International Currencies Made EZ #2

by | Dec 10, 2004 | Archives

Few economic events can have as much impact on your life as the falling U.S. dollar. I am learning this right now while on a trip to London. If one converts what things cost here in dollars…well its just better not to.

While I am away, the Gary Scott messages each day contain a review from the course International currencies Made EZ. This information can help you understand why and how currency parities move. Here is a section from Chapter Two. This report is dated but do not let the dates and numbers get in the way. The fundamentals remain the same.

How to Have Global Purchasing Power

The first way to have a stable currency base is to balance your investment portfolio so that you protect your global purchasing power.

Purchasing power can best be understood by looking at a currency's ability to buy something. Take a loaf of bread, as an example. If in one year a dollar will buy a loaf of bread and the next it takes two dollars to buy the same loaf, then the dollar's purchasing power has fallen by 50% in terms of loaves of bread.

But understanding purchasing power is not enough! We need to extend this understanding, since we live in a global economy, to our currency's purchasing power around the world. We buy and sell things from all over the world and need to understand the global purchasing power of our wealth.

Global purchasing power is our currency's ability to buy things in other countries. Take buying Toyota automobiles in U.S. dollars as an example. Twenty five years ago when one U.S. dollar was worth 400 Japanese yen, a Toyota priced at two million yen, had a price in U.S. dollars of US$5,000. Today with the dollar worth about 100 yen, (assuming all other factors remain the same), the same car costing two million yen would cost nearly $20,000.

If our currency depreciates versus other currencies, so does our global purchasing power. A falling currency can ruin our wealth!

To protect the purchasing power of our wealth, we need to hold many currencies or hedge against the fall of our own. As an example, if we want to be sure we can always afford to buy Japanese imports even if our currency falls, we need to hold investments denominated in yen (or hedge our investment portfolio versus the yen). If we always want to be sure we can buy goods in Germany, we need to hold investments in German marks or hedge against a rising mark.

At least 30% of the goods and services most of us buy are imported from abroad. Thus we should invest (or hedge) 30% of our portfolios in currencies other than their own.

Thus a portfolio position with at least 30% of one's investments held in a mixture of currencies (other than your own) should be the stable currency base from which you fix your personal financial navigation.

It is impossible for any of us to know the exact percentage of imports we buy in relation to our total spending. Even if we did, it would be even harder to know which exact currencies (via imported goods) we spend. So to keep things easy, we must make some assumptions.

One simple assumption is that 30% of the goods and services we buy are imported and that a third of these imported goods come from Europe, a third from Asia-Japan and a third from the other countries. Based on this assumption, one simple way to attain a balanced portfolio is to hold in theory about 10% of one's portfolio in Japanese yen, 10% in ECU (European Currency Unit) and 10% in other non U.S. dollar currencies, (such as Australian dollars).

If you live outside the U.S. where more imports come from some other countries, you can use the same system above, just adjust the currencies to fit your own import realities.

Keep the other 70% in your own local currency. This position of 70% in your own currency and 30% in other currencies is your stable currency base. This is your neutral position for times when you do not have a currency view. This position today is similar to being in just your own currency 30 years ago when currencies were stable.

This neutral position is designed to equalize the global purchasing parity of your investments without risk. If your currency falls versus currencies elsewhere, the profit you make on the non local currencies you hold makes up for your currency loss in purchasing power.

On the other hand, if your local currency rises versus the other currencies in your portfolio, the additional purchasing power you gain abroad makes up for the loss in the 30% of the currencies you hold.

From this neutral base you can then speculate if you choose. If you feel that your own currency is very weak, you may choose to increase the percentage of non local currencies you hold. If you feel your local currency is going to be strong, then you can reduce the amount of non local currency you hold in your portfolio.”

Until next message, good investing!