Ok, there is a question for you all. What is the best way to handle the decision of how much to hold in which currency? Assume for the moment that you have no particular view on the price or value of any currency. This choice is actually more tricky that it appears.
Take a US citizen, for example. I bet almost all of them have all their money in dollars. Well, this creates a problem. What happens if the dollar falls 75%? If you just live and work in the USA, this is not *too* bad, since your local costs have fallen too. However, what if you travel frequently, and spend up to half your time and living expenses abroad, say Canada or Mexico or the Caribbean, and some trips to Europe and Asia? Suddenly, for that half of your life, you are 75% poorer. Beers now cost $12, a meal costs $200 at a family restaurant and $1000 at a good restaurant. A car abroad costs $50k for a beater and 500k for a Porsche.
Basically you just got fucked. The reason is you had a huge FX risk without realising it. Effectively, in this situation a 100% dollar position is not "flat". You have half your expenses in non-dollars, so what happened was you were short non-dollars without realising it. Imagine letting a short go 300% in your face with no stop. Well that's what just happened in this situation.
So the way to control risk appears to be to work out your expenses and then distribute your assets accordingly. So if 10% of your expected expenses are in Canadian dollars, for example, a 'flat' position is 90% dollars 10% CAD.
However, it's not quite that simple. Firstly, you don't know what your expenses are going to be in a year, and especially not in future years. Maybe in year 3 you want to emigrate to Japan or France or Australian, and live there for 5 years. What if that currency is up 75% by the time you move? You just got fucked again. Secondly, if you try to hedge by keeping money in your expense currencies on a proportional basis, you incur tax liabilities if the foreign currency appreciates. Let's say the dollar halves so your CAD double. You pay capital gains on that, even though you have made NO economic gain at all because your CAD expenses have doubled too. So if you do this long enough, you will get taxed into bankruptcy because you are being taxed on making no money on the way up and then can't claim deductions or refunds on the way back down.
Next, let's pretend you can ignore the tax and relocation issues. Make it real simple: 50% in US, 50% in Europe. So you have 50% USD and 50% EUR. Now you see the European debt problems, so you become concerned about your Euros long-term value. Ok if the Euro falls 30% half your expenses do too. But if you later want to live in Asia, you just lost 15% of your purchasing power. So maybe you think of selling your Euros - but putting them into what? Dollars are your only other base currency with regular expenses. So now you go 100% long dollars - well, with Bernanke at the pump who knows where the dollar will be in 2-3 years? Maybe the Euro AND the dollar both collapse. Fine if you intend to live the rest of your life there, but if you don't, again you risk taking a huge loss relative to other global currencies. And you can't escape the risk by buying Asian currencies - if you are wrong and the dollar and Euro rally back hard (maybe Bernanke goes hard money on us lol) then you just took a whopping loss and you don't have the cushion of falling expenses to offset it either.
I'll give a couple of examples in the next post:
Take a US citizen, for example. I bet almost all of them have all their money in dollars. Well, this creates a problem. What happens if the dollar falls 75%? If you just live and work in the USA, this is not *too* bad, since your local costs have fallen too. However, what if you travel frequently, and spend up to half your time and living expenses abroad, say Canada or Mexico or the Caribbean, and some trips to Europe and Asia? Suddenly, for that half of your life, you are 75% poorer. Beers now cost $12, a meal costs $200 at a family restaurant and $1000 at a good restaurant. A car abroad costs $50k for a beater and 500k for a Porsche.
Basically you just got fucked. The reason is you had a huge FX risk without realising it. Effectively, in this situation a 100% dollar position is not "flat". You have half your expenses in non-dollars, so what happened was you were short non-dollars without realising it. Imagine letting a short go 300% in your face with no stop. Well that's what just happened in this situation.
So the way to control risk appears to be to work out your expenses and then distribute your assets accordingly. So if 10% of your expected expenses are in Canadian dollars, for example, a 'flat' position is 90% dollars 10% CAD.
However, it's not quite that simple. Firstly, you don't know what your expenses are going to be in a year, and especially not in future years. Maybe in year 3 you want to emigrate to Japan or France or Australian, and live there for 5 years. What if that currency is up 75% by the time you move? You just got fucked again. Secondly, if you try to hedge by keeping money in your expense currencies on a proportional basis, you incur tax liabilities if the foreign currency appreciates. Let's say the dollar halves so your CAD double. You pay capital gains on that, even though you have made NO economic gain at all because your CAD expenses have doubled too. So if you do this long enough, you will get taxed into bankruptcy because you are being taxed on making no money on the way up and then can't claim deductions or refunds on the way back down.
Next, let's pretend you can ignore the tax and relocation issues. Make it real simple: 50% in US, 50% in Europe. So you have 50% USD and 50% EUR. Now you see the European debt problems, so you become concerned about your Euros long-term value. Ok if the Euro falls 30% half your expenses do too. But if you later want to live in Asia, you just lost 15% of your purchasing power. So maybe you think of selling your Euros - but putting them into what? Dollars are your only other base currency with regular expenses. So now you go 100% long dollars - well, with Bernanke at the pump who knows where the dollar will be in 2-3 years? Maybe the Euro AND the dollar both collapse. Fine if you intend to live the rest of your life there, but if you don't, again you risk taking a huge loss relative to other global currencies. And you can't escape the risk by buying Asian currencies - if you are wrong and the dollar and Euro rally back hard (maybe Bernanke goes hard money on us lol) then you just took a whopping loss and you don't have the cushion of falling expenses to offset it either.
I'll give a couple of examples in the next post: