Why local returns cannot be realized
When you invest in a foreign market, next to the exposure to the local market you will also get an exposure to the foreign currency. In other words, your return will also be impacted by the movement of exchange rates.
Let’s illustrate this with a very simple example. Assume that you, as an European investor, buy $100 dollar worth of IBM stocks. Furthermore we assume that the Euro – US dollar exchange rate is 1. Your initial investment will be the € 100 you spend on buying the stocks. One year later, the IBM stocks are worth $ 110 and the exchange rate increased to 1,1, meaning that every US dollar is worth € 1,10. Your initial investment is now worth € 121, a financial gain of € 21.
When we try to decompose the gain of €21, €10 is a result of the local market movement of the IBM stock which increased by 10%. If the $100 was not invested, then it would have been worth €110 at the end of the year. Therefore another €10 is due to the change in the euro – dollar exchange rate. So the increase of €20 is explained by the movement of the local market and the currency. However, the total financial gain is €21, so where does the remaining €1 comes from? This increase is due to the cross-over between the local return and the currency return and is called the interaction. The local gain of $10 was worth €10 at the start of the period, but worth €11 at the end of the period due to the change in exchange rate.
The base return therefore consists of three components; the local return due to local market movements, the currency return due to changes in the exchange rates and the interaction between them.
If you would like to receive the local return, you can try to remove the currency component by managing this dimension. Managing the currency dimension is very common for multi-currency portfolios. The reason for this is probably that left unmanaged, currency exposures receive little or no risk premium while it does add to portfolio volatility (according to modern finance theory). The typical way to manage the currency dimension is with currency forwards. Those contracts have the sole purpose to hedge the currency dimension of the portfolio, and therefore the return of the portfolio including those currency contracts is called the hedged base return.
Now let’s assume that we would like to only have a result from the local market, so we do not want to have any currency risk. We would then enter into a currency forward which allows us to exchange $100 (the notional amount) for a pre-defined exchange rate in one year time. This pre-defined exchange rate is also called the forward rate. Most likely the 1-year forward rate is not equal to the exchange rate since it also considers expectations in the market. For our example let’s assume the forward rate is 1,05. The market expects the exchange rate to go up to 1.05 during the year. The forward contract that you entered means that in one year time you have to pay $100 to receive €105. At the end of the year, when the contract expires, the exchange rate is 1.1 which means that you have to pay €110 to get the $100 that you need to fulfil your obligation (pay $100 to receive €105). Instead of actually transferring the notional amounts, it is common to only settle the difference. In this case you have to pay €5 (the difference between the €110 that you have to pay for the $100 in the market at the end of the year and the €105 that you receive from the forward contract).
Currency return can be split up in an expected and an unexpected part
The €5 that you have to pay is not equal to the financial gain due to currency movement, which was €10. This difference is because a part of the currency movement is expected and therefore this is not included in the hedge. The currency movement can be split up into an expected currency movement (which is equal to the forward rate at the start of the year) and an unexpected currency movement. The hedge only removes the unexpected currency movement. Another way to look at it is that an insurance premium has to be paid equal to the difference between the forward rate and the exchange rate at the start of the contract to remove the currency risk.
So why is the realization of a local return not possible?
To conclude, even if the currency dimension is managed, a foreign investor will not be able to receive the local return. Next to the local return, two other gain components will remain:
- Interaction gain due to the interaction between the local and currency return.
- Expected currency gain which is equal to the difference between the forward rate and the exchange rate at the start of the year.
Does this means that it is impossible to get the local return? The answer to that question is no. With the use of a derivative on the IBM stock you can get the local return, or at least come much closer. This however, will be the topic of another insight.