Why the foreign exchange market is so interesting

When someone thinks of the largest financial market in the world, they often think of the U.S. stock market or the bond and fixed-income market. That, however, is incorrect. The largest financial market in the world is the foreign exchange market, also known as Forex, an abbreviation for Foreign Exchange. Despite having a daily trading volume exceeding $5 trillion, its operation and uses are not as well-known as those of other markets.

Unlike other markets, such as the stock market, the foreign exchange market is not an organized market but rather a private one. This means there is no clearinghouse or settlement body to mediate or guarantee the fulfillment of obligations. Despite this, participants in this market range from central banks around the world to multinational corporations, investment funds, asset managers, and individuals.

Regarding its operation—arguably the most interesting and least understood aspect—it has several facets. The first focuses on setting the exchange rate of one currency against another. For example, it determines how many dollars are equivalent to one euro or how many euros are equivalent to one Swiss franc. In other words, it establishes the value of money and its purchasing power.

Additionally, and perhaps even more importantly, it facilitates international trade. For instance, when an Indian company needs to purchase goods from an American company, it first has to acquire dollars to make the payment, which effectively means obtaining ownership of a foreign currency deposit. In any case, it exchanges its rupees for dollars to complete the transaction.

This becomes even more critical in the commodities market. For example, oil is traded in dollars, and all countries must exchange their currencies for dollars to buy oil. This clearly illustrates the importance of the foreign exchange market.

This type of operation is very common among large investment funds, but also among more advanced investors. When investing in an asset denominated in a currency different from one's primary currency, two risks are assumed: market risk and currency risk. The first applies to all assets and relates to the potential decline in the asset's price. For example, when buying a stock, one accepts the possibility that its price might fall. This is an inherent risk that cannot be eliminated.

Currency risk, however, refers to the exchange rate between the investor's currency and the currency in which the asset is denominated. In other words, if someone buys U.S. stocks using Swiss francs or euros and those currencies depreciate against the U.S. dollar, the investment loses value.

To mitigate this, investors use a currency hedging strategy. This involves going to the Forex market and directly purchasing the asset’s base currency. For instance, if an investor buys Apple shares using euros, they are inherently selling euros and buying U.S. dollars. To implement the hedge, the investor would enter the Forex market to buy the EUR/USD pair for the equivalent amount, thus protecting themselves from exchange rate fluctuations.

As mentioned earlier, the foreign exchange market is essential to the operation of international trade. This is where forward portfolios for businesses come into play. While the name might sound complex, it’s actually quite straightforward.

In practice, it is an agreement between two parties to exchange a specific amount of one currency for a specific amount of another currency. For example, agent A might agree to exchange €100,000 with agent B for $110,000 in one year. This locks in the exchange rate and is not based on the spot prices quoted in the Forex market.

This approach can be highly beneficial for businesses, as it eliminates exchange rate volatility and allows operations to proceed with a secure margin, knowing the specifics of the agreement, since currency exchange rates fluctuate daily.

From a pure investing perspective, currency asset allocation simply involves purchasing a currency and holding it in a portfolio as a form of protection or investment. For instance, if an investor seeks conservative protection and expects the euro to weaken against the Swiss franc, their asset allocation strategy would involve exchanging euros for Swiss francs. 

This provides a way to diversify a portfolio and protect against potential devaluations of any given currency. In emerging markets with weaker currencies, maintaining an asset allocation in stronger currencies makes particular sense.

As mentioned earlier, hard currencies are strong currencies such as the U.S. dollar or the Swiss franc. These strong currencies maintain a stable value over time, protecting investors from potential devaluations or, in the case of the dollar, providing exposure to the world’s reserve currency, which is used to purchase most assets internationally.

Throughout history, the Swiss franc has been one of the greatest examples of a safe-haven asset. It has consistently been less prone to devaluation compared to the dollar and the euro, serving as a reliable shield against the depreciation caused by inflation.

Although the Swiss franc has experienced some devaluation and has lost 4.5 times its value over the last 70 years compared to 1956, it remains in a privileged position, far outperforming the U.S. dollar, the world’s primary international currency. To illustrate this with an example: in 1956, 100 Swiss francs would be equivalent to 454.6 Swiss francs today. In contrast, 100 U.S. dollars from the same year would be worth 1,120 dollars today. This means that, over the same period, the dollar has lost more than 11 times its value, compared to the 4.5 times of the Swiss franc. For this reason, the Swiss franc is regarded as a stable safe-haven asset.