Foreign Exchange Risks & Forex Risk Management

Like every other financial market, the Foreign Exchange market incurs many risks, consequently, risk management becomes a vital factor to consider in order to be profitable in the long-run. This analysis will present all major currency risks and specific recommendations on how to deal with them.

 

Major Forex Investing Risks

 

These are the six (6) risks when investing in the Foreign Exchange Market:

 

(1) Exchange Rate Risk

The exchange rate risk is market risk and refers to unfavorable changes in the value of exchange rates. Every active Forex trading position is exposed to exchange rate risk. You can never eliminate it, but you can seriously limit the impact of it.

Hedging against Exchange Rate Risk:

These are some basic techniques to hedge against currency risk:

• Applying multiple portfolio diversification
• Implementing a detailed Money Management (MM) system
• Trading always small sizes
• Limiting the use of trading leverage
• Identifying and hedging against potential correlations between different currency positions

 

(2) Correlation Risk

There are strong correlations between certain Forex pairs. The correlation risk refers to changes in the correlation between two financial instruments over time. Correlation risk can disturb the efficiency of portfolio diversification, and that is why it matters to Forex investors.

For example, the correlation between NZDUSD and EURUSD is diminishing in the past decades. On the contrary, there is an increasing correlation between GBPUSD and EURUSD.

Table: Historical Correlations between major Forex Pairs

The above table contains the correlations between fifteen (15) major Forex Pairs for the period 2000-2018. The table can be found in the book “Historical Correlations between major Forex Pairs”, ► more about the book on Amazon

 

(3) Interest Rate Risk

The interest rate is at the core of every Exchange Rate valuation. An interest rate decision can have a great impact on the currency markets, especially if this decision was not anticipated by most analysts. This is how interest rate risk can affect a portfolio:

(i) Violent exchange rate volatility

(ii) Stop-loss hit, position closing

(iii) Reversal of long-term Forex trends

(iv) Changes in the overnight rates (SWAPs) that majorly affect carry-traders

Hedging Against Interest Rate Risk

(i) Trading always small sizes allows a lot of space for wide stop-loss orders. That means less vulnerability to volatile events, such as interest rate decisions

(i) As concerns short-term, in order to deal with interest rate risk, Forex traders should avoid market exposure when those events are expected to happen

 

3- Credit Risk

When trading Forex, credit risk refers to many different situations. Most commonly, it refers to the inability of a Forex broker to meet its obligations to its customers. That situation can emerge if a brokerage firm faces bankruptcy.

Hedging Against Credit Risk

(i) Trading with regulated brokers offering fully segregated bank accounts to their clients’

(ii) Being aware of the compensation scheme behind your broker and the country of headquarters

(iii) Maintaining several trading accounts on different brokerage firms, not a single huge account

 

4- Liquidity Risk

Liquidity risk refers to the inability of liquidating an investment and thus the inability to accumulate cash when needed. The lack of liquidity may cause the failure of a payment agreement and that is why it is considered particularly important. In other words, an investment shouldn’t be just safe but it must be also highly liquid.

The Forex market is the most liquid market worldwide therefore, the liquidity risk is not as important as in other financial markets. But historically, there were instances, when the liquidity risk caused brokerage firms to collapse. For example, in 2015, when the Swiss franc soared 30% after the central bank abandoned the cap on the currency's value against the Euro. Vast Forex brokerage firms, such as Alpari UK, faced bankruptcy.

Hedging Against Liquidity Risk

(i) Trading small sizes (note that stop-loss orders may not be triggered in extreme cases)

(ii) Being aware of the compensation scheme behind your broker and the country of headquarters

(iii) Maintaining several trading accounts on different brokerage firms, not a single account

 

 

-5 Political Risk or Country Risk

Political or country risk involves sudden changes in the legislation of a country which may unfavorably affect the value of a Forex exchange rate. Situations such as capital restrictions can create chaotic currency volatility. Emerging and developing economies include higher levels of political risk than developed economies.

Hedging Against Political Risk

• Political risk can only be managed by overall portfolio diversification.

 

-6 Systemic Risk

Systemic risk refers to the possibility that the whole financial system will collapse. Systemic Risk exists in every financial market, and as markets are globalized - the collapse of a financial market may spread rapidly everywhere causing an overall collapse. A systemic collapse is a very rare event –but when it occurs it may lead to the total loss of the initial investment.

Hedging Against Systemic Risk

(i) Maintaining physical gold and physical Bitcoin in your portfolio

(ii) Multi-leveled portfolio diversification

 

Conclusions

When you open any position in any financial market you are exposed to some forms of risks. Hedging constantly against all these forms of portfolio risks matters a lot. Effective risk management is the key factor in defining your long-term success as an investor. Professional investors always hedge against risk and avoid trading ‘naked’. These are some important tips to deal with all forms of risk:

Six (6) Key Tips to Deal with Forex Investing Risk

(i) Multi-level portfolio diversification (no exemptions)

(ii) Brokerage diversification (maintaining accounts on different brokerage firms)

(iii) Trading accounts diversification (depositing funds covered by the compensation scheme)

(iv) Trading always small sizes (a professional trader will not risk more than 2% of the portfolio value on any position)

(v) Avoiding high-trading leverage (trading leverage increases your risk and your trading cost at the same time)

(vi) Being always prepared for black-swan events which may cause systemic risk and chaos in the financial markets (maintaining 8% gold and 2% Bitcoin)

 

■ Foreign Exchange Risks & Risk Management

George Protonotarios, January 2020

Forex-investors.com (c)