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Unfavourable time to hold on to cash

+1 vote
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asked Aug 20 in BUS 4027W - Actuarial Risk Management by anonymous

One of the questions from the Q&A asks which circumstances may holding a money market instrument be unattractive. One of the solutions says:

"Expectations of a strengthening domestic currency"

This does not make sense to me. If the local currency (which your money market instrument is denoted in) strengthens, does this not mean that your investment has a greater value than comparative investments in a foreign currency. And hence, a strengthening currency is a good thing.

The only argument I can think of is that the government may reduce interest rates (in order to maintain a constant exchange rate) which is not good for money market instruments (and since equities and bonds are likely to do better in the low-interest environment)

1 Answer

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answered Aug 22 by ErichMaritz (500 points)
The elements to consider are local and offshore cash yields (and returns) in an environment where the local currency may strengthen.

If the local does strengthen, like the particular investor expected, then local investments would (in the short term) be preferable to offshore investments, purely because we don't want a currency-related loss.

Looking further into the future, if the strengthening persists, a strong local currency would mean cheaper imports, causing lower inflation, which might cause the reserve bank to lower interest rates. If the reserve bank had the task of currency stability (which our reserve bank does not have) they might react sooner in lowering interest rates. Anyhow, the outlook here is that local cash rates might fall, so one should be on the lookout for other (presumably local) assets to invest in. A strong currency might be indicative that some economic fundamentals in the country has improved and investors therefore bought investment assets, and/or efficiency or product quality improved, improving exports, strenghtening the local currency. This makes local equity a good investment, unless of course all the positive news is already priced in.

To conclude, you can compare the fortunes of local currency with foreign currency, but also with local assets such as equity.

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