has its own snags. It costs money, whether born separately by you as an investor, or in the shape of higher costs via a hedged fund. You also give up potential rewards, which is always the unarguable price of hedging but still annoying when it happens.

Some notable investors believe currency risks can be ignored if investing in overseas equities for long periods. Sir John Templeton, the grandfather of far-flung investing, believed currency movements were neutral over the long-term when investing in equities.

Overseas bond funds are usually best hedged though – the shorter life of bonds reduces the time for currency affects to even out.

Not all foreign investments expose you to currency risk, especially if you’re an American investor. Many emerging market countries have currencies pegged to the dollar. This means their currencies rise and fall with the dollar, so currency risk can be ignored by U.S. investors putting money there.

Hedging as a side product of an investment

Some investments are inherently hedged.

Suppose you’re a U.S. investor, and you buy shares in AstraZeneca, the UK-listed drugs giant.

The value of your investment is determined by:

a) the performance of the AstraZeneca share price, and

b) currency risk.

The currency danger for you as a U.S. investor is that the pound may fall versus the dollar after you’ve made your investment.

Let’s say you buy $1,000 worth of Astra shares at an exchange rate of $2 to £1. You have £500 in Astra shares.

Now suppose that after some years the pound falls to parity with the dollar, so £1 is worth $1.

If the AstraZeneca share price stayed the same over the period, you’d have only $500 when you sold up and brought your pound sterling money back into dollars. You’d have lost $500 due to the change in the exchange rate.

However – the Astra share price would be very unlikely to stay the same if the exchange rate changed like this, because Astra does most of its business in dollars.

As the dollar strengthened towards parity with the pound, the dollars that Astra made overseas would be worth more pounds when repatriated back home to the UK.

Astra’s earnings and profits would thus rise in pound terms purely from this exchange rate change, and its share price would almost certainly rise too.

For US investors, such a rise in the share price could potentially cancel out for U.S. investors the loss from the exchange rate change!

Good reads from around the Web.

Josh Brown is a curious blogger and acerbic wit who publishes financial market arcana for his fellow investment pros, sprinkled with the odd post about how stupid and venal some of them are.

I like his blog, The Reformed Broker, a lot, even though it’s wildly inconsistent and goes into the unlikely-to-prove-profitable ‘guilty pleasure’ bracket alongside spread betting and CNBC1.

Anyway, this week he flagged up two factoids revealing how so-called ‘dumb money’ can be pretty smart.

In his post Why Behaviour Is Half The Battle, Josh shared a graph from Fidelity showing how keeping up steady investment throughout the turbulent market has delivered a solid result for American pre-retirees:

He notes:

Behavior, ie continuing to contribute through the difficult conditions of the Great Recession and Credit Crisis, was about half the battle. Market performance did the half of the heavy lifting and those who did the right thing have been2 richly rewarded for it.

These simple investors don’t realize it, but they have outperformed almost every hedge fund manager and smart-ass market-timer in the universe.

Or perhaps they do realise it? Anyone who digs through our passive investing HQ should have a good grasp of the essentials. (i.e. That returns from expensive fund managers lag those from cheap index funds, and forecasting the market doesn’t work).

A couple of days later Josh brought us stats from Merill Lynch revealing that retail investors – that’s the likes of you and me – were happily buying the shares that gibbering money managers were throwing overboard as the market tanked.

Josh comments:

The hedge fund segment sold again last week, three in a row. They are now net sellers of the equity market on the year – they were only net buyers during the March and April period of new highs, because, en masse, they are essentially benchmark-chasing pussies who jump in and out of the tape like they’re “managing risk” and then lever up like maniacs when they begin to trail the markets.

… and of course they charge 2-and-20% for doing so. Then again, I’m blogging about how silly they are, and they are driving Ferraris. Who’s the muppet?

I wonder what car Josh drives? Metaphorically speaking, I mean. Perhaps he takes the subway when it comes to actual non-metaphorical transport.

[continue reading…]

1. Which I just remembered he also appears on. Maybe I’ve got a man crush? [↩]
2. Josh actually wrote “ben”, but I am happy to correct the error and make him look good, due to my man crush. [↩]

Which annuity is the best way to fund your retirement – a level annuity or an escalating annuity?

• A level annuity provides a fixed income that won’t change until the day you die. In real terms though its value is gradually lapped away by inflation’s sand-papery tongue.

• An escalating annuity (also known as an index-linked annuity) will offer a comparatively puny income today. But it will grow over time – its fortunes are hitched to the Retail Prices Index (RPI) or Consumer Prices Index (CPI).1

Jam today

When you compare the two types, it’s hard not to be seduced by the instant riches offered by the level annuity.

For example, I can currently bag a £20,800 level annuity2 for the same price as a £12,500 escalating RPI annuity. That’s over 66% more income for taking the fix.

That’s gotta be worth something, right?

And as it turns out it is.

Compelling research by Professor of Retirement Income, Wade Pfau, suggests that the most efficient asset allocation for retirees may well be a mix of equities and level annuities.3 In this scenario, any surplus cash generated by the level annuity over and above the retiree’s income needs is invested 100% into equities to create some upside.

So, continuing the example above, I can invest £8,3004 of my £20,800 level annuity income into the stock market (in year one of my retirement), given that I had intended getting by on the £12,500 a year offered by the escalating annuity.

As and when inflation erodes the level annuity’s real income below my minimum income floor, then the equity portfolio can be tapped for a top-up or to buy another annuity.

Equally, the equity portfolio can be a source of lifestyle income, emergency funds, or a legacy when the time comes.

Hold the jam, pass the spreadsheets

Let’s say I am 65. I took to my spreadsheets and worked out that I could maintain my income for 44 years until I age 109 using the Pfau strategy.

If I shuffled off at 84 then I would leave an inheritance of £120,000 in today’s money into the bargain. If I lived any longer, then I spend the lot on another level annuity to keep myself going.

£120,000 is a lot of buffer money and I got there assuming historically average levels of inflation and equity growth.5

Indeed the major flaw in my calculations is that I assume inflation and asset growth trot along smoothly at their historically average levels.

In reality that never happens – for better or worse – as the violent swings of the UK’s inflation history shows:

A Monte Carlo sim would give me a better idea of the range of possibilities. In some inflation and growth rate scenarios I’d end up filthy rich. In others, filthy poor.

Hang on, I’m running out of jam

Where things really come unstuck for the level annuity though is when inflation makes like David Banner and bursts out of its corset in a big, green, income smashathon.

You can estimate the damage for yourself using a level vs escalating annuity calculator.

If inflation pootles along at 3%, the escalating annuity only pays out a higher annual income by the time you’re 83. You’ll have to hang on until age 97 for it to pay out a higher income overall.6

From then on you can die happy.

Right now, UK males live on average until 79 and females until 82. So you’ll need exceptionally youthful genes to make an escalating annuity worth your while. (Or the kind of bitterly tenacious grip on life that’s normally reserved for Dickensian crones with scores to settle.)

But, but, the tide can turn against the level annuity very quickly when inflation runs wild. If prices rise by 13% a year then the escalating annuity pays a higher income within five years. And it pays a higher total income in just eight – that’s shockingly fast.

So when did inflation last average 13% a year in the UK?

In the 1970s, peaking at 25% in 1975.

Ultimately, a level annuity offers more flexibility, growth, and value for money, but it does not offer certainty, security, or safety.

An escalating annuity is the superior product if those are your retirement goals, and frankly who doesn’t want some of that in their retirement?

Take it steady,

The Accumulator

1. You decide as part of selecting your escalating annuity which inflation index to  track, or you can choose a fixed number say 3% or 5% a year. [↩]
2. 100% conventional: no dependents, no guarantees, no bells, whistles and big bass drums. [↩]
3. Level annuities are known as fixed Single-Premium Immediate Annuities or “fixed SPIAs” in the US. [↩]
4. I can actually invest £6,640 after tax. [↩]
5. I assumed a consistent inflation rate of 3% p.a. and a real equity return of 5% p.a. The personal allowance is £10,000 (2014-15 rate) and uprated by 3% inflation p.a. My minimum required income was £12,000 after tax. My level annuity income was £20,800. When inflation forced my level annuity income below my minimum required income (in real terms) then I used the accumulated equity portfolio to buy another level annuity. This worked until age 104 when my final £5,000 went into cash and kept my head above water until I was 109. Even then I wasn’t out of money. I was just forced to live on less than £12,000 a year as the level annuity continued to grind down. Perhaps I’d sell my house at that stage. Or an antique kidney. [↩]
6. I’m still using the £12,500 escalating annuity vs the £20,800 level annuity example. [↩]