Summary: Something often overlooked by investors when making their early investments is the added potential problems posed by currency exchange risk. For most people, this will never be an issue, until they choose to invest abroad...
As a rule, most investor's first investment will be at home, in their country of residence. This may take the form of a bank account, or a pension fund or something else, but typically it is in their own country and currency. For example, a person living in the United Kingdom would typically be earning money in sterling (GBP), spending money in sterling and also saving and investing it in sterling. So far so simple.
However, when that person decides to invest in a fund that buys assets in the United States, for example, their investment is suddenly exposed to the movements of the foreign exchange market. This means that their investment can be a winner – the fund they bought into rises in value – but their actual return is negative because of the change in price in the currencies.
Currencies are traded in pairs, meaning that there is a direct relationship between all major currencies that can be easily tracked from any newspaper. There is, of course, a relationship between the smaller currencies as well, but this is less important for the currency markets, trade and most investors.
Thus, staying with our example, if the price of the US dollar
falls by 10% while the investment fund value rises by 5%, the investor
has actually lost money despite being able to see a positive return on
the fund. Conversely, a fund could be a bad investment and fall in
value, but currency appreciation can stll make an investment profitable.
It is worth pointing out that these gains or losses are made when the
investment money is returned to the original currency.
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For more sophisticated investors, the larger and more diverse the holdings, the more likely it is that there will be currency in investment portfolio risk. This is because larger and more experienced investors will often look beyond the shores of their own country for opportunity and to diversify. In other words, many large investors actively seek out this type of risk.
Currency exchange risk can be taken – knowingly or not – in many forms. For example, there are lots of people from northern Europe that purchase holiday or retirement properties in southern Europe. A person from perhaps Denmark, Sweden, Norway or the UK, that purchases a property in Spain, Italy or Portugal for example, is actually taking a substantial currency exchange risk with their money.
As has happened to many British retirees that moved to Spain, the cost of living has increased and at the same time, the amount that their fixed pension (in GBP) will buy in euros has fluctuated significantly from month to month. These unfortunate folk have taken currency risk with their life savings (to buy the home) and their monthly income (to live).
A similar example on an equally large scale has occurred in Poland. Mortgages have been sold with low interest rates that were denominated in Swiss francs for property purchases in Poland. These are to normal Poles with normal jobs, not some high flying financial elite...
As the euro currency crisis unfolded, the Swiss franc gradually strengthened in value. This sounds harmless enough, but the impact in Poland has been for several million people to find that their monthly mortgage costs have risen substantially while their incomes have not. This is a very real and very painful example of currency exchange risk.
This can go the other way though. If for example, you lived in one country but were mostly invested in another country and currency, moves at home could make your portfolio more valuable.
For example, in early 2015 the European Central Bank announced the start of a plan of quantitative easing. Naturally, the value of the euro dropped against the other major currencies. If, in circumstances like this, your investments were in US$ but you have no actual desire to spend in dollars, your portfolio just appreciated when compared to your own currency.
Your author has an American friend that lived for some time in Europe. He had the unfortunate experience of saving some money in a bank in Europe for a couple of years and making a "notional" profit on exchange rates. At the time, he saved in euros and the interest rate was under 2% pa, so he didn't make much money. But the USD/euro rate moved so that he had made a theoretical profit in US dollars. According to US tax law he had to (and did) pay taxes in the US on his non-existent profit.
The impact of central bankers
It might be worth noting that there are really very few "major" currencies in the world. The United States dollar has been the world's reserve currency for decades, but behind it comes the euro. Despite the problems of the eurozone and it's banking and sovereign debt crisis, any currency used by 17 nations as a bloc has to have some power. The other major currencies are the British pound (GBP) and the Japanese yen.
The power of these four currencies really is overarching compared to most others. For example, there are many countries within central America and the Middle East that have pegged the exchange rate of their currency to the US$. In the Middle East this is mainly because of their dependence on the oil market.
Tied to the euro (either via a peg or simply having adopted it themselves) are a number of EU neighbours such as Croatia and Montenegro.
Then there are a number of nations that are in the Commonwealth and were once territories of the United Kingdom that either use the pound or have pegged their own currency to it.
All this means that the moves and decisions made by just a few central banks and Finance Ministers have wide ranging, but often unseen, impacts in other parts of the world. In our hyper-connected globalized world, currencies are one of the lubricants that keep things moving. Be sure to keep a watch on the impact currency moves will have on your portfolio.
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