Foreign Exchange (Forex)

Foreign Exchange (also known as 'Forex' or 'FX') is the global marketplace where the world's currencies are traded. Think of it as a massive, decentralized bazaar, open 24 hours a day, five days a week, where instead of spices or silk, participants are buying and selling currencies like the US Dollar, the Euro, or the Japanese Yen. It is, by a huge margin, the largest and most liquid financial market on the planet, dwarfing even the stock market. Every time you travel abroad and swap your money for the local currency, you've participated in the Forex market. The price you pay is determined by the exchange rate, which is simply the value of one currency expressed in terms of another. For instance, if the EUR/USD exchange rate is 1.10, it means one Euro can be exchanged for one dollar and ten cents. This constant dance of currency values is driven by everything from international trade and tourism to massive investment flows and government policy.

At first glance, Forex might seem like a frantic trading pit for day traders and giant banks, a world away from the patient, business-focused approach of value investing. And you'd be partly right! Most value investors, including luminaries like Warren Buffett, don't speculate on short-term currency movements. However, ignoring Forex entirely would be a mistake, because it introduces a crucial and often overlooked layer of risk and opportunity: currency risk. Imagine you, an American investor, find a fantastic German manufacturing company. You do your homework, love the business, and buy its shares on the Frankfurt Stock Exchange for €100 per share when the exchange rate is 1.10 USD/EUR. Your cost in dollars is $110 per share (100 x 1.10). A year later, the business does wonderfully, and the stock price rises 20% to €120. Fantastic! But during that same year, the Euro weakens against the dollar, and the exchange rate falls to 1.00 USD/EUR. When you translate your investment back to dollars, that €120 share is now only worth $120 (120 x 1.00). Your investment in Euro terms is up 20%, but your actual return in your home currency is only about 9% ($120 / $110 - 1). The currency fluctuation ate nearly half of your gains. The reverse is also true: a strengthening Euro would have amplified your returns. This is currency risk in a nutshell, and it’s a vital consideration when you own international assets.

Currency values aren't random; they are influenced by a country's economic health and the decisions of its leaders. While billions are traded on pure speculation, the underlying fundamentals are what matter to long-term investors.

These are the heavy hitters that shape a currency's long-term trajectory:

• Interest Rates: This is arguably the biggest driver. A country's central bank (like the Federal Reserve in the U.S. or the European Central Bank in the Eurozone) sets benchmark interest rates. Higher rates offer lenders a better return, attracting foreign capital and increasing demand for that country's currency, which tends to strengthen it.
• Inflation: High inflation is like a slow leak in a currency's value. It erodes purchasing power, meaning your money buys less over time. Generally, countries with consistently high inflation see their currency depreciate against those with lower inflation.
• Economic Health & Stability: A strong, growing economy with low unemployment and political stability is like a magnet for investment. This increases demand for the country's currency, boosting its value. Key indicators include GDP growth and employment data.
• Balance of Payments: This is a record of all transactions between a country and the rest of the world. A country with a large and persistent trade deficit (importing more than it exports) may see its currency weaken over time, as it must constantly sell its own currency to buy foreign goods.

It's important to acknowledge that a vast portion of daily Forex volume comes from speculators—from hedge funds to the trading desks of big banks—betting on minute-to-minute price changes. They provide liquidity but also create the wild short-term volatility that makes Forex forecasting a notoriously difficult, if not impossible, game. As value investors, our goal isn't to play this game, but to understand its effects.

So, how do we apply a value mindset to the world of currencies? We don't try to predict; we prepare and look for opportunities.

Hedging is the act of taking a position to offset the risk of another. In this case, it would mean using financial instruments (derivatives like a currency forward) to lock in an exchange rate and protect your foreign investments from adverse currency moves. For most individual investors, this is often more trouble—and cost—than it's worth. The classic value investing take is that for a truly long-term investor holding a diversified portfolio of excellent global businesses, the need for explicit hedging diminishes. Over decades, currency fluctuations tend to even out. More importantly, a truly great global company (like Coca-Cola or Nestlé) earns revenue in dozens of currencies. They have entire departments dedicated to managing their own currency risk. By buying their stock, you are, in a sense, outsourcing your currency management to the experts.

Here’s where a value investor can turn Forex knowledge into an edge. Sometimes, a currency can become temporarily “cheap” for reasons of fear or political turmoil rather than long-term economic decay. Think of the UK's Brexit vote, which caused the British Pound to plummet. A value investor wouldn't just see chaos; they would see a potential opportunity. If you could find outstanding British companies whose underlying business value was unaffected by the political drama, you could buy their shares at a “double discount”: a fair price for the business, paid for with a temporarily depressed currency. When sentiment eventually normalizes and the currency recovers, you stand to benefit from both the business's success and the currency's rebound. This is how you use market fear, whether in stocks or currencies, to your advantage.