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Forex as an asset class: enhancing diversification

The forex market has always been associated with speculation, given its peculiar characteristics, especially regarding the use of leverage, which gives the investor the possibility to actually trade a multiple of the available sum on his trading account.

It has lately gained the spotlight following the sudden decision on January 15 by the National Bank of Switzerland to remove the floor of 1.20 on EURCHF, a decision which provoked a sudden drop of over 30 per cent of the value of euro against Swiss franc. The movement was so sharp that many investors faced losses which were directly related to the amount of leverage used, thus reinforcing the view of forex exchange trading as purely speculative.

While we may agree that the excessive use of leverage and an improper money management may lead to a loss of control of the investment per se, a more structured approach – which considers forex in the scope of a general asset allocation of an investment portfolio – will lead to an enhancement of one of the most important aspects of a structured investment process: diversification.

In order to reduce risk in an investment portfolio, the available assets are divided into different classes, such as bonds, stocks and cash. The allocation of the portfolio to each asset class will then depend on the investor profile, the risk tolerance and the time span of the investment. The modern portfolio theory by Harry Mark Markowitz studies the effect of diversification in evaluating the efficiency of investment portfolio and, in doing so, he underlines the importance of asset class correlation in order to operate a true and effective diversification of an investment portfolio.

If we take a closer look at this approach, we notice that diversifying asset classes may not be as easy and intuitive as it may seem. This is where the element of correlation comes into play: if asset class returns are highly positively correlated, the investor may incur a false diversification of the portfolio with the consequence of lack of risk control and excessive return volatility.

During the ongoing financial crisis that is hitting Europe, for example, we witnessed that, unlike any recent precedent , there is an apparent increased positive correlation between bonds and stock returns of southern European countries, which cannot be mitigated by using bonds emitted by more stable counties, as their return – given the interest rate level – is too low.

Is diversifying a portfolio only a matter of using a higher number of asset classes or could different strategies come into the picture? The answer is certainly the latter and this is where, given its unique characteristics, trading the forex exchange market may well come into play.

The forex market is characterised by a high level of efficiency, given its high liquidity and the extremely low transaction costs, which allows a very wide range of investment and trading strategies, coupled with the advantage of a wise use of the leverage aspect and the intrinsic non- directionality of currency trading, which will ultimately lead to a de-correlation of returns.

Moreover, one of the traditional ways of diversifying an investment portfolio is to invest in multiple countries, both in stocks and bonds. Here again, we have witnessed an ever increasing positive correlation, especially between international stock markets, which not only lead to a lesser efficient diversification, but also exposes the investor to the risk of fluctuation of the relative value between the currency in which the financial instrument isdenominated and the base currency of the investor.

Given the mentioned unique features of currency trading, one can then use forex exchange not only as a direct asset class to invest in, so as to diversify the portfolio, but also to actively hedge, both through leveraged spot trading and currency options, against excessive fluctuation of the currencies in which the different asset classes may be denominated.

FXDD Malta Limited
www.fxdd.com
Tel: 2013 3000

Disclaimer
FXDD Malta Ltd is licensed to provide investment services by the Malta Financial Services Authority.

High risk warning: Foreign exchange trade carries a high level of risk that may not be suitable for all investors.

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