Gambling On The Dollar: Time To Reign In Forex Trading

With the value of the Australian dollar falling more than 10 cents in the past few months, should we all be hedging our bets and trading the Aussie for a fast profit?

There’s no shortage of foreign currency trading companies spruiking their services online, keen to help Australians become foreign exchange traders, with the promise of easy returns.

Forex trading can be risky for mum and dad investors, and should never be treated as an investment opportunity. In Australia, it is disappointing companies can promote forex trading to unsophisticated investors, by advertising prominently in magazines and online.

A zero sum game

For more than a century, the average real return on investment in the share market has been in the order of 6%. Of course some investors do better than this, and some do worse, but buying and holding shares in a diversified portfolio should yield a solid return over long periods.

But in the case of exchange rates there is no reason to believe investors receive anything more than a zero return from trading. There is very strong evidence that a currency like the Australian dollar moves in directions that are completely unpredictable.

Investors should also be wary of forex trading due to the high leveraging of many promoted forex products, where traders use borrowed money for their trades, and increase the potential loss.

The Australian Securities and Investments Commission (ASIC) (https://www.moneysmart.gov.au/investing/complex-investments/foreign-exchange-trading) explains the risks of foreign exchange trading for consumers, by way of an example of a typical foreign exchange trader who invests A$500 in a margin contract to buy Australian dollars at $0.91. If the Australian dollar rate falls to $0.885, the trader will lose A$2825 – and will actually have to pay another A$2325 in addition to the original A$500 in order to close out this contract.

Volatility rules

How unpredictable is the Australian dollar? In December 1983, when the dollar was floated, the exchange rate was $0.90, remarkably close to the exchange rate today – 30 years later.

More than 10 years ago, the lowest point of the Australian dollar was under $0.50, and more recent highs have been close to $1.10. In eight of the past 30 years the Australian dollar has moved by more than $0.10 in a calendar year.

There is no question that there has been, and is likely to continue to be, a huge amount of volatility in the exchange rate, but a considerable body of academic research finds little or no predictability in floating exchange rates.

As early as the late 1970s, work on the random nature of exchange rate movements confirmed the unpredictability of exchange rates floating against the US dollar. Despite a range of academic literature which tries to find predictability in floating exchange rates, empirical studies have not found any compelling evidence that exchange rates can be successfully forecast.

If exchange rates are unpredictable why would anyone trade forex?

Many do so in the ordinary course of their business. A clothing retailer in Australia might import goods from China and needs to pay its suppliers in US dollars in a few months time. In order to “hedge” the risk of a rising US dollar, the retailer might decide to purchase a foreign exchange product (called a forward contract), which locks (at today’s rate) the cost of the future US dollar commitment.

But there are many examples of companies that do not hedge (when sometimes perhaps they should), and also of companies that hedge when they do not need to and subsequently get into difficulty. Hedging forex risk is a complicated business, and even multinational companies need to tread carefully.

Unpredictability means that for every forex trader who wins there is at least one trader who loses. The only sure winners in forex trading are the forex companies that collect fees and make money on the foreign exchange spread (the difference between the buy and sell price), thus ensuring that on average, individual forex traders make a negative return. Borrowing money to trade forex is not a sensible strategy, and not one that any investment advisor ought to recommend.

Time to tighten the rules

In the regulator ASIC’s view, even with years of skill and experience, forex trading remains risky. Despite these warnings, companies advertising online forex trading are able to convince traders they can learn forex trading in a few short lessons, and make it easy to set up a trading account and “start trading in just five minutes”.

If we allow people to bet on the flipping of a coin, it’s probably fine to bet on whether currencies rise or fall. But let’s call it what it is – gambling, not investing, and regulate the industry accordingly.

Regulations should specifically stop private investors from leveraging forex trades, and also limit advertising by forex trading companies, so that individual traders are properly informed of the risks.

This article was originally published on The Conversation. Read the original article.

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