Basics of Foreign Exchange Currency Trading

Most often referred to by investors as FOREX or FX, the foreign exchange of currencies can now be done over the counter. This new investment tool has become increasingly popular as investors search out new ways of making money in a challenging economy. The main purpose of the foreign exchange to assist in international trade, wherein businesses selling to overseas markets (or buying from them) can take in one currency and then exchange it for another (for example, converting dollars to yen or Euros to Indian rupees, and so on). This foreign exchange market helps determine the currencies’ values.

Risks, Speculation, and the Carry Trade

One risky side of the FOREX is that it opens the door to speculation and allows for the “carry trade.” To “carry” means to hold an investment; this can result in a profit (when the investment gains in value over time) or loss (if the same investment loses value by the time it is ready to be sold). In regard to currency trading, it refers to the practice of borrowing low-yield currencies to invest in high-yield currencies.

Critics have blamed the carry trade on weakening already low yield currencies and causing volatility in the marketplace. One example of its negative impact happened in the years 2007-2008. By 2007, nearly $1 trillion US dollars was allocated to the yen carry trade because of stable Japanese interest rates. This money was borrowed in yen, and then invested in instruments such as sub-prime mortgage lending, which eventually collapsed.

Another example is Icelandic financial crisis in which the carry trade in Euros was used to fuel home purchases in Iceland. However, most of these loans ended in default, causing a huge national crisis for that country in 2008-2009.

Reasons to Invest in FOREX

Despite the attendant risk that accompanies the foreign exchange of currency, there are many factors that make this a unique investment tool. Considered to provide investors with the climate of “perfect competition” (notwithstanding currency manipulation by national governments), FOREX is a great tool for many reasons. These include its liquidity, the constant activity (24 hours a day, except on weekends), widespread dispersal around the globe, any number of factors that affect currency changes, and the ability to use leverage to enhance profit margins.

The market for FOREX is huge and growing by about 20 percent in less than five years’ time. Last year, 2010, the average daily turnover was nearly $4 trillion. The UK is the most important FOREX center, with the US and Japan in second and third place, respectively.

Access to the FOREX Market

Unlike the stock exchange, access to FOREX is divided into levels, with commercial banks and securities traders at the top level. This is due to their “line” size (or the amount of money to trade). Lower levels include smaller banks, multinational corporations, hedge funds, and the retail FOREX trade.

For individuals wishing to invest in foreign currency, there are two options: dealers (also called “market makers”) and brokers. A broker serves as the agent of the individual investor, seeking the best price on the investor’s behalf. Brokers charge a commission (or mark-up) for their service. Dealers, on the other hand, act as the principal and will offer the individual investor a price to accept or reject. No commission is paid, but the individual investor also remains in the dark as to whether the price being offered is the best price available in the marketplace.

There are any variety of ways to purchase foreign currencies, and these include forward, spot transaction, FX swap, FX option, and futures contracts.

While foreign exchange currency trading may appear to be an appealing new field for many investors, using due diligence before making the first investment is always wise. Many institutions (like pension funds and insurance companies) have become active in FOREX, as have individuals buying from local brokers and dealers. Like any investment tool, the more knowledge one has before beginning, the better the results are likely to be.