The Risks of Trading in the World Money Market - dummies

The Risks of Trading in the World Money Market

By Michael Griffis, Lita Epstein

Leverage, which means borrowing money to trade, is the number one risk to your portfolio when trading in money markets. Success on the foreign currency exchange market means having to trade in large sums, because profits are made at exchange-rate differences of only fractions of a cent.

After you’re approved for trading, customers are given a set amount or allowance on which they can trade on margin. A common starting allowance for trading on margin is 5 percent, which means that if you put $100,000 in the bank, you’re allowed to execute transactions of up to $2 million.

When trading at those high margin levels, even a minor mistake can wipe out your entire deposit.

You also face a number of different kinds of risk, including market risk, exchange risk, interest rate risk, counterparty risk, volatility risk, liquidity risk, and country risk.

Market risk

All traders and investors face market risk. Basically, market risk is comprised of changes in price that adversely impact your trade or investment. Market risk is in play from the moment you enter into a foreign currency exchange position until the moment you exit it. The foreign exchange rate can change any time during that period.

Exchange risk

Foreign exchange traders take on exchange risk the moment they buy or sell a foreign currency. Every time you take on a new foreign exchange position, you’re immediately exposed to the potential that the exchange rate will move against your position, making it worth less than when you bought it. In only a matter of seconds, a profitable transaction can turn into an unprofitable one.

Interest rate risk

Foreign exchange positions can change in value not only because of the exchange rate but also because of the currency’s underlying interest rate. Whenever a country’s central bank (think Federal Reserve) raises or lowers the underlying interest rate for its currency, the impact on any positions you’re holding in that country’s currency can be a major one.

Counterparty risk

In the currency trading world, a counterparty is the other entity involved in a transaction — a bank or banker, a broker, or another trader. When you buy a currency option or execute a forward transaction, you risk the possibility that the counterparty to your transaction won’t be able to meet his, her, or its obligations.

Whenever you buy the option through an exchange, rather than directly from the counterparty, this risk is not a factor. When that happens, you run into additional replacement costs, because you’re forced to enter into another currency transaction to meet your own foreign currency needs.

The key to avoiding this kind of risk is entering into contracts with known entities that have high credit ratings. Additionally, you need to investigate whether the counterparty with which you’re trading has had any problems with regulators, insolvency, or questions of ethical conduct. One good place to begin your investigation is the consumer protection section of the CFTC.

When evaluating a company, you first need to consider its credit risk. You can find credit rankings for many major banks at the Standard & Poor’s website. You can research a company’s creditworthiness by investigating the standards it uses when providing credit to its customers.

Volatility risk

Volatility risk relates to the possibility of rapidly changing exchange rates that can impact your positions in foreign currencies. Currency prices can change thousands of times per day. Options on currencies are valued according to volatility and underlying changes in the prices of the respective currencies.

If a trader sees an increase of 100 percent in volatility, or a doubling of volatility, then the price of the option can increase 5 percent to 10 percent. If you’re trading on credit, which is highly likely, your bank or broker can reevaluate the credit it’s extending to you whenever it sees a dramatic increase in the volatility of your holdings.

Liquidity risk

Liquidity risk is a factor if you decide to trade in less active currencies, it can become a factor when you’re unable to sell a currency you hold at the expressed time you want the sale to take place, especially when the market for that currency is not active. You can avoid liquidity risk by buying currency options or futures on an exchange.

Country risk

Country risks come in several different varieties, all of which you need to consider whenever you trade in foreign currencies. Among those aspects are

  • Political risk: This variety relates to the political stability of the country in whose currency you’re trading. Although there haven’t been any recent seizures of commercial assets by any nations, it has happened in the past. If you trade in currencies of countries that are at risk of possible destabilization, the currency you buy can become worthless if the country changes political leaders.

  • Regulation risk: This variety relates to what can happen after you establish a position in a country’s currency. Its government can change its regulations, and in effect, put restraints on the ownership established by your position in the currency and by the position of your counterparty — and that can get messy.

  • Legal risk: This variety relates to which country has jurisdiction to rule on a contract if your counterparty happens to default. Unfavorable contract law in the host country of your counterparty can end up determining that the contract is invalid or illegal, and you can lose your position. Be sure that you understand from whom you’re buying and under which country’s laws any disputes will be settled.

  • Holiday risk: This variety relates to the possibility that the country in whose currency you’re trading has different religious, political, or governmental holidays that can shut down trading in that currency right when you need the money. Be sure you know the holiday schedules for the countries in whose currencies you trade.