Dubai: In a context of predictably very low long-term returns on the main market assets (both financial and non-financial), many investors are turning their attention to currencies as an additional source of profitability. But how is the best way to invest in currencies?
Investing in foreign currency can be a great way to diversify your portfolio. Foreign currency trading, or forex for short, is a little more complex than trading stocks or mutual funds, or shoring up your investment strategy with bonds.
Learning the basics, however, can give you a solid foundation to build on if this is an asset class you’re interested in exploring. This guide walks you through everything you need to know to get started with investing in currency.
For example, you might buy US dollars and sell British pounds or vice versa. While you could technically exchange any foreign currency that’s traded on the market exchange for another, it’s more common to trade using pre-establishing pairings.
How foreign currencies are typically grouped
• Major pairings: This group includes the most frequently traded currencies. The US 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.
• Mixed pairing: 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.
What factors should you take into account when investing in currencies?
Forex trading attempts to capitalise on fluctuations in currency values. It’s similar to trading stocks. You want the currency you buy to increase in value so you can sell it at a profit. Your profit is tied to the currency’s exchange rate, which is the ratio of one currency’s value against another.
When looking at pairings, you may want to consider how they’re ordered. For example, in a USD/GBP pairing, USD is the base currency while GBP is the quote currency. The exchange rate is used to calculate how much you’d have to pay in the quote currency to buy the base currency. Any time you buy a currency pairing, you’re buying base currency and selling quote currency.
The behaviour of currencies is very difficult to predict in the short term because their performance depends on numerous variables. For example, to put it simply, the price of a bond only depends on the return generated by the bond, or the rate offered by the particular issue.
Currencies influenced by many factors
By contrast, currencies are influenced by multiple economic and political factors, as well as relative factors between two countries or regions. So it is not just a question of predicting how a country will perform in absolute terms, but of determining how it performs relative to another region.
That said, the long-term fundamentals of some currencies are more stable or predictable than others because the structural economic characteristics of certain regions impact the depreciation or appreciation of their currency in the long term. For instance, the Swiss franc is the strongest currency in the world, with the country having one of the most competitive economies in the world.
Another thing to bear in mind when investing in currencies is that there are several alternatives to choose from. One of them is to buy assets from the country or region in question. In the case of the Swiss franc, for example, this would mean buying bonds or shares in Swiss companies.
How to investing in foreign currency
Stocks, bonds mutual funds are traded on a centralised exchange or bourse, Forex is not. Instead, it’s traded through the foreign exchange market, which is managed by banks and other financial institutions. All trades take place electronically and trading can be done 24 hours a day, 7 days a week.
Forex trading can be done through a brokerage. There are three fundamental ways you can trade foreign currency:
• Spot trading: In this kind of trade, currency pairs are exchanged when the trade is settled. This is essentially instant trading and the spot price represents the price at which a currency can be bought or sold.
• Forward trading: When you trade forex forward, you agree to buy or sell foreign currency at a set price on a set date in the future. The spot price will be settled and you’ll insulated from volatility when it’s time to trade.
• Future trading: Future trading is similar to forward trading, with one key difference. In a future trading contract, you’re legally bound to make the trade. The price of the contract is based on the foreign exchange rate of the currencies involved.
Deciding on whether you should buy or sell
Once you’ve decided how to trade, you determine whether to buy or sell. The exchange rate may influence that decision. If you’re buying a pairing, you expect the base currency will go up in value. If you’re selling a pairing, you’re selling the base currency and buying the quote currency. You’re also hoping the base currency’s value will drop so you can buy it back at a cheaper price.
There are two other forex trading terms every investor should know: bid and ask. The bid is the price at which a broker will buy a foreign currency pair from you. The ‘ask’ is a broker’s asking price for a particular currency. The difference between the two prices is the spread. Knowing what these terms mean can help you read forex quotes and understand the price of a trade.
The first number is the bid. So, in this kind of pairing, the broker would pay you 1.2545 USD for one euro. The second number is the ‘ask’, which means the broker wants you to pay 1.2572 for one US dollar.
Perks and risks of forex trading
Investing in currency can offer several advantages, some of them include:
• Accessibility: Stock market exchanges operate during set hours. While you can trade pre- or after market, it isn’t 24/7. Forex trades, on the other hand, can be made at any time of the day or night.
• Diversification: Diversifying your portfolio can help manage risk. Foreign currency is an alternative asset class to the traditional mix of stocks, bonds and mutual funds.
• Lower costs: Unlike trading stocks, there may be fewer commissions associated with trading foreign currencies. That allows you to hold on to more of your returns.
However, while the above reasons make up for most reasons why majority investors would invest in currencies, there is one main drawback to investing in currency – volatility.
While forex trading can be lucrative, there may be more ups and downs than the stock market, making it risky for newbie investors or beginners. The risks may also be higher compared to other investment strategies, so it’s important to assess your risk tolerance carefully before jumping in.
Key takeaway and a tip from experts
Investing in currency may be new territory, so it’s helpful to have some perspective on how foreign currencies may be impacted by movements in the broader stock market, geopolitical concerns and the economic climate in the countries you’re interested in investing in.
Experts suggest to consider investing in currency exchange traded funds if buying and selling on the forex market seems too complicated. These funds trade on an exchange like a stock but they tend to be more tax-efficient than other mutual funds. Foreign currency ETFs may also carry a lower risk factor, compared to trading forex through a broker as these funds are actively managed.
Is this the right time to dive into forex?
In short to medium term, dollar is likely to weaken as more fiscal and monetary stimulus (economic cash injection by the US government) looks imperative for US economic recovery.
With the new administration supporting a $2.3 (Dh8.45) trillion stimulus and the interest rate at near zero territory, the dollar should remain subdued, evaluate analysts and trend watchers. Even if the new government administration is not able to pull off a large stimulus, the US Federal Reserve will be forced to step in with extraordinary monetary policy tools to bail out the economy, like quantitative easing and bond buying.
How does that work? To execute quantitative easing, central banks increase the supply of money by buying government bonds and other securities. Increasing the supply of money lowers the cost of money—the same effect as increasing the supply of any other asset in the market. When interest rates are lower, banks can lend with easier terms.
However, in recent years, legislatures in advanced industrial economies have for the most part been reluctant to use fiscal tools, in many cases because of concerns that government debt is already too high.
In this context, Nobel Economics prize-winner US economist Milton Friedman’s idea of money-financed (as opposed to debt-financed) tax cuts—“helicopter money”—has received a flurry of attention, with influential advocates.
In more prosaic and realistic terms, a “helicopter drop” of money is an expansionary fiscal policy—an increase in public spending or a tax cut—financed by a permanent increase in the money stock.
Current forex market outlook and risks
Market analysts warn against investing in emerging market currencies. The ten major emerging market economies are Argentina, Brazil, China, India, Indonesia, Mexico, Poland, South Africa, South Korea and Turkey.
(An emerging market economy is the economy of a developing nation that is becoming more engaged with global markets as it grows.) In pandemic response, many emerging markets have piled up hard currency debts. The liquidity tide has helped to boost some asset prices, especially stock values, like for example in the case of Indian stocks.
This in turn has boosted the government’s ‘current account’ (a country's current account records the value of exports and imports of both goods and services and is an indicator of the economy’s health) and consequently these currencies have been strengthening.
When stimulus begins to ebb and central banks start to tighten rates, many emerging markets will face the ‘triple-whammy’ of high debt levels, high cost of funding (as credit agencies downgrade credit ratings for the countries), flight of capital as asset prices revert back to normal levels, resulting in government treasuries turning negative, and ultimately their currencies taking the hit.
However, during pandemic months because of the sharp decline in imports, many emerging markets balanced their current accounts, which led to currencies largely stabilising. So if looking for the ideal time to enter the forex market, with a favourable outlook currently eyes, now is weighed by many as a considerably better opportunity than how it was at the peak of the health crisis.
When it comes to developed market currencies there is considerably lower risk to investing in them compared to emerging market currencies, so keep in mind the current risks discussed above when it comes to investing in the latter.