Foreign currency is bought and sold to buy or sell foreign assets. U.S. companies and individuals buy foreign assets for much the same reasons as they hold domestic assets – they are balancing expected returns and anticipated risks. For example, some U.S. pension funds include foreign stocks and bonds in their portfolio of assets. U.S. multinational companies purchase factories and office buildings overseas. Pension fund managers and multinational corporate treasurers may think that the returns to foreign assets are higher than the return to U.S. assets, or they may think that the overall risk of their portfolio of assets is reduced by diversifying and including foreign assets. Similarly, foreigners purchase U.S. assets, such as U.S. government securities, real estate in New York or Los Angeles, or factories in Ohio.

All of these transactions involve foreign exchange. For example, a Japanese insurance company may decide to purchase an office building in Los Angeles. It deposits funds in yen into an account in a Japanese bank and the bank then arranges to exchange the amount in yen and transfer it into a deposit in a dollar account in a U.S. bank. These funds in dollars are then used to purchase the building. Because international investors require foreign exchange, international buyers and sellers of assets participate in foreign-exchange markets along with importers and exporters of goods and services.

Individuals and institutions that manage portfolios of assets look for the best combination of risk and return they can find. If the best opportunities are from buying financial assets in another country, then this is what they will do. Similarly, companies with profits to reinvest will weigh the returns from building a new factory at home against the returns from buying out a foreign company or expanding one they already own.

When people or companies hold foreign assets, there is an extra source of possible gain or loss, over and above the rate of interest or rate of profit earned by the asset itself. The extra risk comes from fluctuations in the exchange rate of the currencies involved. Gains or losses in the value of a foreign asset can be reversed or increased by changes in currency values, even when there is no change in the economic performance of the asset.

Consider specifically the return to holding a foreign financial asset, such as a government or commercial bond. The return on the bond will depend on the interest earned and on the future value of the bond when converted back to domestic currency. Since the rate of conversion that will apply to the future payments of interest and principal is the future exchange rate, the decision to purchase a foreign asset is affected by both the interest rate earned on the asset and expectations about the future value of the exchange rate.

http://yopages.com Nick Larson

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