The currency markets are the largest and most complex financial markets in the world. With nearly $7 trillion of value transacted every day, the currency market is about 30 times larger than the New York Stock Exchange. Currency is traded not on an exchange, but within a computer system controlled by a handful of global banks.
About 180 currencies exist today. Theoretically each currency is convertible into any other currency. As a practical matter, about 90% of the transacted value on any given day involves at least one of the top ten currencies. Currencies are traded and quoted in pairs; over 50 active quotes exist at any one time for the U.S. Dollar (USD) alone.
The currency markets never close, except on weekends. The Tokyo market opens when the New York market closes. The London market opens when the Tokyo market closes. The New York market is open again when the London market closes. The currency markets literally follow the sun around the earth.
The price of a currency is the ratio of two values. Just as the price of a gallon of milk expressed in USD is the value of a USD divided by the value of a gallon of milk ($/gallon) so too is the price of a Swiss Franc expressed in USD is the value of a USD divided by the value of a Swiss Franc ($/CHF). The value of the Swiss Franc expressed in USD can therefore increase in one of two ways: the value of the USD can decline or the value of the Swiss Franc can increase.
We view the currency markets like a swimming pool. The pool is filled with global currencies. If you have Currency A and want Currency B, you dump Currency A into the exchange pool and take out Currency B. The one rule is the proportion of Currency B you take out relative to Currency A you put in is the same as the relative proportions of those two currencies that exist in the pool at the time of the conversion.
If Currency A and Currency B exist in the exchange pool in the exact same proportion, the exchange rate is one-for-one: you can take out one B for every A you put in. If there are twice as many As as Bs, you put in two As for every B you take out.
That sounds fairly basic, but that is more-or-less how the currency markets work.
The next time you exchange currencies at the airport, imagine dumping in the currency you have and pulling out the currency you want in the same proportion that the two currencies exist in the exchange pool.
Two things make the exchange pool especially interesting.
First, the actions of the users of the exchange pool change the ratios of the currencies in the pool. If you dump in Currency A and pull out Currency B, the ratio of Currency A to Currency B goes up ever so slightly. Currency B becomes scarcer relative to Currency A. We say in that case that Currency B strengthens relative to Currency A because anyone exchanging currencies after you exchange yours will need to put in slightly more Currency A for every Currency B they take out. Currency B becomes more valuable relative to Currency A.
The key thing to keep in mind is the currency that is being depleted in the exchange pool is becoming more valuable relative to other currencies.
Second, everyone uses the same exchange pool. Just as your actions change the ratios of currencies in the pool, so too do other people’s actions change the ratios of currencies in the pool. If someone has currency B and wants Currency A, his actions in the exchange pool will offset your actions. You dump in Currency A and pull out Currency B. He dumps in Currency B and pulls out Currency A. If the two of you match up perfectly, your actions will offset his and his actions will offset yours. The ratio of Currency A to Currency B will stay the same. It is the net effect of all actions in the exchange pool that changes the ratios.
As international investors, does the exchange pool really matter? You bet it does.
At KP7, our goal is to generate returns in USDs. If we make an investment outside the United States, the return we realize in USDs depends both on the return we achieve in local (i.e., foreign) currency terms and also on the movement of the exchange rate during the time we hold the investment. Exchange rate movements during the investment period can either add to or detract from the return we achieve in the foreign currency.
If the users of the exchange pool deplete the exchange pool of USDs or dump in lots of local currency relative to USDs during the time we hold the investment, the number of USDs we get out on a relative basis at the end of the investment period is less than the USDs we put in at the beginning of the investment period. The USD strengthened versus other currencies in the exchange pool during the time we held our foreign investment. Because of the strong USD during the investment period, we had to put in more local currency for every USD we took out at the end of the investment. That would detract from the returns we realized in the foreign currency.
The net effect of the users of the exchange pool worked against us in this case by strengthening the USD.
It is not unusual for the exchange pool to offset positive local returns completely or even turn a positive local return into a negative USD return after converting back to USD.
Alternatively, if the users of the exchange pool deplete the local currency or dump in lots of USD relative to the local currency during the investment period, we would get more USD out of the exchange pool on a relative basis than we put in, which would add to the returns we achieved on a local basis. The exchange pool worked in our favor during the period of investment in this case, adding to the returns we achieved in foreign currency terms.
It is not unusual for the exchange pool to turn a mediocre investment at the local level into an extraordinary investment once converted back to USD.
The key thing to keep in mind here is a strengthening local currency relative to your home currency adds to the local returns for an international investor and a weakening local currency detracts from the local returns.
When we analyze an investment outside the U.S., we assess who is likely to use the exchange pool during the expected investment period. We try to anticipate future activity in the pool that will deplete the exchange pool of the local currency of the country we are investing in. That will add to the returns we achieve locally in the foreign country. We likewise do our best to avoid those countries whose currencies will accumulate in the exchange pool. That would detract from the returns we achieve in the foreign currency. By successfully anticipating the future use of the exchange pool, we set ourselves up for an exchange pool that will add to our local currency returns during the time we hold international investments.
