The value of the currency in our pockets continually fluctuates based on world events. For example, immediately after the UK announced its intention to leave the European Union in June 2016, the pound fell in value against the dollar from $1.42/£1 to $1.36/£1. Although this may seem like an abstract price movement for an ordinary member of the public, the price movement of currencies can actually have a significant impact on our investments.
Why Do Currencies Change Value?
The value of a currency is affected by a variety of variables. However, chiefly, the exchange rate of two currencies fluctuates depending on levels of supply and demand. This is often determined by the rate of inflation, the monetary policy of that country, and the country’s political and economic conditions, as well as a number of other factors. A stronger economy generally implies a stronger currency, as strong economic performance makes global investors more inclined to buy assets denominated in that currency.
However, it should also be noted that all of these factors create a level of systematic and unsystematic risk for investors, as many of these political announcements and policy decisions can be hard to predict.
How Do Changing Currency Prices Impact My Investments?
Forex traders are directly exposed to fluctuations in currency prices. Currencies are bought and sold in pairs, which will then rise or fall in value against the other. In addition, in these trades, bought currencies earn interest while sold currencies impose interest.
But, you don’t need to be investing in the forex market for currency price movements to affect your investments, particularly if you invest in foreign stocks or bonds. This is because any profits or losses you make can be offset by a shift in the currency’s value against sterling.
For example, if you buy shares in a European firm worth €5 per share and the exchange rate is €1.5/£1, each share is worth £3.33. Should you buy 50 shares, you will pay £166.50. If, one year later, the share price remains €5 but the exchange rate changes to €1.34/£1, your shares will be worth £186.56, meaning you have made £20.06 as a direct result of fluctuating currency prices.
Likewise, even if you only hold UK assets, you’re exposed to fluctuating currency values, as many UK companies make their sales abroad, which leads to rising and falling profits when these deals are translated back into sterling.
How Do I Protect Myself from Fluctuating Currency Prices?
Currency price movements are incredibly difficult to predict, and although you can avoid direct exposure by not investing in the forex market, it’s incredibly difficult to avoid indirect exposure in other investments.
By diversifying your portfolio of investments to include small firms, blue-chip companies and overseas investments, you can help to mitigate some risk through geographic diversification. In addition, by spreading your investments out, losses in one market may be offset by good performance in another.
However, remember that if you buy shares in a foreign company, for example, you’re making investment decisions based on the company and the performance of the currency, so you’ll need to assess both factors before you invest.
By ensuring that your portfolio is diversified, you’ll be able to ensure that you’re not overly-exposed to a particular risk. However, before you make any investment decision, you should remember the potential impact of the risk caused by fluctuating currency prices. Overall, your level of exposure to currency risk is likely to be predicted by your risk tolerance level.