The Forex Market

The foreign exchange market, also known as the forex market, is the largest market in the world. In 2007, for example, it garnered $3.2 trillion worth of transactions each day. It’s the quiet giant of finance and dwarfs all other capital markets worldwide.

Unlike most other trading, such as futures, stocks or options, forex trading doesn’t happen on an exchange. It’s not controlled by any governing body, has no central exchange and there are no clearing houses involved guaranteeing trades. It’s a global network, made up of banks, corporations and individuals. The forex is also the most liquid market – there are always ready and willing buyers and sellers for the currency someone is seeking to trade.

The vast majority of currency trading is done bank-to-bank, and when each party enters into an agreement, they both take on the counterparty risk of the other. They’re not only competitors, but they’ve got to cooperate, as well.

There’s no actual buying and selling in the currency market – only trading, hence the need for cooperation.

Exchange traded funds (ETFs) have made entering this market much easier than it used to be. Prior to the launch of currency-related ETFs in 2005, the forex was a challenging market for individual investors to gain access to. Many investors might find this simplified access appealing, especially when you’re talking about a market that’s open 24 hours a day. If you’ve been eager to play this market, there are a rapidly growing number of opportunities to play the currency markets in the form of both ETFs and exchange traded notes (ETNs), which we’ll detail later.

Currency Basics

When entering the currency market, much of the focus is on the eight major currencies, which give you the best over- or under-valued opportunities. The eight major countries that make up the currency trading market are the United States, the Eurozone (Germany, France, Italy and Spain), Japan, United Kingdom, Switzerland, Australia, Canada and New Zealand.

There are many, many more currencies beyond the eight majors, such as the Brazilian real, Polish zloty and Hungarian forint.

Some of the key points to consider when you’re investing in currencies are:

• When trading currencies, yield drives return. Every currency has a yield.
• The forex allows huge leverage; often as high as 100:1 – which means that you can control $10,000 worth of assets with as little as $100 of capital. Remember, leverage works both ways, though.
• Since currency values never stay the same, the carry trade became a popular theory. Carry traders hope to earn not only the interest rate differential between the two currencies, but also look for their positions to appreciate in value. We’ll discuss this in more detail in the next section.
  
• Interest rates matter – a lot. Becoming familiar with the economics of the country in which the currency you are trading holds will help you understand when inflation is looming and when opportunity is knocking.

In currency markets, there’s always a bull somewhere. Why? The foreign exchange market is all about opposites and all about relativity. As one currency gains value, another has to be losing.

Dan McCabe, CEO at Next Investments, points out that one of the biggest advantages to investing in currencies is that it’s a great way to get non-U.S. dollar exposure.

“As an investor, I have nearly all my stuff in U.S. dollars. When I want to buy something, it’s often foreign-made. If I don’t have a hedge for the fact that the U.S. dollar may depreciate, I’m just losing my buying power on the world stage.”

For example, have a look at this five-year chart of the euro vs. the U.S. dollar. For the last three years, the euro steadily gained before falling off mid-way through 2008:

This means that as the euro gained strength, perhaps tourism in Europe suffered as Americans couldn’t afford to go over there and spend as much. But on the flip side, it likely brought tourists over here who were itching to spend and find bargains. Currency is all about relationships, and a currency being either weak or strong doesn’t necessarily mean it’s bad or good.

McCabe sees currencies as more of a buy-and-hold hedge instead of getting caught up in trading. “You’d rather just come in, buy it and put it away and look at it like a foreign money market account,” he says.

The Carry Trade

One of the most popular ways for institutional investors to play currencies is with the carry trade. Putting it simply, the carry trade involves borrowing currencies from countries with low interest rates and investing it in high interest rate countries. The strategy aims to take advantage of the wide spread in interest rates between certain currencies.

As of June 24, some interest rates for various currencies were:

• Australian Dollar, 3%
• New Zealand Dollar, 2.5%
• Euro, 1%
• U.S. Dollar, 0.25%
• Japanese Yen, 0.1%

You can track these interest rates at Daily FX.

With these interest rates in mind, an investor utilizing the carry trade would want to buy Australian dollars with the much lower-yielding Japanese yen, which is one of the most popular carry trade combinations around.

The carry trade isn’t a risk-free strategy, though. One of the biggest risks is if the exchange rate devalues by more than the average annual yield. If you’re using leverage, your losses could be even greater.

ETFs have simplified the carry trade for retail investors. The PowerShares DB G-10 Currency Harvest (DBV) tracks the interest rates of the U.S. dollar, euro, Japanese yen, Canadian dollar, Swiss franc, British pound, Australian dollar, New Zealand dollar, Norwegian krone and the Swedish krona. DBV looks at the three-month interest rates of the G10 currencies and goes long on the three with the highest rates and short on the three with the lowest. The ETF seeks to capitalize on the trend that the currencies with high interest rates generally tend to rise in value relative to currencies that have low interest rates.

Currency Risks

McCabe points out that currencies are non-correlated assets. “The risk you have oftentimes is performance vs. the underlying currency you’re purchasing in.”

As an example, assume that $1 equals 1 yen. If the dollar increases in value, you might get 1 yen for 90 cents – great if you’re traveling to Japan when this happens. However, it’s not so great if you have an asset priced in yen that you bought when dollars and yens were of equal value.

The flip side also works: if the dollar falls against various currencies, you stand to make money on assets based in those currencies if you bought them before the dollar weakened.

When searching for currencies to invest in, McCabe looks at the country behind it. Political upheaval can wreak havoc on a currency.

“I would look for a stable country with strong jurisprudence and rule of law…a country you believe is going to be stable, in case of turmoil.”

Why Use ETFs Instead?

Investing in currencies on your own, without an ETF, can be an arduous task. The currency market is one that never closes. Twenty-four hours a day, trillions and trillions of dollars in trades are taking place. You could find yourself sitting up in the middle of the night, waiting for a key signal to pounce on a trade.

That probably doesn’t sound like the average retail investor’s idea of a good time.

There are now two options for exchange traded currency investing: ETFs and exchange traded notes (ETNs).

Two key differences between currency ETFs and ETNs are:

1. Currency ETNs (like all ETNs) are backed by the full faith and credit of the issuer. If the issuer goes under, you have to get in line with all the other creditors. It’s a small risk, but it’s one to keep in mind.
2. Currency ETNs linked to a single currency are treated like debt for federal tax purposes, according to a 2007 IRS ruling. It means that any interest is taxable to investors, even though the interest is reinvested and not paid out until the ETN is sold or upon maturity of the contract. It also means that investors can’t elect capital gains treatment.

Not all exchange traded currency products are structured in the same way, either.

McCabe points out that it’s wise to be aware of what makes currency products different from one another. For example, Rydex’s CurrencyShares funds are grantor trusts – they hold the actual currency.

The interest earned on them is accrued on a daily basis and reinvested monthly. This reinvested interest is then reflected in the fund’s net asset value (NAV).

On the other hand, PowerShares‘ currency ETFs, PowerShares DB US Dollar Bullish Fund (UUP) and PowerShares DB US Dollar Bearish Fund (UDN), hold futures contracts and are registered as open-ended ETFs. Any gains from futures contracts are subject to 60/40 tax treatment, in which 60% of the gains are long-term, 40% are short-term.

In the bullish fund, the futures contracts are designed to be long on the U.S. dollar against the euro, yen, pound, canadian dollar, Swedish krona and Swiss franc. The bearish fund is designed to be short on the U.S. dollar against those currencies.

WisdomTree’s currency income ETFs invest in either non-U.S. moey market securities, or in a combination of money market instruments designed to provide exposure to non-U.S. money market securities or rates. They are not money market funds. They seek to give investors current income reflective of foreign money market rates available to U.S. investors, as well as exposure to changes in the value of a specific currency relative to the U.S. dollar.

Market Vectors‘ currency ETNs are senior, unsecured debt securities that give exposure to the exchange rate between U.S. dollars and foreign currencies. The underlying indexes are also affected by movements in interest rates in the country of the underlying currency and that of the United States’.

Market Vectors and ProShares also have some double long and double short ETNs for investors looking to enhance their exposure. They aim to double the daily performance of a specific currency. Know the risks of short and leveraged funds before you invest, however. They aren’t for everyone.

Barclays’ iPath currency ETNs measure the relative values of two currencies. In the EUR/USD fund, for example, when the euro rises against the U.S. dollar, the fund increases, and vice versa. The provider also has a currency carry ETN, iPath Optimized Currency Carry (ICI), that seeks to capture the returns potentially available from a carry trade. The pool of currencies the index may apply its strategies are known as the “G10″ currencies, which includes the U.S. dollar, euro, Japanese yen, Canadian dollar and Swiss franc.

How to Choose

At this point, there are enough ETNs and ETFs targeting currencies that investors have a whole range of choices when it comes to figuring out how they want to play them. When choosing currency ETFs, consider the differences between the available funds, how they access currencies and their tax treatment. In short, know what you own.

Perhaps one of the easiest ways is via a broad basket of currencies, which help spread out the risk and lessen the blows a volatile stock market can deliver. Some examples:

• Barclays Global Emerging Market Strategy [GEMS] Asia 8 Index ETN (AYT)
• Barclay’s iPath Optimized Currency Carry Exchange Traded Note (ICI)
• PowerShares DB G10 Currency Harvest Fund (DBV)
• WisdomTree Dreyfus Emerging Currency Fund (CEW)

There are a number of single-currency funds available, as well, along with a number of others that are in registration:

• PowerShares DB US Dollar Bullish Fund (UUP)
• PowerShares DB US Dollar Bearish Fund (UDN)
• CurrencyShares Australian Dollar Trust (FXA)
• WisdomTree Dreyfus Brazilian Real Fund ETF (BZF)
• CurrencyShares British Pound Sterling Trust (FXB)
• iPath GBP/USD Exchange Rate ETN (GBB)
• CurrencyShares Canadian Dollar Trust (FXC)
• Market Vectors – Chinese Renminbi/USD ETN (CNY)
• WisdomTree Dreyfus Chinese Yuan Fund ETF (CYB)
• CurrencyShares Euro Trust (FXE)
• iPath EUR/USD Exchange Rate ETN (ERO)
• WisdomTree Dreyfus Euro Fund ETF (EU)
• Market Vectors – Indian Rupee/USD ETN (INR)
• WisdomTree Dreyfus Indian Rupee Fund (ICN)
• CurrencyShares Japanese Yen Trust (FXY)
• iPath JPY/USD Exchange Rate ETN (JYN)
• WisdomTree Dreyfus Japanese Yen Fund ETF (JYF)
  
• CurrencyShares Mexican Peso Trust (FXM)
• CurrencyShares Russian Ruble Trust (XRU)
• CurrencyShares Swedish Krona Trust (FXS)
• CurrencyShares Swiss Franc Trust (FXF)
  

There are also leveraged funds, which enable investors to maximize the movements of a particular currency. The following funds all double exposure by 200%:

• ProShares Ultra Yen ETF (YCL)
• ProShares UltraShort Yen ETF (YCS)
• ProShares Ultra Euro ETF (ULE)
• ProShares UltraShort Euro ETF (EUO)
• Market Vectors Double Long Euro ETN (URR)
• Market Vectors Double Short Euro ETN (DRR)

In registration include CurrencyShares for Hong Kong, Singapore and South Africa, as well as WisdomTree funds for the Czech koruna, Chilean peso, Israeli Shekel, the Russian ruble and many more.

Read the disclaimer, as Tom Lydon is a board member of Rydex Funds.

For more stories on currencies, visit our currency ETF category. For more special reports, view our special report page.

It is clear that the emerging market is recovering faster than developed ones, according to ETF Grind. While developed markets are spurred by consumption, emerging markets are driven by investments. ETF Grind provides some funds that an investor may peruse so as to capitalize on the emerging markets over the next few years.

We should note, too, that there are many other ETFs that can provide similar exposure as the world decouples – this is merely a sampling:

• First Trust ISE Glb Engineering and Construction (FLM): up 12.2% year-to-date. The FLM  includes firms that specialize in designing and building infrastructure products. It also includes big-margin engineering and design firms, and focus less on materials and equipment.
• iShares MSCI BRIC Index (BKF): up 53.4% year-to-date. Emerging market funds often include countries that may not decouple as easily, such as South Korea, Mexico and Poland. But BKF provides exposure to the four BRICs emerging markets.
• PowerShares Emerging Markets Infrastructure (PXR): up 55% year-to-date. PXR it invests almost exclusively in firms that build infrastructure, and not in companies that operate and maintain infrastructure. The fund includes emerging market leaders and a few Western companies.
• Claymore/Delta Global Shipping (SEA): up 32.7% year-to-date. SEA invests in companies within the global shipping industry.
• PowerShares DB Commodity Index Tracking (DBC): up 12.7% year-to-date. DBC invests in the six most traded commodities: crude oil, heating oil, aluminum, wheat, gold, and corn.
• iShares S&P Global Materials (MXI): up 30.5% year-to-date. MXI tracks globally active firms that deal in materials. The fund is heavily weighted toward firms situated in developed markets, but they are international conglomerates with operations in emerging markets.
• Emerging Global Shares DJEM Energy Titans (EEO): This brand new fund holds 40 energy firms in emerging markets.  It is weighted toward Russian companies, which make up around one-third of the holdings.
• CurrencyShares Australian Dollar Trust (FXA): up 15% year-to-date. The Australian Dollar is a true “commodity currency” since its value is dependent the country’s natural resource exports.
• Market Vectors Agribusiness ETF (MOO): up 36.2% year-to-date. MOO invests in international agribusinesses.
• WisdomTree Dreyfus Emerging Currency (CEW): up 0.4% in the last week. CEW is new on the scene. It invests in a range of emerging market currencies that could appreciate against the U.S. dollar. It includes currencies such as the Chinese Yuan, Indian Rupee, Brazilian Real and South African Rand.

Emerging markets do have a higher risk profile than those of established foreign and U.S. markets, writes Jim Lowell for MarketWatch. But high inflows into emerging market ETFs warrants another look into this potentially lucrative area. Lowell provides the following areas of interest in the emerging markets:

Brazil. It is a viable and diversified economy that has also has good ties to the global economy.

• iShares MSCI Brazil Index (EWZ): up 64% year-to-date

South Korea and Taiwan can be traded depending on the technology sector.

• iShares MSCI South Korea (EWY): up 33.8% year-to-date
• iShares MSCI Taiwan Index (EWT): up 50.2% year-to-date

India moves along side with the global economy and China is an economic powerhouse in the global stage.

• PowerShares India (PIN): up 57.8% year-to-date
• iShares FTSE/Xinhua China 25 Index (FXI): up 35.9% year-to-date

In Emerging Europe, Russia could be played in relation to the price of oil.

• Market Vectors Russia ETF (RSX): up 97% year-to-date

Israel has strong industries in technology, biotech, and defense.

• iShares MSCI Israel Cap Invest Mkt Index (EIS): up 40.1% year-to-date

South Africa is noted for its metals and mining, or gold industry.

• iShares MSCI South Africa Index (EZA): up 27.6% year-to-date

Read the disclaimer, as Tom Lydon is a board member of Rydex Funds.

For full disclosure, some of Tom Lydon’s clients own shares of MOO.

Max Chen contributed to this article.

The U.S. dollar is under attack and there are several factors that are eating away at the dollar’s strength, remarks Ron DeLegge for ETF Guide. The Chinese yuan is being pushed to be included in the IMF’s basket of fund payments for bilateral trades, and the currency may overtake the U.S. dollar as the world’s reserve currency. The U.S. government is also continuing its defacement of the dollar by increasing spending and deficits.

• WisdomTree Dreyfus Chinese Yuan (CYB): up 2.7% year-to-date
• PowerShares DB US Dollar Index Bullish (UUP): down 2.6% year-to-date
• PowerShares DB US Dollar Index Bearish (UDN): up 1.8% year-to-date

How can an investor protect one’s wealth against a falling dollar?

Currency Funds. These types of ETFs let you capitalize on the strength of foreign currencies. Currency ETFs short the dollar to  its corresponding currency. Top-performing Rydex Investments currency ETFs include:

• CurrencyShares Australian Dollar Trust (FXA): up 10.4% year-to-date
• CurrencyShares Canadian Dollar Trust (FXC): up 8.5% year-to-date
• CurrencyShares Mexican Peso Trust (FXM): up 5.9% year-to-date

Hard Assets. These are assets not correlated to the dollar. Such investments include precious metals such as gold and silver. While the physical metals are lovely to look at and lovely to hold, ETFs are also an easy to way to invest in the metals, mainly because they eliminate the hassle of finding and paying for storage.

• SPDR Gold Shares (GLD): up 8.0% year-to-date
• iShares Silver Trust (SLV): up 30.2% year-to-date

International. An investor could also diversify an investment portfolio with foreign ETFs. All international and emerging market stocks and bond ETFs also offer unhedged currency exposure.

• Vanguard FTSE All-World ex-US ETF (VEU): up 9.7% year-to-date
• iShares MSCI Emerging Markets Index (EEM): up 27.2% year-to-date
• SPDR MSCI ACWI (ex-US) (CWI): up 9.2% year-to-date

Read the disclaimer, as Tom Lydon is a board member of Rydex Funds.

For full disclosure, some of Tom Lydon’s clients own shares of SLV and GLD.

Max Chen contributed to this article.

The Australian dollar, or “Aussie,” is forecast to fall 17% this year against the U.S. dollar and it is estimated that the Aussie will depreciate to 53 U.S. cents this year, writes Candice Zachariahs for Bloomberg. The weakening Aussie is a result of the Australian Reserve Bank cutting interest rates by 4% from September to February.

After a drop of 35% since hitting a 25-year high back in July, the Aussie may further depreciate as the country tackles its external debt that is around 89% of its GDP. It is thought that 34%, or $287 billion, of total external debt are in short-term loans.

In response to shrinking exports and increased pressure to further cut rates, the economy contracted 0.5% in the fourth quarter, a first in eight years. It is believed that the downward economic trend is likely to increase as a result of a long-reaching financial debacle.

Exports diminished by 5% with coal shipments down 19%. The trade surplus dropped to $624 million in January compared to earlier forecast of $704 million. It is predicted that there will be a $384 million deficit in 2009.

• CurrencyShares Australian Dollar Trust (FXA): down 2.7% in the last month; down 1% in the last three months

Read the disclaimer, as Tom Lydon is a board member of Rydex Funds.

The greenback is at a six-month high against the euro on speculation that as the global economy cools off, our currency will heat up, report Ye Xie and Gavin Finch for Bloomberg.

The dollar is on track for its biggest one-month gain since the euro debuted in 1999, and is at an 11-month high against the Australian dollar. It’s also making gains against the New Zealand Dollar, the British Pound sterling and the Swedish krona.

The sharpest advance this month is against the Australian dollar, by 10.1%, while the slowest was 1.4% against the Mexican peso.

The PowerShares DB US Dollar Index Bullish (UUP) is up 0.3% year-to-date, and 5.2% in the last month.

ETFs that could be muscled aside by a stronger dollar include:

• CurrencyShares Australian Dollar Trust (FXA), down 1% year-to-date; down 9.6% in the last month
• ELEMENTS British Pound (EGB), down 6.5% since March 26 inception; down 6.3% in the last month
• iPath EUR/USD Exchange Rate ETN (ERO), up 3.2% year-to-date; down 5.6% in the last month
• Market Vectors Double Short Euro (DRR), up 11.8% since May 22 inception; up 13% in the last month
• CurrencyShares Swedish Krona Trust (FXS), up 2.1% year-to-date; down 4.8% in the last month

For full disclosure, some of Tom Lydon’s clients own shares of UUP.

Read the disclaimer, as Tom Lydon is a board member of Rydex Funds.

However, it is important to understand and know what to expect from currency ETFs before investing in them, as Anthony Welch for Index Universe explains.

Welch first points out that currency ETFs are not substitutes for money markets. Currency ETFs can and often do fluctuate in value, despite most of them paying monthly interest.

Similarly, currency ETFs are not substitutes for bonds. This is because bonds have a fixed date where an investor expects a return of principal. Meanwhile, currencies can decline for long periods of time and possibly never get back to the highs they once achieved. As a result, currencies are not something investors can buy and hold in the long run with a true degree certainty.

Currencies are also not similar to stocks. The currency market is enormous, being that currencies trade 24 hours a day and represent all the money in the world in a sense. Unlike most stocks, many currency traders have reasons to trade without the intention to make money, but rather to hedge risk.

Although currency ETFs are not like money markets, bonds, or stocks, they are very simple. Currency ETFs are nothing more than a relationship between two currencies, one of them usually being the U.S. dollar. These relationships fluctuate based on an extenuating number of circumstances ranging from interest rates, political climate and economic and GDP activity.

Some of the many Currency ETFs include:

• CurrencyShares Australian Dollar Trust (FXA), up 3.3% year-to-date
• CurrencyShares Euro Trust (FXE), up 4.2% year-to-date
• WisdomTree Dreyfus South African Rand (SZR), down 1% since July 8 inception
• WisdomTree Dreyfus Japanese Yen (JYF), down 4.5% since May 22 inception
• PowerShares DB US Dollar Index Bearish (UDN), up 1.9% year-to-date
• PowerShares DB US Dollar Index Bullish (UUP), down 0.4% year-to-date

For full disclosure, some of Tom Lydon’s clients own shares of UUP.

Read the disclosure, as Tom Lydon is a board member of Rydex Investments.

The top performer was the WisdomTree South African Rand (SZR), which returned 7.6% in July, reports Jesse Emspak for Investors Business Daily.

Although the dollar rose up against the British pound and yen, it fell against the rand by 5.4%.

Also ahead of the dollar were the BRIC currencies, particularly the WisdomTree Dreyfus Brazilian Real (BZF). The fund was up 3.3% for the month.

The dollar has fallen against the Mexican peso by 8.2% since the start of the year. CurrencyShares Mexican Peso Trust (FXM), up 13% year-to-date, reflects this.

Among the funds that have one-year records, the numbers are impressive:

• CurrencyShares Euro Trust (FXE) is up 18% in the last year
• CurrencyShares Australian Dollar Trust (FXA) is up 17.1% in the last year, although it has taken a hit in the last month by falling 1.3%

Some of the top-performing funds belong to currencies in emerging markets. Why? High interest rates.

Read the disclosure, as Tom Lydon is a board member of Rydex Funds.

Australians have been tapped out by rising fuel costs and increasing mortgage rates, says Carl Delfeld for ETFXray. Consistent growth still reigns, but there have been some signs of slowing.

Evidence of a hesitant consumer and a sluggish economy is chipping away at the Australian dollar, which has fallen to a three-month low, taking the New Zealand dollar with it. The Reserve Bank of Australia left borrowing costs at 7.25%, reports Ron Harui for Bloomberg. On the news, the New Zealand dollar dropped to its lowest since Sept. 19, while the Aussie fell to its lowest since April 14.

Australia’s central bank showed signs of cutting borrowing costs, a first in almost 7 years. The slower economic growth has helped to stave off inflation. This has been a trend of banks around the world, as bakers try to cushion their economies from slower growth, reports Jacob Greber for Bloomberg.

ETFs that can relate down under:

• iShares MSCI Australia Index (EWA), down 16.1% year-to-date
• CurrencyShares Australian Dollar Trust (FXA), up 7.8% year-to-date
• Australia NETS Trust (AUS), down 11.1% since April 10 inception
• WisdomTree Dreyfus New Zealand Dollar (BNZ), launched on July 8
• Elements Australian Dollar (ADE), up 1.2% since April 4 inception

Read the disclosure, as Tom Lydon is a board member of Rydex Funds.

Roger Nusbaum for Seeking Alpha has a few examples for investors who may wish to use a currency investment as a proxy for commodities.

His first example is the WisdomTree South Africa Currency (SZR) as a proxy for gold.

But if an investor holds SPDR Gold Shares (GLD), there can be somewhat of a negative correlation. South Africa has a few imbalances and is facing inflation, so the correlation of the two will get better. Instead, Nusbaum suggests CurrencyShares Australian Dollar (FXA). If your portfolio holds Australia already, however, then avoid over-allocation.

CurrencyShares New Zealand Dollar (BNZ) would be a better diversification tool, and many consider the kiwi to be a commodity currency, because of the amount of meat, dairy and wool that is produced in New Zealand. So, rather, BNZ could be an agriculture proxy, and it avoids the volatility of the agriculture funds.

Nusbaum is not suggesting you buy either ETF, he is showing investors how to recognize themes and using other methods to access various asset classes that may not be so obvious.

Read the disclosure, as Tom Lydon is a board member of Rydex Funds.