Currency Trading: Not everybody's cup of tea

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It is often said that if you want to make big money, trading in currencies or foreign exchange (forex) is the perfect place to be in. This is possible considering a very high leverage.

For example, if you have just Rs 100 in your pocket, a position of about Rs 2,000 can be taken in the forex market because the margin money requirement is only 5 per cent. No wonder, one can take large positions in the market with a rather small amount.

At present, domestic exchanges such as the National Stock Exchange and the Multi-Commodity Exchange offer derivatives products such as future and options in four major currencies – dollar, yen, pound and euro.

And the Indian retail investor is ready to play the game. More than hedging, many retail investors are opting to trade. Even brokerages are pushing this product to clients.

“About 70 per cent of the trades are done by bankers and companies. The retail segment accounts for about 25-30 per cent of the total turnover,” said Navin Mathur, associate director (currency and commodities), Angel Broking

Brokers said the market was expanding quite rapidly because of the increased awareness. “The market wide average daily turnover has increased by about 100 times in the 16 months since the product’s inception. In August 2009, the average daily turnover stood at Rs 291 crore. It rose to Rs 29,900 crore in February 2010,” said Jatin Damani, head (currency derivatives), Bonanza Portfolio.

And, while there is money to be made in the currency market, risks are quite high as well. Typically, a currency is used not only for hedging, but also for investment diversification. Let’s understand this with an example:

Kinds of hedging: For instance, a family receives foreign remittances of $15,000 every month. If the dollar slides from Rs 46 to Rs 44 against the rupee in a particular month, it means that the family’s receivable coming down by Rs 30,000 in that month. However, this can be hedged if an equal amount of dollar is sold at Rs 46.

One can also hedge if your child is studying abroad. In this situation, the loan can be taken in rupees. However, the payment to the foreign agency is usually made in foreign currency, mostly in dollars.

Say, if you have taken a Rs 15 lakh-loan for two years. The net exposure in this case would be for $32,609 ($1= Rs 46). But if you decide to stay abroad and repay the loan in dollars, there could be a currency risk involved. If the dollar depreciates against the rupee from Rs 46 to Rs 40 in two years, the whole loan will be costlier by $4,892, or Rs 2.25 lakh. This can be hedged by selling an equal amount of dollar in the market.

Risks: However, there are a lot of risks because of leveraging. Of course, there are examples of prominent investors, such as George Soros, who made a neat profit of $1 billion by betting against the pound in 1992. But most retail investors would not have Soros’ risk appetite, more importantly, his sources of information.

So, a fluctuating currency can allow you to make money, but it can erode your wealth just as quickly (See: High risk, high return). As the table shows, even 1 per cent depreciation can lead to a loss of 22 per cent. And an appreciation of 2 per cent will give profits of 43 per cent. And the simple reason is volatility. Here’s another example:

The average daily rupee/dollar volatility has been 0.30-0.47 per cent since January. And this number keeps on increasing due to various events. This February, as the Union Budget came closer, volatility rose to 0.45-0.60 per cent.

However, the risk involved is steep because the leverage here is 20 times, unlike in the equities market, where it is about four times. While this increases the risk-taking ability of the investor in the forex market, but losses can be much more too.

Also, currency markets are influenced a lot more by global events. The fear of Greece’s sovereign default is an example where the euro fell sharply. And such intricate developments can rarely be tracked by retail investors.

As a result, it is important that a retail investor weighs the pros and cons before investing in currency futures. Ideally, don’t get into the market at all. But if you cannot resist, don’t use more than 5-10 per cent of your portfolio’s exposure in currency futures

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