Currency ETFs – How They Work

Foreign currency ETFs invest in a single foreign currency or a basket of foreign currencies. These investment funds typically achieve their returns by holding the foreign currencies directly or by investing in short-term debt that is denominated in that foreign currency.

Foreign Currency ETFs – Summary of How They Work

  • Foreign currency ETFs invest in a single foreign currency or a basket of foreign currencies
  • Fund values increase and decrease based on the value of the fund’s underlying foreign currency investments
  • Currency ETFs can be risky investments
  • Interest rates and central banks have a major impact on foreign currency returns
  • Many other country factors affect the value of foreign currencies including political and economic events
  • Foreign currency ETF investing strategies include simple, leveraged and inverse investing strategies

What Are Foreign Currency ETFs?

In their simplest form, foreign currency ETFs invest in a single foreign currency or a basket of foreign currencies. Before there were foreign currency ETFs, only institutional investors, hedge funds, and banks had access to the foreign currency asset class.

The value of foreign currency ETFs increases or decreases based on the value of the fund’s underlying foreign currency investments.

The value of foreign currencies can change significantly in short periods of time, so some people argue that retail investors should be investing in foreign currency ETfs.

What Factors Affect Foreign Currency ETF Values?

various foreign currencies

Interest Rates Have a Major Impact on Foreign Currency Values

Interest rates are considered to be one of the most important factors in determining the value of a foreign currency. Typically, when a country’s interest rate declines, the value of that country’s currency decreases when measured against the value of other countries’ currencies.

On the other hand, when a country’s interest rates rise, the value of that foreign currency, measured against other currencies, increases. As interest rates in a country rise, foreign investors purchase more of that country’s currency to invest in that country. This flow of funds causes that country’s currency to rise in value.

Since a country’s central bank‘s activities have a major impact on domestic interest rates, an investor must be very comfortable predicting those activities before investing in a currency ETF based on that country’s currency.

For most investors, central banks’ activities are difficult to predict. Hence, interest rates are difficult to predict. Sometimes, this is best left to the professionals.

Many Other Factors Affect Foreign Currency ETF Values

Many other factors affect foreign currency ETF Values. Some important variables that affect these values are:

  • Political stability and events
  • Government expenditures and deficits
  • Banking system stability
  • Capital controls
  • Currency controls
  • Natural disasters
  • Terrorism
  • Wars

One or more of the above factors can be more important than a country’s interest rates in determining currency values.

Single or Multiple Country Foreign Currency ETFs

Single currency ETFs exist for all major currencies and countries. Multi-currency ETFs provide exposure to geographic regions or market types. For example, an Asian ETF or an emerging market currency ETF.

How Foreign Currency ETFs Invest

Different ETFs invest differently in foreign currencies.

The simplest fund strategy is to invest in the foreign currency by investing in bank deposits denominated in that foreign currency. The ETF earns interest on the deposit and fund return rises or falls based on the appreciation or depreciation of the foreign currency.

In contrast, some foreign currency ETFs use more complex investment tactics and purchase currency forward contracts and currency swap contracts. These investments can be riskier than investing in bank deposits, depending on the country and banking system.

Lastly, there are leveraged and inverse currency ETFs. A leveraged foreign currency ETF attempts to earn 2X or 3X the appreciation of a foreign currency. An inverse currency ETF attempts to invest such that the ETF fund value rises when the foreign currency value falls.

Read about another way to diversify your investments.