As an island with its own currency, exchange rate movements affect us more than many. And it's not just the cost of foreign holidays that's affected, currency movements can impact the cost of your weekly shop, fuel prices and investment performance.
How does currency affect prices?
If an item or service is priced in a different currency, then the cost to us is determined by the exchange rate between that currency and the British pound (GBP).
For example, suppose you buy a television made in the US that's sold for $200. At an exchange rate of £1 = $1.6 it'll cost £125. But if the pound falls to £1 = $1.4 the price will increase to £143.
Of course, the US doesn't make many tv's nowadays, they're made in China. But Chinese exports are mostly sold in US dollars (USD) or Chinese Renminbi (which is loosely pegged to the dollar), so the example above still generally holds true.
Oil and other resources/foods are also traded globally in US dollars, meaning the cost of fuel and (to a lesser extent) food at your local supermarket depends, in part, on the GBP/USD exchange rate.
Does currency move a lot?
It can do. Take a look at the chart below showing the GBP against the USD over the last 10 years.
The exchange rate has varied from £1 = $1.4 to over $2. To put this in context, if you'd bought the $200 tv in November 2007 when the exchange rate was £1 = $2.04 it would have cost £98. But the price would have soared to £130 a year later when the USD had strengthened to £1 = $1.54.
Do currency movements affect my investments too?
Yes, in two ways. If you own investments priced in a foreign currency then their value when converted back into GBP will depend on exchange rates. But even shares in UK companies can be affected, as currency determines the cost of imports and exports.
Impact on investments priced in foreign currencies
Suppose you buy units in a European fund for £1,000. The fund manager uses the money to buy European shares in euros, so he or she will convert it at the prevailing exchange rate, just as you would when going on holiday to Europe. Let’s assume the exchange rate is £1 = €1.10, the manager buys €1,100 of shares with your £1,000. A month later and we'll assume the pound has strengthened against the euro to £1 = €1.2 but the share value remains unchanged at €1,100. Convert the investment back into pounds and it's worth £917 - you've lost money due to exchange rate movements. If the pound had weakened against the euro you would have made money.
In summary: a weak pound increases the value of investments held in other currencies while a strong pound reduces their value.
Some investment funds try to remove the risk of currency movement by ‘hedging’ currency. This means they effectively fix the exchange rate for your investment – useful when trying to reduce risk.
Impact on UK companies and investments
If the pound is weak it makes our imports more expensive and exports cheaper. So while this might be bad news for companies that import goods and raw materials, it should boost British companies that rely on exports. It also means that foreign investors are more likely to invest in Britain as the exchange rate is more favourable for them – and tourism could rise for the same reason.
Can you bet on currency movements?
If you own foreign investments or have bought your holiday money early, then you already stand to gain or lose from currency movements. But you can bet directly on currency movements in several ways:
- Buy foreign money - the simplest option, buy a foreign currency, stick the cash under your mattress and hope it strengthens against GBP. However, foreign exchange charges and spreads can eat into potential profits.
- Spread betting/Forex trading - bet on movements between currencies, although potentially high risk as you can lose more than your initial stake.
- ETFs - there are a few ETFs available that track currency movements.
- Foreign government bonds - buying the foreign equivalent of gilts will expose you to currency movements with an underlying investment that should be safer than shares.
What determines exchange rates?
Exchange rates depend on demand for and supply of a currency. The greater the demand, the stronger the currency will likely be. If supply increases, e.g. a country prints lots more money, you'd expect it to weaken.
The main factors that affect demand include:
- Interest rates – high rates relative to other countries can attract demand.
- Inflation – high inflation usually makes a currency less attractive.
- International trade – if a country exports more than it imports demand for its currency is likely to increase.
- International investment – investment money coming from overseas will probably push up demand.
- Political and economic stability – if other countries believe a particular country is weak they probably won’t want to own its currency.
- Government intervention - governments might sometimes manipulate exchange rates by buying or selling their currency. The Chinese did this formally in the past (selling their currency) to peg their Renminbi to the USD and still does so less formally.
ConclusionvIt's a good idea to understand the concept and impact of currency movements, even if you don't directly bet on it. It affects our everyday costs of living and will very likely impact on your investment portfolio, even if you only invest in UK companies. I think betting directly on currency is a step too far for most of us, but if you're feeling especially brave or insightful it can be profitable - George Soros famously made £1 billion by betting GBP would weaken against European currencies back in 1992.
If you're interested how currency movements (euro or dollar) have affected your overseas investments, take a look at the new Currency Calculator I've put together.