Lesson Four Free Course
on Currency Investing
By
Gary Scott
Most investors are always alert for ideas on how to gain
profit. Yet few know much about currency investing basics.
The first rule of currency investing basics is to look
at risk as well as potential profit. Only when you face potential
rewards and risks, can you make a truly sound currency investing
basics investment decisions. This special report begins by
looking at ways to view currency investing basics risk. Then
future lesson look at what I have written about the Multicurrency
Sandwich over the past five years and some Multicurrency
history that goes back a decade.
This third lesson began looking at currency investing basics
risk assessment data I sent my readers about currency investing
basics in 1993.
Currency Investing Basics Risks Assessments
"Now
let's look at the currency investing basics risk assessment
to see what happens if we borrow yen to invest
in pesos and then the yen rises 15% versus the peso. This
seems unlikely in light of the evidence we saw last lesson,
but we should always know what will happen if our expectations
are not met. We must review the risk in case our research
missed something or we drew incorrect conclusions or the
statistics and currency investing basics risk assessment
we used were wrong. We must prepare for the unexpected.
Jyske Bank
Let's look at five risks
we should review.
Currency Investing Basics Risk Assessment Risk
#1: The bank where we hold our money goes broke.
This is one of the least risks if you deal with a major
bank. To reduce this risk here are steps you can take.
Currency Investing Basics For Protection
#1: Look at the bank's balance
sheet. #2: Look at how long the bank has been in business.
#3: Ask if there is any type of government or industry guarantee
on your account. #4: See if the assets the bank holds for
you will be held by the bank as a fiduciary. If so even if
the bank goes broke, the assets should be safe unless fraud
is involved. #5: Ask a banker or investment professional
you trust to get a credit rating or reference on the bank.
Currency Investing Basics Risk Assessment Risk
#2: In 1993 the Mexican government's debt rating
was not of a high standing. Mexico 's debt load from money
borrowed in the 80s was still high. According to Standard & Poor's,
one of the best known credit rating agencies, the Mexican
government was rated BB+ and the outlook was stable. BB
was not a Standard & Poor's investment grade rating.
It was a speculative grade rating. Standard and Poor's
defines their ratings AAA, AA, A and BBB as investment
grade. BB, B, CCC, CC and C are speculative grade ratings.
Mexico at a BB+ was the highest grade speculative rating,
but this investment was a speculation.
Currency Investing Basics Risk Assessment Rating Description
"Standard & Poor's describes a BB rating as, "One
with less near- term vulnerability to default than other
speculative issues. However it faces major ongoing uncertainties
or exposure to adverse business, financial or economic conditions
which could lead to inadequate capacity to meet timely interest
and principal payments."
There were positive factors that mitigated the risk. The
speculation involved short term instruments (90 day T-Bills),
that Mexico seemed least likely to default on. The fact that
those bonds returned 12% made up for some risk as well.
I urged the readers to understand
the risk and then decide whether or not to accept this risk
but to be sure not to ignore risk!
Currency Investing Basics Risk Assessment Risk
#3: The returns that Mexican Peso T-Bills offer
could fall (and they did). If the Mexican economy strengthened
(as it did) and if the perception of risk in these investments
diminished (it did), it was possible that the return on
those T- Bills would fall. So we looked at what would happen
to the investment as the yield dropped from 12% to 10%
or 8%.
There was no guarantee that the yield on these T-Bills
would last longer than 90 days. Those instruments were bought
at a discount for 90 days.
Currency Investing Basics Risk Assessment Projections
For currency investing basics risk assessment projection
purposes, we assumed an investment of US$25,000 into Mexican
pesos 'Cetes' T-Bills. This was used as collateral for a
US$100,000 yen loan also invested into Mexican peso Cetes
T-Bills.
"Keep
in mind that when we looked at the performance projections
we looked only at the return before foreign exchange
profit or loss. We looked at the foreign exchange portion
of the profit later.
PERFORMANCE PROJECTIONS OF YEN-PESO LOAN WITH 10% T-BILL
RETURN
"Convert
$25,000 to Mexican pesos and buy Cetes 3 month T Bills
Use the T Bills To borrow U.S. $100,000 of
yen at 3.875%. Invest the loan in Mexican peso T-Bills as
well.
PERFORMANCE PROJECTIONS OF YEN-PESO LOAN WITH 10% T-Bill
Return $100k
$100k Mexican Peso Yield 10.00% less 3.87% 6.13% $6,130
Extra Earned From Loan $6,130
$25k Mexican Peso Yield 10.00% $2,500
TOTAL RETURN ON $25,000 INVESTED IS 34.52% or $8,630
PERFORMANCE PROJECTIONS OF YEN-PESO LOAN WITH 8% T-Bill
Return $100k Mexican Peso Yield 8.00% less 3.87% 4.13% $4,130
Extra Earned From Loan $4,130
$25k Mexican Peso Yield 8.00% $2,000
TOTAL PROJECTED RETURN ON $25,000 INVESTED IS 24.52% or
$6,130
As you can see from the projections above, every time the
return on the Cetes T-Bills fell 1%, the return on the portfolio
fell 5%. With this knowledge were able to project in advance
the actual return (without the foreign exchange profit or
loss factor) at each level of T-Bill yield:
T-Bill Yield Portfolio Return
12% 44.52%
11% 39.52%
10% 34.52%
9% 30.92%
8% 25.92%
7% 20.92%
6% 15.92%
5% 10.92%
Currency Investing Basics Risk Assessment Risk
#4: The interest rate on the yen loan could rise.
Normally your banker will not give you a fixed interest
rate on your yen loan. The normal collateral loan is linked
to the London Interbank Interest Rate and can change at
any time. Every 1% rise in the interest rate of the yen
loan reduced the return by 5%. The portfolio return projections
above could thus be applied to see what happened to profits
if the yen interest rate rose. (History shows they actually
fell).
All this had been calculated without taking the foreign
exchange fluctuations into account. However foreign exchange
fluctuations between the yen and peso could have had the
biggest impact of all on this portfolio. It could brought
the biggest profit, but also created the biggest loss! This
was the fifth and largest risk.
Currency Investing Basics Risk Assessment Risk
#5: The Mexican peso could fall versus the Japanese
yen. We saw earlier how a 5%, 10% and 15% fall of the yen
could add enormous profit to this portfolio. Now let's
look at how a 5%, 10% and 15% rise of the yen will destroy
the profits of this collateral loan.
"In
the projections below, we calculated the projected losses
in U.S. dollar terms to keep the calculations simple.
As reviewed in earlier lessons the example shows a 10,800,000
yen loan with the US $/Yen rate at 108.
"If
the yen rises versus the dollar (and hence the peso) by
5% the dollar/yen rate
would be 102.6. It would cost US$105,263 to pay off the yen
loan. The foreign exchange loss would be US$5,263 or 21%
of the US$25,000 invested.
Currency Investing Basics Currency Loss
In other words, a 5% rise in the yen versus the peso reduced
the return on the portfolio from US$11,130 to US$5,867 (assuming
the yen loan rate and the peso T-Bill yield did not alter)
from 44.52% to 23.52%.
"If
the yen rose 10% versus the dollar, the dollar/yen rate
would be 97.2. To pay off the 10,800,000 yen would cost
US$111,111,111. The portfolio suffers a US$11,111 loss or
44% of the US$25,000 invested. This reduces the 44.52% profit
to almost nil.
"In
other words, a 10% rise in the yen would reduce the return
on the portfolio from $11,130 to $29 or almost
no return at all. If the yen rose 10%, the portfolio just
breaks even.
"If
the yen rose 15% versus the dollar, the dollar/yen rate
would be 91.8. To pay off the 10,800,000 loan would
cost US$117,647. The portfolio suffers a US$17,647 loss or
70% loss of the initial $25,000 invested.
In other words, a 15% rise in the yen would reduce the
return on the portfolio from $11,130 to a loss of US$6,517
loss or -26% of the US$25,000 invested.
And the loss could have
been worse because it would take a full year to earn the
44.52% profit on the spread between the loan rate and T-Bill
return. The foreign exchange loss could come in a matter
of months.
Currency Investing Basics Risk Assessment Worst Case
We assessed our risk on a worst case scenario. We projected
that just after the portfolio began, the Mexican peso crashed
in foreign exchange markets. We projected that the peso suddenly
collapsed 15% versus the yen in the first two months after
the portfolio started. The portfolio's return from the interest
rate spread would be 7.42% (two months' worth of profit at
the 44.52% annual rate), but the sudden foreign exchange
loss would be 70%. The real loss at that stage would be 62.58%.
"Most
banks would not allow a 70% loss without asking for additional
collateral. If extra cash, bonds or securities
were not available as extra collateral, most bank will liquidate
the position. The loss in the portfolio becomes real, a real
whopping US$15,645!
The point we wanted top get across was that there are real
risks involved in this multicurrency sandwich. We needed
to realistically proeject them so we could decide whether
to take the risk or not.
We look at how we mathematically projected these losses
next lesson.
Gary Scott
Join Gary Scott
and Jyske bank at an International Investing and Business
Course. Details are at GaryScott.com
To learn more about Gary
Scott go to GaryScott.com
To understand currencies
you need to understand countries.
Learn more about Mexico
and the Mexican peso at Answers.com
Jyske Bank specializes in
currency investing basics. Attend Jyske
investing seminars in Copenhagen. Details available from
Thomas Fischer
at FISCHER@jyskebank.dk
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