The dollar has taken a hit over the past few months and many currency experts believe that it will continue to remain weak because American consumers aren’t feeling confident,  U.S. policymakers want to keep U.S. goods cheap to entice foreigners to buy more of our stuff and the ballooning of the U.S. budget deficit, states Gary Gordon at ETF Expert.

As a result of the aforementioned, 12 out of the 14 “pure play” currency ETFs are trading above their 200-day moving averages and most have year-to-date gains. (The two exceptions are the PowerShares DB U.S. Dollar Bullish (UUP) and the CurrencyShares Mexican Peso (FXM)).

To play currencies, mind the trend lines and have an exit strategy if you’re invested.

Some of the best performing currency ETFs include:

• CurrencyShares British Pound Sterling (FXB): up 12.5% year-to-date

• WisdomTree South African Rand (SZR): up 26.2% year-to-date

• WisdomTree Brazilian Real (BZF): up 20.1% year-to-date

For more information on currency ETFs, take a look at our special report on currencies and visit our currency etf category.

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

Kevin Grewal contributed to this article.

Around 80% of Mexico’s exports go to the United States, report Hugh Collins and Valerie Rota for Bloomberg. The Mexican economy is also heavily reliant on its non-oil export sector, and if that sector slows, then the economy comes to a crawl. In fact, both Standard & Poor’s and Fitch Ratings reduced the outlook on Mexico’s credit rating to BBB+, citing the government’s low tax revenue and dependence on crude oil exports.

President Felipe Calderon says Mexico’s economy contracted at an annualized 9% in the first quarter year-over-year, according to Trading Markets. The Central Bank calculates Mexico’s GDP will fall by 9.5% in the second half of 2009.

Calderon has pointed to the $4 billion in direct investment so far this year as a sign that investors favor Mexico’s lower production and logistics costs. He also expects Mexico to spearhead the recovery of the global automotive industry, noting that the auto sector represents 20% of Mexico’s GDP and supports 3 million households.

• iShares MSCI Mexico Investable Mkt Idx (EWW): up 23% year-to-date

• CurrencyShares Mexican Peso Trust (FXM): up 6.9% year-to-date

For more information on Mexico, visit our Mexico category.

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

Max Chen contributed to this article.

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.

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.

• Fearful investors fled from Mexico and turned to stable economies such as the United States and Japan as soon as the financial crisis hit and credit markets tighten up.
• Mexico’s dependency on the U.S. economy; as the U.S. economy slows down, so does Mexico’s.
• The fading of relatively high interest rates, the Bank of Mexico cut short-term rates from 8.25% to 7.75%.

The Plus Side. On the positive side, the plunge in the peso makes Mexican exports cheaper for U.S. consumers.  However, the Mexican government may be forced to instill a stimulus package to save what is left of their economy, similar to what the developed nations around the globe are doing.

Some ETFs influenced by the decline in the peso are:

• iShares MSCI Mexico Index Fund (EWW): down 19.1% over the last month

• Rydex CurrencyShares Mexico Peso Trust (FXM): down 5.64% over the last month

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

By using ETFs, investors may diversify their portfolios with ETFs that track national indexes or broad baskets of well-known local stocks in emerging-market countries, iShares Emerging Markets Index Fund (EEM), writes Kirk Shinkle for U.S. News & World Report. It is noted that investors should check the holdings of such funds, as they may favor specific countries or sectors.

For those with a high risk tolerance, investors could use country funds, such as China’s iShares FTSE/Xinhua China 25 (FXI), to get in on the long-term action for a fast-growing economy or for short-term trades depending on market-moving news. There are many countires with their related ETFs trading, but among the few hopefuls that we may one day see in the ETF world include Argentina, Colombia, Egypt, Peru and the Philippines.

Funds that track world currencies such as the Russian ruble, CurrencyShares Russian Ruble Trust (XRU), and the Mexican peso, CurrencyShares Peso (FXM), are already at play.

Risky “frontier” markets, Claymore/BNY Mellon Frontier Markets (FRN), are also being traded with ETFs tracking stocks in the Middle East, WisdomTree Middle East Dividend Fund (GULF), and Africa, Market Vectors Africa (AFK).

Some funds track the trading of carbon allowances, like the iPath Global Carbon ETN (GRN).

New ETFs in the works may one day also provide for trading credit default swaps and even a fund tracking the direction of home prices.

Intrepid investors may also consider ETFs from Direxion that offer 3-times leverage on indexes and sectors. These ETFs are best for short-term trades since volitility can wipe away returns over time. It should be noted that these ETFs are not for the novice and faint-of-heart.

Whether you’re an exotic type of investor or you trend more toward the plain vanilla funds, always be sure to watch the trend lines to see what’s moving. Use the 50-day or 200-day moving averages as your guide for both entry and exit.

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

The iShares Mexico Fund (EWW) has fared better than Europe, Russia, Asia, Canada, Australia and Brazil to name a few, so what gives? It could be that although growth is slow, it is steady and consistent. Another reason some big dips might have been avoided is that Mexico has kept its interest rates high enough to do battle with inflation.

Gary Gordon for ETF Expert reports that until recently, the hot money was pouring into Rio, but the commodities selloff and fear of global recession has left the country of Brazil high and dry. iShares MSCI Brazil (EWZ) has taken a hit in the last month, down 8.2%.

Relative to that, Mexico has been strong, down 2.2% in that time period. The fund has been helped along byu companies such as Cemex, a worldwide manufacturer of building materials, and America Movil, Latin America’s largest wireless provider.

The peso is having a nice ride, too: the CurrencyShares Peso (FXM) is above its long-term trendline. FXM is up 8% for 2008, defying the U.S. dollar and taking tourists by surprise that Mexican stuff isn’t so cheap anymore.

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

ETFs have made it possible for the average investor to get exposure to the world’s currency markets – the largest financial market in the world. Before they came along, investors often had to use futures contracts that involved large amounts of currency.

The first fund launched in late 2005, and it opened up a whole new world for people looking to capitalize on the movements in the foreign exchange.

An excellent article on Investopedia addresses the top issues and questions people might ask about investing in currencies. Among the facts:

• Currencies are not traded on a regulated exchange, there is no central governing body and no arbitration panel to settle disputes. Self-regulation has been very effective, because participants must both compete and cooperate with one another.
• In the foreign exchange market, prices are quoted to the fourth decimal point.
• Technically, you are not buying or selling anything in the currency market. All trades exist as computer entries.
• Currencies are traded in pairs, and when a trade is made, one is always long on one, short on the other.

Not all currency ETFs are created alike. They do track a currency, or a basket of them, from around the world.

Rydex’s line of CurrencyShares are designed to hold cash and invest it with banks to get interest. WisdomTree’s line of Currency Income funds seek to earn current income reflective of the money market rates in the country for which the fund is named. They are not, however, “money market” funds.

ELEMENTS currency exchange traded notes (ETNs) are structured to track the performance of the U.S. dollar vs. the currency named in the fund. For example, if the currency in the fund’s name appreciates relative to the dollar, other things being equal, the value of the fund will increase. Market Vectors currency ETNs give exposure to the exchange rate of foreign currencies.

Note that ETNs differ somewhat from ETFs in their structure as well as tax treatment.

• WisdomTree Dreyfus Japanese Yen (JYF), down 4.8% since May 22 launch
• WisdomTree Dreyfus New Zealand Dollar (BNZ), down 5% since July 8 launch
• CurrencyShares Euro Trust (FXE), up 3.5% year-to-date
• CurrencyShares Mexican Peso Trust (FXM), up 12.2% year-to-date

• ELEMENTS Australian Dollar (ADE), down 3.4% since March 4 launch
• ELEMENTS Canadian Dollar (CUD), down 7.2% since March 18 launch
• Market Vectors Renminbi/USD (CNY), down 2.1% since March 17 launch
• Market Vectors Double Long Euro (URR), down 10.7% since May 22 launch
• PowerShares DB US Dollar Index Bullish (UUP), up 0.2% year-to-date

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.

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.

The Chilean peso fell for a third straight day after the Federal Reserve hinted that it would raise rates this year. The central bank wound up keeping interest rates exactly where they were. Tuesday’s loss was reactionary to the drop in major currencies such as the British pound against the U.S. dollar, says Drew Benson and Andrea Jaramillo for Bloomberg.

The Federal Reserve kept the benchmark lending rate at 2%, with the risks to inflation a major concern. Meanwhile, Chile’s inflation rate rose more than economists had forecasted, making another interest rate hike inevitable, reports Sebastian Lloyd on Bloomberg.

Consumer prices in Chile rose 1.1% in July, with annual inflation at 9.5%, the highest since 1994. Policymakers do not think a rate hike will stunt any economic growth.

The dollar against the Chilean Peso:

The Mexican peso, meanwhile, fell down for the second straight day on speculation that the central bank will start buying dollars in the foreign exchange in order to weaken the currency, reports Valerie Rota for Bloomberg. The higher-yielding fixed-income securities remained attractive.

The dollar against the Mexican peso:

Chile’s and Mexico’s ETFs are trading higher today:

• iShares MSCI Chile (ECH), down 4.5% year-to-date
• iShares MSCI Mexico (EWW), down 2% year-to-date
• CurrencyShares Mexican Peso Trust (FXM), down 13.7% year-to-date

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