May 11th, 2012

Why the fixation on foreign exchange?

I’m always surprised and bewildered seeing the “Alert” image and hear the special effects sound whenever CNBC wants to say something about foreign exchange and make it appear as if something really significant has happened.  This morning it was a “breaking news” story about a move (or absence of a move when actually one was expected) in the €EU.

I understand that currency fluctuations are important since the world figuratively revolves around the free exchange of wealth (money) and goods.  And I also understand that countless speculators, investors and governments are involved in foreign exchange markets.  Furthermore, I understand that currency markets are extremely leveraged since the players can put on and lever up to huge positions with small equity of their own.  And finally I understand that the exchange values of one currency against another is based on supply and demand amongst all those players tempered by the policy positions of governments and central banks who attempt to influence (control) and stabilize those exchange values.

But as a trader who trades foreign exchange only on an extremely limited basis through ETFs, I don’t understand foreign exchange as a trading vehicle when currencies don’t fluctuate really that much.  Take the €EU (Euro) as an example.  It may be hard to believe given all the discussion about sovereign defaults and debate about the currency’s possible breakup, the €EU today is where it was in 2006 as reflected in the price of FXE (the Rudex CurrencyShares EuroTrust ETF:

The following chart compares the $US Index (a composite exchange rate index for a basket of currencies of our largest trading partners) with the more volatile S&P 500 Index:

To add another dimension to the €EU’s volatility, I superimposed the FXE on a chart of YUM (Yum Brands) for the same period to compare the two (the FXE is in blue):

Businesses surely need to pay attention to foreign exchange since those fluctuations impact revenues, costs and profits but I don’t understand where the fascination for individual investors comes from given that you’d wind up paying margin interest and wouldn’t earn the dividend yield (which in the case of YUM is currently 1.6%).

Why do most of the search results for the term “technical analysis” focus on foreign exchange?  If it weren’t for the huge margin possibilities (up to 90%) which makes it a more risky game, why should the average investor be interested at all in foreign exchange?  I can’t predict the future of the €EU or the $US but my guess is that fluctuation in the short run future won’t be all that significantly different than they have been in the past regardless of the EU outcome.  Can someone please answer the question “What am I missing?”

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  • Joe – A couple of factual corrections. First, there is no margin interest in forex. Retail forex operates similarly to the futures market in that margin is nothing more than a surety deposit. It is not a loan used to buy securities the way it is in stocks. In fact, no currency ever actually trades hands, just agreements. Related to that, while there’s no dividend yield, there is potentially interest carry (think “carry trade”). Second, US traders need only put down 2% margin for the major currency pairs (exchange rates), and in other places it might be 1% or less.

    Now, wrapping around to the whole “why?” question, you actually brought up the explanation yourself when mentioning huge margin. You’re absolutely correct that exchange rates tend to have less volatility than indices and individual stocks (see Looking at Volatility Across Markets). Once you start applying leverage, though, you have the opportunity to effectively match volatility, and thereby risk and reward opportunities between forex and other markets.