A guide to currencies and why they matter to investors Finance decoded

Civilisations have used currencies to exchange goods and services for thousands of years. Money, which has evolved from ancient coins to paper to digital versions, has long been used by humans as a means of exchange, a method of payment, a store of value and a unit of account. Yet in today’s financial markets, currencies do far more than simply facilitate exchange. How do currencies work in the global system we use today and why do their movements matter so much for investors?

What is a currency? 

A currency is the official money used in a country or region to price, buy and sell goods and services. Unlike shares or bonds, currencies don’t generate income on their own. However, changes in currency values can have a big impact on investment returns, since all assets are priced in at least one currency. 

What is foreign exchange?

Foreign exchange (often abbreviated to FX or forex) refers to the market where one currency is exchanged for another. It underpins all international trade and investment, as most cross-border transactions involve converting currencies. FX is always quoted in pairs, meaning one currency is priced relative to another. 

For example, the pound-dollar exchange rate shows how many US dollars one British pound can buy. If one pound buys more dollars today than it could yesterday, the pound has strengthened against the dollar. If it can buy fewer, the pound has weakened. 

This matters to investors because an overseas investment can be affected by two things: how the investment itself performs and how the currency in which it is priced rises or falls against the investor’s home currency. For example, a UK investor who buys shares in a US company will receive their return in pounds. The company’s share value may rise, but if the dollar falls against the pound at the same time, some of that gain can disappear when you convert the return back into pounds. If the dollar falls far enough, it could even outweigh the gain from the shares. The issue is not that the investment performed poorly, but that the currency loss outweighed the gain when measured in pounds.

What causes changes in exchange rates?

Exchange rates are driven by supply and demand. People, businesses and investors are constantly buying and selling different currencies, while central banks can influence the supply of money in circulation. Because currencies are always measured against one another, their value depends on the relative demand for each currency. If demand for the pound rises relative to demand for the US dollar, for example, the value of the pound will rise against the dollar. If demand for the pound falls relative to the dollar, its value will fall. 

Several factors can affect currency demand:

• Interest rates: Higher rates can offer investors a better return on savings or bonds held in that currency. This may encourage overseas investors to buy it, which can increase demand and potentially strengthen its value against other currencies. 
• Inflation: Inflation is the rate at which prices rise over time. Higher inflation reduces the purchasing power of a currency, which can make it less attractive to hold. 
• Trade: When a country exports more than it imports, foreign buyers may need to purchase its currency to pay for those goods and services. This can increase demand for the currency. 

In reality, exchange rates are the result of all these forces interacting at once, and no single factor is usually enough to determine the direction on its own. That is why currencies can be difficult to predict – even for experienced investors. 

Other factors can also affect currency demand, including a currency’s so-called “safe-haven” status. The US dollar, Swiss franc and Japanese yen are often considered safe-havens as they tend to hold their value and may even appreciate relative to most other currencies during market stress. Because they are seen as relatively dependable, investors may move money into them when they are concerned about the economy or financial markets, which can reinforce their demand and potentially increase their value. 

Other currencies are more closely linked to the prices of key exports. For example, the Norwegian krone and Brazilian real can be affected by changes in oil and other commodity prices, because exporting these resources is important to their economies.

How currency risk can be managed 

As exchange rates can be difficult to predict and can affect investment performance, investors typically treat currency movements less as a source of potential gains and more as a risk factor that needs to be managed within a portfolio. 

One way to manage currency risk is through hedging, which aims to reduce the impact of exchange rate movements on returns. A common approach is to use forward contracts, which essentially fix an exchange rate for a future transaction. It is important to note, however, that hedging is not free and can introduce additional costs, particularly for less frequently traded currencies.

Currency exposure is often hedged in fixed-income investments, such as bonds. Bonds are usually expected to provide steadier, more modest returns than shares, so a large move in the exchange rate can outweigh the return from the bond itself. 

For higher-return asset classes such as shares, long-term returns are more often driven by how the underlying companies grow and perform over time. Currency movements can still affect returns, but they usually have less influence on the overall outcome than they do for bonds. For this reason, deciding whether to hedge currency exposure in equity investments depends on an investor’s financial objectives, such as income needs, time horizon and tolerance for allowing currency risk to impact investment outcomes. 

What does this mean for investors? 

For most investors, the most important currency is their home or “domestic” currency – the one they use for their income, everyday spending, taxes and liabilities. As a result, investment portfolios are typically assessed in terms of their returns in this home currency. This does not mean portfolios should only hold domestic assets, but rather that investors need to be aware of how foreign currency exposure can affect overall returns. 

Different investors will have different levels of tolerance for currency risk. For example, a charity that needs to make regular annual payments in its home currency is likely to be more sensitive to currency fluctuations than an individual investor with a long-term horizon and no fixed liabilities. 

Currency exposure does not mean international investments should be avoided. Rather, it is one of the factors investors need to consider when deciding how a portfolio should support their objectives and financial commitments.

About the author

Andrew Teevan Senior Fund Analyst

Andrew has 8 years of experience in financial services and has just passed five years working at LGT. He currently works on the fund research team, specialising in equity funds. Prior to this he completed a master’s degree at the University of Cambridge and an undergraduate degree at the University of Bristol, studying history with a focus on the development of financial markets.