Budget deficits, interest rate differentials, and diversification of foreign currency reserves are several of the buzzwords and phrases associated with the volatility of the greenback. If you are a reader of the popular press, then you may feel overwhelmed by the proliferation of the aforementioned buzzwords and phrases associated with the falling dollar. Do you think that the future of our beloved dollar is dismal at best? Maybe it's time to learn how a US investor profits from the falling dollar.
Supply, Demand and the Falling Dollar
A host of issues will indeed affect the value of the dollar, including issues related to the buzzwords listed above, but the issue can be boiled down to the supply and demand of the currency. For example, in times of world economic disorder, there is a flight to quality. Foreign investors flock to the US dollar as a safe-haven investment, thus driving up the dollar's value.
On the flipside, if investors' appetite for risk increases, they may sell dollars and buy riskier assets. In this case, the supply of dollars increases and demand wanes, thus leading to a weaker dollar. What does this mean to domestic investors?
How Investors in the US Profit from the Falling Dollar
The simplest way to understand how a US investor profits from the falling dollar is to consider this brief example:
- As a US citizen, you own a widget in a foreign country. You bought the widget for 100 foreign currency units (FC) when the FC was at parity with the US dollar (USD). In other words, you converted 100 USD to 100 FCs and bought the widget.
- After some time, the value of the FC increases and can be exchanged for 2 USD. The USD has fallen in value by 50%. The value of the FC has increased to the USD by 100%.
- You decide to sell your widget for 100 FCs (i.e., the value of the widget has not changed) and convert your FCs back to USDs.
- You convert your 100 FCs to USDs when the exchange rate is as stated above (1 FC equals 2 USD). Since 1 FC can buy 2 USDs, then you have 200 USDs upon conversion.
- You doubled your money despite the fact that the value of the widget (in FCs) did not change.
The MSCI EAFE Index and the Falling Dollar
A comparison of the returns of the MSCI EAFE Index (price index) in local currency (the home-country currency of each stock in the index) versus the MSCI EAFE Index quoted in US dollars is a reasonable way to evaluate the currency effects of international investing. The MSCI EAFE Index represents equity investments in developed countries within Europe, Australia, Asia, and the Far East (EAFE).
For the period 12/31/08 to 10/16/09, the return of the MSCI EAFE Index in local currency was 18.48%. For the same period, the return of the MSCI EAFE Index in US dollar terms returned 30.22%. The 11.74% difference in returns represents the appreciation of the currencies represented in the MSCI EAFE Index versus the US dollar.
Yes, it’s that simple. The return of the foreign asset (in this case the MSCI EAFE Index in local currency) plus the exchange rate movement (in this case the currencies represented in the MSCI EAFE) equals the return for the US investor.
Now that you understand how US investors gain from a falling dollar, learn how mutual fund investors can profit from a decline in the greenback.