Currencies and Currency Risk

The foreign exchange market is the largest financial market in the world. According to the Bank for International Settlements, currencies worth several trillion dollars change hands every day. As an individual investor you rarely trade currencies directly – but you are exposed to them as soon as you own anything outside your home currency. With a global ETF, that’s the norm.

How exchange rates are quoted#

An exchange rate is the price of one currency in terms of another. EUR/USD 1.10 means one euro costs 1.10 dollars. The first currency is the base, the second the quote currency.

• If EUR/USD rises from 1.10 to 1.20, the euro appreciates – one euro buys more dollars.
• If it falls to 1.00, the euro depreciates – in other words, the dollar strengthens.

Traders also watch the US Dollar Index (DXY), which measures the dollar against a basket of major currencies.

What moves currencies#

Exchange rates are prices like any other, set by supply and demand. What drives them depends on the time frame.

Short term – days to a few years:

• Interest rate differences: Higher rates attract capital. If the Federal Reserve raises rates more than the ECB, the dollar tends to strengthen.
• Risk appetite: In crises, money flows to perceived safe havens such as the US dollar, Swiss franc and Japanese yen.
• Trade and capital flows: Trade surpluses, cross-border takeovers, pension fund investments.

Long term – many years:

• Inflation differences: If prices in one country rise persistently faster, its currency tends to lose value. That’s the idea behind purchasing power parity. It works slowly and imperfectly, but it shows over decades.

Currency risk in your portfolio#

Suppose you’re a US investor buying a European stock ETF. The stocks are priced in euros. Your return in dollars has two parts:

For stocks, currency risk is real but limited:

• Many large companies earn money worldwide. Currency moves affect their profits too, which dampens the effect.
• Over long periods, currency swings partly wash out. Stock returns themselves are much larger than typical yearly currency moves.

For bonds, it’s different. A foreign government bond might yield 3% a year, but the currency can move 10% or more in a single year. The bond meant to bring calm to your portfolio becomes a currency bet.

Currency hedging#

Many international funds come in a hedged version. The fund continuously uses currency forwards to neutralise exchange rate changes, so you get roughly the index return in local currency.

That has a price:

• Interest rate gap: Hedging costs (or earns) roughly the difference between short-term interest rates in the two currencies. Whether it costs or pays depends on which currency has the higher rates.
• Higher fees and sometimes a smaller choice of funds.

Currencies as an investment?#

Speculating on currencies directly – for example through leveraged forex trading or CFDs where they are offered – is a zero-sum game with high costs. In the EU and UK, CFD providers must disclose how many retail accounts lose money; the figures regularly run at 70% and above. More in the lesson on leverage.

For most investors, the right question isn’t “how do I profit from currencies?” but “how much currency risk do I want, and where?”

Summary#

Exchange rates decide what your foreign assets are worth in your home currency. In the short run they’re moved by interest rates and sentiment, in the long run more by inflation differences. For stocks, currency risk is part of global diversification and partly washes out; for bonds it can defeat the purpose – which is where hedging usually pays.