Currencies (FX)

What an exchange rate is

An exchange rate is the price of one currency in another. For example, EUR/USD tells you how many dollars a euro costs. Rates move with interest rate differences, the economy and risk sentiment. For an ordinary investor, currency isn't a separate investment but a factor that comes along with foreign investments.

Exchange rates don't move at random. They reflect differences between economies. The main driver is the interest rate differential: a currency with a higher interest rate attracts capital and strengthens, while a currency with a low interest rate weakens. Inflation differences, the current account and general risk sentiment also play a part. In a crisis, money seeks out safe havens such as the dollar. For a long-term investor, however, currency isn't a separate bet but a by-product that comes with foreign investments.

Currency risk in investments

When you buy a foreign stock, your return depends on the value of the investment and the exchange rate. If a US stock rises 10% but the dollar weakens 10%, your return in euros can be close to zero. This is currency risk. It can either increase or reduce your return.

Currency risk works in both directions. If your home currency, the euro, weakens, your foreign investments return more in euros; if the euro strengthens, they return less. Over the long term these moves tend to even out, so for a broad equity portfolio currency is more noise than a permanent risk. In the short term, however, it can swing your return significantly. That's why it's worth understanding, even if you don't chase it.

Should you hedge?

You can hedge the risk with a currency-hedged ETF, but hedging costs money. For a broad, long-horizon equity portfolio, hedging usually isn't worth it, because currency moves even out over time. In fixed income, where the return is low, currency hedging is easier to justify.

FX trading: a warning

You can trade currencies actively (forex), but it is highly leveraged, high-risk speculation, not investing. Most private forex traders lose money. For an ordinary investor, currency is something to be aware of and to diversify.

What moves exchange rates

A few fundamental factors steer the direction of an exchange rate:

• Interest rate differences: a currency with a higher interest rate attracts capital and usually strengthens.
• Inflation differences: a currency with faster inflation loses value over the long term.
• Current account and capital flows: a surplus supports a currency, a deficit weighs on it.
• Risk sentiment: in a crisis, money seeks out safe havens (the dollar, the franc) and risk currencies weaken.

In the short term sentiment dominates; in the long term, interest rate and inflation differences do.

Interest rate differentials and the carry trade

The interest rate differential gives rise to a classic strategy: the carry trade. You borrow in a low-interest currency and invest in a high-interest currency, keeping the difference in interest as your return. The strategy pays off in calm times but can collapse quickly when risk sentiment turns and the high-interest currency weakens sharply. An ordinary investor doesn't need to do carry trades, but the phenomenon explains why, for example, the weak yen and strong high-rate countries often move in opposite directions, and why the currency market can turn unexpectedly.

Hedged vs. unhedged ETF

The same index is often available in two versions. An unhedged ETF carries the full currency risk: both the investment and the currency affect your return. A hedged ETF removes the effect of currency moves using derivatives, so the return follows the investment in your home currency. Hedging brings stability but costs money (a hedging cost that depends on the interest rate differential), and it also removes the positive moves that a currency can bring. For most long-term equity investors, unhedged is a reasonable choice; hedged suits a shorter horizon or low-yielding fixed income.

The cost of currency hedging

Hedging isn't free. It's usually done with currency forwards, which lock in a future exchange rate. The cost is largely determined by the interest rate differential between the two currencies: if you hedge a higher-interest currency into your home currency, the hedge costs roughly the interest rate difference per year. That can eat up a large part of the return on a low-yielding bond investment. In practice, hedging pays off when currency swings are large relative to the expected return and the horizon is short. Otherwise the cost outweighs the benefit.

The euro as your home currency

For an investor in Finland, the euro is the home currency: the one your expenses and goals are in. That's why currency risk is always measured against the euro, not the dollar. The euro is the world's second most important currency and generally stable, which makes things easier: you aren't exposed to hyperinflation or to the collapse of an exotic currency. The currency mix of a global portfolio is set automatically by its holdings. A broad world index is mostly dollar exposure, because the US dominates. This is good to be aware of, even though it usually doesn't call for any action.

The dollar's special role

The US dollar is the world's reserve currency: a large share of international trade, loans and reserves is in dollars. This has two consequences for investors. First, a global equity portfolio is mostly dollar exposure, whether you like it or not. Second, the dollar acts as a safe haven: in crises it often strengthens as money flows into it, which can soften a euro investor's losses just when stocks are falling. Dollar moves are therefore part of a global portfolio's risk profile, not a separate matter.

Currency as part of the return: an example

An example makes the effect of currency concrete. Suppose the Japanese stock market rises +37% in local currency, but the yen weakens clearly against the euro over the same period. For an unhedged investor measuring in euros, the actual return ends up lower than the local index, because the weaker yen eats up part of the rise. The same applies in reverse: a strengthening foreign currency adds to the return in euros. That's why you should never read a foreign return figure without the currency. The local index and a euro investor's experience can differ a lot.

Currency and different asset classes

How much currency matters depends on the asset class. In stocks, currency is one factor among others and evens out over the long term, so hedging rarely pays off. In bonds, currency swings can be larger than the interest return itself, so a global bond ETF is often hedged to the euro. In gold and commodities, which are priced in dollars, a euro investor also carries dollar risk as part of the return. So the same “currency risk” means different things in different classes: its weight scales with the class's own return and volatility.

Forex speculation: why most people lose

You can trade currencies actively (forex), but it is speculation, not investing, and it doesn't suit an ordinary saver. The reasons are structural: forex uses heavy leverage (up to 1:30 for retail clients in the EU, and even more elsewhere), so a small move can wipe out your capital; the spread and costs eat into the return on every trade; and in the short term, rates are almost unpredictable. The statistics are unambiguous: the vast majority of private forex traders lose money. Currency belongs in a portfolio as a by-product of global diversification, not as a leveraged bet.

Common mistakes with currency

A few mistakes come up again and again: reading a foreign return figure without the currency (a rise in the local index isn't the same as a euro investor's return); buying expensive hedging for a long-term equity portfolio, where it only eats into the return; fearing currency swings so much that you skip global diversification; and mistaking forex trading for investing. The right attitude is aware but calm: understand how currency affects you, but don't let it steer a long-term portfolio.

How to approach currency: a checklist

Your approach to currency comes down to a few points:

• Yardstick: always measure your return in your home currency (the euro), not in the investment's currency.
• Stocks: keep them unhedged; currency evens out over the long term.
• Bonds: consider a euro-hedged version if the yield is low.
• Global exposure: be aware that a broad index is mostly dollars.
• Read the figures correctly: always take currency into account in foreign returns.
• Avoid forex: leveraged currency trading is speculation, not investing.

This way, currency is a managed part of your portfolio, not a source of fear or speculation.