Currency Exchange Rates

Currency Exchange Rates (also known as 'Foreign Exchange Rates' or 'FX Rates') represent the price of one country's currency in terms of another. Think of it like a price tag: if the EUR/USD exchange rate is 1.10, it means one Euro costs 1.10 US dollars. This simple number is one of the most powerful forces in global finance, affecting everything from the price of your European vacation and imported wine to the profits of multinational corporations. For an investor, understanding exchange rates is not just an academic exercise; it's a critical component of navigating the global marketplace. Fluctuations in these rates can dramatically impact the real returns on your international investments, turning a profitable stock pick into a loss, or vice-versa. As value investors, we seek to understand all the variables that can affect the long-term value of our assets, and currency risk is a big one that should never be ignored.

The constant buying and selling of currencies happens in the Foreign Exchange Market (Forex), the largest and most liquid financial market in the world. It’s a decentralized global network where banks, corporations, governments, and individual speculators trade currencies 24 hours a day, five days a week. Currencies are always traded in pairs. For example, in the EUR/USD pair, the Euro is the 'base' currency and the US dollar is the 'quote' currency. The rate tells you how many units of the quote currency are needed to buy one unit of the base currency. Other major pairs include the British pound vs. the Japanese yen (GBP/JPY) or the US dollar vs. the Japanese yen (USD/JPY).

Exchange rates are in constant flux, pushed and pulled by a host of economic and political factors. A country’s currency is like a share in its economy; when the country does well, demand for its currency increases, and its price goes up. Here are the key drivers:

• Interest Rates: This is a big one. Central banks like the Federal Reserve (Fed) in the US and the European Central Bank (ECB) set benchmark interest rates. Higher rates offer lenders a better return, attracting foreign capital and increasing demand for the home currency.
• Inflation: High inflation erodes the purchasing power of a currency. If prices in a country are rising rapidly, its currency will be worth less, causing it to depreciate against others.
• Economic Health: Strong economic indicators—like high GDP growth, low unemployment, and a stable political environment—boost investor confidence, strengthening a currency.
• Public Debt: A country with massive and growing government debt may be seen as a risky bet, potentially leading to currency weakness as investors shy away.
• Balance of Trade: A country that exports more than it imports has a trade surplus. This means foreigners are buying more of that country's goods, which requires them to buy more of its currency, pushing up its value.

Imagine you're a US-based investor and you buy shares in a fantastic French company for €100 per share. At the time, the exchange rate is 1.20 USD/EUR, so your investment costs you $120. A year later, the stock has done brilliantly and is now worth €110—a 10% gain. You decide to sell. However, during that year, the Euro has weakened against the dollar, and the exchange rate is now 1.05 USD/EUR. When you convert your €110 back to dollars, you only get $115.50 (€110 x 1.05). Despite the stock's success, you've lost $4.50 on your initial $120 investment! This is exchange-rate risk in action. It’s the danger that currency movements can erode or even wipe out the gains you make on an underlying asset.

So, what's a prudent investor to do? Try to become a currency-forecasting wizard? Absolutely not. Predicting short-term currency swings is a speculator's game, not a value investor's. Instead, we should integrate currency awareness into our fundamental analysis.

• Widen Your Margin of Safety: When buying a foreign company, your margin of safety should account not only for business risk and price risk but also for currency risk. If a currency looks fundamentally overvalued (e.g., due to an unsustainable economic bubble), you should be extra cautious, even if the company itself looks cheap.
• Focus on Long-Term Fundamentals: Don't get caught up in daily forex noise. Instead, assess the long-term economic stability and prospects of the country whose currency you're buying into. A stake in a Swiss company is also a stake in the long-term stability of the Swiss franc.
• Diversify Geographically: Don't put all your international eggs in one basket. Spreading your investments across several strong, stable economies (and therefore currencies) is the simplest and most effective way to mitigate the risk of any single currency's decline sinking your portfolio.
• Understand Hedging (But Use with Caution): Some professional investors use currency hedging—employing financial instruments like forwards or options to lock in a future exchange rate. While it can neutralize currency risk, it also costs money (which eats into returns) and adds complexity. For most individual investors, diversification is a more practical strategy.