Currency risk and the opportunity to make gains from foreign exchange used to be issues that only concerned bankers and the treasurers of big companies in Canada. But the increasing globalization of markets means ordinary investors must pay much more attention to shifting rates for currencies. Individual portfolios may not contain direct investments in foreign securities, but almost every portfolio will have some exposure to currency risk.
- Investors who buy stocks indirectly through mutual funds are likely to have a foreign currency component, because these institutions will have non-Canadian stocks within many of their portfolios.
- Canadian public companies are increasingly global, and their foreign currency exposure in trade will have a bearing on their earnings outlook, which in turn affects stock prices and the ability to cover bond interest payments. A related factor is that many industries are global and prices charged by foreign competitors can have an impact on the pricing power and profitability of Canadian companies.
One way of looking at currency value is to think of it as the stock price for a country. A strong currency represents solid national earning power. A weak currency represents a weak economy, and any signs of improvement will be reflected in a rise in the currency value. There are several reasons why a currency value fluctuates. When interest rates change more in one country than in others, foreign investors take notice. Higher rates in Canada compared with the U.S. represent a Canada premium to offshore investors looking to place money in North America. High rates attract money into the country, creating a demand for C$s.
That demand pushes up the value of the currency. Strength in the currency allows interest rates to fall, which means swings in currency values will be corrected by the market if there are no other factors in the equation.
But there may be political risks that force interest rates higher, and those risks can depress a currency value. The Quebec referendum on separation is one of the best examples of how political risk can drive down a currency.
Inflation is another significant factor in the mix of influences on currency values. A rapid rise in prices represents an artificial increase in the value of assets within the domestic economy, and the international market will correct that situation by devaluing the currency.
Too much debt within the domestic economy -- either through government or private sector borrowing -- can put downward pressure on the currency. In this situation, the borrowers must rely on foreign lenders, and the currency will suffer if the economy is seen to be dangerously exposed to external creditors.
An important concept in the study of money is the reserve currency, which is the anchor of the international monetary system. The reserve currency is now the US$.
As that name implies, the US$ is the unit of measure for official reserves held by central banks around the world. Those reserves are kept for the defence of the local currency during times of instability.
For example, the Bank of Canada intervened in currency markets -- selling US$s to buy C$s to support the C$'s price -- when there were turbulent trading periods at the time of the last Quebec referendum.
Another feature of the reserve currency is that it is the unit for pricing major commodities. It's also the currency used for the accounts of such international agencies as the World Bank and the International Monetary Fund. While the US$ remains the world's most important currency, the European Union's euro, introduced this year, has become a rival to the US$ as a major reserve currency. The euro is a pan-European currency that replaced 11 currencies, including the German mark, French franc, Italian lira and the Austrian schilling.
There is no comparable currency in Asia and until 1997 many Asian currencies were formally pegged to the US$. The notable exception has been the Japanese yen and financial reform in Asia may involve the emergence of the yen as a regional reserve currency.
The relationships between the currencies of different countries are established on foreign exchange markets in much the same way as the values of other investments are determined -- through supply and demand.
Currencies are traded through a computer and telephone network, much as bonds are bought and sold. Banks and investment dealers that operate internationally form the core of this market, and London is the main centre for trading. New York is also a large currency trading location and Chicago has the leading markets for currency futures.