At any given time, national currencies
move relative to one another. For most citizens of a country, this impact is
usually only felt during international travel, when $10 may only be enough to
buy a cup of coffee in one country but a steak at a five-star hotel in
another. Investors, however, often feel the impact of currency fluctuations far
more - with commodities, equities and foreign exchange markets all being
subject to huge gains or losses based on these daily movements. What causes
these seemingly random ratio changes, and how can investors profit from
understanding them? Supply and demand define one currency’s value in comparison
to another.
There are
currently two kinds of national currencies - fixed and floating rate. The fixed
exchange rate is based upon gold or another fixed rate currency within the
country, and does not fluctuate naturally in relation to other nations. The
United States used this system until 1973, when rising inflation forced the
nation to float its currency due to the irreconcilable disparity of the U.S.
dollar to other currencies. China, which still uses a semi-fixed rate currency
pegged to the U.S. dollar, is now facing intensifying pressure from the United
States to float its currency, due to the perception that the Chinese yuan is
actually stronger than it appears. The United States believes that China
intentionally keeps its currency weak to keep foreign companies invested in
cheap Chinese labor. However, the same fears of inflation and rising interest
rates that plagued America in the 1970s may soon force China to float its
currency. A similar predicament faces the Euro, which uses a fixed exchange
rate pegged to the local currencies of the member countries of the European
Union. If a nation attempts to maintain a fixed rate system, it runs the risk
of deflation, which causes decreasing exports and can only be rectified with
tax increases or higher interest rates. These in turn can lead to political
instability and high unemployment rates.
Political
stability is the first key factor which impacts demand. If a country is in the
midst of a civil war, then its currency will become devalued, due to a large
supply with no global demand. After all, who would want to buy currency which
may become worthless in the near future? If there is political uncertainty
across the world, then investors will exchange speculative currencies for a
“safe haven” currency, such as the United States dollar, which is well
protected from political turmoil. In this case, strong demand and a limited
supply will increase the value of the U.S. dollar in international
markets.
Economic
stability is another factor which affects demand. During the 2008-2009
financial crisis, the U.S. dollar, a safe haven currency, was no longer safe,
and investors exchanged their U.S. dollar for British pounds and Euros. As a
result, the U.S. dollar plunged relative to those currencies. In 2010, when European economies began to
fail, the U.S. dollar rose again as the pound and Euro fell. Foreign investors
divesting from a country’s companies due to the perceived weakness of the
national economy can also sink a currency. Investors are another major factor
impacting currency prices. Professional investors in the foreign exchange
(Forex) markets move currencies in volumes as high as stock markets. Unlike
high-frequency stock market trading, which requires active participation by the
trader, automated algorithm-based programs also exist which execute Forex
trades by the thousands daily around the clock. In addition, large mutual and
hedge funds often use foreign currencies to hedge its other investments, and
large moves by these institutional investors can cause significant currency
fluctuation.
Even if you do
not invest directly in foreign currencies, it is important to understand how
they impact equities. If your portfolio is mainly comprised of American
companies with no international exposure and reported earnings in U.S. dollars,
a falling U.S. dollar can sink all of your holdings. However, if you pick
American companies with significant assets overseas, such as McDonald’s or
General Motors, then a falling U.S. dollar may boost (or at least hedge) your
earnings due to higher profits from its international segment being reported in
U.S. dollars. Some investors recommend investing in international companies
which have no exposure to the U.S. dollar, especially in the BRIC markets, to
take advantage of the growth of a foreign economy and its currency. A
well-diversified portfolio should have purely domestic, partially domestic and
international stocks to limit the impact of currency fluctuations.
By Leo Sun
