Month: September 2020

Replacement risk occurs when counter-parties of a failed bank or Forex broker find they are at risk of not receiving their funds from the failed bank.

Credit risk refers to the possibility that an outstanding currency position may not be repaid as agreed, due to a voluntary or involuntary action by a counterparty. Credit risk is usually something that is a concern of corporations and banks. For the individual trader (trading on margin), credit risk is very low as this also holds true for companies registered in and regulated by the authorities in G-7 countries. In recent years, the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC) have asserted their jurisdiction over the FX markets in the US and continue to crack down on unregistered FX firms. Countries in Western Europe follow the guidelines of the Financial Services Authority in the UK. This authority has the strictest rules of any country in making sure that FX companies under their jurisdiction are keeping qualified customer funds secure. It is important for all individual traders to thoroughly check out companies before sending any funds for trading. It is fairly easy to check out the companies you are considering by visiting the authorities’ websites:

• CFTC
• NFA
• FCA
• PRA

Most companies are happy to answer inquiries from customers and often post notices pertaining to security of funds on their website. It should be noted, however, that minimum capital requirements for Futures Commission Merchants (“FCMs”) registered with the CFTC are much less than those of banks, and under present CFTC regulations and NFA rules, protections related to the segregation of customer funds for regulated futures accounts do not extend fully to funds deposited to collateralize off-exchange currency trading. For these and other reasons, the CFTC and NFA discourage any representation that the registration status of a Futures Commission Merchant substantially reduces the risks inherent in over-the-counter Forex trading.

Interest rate risk refers to the profit and loss generated by fluctuations in the forward spreads, along with forward amount mismatches and maturity gaps among transactions in the foreign exchange book. This risk is pertinent to currency swaps; forward outright, futures, and options. To minimize interest rate risk, one sets limits on the total size of mismatches. A common approach is to separate the mismatches, based on their maturity dates, into up to six months and past six months. All the transactions are entered in computerized systems in order to calculate the positions for all the dates of the delivery, gains and losses. Continuous analysis of the interest rate environment is necessary to forecast any changes that may impact on the outstanding gaps.

A method traders use as a guideline when trying to control exchange rate risk is to measure their intended gains against their possible losses. The idea is that most traders will lose twice as many times as they profit, so a guide to trading is to keep your risk/reward ratio to 1:3. This is illustrated in detail in a later section.

A position limit is the maximum amount of any currency a trader is allowed to carry, at any single time.

The Loss Limit

The loss limit is a measure designed to avoid unsustainable losses made by traders by means of setting stop loss levels. It is imperative that you have stop loss orders in place.

Exchange rate risk is the risk caused by changes in the value of currency. It is based on the effect of continuous and usually volatile shifts in the worldwide supply and demand balance. For the period the trader’s position is outstanding, the position is subject to all price changes. This risk can be quite substantial and is based on the market’s perception of which way the currencies will move based on all possible factors that happen (or could happen) at any given time, anywhere in the world. Additionally, because the off-exchange trading of Forex is largely unregulated, no daily price limits are imposed as exist for regulated futures exchanges. The market moves based on fundamental and technical factors – more about this later.

The most popular methodology implemented in trading is minimizing losses and increasing the potential for return, in order to ensure that losses are kept within manageable limits. This common sense methodology includes: