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Foreign Exchange Market

The global foreign exchange (forex) market has ballooned in recent decades as more and more economies liberalise their capital accounts. The Basel-based Bank for International Settlements said average daily turnover in global forex markets was an estimated US$3.98 trillion as of April 2010.

The promise and pitfalls of FX trading

PUBLISHED : Sunday, 13 February, 2011, 12:00am
UPDATED : Sunday, 13 February, 2011, 12:00am

So, here we are again with personal investors dazzled by the blinding spotlight of uncertainty. Equity investments seem to be only for the brave, the freakish spurt in the gold market may have exhausted itself alongside the even more impressive price rises in other commodities. Meanwhile back in the dreary world of bank deposits, it is hard to find an interest rate that even matches inflation yet alone yields a real profit.

No wonder attention is turning to the foreign currency market, where cautious investors can be pretty sure to preserve their capital while enjoying the prospect of making some real gains, however modest.

Governments have been struggling to keep down the value of their currencies as they strive to make their goods and services more competitive in international markets. This has resulted in a scramble to keep interest rates as low as possible but this cannot go on indefinitely; indeed there are signs of a slow emergence from the low-interest era, with China last week again moving to ratchet up the cost of borrowing. The prospect of a change in fiscal policy direction gives investors compelling reasons to pay attention.

Investors in Hong Kong have more pressing reasons than most for looking at foreign currencies because we live in a territory where the government has abrogated its control over the local currency in favour of a fixed link to the US dollar.

There is constant talk of the US currency not only losing its value in comparison with other currencies but of forfeiting its position as the world's major currency. Some views on the fate of the US dollar are both emphatic and extreme. The well known iconoclast investor Marc Faber recently said: 'I no longer regard the US dollar as a valid unit of account.' He may be wrong, but the prudent holder of Hong Kong dollars, which means US dollars, should at the very least be thinking of some diversification.

Although news about foreign exchange trading is generally confined to the back pages of the business press, the forex market is the largest financial market in the world. It is also the world's most liquid and fluid market and trades round the clock. Volumes in this market can amount to a mind-boggling US$2 trillion per day. Hong Kong is a major player in this market and is estimated to be home to the world's fifth-largest forex centre.

It is also important to recognise that this is overwhelmingly a speculative market; probably no more than a fifth of all trading is for specific corporate purposes, such as paying for liabilities in other currencies. The rest is out there moving rapidly between speculators, registering every pip, as the smallest percentage points are known in this world of forex investing. No physical exchange of currencies takes place; investors simply rely on computer records to know how much they have invested and its current worth. However, in Hong Kong, unlike many places in the world, even smaller bank branches keep stocks of major currencies and so, on the rare occasions that cash is actually required, it can be obtained with a minimum of fuss.

Forex trading also has the distinction of being a transaction without intermediaries - in other words there are no brokers or other middlemen involved. This is a trade primarily between principals. For smaller investors, this generally means buying currencies from a bank which takes its profit not as commission but from the difference between the buying and selling price of the currency.

There are no clearing houses for forex trades to regulate these exchanges and this means there is no external body to adjudicate or settle disputes. All this is done between principals. In general this is a paired investment - in other words trades are between two currencies. Investors who, for example, think the euro will rise against the US dollar are 'long' on euros and 'short' on dollars.

There are, of course, also opportunities for futures trading but this is not recommended for smaller individual investors. Some retail investors have, however, dipped their toes in this arena by establishing forex margin trading accounts which, in common with other margin trading accounts, allow investors to buy up to about 20 times their margin deposit for foreign currencies that they expect to rise in value.

This can be highly profitable when the currency appreciates in value but bankers' caution generally places a limit on this form of speculation and bank customers are usually required to specify a stop loss level to avoid spectacular losses if bets on currency appreciation go the wrong way. Even more risky and potentially profitable is the so-called carry trade, but this really is not recommended for personal investors. This involves borrowing money in a currency bearing a low interest rate and investing the proceeds in a currency carrying a higher interest rate.

A popular trade of this kind used to be between low-interest-rate Japanese yen borrowings and high- interest-rate New Zealand dollar investments. This pairing delivered both high yields from interest rates and currency appreciation gains. As long as it worked it was a fabulous investment, but once the currencies turned, as the yen finally emerged from its seemingly endless downturn, some impressive losses were recorded.

A halfway house, giving smaller investors some access to these complicated trades, are currency funds that provide exposure to foreign currency bonds and other financial instruments based on currency trading. The problem here is that most of these funds have a less than inspiring track record and, as ever, with mutual funds, they are subject to onerous management charges payable regardless of whether the fund manager is making a profit or a loss.

An alternative that is proving increasingly popular in stock markets is exchange-traded funds, or ETFs, based on currencies. Management charges are minimal, as is reliance on fund managers, because these funds merely track what is happening in the market without trying to be clever. Some ETFs are offered in groups of currencies - as, for example, in the case of PowerShares DB G10 Currency Harvest ETF, or the WisdomTree Dreyfus Emerging Currency ETF.

They provide a theme enabling investors to take a view on a group of currencies without having to commit to a single currency. Single-currency ETFs are, however, more common and offered by a number of providers including yuan ETFs, such as the WisdomTree Dreyfus Chinese Yuan ETF and countless others for more popular currencies, such as the US dollar, British pound and Australian dollar.

However, the most popular form of currency investment in Hong Kong, and one offered by all banks, is foreign-currency time deposits. The currencies most commonly offered are the Australian dollar, British pound, Canadian dollar, euro, Japanese yen, New Zealand dollar, Swiss franc and US dollars. Yuan accounts fall into a separate category as there is a daily limit of 20,000 yuan on the amount investors can convert to yuan.

As matters stand, only the Australian and New Zealand dollar offer an interest rate exceeding inflation. However, there is currency risk here, so the final return may well end up below the inflation rate.

There are other ways of boosting opportunities in these conservative currency investments. For example, some banks allow currency switching ahead of fixed-deposit maturity dates to take advantage of any opportunities that occur.

This is not quite as attractive as it sounds, because investors contemplating this kind of switching will be required to specify in advance an intended alternative currency and agree to a fixed exchange rate at the time of embarking on the fixed deposit. This limits the upside.

All this begs the big question of which currencies are likely to make for the best investments. The currency pundits are distinctly unhelpful on this crucial point because their views are so diverse and contradictory. There was, for example, a widespread view that the euro was going to be dragged down by countries like Greece and Portugal, but this has given way to a feeling that the powerhouse of Germany may be able to keep the currency strong.

Then there was a flash of concern over the Australian dollar in the wake of the flooding, but this was illogical, as a huge reconstruction programme would, if anything, tend to push interest rates up.

Here was a clear opportunity to benefit from market illogicality, reminding us that the best moments to buy are when markets become perverse, which usually happens with extreme responses to events.

The shrewd investor need do little more than sit back, watch currency movements and wait for such an opportunity to arise. The only certainty is: that moment will come.

High finance

This mind-boggling amount of money changes hands on the forex market on a daily basis, in US dollars: $2tr

Small change

Investors have a daily transfer limit on yuan of this amount per day: 20,000

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