Foreign exchange is an asset class that most people are very familiar with—at least in Europe and Asia. But while vacationers are used to changing money before they go abroad, retail investors have only come to view FX as an investable asset class in the last 10 years.
The popularity of the biggest and most liquid asset class in the world is growing rapidly, and for once Europe and Asia are catching on more quickly than in the U.S., owing to their greater familiarity with changing money.
The beauty of FX, according to Ilya Spivak, a currency strategist at Forex Capital Markets in San Francisco, is its simplicity. There are fewer variables to consider than in other classes, for example equities, where thorough due diligence requires that investors pore over accounts and annual reports. In FX there is really only one consideration, he said, it's this: What direction are interest rates moving?
Another way of analyzing the market is to consider three independent but connected factors, each of which influences markets—and each other—to different extents and at different times.
Central bank policy, volatility and economic growth are the key drivers of currency movements, said Adam Myers, senior currency strategist at Credit Agricole in London.
A trader’s view of currency moves will reflect a view of which factor is most important at any one time. Currencies with high growth and interest rates and low volatility and inflation are likely to rise.
“An investor looking to trade FX first has to pick a broker, and making the right decision is as important as which currencies you decide to trade,” said Spivak. Trading FX is usually done over the counter, so it is vital that you trade with a reputable counterparty, and there are many firms to choose from.
One choice is whether to use an agency broker or a dealing desk broker. Agency brokers aggregate the liquidity from all the banks and plug traders into it, taking no position themselves and making their money by charging a small commission on each trade.
Dealing desk brokers, by contrast, act as the counterparty to trades themselves, creating a potential conflict of interest that investors should be aware of: If the trader makes money, the bank loses. Fees or other incentives the bank charges can reflect the bank’s view on the trade it's entering into.
Traders should also be aware that the costs charged by any broker can be very high in FX compared to those charged on equity or bond trades. They should shop around for the best rates.
Once a broker has been selected, all that is left is to decide which currencies to trade. They are always traded in pairs: long one currency and short another. The currencies themselves can be broken down into three broad groups, said Myers: safe haven currencies, for example the U.S. dollar and the Swiss franc; growth currencies, which often represent commodity-linked economies, such as the Australian dollar and New Zealand dollar, as well as many emerging markets currencies; and middle ground currencies, such as the pound sterling and the euro.
In reality things are not so black and white, and currencies occupy the gray area between these categories. The yen, for example, falls between safe haven and middle ground, while the Canadian dollar is between the middle ground and the growth end of the spectrum, Myers added.
The most popular trades pair currencies in different baskets off against each other. In times of risk aversion a trader might go short the Australian dollar and long the U.S. dollar. A bullish trader might do the opposite.
An investor putting on multiple trades needs to be aware of the correlation between currencies, and hence trades of a similar type: long U.S. dollar and short Australian dollar will have some correlation with long Swiss franc and short Australian dollar, or even long Swiss franc and short New Zealand dollar.
It is also important to consider the liquidity of a currency, which will determine the cost of the trade. Highly liquid currencies like the U.S. dollar, the euro and yen are cheaper to trade, while emerging markets currencies are more expensive.