Mental Models discussed in this podcast:

• Hedging and Insurance Costs
• Purchasing Power Parity

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Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode59

Understanding Currency Exchange Rates

• Most world currencies are free-floating
• Their value fluctuates in price every day against all other currencies
• They are fiat currencies. Which means no assets back up their value. Such as gold or real estate.
• Instead, the value of all currencies is simply based on trust.
• Exchange rates, therefore, embed assumptions about the future outlook for each country. This can include factors like interest rates, currency creation, or central bank policy. 

Purchasing Power Parity

• Hamburger test: How much does it cost to purchase a McDonalds Hamburger in each country.
  • In some countries, the hamburger will be cheaper than the others. 

How does this relate to investing in companies?

• When you buy foreign stocks, you have two key risks:
  • The company buys and sells its goods in a different currency than the one you use in your country.
  • You bought the stock in a different currency than the one you use in your country. 
• If exchange rates change, you could face additional gains or losses. 

How to manage currency risk

• Question: Should you hedge?
• Answer: No. (Hedging is a form of insurance => Therefore, you lose in the long run.)
• In the long run, currency exchange rates are fairly stable. If you're a long term investor, then currency risk should be fairly minimal. As long as you avoid leverage and only ever buy companies with cash, you shouldn't be forced into a situation where currency risk threatens your well being. 
• With that said, it can be helpful to be aware of potential major macro changes that could affect your investments in foreign currencies. Stuff like Brexit which is a known item that caused a decline in the British Pound during uncertainty could have been expected to rise (as it has) once the uncertainty was reduced. 
• Simply avoid countries where negative surprises are likely. (Dictatorships, Corruption, Massive Debt problems, etc...) [Hint: You should be doing this anyway]

Summary:

Your goal as an investor it to earn an acceptable return on your investment capital over your investing lifetime. One potential risk of earning an acceptable return is for your investment returns to be eroded by changes in the value of foreign currency. You can limit this risk by avoiding countries with large problems that may impact the currency. Hedging this risk is a mistake because it guarantees a loss if you always hedge currency risk over your investment lifetime.