Investing in foreign currency involves purchasing money, or currency, in another country. The market for foreign currency investing is the largest and most liquid in the world.
Foreign currency investing may bring up several questions for investors who aren’t familiar with it. How do you go about buying foreign currency? Is buying foreign currency risky?
Here’s a rundown of the basics:
Investing in Foreign Currency: What You Need to Know
Forex is short for “foreign exchange market,” and refers to trading fiat currencies, or those that are backed by the government that uses them. For example, an investor could trade their United States dollars (USD) for Euros. Or, they can trade their Japanese yen for New Zealand dollars.
These trades can happen at any time throughout the day, since there’s always a foreign currency market open somewhere in the world. Foreign currency investors are typically institutional investors, although it is possible for individual investors to participate.
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There’s no single market that investors use when it comes to foreign currency investments, instead of a physical location, the market is made up of banks, central banks, such as the Federal Reserve in the United States, funds, and commercial businesses.
Because foreign currencies have different values relative to one another, and since those values are constantly changing (on a daily, and minute-by-minute basis), it’s possible to profit by trading currencies.
Trading currencies has some similarities to trading other securities, like stocks, but there are also some differences. Since forex is a highly active market, with lots of buyers and sellers looking to make deals. But it also never takes a break.
While the stock market shuts down after the trading day closes, the forex market keeps on chugging, 24 hours per day. Foreign currency investing may serve as a portfolio diversifier for investors whose holdings are primarily in U.S.-based companies.
What to Know About Foreign Currency Pairs
Generally, investing in or trading foreign currency involves pairs of currencies. That’s because two different currencies are quoted based on their relative value to each other. On an exchange, that may appear as “USD/EUR,” or something similar, while a pairing of Japanese yen and Euros, it may be represented as such: “JPY/EUR.”
Some currencies are more widely traded than others and are “paired” with one another or grouped as “major” currencies:
• U.S. dollars
• Euros
• Japanese yen
• British pounds
• Swiss francs
• Australian dollars
• Canadian dollars
• New Zealand dollars
There are also “minor” and “exotic” currency pairs. These are not traded as widely as the majors, but are still often swapped on exchanges. They may include pairings with the Hong Kong dollar, the Mexican peso, the Singapore dollar, or the Norwegian krone, among others.
Forex Trading Sessions
There are four major forex trading sessions in a 24-hour period, split up by international region:
• Sydney (Australia)
• Tokyo (Asia)
• London (Europe)
• New York (The Americas)
There are minor sessions, too, but these are the four major sessions, and markets can be busy (when the Americas’ session overlaps with Europe’s), or less busy, depending on the time of day, and how many people are actively trading.
How to Invest in Foreign Currency
Foreign currency investment doesn’t typically involve using physical money, so you’ll have to find something else to do with the foreign currency left over from your last international vacation. There are several ways to get started in currency exchange investment.
First, you can work with a foreign exchange brokerage to trade the currency you’re holding (such as U.S. dollars) for another currency (Euros, Yen, etc.). The goal is that the currency you’re trading for, or buying, will increase in value relative to the currency you’re trading away, or selling.
So, if you buy, or trade U.S. dollars for Euros, you’re hoping that in the future, you’d be able to trade the Euros back for more U.S. dollars than you originally used to make the purchase. You’re looking to make a profit, in other words.
While the goal is straightforward, the process can get more complicated. For instance, there are a few ways traders can execute trades, such as spot trading, forward trading, and future trading. Spot trading is an instant trade, whereas forward and future trading may involve settling on terms at a time in the future (similar to trading options).
Further, investors should understand the concept of the spread, which represents the difference between a trader’s cost and the dealer’s profits.
Foreign Currency Quotes
These quotes are similar to stock quotes, which list the current value, or price of a stock. Forex quotes display the bid and ask prices for a currency pair, since one currency’s value is relative to another currency. Here’s an example of a quote for a common pairing, Euros and U.S. dollars:
EUR/USD = 1.2100
In this example, Euros are the “base” currency, and U.S dollars are the “quote” currency. What does the quote say, exactly? That a single Euro is equal to 1.21 U.S. dollars. Or, €1 = $1.21.
Pips
A “pip” is a unit of measure that represents the smallest unit of value in a currency quote. Using the above quote as an example, the difference between the “bid” (1.2100) and the “ask” (1.2104) is four pips.
Why does this matter? Because currency values fluctuate very slightly during the trading day, perhaps only several pips. That means that to make a significant return, traders deal with large quantities of currencies.
Leverage
To get to those large quantities, traders often use leverage. For example, you may give your broker $100 to trade with $10,000 on the markets (using, or borrowing the broker’s $9,900 to make trades is called
“margin” ). Most forex trading is done this way, using leverage and margin in order to generate returns.
That, of course, has its risks, since traders may incur losses, and end up owing money to their brokers. For beginners, it may be best to use lower margins for that very reason.
Volatility
Since forex markets are so active, prices can change quickly, which means it’s a fairly volatile asset class. The news cycle (including economic, political, or social news) can cause sudden and drastic changes to prices. That means it may be a better fit for investors with a relatively high risk tolerance than those who are more risk averse.
Foreign currency funds
For investors who want exposure to foreign currency without making the trades themselves, there is another way to invest in foreign currency: Through funds, such as exchange-traded funds (ETFs). There are currency-based ETFs that trade on the market, allowing investors without the time or expertise in currencies to get in on the action.
The Takeaway
While foreign currency investing can be part of a well-diversified portfolio that includes several different types of investments, it can be a complicated market for new investors. But, you can still get exposure to the market by purchasing ETFs or other funds that focus on foreign currencies.
If you’re more comfortable sticking to other investments, like stocks, ETFs, or even cryptocurrency, SoFi Invest investing platform is an easy-to-use tool that you can use to get started now.
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