The foreign exchange market or the forex market makes it possible for traders to buy and sell currencies. Just like with the stock market, the point of forex trading is to make net profits by buying at a low price and selling at a high price. The forex market has the highest trading volume in the world and forex assets, as a result, are considered liquid assets. The bulk of forex trades consist of forwards, spot transactions, options, currency swaps and foreign exchange swaps.
There are plenty of risks associated with forex trades that can cause significant losses for traders. These include:
1. Exchange Rate Risk
The exchange rate risk happens due to changes in currency values. It depends on the volatile and continuous shifts in global supply and demand. As long as the trader has an outstanding position, this position is typically subject to any changes in prices.
This is a significant risk and depends on the perception in the market about which way currencies will move, based on global events that could occur at any time. Since for the most part forex is unregulated, there are no daily price limits like in the futures exchange.
2. Interest Rate Risk
Interest rates have a substantial effect on a country’s exchange rates. If the interest rates go up, a country’s currency strengthened due to the hike in investments in the country’s assets, and because a stronger currency generates high returns.
The opposite is also true, and if the interest rates fall, the country’s currency weakens as most investors pull out their investments. Due to the interest rate and its effect on the foreign exchange rates, the difference between the value of the currencies causes forex prices to change dramatically. Most traders download the Metatrader4 platform, a trading platform that aids them in assessing the risks involved and avoid them. Majority of brokers provide to their clients the Metatrader4 platform (MT4) alongside their proprietary platforms.
3. Transactional Risks
Risks in transactions are a risk associated with the difference in time between the minute the contract starts and settles. Forex trading is 24 hours and results in some exchange rates dipping or rising before trade settling.
You can also trade currencies at varying prices during the trading hours. The greater the difference in time when you enter and settle a contract hikes the risk of transacting. The time differences give exchange risks time to fluctuate and increase burdensome transactional costs.
.4. Counterparty Risk
When a company provides an asset to the investor, this is known as a counterparty. The counterparty risk is the risk of the broker or dealer defaulting in a transaction. In forward contracts, spot and forex trades on contracts cannot be guaranteed by a clearing or exchange house. In spot currency trading, the risk is from the market maker’s solvency. In volatile markets, the counterparty may be unwilling or unable to follow through with the contract.
5. Country Risk
When a trader is weighing the options of investing in foreign currencies, he or she must access the stability and structure of the issuing country. In most developing countries, the exchange rates are pegged to a global leader like the American dollar.
In these cases, the country’s central bank must have enough reserves for maintaining a fixed exchange rate. A currency crisis may happen because of the continuous balance of deficits in payments, which results in the currency’s devaluation, thus affecting forex trading.
Investing is mostly speculative and if investors feel that a certain currency might decrease its value, they might start to remove their assets, which further devalues the country’s currency. The investors who do not withdraw discover their assets are illiquid and they may suffer from insolvency.
Forex exchange has a long risk list, and because of the leveraged trades nature, a small fee might cause a trader to end up with illiquid assets and huge losses. Political upheavals, shifts, and time differences also have sway in financial markets and foreign exchange rates. Forex assets have high trade volumes, and as much risk attached to them, which can lead to serious financial losses.