When companies sell goods or services in foreign countries, they are usually paid in the currency of the country in which the sale occurs. But currencies can fluctuate, causing the sale to be valued (in the home country) at less than hoped for or expected. To avoid possible loss from fluctuating currencies, companies can hedge, or protect themselves, by trading currency pairs. Protection against the possibility of adverse currency movement helps companies focus on generating revenues.
Sometimes, traders in the international financial market hedge their foreign currency exposures to gain as much as possible from their investments. A mutual fund manager who wants to hold Japanese stocks, for example, may not want to be exposed to movements in the Japanese yen. As the manager hedges against those movements, she secures "pure" exposure to Japanese stock price movements – exposure unhampered by fluctuations. These hedging activities constitute a sizable portion of daily currency turnover. As such, they are important for investors to understand. (To learn more, read A Beginner's Guide To Hedging and Using Interest Rate Parity To Trade Forex.)
The activities of most investors will fall under the broad category of speculation, which involves buying or selling a financial asset, usually in the face of higher-than-ordinary risk, in order to take advantage of an expected move. Speculators in the currency market wager that, in the future, the value of a currency will move higher or lower relative to another currency. In addition to individual investors, speculators in the currency market can include hedge funds, commercial banks, pension funds or investment banks. Currencies are traded in pairs, so in any given transaction, a trader is wagering that one currency will rise while the value of the second will fall. Most currency trading occurs among a handful of very liquid and active pairs. Investors interested in trading these pairs need to formulate an understanding of the characteristics of the currencies involved and the factors that cause the movements between the currencies that constitute these pairs. Popular pairs will be covered in much greater detail later in this tutorial. (For more insight, check out Using Currency Correlations To Your Advantage and Finding Profit In Pairs.)
Other Trading Strategies
In addition to trades that focus upon the relative value between two currencies, there are also other popular types of currency trades. In arbitrage trades, an investor simultaneously buys and sells the same security (perhaps a currency) at slightly different prices, hoping to make a small, risk-free profit. While this is obviously an attractive proposition, arbitrage opportunities are very rare in efficient markets because there are many other investors also seeking to exploit these opportunities. Therefore, any arbitrage possibilities that do exist disappear quickly. Investors interested in arbitrage opportunities need to closely monitor market developments and act immediately when opportunities appear. When opportunities are available, the price differential is usually quite small. To generate a substantial profit, investors need to trade in sizes large enough to magnify the small price differentials. (To learn more about this strategy, read Trading The Odds With Arbitrage and Arbitrage Squeezes Profit From Market Inefficiency.)
Another popular category of currency trade is the carry trade, which involves selling the currency of a country with very low interest rates and investing the proceeds in the currency of a country with high interest rates. In this category, the trader generates a profit as long as the relationship between the two currencies is relatively stable. The carry trade is usually practiced by large, sophisticated investors (such as hedge funds) and is extremely popular during times of low market volatility. During high volatility, large fluctuations in the value of currencies and other financial assets can quickly overwhelm the traditionally slow-and-steady profits found in the carry trade. Therefore, investors tend to shun the carry trade when market volatility rises. (Learn more about this trade in Currency Carry Trades Deliver and Profiting From Carry Trade Candidates.)
Forex Currencies: Ways To Trade
TradingCovered interest arbitrage is a trading strategy in which an investor uses a forward currency contract to hedge against exchange rate risk.
InvestingHedging against currency risk can add a level of safety to your offshore investments.
InvestingIn an attempt to dampen down the impact of the stronger dollar, investors have been turning to currency hedged exchange traded funds (ETFs) in a big way.
InvestingLearn how currency hedging can help reduce exchange rate risk for a portfolio of foreign stocks. Consider the cost of hedging and its potential benefits.
TradingLearn about the forex market and some beginner trading strategies to get started.
TradingCurrency fluctuations are a natural outcome of the floating exchange rate system that is the norm for most major economies. The exchange rate of one currency versus the other is influenced by ...
TradingInvestopedia explains how to hedge foreign exchange risk using the money market, the financial market in which highly liquid and short-term instruments like Treasury bills, bankers’ acceptances ...
TradingLearn about the most traded currencies and the strategies used to trade them.
InvestingHedge funds earn big returns for investors. Find out how they do it and whether you can too.