Introduction to Forex Trading Part 2: Safe-Havens, Emerging Markets, and Risk Trades
Foreign exchange (forex) trading can present unique opportunities for traders interested in investing based on global theses. As the most liquid market in the world, forex can provide a venue conducive to frequent trades. Investors familiar with the concepts in An Introduction to Forex Trading, may also learn to differentiate between safe-haven currencies, risky currencies, and other currency classifications.
Safe-Haven versus Risky Currencies
Safe-haven currencies, also known as hard currencies, are stable and globally traded. In addition, they are expected to serve as a reliable store of value. Currencies regarded as safe-havens include the U.S. dollar, the euro, the Japanese yen, the British pound, and the Swiss franc. For example, at the end of 2011, the U.S. dollar made up approximately 62% of foreign currency reserves according to the International Monetary Fund (IMF), a sign that other nations have faith in the stability of the greenback.
Demand for hard currencies generally increases during times of turmoil. For example, in times of financial crisis, military turmoil or government imposed capital controls, people generally drop less stable currencies in favor of safe-haven ones. For example, just before the fall of the Soviet Union, the ruble devalued and demand for dollars increased. In June of 1992, the ruble traded at a rate of 200 ruble per dollar. By December of that year, the ruble fell to a rate of 500 rubles per dollar. In this period, Russians flocked to the dollar in order to protect the purchasing power of their wealth.
Hard currencies are extremely liquid. Because central banks keep money supply sizes proportional to economies, one might correctly assume that the larger economies have more liquid currencies.
Currency Quoting Hierarchy
Safe-haven currencies are part of a larger subset of currencies known as majors. Major currencies are a group of currencies made of liquid, actively traded, freely floated currencies.
Major currencies follow a hierarchical system in the way that they are quoted. The hierarchical order is as follows: euro, pound, Australian dollar (known as the Aussie), New Zealand dollar (known as the Kiwi), U.S. dollar, Canadian dollar, Swiss franc, and the Japanese yen. This order is in place so traders know how to quote pairs. When trading currencies, one is always traded as compared to another. The currency at the top of the list, the euro, is always in the numerator of a pair, so when quoting the euros priced in pounds, convention is to quote the EUR/GBP rate, not the inverse. Similarly, the yen is always in the denominator when priced against another major currency.
For reference, investors typically use abbreviations for each currency. These abbreviations are:
- Great Britain pound sterling = GBP
- Australian dollar = AUD
- New Zealand dollar = NZD
- U.S. dollar = USD
- Canadian dollar = CAD
- Swiss franc = CHF
- Japanese yen = JPY
An example of the currency quoting hierarchy is as follows: when quoting the exchange rate between euros and U.S. dollars, one always quotes the EUR/USD. However, when quoting the exchange rate between U.S. dollars and yen, convention is to quote USD/JPY.
Minor currencies, including the Chinese renminbi (also known as the yuan) and other emerging market currencies, are usually quoted against a major currency, rarely against themselves. This is due to the fact that emerging market currencies are generally less liquid. Trading one rather illiquid currency against another can incur large risks. Thus, for example, traders tend to quote the Brazilian Real against the U.S. dollar or the Polish Zloty against the euro. The major currency chosen generally has to do with geography, as the Poland is near the European Monetary Union and Brazil is near the U.S. Most are quoted against either the U.S. dollar or the euro, however.
Gold and Silver as Currencies
New traders rarely consider gold and silver to be currencies. However, Gold, and less so silver, are often traded like currencies on the spot market. Gold trades with the symbol XAU and silver with XAG. Gold, more so than silver, is what some refer to as a real currency rather than a fiat currency. A fiat currency is a paper currency not backed by hard assets. Gold has no large industrial uses, so the quantity of gold in the world is relatively constant. Resultantly, many recognize gold as a store of value. Thus, in the age of fiat currencies, gold is often used as a hedge against devaluation. Silver does have industrial use in cell phones and other gadgets. Accordingly, silver is less of a pure currency than gold. Even so, silver is often still traded like a currency.
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