By John W. Schoen Senior Producer
msnbc.com

After this column was originally published, a reader correctly pointed out that, as of late November 2004, the Colombian peso was strengthening against the dollar, thank you very much. It turns out the Web site we originally consulted to research the answer gave us a faulty quote.

Q: How will a weakening dollar affect investments overseas, particularly international bond funds? — Corinne R., Mansfield Center, Conn.

A: Gauging the impact of the global currency markets on your investments is a little like talking about the impact of the weather on your backyard barbeque. If everything lines up right (wind, humidity, temperature, rain, etc.) you won’t notice it. But when any one of these forces of nature turn bad, the impact is pretty hard to ignore.

The value of the dollar is intertwined with a host of other financial forces that include interest rates, inflation, economic outlook, investor psychology, and the myriad of business conditions that surround a specific investment. So it helps to divide this answer up into direct and indirect impacts.

The direct impact of the falling dollar is easiest to see: in general, it boosts the value of any investment denominated in a strengthening foreign currency. Even if the value of that foreign stock or bond stays flat in terms of the local currency, you’ll make money (by holding it while that local currency strengthens against the dollar) when you sell it and convert the proceeds back into dollars. That’s one reason many financial advisors recommend putting some of your investments in foreign stocks or bonds.

Keep in mind that, while the dollar usually moves the same way against other countries currencies, that’s not always the case. When you hear it reported that “the dollar is falling,” that’s usually short-hand for a comparison with the euro and the Japanese yen. (Right now, for example, the value of the dollar is doing just fine against the Colombian peso and the Sri Lankan rupee).

So it also matters where you invest and just what currency is being used to denominate your investment.

A falling dollar can also have a variety of “indirect” impacts because it affects all those other financial forces working on your investment. Here are a few to consider:

A weaker dollar, over time, tends to push up interest rates in the U.S. That’s because foreign investors who hold U.S. bonds as the dollar falls lose money when they convert those dollars back into their home currency. So Uncle Sam has to pay those foreign investors higher interest rates (along with everyone else) to keep them coming back to the Treasury debt auctions. (And with U.S. budget deficits ballooning, the Treasury is in no position to haggle these days.) That puts pressure on other countries to raise their rates — and higher rates usually lowers the value of bonds that have already been issued.

The falling dollar also hurts some companies in countries with rising currencies. The people who make Volkswagens, for example, get paid in euros; the sticker price on the cars shipped to American is based on the cost of making the car, plus a profit. Now, if the dollar falls, Volkswagen gets less money when it converts those dollars back into euros. Only one of two things can happen: either the company makes do with less profit (it could also cuts wages, but that’s not likely) or it raises the sticker price in the U.S. That’s good news for General Motors and Ford, because their cars are now “cheaper” by comparison.

Those American car makers could also take advantage of the situation by raising their sticker prices too, and pocketing the difference as profit. If that keeps up, and other U.S. companies raise prices too, you could see U.S. inflation pick up. (There’s another potential indirect impact of the falling dollar.)

All of this gets a bit more complicated when you talk about mutual funds. Since you’re not holding direct investments, a lot depends on individual style and goals of the fund manager. Remember too that while bonds tend to be safer than stocks, bond funds can be more volatile that holding bonds outright. That’s because the fund manager is buying and selling bonds in the portfolio, so your return depends heavily on the skill of that manager.

In the case of mutual funds that invest in foreign stocks and bonds, one big question is whether or not the fund is “hedged” against currency risk. Some fund managers try to shelter their bets from the changes in value of one currency with respect to another. (They do this by buying and selling contracts in the currency futures markets — a topic for another day.)

If the fund is fully hedged, you won’t get same lift from a falling dollar as you would from an unhedged fund. Some funds are fully hedged, some not at all, some hedge from time to time based on what’s happening in the currency markets. The only way you can find out is by asking the broker who sold you the fund, or by reaching the fund on Web sites that provide detailed fund descriptions. Or, you can always curl up with a little reading material most fund investors toss in the garbage: the fund prospectus.

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