The foreign exchange market (forex) is a market where world currencies are traded 24 hours a day. For some, it's simply a mechanism for changing one currency into another. Multinational corporations doing business in various countries rely on these markets to exchange currencies from around the world. However, the market is also occupied by traders who bet on movements of currencies relative to each other.
The forex market operates between individuals represented by brokers, between brokers and banks, and between banks. Here are five ways for a retail investor to participate in this market.
- Because of liquidity and low transaction fees, trading currencies is exceptionally popular.
- Currency traders are not bound by the margin limits imposed by the Securities and Exchange Commission (SEC) on securities traders. This means those traders can make heavily leveraged trades.
- The most popular way to invest in currencies is by trading currencies in the forex, but investors can buy mutual funds, ETFs, or ETNs.
- Investors can be exposed to global currencies by investing in multinational corporations.
- Like all investments, investing in currencies involves risk, especially during volatile economic times or periods of high geopolitical tension.
Standard Forex Trading Account
You can open an account with a forex broker and trade currencies from around the world. There are several differences in how this market operates when compared to the U.S. stock exchanges:
- Currencies are traded in pairs—you are betting one will go up (long) and the other will go down (short).
- There are no regulated currency exchanges and no central clearinghouse for trades.
- There is no uptick rule for taking short positions.
- There is no upper limit in the size of your position.
- Currency dealers generally make money on the bid-ask spread, rather than charging commissions.
CDs and Savings Accounts
TIAA Bank offers a WorldCurrency certificate of deposit (CD) that earns interest at local rates in specific countries. It also offers a basket CD that includes a mix of various currencies. Last, TIAA Bank offers a foreign currency account that functions like a money market account and allows the transfer of money between major currencies.
The CDs are subject to exchange rate fluctuations but feature a higher interest rate than dollar-denominated CDs. When the CD matures, you will get back fewer dollars than you invested if the dollar strengthened against the foreign currency. FDIC insurance protects you against bank insolvency but not the currency risk.
Foreign Bond Funds
There are mutual funds that invest in foreign government bonds. These mutual funds earn interest denominated in the foreign currency. If the foreign currency goes up in value relative to your local currency, the earned interest increases when converted back to local currency.
Investing in foreign bonds allows investors to select their preferred level of risk and pursue additional yield for Examples of such funds include the Merk Hard Currency Fund, Aberdeen Global Income Fund, and Templeton Global Bond Fund.
Many stockholders indirectly participate in the foreign currency markets through their ownership in companies that do significant business in foreign countries. Some of the better-known American companies with overseas exposure are Coca-Cola, McDonald's, IBM, and Walmart.
The revenues and profits derived from overseas operations are boosted if the foreign currency appreciates versus the dollar. This is because those revenues are converted back into dollars for financial reporting purposes, and a stronger foreign currency will yield more dollars in exchange.
ETFs and ETNs
Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are traded like stocks and can be a way to invest in currencies without needing to trade the forex. With a standard investing account with most brokerages, investors can buy access to currency ETFs such as UUP, the Invesco DB US Dollar Index Bullish Fund, or EUO, the ProShares UltraShort Euro.
ETNs are more similar to corporate bonds than a collection of stocks, but they tend to have a similar exposure to the currency market as ETFs. On the same exchange, you would trade ETFs, you can also find common currency ETNs such as the iPath® GBP/USD Exchange Rate ETN (GBB).
Opportunities and Risks of Forex Trading
Forex trading is very popular, so markets typically have high liquidity with low transaction fees.
Investors diversify their portfolio by gain assets outside of their normal trading location.
Traders can enter highly leveraged trades, potentially multiplying profit.
Forex markets run all day long, and investors can trade whenever they want.
No central exchange or regulator controls the market.
Traders don't have much transparency due to the deregulated nature of the market.
Forex rates are influenced by many factors; the process of determining the price of a currency is complex.
Trades can enter highly leveraged trades, potentially multiplying losses.
Forex markets have historically been highly volatile.
Unlike with stocks, forex trades often don't have access to portfolio advisors.
What Are the Benefits of Investing in Foreign Currency?
The Forex market is huge, and it's relatively easy to access for beginners. Since different international markets have staggered hours, it's possible to trade Forex around the clock. There are typically low transaction fees because it's a market with high liquidity.
What Are the Risks of Investing in Foreign Currency?
Exchange-rate risk, also referred to as currency risk, occurs when the price of one currency changes in relation to another. Transaction risk is the change losses that occur due to delays between when transaction and settlement of trades occur. Other risks such as political risk are specific to the underlying currencies losing their value due to economic or government events.
How Safe is Forex Trading?
The foreign exchange currency market is volatile and carries substantial risks. Using high leverage also magnifies potential losses. In addition, it is important to identify reliable and valid brokers to avoid common Forex broker scams.
The Bottom Line
Currencies are impacted by world events around the clock, and the Internet and wireless communications provide almost instant access to even small investors. Currencies provide some measure of diversification for people who invest primarily in U.S. securities. Alternatively, traders can take advantage of changes in relative currency strength by investing in global currencies.