[MUSIC] Hi, everyone. Today, we're going to talk about currencies and we'll see that they represent key asset class. So in this video we will see four things. We will see what an asset class is, how we can define it. The different ways of quoting exchange rate, how they may impact your investment decisions and why they should be treated separately. When we talk about an asset class, can we define it more precisely? Well there are no exact definitions, but maybe the best definition we can think of is that they represent a group of securities that has similar characteristics either they to move together. So when we talk about asset classes, normally we think of cash, we think of bonds, which we have seen in a couple of previous videos and equity markets as well. Whether currencies do represent an asset class per se, remains an open question, and I personally believe that currencies are a separate asset class. They should be treated separately, and I'll show you why in a minute. But more importantly and first and foremost, we need to know that currencies do represent the largest financial market in the world. Indeed for one very simple reason, every other market is labeled in a currency, so it's no wonder that currencies do represent the largest financial market in the world. You can see here some figures. These are daily figures, daily volume on the Forex market, the Foreign Exchange Market. So survey conducted every three years by the Bank for International settlements and you see the figures here, these are trillion dollars. So every day you see $5.3 trillion, so 5000, $3000 billion are treated on the currency market and you see that this number now has been increasing steadily over the years. When we deal with this big numbers, it's always interesting to put them in perspective either to a GDP figure gross domestic product or international trade. So here what we've done is we show you how these figures compare to GDP and when I first looked at this chart I thought, I see these lines in the bottom, the rock bottom. Actually the blue and the green line, United States and Japan they kind of mingle together. It's hard to differentiate both but you see that they're very, very, low close to zero, close to ten. So I thought, well 10% of GDP for the volume of the US dollar and the yen respectively to respective to their GDP. That's not very high, but then I realized that these were not percentages, they were time. So here we're dealing with a country which has daily volumes in the foreign exchange market, which represent 14 times the size of the economy so that's a lot. And you can see that even for smaller countries like Switzerland, this is more than 100 times. So the daily volume traded on the Swiss francs are more than a 100 times the size of the Swiss economy, the number is 250 times for Hong Kong, and the record is for Singapore with more than 300 times. In terms of volumes, it's the dollar which dominates the scene, it represents 87% of the volume treated on the Forex market. Then the second currency is the Euro with 33%, and the Japanese yen with have 23%. What we don't see in this chart but what I can tell you is that emerging market currencies do represents a minor, still low part of daily volumes in the Forex market, but this is growing very fast. So stay tuned to watch how these currencies will become increasingly important in the Forex market. When we talk about currencies, we need to know that there are two ways of quoting them. There's the direct way and the direct quote and there's the indirect quote. So the direct quote is the number of units of domestic currencies, which are needed to buy or to exchange, either buy or sell a unit of foreign currency. So for an example, if we think of an investor who has Swiss franc as a reference currency, he needs to consider whether he wants to buy some dollars. You will have to spend 0.99 today and that's the current exchange rate Swiss franc to purchase $1 or the same can be said about the euro. It needs 1.08 Swiss franc to purchase one unit of foreign currency, the euro in this instance. So this is the norm in every country, this direct quote except and you see the countries here. The UK, Australia, New Zealand, Canada and the Eurozone. In this country, we talk about indirect quotes so here it's the number of unit of foreign currencies corresponding to one unit of domestic currency. So it worth my 1 euro, how much can I purchase of say US dollar or Canadian dollar or what have you? So here you see some example. 1 euro is $1.09 US currently. 1 Australian dollar is worth $0.71 US. Okay, so now we are going to illustrate the impact to a currency may have on a financial market and here I take the example of the US equity market. We see this blue line, it's the index called the S&P 500, which represents the 500 largest companies quoted on the US equity market, and the red line line or below is the same index but expressed in Swiss francs. The first is expressed in US dollars the second one in Swiss franc and that reminds me of a story that happened to me a couple of years ago. I was head of research at a private bank here in Geneva and this portfolio manager comes to me and he says, Michelle you always showing this chart saying that the US security market is expensive. The valuation is stretched and you see what that means in videos down the road. And also okay, basically you say, well the index is at it's peak, so maybe we should be a little bit cautious. Then you said, hey look, look at this chart I'm investing from my point of view it's in Swiss franc when I buy the US equity market and I make some gain or losses I translate them in Swiss franc. So for me as a Swiss franc based investor it's the US equity market expressed in Swiss franc which matters. And on this chart, the US equity market was way above, and the US equity market expressed interest rank was way, way at the bottom. So you tell me, it's not expensive once you express it in Swiss franc. But I told this portfolio manager that he was maybe not, he was confusing two things, the market for one and the currency in which it is expressed for two. And basically, and you see the reason why it looked apparently so cheap when you express the market in Swiss franc is because the Dollar had collapsed in the mean time. We see this on this long term chart. You see that up until 1973, currencies were fixed and the parity comes after the agreement which was made post World War II. So called Bretton Woods agreement. Whereby they fix the parities between currencies and the parity of the Swiss franc was roughly 4.3 to the dollar. This is way more than the one we currently have today. And you see that this line has been trending down over the years. So it's not surprising that when you express a market in a currency which has been appreciating, over all this years like the Swiss franc then the line may look correspondingly cheap, but it's not. So with this example I really want to make a case here that currencies should be treated separately, that's for sure. And they are actually a separate asset class because they can move independently from other markets. The best example I can give you here, is the example of Japan. Currently what we have in Japan is, and we will see that when we talk about central banks. We have a central bank, which is conducting a very accommodative policy. Very low interest rates and program, which we will see of what it that means of quantitative easing, so they're injecting a lot of liquidity in the market. This has two impacts. It has the impact of propping up the equity market. So giving some support for the equity market to go up. But at the same time, also it puts some pressure on the currency. We have the same example actually, even in the Eurozone, with the European Central Bank conducting exactly the same policy. So rather a positive for the equity market and rather a negative for the currency. So what you should do as an investor if you are buying the Japanese market and you're based say in US dollars then you should buy, you should get exposure to the Japanese equity market. But you should hedge and we will see how we do this when we talk about ways of insuring that your portfolio is not affected by currency moves. Basically, you should hedge for the risk that the yen will fall against the dollars. So you should treat both decisions separately by the market, but hedge the currency in which it is labeled. Okay, so in conclusion we saw that the Forex market is actually a very large, it's actually the largest financial market in the world. With daily volumes which are in excess of $5,000 billion per day. We also saw that there are two ways of quoting exchange rates, there's the direct quote way which is commonly used. It's so much units of domestic currencies to purchase or sell a unit of foreign currencies but then there's also the indirect quotes which is used in Canada, in Eurozone, in Australia and New Zealand. And also we thought more importantly that gains that you make in financial markets, we took the example of the US equity market, can be raised if the currency in which they are labeled falls versus your reference currencies. And hence, it's very important that you should consider currencies as a separate asset class. [MUSIC]
