The forex market is a huge market. No doubt there’s a huge chance you’ll gain something from it. However, keep in mind that there’s an equally high level of risk that you would lose your money. Here are some of the most common forex market risks you need to know.
Exchange Rate Risk
The exchange rate risk is the risk that arises from the changes in the value of the currency. Exchange rate risk comes from the continuous and volatile shifts the world’s supply and demand balance.
The exchange rate risk can be quite huge. That’s because it comes from the market’s perception of how much the currency will move relative to another due to all possible factors.
To manage this risk, you can use the following methodologies:
- Position limit – limiting your position puts a cap on the amount of any currency you carry any given time
- Loss limit – you can use this to avoid huge, unsustainable losses through stop loss levels
- Risk/Reward ratios – another way to control this risk is measure possible risks against the possible gains
Interest Rate Risk
Interest rate risks refer to the profit and loss that comes from the movements in the forward spreads. You can usually find this risk among futures, options, and currency swaps. This also usually arises in amount mismatches and maturity gaps among transactions.
One thing you can do is to separate the mismatches according to their maturity dates. Categorize them between those that mature in six months and beyond six months.
Credit risks refer to the risk of the current position not being paid according to the terms of contract. This is also called the counterparty risk, because this risk lies on the other party you’re dealing with.
Corporations and banks typically worry about this risk. However, for the individual trader (margin trading), the credit risk is very low as long as the forex broker is regulated by any known regulating body.
Credit risks can take different forms, but the most common forms are:
- Replacement risk
- Settlement risk
- Counterparty default risk
Liquidity and Country Risk
The forex market is not only the biggest financial market out there. It’s also the most liquid. Times of illiquidity still occur, particularly outside the US and European trading sessions.
At the same time, several countries have also imposed trading restrictions or limits on the fluctuation of a forex rate, the volume which may be traded, and other aspects of trading.
These restrictions may prevent the trade to be executed during a given period of time. It may also prevent the trader from executing an unfavorable position, which means he or she may suffer from significant losses.
And last but not the least, leverage may also be of great risk to your investment. Even though leverage may mean you can benefit from even the smallest movement in prices, it may also mean that a small price change can wipe out all of your investments.
This is the reason why forex traders and brokers treat leverage as a double-edged blade that cuts both ways.