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Currency Markets
Part I
by WealthEffect Staff


Currency affects corporate profits
  Currency affects the trade between countries  
  The value of a dollar is based on what it can buy  

The strength of the dollar in recent years has affected profits, as well as inflation trade. When the dollar rises in value, it reduces the profits of U.S. corporations which do business in other countries: The profits earned in foreign countries are worth less when converted back to dollars. The impact of a stronger dollar has been significant on multinational companies such as Coca-Cola, Gillette and McDonald's.

Fluctuations in the prices of currencies also affect trade between countries. A rising dollar reduces the cost of the goods and services bought from other countries, which keeps U.S. inflation low but it also raises the cost of goods and services sold to other countries. A strengthening currency therefore hurts the competitive position of businesses — this in turn worsens our trade deficit (more imports than exports).

Currency prices are important because this is how we measure the value of the assets we own. The value of any asset in the U.S., whether food or cars or stocks, is stated in terms of dollars. If for example a gallon of gasoline doubles in price from $1 to $2, gasoline is now worth twice as many dollars. At the same time, the dollar — in terms of that gallon of gasoline — is worth less; in this case, the value of a dollar has fallen from 1 gallon to gallon. The foreign-exchange markets are the same — here, dollars are valued in terms of other currencies such as Japanese yen, British pounds, West German marks, etc.

Currency Markets
Part II


How interest rates affect currencies
  How purchasing power affects currencies  
  How the real world affects currencies  

In theory, the value of a currency responds to the Interest Rate Parity Theory (IRPT) and the Purchasing Power Parity Hypothesis (PPP). The IRPT states that money will flow into the currency that offers the highest interest rates on that money, after adjusting for the gain or loss of converting that interest back into your own currency (through foreign-exchange futures).

For example, let's say that you can earn 5% on your money in the United States for a year and 4% in Switzerland, but the Swiss franc is selling at a 3% premium to the U.S. dollar one year out. Your total return of 7% from investing in francs would be higher than your 5% return in the United States, encouraging you to invest in Switzerland: Buy francs, invest them at 4%, and sell currency futures so you can convert your francs back to dollar in one year.

Similar to this theory is the argument that you should invest in countries with the highest real interest rates — the stated rate minus inflation — with a subjective adjustment for political and economic risk, without worrying about buying or selling currency futures.


On the other hand, the PPP argues that currencies should sell at levels that equalize the cost of purchasing the same products in different countries. Unfortunately, this parity is difficult to determine, since even similar products can vary widely in quality between countries.

In the real world, the value of a currency should tend toward this interest-rate and purchasing-power parities over time, much as a stock will tend towards its intrinsic value. George Soros, the legendary speculator, disagrees with this logic, however, and further argues that the speculative flows in the foreign exchange markets are even more dominant than those in the stock market. Put more simply, the currency markets are more at the market of trend-followers, and intrinsic value gets ignored more dramatically than in the stock market.

Considering the importance of the dollar in world trade, its instability might seem a bit surprising. Various governments do intervene, alone or in combination, by selling or buying currencies; their goal is usually to smooth out fluctuations in the foreign exchange market, and sometimes to give it a specific direction. Still, the best-laid plans of central banks are often submerged under the flood of money from private investors and speculators.

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