“Investing in foreign currencies can be a great way to diversify your portfolio,” said longtime UAE-based trader and analyst Amit Trivedi. “Foreign currency trading, or forex for short, is a bit more complex than trading stocks or mutual funds, or backing up your investment strategy with bonds.
Investing in foreign currencies can be a great way to diversify your portfolio
“Learning the basics, however, can give you a solid base to build on if this is an asset class you want to explore. This guide tells you everything you need to know to start investing in currencies.
How are foreign currencies traded and where?
As mentioned above, investing in currencies involves buying the currency of one country while selling that of another, and this is done through the forex market. Forex trading is always done in pairs. For a transaction to be complete, one currency must be exchanged for another.
For example, you can buy US dollars and sell British pounds or vice versa. Although you can technically trade any foreign currency traded on the market for another, it is more common to trade using pre-made pairs.
How Foreign Currencies Are Usually Grouped
• Main agreements: This group includes the most frequently traded currencies. The US dollar (USD), euro (EUR), Japanese yen (JPY) and British pound (GBP) are usually included.
• Minor chords: This group also includes many frequently traded currencies in the major pairs category, excluding the USD.
• Mixed agreement: Here you will usually have pairs of a heavily traded currency against a less traded one. For example, the USD can be paired with the Hong Kong dollar (HKD) or the Singapore dollar (SGD).
• Regional agreements: In this category, the currencies are matched according to the region. So, you might see Asian or European currencies from the same geographic region being traded against each other.
Here is an illustration on how currencies are paired
A quote for a pair might look like this: EUR/USD = 1.2545/1.2572
The first number is the bid. So, in this type of pairing, the broker would pay you 1.2545 USD for one euro. The second digit is the “ask”, which means the broker wants you to pay 1.2572 for one US dollar.
How to invest in foreign currency
Stocks, bonds, mutual funds are traded on a centralized stock exchange or exchange, forex is not. Instead, it is traded on the foreign exchange market, which is operated by banks and other financial institutions. All transactions take place electronically and transactions can be made 24 hours a day, 7 days a week.
Forex trading can be done through a brokerage. There are three basic ways to exchange foreign currency:
• Cash trading: In this type of trade, currency pairs are exchanged when the trade is settled. They are essentially instant exchanges and the spot price represents the price at which a currency can be bought or sold.
• Futures trading: When you trade currency forwards, you agree to buy or sell foreign currency at a set price on a set date in the future. The spot price will be settled and you will be protected from volatility when trading.
• Future Trade: Futures trading is similar to futures trading, with one key difference. In a future business contract, you are legally bound to complete the transaction. The price of the contract is based on the exchange rate of the currencies concerned.
Advantages and risks of forex trading
Investing in currencies can provide several benefits, some of which include:
• Accessibility: Stock exchanges operate at set times. Although you can trade before or after the market, it is not 24/7. Forex trading, on the other hand, can be done at any time of the day or night.
• Diversification: Diversifying your portfolio can help manage risk. Foreign currencies are an alternative asset class to the traditional combination of stocks, bonds and mutual funds.
• Reduced costs: Unlike stock trading, there may be fewer commissions associated with foreign currency trading. This allows you to keep more of your returns.
However, while the reasons above constitute most of the reasons why majority investors would invest in currencies, there is one major downside to investing in currencies: volatility.
“Although forex trading can be lucrative, there can be more ups and downs than the stock market, which makes it risky for new or novice investors. The risks can also be higher compared to other markets. other investment strategies, so it’s important to carefully assess your risk tolerance before jumping in,” Trivedi added.
Although forex trading can be lucrative, there can be more ups and downs than the stock market, which makes it risky for new or novice investors.
4 factors to consider when investing in currencies
The behavior of currencies is very difficult to predict in the short term because their performance depends on many variables. So here are four key factors to consider when trading currencies:
1. What is first, second (BASE/QUOTE or BUY/SELL)
If you are looking to trade currencies, when looking at currency pairs you may want to consider how they are ordered. For example, in a USD/GBP pair, USD is the base currency while GBP is the quote currency.
The exchange rate is used to calculate how much you would have to pay in the quote currency to buy the base currency. Each time you buy a currency pair, you are buying the base currency and selling the quote currency.
2. Fluctuating exchange rates
“Forex trading attempts to capitalize on fluctuations in currency values. It is similar to stock trading. You want the currency you are buying to appreciate in value so that you can sell it back for a profit. Your profit is tied to the rate exchange rate, which is the ratio of the value of one currency to another,” explained Trivedi.
A country’s currency is valued based on supply and demand. Thus, it is always in a state of flux. This type of exchange rate is known as a floating exchange rate. Similarly, the value of a currency is determined by market forces. Factors such as imports and exports, interest rates and inflation affect the value of currency.
3. Currencies reflect economic strength
Currencies, on the other hand, are influenced by multiple economic and political factors. It is therefore not only a question of predicting the performance of a country in absolute terms, but of determining its performance in relation to another region.
That said, some currencies are more stable or predictable than others because the economic characteristics of regions impact the depreciation or appreciation of their currency over the long term. For example, the Swiss franc is the strongest currency in the world, thanks to the stability of the country.
4. Consider regional assets outside of currencies
“Another thing to keep in mind when investing in currencies is that there are several alternatives to choose from. One of them is to buy assets from the country or region in question. In the case of the Swiss franc, for example, that would mean buying bonds or shares of Swiss companies,” Trivedi added.
When investing in currencies, you have several alternatives to choose from, one of which is to buy assets from the country or region in question.
How exchange offices work, make money
Foreign exchange companies or platforms serve as the basic link between the local market and the foreign currency market. Once a bank or money changer offers the exchange rate, the customer chooses whether or not to accept the rate. If they accept, the transaction is accepted.
In addition to the exchange rate conversion, certain transaction fees may also be applied to send or receive an international money transfer, which includes their profit margin. Rates and fees can vary widely from bank to bank and exchange to exchange.
Separately, there are also trading platforms that allow traders to buy and sell currencies through forex transactions depending on the fluctuation of exchange rates.
When the value of one currency rises against another, traders make profits if they buy the appreciating currency, or incur losses if they sell the appreciating currency.