Funny money; Serious profits

September 29, 2015 01:00 PM

The foreign exchange market dwarfs the liquidity of every other traded market by a substantial margin, with more than $5 trillion in average daily volume. As any experienced forex trader will tell you though, the vast majority of that volume flows through just a few major currency pairs. According to the 2013 Bank for International Settlements triennial central bank survey, fully 65% of the volume flowed through the “major” currency pairs: EUR/USD, USD/JPY, GBP/USD, AUD/USD, USD/CAD, and USD/CHF. Beyond these majors, so-called “crosses” between two major currencies (e.g., EUR/GBP or EUR/JPY) accounted for the majority of the remaining volume. 

Nonetheless, with a market as big as foreign exchange, there is still plenty of opportunity that spills over into the last category: Exotic currency pairs. The exact definition of “exotic” differs from trader to trader, but this category typically includes everything from larger emerging market currencies like the Russian ruble (RUB), South African rand (ZAR), Turkish lira (TRY) and Brazilian real (BRL) to nascent frontier market currencies such as the Nigerian naira (NGN), Vietnamese dong (VND) and the Ukrainian hryvnia (UAH). These exotic currencies offer unique opportunities to take advantage of under-the-radar trends and trading strategies, but also pose distinct risks to prospective traders.

Exotic currency opportunities

While some traders see no need to venture away from the major currency pairs, there are several considerable advantages to taking the plunge into trading exotics. By definition, trading a wider variety of instruments can present opportunities that more specialized traders miss out on, especially when it comes to carry trades, intermarket correlations and “black swan” bets.

For the uninitiated, carry trading is a strategy in which a trader sells a currency with a relatively low interest rate and uses the proceeds to buy a higher-yielding currency. With most of the developed world stranded in a low-yielding purgatory, this type of strategy is rarely used with major currencies, but there are still some exotic currencies that offer the interest rate differentials required for a successful carry trade. 

As an example, a trader could buy ZAR/JPY, selling the perennially low-yielding Japanese yen and using those funds to buy the higher-yielding South African rand. Though the ZAR/JPY exchange rate has not formed a long-term trend, merely oscillating 10% above or below the 10.00 level during the last four years, a carry trader still could have profited by earning South Africa’s relatively high interest rate, which has fluctuated between 5% and 6% during that period, exceeding the essentially 0% interest rates in Japan (see “A different carry trade,” below).  

Beyond carry trades, exotic currencies also present different ways to play intermarket correlations. The default for many forex traders anticipating higher oil prices would be to buy the Canadian dollar, given its close correlation with oil prices. However, if the trader were otherwise wary of going long the loonie, he could also consider buying the Norwegian krone or Russian ruble, both of which support heavily oil-dependent economies (see “Oil money,” below).

A final rare, but potentially lucrative advantage of trading exotic currencies is the ability to place trades in anticipation of currency regime changes. When the Swiss National Bank decided to abandon its cap on the franc back in January, it sent the currency soaring by nearly 20% in one day and sparked reverberations throughout global asset markets. Now, the only remaining “pegged” currencies are exotics, so traders looking to speculate on a tectonic shift in currency policy must venture away from the majors. Some analysts have speculated that central banks of Denmark or the Czech Republic could follow their Swiss comrades in abandoning their euro pegs, and patient speculators may want to consider short positions in the Danish krone (DKK) or Czech koruna (CZK) as a result. Other traders may want to monitor the sustainability of the Hong Kong dollar’s peg against the U.S. dollar, especially in the wake of the recent devaluations of China’s yuan.  

Page 1 of 2
About the Author

Senior Technical Analyst for FaradayResearch. Matt has actively traded various financial instruments including stocks, options, and forex since 2005. Each day, he creates research reports focusing on technical analysis of the forex, equity, and commodity markets. In his research, he utilizes candlestick patterns, classic technical indicators, and Fibonacci analysis to predict market moves. Weller is a Chartered Market Technician (CMT) and a member of the Market Technicians Association.