EAFE’s 2008 Currency Risk

2008 was a year of realized risk among many asset classes. It followed a period of lower volatility in many asset classes like foreign 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 assumptions.

By looking at MSCI EAFE USD Index and the EAFE Local Currency Index currency risk can be shown through the differences. 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 increases standard deviation. As seen below, the volatility of currency exchange rates to the dollar caused a currency difference. During 2008, The USD 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%.