The Basics of Currency Fluctuations

Exchange Rates reflect the balance of supply and demand for currencies. Two key factors affecting supply and demand are interest rates and the overall strength of the economy. Economic indicators such as GDP, foreign investment, and the trade balance reflect the general health of an economy, and are, therefore, responsible for the underlying shifts in supply and demand for that currency.

The total return on an international investment is based on two factors:
1) The Return on Investment (ROI) in local currency, and
2) Gain or loss because of currency fluctuations.

For example, suppose, you purchase an Indian stock whose price increases 10 percent in one year in terms of INR. If during that same year, the INR increases in value by 5 percent compared to the US dollar, your total return - Net ROI - would be 15 percent that is because of gain of 10 percent from the surge in the stock price plus gain of 5 percent from the currency fluctuations. However, if the INR decreased in value by 5 percent, your total return would be only 5 percent.

When the US dollar declines compared to the other currency, your investment increases in value, because more dollars are then required to purchase the investment. An increase in the US dollar compared to the other currency means your investment decreases in value.

Most countries use a system of managed floating exchange rates. Supply and demand factors set the exchange rates most of the time, as international banks, investors, tourists, consumers, and multinational companies buy and sell foreign currencies and goods. Governments typically only intervene to prevent massive fluctuations in exchange rates.

Demand for a particular currency is determined by many factors, including a country's inflation, interest rates, political and economic outlook, monetary policies, and speculation. The US dollar does not move uniformly against all currencies - it can be rising against one currency, while it is declining against another.

In general, a rising dollar makes it less expensive for Americans to travel abroad, to import foreign goods, and to purchase foreign investments. However, US companies may suffer since cheaper imported goods hurt sales of domestic products. When the dollar is declining, it becomes more expensive for Americans to travel abroad, and to import foreign goods, but US goods become more competitive on international markets.

When considering international investments, consider these tips about currency fluctuations:
1) Foreign bonds are subject to more currency risk than foreign equities.
2) Currency fluctuations tend to be more moderate in parts of the world where political and economic factors are stable and the local currency is strong. Avoid areas where inflation rates are extremely high.
3) Diversifying your investments by country and region can help reduce the overall effects of currency risk.