What to Know Before Trading Foreign Equities
Before trading foreign equities denominated in a different currency, it’s important to understand that it’s not just the returns, but returns + the currency movement.
For example, if the USD has a higher nominal interest rate than the JPY, it will have implications for the forward curve of the USD/JPY currency pair.
We’ll give a breakdown of the impact.
- Currency Fluctuations:
- Foreign equities trading exposes traders/investors to currency risk, where exchange rate shifts can significantly impact overall investment returns.
- Hedging Options:
- Utilize currency derivatives like forward contracts to hedge against potential currency risks, safeguarding your international investment portfolio.
- Global Diversification:
- Despite currency risks, foreign equities offer global diversification, potentially enhancing returns and reducing portfolio volatility.
Interest Rate Parity
According to the theory of interest rate parity, when one currency has a higher nominal interest rate than another, it is expected to depreciate against the other currency in the forward market.
This is because investors will be attracted to the higher-yielding currency in the spot market, leading to an appreciation of that currency in the short term.
However, to prevent arbitrage opportunities, the forward rate will adjust so that the currency with the higher interest rate is expected (i.e., discounted to do so, not guaranteed) to depreciate in the future.
Forward Curve Implications
Given the interest rate parity, if the USD has a higher nominal interest rate than the JPY:
The forward rate for USD/JPY will be lower than the spot rate. This means that the forward curve will be downward sloping or “inverted.”
In other words, the forward price of the USD in terms of JPY will be lower than the current spot price.
Let’s say the current spot rate for USD/JPY is 110.
If the USD has a higher interest rate than the JPY, the forward rate for a contract maturing in one year might be set at 108, indicating that the USD is expected to depreciate against the JPY over that period to account for the rate differential.
If the forward rates do not reflect interest rate differentials, there could be arbitrage opportunities.
Traders could borrow in the currency with the lower interest rate, invest in the currency with the higher interest rate, and simultaneously enter into a forward contract to convert the investment back to the original currency at maturity.
This would lock in a risk-free profit.
However, there are generally reasons why the real-world value is different from the theoretical value, such as taxes, transaction costs, and liquidity considerations.
While interest rate differentials do have a significant role in determining forward rates, they’re not the only factor.
Other elements, such as market expectations about future exchange rate movements, risk premiums, and liquidity conditions, can also influence the forward curve.
If the USD has a higher nominal interest rate than the JPY, the forward curve for the USD/JPY currency pair will typically be downward sloping, indicating an expected depreciation of the USD relative to the JPY in the forward market.
This is relevant to trading foreign equities because the total return on foreign investments is affected not only by equity price movements but also by currency movements.
The fluctuation in the exchange rate can significantly impact the total return on investment.
For this reason, many traders will hedge this currency risk.
At the same time, some traders want this currency diversification in their portfolio to help diversify away from their own domestic currency.