Executive Summary
In the modern times with the tremendous development of communication and other technological and managerial skills the mode of business is also changing and adapting some extraordinary features. Now one can invest in the far situated foreign exchanges just with a click on the mouse.
Foreign Exchange market is touted as the largest financial market in the world. It has so many positive aspects. Especially its flexibility in the business hours, the liquidity of the market and the modern trends make it very much attractive for the investors. The investors usually earn profit with the foreign currency movements. Foreign exchange market has a great impact on the international commerce and it helps to boost up the economy of the host countries as well due to the large inflow of money.
Until few years back Foreign Exchange market was only for the elite and professional traders. But now it’s open up to the common individuals also who can start trading in this exchange market with the basic capital of $5000 also.
More people are investing in this foreign exchange market cause of its various important yet beneficiary characteristics. Especially the use of leverage, its various trends which are long lasting, innovative ideas like demo trading to get a clear picture of the market without even investing are alluring facts.
But there are some risky factors also that a investor should keep in his mind. Specially the fluctuation in the currency rates, the taxation and portfolio risk in the foreign countries can be a matter of concern for the investors. Still foreign exchange has its own identity and it has the potential to give a new direction to the international business.
Introduction
“There will be no geography.”-Kamal Nath, Indian Commerce Minister, Doha WTO summit 2005.
In the modern world globalization has swept across all the oceans and continents and reaches to the every corner in this world. With this fascinating factor emerging as one of the foremost important characteristics that’s shaping the new world order, so many others are evolving with time. The miraculous development with the internet and other communication processes has also fuelled the overseas commerce. Now investing abroad is not a complex job by sailing with several ships and men and presenting gifts to the King of the lands. Everything is possible with the click of the mouse now. You can buy and sell assets abroad sitting on your chair comfortably.
The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another. It is the largest and most liquid financial market in the world, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The average daily trade in the global forex and related markets is continuously growing and was last reported to be over US$ 4 trillion in April 2007 by the Bank for International Settlement. (Triennial Central Bank Survey 2007).
Let us assume, then, that a New York banker is asked to negotiate a sterling long bill for ten thousand pounds, drawn on a banker in London. In order to negotiate this bill without investing it, the banker must recover the money he spends, immediately. He first calculates the amount of sterling credit the bill will create when discounted immediately after acceptance in London.
Utilizing the appropriate discount rate of the London market — let us assume it to be 5 per cent – and the bill’s length of life (sixty days) he finds the acceptance will sell for £9948 4s. and 4d. (10,000 X 3/100 ÷ 63/365). A stamp charge of 1/20 per cent will be levied in London; this will reduce the amount by £5, leaving a net sterling credit of £9943 4s. And 4d. If the sight rate for sterling on this day is 4.85, the banker can sell this London credit for $48,224.61 (9943.21 X 4.85). By paying somewhat less than this amount for the sterling long bill and immediately proceeding to sell sterling sight drafts which will exhaust his London credit, the banker will avoid making an advance of funds and yet draw a profit from the transaction. In another way we can see that expected cash flows in foreign currencies can generally be translated into domestic currency at the forward exchange rate because that value must represent a consensus forecast of risk-adjusted future exchange rates or investors would continue to buy or sell that forward contract until its price were driven to the consensus forecast. The forward exchange rate is the rate at which one can contract now (with banks or other investors) to exchange currencies in the future. The forward exchange rate may differ from the current rate at which one can exchange currencies (which is called the spot exchange rate) due to expectations and risk. (Murphy 2000, p.75)
Investing in foreign companies can be a lucrative option for those who want to have a strong portfolio but it seamlessly coming up with new problems. Many more people now investing abroad expanding their network, but it also bear the risk of market fluctuations and other impacts.
Fluctuations in these currency values, whether the currency or the foreign currency, can either enhance or reduce the returns associated with foreign investments.
But still foreign exchange market is unique in many ways. Its functioning is quite different from the others. There are some major factors which lure the investors in the foreign exchange markets are the extreme liquidity and the trading volume of this kind of market. It also interests
the investors that the large and number of traders and their variety in the market can give a broader scope. The geographical dispersion of such market gives a broad arena where business can be done. No other market has such long period of trading hours as this Foreign Exchange market. Except for the weekends the market is open for 24 hours. The use of leverage and the factors affecting exchange rates attracts the investors in it. The most important characteristics of it is the low margins of profit compared with other markets of fixed income and the profit may be higher due to the larger trading volumes.
This essay aims to find out the benefits and risk in investing in foreign exchanges and also the patterns of its returns. This will provide a better outlook for the future investors to ponder upon much on the existential differences before investing in Foreign Exchanges in different nations.
Mechanisms of Foreign Exchange
Markets are the places where goods are traded, and the same applies with the foreign exchange market. In such type of market the ‘goods’ are the currencies of various countries (as well as gold and silver). For example, one may buy euro with US dollar, or one may sell Japanese Yen for Canadian dollars. It’s as basic as trading one currency for another.
Of course there are provisions that one don’t have to buy or sell actual, physical currency: one just trade and work with one’s own base currency, and deal with the currency pair he wishes to.
The investor’s goal in foreign exchange trading is to profit from foreign currency movements.
And it can be seen that more than 95% of all foreign exchange trading performed today is for speculative objectives ( e.g. to profit from currency movements). The rest belongs to hedging (managing business exposures to various currencies) and other activities. (A quick guide to trading forex 2006)
Overview of the Exchange market
Recently all the major economic changes have shifted the focus on the behavioral features in the foreign exchange markets. One typical example is the fluctuation of exchange rates. A large fluctuation (a rate bubble) is said to be mainly caused by bandwagon expectations (Yukihiro & Naomichi 2006)). This fact shows that an exchange market has some features of multi agent systems.
These multi agent features are related to the micro-macro problem in economics. Because agents in economic systems interact with each other, there are complex relations between the micro behavior of agents and the macro behavior of whole systems. In complex economic systems, agents should be adaptive to the change of whole systems: they must always change their own mental models of economic systems in order to improve their prediction. (Izumi & Ueda 2002)
Foreign Exchange market is the largest financial market in the world. The majority of the traders in this market are large, professional, institutional investors and their tests of the weak form of market efficiency in this market are often rejected. And in such a market which is weak form efficient, traders should not be able to generate significant excess returns by trading purely on the basis of the past , publicly available information. (Charlebois & Sapp 2007)
The study of the existing foreign exchange market is extremely important in order to invest in it and seek profit thereafter.
Effect of Investment in International Commerce
There is a substantial impact of the investments overseas upon the International Commerce. After simplifying by disregarding the innumerable transactions of individuals and viewing only the relationships of the nations as a whole, the upshot of foreign investments upon international commerce becomes quite clear: the purchase of foreign bills of exchange, by individuals within the country enables a nation to export more than she imports. But the actual process of the exchange market, by means of which myriads of unrelated transactions work out this national result, remains to be explained.
The rate at which one currency is exchanged for another depends not only on economic variables prevailing in both countries but also on the exchange rate policies in those countries including non transparent interventions by the authorities in both countries. Typically, a large country will not intervene in the currency exchange with a small one (e.g. the ILS/USD market). Thus, in a small open economy the exchange rate will depend on the policy in that country in addition to the economic variables that determine the demand and supply of the currency. (Brenner & Schreiber 2006)
Let us see what happens when one invest in the foreign exchanges. It is known that the banker must recover his money immediately by selling a demand draft of equal value in order to buy a commercial long bill without making an advance of funds. His ability to sell the demand draft the proof that some individual in his market is compelled to make a transmittal in a foreign country, an obligation which come as the result of the proof of payment from overseas of a valuable consideration- either goods or services imported, or a release from a previous debt, or a property right in the wealth of a foreign people, something else. The banker’s purchase price for the commercial long bill represents an exporter’s receipt for something of value exported; the banker’s sale price for the demand draft represents an importer’s payment for something of value imported; any discrepancy between these two amounts is the banker’s remuneration for his services as a middleman. If the two commercial transactions in which the long bill and the demand draft are employed be brought together in a single account, it will appear that the nation has both given up and received things of equivalent value, although each business man carries on his transaction with a view solely to his own profit and with no thought as to the effect upon the nation’s trade as a whole. The whole trade of the nation must be taken into account when tracing out the effects of these investments, but when this view is taken, the fact is clear that foreign investments enable the nation to finance an excess of exports.
Although an excess of exports can be financed through the purchase of foreign long bills for investment, this type of investment is so short-lived that it can afford only temporary relief to the exchange market.
The relationship between overseas investments and the currents of international commerce may be drawn from the trade history of the United States. As a young country, possessed of emergent resources, the United States was a borrowing nation, importing goods and services in excess of exports and offsetting the fault-finding balance of trade by selling in foreign markets the stocks and bonds of her industries and governments. The sale of these securities creates foreign credits in favor of American banks against which bills were drawn in payment of the excess of imports. Succeeding this stage, and as a consequence of it, the United States was placed in the position of a debtor nation whose compulsion to make payments of interest and principal exceeded her annual borrowings from abroad, leaving a net disbursement to be discharged by means of an excess of exports. The American bankers who made these payments on behalf of the debtors within the country employed foreign bills of exchange for this purpose, thus affording an outlet for the bills of exporters. These two periods covered the history of the United States from its origin as an independent nation down to the outbreak of the Great War.
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Foreign Exchange and recent developments
In the 2008 some of the weeks proved to be the most tumultuous for the equity markets in the last few decades. Specially the fears about the U.S housing market, banking write-downs, and slumping consumer confidence has dominated the headlines, and become the reason to perturb the investors.
But still all these developments are the kind of opportunities to gauge the benefits of investing in foreign exchange markets which is becoming an increasingly popular asset class for retail investors. And its simply cause of the like commodities and private equity funds. Foreign exchange is proven to have low correlation with bond or equity market returns. Between 1980 and 2006 foreign exchange had a five per cent correlation with equities and a minus 21 per cent correlation with bonds. Equities and bonds, meanwhile, had a 26 per cent correlation rate over this period, which demonstrates how foreign exchange can be a useful tool in assisting to diversify an investment portfolio – particularly when times on the equity or bond markets get tough. (Waters 2008).
Until 10 years ago, investing in foreign exchange was exclusive to an elite group of hedge funds, investment banks and other multinational corporations. And these functionaries safeguarded their territory quite sternly and there is no matter of surprise in it. Between 1990 and 2006, Foreign exchange investments returned 9 per cent a year, more than either bonds or equities over the same period.
Foreign exchange trading increased by 38% between April 2005 and April 2006 and has more than doubled since 2001. This is largely due to the growing importance of foreign exchange as an asset class and an increase in fund management assets, particularly of hedge funds and pension funds. The diverse selection of execution venues such as internet trading platforms
offered by companies such as First Prudential Markets and Saxo Bank have made it easier for retail traders to trade in the foreign exchange market. (International Financial Services 2007)
The ten most active traders account for almost 73% of trading volume, according to The Wall Street Journal Europe, (2/9/06 p. 20). These large international banks continually provide the market with both bid (buy) and ask (sell) prices. The bid/ask spread is the difference between the price at which a bank or market maker will sell (“ask”, or “offer”) and the price at which a market-maker will buy (“bid”) from a wholesale customer. (Foreign Exchange, Wikipedia n.d.)
Top 10 currency traders
% of overall volume, May 2008
Rank
Name
Volume
1
Deutsche Bank
21.70%
2
UBS AG
15.80%
3
Barclays Capital
9.12%
4
Citi
7.49%
5
Royal Bank of Scotland
7.30%
6
JPMorgan
4.19%
7
HSBC
4.10%
8
Lehman Brothers
3.58%
9
Goldman Sachs
3.47%
10
Morgan Stanley
2.86%
Source: Euro money Foreign Exchange survey Foreign Exchange Poll 2008: The Euro money FX survey is the largest global poll of foreign exchange service providers)
Components of Foreign Exchange Deal
A foreign exchange deal is a contract agreed upon between the trader and the market maker i.e. the trading platform. The contract is comprised of the following components:
The currency pairs (which currency to buy which currency to sell)
The principal amount ( or ‘face’ or ‘nominal”: the amount of currency involved in the deal)
The rate (the agreed exchange rate between the two currencies.)
The provided time frame is also a factor in some deals. However deals can be renewed and renegotiated to the next day for a limited period of time.
So the foreign exchange, in this context is therefore always an obligation to buy and sell a specified amount of a particular pair of currencies at a pre-determined exchange rate.
Foreign exchange trading is always done in currency pairs. The methodology of investing in the foreign exchange is when one expects that he is buying to increase in value relative to the currency he is selling. If the currency he is buying does increase in value, he must sell back that currency in order to lock in the profit.
It is always thought that % of the foreign exchange market is speculative. In other words the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. (A quick guide to Forex 2006)
Why to Invest in Foreign Exchange
In the past investing in Foreign Exchange was not an easy job. With minimum trades as high as $1 million, myriad complex legal documentation and extensive credit checks required before a bank would even consider trading foreign exchange with somebody, it was only a realistic investment option for the very wealthy, and the very patient!
But since the past 10 years the things have changed drastically and for the benefits of the individuals who dream to invest and earn money. And thanks goes to revolutionary growth of the Internet, which has led to the development of sophisticated online trading systems such as Deutsche Bank’s dbFX – giving ordinary investors the opportunity to set up an online account and start trading almost instantaneously. Nor does one need large amounts of capital to get involved; it is possible to set up an account and start trading with an initial investment of $5000.
i) Flexible time frame
Foreign Exchange trading day starts in Wellington, New Zealand followed by Sydney, Australia, Hong Kong and Singapore. Three hours later trading day begins in Dubai (UAE) and other Middle Eastern countries. In couple of hours they are followed by Frankfurt, Zurich, Paris, Rome… London is the last one to open in Europe and five hours later it is followed by New York, Chicago and finally the West Coast. The busiest hours are early European mornings because at that time major Asian exchanges are still open and European afternoons because at that time major US markets are open at the same time as Europe.
Therefore, wherever someone lives and whatever his work hours are one can always find some time to participate in foreign exchange trading as opposed to stock market where they are usually limited to the regular business hours. ( Forex trading strategy 2005)
ii) Leverage
Another vital and very important characteristic of foreign exchange market that transforms it as an brilliant trading instrument is the use of leverage. Many novice traders don’t entirely understand the concept of leverage.
Basically, if one has a start up capital of $5000 and if he trades on a 1:50 margin, he can easily and successfully control a capital of $ 25000. However a two percent move against him can be fatal. So if one is a beginner he should not use more than 1:20 margin until he gets comfortable and profitable and then and only then one can attempt to use higher margins. Now exactly, what 1:20 in foreign exchange means? It means that with $5000 one has the control on a capital of $100,000. If one trades EUR/USD, then it means he is betting that USD will depreciate against Euro. For example if the current EUR/USD rate is 1.305. And somebody has the trading capital of $5000; it means with 1:20 leverage he practically can be exchanging $ 100,000 to Euros. If the current rate is 1.305 he would receive 100,000/1.305 = 76,628 Euros.
If the trade goes favorably and if the margin works then 1% decline in USD would mean 20% increase in the start up capital. So if the EUR/USD rate moves from 1.305 to 1.318 a trader can exchange that 76,628 Euros back to $101,000 for a profit of $1,000. So the equation would be then that as the start up capital was $5000, there would be 20% augmentation in that traders account. But if the luck does not favor the opposite can happen and one can incur loss of the same amount.
Other important property of the foreign exchange market is that trends in such market last longer and they are precisely defined than any other trading instrument.
iii) Liquidity
The foreign Exchange market is so large these days and it’s constantly growing. So it is extremely liquid. This means that with a click of a mouse one can straight away buy and sell at will. One is never ‘stuck’ in a trade. You can even set the online trading platform to automatically close your position at your desired profit level (limit order), and/or close a trade if a trade is going against you (stop order).
iv) Free demo accounts, news, charts and analysis:
Most Online foreign exchange firms offer free ‘Demo’ accounts to practice trading, along with breaking foreign exchange news and charting services. These are very valuable resources for traders who would like to hone their trading skills with ‘virtual’ money before opening a live trading account.
v) Profit in both ‘rising’ and ‘falling’ market
As compared to the stock market where one can only make money if shares rise and in the modern days of economic recession and falling ‘bear’ markets there is little scope of making big money, things are quite different with foreign exchange market. One of the most exciting advantages of foreign exchange trading is the ability to generate profits whether a currency pair is ‘up’ or ‘down’. A trader can profit by taking a ‘long’ position, (buying the currency pair at one price and selling it later at a higher price), or a ‘short’ position, (selling the currency pair and buying it back at a lower price). For example, if one thinks the US dollar will increase in value vs. the Japanese Yen then he would buy Dollars and sell Yen(long position). If he thinks the Yen will increase in value against the Dollar then he would sell Dollars and buy yen (short position). As long as the trader picks the right direction, a potential for profit always exists.
Risks in Investing in Foreign Exchanges
i) Portfolio risk
The political climate of any country creates portfolio risk because government and political system are always in an unrest situation. And this typically has a direct impact on the economic and business sectors.
Political risk is considered a type of systematic risk associated with specific countries, which can be diversified away by investing in a broad range of countries, effectively accomplished with broad-based foreign mutual funds and exchange traded funds. (Balzarotti, Falkenheim & Powell 2002)
ii) Taxation
Foreign taxation is always a matter of concern for the investors. Just as foreign investors with US securities are subject to U.S government taxes, foreign investors are also taxed on foreign based securities. Taxes on foreign investments are characteristically suspended at the host country before an investor can become conscious of any gains. Profits are then taxed again when the investors send back the funds. (Kumhof 2003)
iii) Currency Risk
And lastly the fear of currency risk always linger. Fluctuations in the value of currencies is a natural phenomena and it can directly impact foreign investments and these risk specially hover more on the investments in non-U.S assets. For example someone’s foreign investment portfolio generated a 12% rate of return last year, but his home currency lost 10% of its value. In this case, his net return would reduce when he would convert his profits into US dollars. (Hicks 2000, p.79)
And in spite of this fear in investing in foreign exchanges, any investor can reduce the risk of loss from fluctuations in exchange rates by hedging currency futures.
It is simply that, hedging involves taking on one risk to offset another. Investors expecting to receive cash flows denominated in a foreign country on some future date can lock in the current exchange rate by entering into offsetting currency future positions. However, margined currency trading is an extremely risky form of investment and is only suitable for individuals and institutions capable of handling the potential losses it entails. (Pareto 2008)
What Investors should keep in mind
Investors must have to be careful before investing in the foreign exchanges. They must possess adequate information on the macro economic situations in that country exchange where they are investing. An investor must find time first to glean technical information like interest rates, equity funds and mode of international trade in that particular country.
He must have to be well aware about the market strategies which can have a major impact on the returns of his investments. The main three components of currency trades are- the carry, momentum, and value trade. Momentum tracks the direction of currency markets; the carry strategy sees investors selling currencies with low interest rates and buying those with high rates; and the valuation strategy takes a position based on the investor’s view of a currency’s value. However the market strategies can be individuals own approach which suits investor own way of gaining profit. (Waters 2008)
There are may be more than hundred currency pair in the market but a trader remain focused on the right one for his own benefit. The main aspect a trader must consider is the liquidity, transaction costs and the volatility of the currency pair. (Harris 2007, p.396)
One will have to understand that one can’t win every time. So before investing one must have a long term strategy to counter the future risks. So patience is a great virtue especially when someone is investing in the foreign exchanges.
Conclusion
From whatever is written above it is clear that world has already entered in a new era of international capital movements. The movement of capital flow has also adapted a new way which can be beneficial for the individual and for the country both. ( Kim 2003, p.528)
To maximize the profit and to minimize the lose and also for the collective development of the host nation there must be precise rules and guidance for the cash flow statement. The main aim should be the overall development through all these process. (Cheung & Menzie 2001)
There are undoubtedly years of experiment in finding new combinations of the international investment process and new means of transmitting skills and knowledge across national boundaries in varied terms (Clark & Ghosh 2004).
From a private investor’s viewpoint, the improvement of investment, more fiscal incentives (Bollen et. Al 2000), and the removal of foreign exchange obstacles would do much to help.
Because foreign markets lack direct correlation, investing outside can be an effective way to diversify one’s portfolio. However, investing abroad can also expose to risks associated with exchange rates, political or economic instability, and differences in reporting and tax regulations. Still, in understanding these risks in relation to the potential rewards, investors have the opportunity to access foreign markets through various instruments. (McClure 2008)
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