With globalization and easier access to foreign markets, investing in foreign currencies has become an attractive option for many investors. However, there are both opportunities and risks associated with foreign currency investment that need careful evaluation. This article provides an overview of the key considerations when deciding whether to invest in foreign currencies.
The main appeal of foreign currency investment is the potential for higher returns. Currencies in emerging markets with high economic growth often appreciate strongly against mature currencies like the US dollar. Savvy investors can profit from the upward trajectory. But this higher return comes with higher volatility and unpredictability. Government policies, speculative activity, political changes etc. can trigger sudden drops in currency values. So one needs strong risk appetite and active management to succeed here.
Diversification is another reason to add foreign currency exposure. With low correlations to US stocks and bonds, it provides non-US investments that enhance portfolio returns while reducing overall risk. However, proper diversification requires investing in a basket of currencies from different countries. Focusing on just one or two currencies increases concentration risk. Proper knowledge of currency markets and valuation techniques is also vital to avoid making losing bets.
In conclusion, foreign currency investment offers opportunities like higher returns and diversification but also has risks like volatility and lower liquidity. Investors should carefully weigh the pros and cons before allocating funds here.
Currencies in emerging economies can rise strongly during growth years
Many emerging economies like China, India, Brazil, Malaysia etc. have experienced rapid growth in recent decades. During strong economic expansion, demand for their exports rises. This increases foreign capital inflows for trade and investment. If the central bank does not intervene much in currency markets, these inflows naturally cause the local currency to appreciate against mature counterparts like the US dollar.
For example, despite bouts of volatility, the Chinese yuan has appreciated by over 30% against the US dollar in the last two decades of high growth. Similarly, the Indian rupee has gained nearly 60% against the dollar since 2000. An investor buying these currencies would have earned significant returns from the appreciation over time.
However, past returns are no guarantee of future performance. Growth in emerging economies is cyclical and prone to booms and busts. During downturns, the rush towards safety may cause a sharp drop in emerging market currencies. But patient investors with a long-term horizon can benefit from the long-term currency appreciation of fast growing economies.
Foreign currencies provide diversification benefits but need skillful management
The exchange rates between mature, developed economy currencies like the US dollar, Euro, British pound, Japanese yen etc. are driven by differences in relative economic growth, inflation, interest rates and other macro factors. These influence currencies very differently than micro drivers like company earnings that determine stock prices. So foreign currency exposure provides diversification benefits as it is uncorrelated to traditional US-centric stock and bond investments.
However, diversity within a currency portfolio is needed to get meaningful risk reduction. Just holding one or two foreign currencies might expose an investor to idiosyncratic risks related to those economies. Constructing a basket across 15-20 currencies reduces this concentration risk. But proper weights based on risk and return profiles of different currencies is key. This requires an understanding of drivers like monetary policy, fiscal deficits, trade balances etc. that impact currency values.
Passive exposure via currency ETFs provides a simpler option for most individual investors. But active trading strategies based on economic trends may be needed to maximize gains from short-term swings. This needs specialized knowledge and constant vigilance due to 24-hour trading in currency markets.
Volatility and lower liquidity are key risks in currency trading
Unlike stocks tied to company fundamentals or bonds linked to interest rate changes, currencies often swing wildly due to speculative activity and investor sentiment. For example, between 2000 and 2020, the average 12-month volatility of the US Dollar Index was 8.4%, more than twice that of the S&P 500 stock index. Sudden economic or political changes trigger even higher short-term volatility.
Many emerging and exotic currencies are also much less liquid compared to major pairs like EUR/USD or USD/JPY. High liquidity enables entering and exiting positions rapidly with minimal price impact. But with illiquid currencies, a large order can move rates substantially before it gets filled. This slippage due to wider bid-ask spreads poses additional trading costs.
Finally, proper valuation techniques are needed to avoid making losing bets. Unlike stocks with established ratios like P/E to gauge cheapness, currencies have multiple complex drivers that defy easy modeling. Blindly chasing high yields or simply speculation often leads to buying overvalued currencies and losses when the trade reverses.
Indirect currency exposure mitigates risks for passive investors
For passive investors unwilling or unable to devote much time to understanding currency markets, direct trading in currencies may be unsuitable. But they can still benefit from diversification into foreign currency exposure in a prudent manner.
Mutual funds and ETFs that invest in foreign stocks already provide some indirect currency diversification. As overseas market returns are converted back to US dollars, the foreign currency component enhances overall portfolio diversity. Actively managed funds also use currency forwards judiciously to manage excessive volatility from currency swings.
Specific currency mutual funds and ETFs that invest in a basket of global currencies are another low maintenance option. These are easily integrated into an existing portfolio like any other fund investment. The fund managers actively trade the currency basket based on economic trends and valuations. For investors, it provides the advantages of currency diversification without the need for direct involvement.
Foreign currencies provide portfolio diversification but need active trading and risk management. Passive investors can access suitable funds, others require market knowledge.