Foreign Exchange: A New Market to Explore

The first weeks of 2008 have been some of the most tumultuous for equity markets in decades. Fears about the U.S. housing market, banking write-downs, and slumping consumer confidence has dominated the headlines, and worried the minds of many investors.

This backdrop provides the perfect opportunity to examine the benefits of investing in foreign exchange (FX), which is becoming an increasingly popular asset class for retail investors. Why? Because like commodities and private equity funds, FX is proven to have low correlation with bond or equity market returns. Between 1980 and 2006 FX had a five per cent correlation with equities and a minus 21 per cent correlation with bonds. Equities and bonds, meanwhile, had a 26 per cent correlation rate over this period, which demonstrates how FX can be a useful tool in assisting to diversify an investment portfolio – particularly when times on the equity or bond markets get tough.

So why haven’t more investors caught on to FX trading sooner? For the simple reason of access. Until 10 years ago, investing in FX was exclusive to an elite group of hedge funds, investment banks and multinational corporations. These institutions guarded their turf fiercely and no wonder. Between 1990 and 2006, FX investments returned 9 per cent a year, more than either bonds or equities over the same period.

For individual investors, the FX market was difficult for individuals to access. With minimum trades as high as $1 million, myriad complex legal documentation and extensive credit checks required before a bank would even consider trading FX with you, it was only a realistic investment option for the very wealthy, and the very patient!

Over the past ten years or so this has all changed. A large part of this is thanks to the revolutionary growth of the Internet, which has led to the development of sophisticated online trading systems such as Deutsche Bank’s dbFX – giving ordinary investors the opportunity to set up an online account and start trading almost instantaneously. Nor do you need large amounts of capital to get involved; it is possible to set up an account and start trading with an initial investment of $5000.

Having access to up-to-date data is vital in the fast-moving, 24-hour a day world of FX, and investors can obtain all the data they need to trade FX at negligible cost, usually from their online platform provider. This provides access to streaming real-time executable prices and access to up-to-the-minute research to help ensure clients have the right information they need to make educated and sound investment decisions.

So with all the tools and processes in place, how can currency trading add value to an investment portfolio? One of the most important reasons to consider investing in FX is that it often generates positive returns. For example, the Deutsche Bank Currency Returns index, which tracks the returns of a diverse FX investment portfolio, delivered annualised total returns of 11 per cent between 1980 and 2006. However, as with other asset classes, past performance of FX investments is not necessarily indicative of future results.

From an asset allocation perspective, investors know that deciding what proportion of risk should be allocated to a given asset class is not a precise science. However, as a generalisation, it appears that while adding FX to a portfolio of bonds and equities can increase the average annual returns, the biggest benefit appears to be in reducing volatility of returns and periods of draw-downs.

FX also has an unusual attribute not shared by other asset classes, namely that a significant proportion of its trades are executed to hedge risk and not to generate profits. As a result, these characteristics create regular trading opportunities for investors – who have the technology to keep in touch with market-changing events and react to them.

When it actually comes to investing in currency markets for the first time, some of golden rules traders consider are:

1. Know what moves currency markets. Like any asset class, there are a number of factors that drive currency performance. A country’s macroeconomic situation can have a major influence – economic data releases, policy decisions and political events can change an economist’s outlook on the country, and therefore the currency. There are also technical factors such as interest rates, equity markets and international trade which may have an impact. Spend time getting to know these.

2. Understand the strategies. Yes there is a method to the madness. There are three crucial trading strategies which are often used by currency traders; the carry, momentum, and value trade. Momentum tracks the direction of currency markets; the carry strategy sees investors selling currencies with low interest rates and buying those with high rates; and the valuation strategy takes a position based on the investor’s view of a currency’s value. However, the strategies you use are up to you.

3. Be focused. There are potentially hundreds of currency pairs that can be traded in the currency markets, each of which have their own characteristics and considerations to understand and analyse. Part-time traders usually concentrate on just a few pairs and commit to thorough and robust research on those few, rather than superficial research on the many. Some key things traders must consider when analysing a currency pair are its liquidity, transaction costs (the spread), and its volatility. As a general rule, major currencies usually have better liquidity, tighter spreads and lower volatility, versus emerging market currencies which have poor liquidity, wide spreads and volatile movements.

4. Stick to a long term plan. It’s one thing to have a plan, it’s quite another to execute it. It is important in currency trading to not get caught up in the moment – the markets are fast moving and in the short term can be unpredictable. Good currency traders may make money in the long term by being disciplined, not necessarily by making short term bets.

5. You will not win on every trade. That may not sound like much of a sales pitch, but even the most successful of traders don’t win on every trade. What they do have is a robust plan and long-term strategy which carefully considers the risks. So don’t necessarily be disheartened if a trade doesn’t go your way; review why it went wrong and see if there is anything to learn from the experience. But don’t think that currency trading is an option for those seeking quick money, because like any investment, it only should be played by those with a long-term end-game in mind. Ultimately, if you have a sound risk / reward strategy in place, you will be able to sustain losing on more than 50 per cent of your trades.

Ultimately, FX is only one of the many asset classes investors should be considering. But with the right preparation, research, and strategy, online trading can add real, and uncorrelated, value to a diversified investment portfolio. Particularly pertinent considering the state of today’s uncertain equity markets.

Betsy Waters is Global Director of dbFX, Deutsche Bank's state of the art online retail trading platform. Betsy oversees sales and trading for dbFX’s retail client base. Prior to joining Deutsche Bank, Ms. Waters worked at Goldman Sachs and Citibank covering Foreign Exchange sales to banks and international corporations. She has over 20 years' experience in sales and trading for FX markets.