Forex risk refers to the losses that occur due to currency fluctuations. Currency risk/FX risk or exchange-rate risk is a risk of financial impact and describes the possibilities that the value of an investment may decrease as a result of a change in relative values of the involved currencies. There are plenty of risks associated with forex trading which are discussed below:
1. Exchange Rate Risk
In forex trading, traders purchase the currency of one country with the currency of another country. As a result, a change in the value of currencies will affect the profit of traders. When traders buy and sell currency, they speculate on how different countries’ currencies will change in value against one another. This risk is closely associated with the country’s interest rate risk. The increase in interest rate will cater to more investment in a country and a falling interest rate will result in disinvestment. Forex traders must understand this relationship before heading into the trade to avoid losses.
2. Leverage Risk
To gain access to substantial trades in foreign currency, leverage requires a small initial investment called margin. While trading a margin, investors need to borrow money from brokers to finance trades that require funds in excess of the actual cash balance. A minute price fluctuation can lead to a margin call where the investor is required to pay an additional margin. Leverage can exponentially increase profits but the aggressive use of leverage during volatile market conditions will result in losses.
3. Interest Rate Risk
Interest rates also impact the exchange rates of countries. A rise in the interest rate of a country will strengthen its currency. And if the interest rates fall, the currency of the country will weaken due to the withdrawal of investment by the investors. The differences between currency values as a result of the nature of interest rate and the devious effect of interest rate on exchange rate cause a dramatic change in FOREX price. To forecast the changes that might impact the outstanding gaps, constant analysis of the interest rate environment is essential.
4. Transaction Risk
This exchange rate Forex risk is associated with the time differences between the starting of a contract and when it settles down. Since Forex trading occurs 24/7, the exchange rates may change before the trades get settled. As a result, currencies can be traded at different prices at different times during different trading hours. The more the time difference between entering and settling the contract, the more will be the transaction risk.
5. Country Risk
While deciding to invest in a currency, one must assess the structure and stability of the issuing country. A frequent balance of trade deficit may lead to a currency crisis and result in the devaluation of a country’s currency. Thus, it will also affect the forex trade and prices. Country risk is bifurcated into two parts:
Straightforward- Currency is affected by instability in a country. The occurrence of adverse events causes fear among traders and as a result, traders withdraw their investments out of the country’s currency, which results in currency devaluation.
Devaluation Risk- To compete more effectively from a trade standpoint, the company purposefully decreases the value of its currency.
Takeaway
There are various Forex risk and losses associated with forex trading. Due to its speculative nature, a small initial fee can result in substantial losses and illiquid assets. The various political factors and time differences also have a significant impact on the country’s currency and financial markets. The risks involved in forex trading is high because of the highest trading volume and may result in severe losses.
