With the global economy in such a volatile state, more and more people are beginning to see the advantages of putting some of their capital into forex markets. There are spot markets (cash) and derivative markets (forwards, futures, options, and currency swaps) in the forex market. Several reasons drive market participants to use forex, including hedging against international currency and interest rate risk, speculation on geopolitical events, and portfolio diversification. In this blog, we will discuss each of these reasons to invest in forex so that you can decide whether it is a good use of the forex markets for you.
The use of forex for hedging
Buying or selling goods or services outside of a company’s domestic market puts them at risk due to currency fluctuations. In foreign exchange markets, a rate can be fixed at which a transaction will be completed to hedge currency risk.
A trader can lock in an exchange rate by buying or selling currencies in advance in the forward or swap markets. Imagine a situation in which a company plans to sell U.S.-made toasters in Europe at a parity exchange rate of €1 for $1.
The toaster costs $100 to manufacture, but it will be sold for €150 — competitive with other blenders made in Europe. Due to the even exchange rate between EUR and USD, if this plan succeeds, the company will make $50 per sale. Sadly, the dollar’s value rises against the euro until the EUR/USD exchange rate reaches 0.90, making buying €1.00 cost $0.90.
Even though the company is still spending $100 on manufacturing the toaster, they can only sell it at a competitive price of €150, which, when converted back into dollars, only represents $135 (€150 × 0.90 = $135). Profits were much smaller than expected due to a stronger dollar.
When the euro and U.S. dollar were at parity, the toaster company should have short-sold the euro and bought the U.S. dollar to reduce the risk. In this way, if the dollar rose in value, the profits from trading would offset the reduction in profit from toasters. To offset the losses in the trade, the better exchange rate would increase profits from the sale of toasters if the dollar fell in value.
Currency futures can be used to hedge such risks. As a result of standardized contracts and central clearing, futures contracts are advantageous to traders. It should be noted, however, that currency futures may be less liquid than forward markets, which are decentralized and operate within the global interbank system.
Speculation as a use of forex
Several factors affect the supply and demand of currencies in the forex market, including interest rates, trade flows, tourism, economic strength, and geopolitical risk. The value of one currency can increase or decrease if the value of another currency changes. Currency pairs are traded as pairs, so forecasting one currency’s weakness is essentially the same as predicting the other currency’s strength.
Suppose a trader thinks interest rates will rise in the United States versus Australia, while the exchange rate between the two currencies (AUD/USD) is 0.71 (i.e., USD 0.71 buys AUD 1.00). According to the trader, higher U.S. interest rates will result in a higher demand for USD, which will lead to a lower AUD/USD exchange rate since fewer and stronger USD are needed to buy AUDs.
It is assumed that the trader is correct and interest rates rise, resulting in an exchange rate of AUD 0.50/USD. To buy AUD 1.00, you need USD 0.50. Shorting the AUD and going long on the USD would have resulted in a profit for the investor.
Diversity your portfolio with forex trading
“Don’t put all your eggs in one basket” is a common saying. Portfolio diversification is based on this principle.
Diversified portfolios consist of several investments blended. To reduce overall risk, it is generally considered prudent to create a diversified portfolio rather than risk all your money in one company, industry, or asset type.
We’ll look at a simplified example to illustrate how portfolio diversification reduces risk.
Suppose you put all your capital into one company’s stock and invest all your capital there. You may lose all of your money if that company fails and goes bankrupt.
Think about what would have happened if, instead of taking this course of action, you had invested your available capital in 20 different stocks equally. A failed investment will certainly affect your portfolio, but you will still have 19 stocks in your portfolio, which may even compensate for the loss incurred by your failed investment.
Now consider, not just stocks, but many different types of investments. If, instead of investing in only stocks, you were to invest in stocks, venture capital, derivatives, and other investments, you could further mitigate the risk of investing. This is a great opportunity and use of forex trading. By investing some of your portfolio in foreign exchange, you are less likely to lose all your money should the US stock market fail.
There are many ways that the forex market can be put to good use, we have covered only a few here today. If you are interested in investing in forex, create an account on Telegram.forex to see how a quality telegram service can help increase your portfolio.