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Foreign exchange fundamentals explained

While it is known that trading in foreign currency is one of the most liquid markets in the world, trading 24 hours a day and averaging trillions of dollars per day in trades, the risks of dealing in foreign currencies must be considered before going that route.

Foreign exchange (FOREX) is basically the simultaneous buying of one currency and selling of another.  Such a transaction is represented by a currency pair.  For example, in the USD/EUR currency pair, USD is the base currency and EUR is the quote currency.  In other words, you are selling Euros and in exchange, receiving, or purchasing, US dollars.  Investors in FOREX keep a close eye on the market for fluctuations in currency pairs so they know when to buy one currency and sell another.

While many factors can affect the rates of currency exchange, daily fluctuations are usually quite small.  For this reason, FOREX speculators rely on leverage, basically borrowed capital, to increase the value of a currency trade, and this is where the biggest risk  comes into play.  For example, with a leverage of 100:1, an investor need only invest $1000 to trade a $100,000 lot.  Sounds great, but this is actually a double-edged sword.  If this trade increases by 100 points in a day (which is alot smaller of a move than it sounds, and is actually quite common), at $10 per point, the trader will have earned a 100% return on investment.  Just the same, a 100 point decrease would essentially wipe out your entire investment in a matter of seconds.

Related to FOREX, another currency risk is the "carry trade", which is borrowing the currency of one country whose interest rates are low, and investing those borrowed funds by buying the currency of another country whose interest rates are relatively higher.  While it is true that the United States and many other economic powerhouses have relatively low interest rates, the fact is that this isn't the case in other countries throughout the world.  Some countries have interest rates over 5-6%, which seems like a pretty good incentive to buy and invest some currency overseas.  However, this was not the case in 2008, for Japanese carry traders.  In the years leading up to the credit crisis of 2008, the Japanese interest rate had held at 0%, while the Australian interest rate had consistently remained at over 5%.  This differential in interest rates made AUD/JPY the ideal currency pair for carry traders because while they were borrowing in yen at 0% interest, they were converting it to AUD and making over 5%.

Japanese carry traders had hoped that when the time came to convert their money back to yen, the AUD would have fallen in value.  If the AUD/JPY rate would have fallen even 5%, it would have wiped out their interest gains.  The AUD/JPY rate did not fall by 5% however - it fell by nearly 45%.  Not only were their interest gains eradicated, but, considering that the majority of carry traders were highly leveraged, many also took some pretty hard hits to their principal.
While there is no doubt that trading in currency has the potential to be quite lucrative, one must consider whether the risks outweigh the benefits.
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