Exchange traded funds (ETFs) are investment products that can replicate the movement of an index or a specific asset class such as currency pairs. ETFs allow investors to enter and exit their positions during normal trading hours such as a stock. Currency ETF’s have come into prominence during the past decade. During the past three years while the European debt crisis has unfolded, the demand for currency products has generated additional appetite for currency ETFs.
ETF’s differ from mutual funds in that they provide intra-day liquidity and the ability to allow investors to exit at the current live price as opposed to an end of day price. ETFs are considered attractive as investments because of their low costs, and stock-like features.
Currency exchange-traded funds mimic the return profile of a currency pair or a basket of currencies. The returns are generated in a fund or a trust by holding foreign cash deposits or currency futures contracts. Currency ETNs (exchange traded notes) are non-interest paying debt instruments whose price fluctuates with an underlying currency exchange rate.
Currency futures contracts are leverage instruments that replicate the movement of a currency pairs, which is delivered at a specific forward date. A currency pair is the relative performance of a base currency relative to a counter currency.
The Currency Market
The Foreign Exchange market is the largest and most liquid financial markets in the world, with nearly 4 trillion in daily turnover. The market allows individuals, corporations, banks and speculators to exchange one currency for another. In a typical currency transaction, one party exchanges a quantity of one currency for a specific quantity of another currency.
A currency pair is made up of a currency that will be purchased and a currency that will be sold. For example, if an investor where to purchase Euros and sell the US dollar, the currency pair or security is EUR/USD. Certain currencies take precedence when paired with other currencies and it is important prior to transacting the parties to the transaction clarify the currency they are buying and selling. The currency markets perform an important function in global trade, and even more important is the liquidity that the currency market provides.
The major currency pairs with the most volume are mainly exchanges against the US dollar. These currencies include: The Australian dollar (AUD), the Euro (EUR), the British Pound (GBP), the Japanese Yen (JPY), the Swiss Franc, and the Canadian dollar (CAD). When currencies are traded or quoted against currencies other than the US dollar, they are called cross pairs.
The major crosses are EUR/JPY (the Euro vs. the Japanese Yen), EUR/GBP (Euro vs. British Pound), AUD/JPY (Australian dollar vs. the Japanese Yen), and GBP/JPY (British Pound vs. Japanese Yen), CHF/JPY (Swiss Franc vs. Japanese Yen), EUR/CHF (Euro vs. the Swiss Franc), EUR/AUD (EURO vs. Australian dollars), CAD/JPY (Canadian dollar vs. Japanese yen). There are also a number of minor currency pairs that have significant liquidity in the currency trading market. These include: The New Zealand Dollars (vs. the US dollar the Australian dollar and the Japanese Yen), the Mexican Peso, (vs. the US dollar), the Norwegian Kroner (vs. the Euro), the Swedish Kroner (vs. the Euro), the Hong Kong Dollar, and the Singapore Dollar. With less liquidity, there are also a plethora of Emerging Market currencies that are traded throughout the globe.
The Participants
The currency market has a diverse number of participants. Approximately 50% of all transactions take place within the inter-bank market. The inter-bank market is an over the counter market place where large financial companies transact with one another. These players dominate market flow facilitate currency transactions.
Generally, hedge funds, mutual funds and pension funds transact with interbank participants who act in a dealing capacity. A third tier is where the daily exchange of small volume is transacted from one individual to another. Approximately 80% of all Foreign Exchange transactions are considered speculative. The other 20% is made up of: commercial corporations hedging currency exposure, pension or mutual funds converting one currency to purchase a foreign security, or central banks trying to control monetary issues like money supply.
Market makers within the Foreign Exchange market create a bid offer spread. A market maker is a trader that creates a market by determining where they will buy an instrument and where they will sell an instrument. The bid is where the market maker is willing to purchase a currency pair, and the offer is where the market maker is willing to sell the currency pair. The liquidity within the Foreign Exchange market has driven bid offer spreads to very tight levels. Liquidity plays a very important role within bid offer spreads. The easier it is to transact when trading a currency pair, the tighter the bid offer spread.
Forex ETFs
Currency markets represent an alternative asset class in that they are generally not highly correlated with other asset classes such as stocks, bonds and cash. Currency movements are less volatile than stocks and generally trend in the direction of interest rate differentials.
Currency ETFs tend to have fairly high annual expense ratios, and the high turnover due to the use of futures that lead to above average trading costs. The currency markets off extensive leverage in which invest to lever a dollar at 100-1. The leverage that is available in currency ETF averages 3-1, which is much less than the average retail currency broker.
The following are a number of popular currency ETFs:
- Single currency ETFs or ETNs are available for Australia (FXA) Britain (FXB, GBB) Canada (FXC) China (CNY) the Euro (FXE, EU), Japan (FXY, JYN)), Mexico (FXM), South Africa (SZR) and Switzerland ((FXF)
- Inverse currency ETFs allow you to double-short the Euro (DRR) and the Yen (YCS)
- Multi-currency ETFs provide exposure to regions — emerging markets (CEW)and Asia (AYT). A simpler strategy for many people is U.S. Dollar Up (UUP) or Dollar Down (UDN)).