Have you ever heard of forex?
Forex market operates the buying and selling of currencies across the world, which also has the name foreign exchange market, FX market or simply forex. An individual can profit by buying low and selling high in forex just like in a stock market. Forex market is one of the most liquid markets globally, due to its high trading volume. In fact, the forex market has the largest trading volume worldwide. However, you must know what the forex risks are before you jump straight into trading forex on your laptop. The simplest one to explain is when you place a trade, but the price goes the opposite direction and results in a loss. There are even more risks if you decide to use leverage which could result in substantial losses.
Categories of forex risks
Every definition is best explained with visual and alive examples, so here we go. To clear things up, you need to know that most majority of forex trades are placed by banks. The banks use forex as a tool to minimize the risks associated with currency fluctuation. They achieve this by using the complex algorithms on the computerized trading systems to manage the risks. As individual forex traders, we are less affected by these risks. Besides, any individual can implement effective trade management to minimize their potential exposure to these risks. However, you need to keep in mind that there are risks which you may lose much more than your traded margin on any investments. Below is the list of different categories of forex risks:
- Country Risk
- Transaction Risk
- Exchange Rate Risk
- Risk of Ruin
- Credit Risk
- Leverage Risk
- Liquidity Risk
- Interest Rate Risk
- Counterparty Risk
With only small and insignificant initial investments, or margin, traders can utilize the powerful tool of leverage to trade in substantial amounts. Clearly, even small price fluctuations will cause significant losses. Leverage is a kind of forex risks best portrayed as a double-edged sword. When you are using leverage, you are borrowing other people’s money to invest. For example, you can trade up to $100,000 for every $1000 in your account by using a leverage of 100:1. In this way, leverage will enlarge your profits and losses potentials in the same magnitude. Just keep in mind, aggressive use of leverage will result in substantial losses in a volatile market.
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Before you decide to invest in any country’s currency, be sure to do extensive research on the structure and stability of the chosen country. Country risks will eventually harmfully affect your business through changes in the business environment of the country you are doing business in. Country risks are caused by political, macroeconomic mismanagement, war and other factors. Change of leadership, ruling parties and war are some of the political factors. On the macroeconomic level, factors of country risks include inflation, recession and increase of interest rates.Subsequently, the country’s currency is affected by the change in the country’s environment.
To explain the concept in a clear and easy way, credit risk is a type of forex risks which happens when cannot pay the other party in a trade. One party cannot pay the other party when either party defaults or bankrupts. To manage credit risks, you need to properly manage your credit risk exposure. Credit risks are particularly important to banks and corporations, and it is of less relevance to individuals and companies regulated by authorities in G-7 countries. In the US, forex markets are regulated by the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC). Before you deposit any trading funds, carefully examine the companies to avoid unnecessary risks and to keep your funds secure. Visiting the authorities’ websites is aneasy way to examine the credibility of the companies.
Exchange rate risk
Forex risk which involves the change of the value of the currency is called exchange rate risk. This type of risk is caused by the shifts in the global supply and demand balance. Exchange rate risk has the most substantial influence on companies with operations in multiple countries and those who frequently export their products. Exchange rate risk affects particularly the profit and margin of international companies, domestically and internationally. For investors, the exchange rate risk will affect what the investors actually receive.
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Interest rate risk
Interest rate risk in forex risks deals with interest rate fluctuations. Simply, the lending party will impose certain interest rates on a loan when an individual or organization is borrowing money from the lending party. A lender will require a higher interest rate when the borrower is riskier and a lower interest rate when the borrower is less risky. A country’s interest rate is closely related to the currency exchange rates. When the country’s interest rate increases, investments will enter, and the currency will flourish. Conversely, when the country’s interest rate decreases, investors will begin to exit their investments which will cause the currency to weaken. You should carefully speculate on the interest rate movements to know where major institutions are investing so that you can maximize your profits.