Nowadays, goods are exchanged by money. All transactions are in cash even if in online trading there is not a physical exchange of currency.
We do not ever forget that the value of our investments is significantly impacted by changes in global currency exchange rates.
We have already seen what impacts on currency exchange rates, but it is important to consider that currencies influence also the other assets. The foreign exchange market has a dramatic influence on the stocks they own.
So it is not just to look at the chart of EUR / USD for example and judge whether the single currency rises or falls relative to the U.S. currency. There are external market forces that push a currency downward or upward and this affects the price of the financial assets.
To analyze this topic we need to understand the meaning of correlation. It is a statistical measurement of the relationship between two or more assets and their dependency.
Remember that the goal of a trader is to combine assets with a low correlation. Combining different assets that have a low correlation reduces the volatility of the portfolio as a whole and allows the portfolio manager to invest more aggressively.
Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves, either up or down, the other security will move in the same direction. Alternatively, perfect negative correlation (a correlation co-efficient of -1) means that if one security moves in either direction the asset will move in the opposite direction. If the correlation is 0, the assets have no correlation.
As real exchange rates go up and down, the currencies undergo a change so the price of the assets changes too.
Let’s make an example using an Italian Company. Assume that the euro, increases substantially against other currencies. The Italian Company is affected in a lot of ways.
First, the appreciation of the euro would affect the entire Italian economy. Italian goods would become more expensive and net exports outside of Europe would likely decrease. The Italian Company as an exporter, would be selling more expensive products overseas and would probably experience a decrease in total sales. If sales decrease, the Italian Company’s profitability would be hurt and the stock price may decline.
Alternatively, if the franc were to depreciate substantially against a basket of currencies, the Italian Company would become price competitive and the stock price may increase.
Based on this example, it’s clear that stock prices or other financial assets are influenced in turn. The coin that has the greatest influence on other assets is the US dollar.
Many raw materials, including oil, are priced in dollars. U.S. dollar depreciation typically increases the price of raw materials, while a dollar appreciation tends to decrease commodity prices.
Let’s see below some examples of correlations between currencies and commodities.
US Dollar and Gold as seen as substitute goods and Gold is considered a safe heaven in times of uncertainty. The U.S. Dollar is negatively correlated with Gold. Usually, when the price of Gold rises, the dollar is expected to fall.
The Euro is positively correlated with the Gold. Even if the Euro is taking on the role of anti-dollar, the reason lies in the fact that if the dollar falls and gold rises, the euro tends to rise.
The Japanese Yen has a negative correlation with the oil. When the price of oil goes up, it damages the Japanese economy and the Yen.
Also the Swiss Franc is considered a safe heaven currency in times of uncertainty.
The relationship between currencies and assets is critical and the best thing to do is investing both in assets and currencies that are negatively correlated. This is the basis of a diversified portfolio.
By understanding the impact of currencies on assets, and their correlations, investors are better able to evaluate the potential of their portfolio.