by Rachel Stockton

Created on: January 23, 2009   Last Updated: January 27, 2009

As most of us expected, the world-wide economic crisis not only has far reaching implications, it's also difficult to quantify, in terms of what triggered what. Merely taking a look at the investment trends throughout the United States, Europe, and Asia, it's apparent that economics, at best, is theoretical. Fiscal reality is anything but predictable.

As the dollar weakens, it's becoming more and more common for Americans to invest in foreign currency; online transactions in which currency is purchased through certificates of deposits and exchange traded funds and notes are relatively simple these days.

What drives exchange rates, and how can investors profit from their fluctuation? It can be an extremely tricky (not to mention, risky) dance. The principle is based on what most college students learn in Economics 101: the law of supply and demand.

Purchase of Foreign Products

On the one hand, most of us are involved, to a greater or lesser extent, in currency exchange transactions on a daily basis. When we buy electronics that are manufactured in Japan, we pay for them in dollars, which are eventually converted to yen. This means that the lower the yen, the more attractive the foreign products, meaning Americans will invest in Japanese goods.

But some investors, world wide, have decided to diversify their portfolios by investing in the foreign currency itself. The Bank of Japan, one of the world's four central banks, recently began selling the yen in order to keep it cheap; the motive, of course, is obvious.

Japanese investors are also involved in the process. When interest rates are high, the Japanese (and the Taiwanese and Chinese) purchase treasury bonds. But this is where it gets a bit dicey. To invest in these bonds, they must sell yen and buy dollars. However, eventually those dollars are, once again, exchanged back into yen; therefore they become very interested in future fluctuation in the exchange rates.

American Investors

Certainly, the thrill of the game sounds appealing, but there are quite a few risk factors to consider before you start mapping exchange and interest rates of foreign currency. Huge losses can occur because of the volatility of the world market; investing in foreign currency is not an exact science. Anomalies can occur at the drop of a hat; foreign governments can increase or decrease interest rates, and the central banks that control them can have an agenda that might not coincide with that of the individual investor.

In a recent article in the New York Times, Nouriel Roulini, professor of economics and internation business at New York University urges American investors to refrain from investing in the currency directly. Instead, he suggests they purchase the currency through cds and exchange treaded funds and notes.

Even still, he urges caution; the ease of these online transactions can raise expectations to an urealistic level. As part of an overall strategy, it might work, but if your investment plan strictly involves exchange currency trading, the long term risk may outweigh any short term benefit.

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