Money is a commodity and actively traded as any grain or mineral. The foreign exchange market (forex) is where currencies are traded. For speculators and investors, this market provides opportunities to take advantage of movements in exchange rates. There are different reasons why currency may be an attractive investment for individual investors.
Currency is one way to add balance to your portfolio. It is especially true if you are invested heavily in United States’ equities. The way the currency market works is if you think that the dollar will drop in the future, you can buy one or more currencies that you think will rise. A difference to keep in mind between stocks and currencies is that stocks move independently of each other while currencies move relative to each other. This means that when one currency is rising, another must be falling.
Another consideration is that the news that causes currencies to rise and fall is available to everyone on a real-time basis. Since events that influence a country’s economic health determine currency values, you can do your own research to judge what is going to affect any particular currency. You can select currencies based on how you perceive their relative values will change over time.
Something that currencies have in common with other commodities, as well as stocks, is the high volatility. If the value of your currencies rises against the dollar, you will profit. If your currencies fall relative to the dollar, you will lose money.
For example, investors who believe that the euro will strengthen against the dollar might buy euros with dollars. If the euro appreciates, these investors can then convert the euros back to dollars to lock in a profit. While there are more than 100 global currencies, the U.S. dollar is the benchmark and accounts for about 90% of the more than US$5 trillion in forex trading volume.
Here’s how foreign currencies are typically grouped:
Major pairings: This group includes the most frequently traded currencies. The U.S. dollar (USD), euros (EUR), the Japanese yen (JPY), and British pounds (GBP) are typically included.
Minor pairings: This group also includes many of the frequently traded currencies in the major pairings category, with the exclusion of USD.
Exotics: Here, you’ll typically have pairings of a heavily traded currency against a thinly traded one. For example, USD may be paired with the Hong Kong dollar (HKD) or Singapore dollar (SGD).
Regional pairings: In this category, currencies are paired together based on region. So you might see Asian or European currencies from the same geographic region being exchanged for one another.
While the concept of how investing in currencies appears simple, there is substantial risk involved. You need to have an understanding of international relations and economics to help figure out how the ramifications of crucial world events will affect currency values. In today’s world, significant events can happen at a moment’s notice, which can bring a considerable measure of volatility to short-term currency values.
As you have seen in the news over the past few years, politics can significantly affect currency values. Accusations have been made toward China that the country manipulates its currency to put itself into a favorable economic position regarding the rest of the world. Other countries have conducted similar strategies, which can make it difficult to judge the monetary market. Tracking hurricanes is a more exact science than figuring out what politicians will do! Unfortunately, they have a crucial influence on what happens with a county’s currency.
U.S. News and World Report interviewed Mayra Rodriguez Valladares, managing principal at MRV Associates, about trading currencies. She started her career in foreign exchange at the Federal Reserve Bank of New York and believes the foreign exchange market is the most volatile one in which to trade, after commodities. She said, “In order to be a good currency trader, you need to know a lot about country and economics risks, because currencies are very sensitive to country risks like sovereign defaults, expropriation, nationalization, corruption, unstable governments, and economic risks like inflation, GDP levels, and employment rates.”
To minimize your risk, it helps to spread your investments as you would with equities. Choose countries that you will follow carefully. It is best to invest in currencies whose countries have a stable banking, financial, and political system.