Question

Explain how exchange rate fluctuations affect the return from a foreign market measured in dollar terms. Discuss the empirical evidence on the effect of exchange rate uncertainty on the risk of foreign investment

Answer 1

Answer:

Exchange rate Fluctuation of one currency (say, dollar) is influenced by various factors such as, Political Stability, supply and demand of currency, inflation rate of country, interest rate etc.

If U.S. $ appreciate against Foreign currency like Pound, Euro, Yen etc. then,

• investment denominated in U.S. $ will give higher return then expected due to appreciation of $ and
• investment denominated in foreign currency will give lower return then expected due to appreciation of $.

So, Apart from other risks, the foreign exchange fluctuation risk always exist whenever the investment was held in foreign currency.

If the value of investment is very material then, Investor may also go for hedging strategy to protect value of investment from Currency risk.

While Appreciation of U.S. $, " non-hedged " investment (held in $) gives higher return and vice-versa.

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