Another day, another dollar. Spend a yen. The euro crisis. Not worth a franc. Two cents’ worth. Let me give you my two cents: currencies shape the way we talk about value, resources and decision-making. 

A currency acts as a medium of exchange, allowing people to trade goods and services using a standardised payment method and acting as a standard measure for valuing goods and services. This uniformity is essential for economic stability and planning. 

An exchange rate is the relative price of two currencies

In most countries, the currency issued by the central bank is considered to be legal tender and must be accepted as a form of payment within that jurisdiction. This means that, as a resident of one jurisdiction, you have to exchange your currency for another when you intend to buy goods or services from another jurisdiction. 

When you make exchanges like these, you pay an exchange rate. This rate changes day to day depending on the supply and demand of that currency. For holidaymakers, it can be a nice surprise when you get more than expected in a currency exchange. Other times you can feel like you’ve been short-changed before your plane leaves the runway. That’s why it’s often a good idea to watch the foreign exchange market as soon as you’ve booked a holiday, so that you can pounce on favourable rates. 

The impact of foreign exchange rates on your investments

While it’s one thing to buy and hold a currency, either to spend on holiday or purchase goods made overseas, investing using currency is another. Let’s say you take your Swiss francs and exchange them for euros to buy a house. The asset is then real estate and not the currency itself. Similarly, you might exchange your Swiss francs for US dollars so you can buy a US-listed fund or stock. In this case, you pay the exchange rate to change your francs to dollars before you buy. While you might make a few percent on the fund, depending on the exchange rate, you might lose some of your return changing the dollars back to francs when you want to close the investment. As this example indicates, changes in exchange rates can have a significant impact on your investment portfolio. 

If European stock prices are soaring to new highs while the dollar is strengthening considerably against the euro, US investors who had invested in shares listed in euro would see the value of their holdings drop due to the unfavourable rate. 

Balance out the uncertainty by hedging your positions

How can you protect yourself against this uncertainty? One option is to “hedge” against potential changes in value against your home currency. So, at the same time as you exchange your francs to dollars to invest in a US fund, you simultaneously agree to sell the same amount of dollars in an opposite trade. In this way, you have no exposure to any movements in one currency against another, like the balancing of scales.

Hedging typically takes place on the forwards market, where you can eliminate exposure to one currency against another without needing to actually hold that currency. This is possible thanks to “leverage”, whereby you only need to hold a given percentage of the amount you want to buy as collateral. Let’s say you put a million dollars into that US-listed fund you wanted to buy into. Rather than needing another million to balance out the currency trade, the bank might offer you leverage of 10%, meaning you only need USD 100k to secure your position. 

At the end of the term of the hedging trade, you could roll the hedge over again for another fixed term. This is called a “swap” and allows you to maintain your protection against currency fluctuations. 

Leverage enables speculative investors to amplify their exposure

In addition to hedging, investors can also use leverage and the forwards market to speculate on movements in currency prices. But as with any investment, they would be taking on a risk that the dollars – as in our example – goes down. And as with any leveraged investment, this means you could lose your collateral. It takes considerable knowledge and monitoring of factors such as interest rates, central bank policies and global trade flows to gauge the effect on foreign exchange rates, and even with that knowledge, investors could still lose out if unexpected developments change market sentiment. 

Why are safe haven currencies important for investors?

That’s what makes “safe haven” currencies popular among investors. These are currencies – including the US dollar, the Japanese yen or the Swiss franc – which typically strengthen or maintain their value in times of global economic uncertainty caused by political developments or economic swings. 

As in many other areas of investing, however, the safest haven of all when it comes to protecting your hard currency is likely to come from entrusting your assets to professional advisors with the expertise and experience to navigate the dynamics, impact and role played by the forex markets. After all, you don’t want your currency positions to cost you a pretty penny.