foreign exchange, forex markets

How to play the currency markets

14.12.2007

by Tim Bennett

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As volatility rises in stockmarkets and property turns into a losing bet across much of the globe, it’s easy to see why many investors are turning to foreign currency trading.

The foreign exchange (forex) market is the biggest and most liquid in the world – average daily turnover is around $2.7bn. More importantly, because currencies must strengthen or weaken against each other (they can’t all fall at the same time), there’s always a way to profit by playing one against the other.

With a growing range of retail products available, the once-inaccessible and arcane forex market is steadily opening up to private investors. But which products are worth buying?

Foreign currency bank accounts

These involve opening a bank account in sterling, which a bank then converts into another currency, such as US dollars or euros. So, if you believe the dollar will rally next year, you could use £5,000 to create a deposit of $10,000 now at a rate of $2 to £1. If the dollar does rally against sterling in the spring, you could convert the deposit back – at a rate of, say, $1.80 to £1. This turns $10,000 into £5,555, a profit of £555 plus any interest earned on your dollars in the meantime.

Most of the UK’s clearing banks offer this service for a range of foreign currencies. But the time, effort and cost involved to open such accounts, combined with large minimum deposit requirements on those that pay a competitive rate of interest, mean these accounts are usually better suited to businesses grappling with regular foreign currency receipts and payments, than to private investors.

Currency ETFs

These relatively new products are shares that track how individual currencies perform against the US dollar. Like other exchange-traded funds (ETFs), the New York-listed “Currencyshares” offered by manager Rydex can be bought and sold via most brokers.

The value is based on the exchange rate for a fixed amount of the underlying currency, typically 100 units. So, for example, the Currencyshares Eurotrust (NYSE:FXE) is priced at $147 when the euro/dollar rate is $1.47, and the British Pound Trust (NYSE:FXB) is priced at about $204 when the pound/dollar rate is $2.04 (be aware, though, that the Japanese Yen Trust (NYSE:FXY) is based on a deposit of ¥10,000).

Say the euro/dollar rate moved from $1.47 to $1.57 and you owned a single share, you would be up a modest $10, minus dealing costs and a fixed annual management fee of 0.4%. You also receive a dividend based on the interest rates in the underlying currency – the highest is the Australian Dollar Trust (NYSE:FXA), offering 6.03% annually.

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Dollar bull and bear Powershares

A broader option comes from Powershares, which offers ETFs tracking the performance of the US dollar against six other currencies, using New York Board of Trade (NYBOT) dollar index weightings (for the euro, 57.8%; sterling, 11.9%; the yen, 13.6%; the Canadian dollar, 9.1%; the Swedish Krona, 4.2%; and the Swiss Franc, 3.6%).

With the US housing market seemingly in terminal decline, interest rates being cut and the IMF forecasting slowing economic growth, the US dollar seems likely to weaken further, which makes the Powershares DB Dollar Bearish fund (NYSE:UDN) seem a good bet. The shares have risen nearly 15% so far this year, pay interest based on three-month US Treasury rates, but come with an expense ratio of 0.55%. There is also a bullish version for those who think the dollar will rise.

For anyone who doesn’t have a specific directional view on individual currencies, but wants to profit relatively easily from carry trading (this is where investors make money by borrowing in low-yielding currencies, such as the yen, in order to reinvest in others, such as sterling, that offer a much higher interest rate), there’s the G10 Harvest Fund (AMEX:DBV).

This is structured to take a long (bullish) position using futures on the G10 currencies that offer the highest interest rate or yield – currently sterling, the New Zealand dollar and the Australian dollar – and a short position (bearish) on the three with the lowest yield – right now that’s the Swiss franc, the yen and the Swedish krona.

So far this year the fund is up around 10% – but on the downside, at 0.75% the management fee isn’t cheap and with the credit crunch in full swing, carry trading is becoming more risky as interest rates in G10 countries start to converge.

While certainly more convenient than opening a foreign currency bank account, to make a decent return from ETFs, you’ll need to buy enough shares to justify dealing costs, spreads and the management fee. But more importantly, all the available ETFs – and therefore your returns – are dollar denominated, which is pretty self-defeating if you’re a sterling investor betting on a dollar decline.

So, if you really want to bet on currencies, an account with a UK spreadbetting firm is probably a better bet, as long as you make use of stop losses to limit your downside. These bring a greater choice of currencies to bet on, and trading costs, such as bid-to-offer spreads and commissions, are lower. For more on spreadbetting, see How to profit from market turmoil.

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