Currency risk: how exchange rates change your return

Basics8 min read · updated 5 October 2026 · 4 sources

If you are a US investor buying European, Japanese or emerging market equities, you carry currency risk: the value of the investment in dollars depends not only on the share prices but also on the exchange rate. A strong dollar can wipe out a good year on a foreign stock market, while a weak one can double it. This article shows how the calculation works, which currency really matters and when hedging pays off.

How the exchange rate affects the return

The return in dollars is made up of two parts: the return of the investment in its own currency and the change in the exchange rate. The two are multiplied, not simply added.

Exchange rates fluctuate a lot. For equities, this matters less, because the equities themselves fluctuate even more and the two effects partly offset each other. Bonds are a different story: a government bond in euros or yen fluctuates little in its own currency, but the exchange rate fluctuates a lot. For US investors, a calm bond thus turns into a volatile currency bet.

Which currency really matters

A common misconception concerns the fund currency. An international equity ETF listed in the US is denominated and traded in dollars, yet that does not make it a dollar investment. Neither the fund currency nor the trading currency determines the currency risk. What matters are the currencies of the securities in the fund. A global ETF holds stocks in dollars, yen, pounds, euros and other currencies, regardless of the currency in which the fund price is quoted.

According to MSCI World Factsheet (2026), the US weight in the MSCI World was 72.94% at the end of September 2026, and Japan's 5.91%. For a US investor, a global ETF is therefore a dollar investment for only around three quarters of its value; the rest carries foreign currency risk, even though the ETF is bought in dollars and its price is displayed in dollars. Likewise, an ETF on European equities moves with the euro and the other European currencies, whatever currency its price is quoted in.

Rule of thumb: a fund's currency risk follows the countries it invests in, not the currency on the factsheet.

Hedging and what it costs

Currency-hedged ETFs and share classes (usually labeled “hedged” or “USD hedged”) hedge the exchange rate continuously with currency forwards, usually rolled monthly. The investor then receives roughly the return in the foreign currency plus the interest rate differential between the dollar and the foreign currency. If the foreign interest rate is above the dollar rate, hedging costs this differential; if it is below, hedging earns a little. On top of this comes the higher expense ratio of the hedged version.

Whether hedging “costs” anything in expectation is disputed. According to a widely held view, a currency's higher interest rate offsets its expected depreciation; in that case, hedging would be free on average. In practice, this equation often fails to hold over short periods, but tends to hold better over long ones.

For advanced readers: why hedging costs the interest rate differential

A currency forward fixes today the exchange rate for a later date. Banks set this forward rate so that there is no risk-free profit opportunity (covered interest parity): anyone who exchanges dollars for a foreign currency today, invests the money at the foreign rate and locks in the conversion back with a forward must not earn more than with an investment at the dollar rate.

Example: one dollar costs 1.10 units of a foreign currency today, the foreign rate is 4% and the dollar rate 2%. The one-year forward rate is then 1.10 × 1.04 / 1.02 = 1.1216 units per dollar. If you hedge your foreign investment, you will therefore convert back in a year at a rate around 2% worse for you. That is exactly the interest rate differential. If the dollar rate is above the foreign rate, the sign reverses and hedging produces a small gain.

What the research shows

Perold and Schulman (1988) argued that hedging foreign currencies is a “free lunch”: it lowers the risk of an international portfolio without reducing the expected return, because currencies earn no return of their own in the long run. This view shaped the practice of many pension funds for a long time.

Froot (1993) disagreed for long horizons: the ability of hedges to reduce fluctuation holds over short periods, but not over several years. Over long horizons, full hedging did not reduce fluctuation, and for many portfolios it even increased it. One reason: in the long run, exchange rates tend to offset differences in price levels.

Campbell et al. (2010) showed that currencies behave very differently in crises. From 1975 to 2005, the US dollar, the euro and the Swiss franc moved against global equity markets: they tended to gain when equities fell. For equity investors who want to minimize risk, such currencies are therefore attractive, even if they earn little on average. For pure bond portfolios, by contrast, they arrived at almost full hedging.

When hedging pays off

Many investors opt for a simple approach: global equities unhedged, and the safe portion in Treasury bonds or a high-yield savings account. That puts the currency risk where it does the least harm, and the safe portion stays genuinely safe. More on the country allocation in the world portfolio, and on the role of the safe portion in the 60/40 portfolio.

Emerging markets and smaller currencies

With emerging markets, the currency risk is often larger and hedging is more expensive, because interest rates there are usually higher than in the US. Hedged emerging market equity ETFs are therefore rare. For emerging market bonds, a distinction is made between bonds in dollars (hard currency), which carry no exchange rate risk for US investors, and bonds in local currency, where the currency is a significant part of the expected return and of the risk.

Limits and misconceptions

• “A dollar ETF has no currency risk.” Wrong if it holds non-US equities. Only the securities count.
• “Hedging is free.” It costs the interest rate differential and usually slightly higher fees; whether that is a loss in expectation is an open question.
• “Hedging makes equities safe.” It only removes the exchange rate risk; the price risk of the equities remains in full.
• “Short-term exchange rate forecasts help.” Exchange rates are barely predictable in the short term; hedging by gut feeling is market timing with currencies.

How Portfolio Lab calculates it

Portfolio Lab converts every price series into the chosen currency, US dollars by default, using daily exchange rates. A European index fund in euros therefore shows in the Backtest the return a US investor would actually have experienced, including the exchange rate. Currency-hedged share classes are separate securities with their own price series and can be compared directly with the unhedged version. The backtest methodology describes exactly how the conversion works.

This article explains a method; it is not investment or tax advice. Worked examples are simplified and rounded. All terms in the glossary.