Although G-10 currencies such as the U.S. dollar, euro and yen dominate much of the trading activity in today’s markets, smaller, more exotic currencies can offer additional investment opportunities.
An exotic currency is a currency that is not commonly traded in the foreign exchange market. Exotic currencies are usually from developing countries such as parts of Asia, the Pacific, the Middle East and Africa. Most of these currencies are not easy to trade because the market does not have the same amount of action for exotic currency as it does for main currencies. They lack market depth and trade at low volumes.
The relative lack of activity in the exotic currency market means the currencies can have a high cost and can carry a high risk. High risk creates opportunities for high profits and there are many forex traders willing to chance these risks. Forex brokers such as FXCM.com list exotic currency pairs among their asset classes.
The exotic currency market is not easy to understand and it is not secure. Trading exotic currencies can be inherently more volatile than trading the majors because the political and financial environments in developing countries may change quickly and cause the country’s currency to rise or fall in value.
Even as volatility can be a blessing for a certain type of trader, when coupled with the notoriously illiquid markets in some exotic counters, it can just as easily be the kiss of death. The lack of liquidity as compared to trading on the majors such as EUR/USD or GBP/USD can result in large swings on thin volumes. In addition, the spreads on exotics are much greater, sometimes as much as ten times, than that of the majors.
How are emerging countries affected by these currencies?
Foreign exchange activity is beneficial for a country’s economy. Over the last few years, some emerging countries have shown unusually strong economic expansion. China, for example, reported a growth rate of about 10 % in 2012 which produced a large amount of wealth and money. The result is that the value of the Chinese currency, the Chinese Yuan, is now highly volatile over base currencies.
In fact, since 2010, the Yuan has increased by 25 % against the U.S. Dollar. This is how exotic currencies can generate big profits for Forex traders. For example, if an investor had bought 50,000 Yuan in early 2010 and sold them at the end of 2012, he would have realized a net profit of 25 % on each transaction.
Currently, there are three exotic currencies experiencing exponential growth. These three currencies are the Chinese Yuan, the Indian rupee and the Brazilian real. Other exotic currencies have been growing at a slower pace.
Emerging markets are becoming an important part of the global economy. According to the International Monetary Fund, smaller currencies as a percentage of allocated bank reserves rose to 6.1 per cent at the end of 2013, up from just 1.8 per cent at the end of 2007.
Developing countries have led this trend. While advanced economies now hold 5 per cent of their allocated reserves in alternative currencies, emerging ones held 7.4 per cent at the end of 2012, up from 6.6 per cent in the third quarter of the year, the IMF data show.
The Federal Reserve’s bond-buying program has indirectly contributed to the rise in their reserves.
As the dollar has weakened in recent years, emerging market central banks have reacted by intervening to prevent their own currencies from getting too strong – buying more foreign exchange and adding to their stockpiles of reserves. It is primarily these extra reserves that central banks are diverting into exotic currencies, pouring more dollars and major currencies into the economy of the emerging country and indirectly supporting their growth.
Strategists and fund managers stress that emerging market currencies will remain a niche holding for the foreseeable future. While some reserve managers are taking more risk, for many the dollar and the euro remain the staples of their holdings as the world’s two most liquid currencies.
The most important thing to remember when trading exotic currencies is to use a brokerage that will provide reliable spreads. Ava Trade is one of the top brokers that offers the trading of exotic pairs, but it’s always good to read an AvaTrade review to make sure that the brokerage offers the pairs, spreads and services you need.