Investment strategy: side-step inflation using forex

Inflation is an investor's worst nightmare because it can be bad news for almost every asset class from bonds to property. Fortunately, there is one corner of the financial markets where you can make money regardless of whether inflation, deflation, or even stagflation (rising prices and falling growth) prevails.

The beauty of forex investing

Stock markets around the world can all fall at the same time, but because currencies are valued relative to one another, if one weakens then another must get stronger. That means there is always money to be made.

The foreign exchange (forex) market is also huge daily turnover is about ten times that of global equity markets and very liquid, so deals of all sizes and in virtually all currencies can be done quickly and easily.And, as David Stevenson in the FT notes, thanks to lots of competition between forex brokers, bid-to-offer trading spreads (trading costs, in other words) are now tiny compared with the most liquid of equity markets.

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Even the traditional argument against currencies, that exchange rates are too volatile for the average private investor, doesn't necessarily stack up. The three-month volatility of each major currency pair since 1999, for example, falls into a range of between 5% and 15%, says Stevenson, which, compared with many individual equities, is "fairly tame". So, there are plenty of reasons to look at foreign currency as an asset class, but what's the best way to invest?

Forex investing: currency spreadbets

Spreadbetting firms, such as CMC Markets and Capital Spreads, offer forex bets. Choose a currency pair, say sterling (GBP) against the US dollar (USD). This is quoted as the "GBP/USD pair". You buy it if you think the pound will rise (strengthen), and sell it if you think the pound will drop (weaken). You then decide how much to bet per point (a point represents the last digit in a standard quote).

So, for example, you could buy the GBP/USD pair for £5 per point, having been quoted a spread of 1.9850/1.9853. If sterling strengthens you might close your position by selling the same pair, now quoted at 1.9865/1.9868. Your profit is 12 points (1986519853 = 12), which is £60 at £5 a point, tax-free. If, of course, sterling had weakened, you would have lost money.

Trading individual currencies requires a decent knowledge of the factors that could influence exchange rates. The big one is expectations about relative interest rates a rising Bank of England base rate, relative to the equivalent US Fed rate, would usually make sterling attractive relative to the dollar and push the GBP/USD rate up but there are a host of others. Also, since exchange rates can move quickly, big losses are possible should a bet on a currency pair backfire.

Forex investing:currency ETFs

For investors who prefer a bit less risk, there are now income exchange-traded funds (ETFs) available from some American fund managers, such as Wisdom Tree, which use US dollars as collateral for an investment in, among others, individual emerging money markets.

So, for example, the average one-month Brazilian money market rate is currently around 12% versus just 2.3% in the US (although these rates can change quite quickly). The Brazilian Real ETF (NYSE:BZF) benefits if this gap widens (which also suggests the real will rise against the US dollar). As well as the new BZF ETF, Wisdom Tree now offers similar products based on the Chinese Yuan (NYSE:CYB) and the Indian Rupee (NYSE:ICN), with an expense ratio of 0.45%. Remember that, as a UK investor, you are also exposed to changes in the sterling/US dollar rate.

Forex investing: mixed currency funds

For those not keen on single currency bets, which could take a battering should "emerging markets take a dive", says Stevenson, Barclays GEMS fund (AMEX:JEM) gives broader exposure and looks less risky, being driven by the performance of 15 local currencies across five regions, including Asia, Latin America and the Middle East, against the US dollar. The fund comes with a heftier expense ratio of 0.89%.

Or there's the somewhat clumsily-named Invesco Powershares DB G10 currency harvest fund (NASDAQ:DBV). This aims to make money by borrowing in the three lowest-yielding developed market currencies (currently the Swiss franc, yen and US dollar), from a list of ten, to invest in the three offering the highest yield (currently the Norwegian Kroner, and the Kiwi and Aussie dollars).

Forex investing: buy a currency manager

If you want a way to profit from growing investor interest in the forex market, but don't want to join in yourself, you could try shares in a currency management firm such as Record plc (LSE:REC), run by former Bank of England economist Neil Record. The group has raced to $55bn under management, has implemented a new fee structure that will reward absolute returns, and trades on a price/earnings ratio of just seven, which makes it look a decent long-term bet.