The foreign exchange market, also known as forex, facilitates the purchase and sale of currency around the world. Like stocks, the ultimate goal of forex is to make a net profit by buying low and selling high. Forex traders have the advantage of choosing currency pairs, unlike stock traders who need to analyze thousands of companies and sectors. In terms of trade volume, foreign exchange markets are the largest in the world. Due to the high volume of trades, foreign currency assets are classified as highly liquid assets. Most foreign exchange transactions consist of spot transactions, forwards, currency swaps and options.
Before embarking on the stock market, the trader should be aware of all the possible risks that he may face. It is unacceptable to conclude transactions without a full understanding of their consequences, but, unfortunately, practice shows that the majority of novice traders prefer to understand the features of trading on the Forex market along the way. And, as a result, they often find themselves in the big minus. Therefore, it is necessary to correlate your financial resources and experience with the goals set and the available market opportunities in order to work with profit.
This primarily concerns traders trading on the foreign exchange market. Almost all transactions are carried out using leverage, but at the same time a trader may lose his pledge and additional assets that were deposited to maintain the position. If the level of the deposit made as a pledge increases and there is not enough margin on the trader’s account, a request is sent to which the position should be maintained. If the trader does not do it in a certain time, his position is closed with a loss.
Placing orders to limit the risk within the specified amounts does not always give the expected result, since in some cases their execution is simply impossible.
Also, the trader needs to understand what he pays commissions to the broker, because his profit depends on it. Reviews on the work of TeleTrade and other brokerage companies show that transparency in the formation of commissions, additional margins, discounts, etc. is the decisive factor that determines the desire of the trader to work on a specific platform.
In addition, it is necessary to take into account the fact that the foreign exchange market is constantly changing, and this determines the profitability of transactions. The electronic trading tools used now are quite vulnerable, and any technical failure may adversely affect the settlement of transactions. Problems with the software, interrupted Internet connection – all this may lead to the fact that the trader’s instructions are not executed, which will lead to unpredictable consequences.
The trader may also incur losses due to restrictions imposed by the bank, market, broker, so it is worthwhile to find out in advance all the nuances and details that may be relevant in this case.
Top 5 Forex Risks
Investopedia highlights the top 5 forex risks that traders must take into account:
In forex, due to the presence of leverage, a large amount of initial investment is not required in order to gain access to significant transactions in foreign currency. Small price fluctuations can lead to negative margins, when an investor needs to spend part of the money on the account. During unstable market conditions, the aggressive use of borrowed funds leads to substantial losses in excess of the initial investment.
From the basic macroeconomic rates, we know that interest rates affect the exchange rates of currencies of different countries. If interest rates in a particular country rise, its currency is strengthened by the inflow of investments in the assets of that country, because a stronger currency provides higher returns. Conversely, if interest rates fall, the currency of such a country will weaken as investors begin to withdraw their investments. Due to the nature of the interest rate and its effect on exchange rates, the difference between the value of currencies can lead to a sharp change in forex prices.
Transaction risks are currency risks associated with the temporary difference between the commencement of the contract and the time when it is paid. Forex works 24 hours a day, which can lead to changes in exchange rates at any time. Consequently, currencies can be sold at different prices at different times during trading hours. The greater the time difference between the conclusion of the contract and its payment, the higher the risk of the transaction. Any temporary differences allow currency risks to appear, and individuals and corporations involved in currency trading face increased, and possibly burdensome, transaction costs.
A counterparty in a financial transaction is a company that provides an asset to an investor. Thus, the counterparty risk relates to the risk of default at the dealer or broker in a particular transaction. In foreign exchange trading, spot and forward contracts for exchange rates are not guaranteed on the stock exchange or intermediaries. In spot currency trading, the counterparty risk comes from the market maker’s solvency. During unstable market conditions, the counterparty may be unable to fulfill or refuses to adhere to the contract.
When weighing the possibility to invest money in a currency, it is necessary to evaluate the structure and stability of their issuing country. In many developing countries and in third world countries, exchange rates are fixed to a world leader, such as the US dollar. Under these conditions, central banks must maintain sufficient reserves to maintain a fixed exchange rate. The currency crisis may occur due to a large balance of payments deficit and lead to a devaluation of the national currency. This can have a significant effect on forex and pricing.
Due to the speculative nature of investment, if the investor believes that the currency will decline in value, he can begin to withdraw his assets, stimulating further currency depreciation. Those investors who continue to trade currency may face the fact that their assets will become illiquid, or face problems at dealers. As for foreign exchange trading, currency crises exacerbate the danger of liquidity and credit risks in the direction of reducing the attractiveness of a country’s currency. This was especially true during the Asian financial crisis and the crisis in Argentina, when the economy of the host countries eventually collapsed.
Given the long list of risks, losses associated with foreign exchange trading may be greater than originally expected. Due to the nature of trades and the share of borrowed funds, a small down payment can lead to significant losses and illiquid assets. Moreover, differences in time and political problems can have far-reaching consequences for financial markets and national currencies. While foreign exchange assets have the highest trading volume, the risks are obvious and can lead to serious losses.