For a fistful of dollars

Currency: Exchange rates mean more than holiday cash

For most of us, most of the time, foreign currency is an issue to be addressed once or twice a year during a foreign holiday as we painstakingly count out the drachmas or the pesetas to pay for our ice creams.

We all know holidays abroad become much cheaper when sterling is strong. Trips to France cost a lot less now that a pound buys nearly nine and a half French francs.

Perhaps not surprisingly, few people realise the role such fluctuations can have on their daily lives. "People are aware of [currency changes], but not the potential impact they can have," says Tim Cockerill, investment director at Whitechurch Securities in Bristol. This is particularly the case for millions of small investors.

Even if your money is invested within the UK, the pound's struggles abroad have an impact on shares. For example, many private investors are unaware of indirect holdings by their fund managers in foreign bonds and shares. A unit trust may be quoted in sterling, for example, though most of its underlying assets are in foreign currencies. If you invest in an international growth unit trust, for example, or a European equity fund, then the value of your investment will be hit by sterling's fate.

Even for those with no direct equity investment to their name, the pension funds they belong to will usually have some overseas investment, and exchange rate fluctuations make themselves felt. If sterling is weak against major currencies, foreign investment returns are magnified and vice versa.

Even your mortgage payments could be affected by the pound. Remember 1992 when the government tried to shore up sterling by pushing interest rates sky-high?

Why do currency values change? A currency becomes strong when it is in demand. It is in demand when it gives investors a good return. So, if interest rates are higher in the UK than in the US, the pound is likely to rise, and vice versa.

But big investors are always looking ahead: they don't wait until it is obvious to everyone that interest rates in the UK are rising. They aim to predict a rise much earlier, so they can buy the pound before it has become expensive.

Financial institutions often manage to make huge amounts of money by betting on future currency movements. Traders made a killing out of sterling's abrupt departure from the European exchange rate mechanism in 1992, for example.

Conversely, sterling's recent strength against the mark has hit British exporters hard, as their goods are priced out of foreign markets.

The pound has climbed to dizzy heights in the last year against the German mark and the dollar. But dangers lurk. JP Morgan currency analyst Avinash Persaud sees the pound falling as low as 2.67 marks in the next two months, from a recent level of 2.82, as the uncertainty over the imminent Budget takes its toll. "There is a currency risk with every overseas investment," says Brian Turner, treasury director of Henderson Investors. Henderson runs a European fund, where returns in cash terms have been hit by sterling's latest show of strength. "Gains have most certainly been reduced," Mr Turner says. Sterling's trade-weighted exchange rate has risen 15 per cent since July.

Fund managers can erase the risk of currency fluctuations by what is known as hedging. This basically means they pay a third party to take the risk on for them, by means of complex financial instruments called derivatives.

Can small-time players get a piece of the action? In theory - but remember, the foreign exchange market is full of highly-paid individuals trying, and often failing, to forecast accurately how currencies will move.

You can hold a certain type of deposit account where you can switch your money from one currency to another at a very low cost. Fidelity Currency Funds are just such an account. In theory you could use this to bet on currency movements, moving out of sterling if you think it's value is about to fall, into marks. When the movement is over, you could move back into sterling, having made a profit.

But this is a highly risky business. Without the back-up that the banks have - huge economic research departments, whole teams analysing past patterns of currency behaviour and so on - you stand little chance of winning your bet.

For most of us, most of the time, the drama will be limited to getting our sums wrong over that cheap meal in a Greek taverna.