Forex, or foreign exchange, involves currency pair trading. For eg, when you go long on EUR/USD, you hope that the value of the Euro will rise relative to the U.S. To the pound. You could guess wrong and the trade could turn against you, as with any investment. That is the most apparent danger when the FX markets are traded. By trading less common (and therefore less liquid) currency pairs and getting into a situation where the trade itself is unstable, you can incur additional risk because you have not handled your margin account correctly or have selected an inefficient broker or trading exchange.
It is useful to bear in mind that banks, not individuals, make the vast majority of forex transactions, and they are simply using forex to reduce the risk of currency fluctuation. In their computerized trading systems, they use complex algorithms to handle some of the risks listed below. As an entity, you could be less subject to many of these threats, and by sound trade management, others could be minimized. Up to the point of losing much more than the value of your trade while trading on margin, any investment that provides future benefit often has a downside risk. This article will help you to learn more about the risks in order to trade with greater confidence.
In FX trading, the following are the main risk factors:
Exchange Rate Risk
Interest Rate Risk
Credit Risk
Country Risk
Liquidity Risk
Marginal or Leverage Risk
Transactional Risk
Risk of Ruin
Exchange Rate Risk
Exchange rate risk is the risk created by currency value shifts. It is focused on the effects of constant and typically unpredictable changes in the balance of supply and demand around the world. The position is subject to all market fluctuations for the time that the trader’s position is outstanding. This risk can be very significant and is focused on the view of the market of how the currencies will shift based on all potential factors that exist (or may occur) anywhere in the world at any given time. In addition, because Forex off-exchange trading is essentially unregulated, no regular price limits for regulated futures exchanges are enforced as they exist. Based on fundamental and technical variables, the market swings – more about this later.
To ensure that losses are kept within reasonable limits, the most common technique applied in trading is to minimize losses and increase the potential for return. This approach for common sense includes:
1) Limit of Place
A position limit is the maximum volume, at any one time, of any currency that a trader is allowed to hold.
2) The Cap on Loss
The loss limit is a measure intended to prevent traders from making excessive losses through the setting of stop loss thresholds. It is imperative that you have in place stop loss orders.
3) Ratios of Risk / Reward
When attempting to manage exchange rate risk, a tool trader use as a guideline is to compare their intended profits against their potential losses. The assumption is that most traders would lose twice as many times as they gain, so holding your risk/reward ratio to 1:3 is a guide to trading. In a later segment, this is explained in detail.
Interest Rate Risk
Interest rate risk refers to the profit and loss caused by volatility in the forward spreads, along with mismatches in the forward amount and maturity differences between the foreign exchange book transactions. For currency swaps, this risk is relevant; forward outright, futures and options. One sets limits on the total size of mismatches to minimize interest rate risk. A typical method is to split the mismatches into six months and six months, based on their maturity dates. In order to determine the positions for all dates of delivery, profits and losses, all transactions are entered into computerized systems. In order to predict any developments that will affect the outstanding holes, continuous monitoring of the interest rate environment is important.
Credit risk
The recognized credit risk forms are:
1) Replacement Risk
When counterparties of a failed bank or Forex broker find they are at risk of not obtaining their funds from the failed bank, substitution risk arises.
2) Danger in Settlement
The possibility of settlement exists due to the disparity between time zones on different continents. Consequently, currencies can be exchanged during the trading day at various rates at different times. First the Australian and New Zealand dollars are credited, then the Japanese Yen, then the European currencies, and then the US Dollar. Therefore, before the party makes its own payments, payments may be made to a party that declares insolvency or is declared insolvent. The trader must take into account not only the market value of their currency portfolios, but also the future exposure of these portfolios when determining credit risk.
The future exposure can be estimated by probability analysis of the outstanding position over time to maturity. In enforcing credit risk policies, the computerized systems currently available are very useful. There is fast tracking of credit lines.
3) Counter-Party Risk Default
Over-the-counter (“OTC”) spot and forward currency contracts are not exchanged on exchanges; rather, in this sector, banks and FCM’s usually operate as principals. Since every exchange or clearing house does not guarantee the performance of spot and forward contracts on currencies, the consumer is subject to counterparty danger—the risk that the principal with the trader, the trader’s bank or FCM, or the counterparty with which the bank or FCM is dealing, may be unable or may refuse to execute those contracts. In addition, principals in the spot and forward markets are under no obligation to continue to trade in the spot and forward markets.
Liquidity risk 
While OTC Forex’s liquidity is generally much higher than that of currency futures traded in exchange, periods of illiquidity have nevertheless been seen, especially outside of US and European trading hours. Furthermore, in the past, many governments or groups of nations have placed trade limits or restrictions on the amount by which the price of certain foreign exchange rates may differ over a given period of time, the volume that may be traded, or have imposed over time restrictions or penalties on holding positions in certain foreign currencies. During a given trading period, such limitations can prevent trades from being executed. Such limitations or limits could prohibit a trader from liquidating unfavourable positions promptly and, thus, could inflict significant losses on the trader’s account.
Leverage risk
Low margin deposits or trade collateral are normally needed in Foreign Exchange (just as with regulated commodity futures). A high degree of leverage is enabled by these margin policies. A relatively minor price change in a contract may also result in immediate and significant losses in excess of the amount invested. For instance, if 10% of the contract price is deposited as a margin at the time of payment, a 10% reduction in the contract price would result in a complete loss of the margin deposit prior to any deduction for brokerage commissions if the contract was then closed. The overall loss of the margin deposit will result in a decrease of more than 10 percent.
Transactional Risk
Unforeseen losses can result from errors in the contact, handling and confirmation of orders of a trader (sometimes referred to as “out trades”). Often, even when an out trade is significantly the responsibility of the trading counter-party institution, the trader/recourse customers can be limited in obtaining compensation for resulting losses in the account.
Risk of Ruin
Even if the medium to longer term view of the market of a trader/customer will eventually be right, the trader may not be able to tolerate unrealized short-term losses financially, and will close a position at a loss simply because he or she is unable to meet a margin call or otherwise maintain such positions. Therefore, even though the market view of a trader is right and a currency position may eventually turn around and become profitable if it is retained, traders with insufficient capital can suffer losses.