Quizmaster, Doug Hutchinson, has come up with another great quiz. This time he tests our knowledge of how currency risk can impact an investment.Good luck!
Consider this scenario:
Your friend Katrina bought $10,000 of an Exchange Traded Fund (ETF) that tracks the performance of an index of Japanese equities.
After holding the ETF for one year, Katrina noticed that the Japanese equity Index was up 5% over her one year holding period. She was very surprised to learn that the market value of her ETF was below her $10,000 purchase price even though the index that the ETF tracks was up 5% over the same time period.
What factor did Katrina fail to consider? (For the purpose of this example ignore transaction costs, the expense ratio of the ETF, and any periodic dividend or capital gains distributions from the ETF.)
Answer:
Katrina's ETF position is exposed to currency risk. An unhedged ETF that invests in foreign securities will typically own shares in the foreign currency, however Katrina purchased the ETF in US dollars. Katrina is exposed to movements in the foreign exchange rate between the currency that the ETF is listed in (US Dollars) and the currency in which the ETF's assets are held (Japanese Yen).
The value of the ETF is determined by the value of the underlying stocks and the value of the currency. This means that the underlying stocks can rise in value but the value of an investment as a whole can fall due to changes in the value of the currency.
In this particular scenario, the negative return of the currency more than offset the 5% return of the Japanese equities, which caused the market value of her $10,000 investment to decline after a year.
Next time, Katrina will seek to understand all of the relevant risks of a strategy before making a decision to purchase that investment.
Check out another quiz from Doug's Quiz Corner!
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This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
