Investing in Currency Definition
Investing in currency refers to the act of buying one currency by selling the other pair or leg, which is usually done through a foreign exchange market known as forex.
How to Invest in Foreign Currency?
Usually, there are the top 3 ways in which you can invest in a foreign currency, and they are listed as under
- Spot Trading: In this method of investing, one currency is exchanged for the other, and the settlement usually happens on a T+2 basis (Trade date+2 days)
- Forward Trade: In this investing contract, the party enters into a contract to exchange one currency for the other at a set price on a certain future date. It is OTC (Over The Counter ) traded and is sometimes customizable.
- Futures Trade: It is similar to a forward trade of currencies except that the contract is furthermore standardized.
Examples of Investing in Foreign Currency
Below are examples of investing in foreign currencies.
Mr. Smith is observing the USD/INR fluctuations. He has reason to believe that the USD will strengthen against the INR. Hence he may enter into a spot contract of buying 1 USD at 70.83 INR per USD and then sell into a three months futures contract at USD/INR=71, thereby making a profit in terms of 0.17 INR
An exporter in the US is looking at the exchange rate, which is currently going on at USD/GBP=0.81. He is concerned that the USD may appreciate the GBP in 3 months when he would get his receivables from the UK. Home currency appreciation is bad for the exporter. Hence he may hedge this contract with a three month forward on USD and GBP by buying a USD forward at the same rate of USD/GBP=0.81.
SuperMoney LLC, a hedge fund that has entered into a short trade of security ABC Co in a different currency with a time horizon of 3 months and is worried about the FX rates when it needs to undertake cover trades and hence may enter into an FX transaction to hedge the exposure in this regard
Some of the advantages of investing in currency markets are as follows –
- Availability: It is often noted that stock markets operate during a fixed period of time in a day. However, a currency market is open 24*7 round the clock as the closing of one market in one country would open up another market in another part of the world. Hence there is a great convenience in currency trading as forex markets are open all the time 24*7
- Hedging: It serves as a great tool to protect the investors from uncertainties related to FX rate changes over time. A hedge fund may be concerned about the FX rate when it wants to cover a short trade over a time horizon of certain months, involving a different currency and hence may choose to hedge and protect itself by having to enter into forward and futures contracts so that such uncertainty is avoided. Similarly, even an exporter or importer may be very well worried about the FX rates when they have to receive/make payments for the trades in a foreign currency and thus, to protect themselves from the varied uncertainties, they may very well choose to enter into a forward or even a futures FX contract so that they are not affected by such fluctuations
- Diversification: A fund manager or even an individual investor may choose to add currencies in his/her set of portfolios so as not to put all the eggs in one basket and achieve the benefit of diversification, thereby managing risk. Currencies stand as an asset class compared to a traditional mix of stocks, bonds, and even mutual funds for the common investor
- Scope for profit: A person can very well try to speculate in the currency market and make short term profits if he/she understands the forex markets very well. It becomes imperative that one has a clear idea of the trends and keenly follows on this market and to take advantage of market opportunities
- Lower costs: Unlike stocks, trading in currencies involves comparatively lesser costs and thus seeks to enhance returns for the investor when undertaking trade/investment in such forex markets involving currencies.
Disadvantages of Investing in Currency Market
Given below are the pointers that seek to elucidate on how investing in currency markets tend to be disadvantageous in some regards –
- Huge volatility: No doubt that the currency market stands to be a strong source of hedging; it exposes one to significant volatility much more than what one would expect in the normal course of stock movements. Hence it becomes important for the amateur investor to very well understand their tolerance of risk and only then venture into investing in currencies. The risks too, tend to be higher than the other investment strategies
- Scope for Speculation: Given the high amount of volatility that is prevalent in the stock market, there is often a great amount of speculation that is involved with regard to the currencies and their movements. Sometimes the bets or positions entered into may go down south and cause a huge amount of losses to the investors. Hence it becomes important that the investor be really cautious in this regard and not indulge in excessive speculation.
Investing in the currency market is not simple, contrary to investing in equity markets. Thorough knowledge and understanding of the forex market are required to undertake any investment trades or contracts involving currencies. These currency markets stand as a brilliant source for an investor or a fund to hedge their foreign currency exposure, to diversify their portfolios, and also gain from FX gains in the process.
However, one needs to understand that the currency markets are quite complicated with lots of uncertainties and fluctuations, thereby creating scope for a huge amount of speculation, which may seem un-appropriate for the common amateur investor. Hence before venturing into investing in the currency market, one needs to understand and be clear of the dynamic to avoid huge unnecessary losses. Nevertheless, over the years, the currency markets have provided an excellent hedging source for investors and funds alike to protect them with their FX exposures.
This has been a guide to Investing in Currency and its definition. Here we discuss the types of investing in currency exchange markets along with the examples. You can learn more about investment banking from the following articles –