Many people think that investing in foreign currency sounds like an exotic yet risky venture. The foreign exchange (or "Forex") market is largely dominated by banks and institutional investors. Online brokerages and readily available margin-trading accounts have made forex trading accessible to everyone.
You can benefit from understanding the benefits, risks, and most effective ways to invest in foreign currency.
Benefits and Risks of Investing in Foreign Currency
There are many factors to consider before deciding to invest in foreign currency. It's the largest and most liquid market in the world, so you should know the many risks that set it apart from normal equity and bond markets. Notably, the high leverage (high debt level) used when investing in foreign currency can result in high volatility (price changes) and greater risk of loss.
The key benefits of investing in foreign currency include:
- A large and liquid market: The foreign exchange market averages daily trading volume in excess of $6 trillion.
- Diversification: The foreign exchange market offers investors a way to diversify away from the potential risks of trading currencies through exchange-traded funds.
- Trading hours: The foreign exchange market operates 24 hours a day, five days a week, which offers more trading time than most traditional equity, bond, or futures markets.
- Potentially low costs: Most foreign exchange trading doesn't involve paying a commission, but the bid-ask spread tends to be tighter than with equities.
The key risks of investing in foreign currency include:
- High leverage: The foreign exchange market moves in very small increments, which makes high leverage (through the use of margins) a necessity. The incremental movements also create risk for investors.
- High volatility: The foreign exchange market has notoriously high levels of volatility due to economic reports, central bank interventions, and other factors.
You should carefully consider risk-management techniques to help mitigate these risks and improve long-term returns. In addition, you need lots of capital on hand to avoid the risks of using debt to trade directly on foreign capital.
Investing Indirectly With ETFs
Exchange-traded funds (ETFs) are one of the easiest ways for non-currency experts to invest in foreign currency. These funds purchase and manage a portfolio of currencies on behalf of investors using tools like swaps and futures contracts.
You benefit from ETFs because they do not have as much leverage-related risk. You can also purchase them through a traditional stockbroker rather than a foreign exchange broker.
CurrencyShares and WisdomTree represent the two largest providers of ETFs designed to help you invest in foreign currency. Meanwhile, companies like ProShares offer ways to make leveraged bets for and against a number of popular currencies. You should carefully read an ETF's prospectus before investing, to understand any fees and other important information.
Common long (buy to hold and sell later) ETFs that invest in foreign currencies include:
- CurrencyShares Canadian Dollar Trust (FXC)
- CurrencyShares Swiss Franc Trust (FXF)
- CurrencyShares Australian Dollar Trust (FXA)
- WisdomTree Dreyfus Emerging Currency Fund (CEW)
- WisdomTree Dreyfus Chinese Yuan Strategy Fund (CYB)
You can sell a security you own, or borrow one to sell and buy it back at a lower price (called a "short"). Some short ETFs to bet against foreign currency are:
- ProShares UltraShort Euro (EUO)
- ProShares UltraShort Yen (YCS)
Investing in Foreign Currency Directly
You can directly buy and sell individual currencies on margin (borrowed money) through a foreign exchange brokerage. With an initial deposit as low as $50, investors can buy currencies with margin levels of 50 to 1. Keep in mind that greater leverage obtained by using margin also translates to increased volatility and a risk of a larger loss.
Take the time to review and select a high-quality forex broker. The forex market does not enjoy regulations as stringent as those of the U.S. equity markets. Make sure you avoid foreign brokers that are not regulated by international authorities.
You may want to use currency hedges (risk-mitigation strategies) to protect against losses from currency movements. For example, if you see opportunities in Europe, you may want to hedge against losses in the euro relative to the U.S. dollar, which could erase any gains. The downside is that currency hedging removes some of the benefits of diversification.
Popular currency-hedged funds include:
- WisdomTree Europe Hedged Equity Fund (HEDJ)
- WisdomTree Japan Hedged Equity Fund (DXJ)
- iShares Currency Hedged MSCI EAFE ETF (HEFA)
The Bottom Line
If you're looking for an easy method to invest in foreign currency, you might consider ETFs. These funds are simple to trade with traditional stock brokers and have fewer leverage-related risks.
You can also get more direct exposure to foreign currency by opening a foreign exchange brokerage account and purchasing the currencies directly using margin. Each approach has its own risks and rewards, and you should look carefully at these factors before making investing decisions.
Frequently Asked Questions (FAQs)
Will banks exchange foreign currency for me?
Banks may exchange foreign currency for you, but unless it is a bank that also offers foreign exchange trading accounts, it is unlikely to offer leverage. In other words, you can exchange cash for foreign currency at a bank, but you probably won't be able to invest with the price control and leverage needed to profit as a trader or investor.
What is a foreign exchange rate?
The exchange rate is the price you could get in one currency for another. If one British pound (GBP) can buy you $1.35 worth of U.S. dollars, then the exchange rate is 1.35. These exchange rates typically include the spread and any other fees the exchange will charge for the conversion. Traders sometimes refer to these as "pairs" rather than "rates," so they might instead say, "The GBP/USD pairing is 1.35."