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Investing in Foreign Currencies



April 05, 2012 – Comments (0)

Board: Macro Economics

Author: OrmontUS

Recently, a popular blogger has been promoting a new newsletter with subject matter parallel to that discussed on Metar. I have read the first issue and, while there is much said, there is little new to those who follow the posts here. One of the “selling points” of the rag is a discussion of owning foreign currencies. I figured I’d do a more extensive overview and, while not providing any crystal ball projections, at least give a method to decide on a “short list” from which to choose. I will try to get the time to do a similar type article on choosing foreign stocks (something I regularly do, but which gets little coverage on Metar) sometime in the near future (unless someone else wants to take a whack at it).

A lot has to do with why you are trading/investing in currencies. There is an implication that either you feel that your native currency (presumably the USD) will drop in value or that the one you are buying will rise. This is complicated by the values of currencies being ratios, rather than absolutes. There are a few other reasons which may be important: a “major” event in the US preventing either access to your funds or a swift destruction in the value of the USD. Another reason may be the possibility of the foreign currency being more useful in its native context than USD’s (say living in Europe and having an account in Euro’s or CHF).

Since my currency positions frequently last for a decade or more, a do a fair bit of due diligence that a day trader would ignore. Before choosing a currency, I cross off the list any which are in zones which may experience political or geopolitical unrest. This eliminates some otherwise worthy ones (like the Israeli shekel and maybe the South African rand). I also look for currency “pairs” and eliminate the weaker ones (so the AUD would stay, but the NZD would either go or be de-emphasized). The currency has to be “large” enough to have a liquid world presence (so some worthy ones such as the Norwegian krone are filtered out). There should be no major overhang from a macro basis (so, unfortunately, some worthy ones such as the Yen may bite the bullet as well). Others, such as Brazilian Reals have account restrictions put in place by the parent country (however, sometimes accommodations can take place in unusual ways – such as Swiss franc accounts in Singapore, for example). In the context of not all eggs being in one basket, more than one currency (located in more than one hemisphere) should be used. Once the short list of acceptable currencies is generated, then selecting those that seem to have special merit can begin. It’s sometimes frightening to realize how few currencies are left after some simple common sense filters are applied, yet those few (either directly, or in stocks/bonds purchased in the currency) can be very beneficial in an overall asset allocation format. An example of two currencies which march to different drummers (though sometimes the tunes may rhyme) are the Swiss franc which traditionally (until its recent peg to the Euro) and the Australian dollar which is closely tied to perceptions of Chinese economic prospects.

While, in my attempts to discuss the valuation of combined asset allocation strategies on the basis of a rationalized “global valuation” basis (not specifically USD oriented), most people don’t “get it” because they have only used a single dimensional context throughout their life, rationalizing ones assets by an external index (rather than against the USD) can be helpful in determining what’s “really” happening to their valuation.

Foreign currencies are not a panacea. They are useful as hedges in the context that they are “shorts” on the US dollar. In addition, some pay far higher interest than is available in the US. That said, should the US dollar rise, not only will the US equity market tend to drop, but (almost by definition) so will foreign currencies (in terms of USD). So while your portfolio’s “global valuation” may not have changed too much, its value in terms of US dollars will have dropped. The leg of the stool which will tend to benefit under this scenario has, for the past few years been US Treasury bonds. It is important to realize that this is an artifact of continual low interest rates. Should rates in the US climb, then US dollar cash accounts may provide balance.

As far as how to “hold” the foreign currencies? Well, the ETF’s may be purchased (though those are derivatives and I’m not sure how they would track under duress), accounts at Everbank could be used (but those are again derivatives, pay subpar interest and high conversion expenses), foreign bonds may be purchased (it’s important as to the currency they pay in), accounts at Interactive Brokers can be used (though again you get clipped on interest – however they can effectively be used as a low cost forex conversion point, as can Oanda) or of course bank accounts may be opened abroad.


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