Wealth watch - Volatile exchange rates play havoc with investments

Published on Saturday 2 February 2008 14:51

WHEN it comes to turnover, the foreign exchange market is the largest financial market in the world. Movements in rates can be swift and sharp, with important implications for the institutional and the private investor.

In its last survey of the market in September 2007, the Bank for International Settlements estimated daily average turnover to be $3.2 trillion.

Traditionally the largest participants have been multinational banks which provide foreign exchange pricing for their corporate customers' needs and also take active positions in the markets themselves. However, over the past 10 years there has been a significant increase in volume from institutional investors, in particular hedge funds which are entering the market largely for speculative purposes. Central banks have also become more active in managing their reserves via the set-up of sovereign wealth funds. Private investor flows remain very small.

Exchange rate levels are determined by many factors – some short and some longer term. The traditional longer-term academic approach to forecasting movements is the Purchasing Power Parity (PPP) theory. The idea is that an exchange rate of 1>$2 would mean that a basket of goods bought in Scotland for 10 could be purchased in America for $20. If the goods in America cost $21, the exchange rate should over time move towards 1>$2.10.

It is, however, possible for an exchange rate to vary significantly from its PPP equilibrium level due to other shorter-term factors which influence exchange rates. These include relative economic outlook, relative interest rates and changes in expectations of future interest rates, central bank activities, merger and acquisition flows and domestic politics.

Exchange rates and their movements are important to investors for two main reasons. The first is the impact of exchange rate movements on returns from other asset classes. A good example is to look at the sterling-based returns of a UK domiciled investor with money in a Japanese bond fund. Japanese interest rates have been low for several years, with 10-year bond yields averaging circa 1.7% in 2007. In the second half of 2007 the sterling/Japanese yen rate moved 15% (from a high of 1>251 yen to a low of 1>213.5 yen), implying that the bulk of the absolute return in sterling terms was actually due to yen appreciation and not the returns on the underlying asset.

To understand the other reason that exchange rate movements are important, you must look at the foreign exchange market as an asset class in its own right. Over the past 10 years there has been growing institutional interest in seeking ways of both increasing returns and diversifying away from the more traditional markets such as bonds, stocks and property. Currency funds have benefited from this as foreign exchange returns are largely uncorrelated with the traditional market returns and the currency market is large and liquid.

Over the past year the foreign exchange markets have moved from a position of low to higher volatility. In the first half of 2007, exchange rate trends were broadly based on relative interest rate differentials with participants selling low interest rate currencies such as the Japanese yen or the Swiss franc and buying higher interest rate currencies such as the Australian or New Zealand dollar and emerging market currencies. Sterling also benefited from this so-called "carry trade".

However, as volatility has increased following the start of the global credit crunch and the subsequent economic slowdown, the positive returns from carry trades have diminished. There has been a general trend of risk aversion, repatriation and the pursuit of safe-haven currencies.

Over the past six months sterling has depreciated 4.5% against a basket of currencies of its major trading partners and significantly more against the Japanese yen and the Swiss franc.

It is highly doubtful that sterling will return to the heights of 1>$2.11 seen in November 2007; a slide towards $1.90 is more likely.

Simon Wood is investment director – currency at Standard Life Investments