A European stock can gain 10% in euros over a year and still hand an American investor a loss. Nothing went wrong with the company. The euro simply fell against the dollar by more than the stock rose. That is currency risk, and it applies whether you own the share in Paris, an ADR in New York, or an international fund. Understanding the arithmetic will not tell you where exchange rates are headed, but it will keep you from misreading your own results.
Two returns in one
When you own a foreign stock, your return in dollars comes from two sources: the change in the stock's price in its home currency, and the change in that currency's value against the dollar. The two compound together. The formula is simple:
Dollar return = (1 + local return) × (1 + currency return) − 1
The currency return here is the change in how many dollars one unit of foreign currency buys. If the yen goes from buying 0.0070 dollars to 0.0063 dollars, the yen has fallen 10% against the dollar. The SEC's international investing guide makes the same point in plain terms: exchange-rate changes can raise or lower what you earn when foreign gains and dividends are converted back.
ADR prices embed the exchange rate
Many investors assume a dollar-traded ADR shields them from currency swings. It does not. An ADR represents a fixed number of underlying shares held by a depositary bank, and arbitrage keeps its price close to the home-market price multiplied by the exchange rate and the ADR ratio. If the price drifts too far, traders buy the cheaper version and sell the dearer one until the gap closes.
So an ADR's dollar price moves when the home share moves, when the currency moves, or both. For the mechanics of ratios and conversion, see ADR ratios and pricing, and run your own numbers with the ADR Price Converter.
A worked example
Worked example
A German company's shares trade at €50.00 on Xetra. The euro is worth $1.10, and one ADR equals one share. Fair value for the ADR is €50.00 × 1.10 = $55.00.
A year later the share has risen 10% to €55.00. Meanwhile the euro has fallen to $0.98, down about 10.9%.
New ADR value: €55.00 × 0.98 = $53.90. Your dollar return: $53.90 ÷ $55.00 − 1 = −2.0%.
Check with the formula: 1.10 × (0.98 ÷ 1.10) − 1 = 1.10 × 0.8909 − 1 = −2.0%.
Reverse the currency move, with the euro rising to $1.22, and the same 10% local gain becomes about a 22% dollar gain.
Currency effects can dominate in short periods. Over longer periods they may partly offset, but there is no guarantee of that, and some currencies have weakened against the dollar for decades.
Dividends and conversion timing
Dividends carry their own currency exposure. A company declares a dividend in its home currency. For an ADR, the depositary bank receives the payment, converts it to dollars around the payment date, and distributes it net of any foreign withholding tax and per-ADR fees. The SEC's ADR bulletin notes that depositaries may charge for currency conversion as one of their services.
The practical effect: a dividend that is unchanged in pounds or yen can arrive as a smaller or larger dollar amount than last year. If you track income closely, record the local-currency dividend separately from the dollar amount received. Our page on ADR dividends and currency covers payment schedules, and foreign dividend withholding explains the tax taken before conversion.
Key point
Withholding tax is calculated on the gross dividend in local currency. The currency move then applies to whatever is left. Both reduce, or sometimes raise, what lands in your account.
Hedged vs. unhedged funds
Most international index funds and ETFs are unhedged: you get the local market return plus the currency return, just as in the example above. Currency-hedged versions use forward contracts to offset changes in the exchange rate, aiming to deliver something close to the local-currency return.
Hedging is not free and not perfect:
- Cost of carry. The cost or benefit of rolling forward contracts depends largely on the gap between U.S. interest rates and the foreign currency's interest rates. When U.S. rates are higher, hedging some currencies can add to return; when lower, it subtracts.
- Imperfect coverage. Funds typically reset hedges on a schedule, often monthly. Between resets, part of the position can drift unhedged as prices move.
- Lost upside. If the foreign currency strengthens, the hedge gives back the gain you would have had.
- Expense ratio. Hedged share classes often carry somewhat higher fees than the unhedged version; check the prospectus.
Individual ADR holders rarely hedge directly. Some investors treat currency exposure as part of the diversification they wanted from foreign stocks in the first place. For a fuller comparison of fund structures, see ADRs vs. international ETFs.
Practical habits
- When you review a foreign holding, look at both the local-currency price chart and the dollar chart. The gap between them is the currency effect.
- Remember that the company itself has currency exposure. An exporter that earns dollars but reports in yen can benefit when the yen weakens, partly cushioning the hit to a U.S. holder.
- Know the currency of your costs. Fees charged by a foreign broker or a direct-access account may be in local currency.
- Read country pages such as Japan or Switzerland for currency background specific to each market.
See how a currency move changes an ADR's fair value with the ADR Price Converter.
Common questions
Does buying an ADR in dollars remove currency risk?
No. An ADR trades in dollars, but its price tracks the home-market share price converted at the current exchange rate. If the foreign currency falls against the dollar, the ADR price falls with it even if the home-market price is unchanged.
Should I buy a currency-hedged fund?
Hedging reduces the effect of exchange-rate swings on returns, but it costs something and gives up gains when the foreign currency strengthens. Whether it fits depends on your time horizon and why you hold foreign stocks; there is no universally right answer.
When is a foreign dividend converted to dollars?
For ADRs, the depositary bank converts the dividend at or around the payment date and passes along dollars, typically net of foreign withholding tax and any per-share fees. The dollar amount you receive therefore depends on the exchange rate at that time, not when the dividend was declared.
Sources
Educational content only, not investment, tax or legal advice. The Stateside Report does not recommend buying or selling any security. Tax rules depend on your situation; confirm with a qualified tax professional. Full disclosures.