There are a myriad of reasons to trade forex; from the market’s daily volumes and liquidity to the opportunity to speculate and profit from continual price movements without assuming ownership of the underlying instrument.
While the forex market may also be more accessible than ever before, however, becoming a successful currency trader is far easier said than done. Certainly, the market is littered with real and tangible risks, which can cause losses that are disproportionate to your initial deposit or capital holdings.
In this beginner’s guide, we’ll appraise the common forex risks while asking why you need to understand them.
1. The Exchange Rate Risk
We’ll start with the exchange rate risk; which as the name suggests is caused by sudden and occasionally seismic changes in the value of currency.
This affects the relevant pairings significantly, potentially triggering the type of margin based losses that can weigh heavily on your capital holdings.
Such movements are underpinned by the innate volatility of the forex market, along with wider macroeconomic factors (such as changes in interest rates and monetary policy) and simple supply and demand fluctuations. As a result, this risk is substantial and hard to quantify, so you’ll need to factor it into your wider trading strategy.
You can also use so-called “stop losses” to manage this risk, with this feature automatically closing positions once they’ve incurred a predetermined level of loss. This enables you to minimise losses in real-time without compromising on returns, with this representing something of a Holy Grail for investors.
2. The Interest Rate Risk
This risk refers to the profit and loss generated by fluctuation in the forward spreads, alongside any forward amount mismatches and the maturity gaps that can distort individual transactions.
This risk is particularly pertinent to currency swaps, futures and options, while it’s based on the premise that a fall in a country’s base interest rate (which formed part of a strategy to combat the socio-economic impact of coronavirus in 2020) undermines the value of currency and reduces capital inflows.
To minimise this risk, you’ll need to set limits on the total size of mismatches, by initially separating these on the basis of their maturity dates.
We’d also recommend that you constantly analyse the wider interest rate news pertaining to target currencies, in a bid to forecast any changes that may impact on your portfolio in the near-term.
3. The Credit Risk
Finally, we come to credit risk, which refers to the possibility that an outstanding currency position may not be repaid within a predetermined time-frame.
This may occur as a result of a voluntary or involuntary action that may be taken by a counterparty when forex trading online. While credit risk can be more of a concern for banks and institutional traders, it can also impact retail investors in the market and therefore needs to be given careful consideration.
To negate the present (albeit minimal) credit risk facing individual traders, it’s important to conduct a comprehensive check of participating brokers and banks before sending any funds for trading.
You can do this by checking the Financial Conduct Authority (FCA) website, while also looking for the same accreditation on each company’s and broker’s website.