The foreign exchange market (forex) is the market where world currencies are traded 24 hours a day. For some, it's simply a mechanism for changing one currency into another, such as multinational corporations doing business in various countries. 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. Currency traders are not bound by the margin limits imposed by the Securities and Exchange Commission (SEC) on securities traders. This offers the potential for tremendous leverage and the possibility of significant profits or losses. Here are five ways for a retail investor to participate in this market.
Also see: Forex Trading: A Beginner's Guide
- Standard 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).
- No regulated currency exchange and no central clearing house for trades.
- No uptick rule for taking short positions.
- No upper limit in the size of your position.
- Currency dealers generally make money on the bid-ask spread, rather than charging commissions.
- 3. CDs & Savings AccountsEverBank offers a WorldCurrency certificate of deposit (CD) that earns interest at local rates in specific countries, and a basket CD that includes a mix of various currencies. It also 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, which 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.
Examples of such funds include the Merk Hard Currency Fund, Aberdeen Global Income Fund, and Templeton Global Bond Fund.
- Multinational Corporations 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. (To learn more, see How U.S. Firms Benefit When The Dollar Falls.)
- ETFs and ETNs 10 Reasons To Add ETFs To Your Portfolio
The Bottom Line Like all investments, investing in currencies involves risk, especially during volatile economic times. One advantage of the currency market is that it's, theoretically, a level playing field. Currencies are impacted by world events around the clock, and the internet and wireless communications provide almost instant access to even the small investors. Currencies provide some measure of diversification for people who invest primarily in U.S. securities.
For the latest financial news, see Water Cooler Finance: The Beginning Of A Foreclosure Crisis?