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
| Factor | Impact on U.S. Investments |
|---|---|
| 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 USD/EUR = 1.10, it means $1.10 buys €1.00.
Exchange Rate Systems
| System | Description | Examples |
|---|---|---|
| Floating | Market forces determine rates | U.S. dollar, Euro, British pound |
| Fixed/Pegged | Government maintains rate against another currency | Hong Kong dollar (pegged to USD) |
| Managed Float | Primarily market-driven with occasional intervention | 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 | Who Suffers |
|---|---|
| U.S. importers (foreign goods cheaper) | U.S. exporters (products more expensive abroad) |
| U.S. consumers buying foreign goods | U.S. manufacturers competing with imports |
| U.S. tourists traveling abroad | Foreign tourists visiting U.S. |
| Investors buying foreign assets | U.S. multinational earnings translated to fewer dollars |
Impact of a Weak Dollar
| Who Benefits | Who Suffers |
|---|---|
| U.S. exporters (products cheaper abroad) | U.S. importers (foreign goods more expensive) |
| U.S. manufacturers | U.S. consumers of imported goods |
| Foreign tourists visiting U.S. | U.S. tourists traveling abroad |
| U.S. multinationals (foreign earnings translate to more dollars) | 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 | Stock Return (in Euros) | Euro Change vs. Dollar | Approximate Dollar Return |
|---|---|---|---|
| A | +10% | Euro rises 5% | +15% (currency gain adds) |
| B | +10% | No change | +10% |
| C | +10% | Euro falls 10% | 0% (currency loss offsets stock gain) |
| D | +10% | Euro falls 15% | -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
| Strategy | Description |
|---|---|
| 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:
| Term | Definition | U.S. Situation |
|---|---|---|
| Trade Surplus | Exports > Imports | Rare for U.S. |
| Trade Deficit | Imports > Exports | 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 > 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.
| Feature | Description |
|---|---|
| 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 | Where Traded | SEC Registration | Can Raise Capital in U.S.? |
|---|---|---|---|
| Level I | OTC only | Minimal (exempt) | No |
| Level II | NYSE/NASDAQ | Full registration | No |
| Level III | NYSE/NASDAQ | Full registration | Yes |
Sponsored vs. Unsponsored ADRs
| Type | Description | Information Quality |
|---|---|---|
| Sponsored | Foreign company participates in creating the ADR | Better (company provides information) |
| Unsponsored | U.S. bank creates without company involvement | Lower (limited information flow) |
Emerging Markets
Emerging markets are developing economies with faster growth potential but higher risk:
Characteristics
| Opportunity | Risk |
|---|---|
| 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
| Risk Type | Description |
|---|---|
| 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:
| Term | Definition | Market Impact |
|---|---|---|
| Tariff | Tax on imported goods | Raises costs; may benefit domestic producers |
| Quota | Limit on quantity of imports | Restricts supply; raises prices |
| Embargo | Complete ban on trade with a country | Eliminates market access |
| Free Trade Agreement | Reduces/eliminates trade barriers | 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:
- Strong vs. weak dollar effects on different economic actors
- Currency risk and how it affects international investment returns
- Balance of trade vs. balance of payments
- ADRs and how they work
- Emerging market characteristics and risks
Expect 1-2 questions on global factors. 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 > 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
Which of the following would benefit from a STRENGTHENING U.S. dollar?
What is an American Depositary Receipt (ADR)?
An investor buys shares of a Japanese company. The stock price increases 8% in yen, but the yen falls 12% against the dollar. What is the approximate return in dollar terms?