What is forex?
Forex market is the short term for the foreign exchange market, also called forex or FX market, which operates the buying and selling of currencies across countries. Forex trading is like stocks, from which trader profit by buying low and selling high. Forex operates with high trading volume, which results in its high liquidity. In fact, forex marketsare the largest in term of the trading volume. But, before you jump right into trading forex in front of your laptop, you need to know that what the forex risks are. The most obvious risk is that you made a wrong guess and the trade goes the opposite direction. Additionally, as a leveraged product, there are even more risks which could result in significant losses.
Types of forex risks
So, what are some of the examples? You should know that most majority of forex trading are made by banks. They use forex to decrease the risks associated with currency fluctuation. They use complex algorithms to manage the risks on their trading systems. However, as an individual forex trader, you are less affected by these risks. Anyone can minimize these risks through effective trade management. Just keep in mind that there are risks involved with any types of investments up to a point where you will lose much more than your traded margin. Below are some of the different types of forex risks:
- Credit Risk
- Leverage Risk
- Transaction Risk
- Liquidity Risk
- Exchange Rate Risk
- Counterparty Risk
- Country Risk
- Interest Rate Risk
- Risk of Ruin
In a way which anyone can understand, credit risk is akind of risk where one party is unable to pay the other party in a trade. This could happen when either party defaults or bankrupts. You can successfully manage credit risks by implementing the proper credit risk exposure. Credit risk is usually related to corporations and banks, and it is very low for individual traders andcompanies regulated by authorities in G-7 countries. FX markets in the US are controlled by the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC). To avoid unnecessary credit risks and keeping your funds secure, you should thoroughly examine the companies before depositing any trading funds. You could easily check out the companies by visiting the authorities’ websites.
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Leverageallows traders to trade in substantial amounts with small initial investments or margin. Consequently, a small price movement may lead to significant losses. Leverage is a double-edged sword. Leverage involves borrowing money from other people to invest. For example, if the leverage in the market is 100:1, you can trade up to $100,000 with every $1000 in your account. This will enlarge the potential of profits and losses in the same magnitude. Aggressive of leverage will result in significant losses in volatile market situations.
Interest rate risk
This major component of forex riskdeals with interest rate fluctuations. In a visual way, when an individual or organization borrows funds from a lender, the lender will impose a certain interest rate on the loan. Typically, a borrower with higher risk will be required a higher interest rate, while a borrower with lower risk just need to pay a lower interest rate. A country’s interest rates have close relationships with the currency exchange rates. If a country’s interest rates increase, the currency will flourish because of the entry of investments. In the opposite way, if a country’s interest ratesdecrease, the currency will weaken because investors begin to exit their investments. If you carefully speculate on the interest rate movements, you will have ideas where major institutions are investing so that you can gain maximum profits.
Exchange rate risk
Exchange rate risk is a type of forex riskwhich occurs when the value of the currency changes. This is caused by the movements in the global supply and demand balance. Companies with operations in multiple countriesor frequently export their products are particularly affected by exchange rate risk. Exchange rate changes have significant effects on the profit and margin of international companies, in their countries and the countries in which they do business. Exchange rate risk will affect what the investors actually receive.
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It is most important that you do extensive research on the stability and structure of the corresponding country before you choose to invest in their currency. Country risk involves changes in the business environment of the country you are doing business will harmfully affect your business. Political, macroeconomic mismanagement, war and other factors can all cause substantial country risks. Political factors include change of leadership, ruling party or war. Inflation, recession, an increase of interest rates are also factors on the macroeconomic level. These changes in the country’s environment all have subsequent effects on the country’s currency.