by George D. Lambert

Does a falling U.S. dollar or rising euro interest you? Do you want to protect your dollar-denominated assets or profit from a rise in European currency? If so, traditionally you would have to trade currency futures. open up a forex account, or purchase the currency itself to profit from changes in currencies.

However, currency exchange-traded funds (ETFs) are a simpler way to benefit from changes in currencies without all the fuss of futures or forex by simply purchasing ETFs in your brokerage account (IRA and 401(k) accounts included).

In this article, we will look at why currencies rise and fall and check out the different types of currency ETFs available to investors. (To go more in depth into traded instruments, check out Traded Instruments on our Learning Center.)

Why Currencies Move

Foreign exchange rates refer to the price at which one currency can be exchanged for another. The exchange rate will rise or fall as the value of each currency fluctuates against another.

Factors that can affect a currency’s value include economic growth, government debt levels, trade levels, and oil and gold prices among other factors. For example, slowing gross domestic product (GDP), rising government debt and a whopping trade deficit can cause a country’s currency to drop against other currencies. Rising oil prices could lead to higher currency levels for countries that are net exporters of oil or have significant reserves, such as Canada.

A more detailed example of a trade deficit would be if a country imports much more than it exports. You end up with too many importers dumping their countries’ currencies to buy other countries’ currencies to pay for all the goods they want to bring in. Then the value of the importers’ country currencies drops because the supply exceeds demand.

How ETFs Work

For years, many investors have used ETFs instead of mutual funds to track major equity indexes. such as the S&P 500 and the Lehman Brothers three- to seven-year U.S. Treasury Index.

ETFs have a few advantages over mutual funds, including:

• They Are Easy to trade: They can be bought and sold anytime through any broker, just like a stock.
• They Are Tax efficiency: ETFs typically have lower portfolio turnover and strive to minimize capital gains distributions so that investors are only taxed when they initiate a trade.
• Greater Transparency: ETFs disclose the exact holdings of their funds on a daily basis so you always understand precisely what you own and what you are paying for.
• Flexibility: Anything that you can do with a stock, you can do with an ETF. This includes shorting them, holding them in margin accounts and placing limit orders.

With currency ETFs, you can invest in foreign currencies just like you do in stocks or any other ETF. You can even buy ETFs in your IRA. (To learn more bout it, check out Mutual Fund Or ETF: Which Is Right For You? ).

Currency ETFs

Currency ETFs replicate the movements of the currency in the exchange market by either holding currency cash deposits in the currency being tracked or using futures contracts on the underlying currency.

Either way, these methods should give a highly correlated return to the actual movements of the currency over time. These funds typically have low management fees as there is little management involved in the funds, but it is always good to keep an eye on the fees before purchasing.

There are several choices of currency ETFs in the marketplace. You can purchase ETFs that track individual currencies. For example, the Swiss franc is tracked by the CurrencyShares Swiss Franc Trust (NYSE:FXF). If you think that the Swiss franc is set to rise against the U.S. dollar, you may want to purchase this ETF, while a short sell on the ETF can be placed if you think the Swiss currency is set to fall.

You can also purchase ETFs that track a basket of different currencies. For example, the PowerShares DB U.S. Dollar Bullish (NYSE:UUP) and Bearish (NYSE:UDN) funds track the U.S. dollar up or down against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. If you think the U.S. dollar is going to fall broadly, you can buy the Powershares DB U.S. Dollar Bearish ETF.

There are even more active currency strategies used in currency ETFs, specifically the DB G10 Currency Harvest Fund (NYSE:DBV), which tracks the Deutsche Bank G10 Currency Future Harvest Index. This index takes advantage of yield spreads by purchasing futures contracts in the highest yielding currencies in the G10 and selling futures in the three G10 currencies with the lowest yields.

In general, much like other ETFs, when you sell an ETF, if the foreign currency has appreciated against the dollar, you will earn a profit. On the other hand, if the ETF’s currency or underlying index has gone down relative to the dollar, you’ll end up with a loss.

Follows Most Major Currencies

Currency ETFs can be an efficient tool that allow you to diversify away from the U.S. dollar and track the price movements for most major markets, including the:

• Australian dollar (or Aussie)
• British pound
• Canadian dollar (or Loonie)
• Euro
• Japanese yen
• Mexican peso
• Swedish krona
• Swiss franc (or Swissie)

As currency ETFs grow in popularity you will see more and more different currencies being tracked as well as more exotic strategies being used.

The Risks

Some of the specific currency risks that come with currency ETFs include:

• Political problems
• National debt
• Trade deficits
• Interest rate changes
• Government defaults
• Changing domestic and foreign interest rates
• Central banks or other government agencies selling the currency in large quantities
• Commodity price changes

It is important to recognize these risks and the effect they could have on the price of your currency ETF. If you fail to recognize a new political leader as a threat to your rising currency, you could be out a lot of money in a few short days.

The Bottom Line

As ETFs have grown in popularity, there has been an equal growth in the variety of options opening up for investors. These investment vehicles allow us to both hedge and speculate against changes in currency prices. However, like all investment there are risks and it is imperative to understand them before jumping in.