The foreign exchange market, commonly known as forex market, is a place where the buying and selling of currencies around the world takes place. Forex trading, just like the equities market, aims to book a net profit by buying low and selling high. Forex markets have the highest volume amongst all the markets of the world. This is the reason why the forex assets are known as highly classified stocks. The advantage that the forex traders have is that there are a limited number of currencies at their disposal to trade with in contrast to the thousands of companies at the disposal of the stock traders.
Foreign exchange risk considers the primary risk that the fluctuations in the different currencies can alter a person’s investment hugely. There are various risk factors when trading in foreign exchange. These include exchange rate risk, liquidity risk, leverage risk, transactional risk, political risk, credit risk, interest risk, risk of ruin etc.
In forex trading, like trading in other markets, traders make small initial investment and gain access to substantial amount to trade with. This leverage is known as margin. Even very small price fluctuations can amount to a margin call. This is when the investor will be required to add additional funds or exit his position partially at a loss to lower his margin. Aggressive use of margin can lead to huge losses in the initial investment.
Interest Rate Risks
As we know that when a country’s interest rate rises, its currency strengthens. This is because there is an influx of investments in the assets of the companies as it is considered that a stronger currency generates higher returns. Conversely, investors will start to withdraw the investments if the interest rates fall which in turn shall make the currency weak. This is why the forex prices can change dramatically and cause a huge dent in the investor’s initial investment.
An important thing to consider while trading in foreign exchange is to assess the country and the stability of its government of the currency you would be trading in. In many countries, exchange rates are fixed against a world leading currency such as the US Dollar. In this case, the central bank of the countries must have enough reserves so as to maintain a fixed exchange rate. A currency crisis due to deficits and devaluations of the currency lead to compounded effects on foreign exchange trading and the prices.
Political risk also plays a significant role in the way you trade in a foreign exchange market. Elections take place constantly in one or other part of the world. There can be political instability and uncertainty during the elections which can make the forex markets volatile. One should always have a look at the pre election polls so as not to be shocked by the election results. There can be even more uncertainties and greater volatility in the forex market if the government so formed after the elections is not a stable one.
Transaction risks are the risks associated with time difference between the beginning and the settling of the contract. Foreign exchange trading occurs at all hours of the day which may result in the exchange rates changing before an investor’s trades are settled. The transaction risk increases with the greater time differential between the beginning and settling of a contract. This may lead to a net loss even when the trader might have registered a gross profit while trading.
Credit risk refers to the risk of an outstanding currency position that may not be repaid as agreed by counterparty either voluntarily or involuntarily. Credit risk is something which is very low for the retail investors but a concern for the corporations and the banks.
In a financial transaction, the counterparty is a company which provides the asset to the investor. Hence, the counterparty risk implies to the risk of default from the broker in a transaction. The spot and forward contracts on currency trades are not guaranteed by the exchanges in foreign exchange trading. The counterparty may not be able to or may even refuse to adhere to the contracts.
Risk Of Ruin
A trader may be able to comprehend the markets correctly and place a bet accordingly in the foreign exchange market for the long term. However, there may be short term unrealized losses and the trader may not be able to financially bear the losses. This may lead him to close his position at a loss only because he is not able to meet the margin call. Here we see that even when a trader might have placed the correct bets and booked a net profit, he may have to suffer losses only because he had insufficient capital.
The Bottom Line
As we see, there are a lot of risks associated with foreign exchange trading. Such is the nature of the leveraged trades that a small initial fee can amount to huge erosion of the initial investment of a trader. Not only this, there are exchange rate risks and transaction risks too. Add to this, the political conditions in other countries can make the foreign exchange markets volatile and can greatly impact an investor’s trades and even put a dent in the profits of a trader. Though foreign exchange markets have the highest trading volume, it comes with a cost and can lead to huge losses of an investor.