Democratizing Currency Investing

Issue February 2012

 

By Tony Davidow | ETF Strategist | Guggenheim Investments

The Foreign Exchange (Forex) market is the largest and most liquid market in the world, with nearly $4 trillion changing hands every day. Forex, or currency trading, has historically been the exclusive domain of hedge funds, institutions and sovereign wealth funds. Currencies offer a way to capitalize on the economic growth of a country and/or to hedge exposures.

In recent years, through the introduction of Exchange Traded Products (ETPs), investors of all sizes and sophistication have begun to invest in currencies. However, the market is still dominated by “professional” investors, who view currencies as trading vehicles. More and more, advisors are seeking guidance regarding how to use currencies in their clients’ portfolios.

History Lesson
After World War I, world leaders attempted to revive the gold standard, but it collapsed after the Great Depression. Some argued that the adherence to the gold standard prevented the monetary authorities from expanding the money supply rapidly enough to revive the world’s economies.  In 1944, the world’s leaders met in Bretton Woods, New Hampshire to create a new international monetary system. At the time, the US accounted for more than half of the world’s GDP, and held the most gold; therefore the leaders decided to tie its currencies to the dollar, which in turn was convertible into gold at $35 per ounce.

Under Bretton Woods, the various Central Banks were given the task of maintaining fixed exchange rates between their currencies and the dollar. They accomplished this by intervening in the foreign exchange market. If a currency was too high, the Central bank would sell its currency in exchange for dollars. Conversely, if their currency was too low, the Central bank would buy its own currency.  The Bretton woods system lasted until 1971.
In 1971, the US had high inflation and a growing trade deficit. The U.S. urged Germany and Japan to appreciate their currencies, but they were reluctant to intervene since raising the value of their currencies would hurt their exports. Eventually, the U.S. abandoned the fixed value, and allowed their rates to “float” (i.e., fluctuate relative to other currencies). In 1973, the world leaders agreed to allow exchange rates to float.

Currencies Today
Today, most of the world’s currencies trade freely around the Globe.  It is important to note that the value of a currency is “pegged” to another for valuation purposes. Roughly 85% of all currency transactions are pegged to the U.S. dollar. In other words, if the Euro is pegged to the U.S. Dollar at $1.30, it would take 1.30 dollars to buy one Euro.

As the above data illustrates, currencies fluctuate a great deal. Central Banks may choose to intervene in order to stabilize their currencies or help their trade balance. In August 2011, the Swiss National Bank chose to intervene and peg their currency to the Euro. This was done to maintain their competitiveness, as the Swiss Franc had become a “Safe-Haven” currency, and had risen dramatically versus the Euro and the U.S. Dollar.
Currencies can also fluctuate based on shocks to the economy. On March 11, 2011 Japan was shook by an earthquake and tsunami which caused considerable damage. Immediately following the tsunami, the Yen weakened versus the dollar as the country was trying to evaluate the damage. The Yen later reversed course, and the dollar fell to a record low versus the Yen. The move may have seemed counter-intuitive, but the tsunami spurred investment in Japan.

Why Use Currencies?
Currencies may be thought of as an Alternative Investment. They have historically exhibited low correlation to traditional investments, and provide a unique risk-return trade off over time. Currencies can be used in a number of different ways. They may represent a means of capitalizing on economic growth within a country or region. Currencies may serve as a complement to traditional exposure, and dampen the overall portfolio volatility. Currencies can be used to speculate on price movements, or to hedge exposure to a particular market.

Currency can also be used as a means of diversifying cash and picking up yield. The Australian Dollar has been an interesting currency over the last several years. The Australian economy has been strong. They have not been dramatically impacted by concerns regarding the Euro, and represent one of China’s largest trading partners with an abundance of natural resources. In additional to their relative strength and stability of the Aussie Dollar, they also provide an attractive yield (>4%). Currencies can be deployed individually, or as part of a trading strategy. One of the most popular trading strategies is the “Carry-trade”.  In its simplest form, an investor employing the carry-trade purchases the highest yielding currency, and sells the lowest yielding currency. The investor profits from the interest rate differential between the two currencies.
While the Forex market is very large and liquid, the average investor lacks a sufficient understanding of the futures markets to invest directly. Exchange Traded Products (ETPs) provide another means of gaining currency exposure. ETPs may be seen as way of “democratizing” the currency market. However, we would caution investor’s caveat emptor, not all currency ETPs are created equally.

As the above chart illustrates, there are a number of differences between the various ETP structures. The holdings and corresponding results can vary over time. Guggenheim Investments prefers to hold the physical currency, while other firms hold futures, forwards, swaps and/or derivatives. There are also different tax ramifications depending on the structure.

Additional information and a product overview you will find on www.currencyshares.com