Floating Exchange Rates

A Floating Exchange Rate (also known as a flexible exchange rate) is a currency valuation system where a currency's price is determined in the open foreign exchange market (or 'forex') by the constant push and pull of supply and demand. Unlike a fixed exchange rate system, where a government or central bank pegs its currency's value to another currency (like the US dollar) or a commodity (like gold), a floating rate is allowed to fluctuate freely. The value of a floating currency at any given moment reflects a multitude of factors, including the country's economic health, interest rates, trade balance, political stability, and even investor sentiment. Major global currencies like the US dollar, the Euro, the Japanese yen, and the British pound all operate under a floating rate system, meaning their values dance in a constant, dynamic interplay with one another.

Think of a currency like any other good. Its price—the exchange rate—goes up when demand outstrips supply and goes down when supply outstrips demand.

• Demand Drivers: Demand for a currency increases when foreigners want to buy that country's goods, services, or assets. For example, if a German investor wants to buy shares of Apple Inc., they must first sell euros and buy US dollars. This increases demand for the dollar, pushing its value up relative to the euro. High interest rates also attract foreign capital, as investors seek higher returns, further boosting demand for the currency.
• Supply Drivers: Supply of a currency increases when a country's residents need to buy foreign goods or assets. If an American company wants to import French wine, it must sell US dollars to buy euros. This increases the supply of dollars on the market, putting downward pressure on its value.

In a purely floating system, these market forces are the sole determinants of the exchange rate. In reality, most systems are what's known as a managed float (or “dirty float”). This means that a country's central bank will occasionally intervene in the market—buying or selling its own currency—to smooth out excessive volatility or to nudge the rate in a direction that supports its economic goals, without formally committing to a fixed target.

For an investor, especially one holding international assets, a floating rate is a double-edged sword. It creates both opportunities and significant risks.

• Automatic Stabilizer: A floating rate can act as an economic shock absorber. If a country enters a recession, its currency will often weaken. This makes its exports cheaper and more attractive to foreign buyers, which can help stimulate the economy and soften the downturn.
• Policy Independence: Central banks have the freedom to set monetary policy (like adjusting interest rates) to manage domestic priorities such as inflation and unemployment, without worrying about defending a currency peg.
• Transparency: Market-driven rates are generally seen as a transparent reflection of a country's economic fundamentals. There are no sudden, jarring devaluations by government decree, which can happen in a fixed system.

• Volatility and Uncertainty: This is the big one. Exchange rates can be highly volatile, swinging based on news, sentiment, and speculation. This introduces currency risk (or exchange rate risk) to your portfolio. A fantastic gain on a foreign stock can be completely erased if that country's currency plummets against your home currency.
• Speculation: The volatility of floating rates can attract massive amounts of speculation, which can sometimes push currencies away from their fundamental value, creating bubbles or sharp crashes.

Legendary investor Warren Buffett has often warned that currency markets are notoriously difficult to predict, and trying to profit from their short-term movements is a form of speculation, not investment. A value investing approach focuses on a business's long-term intrinsic value, and currency fluctuations add a layer of unpredictable noise that can obscure that value. That said, you can't ignore it. When you buy a stock in a foreign country, you are making two bets: one on the company and one on the country's currency. A great business located in an economy with a chronically depreciating currency can turn into a poor investment.

• Acknowledge the Risk: Always remember that your returns from a foreign investment will be a combination of the asset's performance and the currency's movement.
• Favour Economic Strength: As a long-term investor, it's wise to favour investments in countries with stable governments, sound economic policies, and low inflation. These fundamentals support a strong and stable currency over time.
• Diversify Currencies: Just as you diversify stocks, diversifying your investments across several strong currency regions (e.g., North America, Europe, parts of Asia) can help mitigate the risk of a sharp decline in any single one.
• Don't Try to Be a Trader: For most investors, the best approach is not to try and time currency swings but to focus on buying excellent companies in stable economies and holding them for the long term, letting the currency fluctuations average out over time. More advanced investors might engage in hedging to neutralize currency risk, but this adds complexity and cost.