Investment Fundamentals: Currency

Investment Fundamentals December 2014

Currency

 Currency promotes economic activity by providing a medium for the efficient exchange of goods and services.  Purchasing power varies across currencies, resulting in the need to set currency exchange rates for conversions.  Exchange rates impact you both in terms of prices paid for foreign goods and on foreign investments.

Currency is a system of money put in place as a medium Exhibit 1: Select Exchange Rates of exchange for goods and services. A major benefit of U.S. Dollar Euro British Japanese currency is that it facilitates commerce by eliminating the (USD) (EUR) Pound Yen need to barter. When hiring a plumber, you may not be (GBP) (JPY) thrilled with paying £90 per hour for a house call, but USD 1.000 0.798 0.625 112.105 EUR 1.253 1.000 0.783 140.456 imagine having to barter for that service. You could offer GBP 1.600 1.277 1.000 179.351 the plumber your services as a writer or your spouse’s JPY 0.009 0.007 0.006 1.000 skills as a photographer; however, the plumber may not Source: Bloomberg, as of 31 October 2014. need either of those services. Perhaps you will be countered with a request to mow the plumber’s yard for Interest Rates and Inflation Impact Exchange Rates the next month. Currency significantly simplifies this transaction. With currency, you are now able to work a Exchange rates vary over time. They are influenced by job that pays you pounds. You can use those pounds in demand for a currency as well as prevailing interest and a multitude of ways—hire a plumber, buy a car, eat at inflation rates and other factors including international your favourite restaurant or invest in a mutual fund. trade, government debt levels and political stability. Higher interest rates tend to increase demand for certain However, currency is not that simple. Most countries currencies as investors can earn more nominal (before have their own currency—for example, pounds in the inflation) income from fixed-interest investments U.K., dollars in the U.S. and yen in Japan. Some denominated in these currencies. Conversely, higher countries even agree to form a currency union, such as rates of inflation tend to decrease demand. Export- the eurozone, where Germany, France, Spain, Italy and oriented countries, China for example, often have in- others all use a single currency. Separate currencies demand currencies as foreign consumers purchase the complicate matters. You may wish to travel to New York exported goods. High levels of government debt are for a vacation and take a taxi from the airport to your often viewed negatively, as they can potentially cause hotel. At the end of the ride, the taxi driver may inform inflation and may be indicative of a future default on you that the fare was $20. Since you are in the U.S., he government bonds. Political instability can also is expecting to be paid in dollars not pounds. This is not undermine a currency’s value. just because dollars are the standard currency in the U.S., but also because £20 equal $32 based on current Conclusion: What This Means to You exchange rates, which would be quite a tip. Currency exchange rates can impact you as both a When interpreting Exhibit 1 you should read the table as consumer and investor. A strong domestic currency will one currency unit listed in the left hand column will cost increase buying power for consumers by making foreign the specified total of the currency listed in the top row. imports less expensive due to the currency exchange For example, £1 equals $1.600. This is what is known as rate. Conversely, a strong domestic currency detracts an indirect quote—how many dollars the one unit of the from investment returns for foreign holdings—when foreign currency costs. This is the typical quotation converting your foreign holdings back to pounds you will method for commonwealth currencies from countries need more foreign currency per pound (or in other words such as the U.K., Australia, New Zealand or the euro you will receive fewer pounds when converting back to currency bloc. Other currencies, such as the Japanese your domestic currency). A weak domestic currency will yen, are typically quoted using the direct method—how yield the opposite result in each of these scenarios. This much of the foreign currency can be purchased with $1. concept applies to mutual funds with an international Note that the indirect and direct quotes are simply the focus as well. Even though a fund is priced in pounds, inverse of each other. the underlying investments are often priced in local currencies and, therefore, must be converted to pounds.

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If the investment is withdrawn in the early years it may not return the full amount invested. In addition to the normal risks associated with equity investing, international investments may involve risk of capital loss from unfavourable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. SEI Funds may use derivative instruments such as futures, forwards, options, swaps, contracts for differences, credit derivatives, caps, floors and currency forward contracts. These instruments may be used for hedging purposes and/or investment purposes.

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