Whether you love it or hate it, globalization is a fact of modern life. We live in a time when the world’s 10 biggest companies are spread across five countries and three continents.
Make no mistake, there are plenty of great investing opportunities within the United States. But if you ignore everything happening abroad, then you’re missing out on higher returns and better diversification.
[ad#Google Adsense 336×280-IA]Giving your portfolio international exposure is an important part of asset allocation.
However, it can get tricky because different countries use different currencies.
Exchange rates can have a big impact on your foreign stock and bond returns.
That’s why we’re taking you through the basics of currency market investing.
With these simple techniques, you can hedge your exposure to the various monies of the world.
And you can invest in foreign stocks and bonds without the headache.
Customs and Jargon
Before we get into the meat of the currency market, there are some things you should know about it.
The currency market is, by far, the largest financial market in the world. It dwarfs the world’s stock and bond markets – and it moves a lot faster. That’s partially because currency trading is done over the counter, 24 hours a day. It’s always business hours somewhere.
Another unusual thing about the currency market is its pricing system. Currencies are always priced relative to another currency. So rather than being straight numbers, currency market prices are ratios called “pairs.”
The price of U.S. dollars (USD) in Canadian dollars (CAD) is quoted as “USD/CAD = 1.32.” That means it costs CAD 1.32 to buy USD 1.00.
How to Trade Currencies
When it comes to currency market instruments, you have a few choices.
Traditionally, the bulk of currency trades happened on derivatives markets. Rather than directly trading currencies, investors in the pre-internet era would exchange futures or forwards contracts on sums of currency. However, this method is a bit too technical and risky for most individual investors.
With the advent of electronic trading, the spot market has become more popular. It’s the most straightforward currency trading method. The spot price of a currency pair is the exact price of one currency, in another currency, at this very moment. This over-the-counter market deals in direct cash-for-cash trades – no contracts, shares or notes required.
Although the spot market is the simplest kind of currency market, it’s not necessarily the easiest to use. Trades happen lightning fast, with more than $5 trillion changing hands every day. It’s easy to miss out on potentially lucrative deals, unless you have a team of forex traders working in shifts.
For most investors, currency ETFs offer an effective and more manageable alternative. They’re exactly what they sound like – exchange-traded funds that invest directly in currencies. They do the most intensive currency-trading work for you. Plus, they operate under the familiar rules and hours of the New York Stock Exchange.
Looking to get some exposure to the yen (JPY)? Just pick up some shares of the iPath JPY/USD Exchange Rate ETN (NYSE: JYN). All it takes is a few mouse clicks, just like buying a stock.
Basic Currency Market Theory
Professional forex traders use a variety of complex maneuvers to make big profits. We could go into the details of carry trades, arbitrage and other techniques, but then this article would go on forever.
For our purposes, we’re just going to show you how to use a currency ETF to hedge a position in a foreign equity.
Suppose you want to buy some shares of the iShares MSCI Japan ETF (NYSE: EWJ). However, you’re worried that the yen could fall against the dollar, taking a bite out of your dollar-denominated returns.
To protect yourself against that currency risk, you can take out a small short position on the aforementioned iPath JPY/USD Exchange Rate ETN. That way, you’re hedging your Japanese equity with a bet against the yen.
If the yen falls, then it’ll hurt your Japanese equity returns. However, your yen short will gain, thus making up the difference. On the other hand, if the yen rises, it’ll inflate your equity returns… but your yen short will fall a bit, so you don’t get the extra profit. You’ve protected yourself by completely taking exchange rates out of the equation.
The currency market isn’t for the faint of heart. But it’s also not totally inaccessible to individual investors. In fact, some simple currency market techniques can be very useful in protecting the international portion of your portfolio.
We hope this article has demystified this fast-moving global marketplace. In a time of heightened geopolitical risk, it helps to have some control over what kind of money you’re making.
— Samuel Taube
Source: Investment U