Definition of Forex Risks
There is a market which operates the buying and selling of the currency across countries, and we call it the Forex Market, which is the short term for the foreign exchange market, also called forex or FX market. To make profits in the forex market, a trader needs to always buy low and sell high, just like what happens in the stock market. Due to its high trade volume, forex markets are the one of the most liquid markets in the world. In fact, forex market has the largest trade volume globally. However, you need to know what forex risks are before you start trading forex right away. Most obviously, you could make a wrong guess and the price goes the opposite way. Furthermore, if leverage is used, there are even more risks involved which will potentially lead to significant losses.
Different forex risks
What are some of the examples of forex risks? One fact which everyone needs to know is that most majority of forex trades are made by banks. Forex are used a medium to minimize risks associated with currency fluctuation. Computerized trading systems with complex algorithms are used to manage the risks. As individual traders, such as us, have less exposure to these risks. Through effective trade management, anyone can minimize these risks. However, you should always remember that there are always risks which you may lose much more than your traded margin with any investments. Here is a list of some of the associated forex risks:
- Liquidity Risk
- Credit Risk
- Counterparty Risk
- Exchange Rate Risk
- Interest Rate Risk
- Risk of Ruin
- Country Risk
- Leverage Risk
- Transaction Risk
Traders who use leverage are able to trade in substantial amounts with small initial investments or margin. Therefore, small price movements will lead to significant losses. Leverage can be thought of as a double-edged sword. Leverage allows an investor to borrow funds from other individuals to invest. For example, with a leverage of 100:1, you can trade up to $100,000 with every $1000 in your account. With leverage applied, both profits and losses potentials are magnified. Hence, aggressive use of leverage will always lead to substantial losses in volatile market conditions.
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Before you decide to invest in a country's currency, you need to conduct extensive research on the stability of structure of the selected country. This part of forex risk involves changes in the business environment of the country you are doing business in which will harmfully affect your business. Significant country risk can be caused by either political, macroeconomic mismanagement, war or other factors. Change of leadership, ruling part and war are all examples of political factors. On the macroeconomic level, factors include inflation, recession and increase of interest rates. The country's currency can be influenced by all of these changes in the country's environment.
Interest rate risk
Interest rate fluctuation is a major component of forex risk. Visually, a lender will impose a certain interest rate upon the borrower on the loan when an individual or organization borrows funds from the lender. Conventionally, lenders will require higher interest rates from borrowers with higher risks and lower interest rates from borrowers with lower risks . In any country, interest rates and currency exchange rates are closely related. A country's currency will flourish with the increase of interest rates because of the entry of investments. Conversely, a country's currency will weaken with the decrease of interest rates because the investors begin to withdraw their investments. You can observe where the major institutions are investing and gain maximum profits if you carefully speculate on the interest rate movements.
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In a simple and easily comprehensible manner, credit risk involves one party if unable to pay the other party in a trade. One party will be unable to pay the other party if the party either defaults or bankrupts. By implementing the proper credit risk exposure, anyone can successfully manage credit risk. Credit risk is mostly related to corporations and banks while itis very low for individual traders and companies regulated by authorities in G-7 countries. National Futures Association (NFA) and Commodity Futures Trading Commission (CFTC) regulate the FX markets in the US. In any cases, you should thoroughly examine the companies before depositing any trading funds to avoid unnecessary credit risks and to keep your funds secure. By visiting the authorities' websites, you can easily check the companies.
Exchange rate risk
When the value of the currency changes, we call this kind of forex risk, exchange rate risk.The cause of this change is the movements in the global supply and demand balance. Exchange rate risk particularly affects those companies with operations in multiple countries or frequently export their products. The profit and margin of international companies, in their countries and the countries in which they do business, are significantly affected by exchange rate risk. Exchange rate risk has an effect on what the investors will actually receive.