Shedding Light On Foreign Currency Denominated Funds
A foreign currency denominated fund, as its name suggests, is a pool of funds denominated in a particular foreign currency. The assets invested through the fund can be anything from other currencies to stocks to commodities.
There is fear among some investors that the denominated currency affects returns of such a fund. The assumption is often based on a direct correlation of the currency’s performance with the fund’s performance.
That cannot be further from the truth. There are misconstrued ideas about currency funds and a lack of understanding about the use of currency pairs in such funds. Allow us to shed some light on these aspects.
How currency pairs work
What is a currency pair?
It consists of two different currencies traded in a pair. The Foreign Exchange Market always works through currency pairs.
Think of Forex as a money changer or a bank. If you are a Singaporean living in Singapore, you buy Japanese Yen (JPY) notes from a bank using Singapore dollars (SGD). In other words, you sold your SGD to the bank in exchange for JPY.
The exchange is SGD to JPY according to the exchange rate. The currency pair here is therefore JPYSGD or JPY/ SGD.
The first listed currency (JPY) or Base Currency is bought. The second currency in the pair (SGD) or the Quote Currency is sold in exchange for the Yen notes.
Currency pairs are quoted in numbers to indicate the value of one currency against another. Here is a hypothetical example:
- The pair for EUR/USD is quoted at 1.2500.
- This means that one Euro is exchanged for 1.25 U.S. dollars or it will cost USD125 to buy EUR100.
Currency pairs can be traded just like stocks too, i.e. bought (going “long”) or sold (going “short”). The difference here from the money exchanger example is that a currency pair is always bought or sold as a whole.
There are a few categories of currency pairs:
1. Major Currencies
These have the highest volume traded against the U.S. dollar. They include the EUR/USD, USD/JPY, GBP/USD, USD/CHF, AUD/USD and USD/CAD. All of the major currency pairs have very liquid markets that trade 24 hours a day every business day, and they have very narrow spreads.
2. Commodities Currencies
AUD/USD and USD/CAD are known as such because Canada and Australia are rich in commodities. Both countries’ economies and currencies are affected by commodities’ prices.
3. Minors and Exotic Pairs
These are currency pairs that are not associated with the U.S. dollar. They have slightly wider spreads and are not as liquid as the majors. Some examples include the EUR/GBP, GBP/JPY and EUR/CHF.
Exotic currency pairs include currencies of emerging markets. They are not as liquid, and the spreads are much wider. For instance, USD/SGD.
Foreign currency denominated fund explained
As mentioned earlier, it is a fund that can be invested in a variety of asset classes. The key difference from other types of funds is that it is denominated in a foreign currency.
Let’s take for example, ABC Fund is set up in Singapore and is denominated in USD. A bulk of its assets are in South Korean stocks, which are denominated in Korean Won. Since the assets are Korean stocks, the fund will not be affected by a depreciation in the US dollar.
Instead, the USD merely acts like a middleman. An investor uses SGD to participate in the fund. The SGD is converted into USD to purchase Korean stocks in Won.
Assuming ABC fund has SGD50 million worth of assets in South Korean stocks. Let’s say the exchange rate of SGD to KRW is currently 682 Won per SGD. Thus, the fund has 34.1 billion Won of Korean stocks (or SGD50 million).
What if KRW appreciates against SGD? The fund is still worth 34.1 billion Won assuming there is no change in stock prices. When converted back into Singapore dollars, the fund is now worth SGD55.5 million.
Even though the Korean stock prices did not change, a Singapore investor would have made around 10% due to the appreciation of the Korean Won. The main consideration here is the movement of KRW versus SGD although the fund is denominated in USD.
Returns are subject to movements of the Korean Won on top of the performance of the invested stocks.
Impact of denominated currency on returns
As explained in the previous section, the denominated currency bears no impact on returns. But what if the fund is invested in a mix of currency-based assets? Would there be any difference?
Let us take the Salzworth Global Currency Fund as an example. It is denominated in USD, set up in Singapore, and it trades G10 currencies using CFDs and does FX Spot only.
Here is where currency pairs come into play. The fund manager uses the USD to trade other currencies. The G10 currencies’ Contracts For Difference (CFDs) are all bought using the US dollar.
The USD is treated as a Quote Currency to buy a Base Currency, which can be any of the G10. Gains from either going long or short for CFDs are determined by the bid and ask prices.
Where does the SGD come in then? An investor in Singapore may choose to use SGD to buy units or shares in the Salzworth Global Currency Fund equivalent to the corresponding value of the USD at the time of purchase.
Thereafter, by holding units of the Salzworth Global Currency Fund, the same investor is then holding the equivalent value worth of units of the fund, in USD.
It is similar to buying unit trust. Any profit or loss is from the movement of the value of the underlying assets, not the value of the SGD against the USD and vice versa. Once again, the USD is simply used as the currency of trade and does not reflect shareholding in the fund.
A vast majority of Singaporeans are, by default, ‘long SGD’, that is to say, their portfolio consists primarily of SGD, given that most investors’ largest holding is their residential property.
Hence, from a diversification perspective, it would make sense for investors to invest in non-SGD denominated products as a form of currency diversification as well.
Why is the USD used as the denominator currency?
It is the world’s top reserve currency. This makes the USD come away as the winner in times of crisis. Reasons: its unlimited availability, enormity of its reach, and its global acceptance as a medium of exchange.
What matters is that the USD is considered a generally accepted means of payment in many parts of the world. Thus, it comes as no surprise that demand for USD increases whenever financial markets take a plunge.
To illustrate: EUR/USD is considered the most liquid currency pair in the world. The second most popular currency pair is USD/JPY.
Why invest in Forex?
The Salzworth Global Currency Fund uses the foreign exchange market as its main market of trade because it is the largest and most liquid market in the financial world. It is open 24 hours a day, every business day, and sees the largest amount of trading volume.
Trading of currency pairs is conducted here as well as the conversion of currencies for international trade and investment. The volatility of forex markets is exactly why traders are attracted to it as it presents immense profit potential, in both bull and bear markets.
However, this also comes with increased risk, which makes it important to manage risk and exposure well. Having specialist advisors, who know that it is not possible to control returns but only risk, can help generate quality risk-adjusted returns and help investors navigate FX investing through the fund.
Why invest in G10 currencies
The G10 currencies are:
- US dollar (USD)
- Euro (EUR)
- British pound (GBP)
- Japanese yen (JPY)
- Australian dollar (AUD)
- New Zealand dollar (NZD)
- Canadian dollar (CAD)
- Swiss franc (CHF)
- Norwegian krone (NOK)
- Swedish krona (SEK)
The main reason why the G10 currencies are so popular and why Salzworth Global Currency Fund focuses on it is because they are among the world’s most popular and liquid currencies. This means traders can buy or sell them without incurring wide spreads due to their highly liquid nature.
What affects G10 currency pairs?
1. Central banks
The base interest rate of a country is controlled by central banks. The banks’ decisions frequently trigger large movements in currency prices.
2. Macroeconomic data releases
The data can indicate how well an economy is doing. It can provide confidence for a country’s currency or otherwise.
3. Political situation
Political uncertainty in the respective country of a currency can affect a currency’s value in trading pairs.
4. Economic crisis
Some G10 currencies exhibit a negative correlation with global economic health. Economic slowdowns tend to hit most currencies hard, but when investors are worried they turn to ‘safe-haven’ currencies such as JPY and CHF.
5. Commodity prices
Some of the G10 currencies are linked to the price movements of commodities because their economic growth is directly related to exports or reliance on imports.
Best trading mechanism for currencies
With advancements in technology, the Forex market moves at an ever increasing speed. Forex transactions can occur in sub milliseconds and affect the corresponding currency values. Thus, trades that are able to be executed quickly, will stand to gain an edge in terms of profitability.
Price determined at the point of the trade is called spot. FX spot trading can be very profitable as long as risk is well managed and drawdowns are kept to a minimum.
Keeping up with fluctuations on both up and down trends on a daily basis while taking into account the macro factors which influence G10 currencies can be an overwhelming task if done manually.
The best mechanism for this nature of price action trading is by using algorithmic trading systems to enable effective and efficient execution of trades.
FX algo trading engines can run 24 hours a day without depending on human intervention. These intelligent systems remove the fallibility of human emotions which can get in the way of objective, instantaneous decision-making.
The foreign currency that a fund is denominated in bears little to no influence on returns of the underlying asset. A foreign currency denominated fund functions the same as other types of funds, except its choice of currency for carrying out investments.
An investor should consider the amount of currency exposure that the portfolio is exposed to, according to individual investment horizon and portfolio composition, with the consideration of a home country bias.