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As part of an appropriate diversification endeavor, investors are increasingly thinking globally when making portfolio asset allocations and investing in foreign currency is becoming increasingly popular. Experienced traders have long recognized that ensuring against native home country risk is an essential component in a balanced investment strategy. The diversification principle applies not only for unstable or small countries where political and economic risks are real and palpable. Cyclical and asset-specific factors affect all classes of investment returns and market participants have an incentive to include in their holdings as many independent instruments as feasible. This prudence extends to investments denominated in foreign exchange currency. As with any investment vehicle, traders must understand and adapt to the specific characteristics of this market before availing themselves of its opportunities.
Risk exposure entails a number of components. First among them is sovereign/national risk. Opening a foreign bank account denominated in that currency is commonly the most efficient means to expose yourself to sovereignty risk alone. Usually, bank deposit insurance minimizes all other risks, but investors should nevertheless familiarize themselves with the country and institutional specifics to ensure their deposits are covered for risks.
Purchasing foreign currency debt instruments is another avenue to both profit from forex and to receive an income stream of interest repayments. Quality bonds of major countries tend to be liquid and secure, minimizing the need to factor in additional risk considerations. Nevertheless, tradable instruments not held to maturity are subject to an interest rate risk component in their pricing. Purchasing securities close to maturity date (less than one year) is one means to minimize this risk.
The most efficient means to introduce to your portfolio foreign exchange fluctuation risk is by trading forex on margin (up to 400:1 with CFDs). Forex risk is, by definition, the fluctuation of value in one currency (the numerator "base" currency) vs. another (the denominator "quote" currency. In short, you adopt a directional bet on the pair. This unrivalled leverage magnification requires trader vigilance, expertise and determination specific to the Forex market. Strategies and attention are required so that the margin magnification available for profits does not turn into losses.
The primary fundamental determinant of currency values at any given instant are the expectations of future relative interest rates. Expectations of a rise in interest rates contribute to a gain in the currency value as investors expect the yield from fixed instruments to be worth relative more than previously.
Other factors of primary importance are the creditworthiness of the economy as measured in a variety of general parameters, both economic and political. Additionally, intangibles like market sentiment and technical indicators can play outsize roles in setting exchange rate considerations.
Professionals employ numerous formulas and frameworks to evaluate if currencies are under-priced or over-priced. Predictably, no one system works in all situations and even established market players with virtually unlimited resources to facilitate automated speed algorithms for profit extraction from even the smallest and most brief of opportunities only minimally.
Alas, 'how to trade forex' is a subject of infinite subtlety and nuance. At any given moment, the market may be responding as a hoard to psychological pressure while it then turns in an instant to digest arcane economic details. Trading forex does offer a unique diversification for any portfolio and with care, diligence and determination, individual traders can make it worth their while.
These are the many concepts a new investor must take into account when investing in foreign currency. By diversifying away from your home country's portfolio, you help to insure that your wealth survives any unusual shock in your home country.