Over the past 15 years we have all gotten a little more acquainted with national currencies, especially after many Americans heard or read about the 1997 Asian currencies crash and the others that followed suit. And more recently we have heard plenty about the European Euro.
What is a currency exchange rate and how does it affect its value. Simply put a currency’s value—what it’s worth in relation to other currencies—depends on how attractive it is in the marketplace. Exchange rates between currencies vary continually and often quite substantially. This variability can be a source of concern for anyone involved in international business. However, the risk can be hedged, that is investments can be made in such a way that rises when a currency declines. Currency futures contracts are most often used when businesses and governments hedge.
Until 1971, major trading nations had a fixed, or official, rate of exchange tied to the dollar—with the gold standard set at 35 U.S. dollars an ounce. Since the gold standard was abandoned, currencies have floated against each other—influenced by the currency trading and by various government controls. The result is that no country can control exchange rates or balance of trade payments. Prior to the Euro in Europe there were some cooperative, but not always successful, efforts at achieving a managed floating rate.
Wild or rapid changes in currency value usually indicate an economy in turmoil, including run-away inflation, defaults on loan agreements and serious balance-of-trade-deficits. The political environment can also cause a currency to rise or fall in value. A threat of war or civil unrest tends to make the dollar more valuable when compared to other currencies.
In time of crisis, investors think of the U.S. government and Treasury as solid and enduring. So many folks around the world believe they’re choosing the safest alternative by parking money in dollars.
The types of underlying economic conditions causes traders pay more, or sometimes less, for a specific currency. There are many times that a big demand for a nation’s goods and services creates a larger demand for the country’s domestic currency in order to pay for those goods and services. When there is a larger demand for a country’s stocks or bonds, that country’s currency will most often rise as foreign investors bid for its currency when they make investments. Often when there is a low inflation rate it reassures the investment community that longer-term purchases in that county, i.e. stocks, bonds and real estate, won’t decline badly in the future.
In most cases countries and their governments want their currency to be stable with small fluctuations. This helps to maintain a constant worth relative to other currencies of their major trading partners. Sometimes they try to intervene with market forces. They do this by buying large amounts of their own currency in the world market or make agreements with trading partners to lower interest rates.
Sometimes a currency declines in value because it is less attractive than others. If interest rates are lowered, for example, fewer foreign investors will want to put money in the country’s banks. They’ll look for better return elsewhere.
Other times, a currency is deliberately devalued. That happens when a government decides to lower the value of its currency against those of other countries, often to make its exports more competitive. That is exactly what has happened in Asia and Russia during the late 1990s.
Currency cross rates, the late New York trading prices of the basic units of eleven major currencies in relation to each other, are published in the financial press. These exchange rates apply to bank trades of $1 million or more, and therefore they most often reflect larger units of foreign currency per dollar than retail transaction would fetch.
Finally, Eurodollars are U.S. dollars on time deposit in non-U.S. banks. They can earn interest, be loaned or used to make investments in American or international companies. But they can no longer be redeemed for U.S. gold.
Quote of the Week: “No man is above the law and no man below it.”—Theodore Roosevelt
Bart Ward is the chief executive officer of Ward & Co. Ltd. an Anoka based registered investment advisor – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.