There’s A Lot Of Money On The Table In The Forex Market Right Now

There’s A Lot Of Money On The Table In The Forex Market Right Now
Reda Farran, CFA

over 2 years ago4 mins

    • FX is the marketplace where currencies are traded, and it’s the biggest and most actively traded asset class in the world.
    • The FX market is not perfectly efficient due to a large presence of non-profit-seeking participants in the market that “leave money on the table”.
    • That means investors can boost their portfolios by exploiting the FX market’s inefficiencies to generate attractive, uncorrelated returns.
  • FX is the marketplace where currencies are traded, and it’s the biggest and most actively traded asset class in the world.
  • The FX market is not perfectly efficient due to a large presence of non-profit-seeking participants in the market that “leave money on the table”.
  • That means investors can boost their portfolios by exploiting the FX market’s inefficiencies to generate attractive, uncorrelated returns.

Mentioned in story

Back in April 2019, forex (FX) trading reportedly reached $6.6 trillion a day – more than Japan’s entire annual economic output. That makes FX the largest and most actively traded asset class in the world, and an opportunity for your portfolio you can’t afford to miss.

🤨 Is FX even an asset class?

It wasn’t thought to be – certainly not at first. That's because FX is a rate of exchange, not an index linked to ownership of some underlying item of value like company assets, physical commodities, pieces of land, and so on. In fact, to buy dollars, you need to sell pounds, or euros, or any other currency.

That’s why investing in FX initially started off as simple currency hedging. See, exposure to currencies was a by-product of investing in international stocks and bonds – one that introduced unwanted volatility into a portfolio without much benefit. So the goal of hedging was to remove that currency risk and lower a portfolio’s total risk, as you can see in the graph below.

Expected volatility reduction from FX hedging across different asset classes. Source: BlackRock
Expected volatility reduction from FX hedging across different asset classes. Source: BlackRock

Now, though, FX investing has since gone from simple hedging to active strategies that generate attractive returns.

📈 What’s the opportunity here?

The FX market isn’t “efficient”, and that’s something you can exploit.

Here’s what that means: the efficient market hypothesis states that share prices reflect all information in the markets. According to the hypothesis, stocks always trade at fair value – i.e. what they’re actually worth based on investor analysis. That makes it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. Currency values, on the other hand, often deviate from their intrinsic values. That’s because there are a lot of participants in the market that aren’t looking for profits.

For example, central banks intervene in the FX market to stabilize currencies, rather than to make a profit. Individuals and companies buy and sell currencies in everyday transactions: travel, goods, imports/exports, and so on. Banks’ trading departments buy and sell currencies to provide liquidity, but not to generate investment returns. Investors indirectly buy and sell currencies when investing in foreign assets, and usually to profit from the assets themselves rather than the underlying currencies.

Look at it another way: stock investors are trying to buy undervalued stocks and sell overvalued ones, and that helps keep stock prices in relative balance. But all the parties above are buying and selling currencies not because of what they think they're worth, but because they have to. That creates inefficiencies, leaving money on the table for FX investors to grab.

💵 Should you add FX investments to your portfolio?

It’s a good idea – for two main reasons.

First, there’s the returns. In a world where stock valuations are sky high and bond yields are near zero, you need to look at other sources of returns – and the FX market can offer just that. In Monday’s Insight, we’ll show you three simple FX investment strategies that you can use to boost your portfolio’s returns.

There’s another way to profit too: you can use currencies as a way to implement some of your top-down or macroeconomic views. Let’s say you think Britain’s vaccination program is moving a lot faster than Europe’s: you might expect its economy to reopen sooner and therefore rebound more strongly. You can take that position by buying the pound sterling and selling the euro.

Second, there’s diversification. The FX investment strategies we’ll be discussing in the next Insight have low correlations with traditional asset classes such as stocks and bonds, which means they don’t follow the whims of the wider market. That means adding them to a portfolio could be a great way to boost its diversification and lower its risk.

Check in on Monday then, and let’s take a closer look at exactly how these strategies work…

Key takeaways

  • FX is the marketplace where currencies are traded, and it’s the biggest and most actively traded asset class in the world.
  • The FX market is not perfectly efficient due to a large presence of non-profit-seeking participants in the market that “leave money on the table”.
  • That means investors can boost their portfolios by exploiting the FX market’s inefficiencies to generate attractive, uncorrelated returns.
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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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