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Ignore currency fluctuations at your financial peril

About the author

Andrea Murad is a freelance investing and careers writer based in New York City.

(iStockphoto)

(iStockphoto)

Americans typically do not trade currencies, also called foreign exchange, while in other countries, individual investors are well-versed in currencies, said chartered financial analyst Ron Rimkus, director of Economics & Alternative Investments at the CFA Institute in Charlottesville, Virginia. In Asia, for instance, people speculate on currency by trading against central bank activity, which requires a strong degree of risk tolerance and sophistication.

But whether they know it or not, American investors often carry plenty of hidden currency risk in their portfolios, such as through many popular mutual funds. Through shares in emerging market companies or US multinationals, like McDonald’s Corp or Apple Inc, American investors have more exposure to the dynamics of foreign economies than they realize.

“[Investors] get a lot of exposure to currency indirectly by buying equities and bonds,” said Richard Levich, professor of finance and international business at New York University’s Stern School of Business

In short, a weak currency helps its country’s stock market go up, but as the US Federal Reserve and other central banks begin to raise rates, there is a risk of market decline and changes in currency valuation. These could create the potential for individual investors to see more swings in their portfolios as multinationals deal with the ripple effect, which could include a stronger US dollar.

That, in turn could cause companies to earn less money on their overseas business, said certified public accountant Ted Sarenski, chief executive officer and president of Blue Ocean Strategic Capital in Syracuse, New York. Weak revenue almost always leads to stock price declines.

Consider the example of McDonald’s, which generates 65% of its income outside the US. Without protections against currency fluctuations, if the dollar is weak, every burger McDonald’s sells in euros generates more profit. On the flip side, if the dollar strengthens, each burger sold in euros would be worth less in dollars and the chain’s revenue — and earnings — would take a hit. In a recent corporate filing, McDonald’s said it expects its diluted earnings per share to move $0.25 if four of the five currencies from the US, United Kingdom, Australia, Eurozone or Canada move by 10% in the same direction.

If the earnings per share decreased, this would likely cause a decline in share price, hurting investors who own either the individual stock or a mutual fund that counts McDonald’s shares among its holdings.

A company like Apple, the maker of iPads and iPhones, exposes investors to currency fluctuation risks on two levels. The company does business overseas as well as produces products overseas. The real risk would be that the currency collapses in an area of the world where Apple and other firms like Google, Microsoft, Yum! Brands, Exxon Mobil and General Electric have substantial operations. Shares of these companies make up portions of many popular mutual funds and can sway stock indexes.

If there’s a gradual rise in interest rates, such a company would be able to readjust its business to lessen the impact, said Sarenski. If there’s a sudden rise in interest rates and the currency collapses because of inflation — a less likely scenario — any longer term hedge for such scenarios would likely not help and overseas sales would be severely devalued.

“People don’t think about the added level of risk from buying stock in a multinational corporation— there’s currency risk in each one of those,” said Sarenski. Indeed, companies comprising the Standard & Poor’s 500 index received 34% of their revenue from foreign sales in 2012, according to a Goldman Sachs report.

“As the US dollar goes down in value, there’s an effect to the value of those investments” in US multinationals, Sarenski said.

Investors can protect their portfolio against the stock market as a whole, and to some extent the currency risk inherent in owning shares in a multinational company, by diversifying into commodities and precious metals that traditionally move opposite the market, said Sarenski.

Some mutual funds also have mechanisms to hedge 10% to 15% of the investments — those strategies are outlined in their prospectus, but that doesn’t mean the fund managers are actually employing the hedge. A mutual fund may use options to hedge a long position of a stock without using any leverage. An investor can find out if a mutual fund is utilizing a hedging strategy by reading the fund prospectus.

Since about 2009, the start of the Great Recession in the US, currency rates have been fairly steady around the globe because the policies central banks around the world have been similar. But, increasingly, analysts and stock market watchers expect that to change.

Companies comprising the Standard & Poor’s 500 index received 34% of their revenue from foreign sales in 2012.