The various ways you can invest in forex
The value of a country’s currency against that of another is constantly changing. A currency of a particular country may appreciate if its central bank raises interest rates. If a certain nation has high inflation, it is likely that its currency will fall in value relative to that of others.
The political situation and the level of economic activity in a country also play a role in determining the relative value of a nation’s currency. In fact, the value of a currency constantly changes based on a combination of these and several other factors.
This variation in exchange rates presents an attractive investment opportunity. An investor who understands the forex market can make significant gains by correctly predicting the rise in the value of one currency against that of another.
Here are several ways in which you can invest in foreign exchange.
1. Forex trading
This involves spot trading in a currency pair. A transaction always involves two currencies, a base currency and a counter currency.
In the currency pair EUR/USD, the Euro is the base currency and the US dollar is the counter currency. If you anticipate that the euro will appreciate against the dollar, you would buy EUR/USD. On the other hand, if you think that the US dollar will gain against the euro, you would sell the currency pair.
The forex market has no physical location or a central exchange. Instead, it is operated by an international network of banks and financial institutions.
Individual investors are increasingly attracted to the forex market. It is possible to start trading with an initial investment of just a few thousand dollars. A forex broker could allow you a significant degree of leverage. A deposit of S$10,000 will allow you to carry out trades valued at S$200,000 if the leverage offered is 20:1.
Forex trading is fairly popular in Singapore with individual investors and there are a number of forex brokers that offer this facility.
2. Foreign currency futures
This is essentially a futures contract where the underlying commodity is a currency exchange rate. Also referred to as forex futures, these are exchange-traded futures contracts that require you to buy or sell a certain amount of a specific currency at a pre-determined price on a pre-decided date.
The Chicago Mercantile Group (currently known as the CME group) offers 49 currency futures and has a high degree of liquidity. But the futures market is much smaller in size than the spot market. There are several other differences between these markets.
The futures market is highly regulated, unlike the spot market.
The degree of leverage is much lower in the futures market.
Currency futures involve the payment of commission to brokers. The forex spot market, on the other hand, works on the basis of exchange rate spreads.
3. Foreign currency options
As the name implies, a foreign currency option confers upon its holder the right, but not the obligation, to engage in a foreign exchange transaction. This right can be obtained by paying an upfront cost, called the premium. Purchasing the foreign currency option entitles the holder to buy a specified amount of one currency against another by or on a specified date.
How is a foreign currency option’s price determined? An important factor in arriving at the option price is the rate at which the currencies will be exchanged if the option is exercised. In addition to this, the current spot price of the currencies and the interbank deposit rates for each of the currencies also play a part in determining the option’s price.
4. ETFs and ETNs
Both these financial instruments are linked to foreign currency rates. A currency ETF (exchange-traded fund) can be associated with a single currency or a group of currencies. Funds are usually deployed in foreign cash deposits. Futures contracts for the relevant currencies may also be entered into. In certain cases, cash could also be invested in government bonds.
A currency ETN (exchange-traded note) is a debt instrument that is linked to an underlying currency exchange rate.
Currency ETFs and ETNs are commonly used to hedge against exposure to specific currencies.
5. Foreign currency time deposit
These are deposits that are pegged to foreign currencies. Investors get the benefit of the interest that they earn as well as any appreciation in the value of the currency during the period of the deposit. Of course, the currency may depreciate as well. In that case, the amount earned would be the interest as reduced by the depreciation in the value of the currency.
Although some foreign currency time deposits may seem attractive because of the higher interest rates, the depreciation in the currency may negate any return that you earn.
You can get an idea about the rates available for foreign currency deposits in Singapore here.
Invest with caution
There are several options available for investors looking to get an exposure to foreign currencies. While some like forex trading, are purely short-term in nature, other financial instruments require you take a longer term exposure.
Each of these investment options carries a certain degree of risk. Investors should ensure that they completely understand the implications and risks of each instrument before committing their funds.