Exploring exotic currency pairs

exotic currency pairs

The US dollar is the most 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 foreign currency exchange.

These are known as the major Forex pairs.

The major FX pairs:

  1. are the most popular
  2. all involve the dollar
  3. are at the top of the table when listed by volume.

To read more on this subject, take a look at our article on Contract Specifications.

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 more liquid market is more open to a trader than a less liquid one.

Specific circumstance 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, USD/MXN 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 peso more sensitive to the election outcome than 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.

We will discuss this is in detail later on.

Along with lower liquidity, there are some other drawbacks with exotic pairs:

  1. the bid/offer spread is wider than for more established currency pairs
  2. analysis, research and news 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 call that 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 new 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.

Another important point is the status of the countries involved.

Consider these points:

  1. majors currencies are from very large economies
  2. the countries from which they come tend to be stable, both politically and economically
  3. 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 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.

These included:

  1. costly military conflict
  2. political instability
  3. high interest rates
  4. 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 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.

usd/rub 2014-2016

The chart above shows the price of USD/RUB going back to early 2012.

As you can see, it has made some serious changes in value since then.

In July 2014, USD/RUB was trading at 34.5000.

Fast forward to the beginning of 2016 and the exchange rate has rocketed to 85.0000.

That's an increase of close to 150%.

That move has retraced somewhat since then, with USD/RUB currently trading somewhere around 63.0000.

So how does this compare to 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 GBP/USD:

GBP/USD Brexit impact

GBP/USD was up as high as 1.71000 in July 2014.

Just prior to the Brexit vote, the rate was 1.5000.

Today, it is trading around 1.2200.

That's a move close to 30% since the high in July 2014.

It's a similar timeframe to the 150% move we saw in USD/RUB.

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 with MetaTrader 4 Supreme Edition.

It can help you gain an advantage when it comes to identifying currency pairs correlation.

MT4 Supreme Edition free download

So are exotic FX pairs worth the risk?

This is not an easy question.

If you have specific view or an unusual strategy...

...you may need a more specialised product that is more tailored to your 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 people, however, find they can satisfy their general hedging needs using standard options.

Only those you have a very specific need 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 you have to give them a go.

Exotic currency pairs may seem newer and more exciting, but you should bear in mind the risks attached.

That said, although exotic Forex pairs are risky, you might find they suit your trading style.

The best way is to give them a try in a risk-free environment.

For example, our