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.