If you’re lucky enough to be heading off to sunnier climes this summer, you’ll naturally be swapping pounds and pence for foreign currency. But, while it’s not always clear, volatile currency markets can have a significant effect on your investment portfolio. Here’s why.

While not always obvious, changing foreign exchange rates can have significant implications for investment performance. It might be the impact on company profits of doing business globally, or on dividends when converting dollar or euro-denominated payouts back to sterling.The effect is best explained using this simple example:

In round numbers, sterling is currently at $1.28 against the US dollar, so £10,000 would buy $12,800 (10,000 x 1.28).

Imagine that in a year’s time the dollar has strengthened so that £1 only buys $1.10. In converting your dollars back into a weaker pound, your $12,800 is now worth approximately £11,640 (12,800 ÷ 1.10), a profit of £1,640.

So far, so simple.

Let’s say the $12,800 had been used to buy an American stock ABC Inc at $100 per share. After a year the share price hasn’t moved, so the investor decides to sell their 128 shares. In converting back to sterling, the same profit of £1,640 is realised - because, as above, the dollar buys more pounds this time - even though the share price has been flat.

Indeed, if the price had moved up by 10% to $11, the investor would realise 128 x $11 ($14,080), a sterling equivalent of £12,800 representing a profit of £2,800 on the original £10,000 investment, made up of both the share price appreciation and the favourable move between the pound and the dollar.

Welcome to the world of currency risk and your investments.

The effect of currency can be negative as well as positive - certainly if sterling had strengthened against the dollar in the period used in the example above.

However, even if your portfolio only consists of UK shares purchased in sterling, there’s also the possibility of indirect exposure to currency risk.

In the FTSE 100 index, for example, it’s estimated that around 70% of company earnings are generated overseas, and most of that figure from the US.

As such, profits made abroad would - as in our first example above when the dollar strengthened against the pound - be more valuable when translated back into sterling. This helps explain the slightly counterintuitive fact that if sterling strengthens against the dollar, and all things being equal, there will be a negative impact on the FTSE 100.

By sector, companies with the heaviest exposure to the US tend to be the oils, miners and pharmaceuticals. Businesses with most income derived from Asia will also be impacted, alongside other companies with a strong exposure to the region.

Remember too that the impact of currency is also seen on dividends. Many of the more generous UK-listed companies pay dividends in US dollars, while some, pay their dividends in euros.

The same principles of sterling conversion apply here, of course, again subject to the performance of the pound against the relative currency. A recent report from Link Group estimated that the strength of the US dollar in 2022 added £6 billion to dividends paid by UK companies given currency effects.

In a global investment landscape, currency exposure is almost unavoidable, be that directly or indirectly.

interactive investor (ii) is part of abrdn. ii is the UK’s leading flat fee investing platform for individual investors.

The information in this article should not be regarded as financial advice. Information is based on interactive investor’s understanding in August 2023. The value of your investments can go down as well as up and you may get back less than you paid in.