Introduction

Market participants and investors are accustomed to finding risk factors about exchange rates when the underlying asset is a non-U.S. index, or a U.S. ETF that tracks non-U.S. stocks.  However, the nature of the risks can differ, depending upon the nature of the underlier.  Accordingly, some care is advisable in adapting risk factors from one offering document to another.  In this article, we will describe in more detail these differences.

Index with Stock Prices Converted into Dollars

Some non-U.S. indices incorporate a mechanism that converts the non-U.S. prices into U.S. dollars, often on each trading day.  As a result, the index itself creates exchange-rate risk for the investor.  If the U.S. dollar increases in value against the relevant non-U.S. currencies, the non-U.S. currencies are exchangeable for fewer U.S. dollars.  As a result, the level   of the index, and therefore the return on notes that track the index, will be lower than it would have been had the deemed currency conversion not taken place.

A similar circumstance exists when the index itself does not have a mechanism to convert the index level to dollars, but instead, under the terms of the notes, the calculation agent adjusts the final index level to reflect the relevant exchange rate.  For example, the EURO STOXX 50 Index may be calculated in euros, but the terms of the note may require the initial index level and the final index level to be converted into dollars, based upon the then current U.S. dollar/euro exchange rate.  For these types of notes, investors face a similar type of currency risk.  If the U.S. dollar appreciates against the relevant non-U.S. currency between the pricing date and the valuation date, the converted index level will be lower, as fewer U.S. dollars may be purchased by each unit of the relevant non-U.S. currency.

Index Without Prices Converted into Dollars

Some non-U.S. indices do not have the type of currency conversion feature described in the preceding section. In the case of an index of this kind, the investor faces the risk that it will miss out on the benefit that would have occurred if the relevant non-U.S. currencies had appreciated against the U.S. dollar.  For example, if an investor had actually purchased the non-U.S. stocks, and later sold them, converting the proceeds back into U.S. dollars, he or she would have realized a benefit by receiving additional U.S. dollars at the time of sale.  In this sense, by investing in the index-linked notes, as opposed to investing in the actual underlying stocks, the investor loses the opportunity to participate in any appreciation of the non-U.S. currency.

ETFs That Invest in Non-U.S. Stocks

An ETF may purchase non-U.S. stocks that are denominated in currencies other than the U.S. dollar. When the ETF’s net asset value is calculated, the price of the stocks held by the ETF will typically be adjusted to reflect their U.S. dollar value by converting their price from the non-U.S. dollar currency to U.S. dollars. As a result, if the value of the U.S. dollar strengthens against the relevant non-U.S. dollar currency, the price of the ETF may decrease even if the market price of the relevant stock increases in its own currency.

A Few General Risks Relating to Currencies

As to any non-U.S. index or ETF, currency exchange rate changes may have a variety of different effects, which may not necessarily be quantifiable or predicted.  For example, if a non-U.S. currency appreciates in value against the dollar, the relevant country’s exports may be adversely affected, as they become more expensive for outsiders to purchase.  Of course, this could reduce the level of any non-U.S. index.  However, this result isn’t guaranteed. A more valuable currency can increase consumption levels in a particular country, which may increase the values of the relevant index. These types of general risks are often addressed in a “generic” risk factor relating to the effects of investing in non-U.S. indices or ETFs.

Currency Risks Unique to a Particular Index or ETF

Some indices and ETFs may have their own unique currency risks.  For example, the index or ETF may involve a   currency hedging strategy, in addition to tracking the relevant non-U.S. stocks. Other indices may invest in stocks that, by their nature (or design), may have additional exposure to currency risks, such as financial institutions and export-oriented companies. In each of these cases, the offering documents may need to be carefully reviewed to ensure that the applicable risks are appropriately described.