If you have ever traveled abroad and used a different currency, you already understand the concept of Forex. In today’s globalized world, Forex, or Foreign Exchange, is an inherent component of all our lives.
We take a look at how you can use the differences between currency rates as a form of investment.
What is Forex?
Investing in Forex is the act of exchanging one set of currency for another with the intention of making a profit on the differences between their rates. Forex is the most traded product in the financial markets. It is worth trillions of dollars and thousands of transactions take place every day. The most traded currencies on the Forex market are the US Dollar, Euro, Japanese Yen and British Pound.
What is distinctive about Forex is that there is no physical marketplace. All trades are done electronically by traders all over the world through computer networks.
Why do different currencies have different value?
A currency’s strength depends on a number of economic factors such as supply & demand, interest rates, inflation, economic performance etc. However, it can also swing based on political situations and change of government in the country.
How do you trade in Forex:
1. Spot Market: The spot market is where currencies are traded according to the current price, i.e. the currency is exchanged ‘on the spot’. When you go to a bank or exchange house and convert currency, you are essentially participating in the spot market. Recently, when the value of Russian Rubles plummeted, many Russian expatriates took this as an opportunity to send money home because they could now receive more Rubles for each unit of currency they exchanged.
2. Futures Market: In the futures market, two parties decide to exchange currency at a future date (commonly known as the settlement date) at a predetermined price. For example, you agree to exchange USD 100 for GBP 63 with a trader three months from now. On that date, USD 100 is only worth GBP 59 in the spot market. Since this is a futures contract, the trader is obliged to pay you GBP 63 resulting in a profit of GBP 4 for you. On the other hand, if USD 100 is worth GBP 67, you lose money because you only receive GBP 63. The trader, in this instance, makes a profit.
3. Forwards Market: Forwards are very similar to futures contracts except that futures are standardized and take place in an exchange whereas forward contracts are private agreements between two parties and can be highly customized.
Companies all over the world use futures/forwards as a way of protecting themselves in their international trades by fixing future prices.
What to watch out for
The Forex market can be highly volatile and unpredictable. Even seasoned investors cannot accurately estimate how a currency will perform weeks or months from now. Even if the currency movement favors you, it is impossible to predict by how much. You don’t know how much money you will make until the settlement date arrives.
Investing in Forex is a great way to hedge against your business or personal risks. However, trading in them by speculating future prices can be highly risky and could cost you a lot.