Currency Exchange-traded funds (ETFs) and their impact on Forex trading.
Defining Currency ETFs
Exchange traded funds (ETFs) are similar to index funds since they track an index, commodity or a pool of assets. The only difference between them and index funds is that they can be traded on a stock exchange. They experience price changes throughout the day as they can be both bought and sold.
Currency ETFs are a type of ETFs. In a currency ETF, an investor can invest in a single currency or a pool of different currencies. They are usually used to duplicate currency movements in the Forex market through direct holding of currencies or short term debt instruments.
Shorting ETFs
The rationale behind shorting of ETFs is that they provide a means of protecting an investors portfolio. In order to short ETFs an investor would need to borrow shares of either stock or an ETF from a brokerage firm which the investor intends to sell. Usually this is done through a margin account. Through a margin account a brokerage firm will lend the money for purchase of securities. A broker may borrow these securities and the ETF is sold on the market. Within this time period the seller of the ETF will be charged interest on the loan and will also have to pay the lender some dividends. It is hoped that this market will fall and the resulting decline will cause the prices of securities to drop as well hence allowing them to be re-purchased at a lower price. The proceeds from the sale are utilized to repay the loan and the earned profit is the difference between the sale price and the re-purchase price.
Since ETFs have several features they are an attractive investment vehicle when used for shorting purposes. ETFs are normally shorted by hedge fund managers, money managers and both aggressive and defensive investors.
Advantages of Shorting ETFs
When shorting ETFs there can be significant advantages for instance trading flexibility is increased. Similarly ETFs are more tax efficient than mutual funds. Also when shorting ETFs risk is quite less when compared to individual shares. When shorting traders try to prevent their losses through purchasing of stocks (i.e. shorting their positions), this eventually leads to increase in prices resulting in increased losses for those who shorted their positions, however this doesnt hold true in the case of ETFs because the number of shares traded can be increased on a trading day.
Disadvantages of Shorting ETFs
Shorting ETFs might not be the best thing to do in some situations. Not only is the shorting procedure quite complex but can also expose an investor to increased risks since ETFs can be exposed to unlimited losses. Moreover only a few types of ETF can be shorted and it is therefore quite challenging to do so in low quantities.
Inverse (Short) ETFs
Inverse ETFs better known short ETFs have been a result of shorting ETFs. These ETFs improve against the momentum of a sector or decline in index. However these ETFs dont require a direct short sale to be made which means there is no need for a margin and certain costs are avoided. These ETFs can also allow the investor to profit from the market yet hedge their downward risk exposure. Furthermore since they are quite new, they dont have any performance history whatsoever and also require spot on market timing. Hence inverse ETFs are not suitable for rising markets.
Energy Commodity ETFs
Investment in energy commodity ETFs can be very helpful in developing diversified portfolios. There are multiple reasons for that
Potential for hedging inflation and currency risk
The value of energy commodities is recognized globally and its value is independent of any nations economy or currency. Energy prices are known to move opposite to the US Dollar therefore they are an effective strategy for hedging against a weak dollar.
Role played in global growth
Emerging markets for instance China and India have come across greater demand for energy commodities. US had an annual consumption of 25 of the global oil production in 2007 and has increase by 3 on an annual basis ever since as per the International Energy Agency (IEA). However global oil production seems difficult to grow from current levels probably because oil reserves are fast dwindling in Saudia Arabia along with other nations of the Arab league. Whereas other nations which continue to be oil rich for example Nigeria, Iraq, Iran, Venezuela etc. seem to be politically unstable and it is questionable whether they will be appropriate sources in future.
Brief History of Currency ETFs
The first ever currency ETF was launched by Rydex Investments in 2005. It was named the Euro Currency Trust and was traded on the NYSE. A year later it launched 6 more currency ETFs under their brand name Currency Shares which tracked major international currencies. In 2007, Deutsche Bank launched its EONIA Total Return Index ETF which tracked the Euro, later it also launched its Sterling Money Market ETF and US Dollar Money Market ETF.
In 2009, currency ETFs saw a groundbreaking development when ETF Securities launched the biggest Forex platform globally which tracked the MSFX index. This index covers 18 longshort USD ETC along with G10 currencies.
Mechanism of Currency ETFs
Currency ETFs are bought and sold through ETF management firms. These firms create a fund in which they hold different currencies. Any investor interested in investing in currency ETFs can buy or sell shares of that fund which is similar to purchasing or selling of shares on the stock market. ETF management firms charge a low management fees for this transaction. Value of the ETF shares is normally 100 times the currency being held.
Individual Currency ETFs
Investors can purchase currency ETFs which track a single currency. This can be beneficial if a foreign currency is expected to rise against for example the US Dollar. In order to benefit from the appreciation of the foreign currency an investor could purchase this ETF whereas if later on a loss is foreseen, then a short sell can be made of the ETF.
Bulk Currency ETFs
Currency ETFs tracking a pool of currencies can prove helpful in protecting the US Dollar (for example) from a rise or fall on a more global level. For example, the Powershares DB US Dollar Bullish and Bearish funds which track the movement of the US Dollar against some major international currencies and help the investor benefit from positive currency fluctuations.
Currency ETFs are much similar to other types of ETFs in that if foreign currency appreciates the investors will earn a profit whereas the situation would be vice versa if the foreign currency depreciates.
Currency ETFs as has been seen are extensively used by investors who intend to benefit from the exposure of the Forex market but dont intend to enter the Forex or futures market to do so.
Currency ETFs are relatively inexpensive to trade secondly investors find them easy to handle as well in order to benefit from currency fluctuations.
Furthermore Currency ETFs are available for major international currencies namely for instance US Dollar, Britain Pound, Japanese Yen etc.
Role played by Currency ETFs in hedging against business risk
Investors are exposed to two types of business risk namely unsystematic and systematic risk. Unsystematic risk usually affects a smaller number of assets in an investors portfolio and can therefore be diversified, whereas systematic risk cannot be diversified probably because it affects the whole market or the relevant segment to say the least.
Currency ETFs have played a significant role in mitigating an investors risk by diversifying their portfolio through investment in the Forex market along with the stock market. This has helped investors benefit from macroeconomic trends around the globe.
Role played by ETFs in hedging against foreign exchange rate risk
Influence of exchange rate movements on currency returns
Investors around the globe have found the first decade of the 21st century to be quite challenging. US investors in particular have seen their investments decline substantially over the period. In fact the SP 500 index has fallen by more 40 which include a decline in both dividends and total returns.
Whereas equity markets in Canada have performed much better for instance the SPTSX Index saw an increase of about 23. Therefore, investors in Canada reaped monetary benefits whereas those in US suffered huge losses.
Hedging against exchange rate risk
In order to hedge exchange rate risk, investors can short-sell their shares. In case the foreign currency appreciates the investors could make a currency gain whereas if the currency depreciates the investor could buy them back. Short selling is a technique in which stock is sold if it is projected to go down.
Margin-eligibility of Currency ETFs
Although most investors are of the opinion that for example, investing in US dollars in a currency ETF against each US dollar belonging to an overseas investment is not a worthwhile option but currency ETFs are margin-eligible meaning that investors can borrow to invest in the currency ETF.
This is usually done through margin accounts. Margin accounts are brokerage accounts issued by brokerage firms which lend their clients some part of the fund to fulfill the needs of both overseas investment and currency ETFs.
This also allows investors with a fixed amount who wish to hedge exchange rate risk to maintain a 50 margin in their investment and place the remaining 50 in a currency ETF. However the various risks associated with making investments through margin amounts are considerable and investors should be aware of them.
Currency risks associated with currency ETFs
Besides exchange rate and business risk, there are many other currency risks as well which include
Political problems
These problems are usually seen in developing economies where unstable or short lived democracy along with longer periods of military rule and other sorts of political unrest can adversely affect the currency of that nation
National debt
Increased urbanization and industrialization in developing economies is usually made possible through the IMF and the World Bank. A countrys economic stability and potential to pay off debts on time can positively affect its currency and is totally vice versa in the opposite case.
Trade deficits
Large trade deficits can force a nations currency to depreciate and hence subsequently affect the gain on currency ETFs which could even lead to losses.
Interest rate changes
Interest rate regimes tend to be different for most countries and significant interest rate changes affect borrowing and lending both at domestic and international level. This also affects exchange rates where borrowing is done from overseas or similar lending is done to for example a foreign customer.
Government default
Defaults made by government on its international obligation can send a nations economy into counter spin. In such cases, global lending organizations like IMF and World Bank will impose more stringent economic measures which will focus more on stability then growth and therefore this would affect its currency value.
Institutional investors vs. individual investors
Currency ETFs are more helpful to institutional investors as compared to individual investors. The reason is similar to other ETFs. Since institutional investors have superior information due to constant movement in and out of asset classes and hence can benefit from pre-determined currency movements via currency ETFs. As for individual investors, currency ETFs are only helpful if an investor is relocating to another country and wants to ensure as to how much he will own once he or she does relocate.
Exchange-traded funds (ETFs) vs. Exchange-traded notes (ETNs)
Exchange-traded notes (ETNs) are unsecured debt security. They significantly differ from different types of bonds and loan notes probably because returns on ETNs are determined through the performance of the market index which it tracks.
Considering this and the fact that ETNs are traded on major stock exchanges, they are similar ETFs. What differentiates them from ETFs is that they possess credit risk whereas ETFs comprise of tracking risk.
Lately, in the wake of the global economic crisis it was witnessed many ETN issuers went bankrupt which rendered the ETNs to be worthless. ETFs on the other hand have little or no credit risk, however returns on ETFs can differ significantly from their underlying index because they comprise of tracking risk.
As a result, the market has responded in favor of ETFs with 91 of all currency assets being currency ETFs and much to the dismay of currency ETFs.
Currency ETFs are a low risk investment instrument
ETFs are similar to savings accounts probably because the cash invested in ETFs is deposited in banks, over which interest is earned which when converted to an appropriate currency doesnt affect the ETF share value significantly. However if the performance of ETFs is measured in US Dollars then floating exchange rates can make currency ETFs highly speculative.
ETFs pay low interest when compared to savings accounts probably due to their unique structure. Moreover an ETF holder also has to incur management expenses and other fund expenses.
Over the years ETFs have also been compared with investment in growth stocks, where although payout ratio is low similar to ETFs but the potential for appreciation in the investment is quite high.
On the whole even with modest returns currency ETFs are low risk currency investment and are particularly suitable for investors with a low risk appetite.
Currency ETFs and Carry trade strategy
Carry trade strategy is a strategy which allows investors to sell currency at a lower interest rate and use the funds obtained from its sale to purchase a higher interest yielding currency. The difference between the interest rates can result in substantial gains for the investor.
This strategy has always been known to be very risky owing to the uncertainty in exchange rates.
Furthermore the current economic crisis has given a heavy blow to the viability of the carry trade strategy, probably because it further fueled both monetary and currency instability.
However currency ETFs still allows investors to successfully adopt the carry trade strategy. Since the interest paid by single currency ETFs is highly reflective of the interest rate level prevalent in the country, therefore investors can benefit from purchasing that countrys ETFs which is particularly true of economies which boast tighter monetary policies for example Brazil, New Zealand etc.
Economic factors and currency trends
Economic factors along with currency trends significantly affect currency investing. Taking the following example
Oil and the Canadian Dollar
Every currency is reflective of an individual country. If a country produces and exports commodities then commodity prices will influence currency values. Three major currencies are denoted as commodity currencies which represent strong relationships with oil, gold and many other raw materials. The Canadian dollar (CAD) is among these currencies.
CurrencyShares Canadian is an ETF which can be traded profitably in relation to movements in the CADUSD pair. Since the Canadian dollar is the aspbase currency in the currency pair, it will force the ETF to rise when oil prices are subject to an increase and fall when oil prices are facing a decline. Furthermore there are many factors as well which influence a currencys value but energy prices play a major role in pre-determining any possible trends (J.Jagerson.n.d).
Defining Currency ETFs
Exchange traded funds (ETFs) are similar to index funds since they track an index, commodity or a pool of assets. The only difference between them and index funds is that they can be traded on a stock exchange. They experience price changes throughout the day as they can be both bought and sold.
Currency ETFs are a type of ETFs. In a currency ETF, an investor can invest in a single currency or a pool of different currencies. They are usually used to duplicate currency movements in the Forex market through direct holding of currencies or short term debt instruments.
Shorting ETFs
The rationale behind shorting of ETFs is that they provide a means of protecting an investors portfolio. In order to short ETFs an investor would need to borrow shares of either stock or an ETF from a brokerage firm which the investor intends to sell. Usually this is done through a margin account. Through a margin account a brokerage firm will lend the money for purchase of securities. A broker may borrow these securities and the ETF is sold on the market. Within this time period the seller of the ETF will be charged interest on the loan and will also have to pay the lender some dividends. It is hoped that this market will fall and the resulting decline will cause the prices of securities to drop as well hence allowing them to be re-purchased at a lower price. The proceeds from the sale are utilized to repay the loan and the earned profit is the difference between the sale price and the re-purchase price.
Since ETFs have several features they are an attractive investment vehicle when used for shorting purposes. ETFs are normally shorted by hedge fund managers, money managers and both aggressive and defensive investors.
Advantages of Shorting ETFs
When shorting ETFs there can be significant advantages for instance trading flexibility is increased. Similarly ETFs are more tax efficient than mutual funds. Also when shorting ETFs risk is quite less when compared to individual shares. When shorting traders try to prevent their losses through purchasing of stocks (i.e. shorting their positions), this eventually leads to increase in prices resulting in increased losses for those who shorted their positions, however this doesnt hold true in the case of ETFs because the number of shares traded can be increased on a trading day.
Disadvantages of Shorting ETFs
Shorting ETFs might not be the best thing to do in some situations. Not only is the shorting procedure quite complex but can also expose an investor to increased risks since ETFs can be exposed to unlimited losses. Moreover only a few types of ETF can be shorted and it is therefore quite challenging to do so in low quantities.
Inverse (Short) ETFs
Inverse ETFs better known short ETFs have been a result of shorting ETFs. These ETFs improve against the momentum of a sector or decline in index. However these ETFs dont require a direct short sale to be made which means there is no need for a margin and certain costs are avoided. These ETFs can also allow the investor to profit from the market yet hedge their downward risk exposure. Furthermore since they are quite new, they dont have any performance history whatsoever and also require spot on market timing. Hence inverse ETFs are not suitable for rising markets.
Energy Commodity ETFs
Investment in energy commodity ETFs can be very helpful in developing diversified portfolios. There are multiple reasons for that
Potential for hedging inflation and currency risk
The value of energy commodities is recognized globally and its value is independent of any nations economy or currency. Energy prices are known to move opposite to the US Dollar therefore they are an effective strategy for hedging against a weak dollar.
Role played in global growth
Emerging markets for instance China and India have come across greater demand for energy commodities. US had an annual consumption of 25 of the global oil production in 2007 and has increase by 3 on an annual basis ever since as per the International Energy Agency (IEA). However global oil production seems difficult to grow from current levels probably because oil reserves are fast dwindling in Saudia Arabia along with other nations of the Arab league. Whereas other nations which continue to be oil rich for example Nigeria, Iraq, Iran, Venezuela etc. seem to be politically unstable and it is questionable whether they will be appropriate sources in future.
Brief History of Currency ETFs
The first ever currency ETF was launched by Rydex Investments in 2005. It was named the Euro Currency Trust and was traded on the NYSE. A year later it launched 6 more currency ETFs under their brand name Currency Shares which tracked major international currencies. In 2007, Deutsche Bank launched its EONIA Total Return Index ETF which tracked the Euro, later it also launched its Sterling Money Market ETF and US Dollar Money Market ETF.
In 2009, currency ETFs saw a groundbreaking development when ETF Securities launched the biggest Forex platform globally which tracked the MSFX index. This index covers 18 longshort USD ETC along with G10 currencies.
Mechanism of Currency ETFs
Currency ETFs are bought and sold through ETF management firms. These firms create a fund in which they hold different currencies. Any investor interested in investing in currency ETFs can buy or sell shares of that fund which is similar to purchasing or selling of shares on the stock market. ETF management firms charge a low management fees for this transaction. Value of the ETF shares is normally 100 times the currency being held.
Individual Currency ETFs
Investors can purchase currency ETFs which track a single currency. This can be beneficial if a foreign currency is expected to rise against for example the US Dollar. In order to benefit from the appreciation of the foreign currency an investor could purchase this ETF whereas if later on a loss is foreseen, then a short sell can be made of the ETF.
Bulk Currency ETFs
Currency ETFs tracking a pool of currencies can prove helpful in protecting the US Dollar (for example) from a rise or fall on a more global level. For example, the Powershares DB US Dollar Bullish and Bearish funds which track the movement of the US Dollar against some major international currencies and help the investor benefit from positive currency fluctuations.
Currency ETFs are much similar to other types of ETFs in that if foreign currency appreciates the investors will earn a profit whereas the situation would be vice versa if the foreign currency depreciates.
Currency ETFs as has been seen are extensively used by investors who intend to benefit from the exposure of the Forex market but dont intend to enter the Forex or futures market to do so.
Currency ETFs are relatively inexpensive to trade secondly investors find them easy to handle as well in order to benefit from currency fluctuations.
Furthermore Currency ETFs are available for major international currencies namely for instance US Dollar, Britain Pound, Japanese Yen etc.
Role played by Currency ETFs in hedging against business risk
Investors are exposed to two types of business risk namely unsystematic and systematic risk. Unsystematic risk usually affects a smaller number of assets in an investors portfolio and can therefore be diversified, whereas systematic risk cannot be diversified probably because it affects the whole market or the relevant segment to say the least.
Currency ETFs have played a significant role in mitigating an investors risk by diversifying their portfolio through investment in the Forex market along with the stock market. This has helped investors benefit from macroeconomic trends around the globe.
Role played by ETFs in hedging against foreign exchange rate risk
Influence of exchange rate movements on currency returns
Investors around the globe have found the first decade of the 21st century to be quite challenging. US investors in particular have seen their investments decline substantially over the period. In fact the SP 500 index has fallen by more 40 which include a decline in both dividends and total returns.
Whereas equity markets in Canada have performed much better for instance the SPTSX Index saw an increase of about 23. Therefore, investors in Canada reaped monetary benefits whereas those in US suffered huge losses.
Hedging against exchange rate risk
In order to hedge exchange rate risk, investors can short-sell their shares. In case the foreign currency appreciates the investors could make a currency gain whereas if the currency depreciates the investor could buy them back. Short selling is a technique in which stock is sold if it is projected to go down.
Margin-eligibility of Currency ETFs
Although most investors are of the opinion that for example, investing in US dollars in a currency ETF against each US dollar belonging to an overseas investment is not a worthwhile option but currency ETFs are margin-eligible meaning that investors can borrow to invest in the currency ETF.
This is usually done through margin accounts. Margin accounts are brokerage accounts issued by brokerage firms which lend their clients some part of the fund to fulfill the needs of both overseas investment and currency ETFs.
This also allows investors with a fixed amount who wish to hedge exchange rate risk to maintain a 50 margin in their investment and place the remaining 50 in a currency ETF. However the various risks associated with making investments through margin amounts are considerable and investors should be aware of them.
Currency risks associated with currency ETFs
Besides exchange rate and business risk, there are many other currency risks as well which include
Political problems
These problems are usually seen in developing economies where unstable or short lived democracy along with longer periods of military rule and other sorts of political unrest can adversely affect the currency of that nation
National debt
Increased urbanization and industrialization in developing economies is usually made possible through the IMF and the World Bank. A countrys economic stability and potential to pay off debts on time can positively affect its currency and is totally vice versa in the opposite case.
Trade deficits
Large trade deficits can force a nations currency to depreciate and hence subsequently affect the gain on currency ETFs which could even lead to losses.
Interest rate changes
Interest rate regimes tend to be different for most countries and significant interest rate changes affect borrowing and lending both at domestic and international level. This also affects exchange rates where borrowing is done from overseas or similar lending is done to for example a foreign customer.
Government default
Defaults made by government on its international obligation can send a nations economy into counter spin. In such cases, global lending organizations like IMF and World Bank will impose more stringent economic measures which will focus more on stability then growth and therefore this would affect its currency value.
Institutional investors vs. individual investors
Currency ETFs are more helpful to institutional investors as compared to individual investors. The reason is similar to other ETFs. Since institutional investors have superior information due to constant movement in and out of asset classes and hence can benefit from pre-determined currency movements via currency ETFs. As for individual investors, currency ETFs are only helpful if an investor is relocating to another country and wants to ensure as to how much he will own once he or she does relocate.
Exchange-traded funds (ETFs) vs. Exchange-traded notes (ETNs)
Exchange-traded notes (ETNs) are unsecured debt security. They significantly differ from different types of bonds and loan notes probably because returns on ETNs are determined through the performance of the market index which it tracks.
Considering this and the fact that ETNs are traded on major stock exchanges, they are similar ETFs. What differentiates them from ETFs is that they possess credit risk whereas ETFs comprise of tracking risk.
Lately, in the wake of the global economic crisis it was witnessed many ETN issuers went bankrupt which rendered the ETNs to be worthless. ETFs on the other hand have little or no credit risk, however returns on ETFs can differ significantly from their underlying index because they comprise of tracking risk.
As a result, the market has responded in favor of ETFs with 91 of all currency assets being currency ETFs and much to the dismay of currency ETFs.
Currency ETFs are a low risk investment instrument
ETFs are similar to savings accounts probably because the cash invested in ETFs is deposited in banks, over which interest is earned which when converted to an appropriate currency doesnt affect the ETF share value significantly. However if the performance of ETFs is measured in US Dollars then floating exchange rates can make currency ETFs highly speculative.
ETFs pay low interest when compared to savings accounts probably due to their unique structure. Moreover an ETF holder also has to incur management expenses and other fund expenses.
Over the years ETFs have also been compared with investment in growth stocks, where although payout ratio is low similar to ETFs but the potential for appreciation in the investment is quite high.
On the whole even with modest returns currency ETFs are low risk currency investment and are particularly suitable for investors with a low risk appetite.
Currency ETFs and Carry trade strategy
Carry trade strategy is a strategy which allows investors to sell currency at a lower interest rate and use the funds obtained from its sale to purchase a higher interest yielding currency. The difference between the interest rates can result in substantial gains for the investor.
This strategy has always been known to be very risky owing to the uncertainty in exchange rates.
Furthermore the current economic crisis has given a heavy blow to the viability of the carry trade strategy, probably because it further fueled both monetary and currency instability.
However currency ETFs still allows investors to successfully adopt the carry trade strategy. Since the interest paid by single currency ETFs is highly reflective of the interest rate level prevalent in the country, therefore investors can benefit from purchasing that countrys ETFs which is particularly true of economies which boast tighter monetary policies for example Brazil, New Zealand etc.
Economic factors and currency trends
Economic factors along with currency trends significantly affect currency investing. Taking the following example
Oil and the Canadian Dollar
Every currency is reflective of an individual country. If a country produces and exports commodities then commodity prices will influence currency values. Three major currencies are denoted as commodity currencies which represent strong relationships with oil, gold and many other raw materials. The Canadian dollar (CAD) is among these currencies.
CurrencyShares Canadian is an ETF which can be traded profitably in relation to movements in the CADUSD pair. Since the Canadian dollar is the aspbase currency in the currency pair, it will force the ETF to rise when oil prices are subject to an increase and fall when oil prices are facing a decline. Furthermore there are many factors as well which influence a currencys value but energy prices play a major role in pre-determining any possible trends (J.Jagerson.n.d).
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