Investing in foreign currency sounds like an exotic and risky venture. In fact, the foreign exchange (or "forex") market used to be largely dominated by banks and institutional investors. But now, online brokerages have changed all of that by enabling investors to make trades with the click of a mouse. In this article, we'll take a look at the benefits, risks and most effective ways to invest in foreign currency.
Benefits and Risks of Investing in Foreign Currency
There are 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, investors should be cognizant of the many risks that set it apart from traditional equity markets. Notably, the high leverage used when investing in foreign currency can result in high volatility greater risk of loss.
The key benefits of investing in foreign currency include:
- Large & Liquid Market. The foreign exchange market is the largest and most liquid market in the world with average daily volume in excess of US$4 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.
The key risks of investing in foreign currency include:
- High Leverage. The foreign exchange market moves in very small increments, which makes high leverage (via margin) a necessity and risk for those directly investing.
- High Volatility. The foreign exchange market is known for 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.
Easily Invest in Foreign Currency with ETFs
Exchange-traded funds (ETFs) represent one of the easiest ways to invest in foreign currency. These funds purchase and manage a portfolio of currencies on behalf of investors. The benefits are that investors do not have as much leverage-related risk and the purchase itself can usually be done through a traditional stock broker rather than a foreign exchange broker.
CurrencyShares and WisdomTree are the two largest providers of ETFs designed to help people invest in foreign currency. Meanwhile, some 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 quantify any fees charged and learn about other important information.
Common long ETFs to invest in foreign currency 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:
How to Invest in Foreign Currency Directly
Investors can also 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 purchase currency with margin levels that range from 50:1 to more than 10,000:1. Of course, greater leverage obtained through margin also translates to increased volatility and risk of loss.
Here are a few resources to get started:
Investors looking for an easy way to invest in foreign currency should consider ETFs. These funds are easier 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.