Geopolitical Risks: How Do They Affect Forex Trading?
As a Forex trader, you face a variety of risks every single day. From simple speculations to international wars, numerous events can affect currency exchange rates. This paper explores the influence of the most unpredictable and global type of risks — geopolitical risks on your trading destiny. First, let's refresh some basic knowledge.
What is Forex?
We can bet that everyone has heard about the foreign exchange market or "Forex" at least once. This global financial market is a crucial element of social relationships, which never remains in the shadow.
The foreign exchange market is an over-the-counter market without a generalized consolidated platform. Its participants are the largest commercial and central banks of different countries, various funds, large multinational companies, and private investors with sufficient personal capital. In Forex, players perform currency transactions on particular currency pairs, for example, EUR/USD (Euro/US dollar), with an insignificant commission.
To put it simply, Forex is a worldwide system of economic and administrative relations allowing both large legal entities and private traders to benefit from currency trading. Players profit not only from the growth of currencies but also from their fall.
The foreign exchange market is the most profitable ever. Can you imagine Forex's turnover reaching up to 5 trillion dollars per day? It is an unbelievable amount!
Exchange rates and affecting factors
As you already know from the abovementioned, currency traders make transactions through Forex and rely on their analysis and expectations regarding currency exchange rate fluctuations. The exchange rate means the value of the national currency in terms of the foreign currency and is a critical aspect of international relationships.
The exchange rate is always dynamic and fluctuates from day to day. Have you ever wondered why we couldn't freeze currency exchange rates? Well, this is impossible due to the multiple aspects influencing the stability of exchange rates. Let's look at some of these factors.
Supply and demand
The law of supply and demand is a shaping factor of each market, including Forex. Let's pretend that the IT sphere in one country is strong and has started to bear fruits. Companies need additional funds and attract foreign investors. When these investors decide to put the money in, they need the country's local currency. Demand for national currency will grow, and the exchange rate will inevitably rise.
An increase in the price level across the country causes a decrease in the national currency's purchasing power and currency exchange rate accordingly.
Central banks of different countries are empowered to change the refinancing rate. By doing so, they attract foreign investors to keep their savings in a currency with a high-interest rate and make a national currency more popular. High-interest rates provide lenders with high spreads, which is undoubtedly enticing for foreign investors.
The amount of government debt may discourage foreign investors from investing in a particular currency by indicating that the nation is on the verge of inflation. Foreseeing a coming inflation, investors begin to sell their bonds, which reduces foreign capital in the country. Thus, the value of the currency becomes low.
The considered factors barely scratch the surface. There are many more aspects affecting currency exchange rates, e.g., speculating, prices for energy and other raw materials, the competitiveness of a country on the global market, etc. However, let's focus on the geopolitical risks that are fundamental and highly strongly influence Forex trading, sometimes getting out of control.
What is geopolitics?
Geopolitics is a specific direction of political science that pays attention to the complex correlation of foreign or domestic policy with geographical factors related to the country. Geographical factors include the location and size of the country, natural resources, and climate. Geopolitics explores how governments, corporations, terrorist organizations, and other parties attempt to achieve their political objectives by manipulating global geographic characteristics.
Geopolitical risks are the possible threats to a country's political, economic, military, and social systems that may result from its participation in international affairs. This type of risk is global and fundamental in terms of causing damage and simply catastrophic from the financial point of view.
What risks should we consider geopolitical?
Political risks arise from various issues and disputes over territory, ideology, resources, or particular government decisions. Here, risks are associated with possible changes in the country's political system, full or partial loss of state sovereignty, chances of creating opposing international coalitions, alliances, etc.
Economic risks arise from the volatility of the global economy. The global economy is a complicated sum of financial actions where all the processes are deeply connected. So, economic events in one region will inevitably affect other areas. For instance, unstable supplies of critical resources can severely impact the state's functioning.
These risks include health risks, environmental risks, and safety risks. Climate changes, dangerous diseases, natural hazards, and terror attacks imminently violate the stability of the affected area.
Cyber risks affect the strategic infrastructure of the state. International cybercrime is a serious issue of our time. This type of crime costs unbelievable amounts of money to the states each year.
Geopolitical risks undeniably impact the viability of every state affecting all the spheres of human existence. Forex trading is not an exception. Geopolitical risks cause logical fluctuations in currency exchange rates. That's why traders must examine all the geopolitical events to apply the most profitable strategy and avoid losses.
Geopolitical risks and Forex trading
Did you watch the breaking news today? It would help if you did this because there might be a basis for your everyday trading decisions and a giant step to success.
Natural disasters, international conflicts, infections, terror acts — that's what you must stay updated about. The listed factors violate the stability of affected states and their currency accordingly. Being a Forex trader, you will succeed only by considering all the current and potential geopolitical events and rapidly responding to them.
Geopolitical events can cause fluctuations in the value of the national currency. For example, the country faced natural hazards, which led to supply disruptions or an epidemic, and it became dangerous to use many services. Thus, an unstable economic or political situation within the country discourages investors and reduces the flow of foreign currency. Conversely, if the state has powerful tools to overcome the conflicts or all the arising challenges confidently, the investing climate becomes more attractive, and the exchange rate of national currency grows accordingly.
It is essential to understand that geopolitical risks can lead governments to change their current legislation, altering the investment climate and the market rules.
Geopolitical events may influence particular currency pairs. Such an influence happens when countries are codependent on exporting and importing some products. For example, a natural disaster causes oil supply disruptions in the Middle East. Therefore, the exchange rate of currencies belonging to importers and exporters will drastically change in terms of the money of the affected state.
It would help if you remembered that the effects of geopolitical events are always unpredictable. The same event may impact different countries and their currencies differently. Often, the currency exchange rates of two or more countries move in opposite directions.
Thus, Forex traders must factor in all the potential geopolitical risks to adapt their strategy accordingly and to make a profit.
Cases from across the history
Let's discuss some famous cases that illustrate the influence of geopolitics on Forex trading.
The second quarter of 2023 has witnessed an escalation of an existing long-lasting conflict between China and Taiwan. The Chinese government has decided to conduct military drills in the waters of the island of Taiwan in the name of Chinese sovereignty. Taiwan sought to gain independence, so the government was ready to counterattack the Chinese. Forex traders monitored the situation and dreaded currency market instability. That's why the demand for the Japanese yen, a safe-haven currency, has grown. Conversely, the value of both the Chinese yuan and the Taiwanese dollar has fallen.
Forex traders who had foreseen the potential influence of the crises on the currency exchange rates have profited from this geopolitical event.
The worldwide pandemic drastically influenced all aspects of our life, including the global economy and Forex trading. The pandemic caused sharp shifts in the US dollar exchange rate, falling oil prices, and, as a result, high volatility in the Forex market. In this regard, many investors began to sell their assets. At the same time, the activity of traders who tried to earn as much as possible on volatility increased.
A tragedy that affected the whole world in 2011 — was the Fukushima earthquake, followed by a tsunami and nuclear catastrophe. This geopolitical event fatally changed the Japanese yen exchange rate. After many years, there are still risks of investing in the Japanese yen due to probable natural disasters.
Brexit and the British pound
"British Pound Falls to its Lowest Against Dollar!" — you probably witnessed such headlines after Brexit happened. Yes, the UK's decision to leave the European Union significantly affected the pound sterling exchange rate, as investors began to worry about the future of the British economy.
How to prevent losses caused by geopolitical risks?
To become a wise Forex trader, you should always be on the alert. Forex traders must adapt their strategies when geopolitical risks show up to avoid potential losses and benefit from current circumstances.
We've collected some valuable strategies for you!
One of the most effective things to do is to diversify your investments. By investing in various currency pairs, you can reduce the overall exposure of your capital to risk. Remember that no crisis can simultaneously hit all industries, companies, and currencies worldwide. The collapse of some systems is always a chance for others.
Forex hedging is a strategy that aims to reduce potential losses from undesirable exchange rate fluctuation. By hedging, you can fix the value of the acquired currency. When hedging, the investor transfers his risks to those who are ready to accept them — to the market. In a nutshell, this risk reduction tool allows you to open additional positions to protect yourself.
Successful forex traders always have a solid risk management strategy. Risk management helps traders survive when something goes against the trading plan. The risk management strategy is based on your knowledge of the risk-reward ratio and all the steps you will take to minimize your potential losses. To mitigate your risks, you can make credit default swap contracts, limit risk exposure and keep yourself updated on geopolitical news.
Now you know that geopolitical risks can drastically influence your trading journey in the Forex market. To prevent potential losses, traders must stick to a sound and comprehensive strategy and stay up-to-date on all the news. Our guides and recommendations will help you. Join us and create your legendary trading path with FBS.