I read the title of today’s Financial Tip on one of those sidebar advertisements on a webpage that you are usually better off not reading. Yet, I couldn’t resist. The trouble is that others might have the same lack of discipline, when it comes to sidebar advertisements. (Folks, I hate to tell you this but you probably won’t make $77 per hour with that on-line job that is being marketed.) I then thought about what is going on with the dollar in relation to other currencies and I wanted to know more. The result is a financial tip on exchange rate risk. It just might be educational.
As a review, we all remember (don’t we?) that there are risks associated with investments and that risks include the possibilities of both losing and gaining more money than we expect at the time we make the investment. We don’t worry much about business risk (the risk of the business doing better or worse than expected) or financial risk (the risk that over-indebted firms do better in good times and worse in bad times), as we can diversify away from these risks. The other risks, however, are always present and we should learn to embrace them – all of them – in order to be properly diversified in our portfolio. As a reminder, the other risks are:
- Interest rate risk – the risk that security prices move in the opposite direction to that of interest rates. If interest rates go up (down) the present value of future earnings/interest payments/dividends goes down (up).
- Market risk – the risk that the psychology of the market causes all investments to go up or down. (Remember how the value of stocks went down from October 2008 through March 2009?) When people are feeling confident, their psychology causes them to place more faith (money) in the future – causing security prices to rise – or when they are uncertain, they horde their money – causing security prices to fall.
- Reinvestment rate risk – the risk that an investment that pays a return of X% per year will have those payments reinvested at a rate either higher or lower than X%.
- Purchasing power risk – the risk that increases (decreases) in prices will erode (increase) the purchasing power of the payments we receive.
- Exchange rate risk – the risk that the currency in which our investment is held will either increase or decrease in value due to changes in what the currency is worth relative to the currency of the country where we live or, more importantly, where we spend our money.
Where do we stand today with respect to exchange rate risk? The chart below indicates that, yes, the dollar has fallen relative to other currencies during 2009. Clearly, there has been a decrease in the value of the US Dollar Index, since March. Yet, if one goes back far enough, the dollar is actually worth more against this basket of securities, than it was in late 2007. (See the following website and change the “Periods” from 60 to, say, 1000 to observe this: Dollar Index Chart.) Moreover, in the face of the financial crisis in Dubai and, some say, the looming financial crisis in Greece, the dollar has recently gained ground against the index currencies, as indicated by the uptick in December. (The index broke above the 50-day moving average, typically interpreted as a bullish sign by technical analysts.)
What does this mean to you? Let’s take a simple example and assume that you could have purchased a 100 units of the “index” (we will call the currency I$), in March, when the dollar index was at 89. The foreign currency “index” would have cost you, in US dollars, $112.36 (= I$100 * (100/89)). Today, when the dollar index is at 76, that foreign currency “index” could be sold for $131.58 (=I$100 * (100/76)), as the dollar is worth 14.6% less, relative to the index. Naturally, if the dollar index would have risen against the foreign currencies, instead of falling, you would have lost money on the transaction.
Another concept that is currently being discussed is that, while the dollar is losing value against other currencies in currency markets, it is actually undervalued relative to what the dollar will buy in terms of real goods and services. (If there is no under- or over-valuation, the market is said to be in Purchasing Power Parity.) That is, how the dollar is trading in currency markets is different than how prices are being charged within and between trading partners for goods. The following table shows that, for the currencies in the index, the dollar is undervalued in “purchasing power” relative to the Swiss Franc, the Japanese Yen, the Swedish Krone, the Euro, the Canadian Dollar, and the British Pound. Or, rather, ALL OF THE CURRENCIES IN THE US DOLLAR INDEX!
“So what do I do now, in order to use this information to help me reach financial success?”, you ask.
I answer, “I don’t know.”
I do know that changes in currency valuations are simply a transfer of wealth from countries whose currencies are devalued and toward countries where their currencies are gaining in value. Yet, for those countries whose currencies are devalued, they should experience an increase in their relatively less expensive exports and a decrease in their imports – thus improving the balance of trade and their economic well-being, over the short run. Moreover, an overvaluation or undervaluation of a currency based on Purchasing Power Parity will, over the long-run, be worked out and exchange rates will adjust toward parity. If we accept this, the dollar is currently undervalued in currency markets and could be expected to increase in value, relative to the index (and foreign stocks), over the long run.
While I remember what the economist John Maynard Keynes said, “In the long-run, we are all dead”, I also remember what I believe about investments and the world. For investments, diversification is a key principle and I believe that some exchange rate risk is good for a portfolio. For the world, regardless of whether the world is getting smaller or if the world is getting flat (as described by Thomas L. Friedman in his book, The World is Flat), we will be increasingly cooperative with other nations and we will find ways to increase the economic well-being of the world. To think we will choose otherwise, defies the lessons of history, the evolution of cultures, and accepts a long-run view where we are, as Lord Keynes said, all dead. I will not accept that vision of the future for our species.