The foreign exchange market is where traders buy and sell currencies from all over the world. The goal is to achieve a net profit that’s higher than the capital invested. Similar to investing in stocks, the main strategy is to buy low and sell high. But even if this market allows you to choose from only a handful of currency pairs to trade, all of which have easily accessible information, there are still many inherent risks you should keep in mind especially if you’re a newbie trader.
In the world of forex trading, you have a small initial investment, called the margin, to use leverage, which in turn grants you access to substantial trades in foreign currencies.
Small price fluctuations can lead to margin calls, where you are required to pay an additional margin. During volatile market conditions, the aggressive use of leverage will lead to substantial losses in excess of the initial investment.
As you probably already know, interest rates have an effect on countries’ exchange rates. If the country’s interest rate rises, the currency will strengthen because the stronger currency offers higher returns that attract more investors.
On the flipside, a fall in interest rates means the currency may weaken because investors will start withdrawing their investments.
Because of the nature of the interest rates and their effects on the exchange rates, the difference between the values of currencies will trigger drastic changes in forex prices.
Transaction risks refer to risks on exchange rates related to the differences between the start of a contract and its settlement.
Forex trading happens on round-the-clock basis, and this can lead to exchange rates changing before the traders have the time to settle.
As a result, currencies may be traded with different prices in different times during trading hours. A bigger time differential between entering and settling a contract increases the transaction risk.
At the same time, fluctuations caused by time differences also trigger higher transaction costs for individuals and corporations dealing in currency markets.
In any financial transaction, the counterparty is the entity that provides the asset to the investors. Thus, the counterparty risk refers to the risk of default from the dealer or broker in a particular transaction.
In the forex market, contracts on spot and forward derivatives are not guaranteed by a clearing house or an exchange.
In spot currency trading, the counterparty risk arises from the solvency of the market maker. In times of high market volatility, the counterparty may be unable or may refuse to adhere to the contract.
Before investing in currencies, you must evaluate the structure and stability of their issuing country. In many developing countries, exchange rates are often fixed to a leading currency, like the US dollar.
In that case, central banks have to maintain sufficient reserves to maintain a fixed exchange rate. Also, there could be a currency crisis if there are frequent balance of payment deficits. It could then result in the devaluation of a currency.