What does currency do to a foreign holding?
Buy a foreign asset and you have made two bets, whether or not you noticed the second one. The first is on the asset. The second is on the exchange rate. They combine multiplicatively, and the second one can easily dominate the first.
The arithmetic
Your total return in home-currency terms is:
(1 + local return) × (1 + currency move) − 1
where the currency move is the change in the value of the foreign currency against your own.
Case 1 — the currency works against you. A foreign equity index returns +10% in its local currency. Meanwhile your home currency strengthens 8% against that currency, so each unit of foreign money now converts into 1 ÷ 1.08 ≈ 0.926 of what it did.
Home-currency return = 1.10 × 0.926 − 1 ≈ +1.9%.
A 10% gain arrived as under 2%. The currency ate eight points.
Case 2 — the currency works for you. Same +10% local return, but your home currency weakens 8% against the foreign one:
Home-currency return = 1.10 × 1.08 − 1 ≈ +18.8%.
Same asset, same year, same local performance — outcomes 17 percentage points apart, decided entirely by the exchange rate.
Why currency matters far more for bonds than for equities
Compare typical annual volatilities, roughly:
- Developed-market equities: ~15%
- Major-pair currencies: ~8–10%
- Developed-market government bonds: ~4–6%
For an equity holding, currency volatility is meaningful but smaller than the asset's own. For a bond holding, currency volatility is larger than the asset's own volatility — an unhedged foreign bond position is, in variance terms, mostly a currency position with a bond attached.
This is why a widely used industry convention hedges foreign bonds back to the home currency and often leaves foreign equities unhedged. Note carefully what that is: a convention with a stated rationale, not a rule and not a recommendation. Plenty of serious investors do it differently, with reasons.
What hedging costs
Currency hedging is not free, and its price is not arbitrary. Over a hedge's life the cost is approximately the short-term interest-rate differential between the two currencies — the forward market prices this in, and it is not optional.
If home short rates are 2% and foreign short rates are 5%, hedging that foreign exposure back to your currency costs roughly 3% per year. If the differential runs the other way, hedging pays you roughly 3% per year. The same hedge can be an expense or a source of carry depending purely on which two currencies are involved and when.
The long-run wrinkle
Over very long horizons, purchasing-power-parity effects mean currency moves have historically contributed relatively little to the average return of a diversified foreign equity holding — they wash out slowly. Over one-year, five-year and even ten-year windows, they have contributed a great deal to the path, and the path is what an investor actually experiences and reacts to. Both statements are true simultaneously, and choosing which one to emphasise is exactly where the hedging debate lives.
In the data
A price is quoted in the currency of the market it trades on, and that currency is worth checking rather than assuming. The same company in London and in New York, with the rate between them:
London quotes most shares in pence, not pounds, so a portfolio that reads the first line as pounds is wrong by a factor of a hundred before any exchange rate is applied. Check the link yourself: ten London shares, converted from pence to pounds and then to dollars at the third line, land close to the price of one New York receipt. What is left over is the two markets closing at different hours.
Try it now
- The same developed-ex-US exposure twice below, five years each: unhedged for a dollar investor, then currency-hedged. The gap between them is the currency effect net of what the hedge cost — which, per the section above, is roughly the short-rate differential — so read the gap as those two together, not as the exchange rate alone.
- Pick the single calendar year in which the two diverged most and compute the difference in percentage points.
- Apply the two-bet formula yourself: assume a +10% local return and a 5% move in each direction, and compute both home-currency outcomes. Note the spread as a fact about arithmetic, not a view on any currency.