At any given time, national currencies move relative to one another. For most citizens of a country, this impact is usually only felt during international travel, when $10 may only be enough to buy a cup of coffee in one country but a steak at a five-star hotel in another. Investors, however, often feel the impact of currency fluctuations far more - with commodities, equities and foreign exchange markets all being subject to huge gains or losses based on these daily movements. What causes these seemingly random ratio changes, and how can investors profit from understanding them? Supply and demand define one currency's value in comparison to another.
There are currently two kinds of national currencies -- fixed and floating rate. The fixed exchange rate is based upon gold or another fixed rate currency within the country, and does not fluctuate naturally in relation to other nations. The United States used this system until 1973, when rising inflation forced the nation to float its currency due to the irreconcilable disparity of the U.S. dollar to other currencies. China, which still uses a semi-fixed rate currency pegged to the U.S. dollar, is now facing intensifying pressure from the United States to float its currency, due to the perception that the Chinese yuan is actually stronger than it appears. The United States believes that China intentionally keeps its currency weak to keep foreign companies invested in cheap Chinese labor. However, the same fears of inflation and rising interest rates that plagued America in the 1970s may soon force China to float its currency. A similar predicament faces the Euro, which uses a fixed exchange rate pegged to the local currencies of the member countries of the European Union. If a nation attempts to maintain a fixed rate system, it runs the risk of deflation, which causes decreasing exports and can only be rectified with tax increases or higher interest rates. These in turn can lead to political instability and high unemployment rates.
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.