Risks when dealing in Foreign Exchange
The foreign exchange market, also known as Forex, is a worldwide and well-known decentralized market which basically trades different currencies. It involves the buying, selling and of course exchange of currencies at a particular price. This sector, which is one of the largest markets in the world, determines the foreign exchange rates. Central banks (major players which represents the government) financial institutions (such as banks), hedgers, speculators and retail are the most popular participants in the foreign exchange market.
However, there are some risks associated with the foreign exchange market. This risks are based on different circumstances caused by many factors.The risks will be discussed below:
- Polity: Politics plays a very crucial role in the foreign exchange market. In investing in currencies, the country of such currency needs to be well assessed. Their structure and “financial tradition” needs to be well understood. The impact of elections cannot be overemphasized. Election period scan bring moments of instability and volatility in country thus leading to significant instability in the currency of such currency. The instability in the currency will, in turn, lead to a volatile exchange rate. Related factors such as outcomes of elections and change in government may also usher in new changes in the country’s exchange rate. A new government may decide to float new policies which can impact the country’s exchange rate positively or negatively. Other factors such as strike action, insurgency and natural disasters may also affect the foreign exchange market.
- Interest risks: Interest is a payment made by a borrower to a lender. It can also be referred to as an amount paid by a depositor, in addition to the amount borrowed. The rate of interest paid is determined by the amount borrowed. However, the central bank also influences the interest rates through various monetary policies. Notably, currency pairs of higher interest rates appeal a lot, thus increasing its demand. If interest rate falls, investors may begin to withdraw their investments.
- Credit risks: Credit risk is a risk in which the other party is unable to make up with repayment. However, this might be caused by unfortunate circumstances such as bankruptcy. It is expedient that every Forex broker strictly abides by the rules and regulations of the country.
- Exchange rate risk: This type of risk which has to do with the dynamism of the currencies. This is caused by the constant supply and demand of currency thus affecting the balance of the market. Every Forex broker will always love to trade the high interest currency pairs thus affecting the balance between demand and supply. Currencies may be traded at varying prices at different times of the day. However, a limit in the currency traded can curb the risk.
- Broker risk: For individuals interested in the Forex market, a good and reputable broker should be selected. A bad or untested broker may be a bomb waiting to explode. Some brokers are unregulated therefore due diligence is required in selecting a good broker. Finding the right broker may help prevent credit risks.