Forex: Monetary Investments in Forex
Once it has been determined that funds are available for investment, the next consideration is how they should be invested on an international basis.
Much of the theory of international monetary fluctuation is based on the concept that money will tend to flow where the interest rates are highest, taking into account the hedging cost. The cost of buying or selling a particular currency for future settlement can be expressed as a percent per annum.
If, therefore, three-month sterling short-term investments yield 8 percent and three-month dollar investments yield 6 percent it would be advantageous to invest dollars in the United Kingdom, provided the cost of selling pounds forward for three-month delivery was less than 2 percent per annum.
According to monetary theory, the higher rates in the United Kingdom would attract funds from the United States. As the supply of funds offered in the United Kingdom increased, U.K. interest rates would tend to be reduced; and as the supply of funds in the United States decreased, U.S. interest rates would tend to increase.
At the same time, sale of forward pounds would tend to increase the cost of forwards. The flow of funds could also generate inflationary or deflationary effects in the countries concerned and that is what might happen under a free market.
However, governments wish to foster certain internal policies and have become aware that fiscal policy management can or should have internal effect. They therefore manipulate interest rates, in an effort to achieve the desired result.
One way to get some advantage from the situation already referred to is to arrange the timing of payments to leave funds in countries with high interest rates as long as possible. There are a number of other reasons including liquidity needs and parochial attitudes, why funds do not flow freely.
If investments can be made abroad, there are ways to approach the hedging cost so as to maximize the yield. It is generally unsound not to hedge short-term investments, because the possible loss on ay one transaction far exceeds the possible gain. The purpose of the transaction is to maximize the interest yield, not to make a foreign investment.
That does not mean that some risk is not acceptable, particularly when there is no immediate pressure on the currency concerned. The way to maximize interest yield is to relate the hedge to the position, not to the specific transaction.
For example, the hedge can be for a different time period and amount than the transaction. It may be desirable to cover principal only and not interest or to obtain a six-month hedge against a three-month investment, or vice versa. The aggressive company, however, can also undertake an unhedged investment in another currency.