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DEFINITION of 'Currency ETF'

Currency ETFs (exchange-traded funds) are designed to track the performance of a single currency in the foreign exchange market against the US dollar or a basket of currencies. This is accomplished by multiple methods like cash deposits, short-term debt denominated in a currency, and future or swap contracts. In the past, these markets were only accessible to experienced traders but the rise of exchange-traded funds over the past decade has opened the foreign exchange market to all types of investors.

BREAKING DOWN 'Currency ETF'

Currency ETFs are used by investors looking for exposure to the foreign exchange market and would prefer to transact outside the futures or forex market. The rising popularity of ETFs offer investors a seamless and cheap method to trade currencies throughout normal trading hours. Most of the movement in the currency market comes down to interest rates, global economic conditions, and political stabilities. Sometimes a natural disaster in an emerging country can rock the currency market, but that occurs independently of trading behavior. Today, currency ETFs track most global currencies including the US dollar, Canadian dollar, Euro, British pound, and Japanese yen.

In essence, trading currency ETFs is a speculative trade on spot exchange rates. Exposure to spot exchange rates is perhaps the most fundamental aspect of investing in currency funds. This means investors are betting on one of two outcomes: the core currency performs well or the counter currency tumbles. The investor always takes a long position on a currency relative to being short another one. For example, the CurrencyShares Euro Trust (FXE) rises when the Euro performs well or the US Dollar tumbles. Besides currency appreciation, investors receive interest rate payments for holding a currency over time.

Currency ETFs add a layer of diversification to traditional stock and bond portfolios by hedging against economic events that might undermine normal trading. Different products offer varying risk-reward opportunities and provide exposure to different currencies. Basket investments in multiple currencies may offer more stability than a currency-specific product, but with less upside potential. Many of the same guidelines of modern finance like diversification and risk management apply to trading the currency market. 

Risks of a Currency ETF

Trading currency ETFs can help improve portfolio returns but there are substantial risks in the foreign exchange market. For one thing, most currency movements are influenced by ongoing macroeconomic events. A sluggish economic release, volatile political move or interest rate hike can impact multiple exchange rates. Overlooking the current macroeconomic environment can be costly for investors thinking about trading in the foreign exchange market.

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