The search for alternative asset strategies to be used as tools to diversify a portfolio can be fulfilled with the addition of an allocation to spot foreign currency trading, commonly referred to as Forex.
The Forex markets are greater in size than the fixed income markets, even with government securities considered. These markets operate globally 24 hours a day, 5 days a week, with the exception of bank holidays in the countries that are engaged in this market. The currency value of any country gives a representation of the "value" of one country in comparison to another. Macroeconomic forces such as the interest rates, political risk, commerce barriers, as well as the country's fiscal and monetary policy affect the current value of a specific currency. Global trade is based on the free exchange and conversion of trade between transactional partners in two different countries.
The spot currency market facilitates the transfer of risk associated with the conversion of trade from one currency to the home currency of each trading partner. Trading in the spot market is done through a network of banks, broker-dealers, Forex Dealer Members (FDM), and other participants that are engaged in this trading. Forex trading is conducted with the use of currency pairs. One currency is bought in favor of another currency that is sold. Profit occurs when the long currency increases in value against the short currency, or the short currency decreases in value in relation to the long currency position. The change in relationship values and the direction of this change determine profit or loss.
A commercial entity that is hedging its exposure to a currency will experience an offsetting effect as a result of entering into a market position. The gain or loss from the hedge will be offset from the extra gain or loss resulting from the currency conversion in the commercial transaction that is covered. An investor can easily enter these markets and seek to profit from the interrelationship change of various currencies.
The public investor that enters the Forex market for the pursuit of profit does so by placing funds on deposit with a party, such as an FDM and places orders to trade currency pairs. The standard contract of a currency pair has a notional value of $100,000 USD. A currency contract on the spot market has a two-business-day life span, and at the end of that period the position can be closed or rolled over into another contract. Mini contracts have a notional value of $10,000 USD and if the FDM offers a micro contract, its notional value is $1,000 USD. A margin deposit is required to establish a position.
Forex trading in currencies issued by countries such as Canada, Australia, New Zealand, Denmark, Norway, Sweden, Japan, Britain, Switzerland, and the European Union are subject to margin deposits of 1%. Other countries that represent greater instability or poor liquidity will be subject to deposits greater than this level, as determined by the intermediaries of the transaction. Forex trading account leverage can be extended further. Recently the Commodity Futures Trading Commission set the maximum leverage of a forex trading account to 50 to 1. For discussion purposes, a $50,000 USD account, levered at 50 to 1, can control a spot forex contract with a notional value of a position requiring the 1% deposit equal to $5,000,000,000 USD or 50,000 contracts. This maximum leverage, while not suggested, will translate into an entire gain or loss on the account with a 0.001% change in the currency pair traded.
In addition to the risks associated with the use of extreme leverage, Forex trading also contains counterparty risk, settlement risk, operational risk, country risk, interest rate risk, liquidity risk, market risk, and exchange rate risk. Funds placed on deposit with a Forex trading partner are not segregated for the customer's protection. In the event of a bankruptcy of the custodian, account holder's become general creditors in the proceedings. Further analysis of these risks should be performed in light of the client's tolerance and portfolio goals.
For the purposes of portfolio diversification, a suggested 5% allocation can be made into this asset class. Depending on the risk tolerance of the investor, increasing the leverage modestly to levels such as 2 to 1, or 5 to 1 may be more appropriate and may allow a greater contribution of this allocation to the entire portfolio. Such an allocation will add a liquid component to the portfolio and a contributing return pattern that has a stabilizing effect on the returns of equities and fixed income due to the nature of the influences of currency values and interest rates of the issuing country.
Jeffrey L. (Jeff) Stouffer, CFP, CAIA, is the principal of Mercantile Capital Group, a Herndon, Va., based introducing broker registered with the CFTC and a member of the National Futures Association. As a practicing financial advisor serving the needs of individuals and small businesses, he believes in using a wide range of investment strategies, including alternative investments. All strategies are client centric and unique. He can be reached at [email protected].