A Guide on Funding and Safe Haven Currencies
The two main aims of global finance are accumulating returns for investors and protecting their capital from losses if they cannot provide returns. Some of these investors include individual traders, banks, pension funds, and asset managers. Regardless of the businesses they are involved in, these participants carry out transactions in specific currencies, intending to see their assets gain value. However, during the exchange of assets, the investors are constantly exposed to currency risks that affect their whole capital and their portfolio’s value.
Currency risk is that exposure that arises from having one currency changing its value against another currency. If there is a negative currency move, this will negatively affect the worth of the investment or lower the overall return gained from the investment. Investors generally want to avoid or minimize their exposure whenever there is a possibility of the two currencies moving adversely and trimming off the returns that would have been made in an investment. Hedging through safe-haven currencies is a smart way to protect your asset value in such a case.
A safe-haven currency is considered a reliable currency to hold and transfer investments with less risk. Whenever there is economic turmoil, it is common for safe-haven currencies to gain in value. Investors usually acquire them as reserves to reduce any risks that may come with holding riskier investments.
What makes some currencies risky?
Risky currencies are mainly so because they are from countries with political instability, weakening GDPs, and having economies that are too dependent on one source of revenue. For example, countries that are too dependent on oil or other mineral commodities can be referred to as commodity currencies.
Good examples of commodity currencies are the Australian dollar and Canadian dollar because they not necessarily because they rely too much on minerals but because their value weakens a lot when commodity prices fall. On the other hand, the New Zealand dollar turns bearish when the dairy industry posts poor results. These currencies are considered risky because their economies require the rest of the world to be thriving for them to thrive.
What would happen if a stock trader based in the USA decides to purchase a stock at 100 Australian dollars, and during that time, the exchange rate drops from 0.75 to 0.65 AUD per dollar? In this case, if the investor decides to sell off the stock at the same price (assuming its price didn’t change), he will have suffered a 13% loss. That loss would come from converting the sales proceeds back to U.S. dollars.
On the other hand, if this investor had hedged the risk by short-selling the Australian dollar at the same time, he would still profit from the Australian dollar’s decline and would have netted off the 13% loss. People can use a proven way to reduce currency risks and keep their risk-adjusted returns almost intact. Using safe-haven currencies protects your portfolio!
Using safe-haven currencies to hedge against currency risk
Most options available for hedging against currency risks are costly but using safe-haven currencies is very affordable. Why should investors settle for costlier options while the overall point is to offset every risky currency unit with a dollar? Hedging using a safe-haven currency is especially recommended for individual investors that do not have large investments. That way, they cannot incur more losses trying to use costlier options.
Here are some benefits and considerations that should guide you to take the safe-haven currency route to hedge against currency risk.
- Consider whether the cost of using a safe-haven currency is a reasonable proportion of the total investment. The cost should not outweigh the downside risk.
- How long do you plan to hold the foreign asset? Hedging through currencies is a clever choice because currencies do not fluctuate by a considerable percentage in the short term.
- When the global economy is stable, safe-haven currencies usually reflect the same stability. You are better off using a safe haven currency instead of taking up a different form of hedging.
The Swiss Franc was the original safe-haven currency
Switzerland’s Swiss franc (CHF) was the first-ever safe-haven currency. Also referred to as the “Swissie,” the Swiss franc gained its trust as a safe haven currency because people had high confidence in how the country runs its banking system. Furthermore, Switzerland has been politically stable through the years and has avoided taking sides in any wars and border conflicts. Its currency has always been coveted by investors who seek stability and want to avoid the volatility other currencies experience. Even with a negative interest rate, people still prefer to pay extra to keep their investments there.
Are you wondering why the country still attracts a lot of attention even though it is not the wealthiest in the world? Switzerland earns more in exports than what it spends on imports. This gives it a healthy trade surplus. Switzerland is considered to be a world-beater when it comes to technology, especially in the engineering sector.
Industrial machinery and fashion accessories that are Swiss-made hold high demand in the global economy. That is why the Swiss franc has remained resilient even when the rest of the world has undergone declining value during major economic crisis events such as 9/11 and the emergence of the Coronavirus pandemic. The franc gained value during the recent crisis.
Why the dollar is the best safe-haven currency
Currently, the dollar is the top safe-haven currency. Even with lower U.S. interest rates, the currency is still the world’s reserve currency, and it remains the most preferred for funding carry trades. Carry trades usually involve borrowing low-yield currencies and funding high-yield ventures, and profiting from the interest. Whenever there is economic uncertainty, investors with plenty of high-yield assets sell them off to buy back the borrowed currency. This keeps the dollar strong when other currencies show weakness.
As of 2021, most of the characteristics of safe-haven currencies still show significant signs of remaining for the next few years to come. The dollar, Swiss franc, and Yen all maintain some of the lowest interest rates in the world, making them low-yield currencies. Recent currency correlations and cash flows show that many investors still prefer these currencies to hedge against other risk events that affect the global economy.