The term forex market stands for the foreign exchange market where traders buy and sell currencies from all across the globe.
Just like the stock market, the end goal of forex traders is to make as high a profit as possible by buying currencies at low rates and selling them at high prices. Forex offers flexibility to traders due to the range of currencies to choose from, as opposed to the limited sectors and companies the stock market offers.
To make informed trading decisions, you need to familiarize yourself with the different risks associated with forex trading. Here’s what you should know:
Interest Rate Risks
Interest rate fluctuations have a significant impact on a country’s exchange rate. A rise in interest rates typically strengthens the country’s exchange rate due to an increase in investments since a stable currency yields higher returns to investors.
On the other hand, when a country’s interest rates fall, its currency depreciates an investors pull out their investments. Due to the relationship between interest rates and exchange rates, the resulting differential between different currencies can cause forex price fluctuations.
The Central Bank of every country determines the monetary policy and, hence, the interest rate. Fluctuating interest rates play an important role in various trading decisions. Experienced traders understand the importance of keeping up with interest rate changes.
Many institutions engage in carrying trades where trading is based on interest rate differentials. Usually, currency pairs with higher interest rates tend to attract the most attention.
When presented with various currency pairs, traders need to consider the stability of the issuing country. Developing and third-world countries, such as Pakistan, have their currencies pegged against a leading currency, such as the GB Pound or US Dollar. In these cases, central banks maintain reserves to keep their exchange rates stable. A currency could be in crisis due to the balance of payment deficits, thus devaluing the currency. This can have a significant effect on forex trading.
Since investing has a highly speculative nature, if investors believe a currency’s value will decrease, they’ll pull out their assets, thereby devaluing the currency. Traders who don’t follow market signals will face problems with illiquidity and insolvency.
Where forex trading is concerned, currency crises aggravate credit risks, liquidity problems, and devaluation. There are many examples of currency crises throughout history, such as the Latin American crisis of 1994 and the Asian financial crisis of 1997.
The counterparty in the forex market is the company with which you open and close trading positions i.e., your broker or dealer. Hence, the counterparty risk refers to your broker or dealer defaulting in a particular transaction, either due to a lack of regulation or bankruptcy.
The best way to minimize this risk is by opting for a broker that’s registered with a regulatory body. To start forex trading, you need to educate yourself and find an excellent broker. The latter can be done easily when you explore forex broker reviews and choose a trustworthy broker that matches your trading style.
One of the most significant risks associated with forex trading is leverage risk. Leverage refers to a minor initial investment, known as a margin, made to gain an advantage of more massive market exposure.
While leverage is used to increase returns on investments, it also increases losses. There is risk associated with leverage since price fluctuations can lead to margin calls, where additional margin needs to be paid by the investor.
Investors need to be careful during unpredictable market conditions since using leverage aggressively can quickly work against you and result in significant losses.
Transaction risks in trading orders occur when communication, handling, and confirmation errors lead to losses. The most common reason for transaction risks is the time difference between the beginning and settlement of a contract.
Since forex trading takes a plan on a 24-hour timeline, exchange rates often change before trades being finalized. As the time difference increases, so does the transaction risk since this gives exchange rates more time to fluctuate.
Political and economic factors play a huge role in determining how you trade in the forex market. Political events, such as elections take place regularly, and the results of these events can significantly influence the investment environment in a country.
During election season, there is a great deal of uncertainty and instability in a country, thereby resulting in increased volatility in the country’s exchange rate. Other political events, such as labor strikes, protests, and scandals, can also lead to exchange rate fluctuations.
While it’s impossible to predict such circumstances, you can minimize the risk by keeping a close eye on a country’s political affairs. You should monitor current events that may affect your trading position so you can react to unforeseen circumstances.
In terms of liquidity and size, the forex market is the largest in the world. Its high liquidity gives traders the ability to enter and exit the market with ease. This high liquidity also means that changes in the demand and supply of an asset will have minimal effect on the price of the asset.
While it is quite liquid, this doesn’t mean it’s exempt from periods of low liquidity during weekends and holidays. Traders need to keep this low liquidity risk in mind since it leads to a rise in the cost of trading.
Due to the wide range of risks associated with forex trading, the resulting losses could be much higher than anticipated. Since trades are often leveraged, a minimal fee could grow into illiquid assets and huge losses. Moreover, since many external factors influence foreign exchange, there is a great deal of unpredictability associated with it.
Regardless of these risks, though, forex trading comes with considerable benefits, too. Risks are always involved with trading financial assets and, as long as you’re prepared, they will have minimal impact on your returns.
What suggestions do you have to manage the risks associated with forex trading? Let us know in the comments below!
By Suren Subramaniam | 30 October 2020