Trading Exotic Currency Pairs - Pros and Cons
The US dollar is the most highly traded currency, making it the king of currencies when it comes to volume. This is a benefit largely born of its position as the de facto global reserve currency. It also helps that its home economy is the largest in the world. Consequently, the currencies from other large economies are heavily traded against the dollar in the foreign currency exchange (Forex).
These are known as the major Forex pairs. The major FX pairs:
- Are the most popular
- All involve the dollar
- Are at the top of the table when listed by volume
Pros and Cons of Trading Forex Exotic Currency Pairs
Because the exotic Forex pairs are more thinly traded, they are by definition, less liquid. Therefore, they should not be traded arbitrarily. All things being equal, a market with higher liquidity is more open to a trader than a less liquid one. Specific circumstances may make exotics pairs an attractive proposition though. They may offer exposures that you can't get elsewhere, or quite in the same way.
For example, in the autumn of 2016, the USD/MXN currency pair behaved as a proxy for Donald Trump's prospects in the US presidential contest. This is due to concerns that a Republican win might threaten trade with Mexico. This made the Mexican Peso more sensitive to the election outcome compared with any other currency.
Another advantage of Forex exotic pairs is their potential to substantially shift in value. Huge shifts in price are not uncommon for exotic crosses, once a fundamental trend sets in. Along with lower liquidity, there are some other drawbacks with exotic pairs:
- The bid/offer spread is wider than for more established currency pairs
- Analysis, research, and news releases tend to be less readily available than for the major and minor pairs.
A general characteristic of the exotic pairs is that they offer an arguably higher profit potential, but entail an inarguably higher risk factor.
Why is that?
First of all, compared to the majors, the number of market participants trading exotic Forex currency pairs is small. It follows that the wider number of people trading the majors leads to a greater diversity of opinion over price.This can lead to generally greater day-to-day price fluctuations. We usually refer to this process as the natural ebb and flow of the market. As fresh news is digested by the market, there is a divergence of opinion over how this should affect price.
This can act as a constraint on how far and how fast prices move in reaction to the latest news. With comparatively fewer people trading the exotics, there is greater homogeneity of opinion. When something fundamentally changes, the consensus of opinion among this relatively small number of players quickly shifts, and we can see extreme price moves as a result. Another important point is the status of the countries involved.
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Consider these points:
- Majors currencies are from very large economies
- The countries from which they come tend to be stable, both politically and economically
- These countries pay low interest rates on the debt they issue, because people trust them not to default.
This is generally not the case for smaller or developing economies, as well as less politically stable nations. Typically, interest rates on government-issued debt are higher for these countries, because the market generally perceives an increased level of risk in debt default.
Case in point – the russian rouble crisis of the late 90s.
This is an example of an almost perfect storm of economic shocks hitting the country at once. Though the Russian economy was large, it faced a number of adverse factors at the time.
- Costly military conflict
- Political instability
- High interest rates
- Untenably high government interest payments compared to tax revenue
These factors led to a number of steps that hugely impacted the value of the rouble. The Central Bank of Russia attempted to defend the rouble, but ultimately ended up devaluing the currency. The last couple of years have echoed this in some ways. The Central Bank of Russia has once again expended large amounts of its foreign currency reserves, and has raised rates in order to defend the rouble. Despite these measures, the rouble has continued to decline in value.
Example: Comparing USD/RUB Movement With GBP/USD
Let's consider the specifics of the rouble over the last couple of years, to gain an insight into how much exotic rates can move:
Source: Admiral Markets MetaTrader 5, USD/RUB, Weekly - Data range: from Feb 15, 2009, to Sept 6, 2019, accessed on Sept 6, 2019, at 15:00 BST. - Please note: Past performance is not a reliable indicator of future results.
The chart above shows the price of the USDRUB currency pair, dating back to early 2009. As you can see, it has made some serious changes in value since then. In January 2014, the USD/RUB currency pair was trading around 35.0000. Fast forward to the beginning of 2016, and the exchange rate skyrocketed to 85.0000. That's an increase of close to 150%.
That move has retraced somewhat since then So how does this compare to the extreme moves in the majors? Well, we actually have a good example of that, with the British pound sinking in the wake of the Brexit referendum. So let's take a look at the GBPUSD currency pair:
Source: Admiral Markets MetaTrader 5, GBP/USD, Weekly - Data range: from March 20, 2011, to Sept 6, 2019, accessed on Sept 6, 2019, at 15:30 BST. - Please note: Past performance is not a reliable indicator of future results.
GBP/USD was up as high as 1.71000 in July 2014. Just prior to the Brexit vote, the rate was 1.5000. In the summer of 2019, it is below 1.2000. That's a huge drop since the high it reached in July 2014. Brexit has had an extreme impact on the pound, but it is a small move in comparison to what we've seen with the rouble.
If you're interested in finding out more about how exotic FX pairs move in relation to the majors and minor pairs, it's worth taking a look at our Correlation Matrix. This is a tool that comes as part of the many specialist indicators available with the MetaTrader 4 Supreme Edition plugin. It can help you to gain an advantage when it comes to identifying currency pair correlations.
So are exotic FX pairs worth the risk? This is not an easy question. If you have a specific view, or an unusual strategy, you may need a more specialised product that is more tailored to your specific needs. This is somewhat analogous to exotic derivatives trading. There are all kinds of exotic options and hybrids to suit all kinds of needs. Most traders, however, find that they can satisfy their general hedging needs using standard options.
Only those who have very specific needs tend to utilise exotic FX options. Going into exotic options trading without that need, or the in-depth specialist knowledge required is likely to end up being an expensive mistake. It is a similar story with other exotic securities. Vanilla solutions tend to suit everyday scenarios.
For example, consider using plain vanilla swaps in the interest rate market, versus the use of an exotic swap, such as a constant maturity swap. The same lesson holds true for exotic FX pairs. You should only get involved if you really know what you're doing, and you have a specific trading need.
A Final Review of Forex Exotic Currency Pairs
When you are new to the market and considering which single currency crosses to trade, the best approach is to err on the side of caution. Remember: just because exotic financial instruments exist, it doesn't mean that you have to trade with them. Exotic currency pairs may seem newer and more exciting, but you should bear in mind the risks attached. A good way of minimising the risks is to implement risk management within your trading.
That being said, although exotic Forex pairs are risky, you might find that they suit your trading style. The best way is to give them a try within a risk-free environment. For example, with our Forex Demo trading account, where you can trade with virtual funds, without risking your capital. It's a good way of testing your trading strategies first, before you apply them to the live markets.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.