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Understanding Purchasing Power and the Currency Triangle

Currency-TriangleCurrencies represent the fundamental liquidity of a personal saver’s investment portfolio. At the end of the day, our ability to spend a dollar represents our final purchasing power, mainly because we don’t really have access to it the end of the day. That being said, in higher volumes, currency values come with an amount of volatility that represents a potential loss if we don’t pay attention.

Looking further then into how currencies play an essential part of planning for international vacations, a personal saver can benefit quite a bit from understanding how it is that banks and traders use an approach known as the ‘triangle method’, to ensure that they are buying and selling their currencies at the best rates.

The Currency Triangle represents how it is that a given currency’s value is based on its ability to be exchanged internationally for other currencies. As such, while the US Dollar (USD) might be worth 0.77 Euros (EUR), we can ask ourselves what the value might be if it represents an exchange from GBP to Euro, and then to USD. This means that we are looking to see if there is an opportunity to buy USD at a better price than that which is quoted in Euros. In order to do this, we setup a triangle that shows the various directions in which a currency transaction could take place, and we determine if there are any discrepancies to take advantage of. Here’s how it starts:

These are all of the listed exchange rates for the relevant currencies in the above exchange. It might seem a bit confusing at first, but the redundancy is just there to help with math, and to help put the comparative value of the currencies into perspective. The next step is to then verify what we are looking at by proving the exchange rates. For example, if we were to buy Euro with USD, and then buy GBP using our new Euro, would it be cheaper than making the purchase directly?

Firstly, we convert $1,000 from USD into 770 EUR. Next, we convert 770 EUR into 669 GBP, and find that we have gotten 0.69 GBP for every USD we used in the purchase, meaning we got 2% more than we would have if we’d simply done the exchange directly. This might not sound like much of a difference, but in terms of large transactions, the amount is huge! $50 in savings on a round trip flight to Europe? A free night or two in a hotel over the course of an entire vacation? Small savings like these are enough to make the difference. Unfortunately, there’s more to this free lunch than what we’d think, because of the way currency exchanges will charge a commission on the transaction.

If we look at the above situation, and include even just a small 1% transaction exchange commission on each transaction, the end result is that we would have the same amount of money going either route on the exchange. The end result is that people will not often see a benefit to using a currency triangle strategy to purchasing funds unless they are travelling to a somewhat remote area, which does not have a particularly liquid currency. By transferring funds through a mutual trade partner, there can sometimes then be savings seen.

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