Forex is the actual asset class that we are referring to the currencies as well as it is short for foreign exchange. Foreign exchange is that act which helps us to change one country’s currency with that of the other country’s currency for various reasons like that of tourism or commerce. Due to globalization, there is a need to transact with the other countries in their own currency.
After the accord at Bretton Woods in 1971, there was the time when currencies were allowed to float freely against one another, but the values of the currencies varied from one another due to which there was a need for the establishment of the foreign exchange services. On the behalf of the clients of the commercial banks and investment banks, this service has been taken up by them, but this service has been simultaneously providing a speculative environment for trading one currency against another by using the internet.
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Forex as a Hedge…
The commercial enterprise which have indulged themselves in doing business in foreign countries face risk due to the fluctuations in the value of currency when they have to do trading in buying and selling of goods or services to the another country. Therefore, the foreign exchange market fixes the rate at which transaction will take place at some future date by the way to hedge the risk.
In order to accomplish this thing, banks always lock the rate of currencies to make clear the traders about the rate of currency being prevailing in the market so that trader can mitigate his risk and can buy or sell currencies in the forward or swap markets. The size of trade and the amount of actual currency involved also acts as the factors to offer a means of hedge currency risk in the future market. The future market is the form of centralised exchange and are less liquid than the forward markets which are the form of decentralised exchange and this also exists within the interbank system throughout the world.
Forex in the form of Speculation…
There are many factors like interest rates, trade flows, tourism, economic strength, geopolitical risk etc., due to which there is a constant fluctuation between the values of currency values of the whole world. There is an opportunity which exists to bet against the changing values by buying or selling one currency against the another currency with the hope that the part of currency which will be borrowed by us will gain its market price or the currency which will be sold by us will weaken against its counterpart.
Currency as an Asset Class
As the asset class, the currency has its two distinct features:
- Differential rate of interest can be earned between two currencies.
- In the exchange rate good amount of value can be earned.
Why Can We Trade Currencies???
Until the arrival of the internet, trading of currency was limited to interbank activity and that too just on the behalf of their clients. Mostly, proprietary desks were being set by the banks themselves in order to trade their own accounts, which were basically being followed by large multinational companies, hedge funds and high net worth individuals.
A secondary market has been established with the help of internet. Due to the emergence of internet, the retail market has emerged their focus on the individual traders because internet has been able to provide an easy access to the foreign exchange markets.
Forex Trading Risks…
Involvement of complexities in the trading currency can create some confusions relating to the risks. The interbank market is very much unregulated and therefore so much risk in being involved due to lack of oversight. Though this kind of perception is not true entirely. This can be better understood by having a proper discussion about the difference between a decentralised market and centralised market risk and then to determine where the regulation will be appropriate.
Several banks have joined their hands with the interbank market trading around the whole world. The banks themselves have to keep them at the safer side by having internal auditing process and they themselves have to accept and determine the sovereign risk and the credit risk. For the protection of each participating bank, the regulations are being imposed by the industry.
Supply and demand determine the market pricing mechanism, though the market is being made by each of the participating banks who are providing offers and bids for the particular currency. Due to high flow within the system, it has become impossible for any of the rogue trader to influence the price of a currency. Even in today’s high-volume market, with almost between $2 trillion to $3 trillion being traded per day, even without the corporation and coordination with other central banks, the central bank cannot move the market for any length of time.
In order to make pricing more transparent, many attempts have been made to create an Electronic Communication Network (ECN), so that buyers and sellers can be brought to a centralised market. This move can be proved to be a positive move for the retail traders as they will gain a benefit by seeing more competitive pricing and centralised liquidity.
Traders who have the direct access to the Forex banks are less exposed than those retail traders who have the dealings with relatively small and unregulated Forex brokers, who can and sometimes do re-quote prices and even trade against their own customers. It seems like the discussion regarding the regulation has arisen due to the need of protection of unsophisticated retail trader who has been led to believe that the Forex trading is a sure-fire profit making scheme.
Now there is an opportunity to open accounts at many of the major banks or the larger more liquid brokers for the serious and educated retail trader. As many financial investments are involved so, it pays to remember the caveat emptor rule- “buyer beware!”.
Pros and Potential Cons of Trading Forex…
There are pros and potential cons of trading Forex if you intend to trade currencies which are laid out as follows:
Pro: The Forex market is one of the largest market in the terms of volume traded in the world, therefore it offers the most liquidity, thus making it easy to enter and exit a position in any of the major currencies within a fraction of a second. The most major centres of Forex trading are Sydney, Hong Kong, Singapore, Tokyo, Frankfurt, Paris, London and New York. The major advantage of the Forex market is that it is being traded for the 24 hours around the clock starting from the day hour of Australia and ending in New York.
Potential Con: Due to the result of the liquidity and ease to enter and exit the trade for traders, brokers and banks offer leverage, which means that a trader can easily control quite large positions with relatively little money of their own. Leverage in the range of 100:1 is a high ratio but not an uncommon ratio. Of course the traders must understand the proper use of leverage and the risks that the leverage can impose on an account. In order to gain benefits from the leverage, then it must be used judiciously and cautiously. A lack of understanding or wisdom can easily wipe out the trader’s account.
Trading currencies is a “macroeconomic” endeavour. There should be a proper understanding regarding the economies of the various countries and their inter-connectedness in the mind of currency trader, in order to grasp the fundamentals that help to drive the currency values. For some traders it is easy to focus on the economic activity to make trading decisions than to understand the nuances of the closed environments that exist in the stock and in the future markets where microeconomic activities needs to be understood properly. However, it is not necessary to understand the company’s management skills, financial strengths, market opportunities and industry-specific knowledge in the Forex trading.
[Note: One of the tenets of technical analysis is that future price action is being predicted by the historical price action. As the Forex market is the 24-hour market, so the large amount of data can be used to gauge future price movements. So this makes the Forex market as the perfect market for the traders that can use technical tools over here. In order to learn more about the technical analysis from one of the world’s most widely followed technical analysts, then check out Investopedia Academy’s Technical Analysis course.]
The ways to Approach Forex Trading…
For most investors or traders with the stock market experience, there needs to be a shift in the attitude to transition into or to add currencies as a further opportunity for the purpose of diversification.
- Currency trading has been promoted as an “active trader’s” opportunity. This type of opportunity suits brokers because it means that they earn more due to the nimbleness that accompanies active trading.
- Currency trading is also being promoted as leveraged trading, and therefore, it is easier for a trader to open an account with a small amount of money than is necessary for trading in the stock market.
Currency trading can also be used to hedge a stock portfolio, besides trading for a profit. For example, if someone builds the stock portfolio in a country where there is a potential for the stock market to increase in its value, but there is also the involvement of the downside risk in the terms of currency (i.e., the US in recent history), so the trader could own the stock portfolio and short the dollar against the another currency such as the Swiss franc or euro. In this way the value of portfolio will be increased and the negative effect will be offset towards the declining dollar. This is true for the investors who are not from the US and who will eventually repatriate profits back to their own currencies. Having this kind of profile in mind, it becomes easier to open a Forex account and a Day trading or Swing trading account.
The second approach for trading the currencies is to better understand the fundamentals and the long-term benefits. When a currency is trending in a specific direction and is offering a positive differential interest which provides a return on investment plus an appreciation in currency value, this proves to be beneficial for the traders. This type of trade is commonly known as “carry trade”. For example, a trader can buy the Australian dollar against the Japanese yen”. If the Japanese interest rate is .05% and the Australian interest rate is 4.75%, then also the trader can earn 4% easily.
However, if the Australian dollar is strengthening against the yen, then is appropriate to buy the AUD/JPY and to hold it in order to gain in both the currency appreciation and the interest yield.