Authored by Christopher Reed in Forex Trading
Published on 12-07-2008
Entering forex is like getting yourself into a risky situation. Basically, there are different kinds of risks that a trader has to fully understand in order to prepare himself for whatever consequences that certain risk has to offer.
Exchange Rate Risk
One kind of risk a trader might encounter is the exchange rate risk. This can be described as the effects of the worldwide market supply and demand as it continuously balances off scale during an outstanding forex period. An outstanding period means that rates can and will be subjected to every price change that there is. In order to lessen your losses and at the same time rally on profitable positions, past losses should be managed properly. To do this, you have to be certain that the losses are within the position limit and the loss limit. The position limit allows a trader to carry only a certain maximum amount to be exchanged at any single time during trading hours. The loss limit, on the other hand, is designed to prevent losses that a trader cannot be sustained. The mechanism can be described as a stop-loss levels setting.
Interest Rate Risk
Interest rate risk is another risk that is worth mentioning here. This is the amount of profit and loss that is generated by changes in the spreads (measured in pips). Together with this is the amount of forward mismatches and maturity gaps of transactions in the forex. To minimize this risk, the trader should set a definite limit on the total size of mismatches. Categorization of mismatches in order of their maturity rates (six months and past six months) is an efficient way to lessen this kind of risk. This way, you will have a baseline in which you can analyze any changes that may have a substantial impact on the outstanding gaps.
If there is a possibility of not being repaid of an outstanding currency position by a counter party, credit risk is involved. This can be usually found in regulated exchanges (example of which is the clearinghouse of Chicago). There are different forms of credit risks. It can be due to a replacement risk whereby counter parties worry about not getting their refunds from the bank where the accounts became off-balance. It can also be due to difference in time zones. One thing traders must remember when dealing with this risk is their currency portfolios. Awareness when it comes to where their portfolios will be exposed is important.
Dictatorship risk refers to the government’s intervention in the activities of the forex. Thus, traders must be able to fully understand the kinds of risks present in a certain state and should be able to realize possible administrative restrictions.