The beginner's guide to currency exchange
Yes, the Saturday papers were hysterical and a lot of rubbish was spoken and written in the following days, but certain unarguable phrases must surely stick out even now. Statements such as: “The pound's dramatic fall started overnight as the outcome of the referendum became clear.
At one stage, it hit $1.3236, a fall of more than 10%,” as stated by the BBC on 24 June and “The pound sank to a fresh 31-year low against the dollar on Wednesday,” which was written The Guardian on 6 July. But what does this actually mean? After all, £1 bought you a bag of Tangfastics at the start of June, and it still got you the same come July.
We all use money every day. We earn it, spend it, fantasise about it, handle it and stress about it. Yet, in a global perspective, currency is incredibly complex - much more so than stocks and shares - and the way it works often conflicts with the idea of ‘common sense’.
This article will look at what currency fluctuations are, what causes them and how they affect you. The aim is to untangle the jargon in order to make currency news less alarming and, ultimately, to make it more meaningful to your life.
The value of currency and why it changes
The history of money is far more interesting than it sounds and it would be easy to write a lot about it. There’s no room for that. Instead it will have to suffice to say that the thing that gives money its value is trust. Trust that other people will accept your money as payment, trust that this works both ways, trust that standardised money will always be fungible and, most importantly, trust that a country’s government will always back it up. You could say that the use of money is an expression of the people’s belief in their government.
So why does the value of money change?
We’re all familiar with exchange rates. The amount of, say, euros you can buy for one pound is constantly shifting, causing no end of headaches in between wrapping up your sun cream in plastic bags and remembering where to get the best cashback from travel insurance. What drives these changes is a collective opinion from numerous traders buying currency with another currency (called currency pairs) on what each one is worth in relation to the other. This opinion is formed by making a judgement on:
- The stability of each country’s government
- Each country’s interest rate
- Inflows/outflows of with the currencies
- Debt - both government and public
- A country’s overall economic performance
- Trade terms with other territories
- And, of course, the self-fulfilling prophecy where other traders see a currency’s value change and act on that.
These traders can range from a person sat in their bedroom in Milton Keynes to computer algorithms running in the basements of New York investment banks to massive players such as George Soros, who famously bet short on the British pound (effectively betting that it would be worth less in the future than it was at the time) in September 1992 and made over £1 billion on ‘Black Wednesday’. Somebody buying or selling vast amounts of currency will cause effects that ripple across the entire economic landscape.
Why do these changing rates matter?
This is where things get a bit messy and the language used seems wrong - specifically the use of ‘stronger’ and ‘weaker’.
One of the main currency pairs (these are called ‘majors’) is the GBP/USD. In this case, GBP is the ‘base currency’ and the other the ‘quote currency’. If GBP/USD were at 1.3373, then £1 would buy you 1.3373 dollars. If this changed to 1.4000 (a huge rise), you would say that the pound is stronger because it buys you more dollars. Conversely, the dollar is ‘weaker’, because it would require more dollars to buy one pound – 1.4 instead of only 1.33.
So, if you’re an American planning to see the Tower of London, a weak dollar is bad news. But if you’re British and off to California to escape the British winter, a strong pound is a good thing.
It’s worth bearing in mind that most currency pairs generally stick within a certain range of each other.
If you want to find the best cash exchange rate before going abroad, use the TravelMoneyMax.com tool. Also, see our Best cards for overseas spending.
However, focussing on how exchange rates affect holiday spending is a little short-sighted. One of the biggest factors changes in rates affects is a company’s earnings. Think back to Brexit - all that reporting on the pound weakening massively, yet… the stock market flew to record highs?
Bear in mind that the reason the pound weakened was because nobody wanted to hold the currency - they had lost faith in its government and its place in the global economy and so pounds were going at bargain prices.
One of the main reasons for this is that the FTSE100, while consisting of the biggest London-listed companies, actually has a massive amount of foreign exposure. The companies listed are earning money in dollars, euros, yen… and so a weak pound means that these companies earned more in sterling than they expected to when repatriating these currencies to the UK. In this case, a weak pound helped them.
Another reason was that as soon as the markets opened after the referendum the FTSE100 dropped, and many investors - overseas ones included - saw this as an opportunity for bargains, pushing up prices as demand increased.
The FTSE250 is less exposed to the international markets and of less interest to overseas investors, and it dipped after Brexit. But it’s important to keep in mind that despite what a lot of publications say, it still has a lot of foreign exposure and its dip was more to do with the companies being smaller in size, which many people believed made them less able to deal with the shock of exiting the European common market. At the time of writing the FTSE250 is climbing high.
If you live in the UK and have a pension, there’s a good chance that will have been invested in the stock market - the improved performance of which will obviously have been a good thing. Those who were planning on doing a drawdown would have been laughing - although trying to time the market specifically is always risky.
For those with annuities, though, the news wasn’t so good. The reasons for this are not so much to do with currency but with bond yields, though.
But thinking that a weaker pound is generally a good thing for people is simplistic thinking. The other side of the coin (pun very much intended) is that if you earn money in pounds but live overseas and have to convert, your spending power will have been eroded. These unfortunates include UK expats earning a UK pension (of which there are over a million people) and sun-worshipping British landlords collecting their rent in pounds.
Above, you can see the GBP drop against the dollar immediately after the referendum vote.
The same happened against the euro, meaning that British people living in, for example, Spain, and recieving a penion in pounds saw their spending power drop dramatically.
Why do people buy a foreign currency?
There’s a slew of people who trade foreign currency because they believe they can exploit the rate changes and make a profit. This is very risky behaviour and, for the individual, often ends in tears. The cost of transactions and the relatively small amount of capital that most individuals have access to means that any gains made tend to be small, and the unlikelihood of making good calls on a consistent basis means the odds start to lengthen.
More commonly, and a generally much more sensible reason for buying foreign currency are those who do it in large amounts and to mitigate risk. This is where you might hear the term ‘safe haven’. This is where somebody holds foreign currency, say the yen, because they believe it will hold its value in a low-growth scenario. Banks won’t be giving you much interest on your currency, but if stock markets drop, because people are looking to move their money elsewhere, suddenly your yen is in demand and so quite valuable. This is one reason why institutions such as the Bank of England hold many different foreign currencies in their vaults.
Foreign currency is risky and difficult to make money from. But think on this: the entire world economy is valued at $60 trillion, and every day, $5.3 trillion of foreign exchange takes place. It’s one of the biggest drivers of the global economy, and all it consists of is people buying and selling one form of money with another.
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
The difference between two currencies; specifically how much one currency is worth relative to each other. For example, if £1 is worth $1.50, converting sterling to US dollars, the exchange rate is 1.5. Converting dollars to sterling at those levels, the exchange rate is 0.66, so $1 is worth 66p. There are a wide variety of factors that influence the exchange rate, such as a country’s interest rates, inflation, and the state of politics and the economy in that country.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.