The foreign exchange (forex) market is a market where world currencies are traded around the clock. For some, it is simply a mechanism for converting one currency into another. Multinational corporations doing business in various countries rely on these markets to trade currencies from around the world. However, the market is also busy with traders betting on the movements of currencies against each other.
The foreign exchange market operates between individuals represented by brokers, between brokers and banks, and between banks. Here are five ways for a retail investor to participate in this market.
Key points to remember
- Due to liquidity and low transaction fees, currency trading is exceptionally popular.
- Forex traders are not bound by margin limits imposed by the Securities and Exchange Commission (SEC) on securities dealers. This means that these traders can perform highly leveraged trades.
- The most popular way to invest in currencies is to trade currencies on forex, but investors can buy mutual funds, ETFs or ETNs.
- Investors may gain exposure to global currencies by investing in multinational companies.
- Like all investments, investing in currencies involves risk, particularly in times of economic volatility or times of high geopolitical tension.
Standard Forex Trading Account
You can open an account with a forex broker and trade currencies from all over the world. There are several differences in how this market works compared to US exchanges:
- Currencies are traded in pairs – you bet one will go up (long) and the other will go down (short).
- There are no regulated exchanges or central clearing houses for transactions.
- There is no upside rule for taking short positions.
- There is no upper limit in your position size.
- Forex traders generally make money on the bid-ask spread, rather than charging commissions.
CDs and savings accounts
TIAA Bank offers a WorldCurrency Certificate of Deposit (CD) which pays interest at local rates in specific countries. It also offers a CD basket that includes a mix of different currencies. Finally, TIAA Bank offers a foreign currency account that works like a money market account and allows the transfer of money between major currencies.
CDs are subject to exchange rate fluctuations but carry a higher interest rate than dollar-denominated CDs. When the CD matures, you will get back fewer dollars than you invested if the dollar has strengthened against the foreign currency. FDIC insurance protects you against bank insolvency but not against currency risk.
Foreign bond funds
There are mutual funds that invest in foreign government bonds. These mutual funds earn interest denominated in the foreign currency. If the foreign currency appreciates against your local currency, the interest earned increases when converted back to the local currency.
Investing in foreign bonds allows investors to select their preferred level of risk and seek additional return for. Examples of such funds include the Merk Hard Currency Fund, the Aberdeen Global Income Fund and the Templeton Global Bond Fund.
Many shareholders participate indirectly in foreign exchange markets through their holdings in companies that do significant business in foreign countries. Some of the best-known American companies with overseas exposure are Coca-Cola, McDonald’s, IBM, and Walmart.
Revenues and profits from overseas operations are boosted if the foreign currency appreciates against the dollar. This is because these revenues are converted back into dollars for financial reporting purposes, and a stronger foreign currency will earn more dollars in exchange.
ETFs and ETNs
Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are traded like stocks and can be a way to invest in currencies without having to trade forex. With a standard investment account with most brokerages, investors can purchase access to currency ETFs such as UUP, the Invesco DB US Dollar Index bull fund or EUO, the ProShares UltraShort Euro.
ETNs are more like corporate bonds than a collection of stocks, but they tend to have similar currency market exposure to ETFs. On the same exchange you would trade ETFs, you can also find common currency ETNs such as the iPath® GBP/USD Exchange Rate ETN (GBB).
Opportunities and Risks of Forex Trading
Forex trading is very popular, so the markets generally have high liquidity with low transaction fees.
Investors diversify their portfolio by acquiring assets outside of their usual trading venue.
Traders can enter highly leveraged trades, potentially multiplying profits.
Forex markets operate all day and investors can trade whenever they want.
No central exchange or regulator controls the market.
Traders don’t have much transparency due to the deregulated nature of the market.
Exchange rates are influenced by many factors; the process of determining the price of a currency is complex.
Trades can enter highly leveraged trades, potentially multiplying losses.
Forex markets have always been very volatile.
Unlike stocks, forex trading often does not have access to stock advisors.
What are the advantages of investing in foreign currencies?
The Forex market is huge and relatively easy for beginners to access. Since the different international markets have staggered hours, it is possible to trade Forex 24 hours a day. Transaction fees are generally low as it is a highly liquid market.
What are the risks of investing in foreign currencies?
Currency risk – also known as foreign exchange risk – arises when the price of one currency changes against another. Transaction risk is foreign exchange losses that arise due to delays between the time the transaction occurs and the settlement of the transactions. Other risks such as political risk are specific to underlying currencies that lose value due to economic or governmental events.
How safe is Forex trading?
The foreign exchange market is volatile and carries substantial risks. Using high leverage also amplifies potential losses. Additionally, it is important to identify reliable and valid brokers to avoid common Forex broker scams.
Currencies are affected by world events 24 hours a day, and the Internet and wireless communications provide almost instantaneous access even to small investors. Currencies provide some diversification for people who invest primarily in US securities. Alternatively, traders can take advantage of changes in relative currency strength by investing in global currencies.