Investing in currencies can be appealing at times. We can do it to speculate if we believe that a currency is going to strengthen or weaken. Or to reduce the risk of our investment portfolio. In this post, we discuss how the forex market works and the types of currencies available.
- Why Buy and Sell Currencies
- Types of Currencies
The foreign exchange market is the most liquid in the world. The daily volume of transactions is said to be between $5 and $7 trillion. In this market, the currencies of different countries and regions are continuously bought and sold.
Investors, banks, corporations, citizens, central banks and governments all participate in the foreign exchange market. They do it for very different reasons. You, as an investor and citizen, can also participate in it.
Next, we will discuss how the foreign exchange market works, and what types of currencies exist.
Currencies are issued by countries or supra-national entities, like the European Union. Nowadays, all existing currencies are fiat currencies. This means they have no intrinsic value. Their value is only derived from the fact that they are accepted as a means of payment.
In the past, some currencies used to be backed by precious metals, such as gold and silver. In the 21st century, although most central banks still hold precious metals in reserves, the value of their currencies is not tied to any metal.
All currencies have an ISO code of 3 letters, such as EUR for Euros or USD for US Dollars.
Because all currencies are fiat, their value is determined by the market, even if some government authorities sometimes intervene. To know the price of one currency, we have to quote it relative to another currency.
For example, if we want to know the price of one Euro, we can say that it is worth 1.10 US Dollars or 0.90 Pounds Sterling. As you can see, the value of one currency is always relative to another.
When we talk about a currency pair, for example EUR/USD, we usually quote how many units of the second currency (USD) we can buy with one unit of the first currency (EUR). If EUR/USD is at 1.14, that means that one Euro is worth 1.14 US Dollars.
Even though some currencies are officially pegged to each other and, therefore, do not fluctuate, their value still comes from the market. After all, if the market does not believe that a peg is sustainable, it will end up destroying it.
A good historical example would be the value of the Argentine Peso in 2001, back when a Peso was worth the same as a US Dollar. The market did not believe that was sustainable given the macroeconomic situation in Argentina and, soon after, the peg no longer existed.
Because the price of one currency is always relative to another, when we buy one currency, we have to sell another. And vice versa. If you use an online platform for currency trading, you can buy and sell any currency pair. For example, if you want to short GBP/JPY, you will be able to.
Why Buy and Sell Currencies
The main reasons why we may want to trade in currencies as part of our investing process is to speculate and hedge.
If we want to speculate, we simply seek to make a profit by buying and selling the right currencies. If we think a currency is going to rise, we will buy it. If we think it is going down, we will sell it. It as simple as that.
We have previously touched on the currency pair between GBP and JPY. If we think the Pound is going to fall in the future, and the Yen is going to rise, we could sell that currency pair. That means selling the first currency (GBP) and buying the second (JPY).
Most people trading currencies focus on technical analysis. That is the study of charts to try and predict how a currency pair is likely to move in the future.
There are also several fundamental indicators that are analyzed to try to guess the future direction of a currency. Next, we discuss some of these indicators. These things would normally be positive for a currency while the opposite would be negative:
- Higher economic growth
- Low inflation
- Fiscal surplus
- Trade surplus
- Political stability
- Sound, stable and predictable monetary policy
- Higher interest rates
- Investment inflows into the country
- The currency is considered a safe haven
Based on these and other elements, we can draw our own conclusions and try to guess the direction of currencies in the future.
The other reason why we might be interested in investing in currencies is to reduce the risk of our investments. As we will discuss later, some currencies are considered safe haven assets and can appreciate in times of financial turmoil.
Types of Currencies
When buying and selling currencies, it is essential to understand which are the most important types of currencies:
G10 currencies are considered the most liquid in the world. That means they can be bought and sold very easily at any time. All of them are developed market currencies and, therefore, their value is usually quite stable. The G10 currencies are as follows:
- USD (US Dollar)
- EUR (Euro)
- JPY (Japanese Yen)
- GBP (Pound Sterling)
- CHF (Swiss Franc)
- CAD (Canadian Dollar)
- AUD (Australian Dollar)
- NZD (New Zealand Dollar)
- SEK (Swedish Krona)
- NOK (Norwegian Krone)
Safe Haven Currencies
Although all G10 currencies are from developed countries, not all of them are considered safe haven assets. In fact, some of them usually go down when there is an economic crisis or a situation of instability in the world.
The safe-haven currencies par excellence are the Swiss Franc (CHF), the US Dollar (USD) and the Japanese Yen (JPY). Every time there is an economic or financial crisis, or geopolitical instability, the value of these currencies tends to go up.
These are also the currencies that, over time, have always tended to strengthen. This is because of their economic strength, moderate inflation, or more stable monetary possible.
Emerging Market Currencies
The other major group of currencies are those of emerging markets. Although all of these are usually put in the same basket, they are a very heterogeneous group. Some emerging market currencies are very strong and more stable than some G10 currencies, while other emerging market currencies are highly speculative and therefore carry considerable risk for those trading or owning them.
Among the strongest emerging market currencies, we could highlight the following:
- CNY: Chinese Yuan
- CZK: Czech Koruna
- TWD: Taiwanese Dollar
- THB: Thai Baht
- PHP: Philippine Peso
- SGD: Singapore Dollar
- PLN: Polish Zloty
- BGN: Bulgarian Leva
- RON: Romanian Leu
Other emerging market currencies with more risk but also greater potential for short-term upside would be the following:
- RUB: Russian Ruble
- MXN: Mexican Peso
- BRL: Brazilian Real
- ZAR: South African Rand
- TRY: Turkish Lira
I hope you enjoyed this introduction to investing in currencies. The foreign exchange market is a fascinating world. Even if you are not interested in buying and selling currencies, it is crucial to understand the role they play in financial markets.
When you invest in stocks around the world, bonds and commodities, you are exposed to currency risk, either directly or indirectly. And there is nothing wrong with that. In some cases, it can even be very beneficial to be exposed to such risks.
Understanding this concept will allow you to realize that owning Swiss stocks in a context of financial instability can be better than owning South African stocks. After all, these assets are denominated in Swiss Francs, and the currency appreciation will cushion the drop in the stock themselves.
I always insist on trying to understand the financial markets and the economy as a whole. You do not need to be an expert. Far from it. But having a general understanding of their mechanisms will make it easier and more effective for you to invest in the long term.
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And if you want to read about why the Forex market should not be seen as an investment in itself, check out the following link:
Why You Should NOT Invest in Forex