How to Invest in Foreign Currency
Investing in Foreign Currency Without Leaving Home
Many people think that investing in foreign currency sounds like an exotic, yet risky venture. The foreign exchange, or forex market used to be largely dominated by banks and institutional investors, but online brokerages and readily-available margin trading accounts have made forex trading accessible to everyone. Individual investors can benefit from understanding the benefits, risks, and most effective ways to invest in foreign currency.
Benefits and Risks of Investing in Foreign Currency
As an investor, you have many benefits and risks to consider before deciding to invest in foreign currency.
While it's the largest and most liquid market in the world, you should be cognizant of the many risks that set it apart from traditional equity and bond markets. Notably, the high leverage used when investing in foreign currency can result in high volatility and greater risk of loss.
The key benefits of investing in foreign currency include:
- A large and liquid market. The foreign exchange market is the largest and most liquid market in the world, with an average daily volume in excess of $5 trillion.
- Diversification. The foreign exchange market offers investors a way to diversify away from potential risks associated with the U.S. dollar as an asset class.
- 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 rather, a bid/ask spread that tends to be tighter than 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 margin, a necessity, and risk for those investing directly.
- High volatility. The foreign exchange market has notoriously high levels of volatility due to economic reports, central bank interventions, and other factors.
Investors should carefully consider risk-management techniques to help mitigate these risks and improve their long-term returns. In addition, investors need to keep ample capital on hand to avoid risks from using leverage when trading directly on foreign exchanges.
Investing Indirectly With ETFs
Exchange-traded funds (ETFs) represent 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.
Investors benefit because they do not have as much leverage-related risk, and the purchase itself can usually take place through a traditional stockbroker rather than a foreign exchange broker.
CurrencyShares and WisdomTree represent the two largest providers of ETFs designed to help people invest in foreign currency. Meanwhile, companies like ProShares offer ways to make leveraged bets for and against a number of popular currencies. Investors should carefully read the ETFs' prospectus before investing in order to understand any fees charged and learn other important information.
Common long ETFs that invest in foreign currencies include:
- CurrencyShares Canadian Dollar Trust (NYSE: FXC).
- CurrencyShares Swiss Franc Trust (NYSE: FXF).
- CurrencyShares Australian Dollar Trust (NYSE: FXA).
- WisdomTree Dreyfus Emerging Currency Fund (NYSE: CEW).
- WisdomTree Dreyfus Chinese Yuan Fund (NYSE: CYB).
- WisdomTree Dreyfus Brazilian Real Fund (NYSE: BZF).
Common short ETFs to bet against foreign currency include:
- ProShares UltraShort Euro (NYSE: EUO).
- ProShares UltraShort Yen (NYSE: YCS).
Investing in Foreign Currency Directly
You can directly buy and sell individual currencies on margin through a foreign exchange brokerage. With an initial deposit as low as $300 to $500, investors can buy currencies with margin levels ranging from 50:1 to more than 10,000:1. Keep in mind though, greater leverage obtained by using margin also translates to increased volatility and risk of larger losses.
Take the time to review and select a high-quality forex broker since the forex market does not enjoy as stringent regulations as those of the U.S. equity markets. In particular, avoid foreign brokers that may not be regulated by international authorities.
As an investor, you may want to use currency hedges to protect against losses stemming 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.
The most popular currency-hedged funds include:
- WisdomTree Europe Hedged Equity Fund (NYSE: HEDJ).
- WisdomTree Japan Hedged Equity Fund (NYSE: DXJ).
- iShares Currency Hedged MSCI EAFE ETF (NYSE: HEFA).
The Bottom Line
Investors looking for an easy way to invest in foreign currency should consider ETFs. These funds are easy to trade with traditional stock brokers and have fewer leverage-related risks. However, those seeking more direct exposure to foreign currency can also open a foreign exchange brokerage account and purchase the currencies directly using margin. Each approach has its own risks and rewards, and investors should look carefully at these factors before making their investing decisions.