Just a little primer on the foreign currency exchange process.
As an investor, how do you diversify? For some investors who are looking at more esoteric uses for their money, currency investments may be worth taking a look at. It’s something that I have discussed with my spouse off and on: should we invest in currencies? Before doing anything on this front, let’s first deal with the mechanics of foreign currency exchange and why anyone might consider investing in it. What follows are just some of the basics of foreign exchange, from the point of view of the consumer and investor.
The Basics of Foreign Currency Exchange
Let’s say you want to buy some Euros thanks to a last minute trip to some place like Germany or Ireland. You have about $100 U.S. in your pocket, and you’ve found a bank that will be more than happy to turn your money into something you can actually use when you get off the plane — for a fee, mind you. A few minutes later, that nice gentleman at the bank hands you a few odd looking bills and some even stranger looking coins and bids you adieu, wishing you the best of trips.
Now, before you leave the counter, you swiftly look through the money you’ve been given and notice a discrepancy. You know that there was a fee involved to exchange the money, but dang! You didn’t realize that it was THAT much. Your $100 just turned into €71.97 (Euro). Confused, you turn back to that nice bank clerk, who, by the way, doesn’t look all that nice anymore, and you begin to complain that he must have made a mistake…but did he?
The Effect of Foreign Currency Exchange Rates
There’s no mistake here, of course. Those of us who’ve traveled out of the country would already know first-hand that the value of money shifts once we leave our borders. There’s a fee when you exchange your money for some other currency, but it’s only one part of the exchange process. The other piece to consider here is the exchange rate.
The exchange rate is basically the value of the currency you are trying to buy in relationship to the currency you are using to buy it with. There are a lot of complex economic theories at work behind this process, but in a nutshell, the U.S. Dollar is only worth a dollar in the U.S. It’s actually only worth €0.72 in Europe (that number changes on the fly).
The value of any particular currency is tied to the economic condition of the area it represents. This means that like stocks and other investments, the value of currency fluctuates constantly. Some days, the dollar is worth €0.72 in Europe and on other days it could be worth €0.80. Sometimes, the value fluctuates so much that it’s hard to keep up with.
When you invest in international or foreign mutual funds, your returns may or may not be hedged against currency movements — that would depend on how your mutual fund manager runs your fund. So if you’re particularly concerned with how currency impacts your returns (for the good or for the bad), you may want to make sure that you read your fund’s prospectus very carefully!
Leveraging Currency Exchange As A Form of Investment
For a savvy investor, there is a lot of money to be made in such a volatile market. Take for instance someone who buys a bunch of Euros when the value of the currency is weaker. This person can then make a substantial amount of cash after the currency gains strength against the native currency he or she bought the Euros with. But, on the flip side, there is a significant amount of risk involved with trading in foreign currencies. You could very easily end up with a lot of paper that is absolutely worthless. For most Average Joe investors trying to save up and invest for retirement, this is not a road that reasonable financial advisers would recommend that you take. However, if you find that you have a couple of bucks and are willing to take the risk, you might want to investigate the world of buying and selling foreign currencies in the foreign exchange market (e.g. Forex investing/trading). A better approach would be to invest in international mutual funds, where you can achieve diversification, not only through the inherent value of the assets of the fund, but also through the effect of currency exchange.
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