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Objectively Valuing Currencies.

In Investment Returns on June 24, 2011 by CQCA

I’ve always thought that foreign currency exchange has to be the worst business to be in. There seems to be no rhyme or reason for why some currencies move up and why some move down. The whole market is a matter of throwing bad money after bad.

Now that I live in China, I have to think about whether or not I want to keep my money in U.S. Dollars or Renminbi. If I were to just base my decision on the money supply, I would rather keep my money in U.S. Dollars. Today I thought of another way to value currencies, and it is similar to how the P/E Ratio is used to value companies. (I am certain I am not the first person to think of this.)

The price of any currency is 1.00, but its earnings for the year is the interest rate that can be earned on an account in that currency.

According to bankrate.com, MetLife Bank is offering a one year CD at a rate of 1.30%. In that case, the equation for valuing the U.S. Dollar is:
1.00 / .0130 = 76.92

The Bank of China (a commercial bank, not the central bank) is offering CDs at a rate of 3.25%. The equation for valuing the Renminbi is:
1.00 / .0325 = 30.77

Using just this method, the U.S. Dollar is way over valued compared to the Renminbi. But the problem with this method is that the inflation rate has to be taken into account. The CPI rate in both the U.S. and China are above the bank rate, so savers are actually losing wealth. Zimbabwe Dollar, which can earn 800% in the bank, would be valued at:
1.00 / 8.00 = 0.125

This shows the weakness of using this method for valuing currencies, because obviously the Zimbabwe Dollar is not the best option in terms of value investing. (Or is now the time to be a contrarian?) Also, gold and silver currently do not have interest rates, but are still the best currency available. This is why I do not trade forex.

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