Making Money from Money: The World of Currencies

Tom Lydon

A dollar doesn’t get what it used to these days. For decades, citizens of the United States who went abroad could eat the finest meals and stay in luxury accommodations, largely on the strength of the U.S. dollar. But those days seem to be over. In recent years, the dollar has become significantly weaker than other major currencies. At one point, US$1 was worth half of £1. After the euro came into being, the weak dollar made traveling to European countries that used the currency an expensive proposition.

But having a strong or weak currency is never uniformly a good or bad thing. You should consider the implications for both circumstances. Imports and exports can suffer when two currencies have vastly different values. With a weak dollar, you may be less inclined to purchase luxury goods manufactured in countries with much stronger currencies. Meanwhile, manufacturers in countries with stronger currencies worry because their U.S. sales are down.

Monitoring the Ups and Downs of Money

The foreign exchange market (or forex, as it’s known) involves a lot of moving parts, especially when it comes to investing in the money supply of all global economies. It’s much larger than the typical stock exchange and every bit as challenging to attempt to predict.

Just as no one knows where the stock market or commodity prices are ultimately going, no one knows where currencies are going on a day-to-day basis, either. No one has come up with a foolproof method of charting the future on a daily basis. And those who think they know how to do it are usually wrong. For this reason, currencies have a place in an overall trend following strategy.

Currencies go through up-and-down trends and can be followed using a 200-day moving average. Currencies can enhance portfolio returns and lower volatility, are independent of stock and bond prices, and can be a way to diversify risk and introduce new sources of return.

As long as the U.S. dollar remains weak, trends tend to favor foreign currencies. Instead of predicting when the dollar will rebound, you can wait for the euro or Swiss franc to go below their trend lines. Although the U.S. dollar finally busted through a long-term downtrend in mid-2008, breaking above its 200-day moving average, many people believe that the dollar will continue its decline against other currencies around the world. Trend followers, of course, let the numbers speak for themselves.

How Currencies Are Valued

How are the values of these currencies determined? A number of factors come into play:

• Political conditions—How stable is the government? Is it corrupt? Can it be bribed? Does the country play well with others, especially big players such as the United States, China, and Russia? Take a look at the form of government: Is it a dictatorship? Communist? A democracy?

• The economy—The unemployment rate, the country’s overall work ethic, inflation, and the general direction of the economy are all factors. Also, is the country older or newer? What is its chief industry (technology, agriculture, manufacturing)? Does the government run a budget/trade surplus or deficit? Does it have to borrow heavily? Are interest rates going up or down within their monetary system? (Up is bullish for the currency.)

• Outside perception—Appearances shouldn’t matter, but like it or not, they do. Perception might have no basis in reality, but news reports, movies, newspapers, and good old-fashioned rumors can affect how a country appears to the rest of the world. Another factor in a currency’s value is how much is known about its country: the less known, the lower the value. This is one instance when it doesn’t pay to be an enigma.

• Demographics—A young population tends to signal a bright future full of people who are open to growth, new ideas, and change.

• Public figures—Whether leading the country or merely being famous, the best-known people in a country can hold great sway over how their homeland is perceived.

• Level of openness—Privacy costs a country’s currency. Cuba has been isolated for some time. China is becoming more open. Venezuela is becoming more isolated. If a country is slowly becoming closed off from the outside world, its currency will suffer.

• Natural resources—How in-demand is a country’s resources? If value is perceived (whether legitimately or not), the currency will go up.

• Weather—Not only is the type of weather and the severity of it important, but also how a country responds to weather-related disasters is a factor in its currency value. All this affects how the outside world perceives the country, and it will be a less attractive tourist destination if its response to disaster is poor.

• War and conflicts—Who are the country’s allies? Who are its enemies? How strong is the military? Is the country at war or experiencing civil conflict, border disputes, internal genocide, or other problems?

• Education—The level of education of a country’s population affects the value of the currency. How connected are they to the Internet? Do they speak a number of languages? Does the country have a lot of scientists, inventors, and authors?

Making the Most Out of Currency ETFs

Currency exchange traded funds (ETFs) have simplified investment in this market for millions of people. In 2007, the forex market garnered $3.2 trillion worth of transactions each day. This makes the market the quiet giant of finance, towering over all other capital markets in its world.

But there are things you need to know about these ETFs, and this complex and interesting market overall. Some of the key points to currency trading are

• When trading currencies, yield drives return. When you trade currencies, you are actually buying and selling two underlying currencies: All currencies are quoted in pairs because currencies are valued in relation to one another. For this reason, the yield between the two becomes important. Say Currency X has a yield of 4% and Currency Y has a yield of 1%. If you go long on X/Y, you will earn 4% but will have to pay 1%. Your net is 3%.

• The forex allows huge leverage—often as high as 100:1—which means that you can control $10,000 worth of assets with as little as $100 of capital. Remember though, leverage works both ways.

• Since currency values never stay the same, the carry trade became a popular play on the market. The carry trade involves selling one currency with a low interest rate and then using the proceeds to buy a different currency that yields a higher interest rate. For example, an investor borrows 1,000 yen and converts the money into U.S. dollars and buys a bond for an equivalent amount. Assuming the bond pays 5% and the Japanese interest rate is 0%, the trader stands to make a profit of 5% if the interest rates between Japan and the United States don’t change. The interest rates are the risk in the carry trade, as well: If the dollar loses value to the yen, money is lost.

• Interest rates matter—a lot. Becoming familiar with the economics and currency of the country in which you are trading will help you understand when inflation is looming and when opportunity is knocking.

When entering the currency market, there are eight major currencies worth trading, which give you the best over- or under-valued opportunities. The eight regions that make up the largest portion of the currency trading market are the United States, the Eurozone (Germany, France, Italy, and Spain), Japan, United Kingdom, Switzerland, Australia, Canada, and New Zealand. There are many more than this, though.

Security Global Investors/Rydex Investments offers eight currency-focused ETFs—the first such ETFs—called CurrencyShares (www.currencyshares.com). They’re structured as grantor trusts that hold the underlying currency, and they gain or lose value based on exchange rates and any overnight interest accrued. Grantor trusts relate to the taxation of a trust’s income—in this case, the grantor pays the tax. (In other situations, the trust and/or its beneficiaries would pay it.)

The CurrencyShares Fund includes these ETFs:

• CurrencyShares Japanese Yen (FXY)

• CurrencyShares Euro (FXE)

• CurrencyShares Swedish Krona (FXS)

Instead of picking a direction for any one currency, and to get the most diversification, you might consider the PowerShares DB G10 Currency Harvest (DBV), launched by PowerShares in September 2006. It trades on the view that, historically, currencies with higher interest rates outperform those with lower rates. (The G10 is a group of the ten major industrialized countries—Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Britain, and the United States.)

Essentially, the ETF incorporates a carry trade by going long on the futures of the three currencies with the highest interest rates and going short on those with the lowest rates. Those rates are reviewed every quarter, and the longs and shorts are reallocated, if necessary. The fund seeks to track the Deutsche Bank G10 Currency Future Harvest Index.

WisdomTree (www.wisdomtree.com) also has a line of currency ETFs that seek to earn current income reflective of money market rates available to U.S. investors. These funds include the following:

• WisdomTree Dreyfus Chinese Yuan Fund (CYB)

• WisdomTree Dreyfus Indian Rupee Fund (ICN)

• WisdomTree Dreyfus Brazilian Real Fund (BZF)

In May 2009, WisdomTree also launched the WisdomTree Dreyfus Emerging Currency Fund (CEW), a basket of 11 emerging market currencies, giving exposure through the use of forward contracts.

There are also two ways to play the movements of the U.S. dollar directly: PowerShares DB U.S. Dollar Bullish (UUP), and PowerShares DB U.S. Dollar Bearish (UDN). If the dollar looks weak, UDN is one way to try to capitalize. On the other hand, as the dollar gains steam, UUP might be an option if a clear uptrend emerges.

Squeezing the Most from Your Dollars

Currency ETFs have grown especially popular in the time since the first such fund was launched. Aside from the diversification they offer, investors enjoy taking advantage of international interest-rate adjustments and geopolitical issues.

The main advantage of trading with a currency ETF is the same advantage offered to other ETFs: transparency. The exchange rate is listed and everyone gets the same price, unlike when you attempt to buy currency in a foreign country and get a little ripped off. Because there’s a minimum trade of one share, the investment an investor has to make is much smaller than in a typical foreign exchange trade.

Worldwide currency can be volatile and is affected by a wide range of factors. Currency ETFs give you a way to bet against the U.S. dollar and gain foreign market exposure without betting, and possibly losing, the entire farm. If you feel that you’re ready to get involved, here’s what you should know:

• Currency ETFs have different tax rules than regular ETFs. Interest income and gains are taxed at the ordinary income tax rate instead of at the long-term capital gains rate.

• Read the newspaper. Check out the political situation of the country’s currency you’ve invested in. Some areas are more volatile than others, but you should always pay attention to the factors that could determine whether the currency rises or falls.

• Don’t put all your eggs in one basket. ETFs can be a simple way to get exposure to a basket of several currencies, thereby spreading around the risk.

• Patience is key. Don’t dive in and out of currency ETFs hoping to score big. Know how much risk is involved.

• Keep in mind that many individual retirement account (IRA)-qualified accounts don’t typically permit currency trading, and institutions often are restricted from holding certain assets but are permitted to hold ETFs. Voilá—the currency ETF solves that problem, and everyone wins while still following the rules.

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