Foreign currencies explained: a Q&A
For most of us, our only contact with foreign currencies is when we go on our holidays. But, whether we have pounds, dollars or euros in our wallets, in a globally connected world currencies have an enormous impact on every aspect of our lives.
1. What is a currency?
Currency, as you or I would know it, is the cash in our pocket or the money in our bank (if we have any). It is generated by the government or a central bank and circulated around the economy. Consumers and companies use currency to buy and sell goods around the world.
A long time ago the Romans used seashells to pay for goods and services. Today's currencies basically do the same job.
2. Why do currencies matter?
Currencies are measured against each other, as you'll know if you've ever been to the Bureau De Change to change your money before you go on holiday.
If your currency is strong you worry less about how much that pint of beer or glass of wine will cost when you go on holiday. If it's weak then you start to hit the panic button.
It's the same for companies. Companies buy and sell goods and services all around the world. It's called importing and exporting.
For instance, in the UK, over half of the food we consume is imported, so the French cheese or Belgian chocolate we buy becomes cheaper if the pound is stronger. However, at the same time, UK products such as gin become much more expensive for foreign buyers (I guess that means more for us then!).
The relative strength or weakness of a currency can impact sales, which can have a knock-on effect for the broader economy.
Governments would generally prefer that their currencies are not too strong or too weak so they don't have to help keep economic performance stable.
3. What makes currencies move up and down?
You may have noticed when you go to change up your money for a holiday that the exchange rate can fluctuate from day to day. These fluctuations relate to movements in money markets.
Money market moves tend to reflect investors' views on the current and future economic strength of a country. But there are other factors that can affect currency valuations, which include:
Generally, higher interest rates are better for currency strength because they offer investors better returns. Think of it like the interest rate of your bank account: the higher the rate is the better it is for your savings.
Unstable governments tend to cause currency weakness. A good example of this was after the Brexit vote which saw the UK Prime Minister resign and the pound to fall 10% in value.
Inflation is the cost of living. Rising inflation means your money is worth less and less each year. For instance, £5 in 2003 would have bought you two and a half pints of beer. Now, that same £5 will barely get you a pint and a half. That's inflation. Persistently high inflation devalues your currency.
The movement of other currencies
Currencies move against each other. Other countries might just be doing better than your own, so no matter how high your interest rates are or stable your government is, when one currency goes up the other must come down.
Currencies in emerging markets which are less developed, such as China, India or Brazil, tend to be a lot more volatile (they move up and down more) than those in developed markets (e.g. the US or UK) which are generally more stable as they are seen as more reliable.
4. What if I want to invest abroad?
Investing abroad is a great way of diversifying your portfolio (spreading risk).
However, whenever you invest your money abroad you are effectively exposing yourself to the changes in exchange rates between your home currency and the currency of the place in which you are investing.
Personally the two pennies I have left in my bank account at the end of the month haven't been worth investing yet, but if you're lucky enough to be able to save a bit more it's worth taking currencies into account.
Here's how it might work:
An investor based in the UK buys a share in Company A, which is traded in the US. To do this, they must convert their pounds into dollars.
The investor buys 10 shares worth $10 each when £1 is worth $2, so they will buy £50 worth of shares: 10 shares x $10 divided by $2 (to every pound) = £50.
Six months later the investor needs to sell the shares.
The shares are still $10 but the pound has strengthened, so £1 is now worth $2.50. The shares would now be worth £40: 10 shares x $10 each divided by $2.50 - £40.
In other words, without the share price moving the investor has lost £10 just because of the currency movement.
It's something to consider if you're looking to invest abroad.