Help me understand U.S. dollar-denominated foreign securities.

I understand some reasons why one might want to invest in foreign instead of domestic securities- diversification, for one; and expectation of a weakening dollar, for another.

I also understand that if you buy the foreign securities in U.S. dollars, you’re in a sense avoiding exposing yourself to unpredictable fluctuations in the foreign currencies; some currencies are much more volatile than the U.S. dollar.

But if you have an expectation of a weakening dollar, does it still make sense to invest in U.S. dollar-denominated securities? Does the fact that the foreign company is presumably transacting the majority of its business in the foreign currency make this type of investment a hedge against a weakening dollar? And finally, are the theoretical implications different for equity instruments than for financial instruments such as bonds (debt)?

The best answers will explicitly exclude investment advice. I do not require investment advice. This is just about understanding — I want theoretical perspectives on the answers to this question.

The main issue is this: Your home currency is what you have to pay the rent and buy the groceries with and the price of rent and groceries does not change in line with the exchange rate.

I’m in Canada so my home currency is Canadian dollars. Let’s say I invested in US-dollar denominated stocks in January 2002, when the USD was worth $1.60 CAD (the Canadian dollar was weak and weakening and no-one was predicting a turnaround). Let’s say that the value of those stocks (in USD) went up 40% since then. Sounds great, right? But now the USD is worth only $1.10 CAD, so when it’s converted back to Canadian dollars, the value of my portfolio has actually gone down.

Now you might say that those Canadian dollars I’ve got now are worth more — but that’s only if I want to buy US dollars with them. If I go to the grocery store, I find that a dollar doesn’t buy me anything more than it did in 2002 — in fact, inflation has continued to eat away at the dollar’s ability to buy groceries.

When you invest using a foreign currency, you are betting not just on the stock but on the currency. You should make the decision about the currency the with the same type of information and understanding required for the stock. If you are just thinking of investing in foreign-denominated stocks because the dollar is weak, that’s like investing in a stock because it’s going up (that is, it has gone up).

Does that make sense?

posted by winston at 7:11 PM on September 3, 2006

Just to clarify, I was mainly addressing, But if you have an expectation of a weakening dollar, does it still make sense to invest in U.S. dollar-denominated securities?

posted by winston at 7:18 PM on September 3, 2006

See the Wiki entry on Eurodollars for a starting place on this.

I’m not a banker so won’t speak to the specific questions you’ve raised. I will however observe that securities listing requirements may be a factor in chosing the denomination of a security. Also there may be regulatory issues for potential purchasers — particularly pensions and insurance companies — which might make a USD instrument more attractive.

posted by dmt at 7:20 PM on September 3, 2006

But if you have an expectation of a weakening dollar, does it still make sense to invest in U.S. dollar-denominated securities?

Yes, if you are investing in an emerging market whose currency is unstable. Your question seems relatively simple. If you expect the dollar to weaken, of course you’d rather be denominated in a strengthening currency. BUT, who is the dollar weakening against? The euro, the pound, the canadian dollar? Maybe. what about the rupee, peso, or real? The dollar may be weakening against G8 currencies, but perhaps it’s strengthening compared to emerging markets (specifically the market you’ve decided to invest in). It’s more complicated than, Hey, the dollar is weakening across the board because very often, that is not the case at all. So you need to take into account the local currency (stable, unstable, strengthening compared to dollar, etc), your home currency, and the investment itself.

Does the fact that the foreign company is presumably transacting the majority of its business in the foreign currency make this type of investment a hedge against a weakening dollar?

Yes, if the business is transacting most of its business in a currency that is strengthening compared to the dollar. However, let’s say that you invested in a toy company in India that sells most of its products to Thailand and receives bahts in exchange. Let’s also say that the baht is weakening against the rupee. Your business is now losing money (unless it raises prices) because of the devalued baht. As another example, let’s assume that the Indian company you invested in does all its transactions in India and the rupee devalues when compared to the dollar (which is devaluing compared to the euro). Now, despite the devaluing dollar, because the rupee is also weaker, the return is smaller.

And finally, are the theoretical implications different for equity instruments than for financial instruments such as bonds (debt)?

This is a great question. I too am now curious about this.

Hmm… don’t know what happened. Let me try again:

You can buy foreign equities denominated in dollars in three ways: ADRs ; foreign ETFs such as EFA. and dollar-based foreign funds. The first two are not hedged against currency risk. Even though your investment is represented in dollars, it’s actually in foreign currency and moves up and down with changes in the exchange rate as well with as changes in the equity price. A mutual fund invest in foreign stocks might hedge away part or all of the currency risk, you’d have to read the prospectus to find out.

ADRs and foreign ETFs indeed are a hedge against a weakening dollar. An ETF gives you widespread diversification; an ADR permits you to pick an individual stock. But they both are investments where your dollars have been converted into another currency upon purchase. Just like a US stock they still expose you to equity risk. If you think the dollar will weaken but you want to be invested in equities, then a foreign ETF or some ADRs makes sense: If the dollar weakens and the foreign equity market goes up, you win twice. And vice versa of course: If the dollar strengthens and the foreign market drops, your loss in dollar terms is magnified.

As for bonds, foreign companies issue dollar bonds all the time. But as opposed to ADRs, those bonds really are denominated in dollars, so you get no currency hedge by buying one. Only if you were to buy, say, a Yen bond issued by, say, Sony then would you have a Yen hedge against the dollar and a Yen interest rate. But the question is theoretical because it’s almost impossible for retail investors to buy foreign bonds.

mono blanco, your answer never occurred to me. If I understand you correctly, even though the value of the investment is denominated in US dollars, the holdings are actually in foreign currencies and so their fluctuations reflect changes in the currency rate as well as changes in the value of the underlying security.

the question is theoretical because it’s almost impossible for retail investors to buy foreign bonds

Yes, but it’s not impossible to invest in a foreign bond fund. This question actually came about because I noticed that 91% of the instruments in that fund are U.S.-dollar denominated and I wasn’t certain how to interpret that in the context of my question. Do you have any opinion?

Further perspectives or information from anyone are certainly welcome.

posted by ikkyu2 at 11:42 PM on September 3, 2006

An structural difference between foreign bonds and foreign equity is that foreign corporate bonds tend to trade in relationship to the government bonds of their home country. The risk that your foreign corporate bond will fall in value due to problems with the foreign government, even if the issuer of the corporate bond is doing fine, is called sovereign risk.

For example, if you buy a Brazilian corporate bond and then the next day (God forbid) the Brazilian military were to stage a coup again Lula, chances are that Brazilian bonds would lose value, and your Brazilian corporate bond would lose value to the same or greater extent, whereas Brazilian stocks wouldn’t necessarily exhibit the same phenomenon. (Equities do have sovereign risk, as well, but it’s not as mechanical.)

posted by MattD at 5:37 AM on September 4, 2006

If I understand you correctly, even though the value of the investment is denominated in US dollars, the holdings are actually in foreign currencies and so their fluctuations reflect changes in the currency rate as well as changes in the value of the underlying security.

That’s correct. ADRs are simply certificates that trade in the US but represent actual foreign denominated shares that trade in another country. As such, the dividend on the underlying (foreign) shares is declared in the local currency and then converted into dollars. This means that for a given level of dividend you will gain as the dollar falls (i.e. one unit of foreign currency can buy more dollars, so the dividend will go up).

The price of the ADR itself will be affected in the same way. Imagine on day 1 that the ADR price is $100 and the share price is £100 and the USD/GBP rate is 1:1. If the dollar weakens on day 2, to 2:1, an arbitrage opportunity exists for a holder of the foreign shares to sell (for £100), convert the proceeds into dollars (£100 x 2 = $200) and then purchase ADRs representing 200 dollars of shares. The demand for ADRs would force the price up until things were level again. For this reason the ADR price adjusts ‘automatically’ to movements in the exchange rate.

On the other hand, dollar denominated bonds issed by foreign countries are, as MB said, actually US dollar obligations. This means that the coupon of 6.00% of the principal amount you hold (e.g. $1,000) will stay the same to you (constantly $60). The exchange rate effect will be internal to the company itself (falling dollar makes it easier for foreign company to pay coupon on dollar bonds) but you will see no change. The falling dollar may improve the creditworthiness of the issuer (because it’s cheaper for the company to buy dollars to py your coupon) but this is likely to be subsumed into the broader economic effects of dollar depreciation that affect the region or specific industry.

posted by patricio at 6:29 AM on September 4, 2006

I typed up a comment last night but didn’t get it posted before the site went down. MattD and patricio covered what I was going to say about ADRs, but I wanted to share my additional thoughts on the fixed income versus equity question:

It helps to remind yourself of the difference between permanent capital and debt capital. Equity is, by definition, permanent capital. The firm does not have to come up with cash to pay you back. Yes, it may pay dividends, but it doesn’t have to. And stock price has certain real time consequences, but usually not the kind of consequences that require cash payments. A firm that trades through ADRs will likely never receive US Dollars related to the sale of those securities—an intermediary handles the deposits and the underlying shares are probably purchased from the secondary market.

On the other hand, when raising debt capital a firm is obligated to make periodic cash payments and will also have to come up with the principal amount in cash at maturity. So when a firm issues a US Dollar demoninated bond, it will have to undertake foreign currency transactions on a regular basis. And will likely engage in hedging activity. In short, by raising debt capital in a foreign currency, a firm is signing up to interact in the foreign currency cash and derivative markets much more so than if they raised equity capital and thus exposing itself (and its investors) to more of this particular type of risk.

MattD’s comment about the price adjustments in equities securities being less mechanical is right-on.

posted by mullacc at 12:59 PM on September 4, 2006

Thanks to all who responded; your careful and thoughtful explanations were very helpful.

posted by ikkyu2 at 10:46 PM on September 4, 2006

You have to be careful when buying international mutual funds and read the prospectus carefully. Some international funds will buy currency hedges to neutralize currency risk. The hedge is essentially an insurance policy to prevent a change in value if the dollar rises or falls relative to the foreign currency. On the other hand, if you want to make a bet that the dollar will fall, then you want a fund that does not have a currency hedge. The foreign fund will then increase in value as the dollar falls. Conversely, if you guess wrong, the fund will lose value.

posted by JackFlash at 10:50 AM on September 5, 2006

ikkuyu2, I looked at the most recent holdings of the fund you lnked to above, and it’s overwhelmingly US Dollar denominated debt (click on your link, go to prospectus & reports, then to the Aug 29 semiannual report).

Even for institutional investors, buying local-currency bonds is difficult. In most emerging markets, companies simply don’t issue local-currency bonds. Why? Because the local debt market is dominated by the local banks, and because many countries are just simply too small to have a local bond market.

So what that Fidelity fund is selling is high-interest-rate dollar-based bonds. The interest rate is high because the default risk is high, but that risk is mitigated by diversification (the likelihood that all the issuers will default is small). Note that they say they may also invest in crappy companies in the US who have to pay exorbitant rates of interest to get anybody to buy their bonds. Well, they don’t phrase it exactly that way, but almost (lower quality debt securities of U.S. issuers). Note that they give themselves the latitude to buy equities as well. It pays to read the prospectus.

But, basically, it’s a dollar based emerging markets bond fund. The real risk with such a fund isn’t that you lose all your money, but that a couple of defaults in the portfolio reduce the average interest rate to zilch or even negative.

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