Foreign Currency Exchange Markets and Their Risks Explained

The inner workings of foreign currency exchange (FX or forex) markets are extremely complicated. That’s because they are affected by a wealth of micro and macroeconomic factors. It’s because of this dependency that the COVID-19 pandemic has caused an extreme rise in volatility in the global FX market. As a result, this affected every economy in the world and will continue to do so. As the crisis continues, the volatility will persist making it harder for traders and businesses that require international transfers. The risks are high for them, but the situation isn’t hopeless. There are ways of mitigating these risks and protecting yourself from FX volatility quite thoroughly.

What is the Global FX Market and Who Operates There?

The forex market is exactly what its name implies, meaning a market where one can buy, sell, or exchange foreign currencies. Every day, over $5 trillion worth of transactions happen in this market. This makes it the biggest market in the world, but even this mammoth is not immune to global economic crises.

Main types of players on the global forex market are:

• Central banks.
  These banks represent a country’s government. One might call them the most important players on the FX market because not only do they trade vast amounts of currency. The policies of these banks also are one of the economic factors that affect the formation of FX rates. Simply put, it’s a central bank of every country that sets the exchange rate for its domestic currency. Therefore, these banks have the power to manipulate the market as a whole. And they often do this in times of economic turmoil in order to stabilize their countries’ economies.
• Commercial and investment banks.
  The biggest amount of money traded on the FX market daily comes from these banks. Both regular and speculative transactions come through these financial institutions.
• Investment managers and hedge funds.
  Combined efforts of portfolio managers and hedge funds make up the second largest (after combined banks) contributor of currency volume to the FX market. It should be noted that Portfolio or investment managers trade on behalf of multiple customers, such as pension funds, foundations, and other owners of big accounts.
• International corporations.
  Huge companies that conduct business all over the world require funds in a wide range of currencies. Businesses, in particular, are frequent users of hedging services. They need to mitigate currency exposure risk, which affects their revenues directly.
• Independent investors and private individuals.
  The money from independent investors and just ordinary people making cross-border money transfers is small compared to banks and big corporations. However, it has been growing steadily in recent years. The volume of global remittances has reached a record of $714 billion in 2019. The number of small investors has also increased exponentially helped by the appearance of affordable money transfer and FX risk mitigation services.

The Effects of the COVID-19 Pandemic on the Forex Market

The impact of the COVID-19 pandemic on forex trading is huge. First of all, it has been marked by the rising value of the USD. This is not a surprising development as the US Dollar is the world’s reserve currency. As such, it always rises in value and becomes more stable during times of recession.

The great stock market crash that occurred at the beginning of March also had a profound effect on destabilizing the forex market. The volatility from one market always affects the other. And for all that the situation has improved, it has yet to stabilize. This won’t happen for a while yet because of the global economic recession. Also, the threat of the second wave of the virus is a big concern for many countries still.

Moreover, pandemic greatly affected global trade. It’s international business that is one of the main driving forces on the global FX market. With trade on hold because of the lockdowns, many currencies went into a meltdown.

Developing countries are the worst affected in this situation. With their currencies devaluating rapidly against the USD. This has a highly detrimental effect on their economies. Therefore, the already bad situation is getting worse. With prices rising yet the income of their citizens falling further, these countries have a hard time combatting the crisis.

At the moment, the global economic recession makes it impossible to tame the level of volatility on the FX market. However, one needs to remember that while the global economy and trade are major factors in determining FX rates, they aren’t the only ones that affect them.

Main factors that affect FX rates are:

• Inflation rates.
  The appreciation of a currency increases as the level of inflation within the country decreases. Sadly, during recessions and other times of economic turmoil, inflation is growing. It’s not only developing economies that are suffering from this condition today. Therefore, many currencies are weakening rapidly. The USD is barely hanging due to its global reserve status.
• Interest rates.
  Usually, higher interest rates translate to higher FX rates in terms of the forex market. At the moment, many countries decrease interest rates in order to help their citizens affected by the COVID-19 pandemic. Also, lending has all but stopped because of risks for lenders are too high. This is another reason why so many currencies are destabilizing and losing value now.
• Country’s current account.
  The current account of a country is the balance of trade between it and its trading partners. Again, at the moment, this is a very unstable factor for many economies. The global trade was extremely affected by lockdowns and the pandemic. Therefore, many accounts are in poor condition.
• Public debt.
  Government aid in offering financing is good for domestic economies. In fact, right now, in many countries, this is the only type of financing available. Programs like the Paycheck Protection Program in the USA pour in trillions into economies. However, the rise of public debt leads to inflation, which leads to currency devaluation.
• Terms of trade.
  This is the ratio between export and import prices. Again, this factor is unstable now due to global trade issues.
• Overall economic performance.
  The state of domestic economies and the global economy all affect the FX market. Therefore, when a recession strikes, volatility is unavoidable.

How to Mitigate Your Currency Risks in During FX Volatility

Hedging is the best solution to mitigating FX exposure risks. Today this tool is easily available to anyone who uses money transfer companies. Online platforms like Moneycorp, OFX, WorldFirst, or Currencies Direct do not only offer cheap transfers. They also provide every customer access to hedging tools, like future contracts.

These contracts allow one to secure a specific FX rate for up to a year. Therefore, the risk caused by volatility becomes all but nonexistent.

Another way to reduce forex risks during volatile times is to use ETFs (exchange-traded funds). These funds provide one with a versatile portfolio that often exposes you to several currencies. Therefore, the overall risks are lower. But during a stock market crash, ETFs themselves become volatile.

Another tool you can use for forex risk mitigation is currency options. The principle of this tool is simper to currency forward contracts. But the latter requires you to buy a predetermined amount of currency when the contract expires. Options, however, give you the right to do this. But they don’t obligate you into completing this deal. This allows you to choose a spot trade instead of fulfilling the terms of the contract. Therefore, you get the flexibility to benefit from current FX rates.No matter what hedging tool you choose to use, now is the time you need to do this. The coronavirus recession is here to stay for at least a year more. Even after the worst of it, the global economy will need time to recover. Therefore, forex volatility will remain an issue for many months to come.

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