Are Exotic Currency Pairs Too Risky for Forex Traders?

10/21/2020 10:01 am EST

Focus: FOREX

Konstantin Rabin

CEO, Finance Makers

When it comes to forex trading, there are many different types of traders. Some market participants prefer to limit their entire trading experience to major currencies, explains Konstantin Rabin of ForexNewsNow.com.

At the same time, some traders also trade emerging market currencies as well. It goes without saying that trading exotic currencies do have some distinct advantages. Firstly, it is worth noting that in the case of the majority of exotic currencies, the central bank interest rates are considerably higher than with major currencies. This allows the market participants to utilize them for carry trades.

What traders can do here is to borrow money in one of the lower-yielding major currencies and invest this amount in higher-yielding emerging market currency and receive a daily income due to interest rate differentials.

In addition to that it is helpful to point out that at any point in time, there are some emerging market currencies that are considered undervalued against major currencies, according to the purchasing power parity and even some other indicators. This allows the market participants to open positions with exotic currency pairs at bargain prices and then potentially benefit from capital appreciation.

Despite some of the advantages of trading exotic currencies, this does have its own risks. Firstly, it is important to keep in mind that due to inflation rate differentials and sometimes even the economic instability, some emerging market currencies are engaged in the long-term downward trend against the US dollar, the euro, and other major currencies. Consequently, buying those exotic currencies and keeping the position open for an extended period of time can be very risky indeed.

It is also worth mentioning that exotic currency pairs are much more volatile and less predictable, compared to the forex majors. Consequently, trading those types of pairs with high amounts of leverage can put the trading capital of the individual under considerable risks and could lead to some sizable losses.

Finally, it is helpful to point out that the number of economic announcements from emerging markets is rather limited. Obviously, there are such reports as the latest GDP, inflation rates, and unemployment rate figures, however, there are many more items on the economic calendar for forex majors, than for emerging market currencies. It goes without saying that this makes the fundamental analysis for those types of currency pairs rather a challenging task.

Now let us go through each of those characteristics of exotic currencies in greater detail.

Currencies with Higher Interest Rates

One of the popular strategies in forex trading is the use of carry trades. Traders use this strategy by finding a currency that has very low yields, preferably close to zero, and borrowing money in that currency to buy higher-yielding currency. As long as traders keep this type of position open, they will receive the daily interest payments from the brokerage firm. This is also known as swap or rollover.

Now, for the last couple of decades, the Japanese yen has been traders’ favorite funding currencies. The main reason for this was the fact that by the late 1990s the Bank of Japan had cut the interest rate repeatedly, until bringing them all the way down to 0.25%.

On the other hand, before the 2008 financial crisis, the Australian dollar has been one of the highest yielding major currencies in the forex market. In fact, by 2007, the Reserve Bank of Australia had raised its key interest rate all the way up to 7.25%.

It is not surprising then that many carry traders held long AUD/JPY positions for an extended period of time, earning from 6% to 7% annual interest rate on their positions. Here it is also worth keeping in mind that if for example, traders used 1:5 leverage, then their annual rate of return would range from 30% to 35%, which is quite impressive. In the case of 1:10 leverage, the annual rate of return would have ranged from 60% to 70%, which was very attractive for many market participants.

To illustrate the influence of this dynamic on the forex market, let us take a look at this weekly AUD/JPY chart:

AUD/JPY

As we can see from the above image, during late 2000, the AUD/JPY pair was trading close to 56 level. During the subsequent years, the Australian dollar has risen steadily against the Japanese yen. In fact, by 2007 the AUD/JPY had reached a peak at near 106 level. This means that in less than seven years, the Australian dollar has gained more than 89%, which represents a significant move.

However, we can also observe from the diagram that during the second half of 2008, the AUD/JPY pair simply collapsed, with the Australian dollar dropping all the way down to 57 level during early 2009. In other words, nearly all of seven years’ worth of gains were simply wiped out in seven months.

This large move in such a short period of time can be quite surprising for many traders. Yet, the reason for this development was the fact that in response to the enormous challenges brought by the 2008 financial crisis, the Reserve Bank of Australia has cut rates repeatedly, bringing them all the way down to 3%.

Those decisions led to the unwinding of the majority of long AUD/JPY positions. The assumption by that time was that the Reserve Bank of Australia was likely to follow the example of the US Federal Reserve and Bank of England, reducing the rates to near-zero levels. As a result, the majority of carry traders have simply decided to liquidate the long AUD/JPY position in order to cut their potential losses.

Now, this expectation has not materialized. In fact, after the initial shock of the 2008 financial crisis was gone, the Reserve Bank of Australia has once more started raising rates, even going above 4%. At the same time, it is worth noting that the Bank of Japan has gradually reduced rates to -0.1%, making the Japanese yen even more attractive funding currency than before.

This once more made the AUD/JPY pair attractive for carry traders. As a result, the Australian dollar has regained most of its losses, rising all the way up to 103 level against the Japanese yen. However, this state of affairs has not persisted indefinitely either. Responding to the somewhat subdued inflation rate, the Reserve Bank of Australia has once more started reducing rates gradually.

However, the largest move came in 2020, when the Australian policymakers responded to the challenges brought by the outbreak of the Covid-19 pandemic, by cutting rates all the way down to 0.25%.

It is not surprising that those decisions lead to further depreciation of the Australian dollar against the Japanese yen, with the AUD/JPY dropping all the way down to 76 by October 2020.

So as a result, carry traders lost one of the most lucrative trading opportunities they had for the last couple of decades. We have eight major currencies in forex: the US dollar, the British pound, the euro, the Swiss franc, the Japanese yen, the Australian dollar, the Canadian dollar, and the New Zealand dollar. Since March 2020, all of them have their interest rates at 0.25% or even lower. Therefore, there are very little trading opportunities for carry trades.

This is why they are looking for opportunities elsewhere. So, one possible alternative for those types of traders is to open positions with exotic currency pairs. By October 2020, there are some emerging market currencies with high yields. For example, the Russian ruble and Mexican peso both yield 4.25%, the Turkish lira -10.25%, and the South African rand -3.50%. Consequently, the emerging market currencies can be one place carry traders can find some attractive rates of return.

Undervaluation Factor

Actually, the higher interest rates are not the only factor that attracts some traders to emerging market currencies. The fact of the matter is that many emerging market currencies are undervalued according to the purchasing power parity indicator, also known as PPP. This measure essentially represents the exchange rate at which the average prices for goods and services will be equalized between the two given countries.

According to the British financial magazine The Economist, adjusting for GDP differentials, by summer 2020, the Mexican peso was still 33% undervalued against the US dollar. The degree of undervaluation was even greater with the South African rand, the Turkish lira, and the Russian ruble. The latter one, RUB being undervalued against the USD by more than 43%.

It goes without saying this allows the market participants to buy some emerging-market currencies at bargain prices  This obviously does not guarantee the market participants that they will always end up with winning trades, but this can improve odds in favor of the long term traders.

Long-Term Depreciation

Despite all of the benefits of trading with exotic currencies, it is important to mention that they have their own downsides as well. One of the most important disadvantages of those currencies is the fact that many of them are engaged in the long-term downward trend against the major currencies. In order to illustrate one example of this, let us take a look at this daily USD/TRY chart:

USD/TRY

As we can see from the above image, back in January 2018, the USD/TRY pair was trading close to 3.70 level. During the subsequent months, the US dollar has made steady gains against the Turkish lira. Obviously, there were some pullbacks from time to time, however, we can take note of the fact that the long-term upward trend remained intact.

By October 2020, 1 US dollar is worth 7.89 Turkish liras. This means that in less than three years, the USD/TRY pair has risen by approximately 113%. Therefore, it seems obvious that the Turkish lira is engaged in a persistent depreciation against the major currencies. The 10.25% interest rate can seem appealing for some market participants, but the sharp depreciation of the lira is likely to wipe out any gains traders might make with carry trades.

This does not mean that every single emerging market currency will always lose ground against the US dollar and other major currencies. It is true that some currencies have stabilized and even have made some gains against the USD. Therefore, it is always helpful for traders to do proper due diligence, before opening positions with exotic currency pairs.

Higher Volatility and Lack of Information

As mentioned above, there are a number of emerging-market currencies, which are not always engaged in a downward trend against major currencies. However, this does not change the fact that the majority of exotic currencies also tend to be very volatile and pretty much susceptible to violent market swings. To visualize this better, let us take a look at this daily USD/ZAR chart:

USD/ZAR

As the above diagram demonstrates, at the beginning of 2018, the USD/ZAR pair was trading close to 12.00 level. During the subsequent months, the US dollar has made steady gains, a trend that accelerated after the outbreak of the Covid-19 pandemic. As a result, by March 2020, the USD/ZAR pair climbed all the way up to the 19.00 mark, which represented more than a 58% increase compared to January 2018 levels. This was followed by a sharp correction, with the pair dropping by more than 13% to the 16.50 mark.

So, as we can see here, the emerging market currencies can be more volatile than Forex majors. It also does not help that the number of economic announcements for those countries can be smaller than with major economies. For example, when it comes to the US economy, we have payroll numbers, consumer confidence reports, industrial production, and other useful announcements.

This is not necessarily the case with the majority of emerging market economies. Therefore, this makes it more difficult to make accurate predictions about the movements of exotic currency pairs.

By Konstantin Rabin of www.forexnewsnow.com - a financial trading news outlet.

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