Growth prospects for the next year are looking ripe for Russia, but the country must overcome the rouble’s highs against the euro. Darya Korsunskaya and Yelena Fabrichnaya for Reuters report that the appreciation of the rouble does allow for lower inflation and more trust in the banking system, despite the dangerous levels. (How to play Russia and China’s gas deal).

On the plus side, next year’s growth could top 2% if oil prices stay high. Greater revenues from taxes on energy companies could also ensure this year’s budget deficit is smaller than expected, according to the Finance Minister. Itar Tass forBusiness Standard reports that serious work is needed at the business and state level. Even if negative aspects of oil’s growth take over, Russia’s economy still stands in a good position, analysts note. (Four things going for Russia).

For more stories about Russia, visit our Russia category.

• Market Vectors Russia (NYSEArca: RSX): up 144.1% year-to-date

• CurrencyShares Russian Rouble (NYSEArca: XRU): up 6.2% year-to-date

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

A bigger budget could allow government to spend more in order to kick up demand, invest in the largest companies in the country and lend more to banks. Lidia Kelly and Andrew Langley for The Wall Street Journal report that the ministry sees the Russian economy potentially expanding 1% next year, a reversal from the 8.5% decline in GDP expected this year.

Analysts and economists are hoping that the measures will prevent any banking or lending crises from taking over. Russia has lowered borrowing costs in hopes of stemming a tide of defaults.

After all, the Russian banking sector is looking dire and the aforementioned moves may not be enough to save the 250 troubled banks from failing. Rana Foroohar for Newsweek reports that bad debts made up 12% of loans made this year, while some bankers say it’s closer to 20%.

The Russian ruble lost 1.3% against the U.S. dollar today after speculation that there could be a devaluation of the currency. The central bank also cut the main interest rate, hurting the ruble further, reports the Associated Press. The rate cut was Russia’s fifth in four months. A Russian banker said that Russia would have to devalue the ruble by 30% to 40% in order to right the economy again.

• Market Vectors Russia (RSX): up 81% year-to-date

• CurrencyShares Russian Ruble Trust (XRU): down 3% in the last month

For more stories about Russia, visit our Russia category.

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

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.

This can be witnessed through the so-called Big-Mac Index. The index is based on the idea of purchasing-power parity, which says currencies should trade at the rate that makes the price of goods the same in each country, reports The Economist.

If the price of a Big Mac translated into dollars is above $3.54, its cost in America, the currency is dear; if it is below that benchmark, it is cheap. So far, the yen has gained fair ground, the pound is looking stronger than last Summer, and the euro is over-valued, but less than last smmer.

The Japanese yen is holding strong to a 13-and-a-half-year peak hit against the dollar and a seven-year high versus the euro the previous day. The strength is rooted from investors uncertainty about the global banking crisis. The British sterling held right above its 23-year low against the U.S. dollar, without making any gains, reports Shinichi Saoshiro for Forbes.

Is the road to depreciation ending for the Russian ruble? The quick and sharp downturn of this currency caught many by surprise. Senior officials have suggested that the Russian ruble may be coming back on the road to health, as the currency rallied for a third day in a row as of Thursday, reports Vidya Ram for Forbes.

This short-term rally is spurred by the temporary increase in demand for the ruble because of an upcoming VAT payment day. Corporates for whom payment is due on this date had expected the currency to depreciate,  so they had not been keen to convert their dollar deposits until now.

• CurrencyShares Russian Ruble Trust (XRU): down 8.6% year-to-date

• CurrencyShares Japanese Yen Trust (FXY): up 1.2% year-to-date

• PowerShares DB US Dollar Index Bullish (UUP): up 5% year-to-date

Read the disclosure, 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.

Rydex Investments recently launched the CurrencyShares Russian Ruble Trust (XRU), a first for Russian currency in the exchange-traded format, writes Eric Rosenbaum for IndexUniverse.

XRU is the first true emerging market currency fund in the Rydex CurrencyShares category. The new fund has an expense ratio of 0.40%, which is 0.05% lower than its competitor’s currency funds.

Recent market activities such as U.S. dollar surge against other currencies and oil’s weakness resulted in the ruble’s two-year low against the dollar in October.

Despite the short-term problems, Russia is still a major oil producer with the third largest monetary reserve in the world. In the short-term, asset gathering could be sluggish.

Investors who access to the ruble will want to play the day-to-day volatility in the markets as well as play one currency against another based on correlation stories.

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