By Brian Perry
While the majority of trading takes place among the currencies of the largest industrialized economies, emerging market economies and their currencies are playing an increasingly important role in the international financial markets. Therefore, investors interested in currency trading will want to achieve an understanding of the unique challenges and opportunities facing the emerging market economies so that they can formulate their own perspective as to the feasibility of trading emerging market currencies.
Emerging Market Economies
Emerging markets are developing countries with transitions occurring in economic, political, social and demographic dimensions. The countries listed (as emerging markets) range from Kenya, with a per-capita income of $350 in 2000, to Mexico with a per-capita income just above $5,000, according to the IMF Working Paper "What Is an Emerging Market?" prepared by Ashoka Mody (September 2004). In emerging market countries, the financial and banking systems are usually still forming (compared to those in more developed economies), and the middle-class population may be small or even nonexistent. These characteristics result in greater financial volatility and larger swings between economic prosperity and economic decline. Additionally, emerging markets often have political systems that are less stable than those of developed nations, resulting in a greater possibility of governmental actions that adversely affect investors. (For background reading, see The New World Of Emerging Market Currencies and What Is An Emerging Market Economy?)
Unique Characteristics of Emerging Market Currencies
Emerging market currencies are unique in several respects. Because emerging market countries are developing economically and/or politically, there are special risks that come with investing in emerging market currencies. Political risk is always a concern for international investors, but emerging markets tend to have an even greater uncertainty in the political arena. Sudden changes in the political regime can result in large unexpected movements in the price of currencies, potentially generating large losses for investors. In extreme examples, some emerging market countries have limited investors' ability to withdraw currency from the country, thereby effectively freezing investing capital. (For more insight, check out Evaluating Country Risk For International Investing.)
Another unique feature of emerging markets is the structure of their currencies. Most of the larger economies, such as the United States, the United Kingdom, Japan and Canada, have independent currencies that are allowed to float relatively freely. In contrast, many emerging market countries do not allow their currencies to float freely. One popular form of governing the currency is "pegging" the domestic currency to a foreign currency. This foreign currency is commonly the U.S. dollar or a "basket" (group) of developed-nation currencies, such as the U.S. dollar, the euro and the yen. For instance, Hong Kong manages its currency in a range against the U.S. dollar, while China's currency floats in a range against a basket of foreign currencies.
Practicality of Trading Emerging Market Currencies
For many individual investors, trading emerging market currencies may not be practical. Emerging markets often suffer from illiquidity and large bid-ask spreads – conditions that are exacerbated during times of market volatility. This volatility stems from the inherent risk involved – the substantially higher economic, financial and political risk. While higher volatility can produce additional trading opportunities, it also drastically increases the chances of suffering large losses. Therefore, emerging market currency trading is often best left to the most experienced and well-capitalized individual traders.
This does not mean that individual investors who are unable or unwilling to trade these currencies directly cannot be exposed to emerging market currencies. When investors buy or sell an emerging market country's stock, bond, mutual fund, or exchange-traded fund, they are effectively buying or selling that country's currency as well. Therefore, an investor with a large holding in Mexican stocks can benefit from a stronger Mexican peso. On the other hand, a U.S. investor who wants to purchase stocks in Thailand hopes that the U.S. dollar strengthens against the Thai baht before the purchase. In short, the U.S. investor should hope for a strengthening U.S. dollar before buying foreign securities and a strengthening of the foreign currencies (relative to the U.S. dollar) before selling the foreign securities.
Although the typical investor's exposure to emerging market currencies (or other foreign currencies) may not seem substantial, international stock or bond investors do make significant wagers on the future direction of currencies. In fact, in a given year, currency fluctuations can add to or subtract from the performance of an international portfolio 10%. This is an important factor to remember and means that even international investors with no intention of directly trading foreign currencies should understand the influence currency movements can have on foreign stock and bond holdings.
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 ...
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