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by the Investors Offshore Editorial Team, November, 2012 , 02 November, 2012
For some of us, the forex, or foreign exchange, market is something we only encounter when going on holiday abroad, and many of us will often be heard to grumble that our pound/dollar/euro doesn’t go as far as it used to. However, for expats living or working temporarily overseas, as well as for companies transacting across borders, managing currency risk is crucial to ensure that income and profits are not gobbled up by volatile exchange rates and transaction costs.
It is almost taken for granted now that our lives are ruled to a large extent by the health of the financial markets. It is usually movements in stock markets that attract the most attention – when the markets plunge, we fear that it will only be a matter of time before the economy falls with it, affecting everything from incomes to job security and pensions and investments. Large swings in the value of currencies can have just as great an impact on spending power, however, and if you have interests overseas, they could have a huge effect on your wealth.
Consider the example of the millions of British expats who suffered as a result of the fall in the value of sterling a few years ago. Towards the end of the last decade, sterling fell about 20% against the euro. This meant that people who had left the country to live in places like France and Spain, but who still received income in pounds from the UK saw the value of their income reduced by a commensurate amount when converted. For those who had retired to a country in the eurozone on a relatively meagre income, this could mean the difference between living a comfortable existence or subsisting on much reduced income. Some were even forced to return home.
Unsurprisingly, the results of a survey published by Lloyds TSB International in June 2012 showed that well over half (57%) of expats are concerned about exchange rate fluctuations and the impact they could have on their finances. However, fewer than one in five (17%) answered that exchange rate movements were “one of their main financial concerns” for the coming year – a more surprising statistic given how the falling value of your home country’s currency can wipe a large chunk off your income in one go. It is though, the main concern for expats living off relative small incomes, and an earlier survey found that almost nine in ten expats with annual incomes of GBP25,000 or less were worried about exchange rate volatility.
To add insult to injury, commission and currency conversion fees will also eat into a cross-border transfer if money is exchanged through conventional means, by which we mainly mean banks. What’s more, you are likely to get a very poor exchange rate when using ‘high street’ banks or a bureaux de change to exchange currency. Indeed, all told, it has been calculated that British expats lose as much as GBP400m annually due to exchange rates and charges when converting their income into the local currency.
Banks and Brokers
So, if you are an expat retiree, or a peripatetic employee who is sent on assignment to a number of different countries, what do you do? Well, as one would expect, the answers range from the simple to the complicated. A simple solution would be to draw cash from your home bank account from an ATM in your host country. This way you are much more likely to have received the interbank rate at which banks buy and sell currencies to one another, rather than the huge buy-sell spread usually offered over-the-counter by banks. You will, however, invariably get charged for this withdrawal, and probably by both banks – your home bank and the one that owns the ATM.
A bank is, however, likely to be your first port of call if you are intending to transfer relatively large sums of money on a regular basis. Most of the major banks now have international or expat divisions which offer specialised currency services to expatriates. Traditionally though, even ‘expat’ banks have charged for transferring money from one currency into another, therefore the fewer transfers you make, the cheaper this will be in the long run. In more recent years though, many banks have begun to offer ‘fee free’ expat banking. Lloyds TSB International for example, introduced fee-free banking on May 31, 2012, while Citibank has recently removed transaction fees on cross-border money transfers.
One of the best ways of sheltering yourself from such currency fluctuations is to use a multi-currency account. These accounts enable you to hold your cash in a variety of currencies within a single account, and these facilities are now offered by many offshore banks, including the offshore branches of the major retail banks. As the name suggests, a multi-currency account may allow you, for example, to hold money in dollars, euros or pounds, and switch your deposits from one currency to another to take advantage of exchange rate trends. Multi-currency accounts also make life easier in terms of receiving income in one currency and paying bills in another; and by placing your currency needs all under one roof, so to speak, you will be charged only one set of fees, preventing you from racking up charges from holding several foreign currency accounts at once. What’s more, you could maximise interest income on your deposits by switching to the currency which attracts the highest interest rate. Like most financial services though, terms and conditions may vary considerably from one bank to another, so it pays to shop around.
Another option to consider is using the services provided by a specialist foreign exchange broker. As these firms tend to specialise only in foreign exchange services, and mostly to deal in larger amounts of currency, they are usually able to secure much better exchange rates than banks and could be more cost efficient to use generally. And because they are more attuned to movements in the various foreign exchange markets, they are in a better position to offer advice on mitigating future risks stemming from exchange rate volatility.
Many forex brokers and banks now offer forward contracts to cancel out the risk of future adverse exchange rate movements. These allow a stated amount of a given currency to be bought or sold at a specific price on an agreed date or range of dates in the future. Typically, a broker or bank will offer two types of contract: a fixed forward contract, where a client sells one currency, in exchange for a different currency, for a set amount, at a specific price, for delivery on a specific date in the future; and an option dated forward contract, where the customer sells one currency, in exchange for a different currency, for a set amount, at a specific price, but for delivery between two dates in the future. These contracts are, however, not an attempt to predict the rate at which two foreign currencies will be trading at a given point in the future. They are in fact calculated by taking into account the difference between the interest rates of the two countries involved. For example, on a six month forward contract, a bank may earn a lower rate of interest holding one currency deposit for the next six months compared with the rate of interest it is paying to borrow the other currency for the same length of time. The difference between the two is the interest rate differential and in this situation the difference is charged to the client by building it into the forward exchange rate itself. It must also be borne in mind that forward contracts such as these are legally binding on both parties.
The Forex Market
We have so far looked at currency issues as they affect expatriate individuals. However, this is just one segment of what is a huge market place. Any company that is buying products and services from another country which has a different currency, say for example a company in the US importing widgets from Germany, will have to use the foreign exchange markets to convert dollars into euros to make the payment. Indeed, reflecting globalisation, such cross-border transactions represented 65% of trading activity in April 2010, the highest share ever. The foreign exchange markets are of course also used by banks, hedge funds and other traders to make money from speculating on currency movements (see below). All this combined means that the global foreign exchange market is the largest and most liquid financial market of them all, with average turnover in the region of USD4 trillion per day.
The global foreign exchange market is also growing. According to the Bank of International Settlements triennial report on global foreign exchange market activity, last published in December 2010, global foreign exchange market turnover was 20% higher in April 2010 than in April 2007. The increase was driven by the 48% growth in turnover of spot transactions, which represent 37% of foreign exchange market turnover. Spot turnover rose to USD1.5 trillion in April 2010 from USD1 trillion in April 2007.
There are no forex exchanges as such. Foreign exchange trading tends to take place between financial institutions clustered in the major financial centres, with London accounting for the biggest single share at about 37%, followed by the US at 18%. There is however, a large market for foreign exchange hedging, and these instruments tend to be listed on the world’s largest financial exchanges.
The main types of foreign currency hedging tools are futures and options. By entering into a forex futures contract you are agreeing to exchange one currency for another at a set price but at an agreed date in the future. So, if our widget importer needs EUR1m to buy his next batch in three months’ time, but is worried that the dollar will fall in value in the meantime – meaning that he will need more dollars to buy the euros - he can sell a dollar futures contract to offset this loss. Futures are, of course, also used by speculators as a means to profit from currency fluctuations.
Entering into an option contract gives the owner the right, but not the obligation, to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The vast majority of these are traded off-exchange in ‘over the counter’ transactions between financial institutions.
The leading exchange for forex derivatives is the Chicago Mercantile Exchange (CME) with over USD120bn in daily liquidity. Listed on the CME are 56 futures and 31 options contracts on 20 currencies, including G10 currencies such as the euro and Japanese yen, as well as the currencies of countries with emerging markets, such as Mexico and China. These products are available for trading electronically virtually around the clock on the CME Globex platform London. The exchange also lists 20 cross-rate FX products that are non-US dollar pairs. These products include 12 contracts involving the euro, three with British pounds, three with Swiss francs, three with Canadian dollars, six with Japanese yen and four with Australian dollars.
As already noted, London and New York are the two locations where over half of the world’s foreign exchange trading takes place, and it is perhaps unsurprising that the US dollar and the euro are the most frequently traded currencies. However, it is also worth noting that the emergence of China as an economic superpower and a huge force in global trade is driving demand for its own currency, the renminbi, and the slow pace of liberalization of the RMB has begun to accelerate over the past two to three years.
Naturally, RMB trading is centred on Hong Kong, which just happens to be a major foreign currency trading centre and is on China’s doorstep. Speaking at the Renminbi Cross-Border Trade & Investment Forum in July 2012, Financial Secretary John Tsang confirmed that, as a Special Administrative Region of China and working under the principle of ‘One Country, Two Systems’, Hong Kong will continue to be “front and centre” in the RMB liberalization process.
However, he also said that Hong Kong's role as China's offshore global financial hub requires reaching out to financial centres around the world. "In particular, we see important opportunities in diversifying the range of RMB products, deepening the RMB market and making the best use of Hong Kong as the leading offshore centre for RMB-denominated business,” he added.
Tsang said that Hong Kong has built a stable platform for developing offshore RMB business supported by three sturdy pillars, namely RMB banking, bond issuance and trade settlement. “The mutually supportive nature of these three pillars is crucial,” he observed. “Together they provide the key ingredients for stable and balanced development of offshore RMB business. They generate offshore RMB liquidity, they open the door for international players to engage in RMB markets, and, perhaps most importantly, they create market-driven demand for RMB financial products."
He also noted that Chinese President Hu Jintao had reaffirmed the support of the Central Government for Hong Kong to develop into the nation's offshore RMB business centre during his recent visit to Hong Kong.
From August 1, 2012 banks in Hong Kong have been allowed to open RMB accounts for non-Hong Kong residents, and offer them a full range of RMB services.
Furthermore, Hong Kong Exchanges and Clearing Limited (HKEx) introduced the world’s first deliverable RMB currency futures on September 17, 2012.
The USD/RMB (Hong Kong) Futures will require delivery of USD by the seller and payment of the final settlement value in RMB by the buyer at maturity. They will be quoted in RMB per USD (for example, RMB 6.2486 per USD) and margined in RMB, with the trading and settlement fees charged in RMB.
Their final settlement price will be based on the spot USD/RMB (HK) fixing published by Hong Kong’s Treasury Markets Association. The following contract months were available for trading on September 17: October 2012, November 2012, December 2012, January 2013, March 2013, June 2013 and September 2013.
"These new futures are part of our strategy to offer a wide range of RMB-related products and expand beyond equities and equity-related derivatives into fixed income, currencies and commodities," said HKEx Chief Executive Charles Li. "In addition, they will help us support RMB internationalization and Hong Kong's further development as an offshore RMB centre."
"Although we do not have any volume or open interest targets, we see great long-term potential in RMB currency futures," said Calvin Tai, HKEx’s Head of Trading.
Currency trading can also be used as a means to make money, or balance out a diversified investment portfolio as well as a tool with which to hedge future exchange rate risk. Indeed, investing in the forex markets for profit is no longer the preserve of large financial institutions, and is becoming increasingly accessible to high-net-worth and retail investors through instruments such as currency funds and currency exchange-traded funds (ETFs).
Many financial institutions now offer currency funds to private clients, and approximately 700 currency funds and ETFs are listed as active by Bloomberg, including offerings from major banks and wealth management firms such as Deutsche Bank, Goldman Sachs, JP Morgan and UBS. There is also now a great deal of choice depending on the investor’s needs and risk appetite. Typically, such funds will take long-term positions in a basket of major currencies like the US dollar, sterling, the euro and the yen, but funds focussing on the currencies of emerging economies are also becoming popular. Currency funds aim to make money in all market conditions and might also utilize forward contracts and options.
Currency funds are normally structured as open-ended funds, but for the more adventurous (and wealthier) investor there are also hedge funds and funds of funds specializing in currency plays.
Currency ETFs are also widely used by investors who wish to gain exposure to the foreign exchange market and would prefer not to enter the futures or forex markets directly. First listed in the US in 1993, and in Europe in 2000, an ETF is an investment company with shares which trade intraday on stock exchanges at market-determined prices. Investors can buy and sell them in the same way as they currently trade in equities on an exchange. ETFs have become ever more popular due to their lower transactions costs and flexibility.
Currency ETFs work in a similar way to most other conventional ETFs in that they are designed to track the performance of an underlying investment. ETFs can invest in a single currency or basket of currencies and they aim to replicate movements in the foreign exchange market by holding currencies either directly or through currency-denominated short-term debt instruments. For example, a US Dollar ETF aims to track the change in value of the US dollar relative to another currency before taking into account fees and expenses. If the US and the other currency are at parity and the US dollar rises by 5% against the other currency, the price of the ETF should also rise by 5%. The assets of each currency ETF are invested in bank deposits denominated in the relevant foreign currency. Any interest earned on the deposits accrues to the benefit of the ETF and will be distributed to investors if the interest exceeds the fees and expenses of the ETF.
One advantage to forex investment is that currency trading movements have quite a low correlation to other markets such as stocks and bonds. And because they trade in relative rather than absolute value, it is possible to profit from currencies even when stock markets are falling.
A note of caution, however: currencies are notoriously difficult to predict, even for the most savvy fund manager (George Soros aside). This is partly because there are so many macroeconomic factors underpinning currency trends, such as interest and inflation rates, national current account balances, sovereign debt levels and so on. What’s more, central banks are prone to intervene in the currency markets in support of a currency in times of crisis at very short notice, which can induce large and unpredictable swings in the value of one currency against another.
Returns from currency funds have been solid, but by no means spectacular over the last five years. According to an equal weighted composite of managed programs that trade currencies on the interbank market complied by BarclayHedge, currency funds produced negative returns of -1.21% and -0.12% in 2005 and 2006 respectively, and have achieved an annual return of no higher than 3.5% since then. Estimated performance of 2012 based on data reported from the 108 currency programmes tracked by BarclayHedge up to the end of October is 0.99%. The compound annual return from these funds since 1987 is also quite puny, at 7.18%.
So, the forex market is something that affects us all either directly or indirectly, eroding the value of our income as currencies rise and fall against each other on the tides of macroeconomic trends. While it is possible to mitigate the risks of unfavourable movements in currencies, attempting to profit from these fluctuations is not for the faint hearted, and as an asset class, most advisors and wealth managers would recommend that they form only part of a well-balanced and diversified portfolio.