Exchange rates present unavoidable risks

Serious Money: Sooner or later, any investor has to confront the vexed issue of exchange rates. Whether we are interested in bonds, equities, commodities or fine wine, the foreign exchanges will become a part of our decision making.

Even if all we do is keep our money on deposit, the rates of interest that we earn are nearly always affected by the vagaries of an exchange rate. And putting your stash under the mattress won't help much, either: the rate of inflation that erodes the value of that hidden pile is partly determined by the external value of the currency.

Successful foreign exchange traders are a bit like brain surgeons - in the sense that they are quite rare (the similarities often end there). Many a successful academic career has been launched with the building of a theoretical model of exchange rate determination that subsequently fails to work in practice.

Technical analysis is often referred to by fundamental analysts as the practice of drawing arbitrary lines, usually straight ones but sometimes the odd curve, on pictures that depict the movement of asset prices.

And technical analysis holds sway across the foreign exchanges: few traders are daft enough to claim they know what drives exchange rates, so they defer to the charts. Which may or may not amount to letting the Mystic Megs of the markets run riot, but who knows.

The problem for investors is that the exchange rate is simply too important to be ignored. Movements in sterling, yen or dollars can wipe out - or greatly compound - the gains from an underlying investment in stocks or bonds.

Exchange rates affect asset prices directly and indirectly. Take, for example, an investment in BMW, the German car company. We might think that since the euro replaced the deutschmark, currency risk has been taken out of the equation - which is true, but only partially. We might no longer have to worry about movements in the deutschmark/Irish pound, but the dollar/euro rate has all sorts of influences on BMW's profitability. The cars made and sold in the US earn, obviously, dollars - so when the dollar is strong, BMW's euro profits are also strong. And vice versa.

BMW also competes with lots of other companies, many with different home currencies. Relative movements in those currencies can have an impact on the competitiveness and profitability of BMW's operations.

What role should currencies play in the investment process? For the larger investor, there is always the option of paying for a specialist to handle the currency risk. The individual punter can try to diversify his risks by having a spread of overseas assets.

By owning assets denominated in dollars, yen, sterling and renminbis, we can hope that movements upwards in one currency will be compensated by down movements in others. But this can be a very hit and miss affair: it could well be the case that the euro goes up against everything.

We might hope that if a currency is falling, the underlying assets are rising (there is some empirical evidence that this effect does indeed work, but only over very long periods of time).

The diversified approach is imperfect, but is probably the best that the small investor can hope for. The alternative is to take explicit bets on where exchange rates are heading - which, as I have already suggested, is something rather hard to do well - not that this prevents an awful lot of people from trying. Never in the field of financial forecasting have so many people been paid so much money to get things so completely wrong.

Take the US dollar, for example. Its demise has been forecast in just about every year out of the last 20 (at least). Some years it goes down, in others it rises. Most people have expected it to collapse in recent years because the US balance of payments deficit is so large.

This, of course, reveals the underlying model of exchange rate behaviour that most people carry around in their heads: if the balance of payments is in deficit, the currency should fall (and vice versa).

The fact that this model, like all others, fails some very obvious empirical tests does not deter the forecasters.

Another class of models, currently trendy in some quarters, relates interest rate gaps and exchange rates: the higher one country's interest rate, the stronger the currency. In similar vein to the balance of payments models, this one does not stand up to any kind of exposure to the facts. Models might work for a short while, but they always break down.

Currently fashionable in forecasting circles is the idea that sterling is due for a tumble. This is of obvious relevance not just for people who have invested in UK bonds and equities: Britain is still Ireland's largest single trading partner.

As it happens, I can't ever remember such a monolithic consensus in foreign exchange forecasting: everyone is convinced that the UK currency has already begun a prolonged period of decline. Our two friends, the balance of payments and interest rate differentials, are to blame. Both are pointing, more or less unambiguously, to a decline in the pound.

Clearly, the consensus could be wrong (it often is). Absolute honesty compels me to acknowledge that I don't have a clue; relative honesty prompts me to admit that I have some sympathy for the bearish view. Hence, a rare piece of currency advice from Serious Money: if you are exposed to sterling, think about a hedge, at least for part of your risk.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.