Profit in foreign exchange trading is based on accurate forecasts of different currencies’ relative values. Margin trading is the standard method of trading foreign exchange. Trades can only be made after a small collateral deposit equal to a fixed percentage of the total trade value.
Foreign exchange, also known as forex trading, is the practice of profiting from fluctuations in the value of different currencies. You can’t make use of stock exchange-style centralized markets because, for one thing, there aren’t any. Another issue is that the potential consequences affect more than just one company or even an entire industry.
Currency trading can be risky, but it’s possible to make money if you’re prepared, always well acknowledged about real-time forex news, and trade cautiously. To help you start forex trading responsibly, below, we’ve outlined some of the most common dangers you may encounter:
Table of Contents
Interest Rate Risk
Interest rate risk refers to profit and loss from forwarding spread fluctuations, forward amount mismatches, and maturity gaps in the foreign exchange book. On foreign exchange, futures contracts and options are vulnerable to this threat.
Limiting the overall size of mismatches is one way to reduce interest rate risk. Mismatches are typically sorted into groups, “up to six months” and “past six months,” based on their respective maturity dates. Positions for all delivery dates and gains and losses are calculated by entering all transactions into computerized systems.
The interest rate environment must be constantly analyzed to foresee any changes affecting the outstanding gaps.
Exchange Rate Risk
The risk associated with fluctuations in currency values is known as exchange rate risk. It is predicated on the impact of the ever-changing, often-volatile global supply and demand balance. A trader’s open position is vulnerable to market fluctuations for as long as the job is available.
The market’s expectation of the direction in which currencies will move in response to any factors occurring (or potentially occurring) anywhere in the world at any given time can be a significant source of risk.
Furthermore, unlike regulated futures exchanges, Forex trading occurs off-exchange without daily price limits. Fundamental and technical factors drive market movement, which we’ll see below.
To keep losses under control, traders commonly limit their downside while expanding their upside potential.
Settlement Risk
The disparity in settlement times between continents is a source of risk. Therefore, the exchange rate of a currency may fluctuate throughout a trading day. Credits are issued in AUD and NZD first, followed by JPY, EUR, and USD. For this reason, making payments to a party that has declared or will be declared insolvent is possible before that party executes its costs.
Traders need to consider more than just the current worth of their currency holdings when calculating credit risk.
Credit Risk
To put it simply, credit risk is the risk that a counterparty will not fulfill its obligation to repay an outstanding currency position, whether that obligation is voluntary or involuntary.
Corporations and financial institutions are typically concerned about credit risk. When dealing with companies registered and regulated by the authorities in G-7 countries, the credit risk for the individual trader (margin trading) is very low.
Before sending any money to a company for trading purposes, individual traders must do extensive research on the company. Inquiring about potential companies via official portals is a breeze:
- CFTC
- NFA
- FCA
- PRA
In addition to posting notices on their websites, most businesses are happy to talk to their customers about the safety of their financial transactions.
Counterparty Default Risk
Spot and forward currency contracts are traded “over the counter” (OTC) between banks and FCMs rather than on exchanges. The client is exposed to counterparty risk, which is the threat that the leaders of a trader, the trader’s bank or FCM, or the counterparties with whom the bank or FCM trades are unable or refuse to perform concerning such contracts.
There is no duty on principals in the spot and forward markets to maintain markets in spot and forward contracts.
Leverage Risk
In Foreign Exchange, margin requirements and trade collateral are typically low (just as with regulated commodity futures). A great deal of leverage is allowed by these margin policies. Even a tiny change in a contract’s price can result in immediate and substantial losses that far outweigh the initial investment.
If 10% of the contract’s price was deposited as margin at the time of purchase, and the contract was closed out after a 10% drop in price, the investor would lose their entire margin deposit (before brokerage fees were deducted). The margin deposit is lost entirely if the value drops by more than 10%.
Country and Liquidity Risk
Even though over-the-counter (OTC) foreign exchange is typically more liquid than exchange-traded currency futures, illiquid periods have been observed, particularly outside US and European trading hours.
There are also restrictions or penalties for holding positions in certain foreign currencies over time, as well as limitations on the amount to which the price of specific foreign exchange rates may fluctuate during a particular period, the volume which may be traded, and so on. This could lead to a period of inactivity during the trading day.
A trader’s account could take a significant hit if they are prevented from quickly closing out unprofitable positions due to these limits and restrictions.
