Currencies have sometimes provided windfall speculative profits for institutional investors with many market participants well aware of the legendary 1 Billion pound trade by George Soros that broke the Bank of England in the early 1990â€™s. However, currencies can also be a slow and steady source of appreciation for both institutional and individual investors alike.
One of the strongest appeals of currency trading is that FX is generally not correlated to other markets and therefore provides a good source of diversification for investors. Currencies are driven by large macro economic and political factors and can serve as both a hedge and safe harbor during volatile market environments. For example during times of stress the US Dollar as world global reserve currency, the Swiss franc as the best managed economy in the industrialized world, and the Japanese yen as the biggest earner of surplus capital, generally serve as safe haven currencies offering a modicum of protection to investment portfolios.
Currencies can also act as speculative views on growth. During times of global expansion commodity currencies such as the Australian, the Canadian and the New Zealand dollars tend to perform well. For example during the 2009-2011 global recovery the Australian dollar boosted by the insatiable demand from China, nearly doubled in value rising more than 78 percent.
One of the most common institutional investment strategies in foreign exchange is the carry trade. At the height of its popularity the carry trade attracted more than 1 Trillion dollars of investment capital from hedge funds and investment banks and other professional investors. With the advent of electronic trading the carry trade is now available to individual investors as well.
The carry trade is simply the art of buying a currency with a high interest rate while selling a currency with a low interest rate against it. The Australian dollar versus the Japanese yen is a classic example of carry trade in action. The Australian dollar presently yields 3% while the rate on the yen is a mere 0.1%. An investor could in principle lock in the near 3 percent difference between the two currencies as he holds the long AUD/JPY position. Furthermore, because the foreign exchange market offers leverage, an aggressive investor can use credit to margin the position to obtain higher returns. If an investor bought AUD/JPY at the start of the calendar year on 10-1 margin and if the interest rate differential between the two currencies remained at 3% and if the currency pair maintained its value, an investor could earn 30% on his position in just one year.
However, the carry trade can also be fraught with peril and can generate massive losses during times of high volatility due to the leveraged nature of the trade so therefore investors must be selective in using this strategy. Furthermore, the carry trade can also reverse its gains if the interest rate differential between the two currencies begins to compress rather than expand.
From short term speculation, to longer term investing, to income generation the currency market offers investors a plethora of choices to consider a variety of strategies, but as with all all speculative instruments education about the market is critical to making informed decisions.