Investing in Currency
Currency investing is more complex than you might think. Many people have trouble understanding how you make money by investing in money. Others don’t understand the details of the market.
There are different ways to buy currency. Currency hedging adds more complexity. Here’s a short primer to help you decide if investing in currency makes sense for you.
First of all, currency is the name given to a money system in use in a country. Currency is also anything that is acceptable for trade in a region.
For example, the U.S. dollar is the name of the monetary system in use in the United States. Currency markets list U.S. government issued money as USD.
The Euro is the currency in use in those countries who have joined the Euro area. As of January 2015, Lithuania will be the 19th country to join the Euro zone.
Currencies have a relative value in relation to each other. The relative value changes based on political and economic events, trade balances, interest rates, energy usage and other factors.
Investors bet on changes in the relative values of currencies through a process known as currency hedging. Currency trade occurs on an exchange known as FOREX. Currency markets only deal in official currencies. The most commonly traded currencies include USD, EUR, GBP, JPY, CAD and AUD.
FOREX does not have a physical location like most exchanges. It is actually a network of banks and governments and people linked electronically. Currency trading happens 24 hours a day. Investors make trades from everywhere in the world.
It is simple to begin trading in almost any currency. An investor merely needs to open an account at a forex exchange. An existing brokerage account may also enable currency trading.
Trading occurs using currency pairs. Currency pairs express the value of one currency in terms of another. For example, euros to USD. Exchanges show this as EUR/USD.
When you buy euros with USD, it means that you are actually selling USD. The same holds true if you buy GBP (Pounds) or any other currency.
Currency quotes always have a bid and an ask price. Bid is the price someone is willing to pay to buy a currency. Ask is the price someone is willing to sell the currency for.
Currencies may have a “peg rate.” A peg rate defines the value of the currency in terms of a different currency. Many small countries peg their currency to USD because it is a stable currency. Pegging to USD means the government of a country states that their currency is always equal to a stated number of USD. The value of their currency floats as the value of USD changes.
Investors usually buy currency on margin. Most brokers require that you keep at least 1 percent of the value on deposit. You can find brokers who will ask for much less.
A typical minimum currency investment is $100,000. Usually, a brokerage requires this minimum transaction amount. Again, you may find a broker willing to work with less.
With a 1 percent margin, a buyer could invest in a typical currency transaction with a $1,000 deposit.
Investors should watch their deposit balances carefully. If they fall below the required minimum amount on deposit, the brokerage can make a margin call. An investor might not have cash to meet an unexpected margin call. This is one reason that currency investing requires attention to detail.
Investors can agree to buy currency in the future. Currency futures trade on open exchanges. Futures usually have a fixed ask and bid price.
Currency futures are over the counter trades. Usually futures do not require any deposit. This makes them easy for investors to purchase.
There is also a form of currency future called forward contracts. An agreement to purchase currency in the future is a forward contract.
A forward contract locks in a specific exchange rate for a defined period of time. It does not matter what the actual market exchange rate is when the parties execute the contract.
Forward contracts are binding agreements. The terms of forward contracts are specific to that contract. They do not need to reflect the general market. Forward contracts carry some risk because they are an absolute obligation to buy at the stated time and price.
Forward contracts and currency futures help minimize the risk of rate changes. Companies with business interests in areas with unstable currencies often use futures and forward contracts to lock in future profits and protect their margins. They may also hedge their profit by buying currency both above and below the expected exchange rate.
Forward contracts and currency futures often confuse new investors. This is a dangerous area of confusion. Sources of potential risk vary greatly between the two instruments. The buyer’s obligation is also very different. Novice buyers need to be certain that they understand the differences. You should always know what you are buying.
Investing in currency requires research to understand how a currency’s value may change. Most currency investors stick to one or two currencies when they are starting out. Currency investing is exciting and easy to get into with a relatively low investment.