As we’ve said before, we’re all invested in the currency market in one way or another. But it wasn’t all that long ago that investment access to the currency market was limited to sophisticated high-net-worth individuals, for the most part. Technological developments and market innovations, however, have opened the market up to just about anyone who wants to take part these days. It’s not as risky as they say – and here are five ways that you can participate. And don’t forget to check out the free e-book “The Smarties’ Guide to Alternative Investing in the Foreign Exchange Market” for more practical wisdom.
1. Investing in Cash Currencies
The simplest form of foreign exchange investing is swapping your home currency (e.g. dollars) for some other. This allows you to benefit from the gains that other currency might make against your own. For example, if you think the dollar is too highly valued against the British pound you could exchange your dollars for pounds, eventually converting back when you think the two currencies are more properly valued. Your profit would be the amount of appreciation the pound experienced in dollar terms.
This sort of “cash” currency investing can easily be done by going to the bank and exchanging your dollars for the other currency of your liking. There are foreign and multi-currency accounts available as well so you don’t have to actually hold pounds or euros or yen in actual cash and can potentially allow for investment in foreign securities. The one thing to keep an eye on, though, is the exchange rate spreads. They are often much wider than market rates when doing small retail transactions of this sort.
2. Currency Investment Vehicles
If you don’t want to worry about the details of currency exchanges and accounts there are other options. The ones that get the most press are currency exchange traded funds and notes (ETFs and ETNs), which trade like stocks. For example, Rydex has a collection of ETFs that invest directly in specific currencies and pay interest based on the rate of the currency in question. There are also mutual funds doing the same thing. Since these are registered securities they are generally eligible for inclusion in retirement and other institutional types of accounts.
As is always the case with these types of vehicles, however, you need to know the specifics. Some of these instruments are single currency, while others are blends. Some aren’t just currency holdings, but actually have managed strategies involved. Make sure you get what you’re after. Also, remember to account for transaction costs when considering these sorts of securities. Recall from the earlier table that ETFs are subject to both commissions and market spreads. Plus, there are fund management fees for both ETFs and mutual funds.
3. Foreign Bond and Stock Funds
A less direct way of playing the currency market is doing so through mutual funds, ETFs, and other vehicles that invest in foreign securities. These sorts of investments have inherent exchange rate exposure because your money is converted into the currency of the country (or countries) in which you are investing. To get an idea of how much impact currency valuations can have on investment performance, take a look at this chart comparing the S&P 500 with the German DAX, with the latter expressed in dollar terms.
German DAX index performance in US Dollar terms compared to the S&P 500. Source: Google Finance
It is worth noting that the DAX did not meaningfully break the 2000 peak in 2007 of its own accord. It’s the impact of the weaker dollar against the euro which produces that higher 2007 peak in the chart above. It should be noted if you’re thinking about investing in foreign stocks via mutual funds, that some hedge that exchange rate exposure. As noted above, you need to make sure to check the specifics before putting your money down.
4. Forex Brokers
Playing the foreign exchange market via a broker has become very popular in the last decade. Where ETFs and the other trading vehicles tend to be more general currency plays, brokers allow traders and investors to play specific currency exchange rates through pairs. For example, through a broker you can trade the euro-dollar exchange rate. Moreover, you can trade the rates between currencies that are not your own. For example, as US trader could play the Canadian dollar-Japanese yen exchange rate. This can all be done in cash currency transactions, of course, but trading through a broker is faster thanks to online access, more flexible, and generally cheaper because of lower spreads.
It is in this broker-based trading where the reputation for serious risk has come into Forex, though, thanks to the readily available access to high leverage. Trading in this way is very similar to trading in the futures markets in terms of transacting in contracts for delivery rather than direct currency exchange, and in dealing with leverage and margin. As such, it’s not as simple and straightforward as cash market investing. It does, however, allow you the opportunity to play a wider array of exchange rates than just those against the dollar. It also opens up the opportunity to apply leverage to take somewhat larger risks if that suits your objectives.
5. The Carry Trade
The carry trade is something that gets talked about in the markets at different points. Basically, this is borrowing money in one currency, exchanging it for another one, and investing the proceeds. The idea is to borrow a low interest rate currency and put it into a currency where the rates of return are higher. The objective is to make the spread between what you pay on the borrowed funds and what you earn on the other end of the position.
For example, an investor could borrow Japanese yen because Japanese interest rates are very low. Rates in Australia are significantly higher, so those yen could be swapped into Australian dollars and invested in short-term fixed income securities. If the rate to borrow the yen is 0.5% and the rate paid by the Aussie dollar investment is 3.0% you make the 2.5% difference.
Of course at some point you’ll have to convert your dollars back to yen to pay off that loan. That means you have exposure to the exchange rate between the two currencies (AUD/JPY). If that rate goes against you it could more than wipe out what you make on the rate spread.
It’s that old saying: There’s no free lunch.