IF you've ever bought a foreign stock or bond, or invested in a fund that's not denominated in your own currency, you already know about foreign exchange (FX). Even more basic than this, however, is your source of wealth creation. Perhaps you bought some property overseas, or built a business from exporting to another country, or even took loans in a different currency. All of these things create FX risk. And where there's risk, there's opportunity.
As the world becomes smaller, and technology evolves faster, it's now possible for a larger number of people to touch global financial markets and access lucrative investment opportunities regardless of geography. Our lifestyles reflect this too, with the property in another location, the children who study in a foreign school or university, and the holiday overseas. And most fundamental of all: the source of wealth. The business reliant on manufacturing in a lower-cost developing country or on exports to western markets, or on raw materials denominated in USD, or even competing with manufacturers in neighbouring countries.
With these come the attendant risks associated with fluctuations in exchange rates. Interestingly, even as business owners look to hedge these risks in their businesses, they seldom stop to think about how these risks could affect their own personal net worth.
Fluctuations in the values of these currencies can have a significant impact, not just on investment portfolios, but even on investors' personal net worth. It might have been possible for investors to ignore the FX impact on portfolios and wealth as recently as even a decade ago, but those who choose not to manage it today, do so at their own peril. Ignoring FX risk on an unhedged portfolio or source of wealth creation is the same as actively taking on FX risk but without the benefit of proactive analysis.
There's also another reason for investors to look at FX: for investment opportunities.
FX is the largest, most liquid market in the world. It is also generally uncorrelated with traditional asset classes, and provides investors with opportunities to generate returns despite overall market direction. (After all, it's the only market in which, when the price of something goes down, it follows that the price of what it's valued in, is going up). Despite these obvious advantages, it is often overlooked by investors as a means of growing their wealth. It is precisely for this reason that the savvy investor needs to look at FX. When equity markets are losing value, and bonds are uncertain due to rising rates or compressing spreads, investors could still find exciting and profitable trades to do in the FX world.
The last few years have seen (and continue to see) tectonic moves in currencies, driven by fundamentals and central bank actions. The macro-driven nature of these moves has made it easy for even relative newcomers to the FX market to form a view on where currencies are headed. These moves can be large, and those who choose not to invest in this market lock themselves out of trades that have the potential to be very profitable.
There are multiple ways to engage in the FX market. Gone are the days when the only trades investors could do in FX were those they perceived as being too risky for them. Investors nowadays have the ability to choose from a range of products designed to suit varying levels of risk appetite. An investor who just wants exposure to a particular market can simply buy/sell the currency of their choice in the spot or forward market. Those who want to participate in the market, but limit the risk of moves against themselves, can buy options by paying premiums. More sophisticated investors have the ability to access a whole range of structured products in FX, which can be tailored to suit their views and individual risk appetites.
In making these trading decisions, it's important for investors to choose banks which have a full range of these product capabilities and also, the size and scale to implement them. It's also important for investors to ensure that they can access the expertise and experience of trained advisers. Trading on an electronic platform can produce instant gratification, but building a balanced well-diversified FX portfolio with risk customised to desired levels needs experienced and well-reasoned advice.
Looking ahead, evolving macro expectations and central banks' actions in 2016 and beyond will lead to several moments when risk re-prices. As expectations change, and markets re-price, there will be increased volatility within broader market ranges. This does of course, result in more risk. And yet, this is also the environment in which investors are most likely to find opportunities for profitable, scalable trades that move the needle for their portfolios. Those who choose to sit out this period could find themselves missing exciting opportunities in the market.
- The writer is managing director, head, FX and structured FICC, Citi Private Bank