Global Investing Opportunities
With the global markets becoming increasingly intertwined, investors are no longer limited to just investing in their local market. In this day and age of advanced technology, US investors can trade UK or Japanese stocks just as easily as they can trade US stocks. The same is true for other investors around the world who are seeing easier access to foreign markets thousands of miles away. However, as certain as you may be about where the Nikkei is headed, investing internationally comes with a risk that may not be as apparent. Foreign or currency risk is a gripe for investors big and small. Sometimes they can compound profits, but just as often, they can significantly reduce losses. Therefore, hedging or at least keeping an eye on the currency market is a must for any investor dabbling internationally. Over the past year, we have already seen currency fluctuations have a profound impact on market returns.
European Markets—A Winner for Some, a Loser for Others
US Investors Compound Profits in European Markets
European stock markets have been performing extremely well over the past year as the Euro zone’s economic recovery accelerates. Since the beginning of 2006, the DAX is up a whopping 12.5 percent while France’s index, the CAC-40 rose 11 percent. For US investors who converted US dollars into Euros, profits are increased even further thanks to a 7.6 percent appreciation in the EUR/USD exchange rate. The strong performance has been due to many reasons including, the European Central Bank’s interest rate hikes, a booming economy and diversification out of US dollars by other central banks around the world. Therefore, this move has worked to the benefit of international investors. Tacking on currency appreciation, US investors in the DAX would have scooped up 20.1 percent on the year while investors in the CAC-40 would have earned 18.7 percent, which is far above the low double digit gains seen before the currency impact.
Investors See Profits Eroded
However, the same cannot be said of UK investors who were in the same trade. The British pound has been selling off against the Euro since the beginning of the year. For investors who would have converted pounds into Euros, the value of their British pounds fell by 2.4 percent against the Euro. Therefore, the 12.5 percent gain on the DAX would have been shaved to 10.1 percent while the 11 percent rally in the CAC-40 would have only been a return of 8.6 percent.
Rise in Japanese Yen Cuts 43.6% of Profits for Some Nikkei Investors
Unfortunately this scenario is not unique to investors in the European stock markets. The Nikkei 225, Japan’s benchmark index has been seeing one of the best performances in years. In 2005, the Nikkei rallied close to 40 percent as foreign investors poured money into a country that has stepped out of a decade of stagnation. Strong demand from China has boosted the profitability of Japanese companies and has even prompted the Bank of Japan to drop their quantitative easing policy. However, at the same, domestic investors continued to move money out of the country in order to capture growing interest rates in the United States. This subsequently created an inverse relationship as the dollar rocketed to multiyear highs against the Japanese Yen. Reverting back to real figures, for the 11 months leading up to early December 2005, the Nikkei climbed 36.7 percent gain, increasing from the 11,500 figure to above the psychological 15,000 level. However, at the same time, the US dollar appreciated 18.9 percent against the yen which meant that for US investors, the Japanese Yen is worth a lot less than its initial value at the beginning 2005. This caused stock market gains to be cut by close to 50 percent.
Mexican Peso Turns Stock Market Profits Into Losses for European Traders
Meanwhile there has also been a lot of foreign interest in the Mexican stock market as well. In the past 2 months, Mexico's benchmark index the Bolsa rose 10.7 percent. On an annualized basis it is up 60 percent. However once again fluctuations in the currency market continue to cut into gains as the Mexican Peso fell 7 percent against the US dollar as the market speculates on another possible interest rate cut by the central bank. This turned a double digit gain for US investors into a mere single digit 3.7 percent rise. For European traders, the Euro appreciated 11.2 percent against the Peso over the past 2 months, which essentially turned a 10.7 percent profit into 0.5 percent loss.
Therefore, it is clear that for any international investor, it is extremely important to keep an eye on currency market fluctuations. For some, it can serve as a benefit to compound profits while for others it can turn profits into losses. Currency volatility is not completely uncontrollable. If you want to exposure only to the stock market and not have to worry about currency movements, you can hedge the FX portion of your investment directly through the spot market with the opportunity of earning interest income.
Take the Nikkei position for example. If you were a US investor putting $20,000 into the Nikkei stock market, at the beginning of January, you would have converted your dollars into yen at an exchange rate of approximately 102.50, giving you 2.05 million Yen. At the same time, to hedge the exposure, you would need to buy two mini lots of the USD/JPY currency pair – this way, you would hedge against a rising dollar and falling yen. Each mini lot would require a margin of $200 to earn interest, so the total margin needed would be $400. Therefore, opening an account with approximately $2500 should be more than enough to weather any adverse fluctuations. By early December 2005, the Nikkei rallied 36.7 percent and your 2.05 million yen investment was worth 2.802 million yen. However the exchange rate at the time increased to 121.40, which meant that that the 2.802 million yen was only worth $23,083.61, reducing the potential profit if exchange rates remained unchanged by $4,256.39. Thankfully, the hedge also appreciated in value, bringing in a total profit of $3,400. Interest income was approximately $800 over the year, which brought the total hedge profit to approximately $4,200. Tack that onto the $23,083.61 stock market return and we are just a few dollars shy of the $27,340 that the position would have earned if exchange rates remained unchanged.
The availability of margin as low as 1 to 2 percent of your investment makes it cost efficient for international investors to insure their stock market investments against FX volatility.
Opportunities Abound in the Currency Markets
Analysis of other markets is just one method that currency traders use to spot trading opportunities. Learn the basics of currency trading.