1.6 Global Economic Factors

Financial markets are increasingly global. Investment advisers must understand how currency movements, trade balances, and international economic factors affect domestic investments and client portfolios.

Why International Economics Matters

Exchange rates: Affect corporate profits, import/export costs, foreign investment returns

Global growth: Many U.S. companies earn significant revenue abroad

Foreign investment flows: Capital flows affect U.S. asset prices and rates

Trade policy: Tariffs and agreements impact company costs and markets

Currency and Exchange Rates

What Is an Exchange Rate?

An exchange rate is the price of one currency expressed in terms of another. For example, if one euro costs $1.10, the exchange rate is $1.10 per euro.

Exchange Rate Systems

Floating: Market forces determine rates. Examples: U.S. dollar, Euro, British pound

Fixed/Pegged: Government maintains rate against another currency. Example: Hong Kong dollar (pegged to USD)

Managed Float: Primarily market-driven with occasional intervention. Example: China (managed against basket)

Strong Dollar vs. Weak Dollar

Exchange rate movements create winners and losers in the economy:

Impact of a Strong Dollar

Who Benefits: U.S. importers (foreign goods cheaper); U.S. consumers buying foreign goods; U.S. tourists traveling abroad; Investors buying foreign assets

Who Suffers: U.S. exporters (products more expensive abroad); U.S. manufacturers competing with imports; Foreign tourists visiting U.S.; U.S. multinational earnings translated to fewer dollars

Impact of a Weak Dollar

Who Benefits: U.S. exporters (products cheaper abroad); U.S. manufacturers; Foreign tourists visiting U.S.; U.S. multinationals (foreign earnings translate to more dollars)

Who Suffers: U.S. importers (foreign goods more expensive); U.S. consumers of imported goods; U.S. tourists traveling abroad; Investors with foreign currency-denominated debt

Currency Risk

Currency risk (or exchange rate risk) is the risk that exchange rate movements will affect investment returns.

Example

A U.S. investor puts $10,000 into a European stock fund:

Scenario A: Stock Return (in Euros) +10%; Euro Change vs. Dollar: Euro rises 5%; Approximate Dollar Return: +15% (currency gain adds)

Scenario B: Stock Return (in Euros) +10%; Euro Change vs. Dollar: No change; Approximate Dollar Return: +10%

Scenario C: Stock Return (in Euros) +10%; Euro Change vs. Dollar: Euro falls 10%; Approximate Dollar Return: 0% (currency loss offsets stock gain)

Scenario D: Stock Return (in Euros) +10%; Euro Change vs. Dollar: Euro falls 15%; Approximate Dollar Return: -5% (currency loss exceeds stock gain)

Key Insight: Even positive foreign stock returns can become negative in dollar terms if the foreign currency weakens sufficiently against the dollar.

Managing Currency Risk

Currency hedging: Use derivatives to offset currency movements

Diversification: Spread exposure across multiple currencies

Unhedged exposure: Accept currency risk as additional diversification

Dollar-denominated ADRs: Invest in foreign companies through U.S.-traded securities

Balance of Trade and Balance of Payments

Balance of Trade

The balance of trade measures the difference between a country's exports and imports:

Trade Surplus: Exports greater than Imports. U.S. Situation: Rare for U.S.

Trade Deficit: Imports greater than Exports. U.S. Situation: U.S. typically runs deficits

The U.S. consistently runs trade deficits, importing more goods than it exports.

Balance of Payments

The balance of payments is a broader measure that includes:

Current Account:

- Trade in goods and services

- Investment income (dividends, interest from foreign investments)

- Transfers (foreign aid, remittances)

Capital Account (also called Financial Account):

- Foreign direct investment (building factories, buying businesses)

- Portfolio investment (stocks, bonds)

- Central bank reserves

Key Principle: The current account and capital account must balance. If a country has a current account deficit (imports greater than exports), it must have a capital account surplus (more foreign investment flowing in).

American Depositary Receipts (ADRs)

ADRs are U.S. securities representing shares of foreign companies, providing a convenient way for U.S. investors to access foreign markets.

What they are: Certificates issued by U.S. banks representing foreign shares

Where they trade: U.S. exchanges (NYSE, NASDAQ) or OTC

Currency: Priced and pay dividends in U.S. dollars

Convenience: No foreign brokerage account needed

ADR Levels

Level I: OTC only. SEC Registration: Minimal (exempt). Can Raise Capital in U.S.? No

Level II: NYSE/NASDAQ. SEC Registration: Full registration. Can Raise Capital in U.S.? No

Level III: NYSE/NASDAQ. SEC Registration: Full registration. Can Raise Capital in U.S.? Yes

Emerging Markets

Emerging markets are developing economies with faster growth potential but higher risk:

Characteristics

Higher growth rates than developed markets: Greater volatility

Large, growing middle class populations: Political and regulatory uncertainty

Infrastructure development opportunities: Currency instability

Diversification benefits: Less liquid markets

Examples

- BRICs: Brazil, Russia, India, China

- Other major emerging markets: Mexico, Indonesia, Turkey, South Africa, Vietnam

Emerging Market Risks

Political risk: Government instability, policy changes, nationalization

Currency risk: More volatile exchange rates than developed markets

Liquidity risk: Harder to buy/sell large positions

Regulatory risk: Less investor protection, changing rules

Transparency risk: Less reliable financial reporting

Trade Policy

Government trade policies affect market returns:

Tariff: Tax on imported goods. Market Impact: Raises costs; may benefit domestic producers

Quota: Limit on quantity of imports. Market Impact: Restricts supply; raises prices

Embargo: Complete ban on trade with a country. Market Impact: Eliminates market access

Free Trade Agreement: Reduces/eliminates trade barriers. Market Impact: Opens markets; increases competition

Current Issues: Trade tensions, supply chain considerations, and reshoring trends are important factors for investment advisers to monitor.

In Practice: How Investment Advisers Apply This

Portfolio construction:

- Consider international diversification for appropriate clients

- Evaluate currency hedging based on client objectives

- Understand that international investments add currency risk as well as diversification

Client communication:

- Explain that a strong dollar hurts foreign investment returns

- Discuss the role of emerging markets: higher growth potential, higher risk

- Help clients understand that global diversification reduces concentration but adds complexity

Monitoring global factors:

- Track major currency movements

- Follow trade policy developments

- Monitor global economic conditions affecting U.S. multinationals

On the Exam

The Series 65 exam tests your understanding of:

1. Strong vs. weak dollar effects on different economic actors

2. Currency risk and how it affects international investment returns

3. Balance of trade vs. balance of payments

4. ADRs and how they work

5. Emerging market characteristics and risks

Common question formats include: "A strengthening dollar would benefit..." or "Currency risk refers to..."

Key Takeaways

- Exchange rates affect corporate profits, trade, and investment returns

- A strong dollar benefits importers but hurts exporters; a weak dollar does the opposite

- Currency risk can turn positive foreign stock returns into negative dollar returns

- ADRs allow U.S. investors to buy foreign stocks on U.S. exchanges in dollars

- The U.S. typically runs a trade deficit (imports greater than exports)

- Emerging markets offer higher growth potential but carry additional risks

- Investment advisers should consider both the diversification benefits and added risks of international investments