Global Financing and Exchange Rate Mechanisms Paper 2
As more businesses become global the need for understanding foreign exchange and implementing hedging strategies could prove to be the one tool that may result in an increase or loss of investment. United States equity investors, international investing, or allocating assets to overseas stocks, is considered by most investment professionals as a legitimate way to strive for either higher returns or to lessen systematic risk in a diversified portfolio. It adds an asset class that is not perfectly correlated with U.S. equities (and if stock selection is effective) can provide excess returns. Returns on overseas investments include two elements: the stocks return in the local market and the impact on return when the local currency value gets translated back into dollars.
Over much of the post-war era, the U.S. Dollar was the primary reserve currency. This, however, is no longer the case. The U.S. Dollar itself can be the currency subject to deterioration in relative value; since September 11, 2001, this has occurred. The combination of a growing federal budget deficit, a trade deficit, declining equity markets, and low interest rates has eroded the strength of the U.S. Dollar. In cases where currency values are changing dramatically, the effect of the currency can radically alter total return results. Intuitively, this makes sense, of course. In the practical world, it is crystal clear.
Here is an example of the importance of hedging in managing risk. An investor decides to buy one share of a Japanese investment company, Yoka Taco, for 2,059 Yen (JPY) on January 17th. With the Japanese Yen trading at 1.68 to the dollar, the investor
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