Forex market, as you know, is about trading currency pairs. Currencies are traded for one another, i.e., in a JPY/USD pair, you would hope that the Japanese Yen would appreciate against the American dollar. Though you should know that the investment realm is dynamic, and in a split second, the market can swallow you up. But well, that’s the forex dangers you take to earn a profit.
There is another forex trading risk and the liquidity risk if you are trading a not so popular pair. It can lead to a situation where you lose your trade, leading to a margin call. In addition to that risk, a forex broker and a trading exchange is a risk as well. Most of the forex transactions are taken up by gigantic banks and not retail traders. These big players use tools to averse the forex trading risk and fluctuations of this realm.
By using certain algorithms and computerized trading, their risk is curbed, and they can make more profitable trades. But if you are an individual, the risk tends to be high, but by applying your knowledge and skills of trade management, you can ace it too.
What is forex risk?
Risk in forex trading represents the possibility of losing some or all of the original investment. For retail traders (individual traders), the most important risk is leverage and marginal risk. Institutional traders involve different types of risks, forex dangers, such as Interest Rate Risk, Exchange Rate Risk, Country and Liquidity Risk, Credit Risk, Leverage/Marginal Risk, Transactional Risk, and Risk of Ruin.
Sometimes, some potentially profitable trades can also be risky, especially when trading on a large margin. It does seem a little complex but worries not, as we have got all your queries covered in this article. So, let’s dive in.
Usually, when we talk about retail traders’ trading risks, we are talking about leverage and marginal risks. Very often, traders risk too much in their positions, and later it is hard to recover. See below risk trading Table:
Now, let us see, in theory, all risks in forex trading.
What Are the Risks of Forex Trading?
The following forex trading risks for institutional traders are quite common to see across the forex market:
- Interest Rate Risk
- Exchange Rate Risk
- Country and Liquidity Risk
- Credit Risk
- Leverage/Marginal Risk
- Transactional Risk
- Risk of Ruin
1. Interest Rate Risk
Interest rate risk occurs due to fluctuations in a forward spread, disrupting profit and loss. It also creates a maturity gap and forward amount mismatch in the foreign exchange book. This risk affects various financial instruments like currency swaps, futures, options, and forward outright.
See the video and get an answer to why are Interest Rates so Important for Forex Traders?
To reduce the interest rate risk, a trader must limit his or her total trading size mismatch. You can also separate these mismatches as per their maturity dates, like 3 months, 6 months, etc. Along with that, continuous interest rate analysis can also help you in future changes that may have the potential to impact the outstanding gaps.
2. Exchange Rate Risk
The change in the value of different currencies creates the exchange rate risk. The volatility in the demand and supply at a global level continuously creates this risk. If, as a trader, you have an outstanding position, you are prone to this risk and changes.
The exchange rate risk is substantial in nature and would mold itself in the market’s perception, having views on the upward or downward directions due to certain factors.
In addition to this, the counter or off the exchange trading is not regulated, and as a result, there is no limit on daily price changes. This thing can have a significant impact on the forex market, and as a trader, you can turn the tables in your favor by doing fundamental and technical analysis.
The best way to avoid the exchange rate risk is to reduce your losses and increase the chances of better return by trading within your limits. This trading strategy includes certain parts, like
The Position Limit
It is the maximum limit that a currency trader can have at any point in time.
The Loss Limit
This limit is imposed to curb the unsustainable loss by implementing stop-loss orders. It stresses more on having relevant and realistic stop-loss levels.
The Risk to Reward Ratio
A forex trader knows how to trade and control the risk by knowing how much risk-taking capacity. The best way to know this capacity is to decide how much risk you are willing to take for getting a certain amount of profit. This is called the risk to reward ratio. So, if your risk to reward ratio is 1:4, it means that for earning $4, you are willing to take the risk of $1.
3. Country Risk and Liquidity Risk
The Counter market is larger than the exchange-traded currencies; they have various liquidity scenarios outside America and Europe. Many nations also put limits and restrictions on volumes, prices, and positions for certain volatility levels. These kinds of limits can prevent traders from trading with ease and create unfavorable liquidity risk.
Sometimes countries also bar traders from trading or transferring a certain country; such restrictions can also create settlement issues and obligate the contract. Such risks are more common among the non-U.S market players as the liquidity issues are higher outside the U.S.
This can also lead to a critical point of placing limit orders, as less liquidity means fewer chances of such orders to get executed. Extreme levels of volatility can also create forex dangers for traders.
4. Credit Risk
Credit risk is the risk of not being paid back for an outstanding currency position because of involuntary or voluntary reasons. This kind of risk is largely faced by large corporations and banks, whereas this risk of individual investors or traders is comparably low. The same thing applies to the firms regulated or registered under the G-7 nations.
Many organizations like the CFTC (Commodity Futures Trading Commission) and NFA (National Futures Association) have applied laws for the United States’ currency market. They are doing their best to have a tight hold over the unregistered forex firms. Western European nations follow the Financial Services Authority in the UK for financial market-related laws. The same authority is the strictest authority to impose forex laws on companies to prevent scams and secure funds.
It also becomes essential for traders to check a company’s background before investing in it or through it. The best way to do so is to visit various regulatory sites such as,
The majority of companies answer customer queries without any hesitation and publish material related to funds’ security.
There are various types of credit risk, as stated below.
Replacement Risk
Replacement risk is the risk that happens when a counterparty of a forex broker or a bank realizes that it can not get the funds back from that institute.
Settlement Risk
Settlement risk happens because of different continents and time zones. A currency can also be traded at different rates at different time periods of the day on different markets. For example, New Zealand Dollars and Australia are credited on priority, after which the Japanese Yen, European, and at last the American Dollar gets credited. As a result, a due payment might be made to a party about to declare bankruptcy even before that party executes the payment.
For evaluating the credit risk, you should look after the market value of that currency along with the potential exopause of your portfolio.
This potential exposure is evaluated by analyzing the outstanding position and its maturity. In that, the latest computer systems can prove handy to implement the policies of credit risk. It also helps in monitoring the credit lines. It was launched in April 1993, after which traders have widely used it to implement credit policy.
Counterparty Default Risk
Over the counter (OTC) market is an unregulated market to trade financial instruments. Thus, OTC spot and forward currency contracts are also not traded on any exchanges, and large banks and FCMs become the principal address here.
As these spot and forward currency contracts are not regulated, they come with no guarantee by any clearinghouse or exchange, thus creating the counterparty risk. It is a risk that a trader faces a principle in case he refuses to perform the contract at expiry. In addition to that, the principles here have no objection to follow the duty of making the market where the spot or forward currency contracts are traded; they are on their will.
Apart from this, the following risk is also faced by traders in the forex market.
Level of Risk
There are chances that a bank of FCM can refuse to perform an order in the forex market, which has more than expected risk to its currency operations. As over the counter, markets are not regulated and have no clearing mechanism. Banks and FCMs implement their own analysis and decide the trades and market’s risk level as per their suitability. That thing has happened quite often in the past, and due to the volatile nature of the currency market, it can happen again.
Different Rates
Also, as there is no central government to provide minute by minute or sales reports, large banks and FCMs have to apply their own skills and knowledge to decide a particular execution price of a trade. The forex market is liquid, but still, there are a few currencies that we know as exotics that have a lower frequency of trading but have large deals. So, if a counterparty is not that experienced, it would take a long time to execute or fill the order or get the price against an experienced or big counterparty. So, it creates the possibility that two market players in the same market and the same security can have two different rates and returns.
Financial Failure
Losses can occur in the forex market if the counterparty fails financially. As stated above, on an Over Counter market, banks or institutes rule as principles, and they are more prone to get bankrupt than individual traders. So, if any such event happens, a trader would only revver a pro-rata share of all the properties available to distribute to the counterparty as the list of counterparties would belong. So, even if you have proof of owning money, you can do nothing!
Lack of Rules and Regulations
If you are trading on an exchange, you would have rules and regulations abiding you as well as the bank or FCM to secure your funds. But there are no such protections in the counter market as FCMs have an exemption from such regulations under the Commodity Exchange Act for acting as counterparties on non-exchange platforms and contracts.
5. Leverage Risk
Leverage is the concept where you get more amount to trade than you have in your account based on the security or deposit you provide. For the forex market, low margin deposits and collateral are necessary if you are trading on a regulated exchange. This margin gives you higher leverage.
Though the issues come when even a small price change can create significant losses due to high leverage, so if you have put 10 percent as a deposit margin, and if your position would lose 10 percent, you would lose your deposit. Still, in addition to that, you have to pay commission and other charges. The aggressive the leverage, the riskier the trade becomes.
6. Transactional Risk
Sometimes any errors while communicating, confirming, or handling orders can create huge losses. It is known as ‘Out Trades.’ If such an error is a fault committed by the counterparty, a trader can recourse it, but I would be limited compared to the losses he or she has already bear in the trading account.
7. Risk of Ruin
Sometimes a trader invests money in the long term having the prediction of price rise later in the future, but that is half part of the story. A trader can be right with the prediction, but the journey till then can be rocky with certain short term losses, making the trader close his or her position to meet the margin call or sustain the existing condition.
Thus, if you lack capital in your account, your knowledge and prediction have the chance to go in vain due to short term consequences.
The Last Thought
As a forex trader, you are prone to such forex trading risk, but you can reduce them by implementing risk management such as stop loss. You can also enhance your knowledge, and with practice comes skills.
We hope that our list has helped you in getting answers to all your doubts. Remember that slow and steady wins the race. So, don’t give up on your goals, and work hard with consistency, and the market will ultimately favor you. All the best!
