Understanding Your Exposure to Currency Values4/22/2016 06:51:00 AM News
The Paper Trail: Understanding Your Exposure to Currency Values
Including foreign currency in your portfolio helps add a global flavor to a portfolio, but be aware of how a changing market can turn an opportunity into a challenge.
If you think about foreign currency only when you're getting ready to head overseas on a trip, you may be missing out on a significant opportunity to diversify your assets.
"Foreign currency can perform several functions toward structuring an efficient portfolio that traditional asset classes cannot," says Mark Merkel, Director and Senior Foreign Exchange Specialist for Wells Fargo Foreign Exchange Solutions Group in Charlotte, North Carolina. Here, he outlines those functions and what to keep in mind when considering making investments in foreign currencies.
The benefits of having currency in your portfolio boil down to two key points: diversification and yield. "Foreign currencies can provide diversification and exposure to other economies to achieve a truly global portfolio for the new global economy," explains Merkel.
So, when your domestic assets aren't performing, foreign denominated assets, like stocks and bonds, may perform, while also providing exposure to commodity and manufacturing-based economies. This type of exposure may also improve your chances of higher cash and bond yields, while investing in actual currency (as opposed to assets) may allow you to secure low-cost capital, which could be invested in higher-yielding assets abroad.
Currency hedging is a technique that may be used to seek to reduce the risk arising from the change in price of one currency against another.
Tracking changes in domestic and international policy
Comprehending currency markets means stepping back and taking a look at the big picture of U.S. and other global economies as well as understanding how the interplay of currencies against each other impacts your potential profits.
For example, take the current state of monetary policy based on economic progress. On one hand, the U.S. emerged in relatively strong shape from the financial crisis, and the Federal Reserve has embarked on a course of fiscal tightening by beginning to raise interest rates and completing liquidity and recapitalization programs, Merkel says.
On the flip side, the rapid pace of growth during the past 10 years in the emerging and commodity-based economies is cooling.
"GDP growth is dropping, unemployment is rising, and inflation — with the exception of hyper-inflationary economies such as Brazil, Argentina, Venezuela, or even Russia, for example — is virtually nonexistent," says Merkel. While economic growth doesn't always correspond directly with equity returns, it's often a major factor.
In more developed regions, such as the Eurozone, opportunities may remain, as the asset outlook is more positive. It's always important to consider, however, your time horizon and desire for diversification when investing in multiple markets.
"Foreign currency can perform several functions toward structuring an efficient portfolio that traditional asset classes cannot." — Mark Merkel, Director and Senior Foreign Exchange Specialist, Wells Fargo Foreign Exchange Solutions Group
Currency hedging to lessen volatility concerns
While having currency as part of your portfolio has its potential benefits, it's critical to be aware of how a changing market can turn an opportunity into a challenge.
When an asset must be converted from foreign currency to U.S. dollars, weakness in the foreign currency can erode any possible gains. Let's say you purchased European equities and bonds for your portfolio when the Euro was trading at $1.40. If you want or need to liquidate that portfolio now, with the Euro only being worth about $1.10, that 20 percent depreciation in the Euro versus the U.S. dollar over the course of your investments could wipe out any investment gains in your portfolio — or even result in your losing money due to currency volatility.
Currency hedging is a technique that may be used to seek to reduce the risk arising from the change in price of one currency against another. For U.S. investors, this strategy is most often used to hedge a foreign equity investment during times when the dollar is expected to gain strength against that other currency. The dollar's composite value has decreased against major currencies since the 1970s so, over the long term, a currency hedge in an equity position may not be successful. But during times when the dollar is gaining strength, such as 1995-2002 or the current period that started in mid-2011, a hedge position on equity may add value. Investors must think about their time horizon and ability to react to changing environments when considering such a strategy, because changes in whether the dollar is gaining or losing strength against other currencies can often happen quickly. The use of hedging to manage currency exchange rate movements may not be successful, could produce disproportionate gains or losses in a portfolio, and may increase volatility and costs.
Bonds generally are not correlated with currency exchange in the same way as equities, so a currency hedge on foreign bonds may be more efficient over time, as it may reduce risk and increase risk-adjusted return.
The way forward
As interest rates and yields diverge, explains Merkel, global liquidity will begin moving more toward safety and performance — likely, the U.S. dollar. If you've been diversifying globally in foreign bonds for higher yields and asset appreciation, you may find yourself in a defensive position as these investments mature and need to be repatriated back to the U.S. dollar.
"Foreign bond yields are decreasing and creating risk in global fixed income markets," says Merkel. "We believe the U.S. dollar will continue to gradually strengthen, creating risk for the repatriation of foreign-denominated assets."
Sarah Tuff Dunn
Thanks to: http://inteldinarchronicles.blogspot.com