Investing in foreign currency involves purchasing money, or currency, in another country. The market for foreign currency investing is the largest and most liquid in the world. There are some differences between investing in foreign currency and investing in stocks or bonds, though, that investors should be aware of.
Further, foreign currency investing can be somewhat confusing to new investors, and it also entails its own unique risks. For that reason, it can be beneficial to learn the basics before folding it into an investment strategy.
Understanding Foreign Currency Investment
As noted, investing in foreign currency means purchasing another country’s currency, or money, as a means of investment. You’re not planning on spending it, in other words, and are hoping that it accrues value to generate a return. It’s also different from exchanging foreign currency, though it may feel similar.
Foreign currency investment is often, or typically done via “forex” trading. Forex is short for “foreign exchange market,” and refers to trading fiat currencies, or those that are backed by the government that uses them. For example, an investor could trade their United States dollars (USD) for Euros. Or, they can trade their Japanese yen for New Zealand dollars.
Key Takeaways for New Investors
Forex trades can happen at any time throughout the day, since there’s always a foreign currency market open somewhere in the world. Foreign currency investors are typically institutional investors, although it is possible for individual investors to participate.
Investors should also know that currencies tend to trade in pairs — more on that below.
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Exploring the Benefits of Investing in Foreign Currencies
Like other types of investments, forex trading, or investing in foreign currencies, can offer up some benefits.
Diversification of Portfolio
For one, investing in foreign currencies can add a degree of diversification to an investor’s portfolio. That means that while an investor may have built a portfolio with a number of other investments, such as stocks, bonds, and ETFs, foreign currency can be another element in the mix. Note, though, that it’s likely foreign currency should only comprise a small portion of a portfolio’s overall holdings.
Convenience and Accessible Markets
The forex markets operate 24 hours per day, 365 days per year, unlike the standard stock exchanges. So, for investors who want to trade around the clock, the markets are almost always accessible.
There are four major forex trading sessions in a 24-hour period, split up by international region:
• Sydney (Australia)
• Tokyo (Asia)
• London (Europe)
• New York (The Americas)
There are minor sessions, too, but these are the four major sessions, and markets can be busy (when the Americas’ session overlaps with Europe’s), or less busy, depending on the time of day, and how many people are actively trading.
Hedge Against Domestic Currency Inflation
It’s possible that while a domestic currency is losing value due to inflation, foreign currencies could retain their value at the same time. That would, theoretically, provide investors with a hedge against inflation — but there’s no guarantee prevailing market forces would work to an investor’s advantage in such a scenario.
💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.
Ways to Invest in Foreign Currencies
Foreign currency investment doesn’t typically involve using physical money, so you’ll have to find something else to do with the foreign currency left over from your last international vacation. There are several ways to get started in currency exchange investment.
1. Standard Forex Trading Account
First, you can work with a foreign exchange brokerage to trade the currency you’re holding (such as U.S. dollars) for another currency (Euros, Yen, etc.). The goal is that the currency you’re trading for, or buying, will increase in value relative to the currency you’re trading away, or selling.
So, if you buy, or trade U.S. dollars for Euros, you’re hoping that in the future, you’d be able to trade the Euros back for more U.S. dollars than you originally used to make the purchase. You’re looking to make a profit, in other words.
While the goal is straightforward, the process can get more complicated. For instance, there are a few ways traders can execute trades, such as spot trading, forward trading, and future trading. Spot trading is an instant trade, whereas forward and future trading may involve settling on terms at a time in the future (similar to trading options).
Further, investors should understand the concept of the spread, which represents the difference between a trader’s cost and the dealer’s profits.
Beyond that, investors should also have a working knowledge of currency pairs, which is how much of the forex market trades. More on that below.
2. Currency CDs and Savings Accounts
Investors can also look into foreign currency CDs (certificates of deposit), which work more or less like traditional CDs but might offer higher yields. Foreign savings accounts are another potential option, and can serve as investment vehicles by accruing interest and currency appreciation, though nothing is guaranteed.
3. Foreign Bond Funds
Investors can look at the possibility of purchasing foreign bonds, which are issued in other countries by foreign governments or foreign companies. There are many types of foreign bond investment types, so investors would do well to do a bit of research to figure out if it’d be a good addition to their portfolio.
4. Currency ETFs
As mentioned, investors may want to look at currency ETFs. These ETFs are similar to foreign bond funds, there are also foreign currency ETFs on the market, which offer many of the same advantages of domestic or traditional ETFs, but can give investors exposure to the forex market. Likewise, exchange-traded notes, or ETNs, which are similar to bonds, are another potential investment investors can check out.
💡 Looking for other alternatives to invest in? Check out: 10 Types of Alternative Investments
The Risks Associated with Foreign Currency Investment
Foreign currency investment isn’t without risk, and in fact, can introduce some types of risk that investors may not otherwise encounter — such as political and interest rate risks.
Market Volatility and Political Risks
Since forex markets are so active, prices can change quickly, which means it’s a fairly volatile asset class. The news cycle (including economic, political, or social news) can cause sudden and drastic changes to prices. That means it may be a better fit for investors with a relatively high risk tolerance than those who are more risk averse.
Political risk is something to consider, too, as currencies are backed by governments. If a foreign government is unstable or otherwise involved in some sort of political drama, it can affect the price of a currency. That can pose a risk to investors.
Interest Rate Risk
Some investments incur interest rate risk, which is when an investment loses value due to a fluctuation in interest rates. Foreign currencies may be subject to such risk, though interest rate risk is more commonly associated with bonds.
Currency Conversion and Transfer Costs
There may also be additional costs associated with currency trading and investing, including currency conversion and transfer costs. These may not always be applicable, but are something that investors should at least be aware of in the event that they do encounter them.
💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.
How to Approach Foreign Currency Safely
In order to invest in foreign currency investing as safely as possible — remember, no investment is completely safe or risk-free — investors should brush up on the mechanics of the forex market, and know what they’re getting into.
Education is Key: Understanding the Mechanics of Currency Investment
A couple of things investors should also know about are “pips,” and the use of leverage in forex trading.
A “pip” is a unit of measure that represents the smallest unit of value in a currency quote. Using the above quote as an example, the difference between the “bid” (1.2100) and the “ask” (1.2104) is four pips.
Why does this matter? Because currency values fluctuate very slightly during the trading day, perhaps only several pips. That means that to make a significant return, traders deal with large quantities of currencies.
And as for leverage? To get to those large quantities, traders often use leverage. For example, you may give your broker $100 to trade with $10,000 on the markets (using, or borrowing the broker’s $9,900 to make trades is called “margin”). Most forex trading is done this way, using leverage and margin in order to generate returns.
That, of course, has its risks, since traders may incur losses, and end up owing money to their brokers. For beginners, it may be best to use lower margins for that very reason.
The Importance of a Bid-Ask Spread
Also noted previously, the bid-ask spread is another important concept to know and incorporate if you’re trading or investing in foreign currency. Effectively, the spread refers to the difference between a trader’s cost and the dealer’s profits. There’s a slight difference in what you’re willing to pay, and what a seller is willing to sell for. In forex trading, the spread can be important to calculating overall potential returns.
Evaluating Risks Versus Rewards
Above all, it’s critical that investors keep their own personal risk tolerances in mind, and weigh that against the potential gains they could see from foreign currency investing. It may not be a good fit for everyone’s investment strategy.
Currency Investment Strategies for Beginners
Forex trading is different from other types of investing or trading. Generally, investing in or trading foreign currency involves pairs of currencies. That’s because two different currencies are quoted based on their relative value to each other. On an exchange, that may appear as “USD/EUR,” or something similar, while a pairing of Japanese yen and Euros, it may be represented as such: “JPY/EUR.”
Some currencies are more widely traded than others and are “paired” with one another or grouped as “major” currencies:
• U.S. dollars
• Euros
• Japanese yen
• British pounds
• Swiss francs
• Australian dollars
• Canadian dollars
• New Zealand dollars
There are also “minor” and “exotic” currency pairs. These are not traded as widely as the majors, but are still often swapped on exchanges. They may include pairings with the Hong Kong dollar, the Mexican peso, the Singapore dollar, or the Norwegian krone, among others.
Additionally, investors should know about foreign currency quotes. These quotes are similar to stock quotes, which list the current value, or price of a stock. Forex quotes display the bid and ask prices for a currency pair, since one currency’s value is relative to another currency. Here’s an example of a quote for a common pairing, Euros and U.S. dollars:
EUR/USD = 1.2100
In this example, Euros are the “base” currency, and U.S. dollars are the “quote” currency. What does the quote say, exactly? That a single Euro is equal to 1.21 U.S. dollars. Or, €1 = $1.21.
So, in terms of a basic trading strategy for a beginner? It may be best to choose a pair and stick to it — at least for a while, until you get the gist of it. After that, you can look at other, more in-depth trading strategies.
Broadening Your Investment Horizon With Currency ETFs
As mentioned, investors may want to look at currency ETFs. These ETFs are similar to foreign bond funds, there are also foreign currency ETFs on the market, which offer many of the same advantages of domestic or traditional ETFs, but can give investors exposure to the forex market. Likewise, exchange-traded notes, or ETNs, which are similar to bonds, are another potential investment investors can check out.
Advanced Currency Investment Options
While investors can trade currency itself, they can also look at more advanced ways of investing in the forex markets. That can include trading futures and options, or other types of relevant derivatives.
Foreign Currency Futures and Options — An Introduction
First and foremost, investors should be aware of the unique risks that financial derivatives can introduce into their portfolios. Trading options contracts is a whole different beast from choosing stocks, so before you dive headfirst into forex options, it may be worth it to speak to a financial professional.
But at their core, currency options are derivatives, with currency itself as their underlying asset. There are calls, puts, and futures — if you’re not familiar with traditional options, it may be a good idea to review the basics before looking at forex options.
In effect, though, these options allow investors to hedge against unfavorable fluctuations of foreign currencies, or to speculate on volatility in the forex market. Again, it’s fairly high-level stuff, so if you feel like it’s over your head, it may be best to bone up on your investment knowledge before including options trading in your overall strategy.
The Takeaway
Trading or investing in foreign currency is yet another avenue that investors can explore in an attempt to generate returns. As discussed, it involves actually purchasing money with money — foreign currencies — with the hopes that the price differences will work in the investors’ favor, and they’ll generate returns. Foreign currency markets are also extremely liquid, which is another potential upside for some traders.
As always, though, there are risks to consider, and learning the ropes of the foreign currency markets may be tricky. If investors feel like they want to get their feet wet in the market, though, without diving straight in, it may be worthwhile to discuss their plans with a financial professional.
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