How To Invest In Foreign Currency
If you’ve ever talked about investing in a foreign currency, odds are you’ll have heard about the Iraqi Dinar. There’s a commonly held belief that the Dinar will be revalued and that anyone who holds Dinar will suddenly see their amount changed overnight into a large sum of money. Unfortunately, the odds of this happening in exactly this manner are infinitesimally small.
That doesn’t mean that investing in foreign currencies are a wild goose chase however. There is a way investors can gain exposure to this asset class other than simply going to an exchange counter and turning your money into an equal amount of another nation’s currency. Through the Forex, investors gain global access and can freely engage in any type of currency trade, from simple spot transactions to futures contracts.
Getting to know the Forex
The Forex (FX) is the premier market for foreign currency trading, open 24 hours a day, 5 days a week, discounting holidays. It’s the largest, most liquid exchange in the world with all known currencies listed and available for trade. Once the realm of institutional investors like hedge funds and governments, currency trading is now as open to investors as the stock market.
Trading on the Forex exchange comes in one of three types of transactions – spot, forward, and futures. A spot contract is the simplest and involves buying one currency by selling another. For example, if you wanted to invest in yen, you would purchase an amount of yen you wanted in US dollars and make the trade. Transactions typically take two days to settle once a trade is executed.
A forward transaction is similar to a spot transaction but settles at a date set in the future. So investors are able to make long term speculation when it comes to foreign currencies and can make trades in any amount and settlement date so long as the date is not on a weekend or holiday.
Finally, the futures market can be used to make currency trades. These contracts are set at a particular amount and future date so investors can speculate, much like forward transactions. Mark-to-the-market accounting is used for futures contracts however, meaning that accounts are tallied and settled at the end of each business day. This makes long-term investments risky as small drops in value can eliminate positions before the settlement date arrives.
There are a number of trading strategies that come with currencies, but the most common in known as a carry trade. In order to execute a currency carry trade, investors will need two currencies with differing yields. The investor profits from the difference in interest rates, assuming the exchange rate remains constant. For example, let’s say that the yen has a 1% yield while the US dollar offers a 3% yield. They would sell yen and convert it to US dollars, resulting in a net yield gain of 2% for as long as the yields and exchange rates remain the same.
Investing directly in a foreign currency is usually not the best way to attempt to make a profit. In the global economy, currencies are considered fiat money – not backed by anything other than the faith and credit authority of the issuing government. The Forex gives investors a safer way of speculating in foreign currencies without subjecting them to the same risks involved in buying the currency directly.