What are the advantages/disadvantages of investing in foreign currency?

Question

I am learning about brokerage accounts and how investors diversify their portfolios within their brokerage or other investment accounts. One of the things I have noticed, especially in the U.S., is that brokerage statements will sometimes list investments in foreign currency. Even if an investor believes that foreign currency will increase in value, why would they take the risk when foreign currency tends to be a very volatile investment?

I have identified three major problems that seem to arise with foreign currency as an investment:

1. Exchange rates tend to fluctuate day-to-day, sometimes by a huge amount.
2. Jurisdiction risk is always a threat to foreign investments because some governments are unstable or pass laws that hurt foreign investors.
3. The fluctuations in value of foreign currency tend to be unstable, leading to high volatility within the foreign exchange market.

Basically, I am wondering why an investor would want to go through the hassle of investing in foreign currency when there are numerous other options to invest in that carry less risk?

Answer 1

Hedging - is a reason.

You might want to offset risk to your own currency by investing in other monetary systems. The famous example here is the Zimbabwean Dollar. In that particular case, hyperinflation was a good reason to have foreign currency investments. And there are other cases where local currency doesn't actually define your local costs - for example in countries with high levels of volatility, even local transactions may ultimately be more stable in another currency (typically people use USD for this purpose).*

Another way of hedging is to offset risks by having foreign debt or foreign assets valued in that currency. I am currently employed in a country and live in another - my (leveraged) assets are in one currency and my salary in another - I could balance this risk with investment.

Any other reason is best left to experts, IMHO. I consider currency trading to be extremely dangerous, because of the volatility and how many different risk factors you are exposed to (local political, global political, financial, natural, socio-behavioural... etc) and I'd have to do a very careful study of that risk in order to understand the relationship between reward and risk of any investment. And currencies affect each other, so you really should understand the entire system to properly understand any currency in particular.

As a final addendum, there are also some shady reasons. It might be beneficial for you to invest in a monetary system that is less transparent than others. Swiss francs, bitcoins, etc.

*) Added from the comment of "Grade 'Eh' Bacon"

Answer 2

There are a few reasons someone might do this:

Investments in a foreign currency may be incidental to the underlying investment. For example, if someone outside of the US wants to invest in APPL, they would be taking on USD risk, which could be a foreign currency to them. From that point, someone may want to hedge that risk (for example, if you have $10k USD invested in a US company, you could borrow $10k USD in debt, and then your net USD position would be Nil; obviously this creates other considerations).

Or, someone may want to directly create a hedge against some other currency risk; as Stian Yttervik mentions, you might have ongoing or future expenses in another currency (for example - planned retirement in another country), so investing in that currency now sets you up to be able to cover those future expenses, whether the currency rises or falls.

Very few people will invest long-term in currencies themselves, given that currencies are a zero-sum game. That means that if you invest in the CAD, and the Canadian economy does really well in the next 5 years, but the US economy does even better, then your CAD-USD investment could still fail - you are betting on the relative success of that currency, rather than investing in the absolute success of that currency.

Some people do put money into currency trades on a short term basis; for example right before a central bank announces interest rates, you could gamble on whether rates go up or down, and take on significant leverage that the currency moves a particular direction (and yes, gamble is usually the more appropriate word to investing in this case). Even such speculators would rarely hold long-term currency positions unless it also met one of the other objectives above. [An interesting scam-level investment 'opportunity' arose immediately after the Iraq war began, that the Iraqi Dinar was supposedly about to be pegged to the USD, and 'to support this fledgling democracy after liberation by US forces', Americans were encouraged by currency brokers to buy this currency which 'would skyrocket any day now'. Speculation like this is similar to dumping money into uncertain penny stocks hoping for a big payday.]

Answer 3

There is a reason that can be used for mid-term saving.

Let's say that you are saving for a large purchase, and know that you have several months or even a year before you have the money. You already know the brand and it is produced outside your own country (or outside of your currency system) - let's say you live in Germany and want to buy a Japanese car, and you are noticing signs that Germany has higher inflation than Japan and expect it to stay this way next year too.

Since you know that, a year from now, you will be paying for something whose producer wants the foreign currency, if you expect that the exchange rate is more likely to get worse for you than better for you, you might want to start keeping your money in the foreign currency - this way, you are reducing the risk of having to pay more.

Of course, there is the risk that an unforeseen event (something like Brexit) suddenly changes the exchange rate into a way you never thought of and in the end, you lose money. But this kind of event is so random, there is about equal chance of unfavorable and favorable catastrophic events, so usually, this is a viable option.

Answer 4

The value of a home currency is as set against foreign currencies. That's particularly true with import or export.

In a forex account an investor can take their own currency against foreign currencies. Or an investor can often get a better interest rate by taking a foreign currency against their home currency.

And an investor in a foreign security can hedge the foreign security with a sell of the foreign currency.

Currencies in general move with economic reports. An investor can get often get a better debt-to-GDP by taking a foreign currency against their home currency.