In 1971, President Richard Nixon took the US off the gold standard and the era of floating exchange rates was born. Since then, the foreign exchange market also known as the forex market has become the single largest financial market in the world. Today, it is the most liquid market in the world with an average daily trading volume exceeding US$5 tril.

What are Forex Markets?

Foreign currency exchange rates are what it costs to exchange one country’s currency for another country’s currency. If you go to England on vacation, you will have to pay your expenses in British pounds (while having to sell some of your ringgit to buy the British pound).

The forex market is an international over-the-counter market (OTC). This means that it is a decentralised, self-regulated market with no central exchange or clearing house, unlike stocks and futures markets.

The main players in the forex market with varying needs and interests are governments and central banks, financial institutions, corporations, investors and traders.

Traditional investors only have indirect forex exposure through assets denominated in currencies other than their own. However, over the years, sophisticated people have increasingly taken a closer look at the forex market as a potential source of compelling investment opportunities.

In the forex market, there is always a winner on the other side of a loser’s trade. Forex prices are influenced by a multitude of different factors – from international trade or investment flows to economic or political conditions.

Speculators try to take advantage of even small fluctuations in exchange rates. One of the most famous currency speculators, George Soros, illustrated his forex prowess in speculating on the decline of the British pound, a move that earned him over £1 bil in 1992.

Forex is a leveraged (margined) product, which means that you are only required to deposit a small percentage of the full value of your position to place a forex trade. This means that the potential for profit (or loss) from an initial capital outlay is significantly higher than in traditional trading.

Forex markets are open on a daily basis 24 hours a day. Trading follows the clock, opening on Monday morning in Wellington (New Zealand) and progressing to Asian trade spearheaded out of Tokyo and Singapore, before moving to London and closing on Friday evening in New York. Traders can take a position whenever they want regardless of the time factor.

Beware of Forex Ponzi Schemes

Real trading is not something that greedy housewives, retirees or street hawkers can do part-time. It is not for someone who believes he or she can do easily as advertised by clever sales people in the Internet or at most seminars in town.

Yeah, you have probably been told it is a land of easy money, secrets of 100% accuracy or earn a regular income every hour. The reality is much tougher. It is a long learning curve covering areas such as money management techniques, research abilities and level of discipline.

Real trading in forex is like watching a school of fish move. One minute is total harmony, the next, complete chaos. The forex market can be very volatile. Sentiment, and thus money flows, can change rapidly.

Understanding Risk

I have always emphasised on the importance of investment diversification in the offshore context for medium to long-term investors. The potential forex risk should not be overlooked.

Most serious investors are usually concerned about whether the local currency of the invested foreign assets will appreciate or depreciate against the home currency.

If the local currency appreciates against the domestic currency, then investors will have additional return to the returns earned from the foreign assets. If the vice versa happens, then loss from the forex will reduce the returns earned, making net returns lesser than should the investment had been transacted purely in the domestic currency.

Once the potential forex risk is identified, investors need to consider whether to hedge or not to hedge. In portfolio management to tackle forex volatility, a fund manager may choose the right hedging instruments such as currency futures to help manage the forex risk.

Although the actual forex rate will continue to fluctuate, the forex rate has been locked over the life of the contract. If volatility resulted from forex market can be reduced significantly, the benefits derived from offshore diversification would become more apparent and manageable.

Greenback vs Yuan

As I run around the country, I hear an all too familiar cry. America has lots of economic problems and the country is doomed. The US dollar is going to collapse and will be replaced by the Chinese yuan.

I say nonsense to all these. For serious investors, an exposure to US dollar is necessary. While the gloom and doomers spend so much time absorbing conspiracy theories from the Internet and bashing the greenback, I have always been a US dollar bull over the years.

Well, who needs that free US dollar collapse guide with the rest of the world in troubles, too? What else are you going to use to survive? Bitcoin? Canned goods? The next time someone tells you that the US dollar is history and you should dump it, consider that person a great Short

by Y.H. Wong