Foreign Exchange Rates

A Foreign Exchange Rate (also known as a Forex rate or FX rate) is simply the price of one country's Currency in terms of another. Think of it as a price tag. If the EUR/USD exchange rate is 1.10, it means you need 1.10 US dollars to buy one Euro. These rates are constantly shifting on the global Foreign Exchange Market, a massive, decentralized marketplace where currencies are traded. For the average person, these numbers might seem abstract, but they have a huge impact on our daily lives. They determine the cost of your Italian holiday, the price of a German car in America, and, crucially for investors, the value of your international stocks and bonds. Understanding the basics of what makes these rates tick is essential for anyone looking to invest beyond their home country's borders.

At its heart, the system is about pairing up currencies. A rate is always quoted in a pair, like GBP/JPY (British Pound vs. Japanese Yen). The first currency (GBP) is the base currency, and the second (JPY) is the quote currency. The rate tells you how much of the quote currency you need to buy one unit of the base currency. When you hear that a currency is “strengthening” or “appreciating,” it means its value is rising relative to another. Conversely, “weakening” or “depreciating” means its value is falling. There are two main systems that govern how these values are determined:

This is the most common system for major global currencies like the US Dollar, Euro, and British Pound. Under a Floating Exchange Rate system, the currency's value is determined by the open market through the forces of supply and demand. If more people want to buy Euros than sell them, the Euro's value will rise. This system is dynamic and reflects a country's economic health and investor sentiment in real-time.

In a Fixed Exchange Rate system, a country's government or Central Bank “pegs” its currency's official value to another country's currency or a basket of currencies. They maintain this fixed rate by buying or selling their own currency on the open market. For example, the Hong Kong Dollar is pegged to the US Dollar. This provides stability and predictability, which can be beneficial for smaller economies, but it also means the country gives up control over its monetary policy.

For floating currencies, a cocktail of economic factors keeps the rates in constant motion. While a hundred different things can influence the price, they generally boil down to a few key drivers.

Central banks set a country's base Interest Rate. If a country raises its interest rates, investments in that country (like government bonds) offer a higher return. This attracts foreign capital from investors seeking better yields. To buy these investments, they first need to buy the country's currency, which increases demand and pushes its value up.

Inflation erodes the purchasing power of a currency. Generally, a country with consistently lower inflation will see its currency appreciate against currencies of countries with higher inflation. The theory of Purchasing Power Parity (PPP) suggests that, over the long run, exchange rates should adjust so that an identical basket of goods costs the same in any two countries.

A country's overall economic performance and political stability are massive drivers. Strong GDP growth, low unemployment, and a stable government attract foreign investment, boosting the currency. A key indicator to watch is the Balance of Payments, which tracks all transactions between a country and the rest of the world. A country with a consistent surplus (exporting more than it imports) typically sees higher demand for its currency.

For followers of Value Investing, currency movements can feel like a distracting noise. The goal is to find great businesses, not to gamble on forex trends. However, ignoring exchange rates completely can be a costly mistake.

When you buy a stock in a foreign country, you're making two bets: one on the company and one on the currency. Imagine you're a European investor and you buy a US stock for $100 when the EUR/USD rate is 1.00 (meaning €1 = $1). Your investment costs you €100.

• Scenario 1 (Good): The stock rises 20% to $120, and the exchange rate stays the same. Your investment is now worth €120. A solid 20% return.
• Scenario 2 (Ugly): The stock rises 20% to $120, but the Euro strengthens against the Dollar, and the EUR/USD rate moves to 1.20. Now, your $120 is only worth €100 (€120 / 1.20). Your stock did well, but the currency move wiped out your entire gain.

So, what's a prudent investor to do? The answer is not to become a currency speculator. Instead, incorporate currency risk into your thinking:

• Focus on the Business: A truly wonderful business with a durable Economic Moat will create value over decades. This long-term value creation is far more powerful than short-term currency swings. Don't let fear of forex movements stop you from buying a world-class company.
• See it as a Pricing Factor: A strong home currency can be your friend. If the Euro is strong against the Dollar, it makes US stocks cheaper for you to buy. This can provide an extra Margin of Safety on your purchase. Conversely, a weak home currency can provide a temporary boost to your returns from foreign assets.
• Diversify: Owning great businesses in different countries and currency zones is a natural form of diversification. Over the long run, the gains and losses from currency movements tend to even out.

The key takeaway is to be aware of currency risk, but not to be guided by it. Your primary focus should always remain on the underlying value of the business you are buying.