Forex Exotic Currency Trading: Risks & Rewards


Forex markets usually classify currencies in three groups: major, minor and exotic currencies.  Exotic Currency is the term given to thinly traded currencies which are illiquid, lack popularity in terms of consistent market activity, and trade with high markup fees at select markets or dealers. 

Since the trading patterns keep changing based on economic and geopolitical developments, the list of forex exotics may change over time.

All these currencies demonstrate the characteristics of thin trading, wider bid-ask spreads and limited trading interest by the market participants.

Exotic currencies don’t necessarily mean weak or undervalued currencies, but it does indicate limited and “not-so-popular” behavior in terms of trading activity. For e.g., the Kuwaiti dinar (KWD) and Saudi Arabian riyal (AED) are two high-valued currencies, but they are still considered exotics due to limited trading.

Risks associated with Forex Exotic Currency Trading: Due to low liquidity and related factors, the following risks are associated with forex exotic currency trading:

  • Apart from speculation, forex rates are fundamentally determined by demand and supply trends following the “Purchasing Power Parity” and interest rates differentials. It gets extremely difficult to track and forecast the developments on such macroeconomic factors for distant countries. Lack of awareness and challenges in keeping track of determining factors leads to higher risks.

  • Low liquidity makes it harder to trade forex exotics. Most transactions occur at banks at pre-determined fixed rates for remittance or similar activities. 

  • An analysis of historical daily data for any of these exotic currency pairs will indicate good profitable opportunities in terms of visible price variations over short, mid and long periods of time. However, high mark-up fees charged by forex dealers may erode the profit potential.

  • In cases where there is political uncertainty in the currency's country, this leads to high fluctuations, making it difficult even for experienced traders to trade on exotic forex. For e.g. wide swings have been observed in Russian ruble (RUB) from 33.5 to 39 per USD in the brief period from July 2014 to September 2014, due to the Ukrainian conflict. Another similar example is the highly popular Iraqi dinar investment scheme, where some investors have been waiting years for their investment to come to fruition.

Rewards associated with forex exotic currency trading:

Besides the mentioned risks, exotic currencies do demonstrate a highly volatile nature with high value price moves in the short to long term, enabling enormous profit potential.

  • Imagine being on the right side of the above quoted example of Russian ruble/US dollar exchange rate – in less than 2.5 months, one could have made a cool profit of around 16.5% (possibly more with the use of leverage).

  • In the long-term period between 2008 to mid-2013, the US dollar (USD) to Indian rupee (INR) exchange rate increased from around 39 to 69, a handsome 77% profit.

Apart from directly purchasing the desired currency, there are several other investment choices to benefit from exotic currency. One can look at more complex offerings like currency futures, currency options and even variants ofbarrier options on currencies available as OTC products in selected markets. Individuals should keep in mind the complex nature of these products, which further add to complexity of exotic currency trading. 

The trader profile for forex exotic currency trading:

Considering the above factors, exotic currencies are definitely not recommended for novices, short term traders, or  traders with limited trading capital.

Experienced market makers and dealers are usually the ones to benefit from trading exotic currencies by capitalizing on the wider spreads, at the expense of other counterparts.

Forex exotics may make a good investment option for experienced long term investors, international fund managers or investors willing to add some diversification to their investments at global level.

Ideally, an individual having a consistent follow-up on a particular country (and currency), with a long term investment potential, can attempt to monetize on the exotic currency with the "set it and forget it” approach. 

The Bottom Line

Trading forex exotics is not for everyone. Short term profit opportunities are marred by high mark-up fees and wide bid-ask spreads, while long term investments require patience, knowledge of economic and geopolitical developments and impacts. One should consider forex exotic investments and trading only with sufficient experience and risk taking potential.

By Shobhit Seth.

Source: "InvestoPedia".
Sep 28, 2014, 9:29 AM
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