Category Archives: ForEx

Foreign Exchange Risk: Your risk.

fx-risk

We live in a financial world full of risks. The most common types of risks that we normally take note of are default risk, credit risk, interest rate risk, liquidity risk, third party risk etc. However, most investors tend to take foreign exchange risk for granted, perhaps because this could be an indirect risk.

Foreign exchange takes place when you or your investment deal in another foreign currency which is not your investment’s base currency, or your country’s base currency. For example, if you are buying a UK Growth Fund, which is denominated in Pound Sterling, you will automatically enter into an exchange rate risk. Why? Let us assume that you invested GBP10,000 in this UK Growth fund on the 1st of June 2016. The European Central Bank (ECB) market rate was at 0.7736. In reality, when you are going to exchange funds from one currency to another, you will be charged a ‘margin/markup’ from your exchange rate provider or bank. The amount of profit the bank will make would vary, normally depending on the amount of the transaction and the expected amount you transact in a year. For retail investors or households, this rate would not be the most exciting thing you have ever seen. On average, the rate will be ‘loaded’ by around 2%. This means that you would be paying an extra 2% ‘hidden cost’ when exchanging your funds from EUR to GBP. Taking this assumption, you would have used the rate of around 0.7580. This means that you would have been required to pay EUR13,192 to get GBP10,000 on the 1st of June 2016.

Around 5 months have passed and we are going to assume that your investment was stable and you have made no losses or profits on the value of shares/units in GBP. However, you realised that the exchange rate today is 0.8866. When you checked with your bank to exchange GBP to EUR, the bank or broker would add another 2% to your exchange rate as a ‘margin/markup’ which would cover the broker’s fees. This would provide an exchange rate of around 0.9045. Hence, if you would like to convert your GBP back to EUR at the rate of 0.9045, you would get around EUR11,055. This would have resulted in a loss of EUR2137 (or 16% on your original investment) in just 5 months based solely on the exchange rate movement.

The above was given as an example to help investors realise the extent of the risk one is taking when entering into foreign currency exposures. Such exposures can be hedged (or covered), however, these are very difficult to be managed for retail investors. The main ways to hedge an FX (Foreign Exchange) exposure are by either opening an exact opposite trade on the market, by locking in a rate on the forward market, by an FX Option or by a Swap agreement. The first two are very common especially for small businesses while the latter two are more common for those large or medium institutions which have an ongoing exposure to foreign exchange.

You may also have an exposure in foreign exchange without being aware of. For example, let us take a UK Growth Fund example again. However, this time, the UK Growth Fund is being offered to you in EUR. Therefore, you will be buying the fund in EUR and you will have no apparent FX Risk. However, when one looks deeper into the matter, one would realise that the fund itself is exposed to FX risk since the manager invests in stocks that are priced in GBP. Thus, it would be a decision of the fund manager or Board of Directors to decide how such a risk is managed. In such a case you will have an indirect FX Risk. Thus, taking the same scenario above, if the fund did not hedge the FX exposure, you would have probably seen a depreciation in the fund’s price in EUR terms. In such a case it would be strongly recommend that the investor read through the Prospectus of the fund and identify the risk management policies of the fund when it comes to FX risk management. If such a policy does not exist, then such a risk must be taken in consideration before an investment decision is made.

How and why are foreign currency rates affected?

There are three main ways of how foreign exchange rates are affected. The first and most common one is through fundamentals. This means, that if the UK economy strengthens and that of the EU weakens, then the value of the Pound would usually rise against the value of the EUR. There is also the case of ‘expectations’ vs ‘reality’. You may have a situation where, for example, you have positive news from the UK and still see the Pound lose value. The reason is that the market could have expected a ‘better’ result even though the result in itself was positive. For example, unemployment rates were published by the UK and these indicated a fall in unemployment. The news by itself is positive. However, the market was expecting the unemployment rate to be even lower than that published. In a highly liquid and transparent market such as the FX market, expectations are also factored/priced in the FX Rate before the actual result is published. Hence, when expectations differ from the real result, one would expect an adjustment in the rate accordingly.

The second way how rates are affected is through speculation.  Speculators would be taking ‘bets’ that a rate would go up or down. Such bets can be aggressive which may affect the rate itself and/or create an influence which would lead to more speculators betting in the same direction making the rate move. The forex market is a large market and in fact trades over US$5 Trillion a day! It is difficult for a single broker or speculator to make an effect on the market on its own. However, a combined effort would have its effects. There is also the issue of a ‘self-fulfilling prophecy’. If everyone thinks the rate will go down if it hits a particular rate level, then everyone would be making bets based on this expectation. This would create a self-fulfilling prophecy and the market would move accordingly. However, one should note that speculation usually affects the market in the short term and it would be fundamentals that would work in the long term.

The third way how foreign currency may be affected is through government intervention. Such intervention is very rare as it may create trust issues when it takes place or other economic effects which may not be desirable. A particular government may use monetary policy to control the value of the country’s currency. This is more easily done when the currency is of a single country. For example, it would be very difficult to see a government intervention from the EU towards the Euro as all countries would need to support such a decision. However, it would be relatively simple for the UK, for example, to impose or use such monetary policy. For instance, the Bank of England may decide to print a lot of Pounds and increase the money supply which would result in devaluation of the Pound. The Bank of England may also buy excess Euro to keep the Pound stable at a particular level. This is normally done to ensure competitiveness in the UK when compared to other markets. This was done in 2011 by the Swiss National Bank (SNB). The SNB at that time guaranteed a rate of 1.20 against the EUR by purchasing excess Euro on the market. However, in early 2015 the SNB decided to discontinue this without warning and the EUR/CHF crashed by over 20% instantly creating panic in the market. This is why government intervention is very rare and it is avoided unless there is a clear requirement from the government to step in and safeguard the country’s interests.

What does a Brexit mean for the Pound?

This is a tricky question as there are far many uncertainties on the future of Britain and how the economy is going to be effected. The market is currently reacting as follows: if the UK exits the EU, then the Pound would lose value, if not, then the Pound would gain. The main probable reason for this is due to the expected taxes that the UK would probably have to pay when dealing with the EU. This would make UK products less competitive in Euro terms when dealing with other EU products as these would be loaded by say 15% tax or so. Hence, for the UK to compete in such a market after being taxed, the GBP would need to lose value to make up for the increase in price due to taxation. However, the biggest issue of such a currency devaluation would be that as it helps exporters to maintain their competitiveness, it would make things difficult for importers as they lose purchasing power when importing goods from the EU and paying in Euro. This is because they would need to fork out more Pounds for the same amount of Euro they would have paid a few months back.

The Bottom Line

Thus, to conclude, for retail investors, ideally one should avoid FX risk. The market is very large and unless you cannot avoid such a risk, then it would probably pay if you just avoid it by sticking to your home currency when investing. For institutions, hedging such an FX risk is important. One should remember that a company is not there to make profit from FX. The importance here is managing your losses and removing uncertainty due to changes in currency valuation. This could simply be done by a forward contract or through innovative FX Options products which are available on the market.

As always this post is for information purposes only and does not constitute any form of advice – the general disclaimer should be kept in mind.

About the Author

This has been a guest post prepared by Mr. John Caruana. John holds an M.Sc in Banking and Finance (University of Malta) and has been working in the local financial services industry for the last 8 years in various roles from investment advisor to ForEx trader. He is currently the managing director, compliance and MLRO of a locally listed investment services company and sits on the Board of various funds.

The Fed Increased its Base Rate – Should You Care?

The Federal Reserve Building
The Federal Reserve Building

In this week’s post I will be focusing on the increase in interest rates that has just been announced by the US Federal reserve which is the central bank of the USA. The Fed increased its base rate from the current 0%-0.25% range to a 0.25%-0.50% range. For 7 years we had witnessed a near 0% base rate making money cheap to borrow. The post will aim to focus on how this affects Malta and the broader Euroland countries. I will first be focusing on the effects of an interest rate rise in general and then move on to focus more on how we as Maltese and other countries that use the Euro as their main currency will be affected. Should we care about what the US is doing?

First, some basic economics to help you understand better the rational for manipulating interest rates. Having low interest rates is expected to lead to cheap money that would in turn cause consumption and private sector investment to go up which would lead to a higher gross domestic product. In simpler terms this means that if households and business can borrow at cheaper rates they would be more inclined to do so. When they have access to the cheaper funds they will spend more, for example on new housing or on building a new factory. In turn this will generate more income for other economic participants and everyone is better off.

On the other hand, if too much money is present in the economy this will lead to a general increase in prices, or inflation. Thus, in order to avoid having too much inflation the central banks can increase interest rates in order to reduce spending and private investment – in technical words they would be tightening. It must be kept in mind that in the real world things are not as simple as I have just described since there are undoubtedly a lot of variables being affected at once. The following video is great to help understand better how the Fed manipulates interest rates:

Who Wins When Interest Rates Go Up?

  1. Banks

The obvious winners as a result of increased interest rates are of course the banks. For a traditional bank that is mainly concerned with taking deposits and making loans their bread-and-butter is their Net Interest Margin (NIM). This is simply the difference between how much the bank is earning from the interest rates on its loans and how much it is paying in interest rates on its deposits. So if interest rates go up the banks can start increasing the interest rates they charge on their loans and this will lead to increased income for the bank.

  1. Insurance Companies

Insurance companies typically invest their money in fixed income assets such as bonds from the higher quality end of the market. As any fixed income investors knows the yields on bonds has been low for quite a while now and hence the income insurance companies can earn on their investment will increase as interest rates go up. Of course there exists the other side to this argument that as interest rates go up the prices of bonds will go down and thus insurance companies would suffer in terms of the value of their capital. Although this is true, one must keep in mind that insurance business is long term business. So if the insurance company has bought bonds with the intention of holding them until maturity, the price drop experienced before maturity does not really affect them. Such companies would use a combination of strategies such as keeping a portion of the portfolio in short dated bonds which would be less affected by interest rates rising.

  1. The US Dollar

In simple terms since the interest rate one could earn from a US dollar investment is now going to be higher than the interest one could earn from a Euro denominated investment, the demand for the USD would increase. This would lead to a higher USD value and lower EUR. Things get a bit tricky however when you consider that the increase in the interest rate has been anticipated for months now and the USD has already appreciated quite a bit now. So one could argue, is the increase in the interest rate already priced into the USD?  

Who Loses When Interest Rates Go Up?

  1. Oil

Since the price of Oil is quoted in USD and the USD has gone up in value versus other currencies it has just become more expensive to buy oil. The oil industry itself is already suffering from a situation of over-supply, so an increase in the price of oil just because the USD got more expensive could be lead to lower demand which would in turn hurt the oil companies.

  1. Gold

Gold also stands to lose value with an increased USD value, like many other precious metals gold is quoted in USD. Just like with oil, the cost to buy gold would have just gone up simply because the USD went up. This could in turn lead to a fall in the price of gold to counter the increased cost of acquiring it. What makes it even worse is that gold does not earn any interest and in fact it cost money the longer you hold gold since insurance costs and storage costs have to be considered.

  1. Home Buyers

With increased interest rates new home buyers will face higher home loan rates and thus will be able to borrow less or will have to pay more for the same level of borrowing. Even existing home owners who have variable rate home loans will have to start paying more in interest, thus increasing their monthly loan payment and thus decreasing their disposable income.

  1. Issuers of USD debt that operate outside the US

Many countries and companies which do not use the USD as their base currency also issue many bonds denominated in USD. With an interest rate increase this means that if they want to borrow new funds in USD they would also have to offer higher rates since the base rate on which all other rates are built has gone up. Furthermore, their outstanding debt has just become more expensive to service. Although the majority of bonds are issued with a fixed interest rate, since the USD would have appreciate against the currency the issuer uses as its base currency it would cost them more to pay the same amount of USD in the form of interest payments and eventually capital repayment.

interest-rates-going-up

How are You affected as a person living in Malta/Europe?

One may argue that the above is all well and good, but it does not affect him/her since we are situated in Malta and our interest rates are determined by the European Central Bank (ECB) and not the Fed. Although this last point is true that our interest rates are determined by the ECB which does not plan to raise interest rates anytime soon, this does not mean that we are immune to what is happening abroad.

The biggest effect that Malta will have from the increase in the Fed rate is the effect on the currency, specifically the USD/EUR exchange rate. So if the USD has gone up and is expected to go up even further this will have an effect on individuals as well as businesses. Let us take a look at some specific areas where we will be affected:

  • Traveling abroad

The cost to travel to the USA will now be higher. So even though you might still have to pay $1,000 for a few days of accommodation in a New York hotel that $1,000 which used to cost you around €715 in 2011 will now cost you around €915. That is close to a 30% increase in the cost. When you consider the total cost of a holiday in the USA this difference would add up to quite a bit of change. This will be true not just for travelling to the USA of course, but to anywhere that prices in US Dollars as a main currency. So for example going on a cruise that accepts only US Dollars would become more expensive as well.

  • Fuel Costs

As previously discussed, the price of oil is denominated in USD. So any other derivative of oil such as diesel and petrol for motors, fuel for airplanes and so on will also be affected by the price of the USD. Luckily for us we are in a situation where oil prices are very low due to oversupply. Hence, the increase that one would expect in the oil price is being counterweighed by the supply side keeping the price down. But if the supply had to be reduced or the demand would somehow increase the price of oil would in fact go up.

  • Cost of Precious Metals

Like oil, the prices of precious metals is denominated in USD. So the cost to acquire these precious metals will be higher, even if the prices had to remain unchanged.

  • Importing of goods in USD

Besides oil, many other items are bought in USD. Anything we import in USD will now be more expensive than it was just a few years ago. So importers will be negatively affected by the fall in the EUR which came about as a result of increased interest rates in the US. This also affects individuals who are used to buying items online for example.

  • Exporting of Good to the USA

It is not all bad news however, the exporters will benefit, specifically the ones that export to the USA. Since in dollar terms EUR items will cost less, the items that are exported to the US would be considered cheaper and be more competitive versus other US made items. So for example the European car manufacturers will now be able to price their vehicles more competitively against their US counterparties. Unfortunately for Malta we do not export many goods to the US. But we do compete with the US in certain services industries. So the higher USD would mean that it would be cheaper to do business through Malta (and other Euroland countries) rather than through the USA.

The Bottom Line

At the end of the day, how we are going to be affected by the Fed rate cut will take quite a while to be seen. Although there will be an immediate effect, the total effect of the move will take months to come to fruition. It all boils down to expectation and real economic indicators in the end, although the Fed said that it will continue to increase interest rates it also said that this will be gradual and it did not commit to any hard target. Jobless rates in the US are still not at desired levels so if we should have weak economic indicators in 2016 the pace of the internet rate hikes will be very slow or stopped completely. What is certain is that whatever happens in the USA will definitely affect us in Euro-land, and not just on the investments side.

KD