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2008 was a year of realized risk among many asset classes. It followed a period of lower volatility in many asset classes, like foreign developed and emerging markets. The foreign developed market index, EAFE (Europe, Australasia, and Far East) is held by many US investors through the iShares ETF, EFA. The appeal of this kind of investment and asset class is its diversification benefits. However, the risks of the EAFE index encompasses currency risk that many investors fail to incorporate into their risk assumptions.

By comparing the MSCI EAFE USD Index and the EAFE Local Currency Index, currency risk can be shown through the differences. Below is a graph charting the 2008 growth of the two indexes. As seen below, during the first half of 2008, the EAFE USD index gave returns over EAFE Local Currency. This was due to the falling dollar relative to many of the currencies included within EAFE. As the credit crisis peaked in September, the dollar began to reverse and strengthened against foreign currencies, creating a lag for US investors holding EAFE.

The currency risk also shows up in the index’s risk. As seen below, the volatility of currency exchange rates to the dollar caused a performance difference. During 2008, a dollar invested in EAFE lost 5.36% more due to unfavorable currency exchange rates. There is also a risk premium that the currency exchange rate causes. During 2008 this risk premium was 3.79%

Disclosure: Author is long EFA

Source: Currency Risk in Foreign Developed Markets