The Basics of Currency Fluctuations
PUBLISHED ON: Jan 25, 2013
There are currently two kinds of national currencies -- fixed and floating rate.
Political stability is the first key factor which impacts demand. If a country is in the midst of a civil war, then its currency will become devalued, due to a large supply with no global demand. After all, who would want to buy currency which may become worthless in the near future? If there is political uncertainty across the world, then investors will exchange speculative currencies for a "safe haven" currency, such as the United States dollar, which is well protected from political turmoil. In this case, strong demand and a limited supply will increase the value of the U.S. dollar in international markets.
Economic stability is another factor which affects demand. During the 2008-2009 financial crisis, the U.S. dollar, a safe haven currency, was no longer safe, and investors exchanged their U.S. dollar for British pounds and Euros. As a result, the U.S. dollar plunged relative to those currencies. In 2010, when European economies began to fail, the U.S. dollar rose again as the pound and Euro fell. Foreign investors divesting from a country's companies due to the perceived weakness of the national economy can also sink a currency.
Investors are another major factor impacting currency prices. Professional investors in the foreign exchange (Forex) markets move currencies in volumes as high as stock markets. Unlike high-frequency stock market trading, which requires active participation by the trader, automated algorithm-based programs also exist which execute Forex trades by the thousands daily around the clock. In addition, large mutual and hedge funds often use foreign currencies to hedge its other investments, and large moves by these institutional investors can cause significant currency fluctuation.
Even if you do not invest directly in foreign currencies, it is important to understand how they impact equities. If your portfolio is mainly comprised of American companies with no international exposure and reported earnings in U.S. dollars, a falling U.S. dollar can sink all of your holdings. However, if you pick American companies with significant assets overseas, such as McDonald's or General Motors, then a falling U.S. dollar may boost (or at least hedge) your earnings due to higher profits from its international segment being reported in U.S. dollars. Some investors recommend investing in international companies which have no exposure to the U.S. dollar, especially in the BRIC markets, to take advantage of the growth of a foreign economy and its currency. A well-diversified portfolio should have purely domestic, partially domestic and international stocks to limit the impact of currency fluctuations.