Investing in Foreign Currencies

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There are two ways to take advantage of the ups and downs of managed floating rates between currencies: Investing and speculating.

Investing

Your main concern should be to conserve your capital, not to make large gains. At any time that your dollars are weak, you want to put them into a stronger currency. For several years, it made sense to put savings into the Euro and Japanese yen.

This has changed, however. While several years ago there were strong and weak currencies, the flight into the strong currencies is coming to an end. The philosophical reason: The strong currencies have become weaker. Currency valuation is based in part on inflation rates, and the inflation level is creeping up in Europe and Japan.

If you have savings, it may be better to have them in another currency than in U.S. dollars at any time the foreign bank pays you 5% interest or better on the other currency. Allowing for inflation and currency depreciation, that could be the equivalent of getting 12% interest on a savings account in the U.S. The problem is converting currency from dollars to another may be costly.

If you can only get a 2% or 3% interest rate on the foreign currency, forgo the option. There is always some inflation and the low interest rate will wipe out any advantage the differential could give.

Speculating

It still offers a way to make large gains on currency fluctuations. For example, if you can anticipate that the British pound will decline in the near future by 3%, then you might think about selling the pound on margin on a forward basis. Then, a 3% decline on a 3% margin will mean a 100% profit on the actual amount put at risk. (If you are a regular customer, you could get the currency forward without paying the margin. If not, it will cost you 5%).

Even experts are frequently misled in foreign-currency dealings. So if you are a rank amateur, you may have a hard time juggling foreign inflation rates, interest rates, and balance of payments, the most important bases for the way a currency will turn.

Excerpt from: Book of Inside Information based on Guenter Reimann, editor-in-chief, International Reports.

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