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Frequently we see a fund that is denominated in another currency. For example, a fund may be denominated in USD. Does that mean that the currency risk is the USD? No of course not because the currency risk is solely dependent on the underlyng currency (unless hedging is involved). This usually causes a lot of confusion to investors. To make matter worst, many financial advisers are also confused and as a result advised their client incorrectly resulting in wrong asset allocation and dangerous currency exposure. I like to illustrate real examples:
Let’s take an example of Investor A who uses SGD to purchase a GBP security. We also consider Investor B who uses SGD to purchase a fund denominated in USD but also buys an identical GBP security. For Investor B, he has to go through an intermediate currency. This is what happens when he buy securities via a fund like unit trust and ETF. For simplification, we assumed that the GBP security never appreciate or depreciate in value. Based on 14/1/2008, the forex rates are as follows: 2.804 SGD/GBP..... (1) 1.433 SGD/USD…..(2) 1.957 USD/GBP…..(3) Note that (2) * (3) = 2.804 which is equal to (1) The above arithmetic in plain English means that if Investor B person would to convert his British Pound to US Dollar (referring to (3) ) and then convert to SGD (refer to (2) ), it is the same as Investor A who simply converts the British Pound to the SGD directly (refer to (1) ). Why is this so? It is because of the mathematically equation: SGD/GBP = SGD/USD * USD/GBP Consider the case which the above equation does not hold true. Let’s say that the RHS>LHS. A clever investor will recognize the opportunity to earn risk-free money. This is done by converting his SGD to GBP (LHS), and then by RHS converts to USD and then back to SGD. By doing this, he will end up more SGD then before. Since this is merely done by transaction (not investing), this is what we call free money or risk-free. As more and more cleaver investors discover this opportunity to earn free money, the market will start moving the exchange rate to equilibrium. Equilibrium is possible because of the following: When the clever investor executes LHS, he needs to convert SGD to GBP. This is done by purchasing the GBP and selling the SGD. If a lot of investors do this, SGD will weaken against the GBP. The numerical value of LHS starts to increase in value when SGD weakens against the GBP. Equilibrium is reached when LHS equals to RHS. When this happens, clever investors cease their operation as there is no more free money to earn. The entire operation is what we call arbitration and these “clever investors” are called arbitrageurs. In real life, there is cost associated with having an intermediary currency. For example, a Investor B who uses SGD to buy a USD denominated unit trust which invests in a UK stock (GBP denominated) has a higher cost then Investor A who does direct. However, there is a difference between cost and currency risk. Cost is only incurred at the point of transaction but currency risk affects the valuation of the investment at all times. The good news is that those who buy ETF will not suffer this intermediary currency transaction cost (will blog on this on another day). So how much is this cost of having a intermediary currency? If Investor A wants to buy GBP 1000, he needs to pay SGD 2,804.26. For Investor B who uses an intermediary currency, he pays SGD 2,804.31. The difference is -0.0016%! This is based on 14 Jan 2008 forex rate. Let’s look at the historical cost. From 15 Jan 2003 to 14 Jan 2008, the 3 sigma cost is 0.0325%. Click HERE for the historical chart. Credit: All forex based on http://www.oanda.com/convert/fxhistory Conclusion: The intermdiary currency does not create an additional foreign currency risk. The currency risk relates directly to the underlying investment. |
