What is Hot Money?
Hot money is the investment of funds between varying vehicles or institutes in order to increase capital gains. In other words, a hot money strategy can be defined as the practice of actively using funds in an attempt to profit from an investment rather than letting the money appreciate over time. These type of investments are generally short-term and high-risk in nature with the potential to provide substantial payouts. They can include:
The Purpose of Hot Money
Hot money investments serve only one purpose. The goal of an investor adopting such investing strategy is to make as much money as possible, as soon as possible, before the market falls again. Investors do not want to wait weeks or years for their returns.
One good example is the Bitcoin craze toward the end of 2017, which saw the cryptocurrency shoot from $8,000 to approximately $20,000. Hot money investors would’ve jumped in as the cryptocurrency rose to ride it up to its peak before promptly selling.
With this type of investments, investors always keep an eye on the market and make sure that their investments are still going strong. Hot money requires active participation and surveillance of investments. These investors are ready to pull the trigger when it looks like their investments will drop. Otherwise, their investments will “go up in smoke.”
Is Hot Money Easy?
Many beginner investors ask such question. If hot money is so profitable, is it something that one can pick up and apply right off the bat? In reality, the hot-money strategy is not without its risks and is definitely not one for beginners. In fact, it may not even be an appropriate strategy for the seasoned investor.
If investors decide to adopt the strategy, however, sound market knowledge and financial acumen are required. It means being able to apply trend analysis and quickly read market inputs.
Risks Involved in Hot Money
It is important to make sure that you know the risks involved with hot money investments. As the saying goes, “With great power comes great responsibility.” The same idea goes for market returns – high rewards are not without high risk.
The main risk in this type of investment is its volatility. By its very definition, hot money requires volatility in order to extract quick returns. A steady investment that is not moving will not generate the required returns in the short amount of time to even be classified as hot money. The big risk is that with the chance of a quick and large return, there is also the chance of a quick and large loss.
Another risk is the volume of transactions. It does not only require a lot of effort on the part of investors but also can quickly eat up any potential returns when transaction fees are taken into account. This is particularly apparent in stock portfolios, which involve charge fees for each trade, selling off debt, and brokerage. However, if arbitrage can be applied successfully, hot money returns may offset even the large fees in this trading strategy.
Factors that Influence Hot Money
Several market factors can influence investor returns from hot money. The factors often contribute to the volatility of the asset in question. If an investor can perfectly predict these factors, however, they could play the market and increase the value of their investments. Failing to take these factors into account, however, can lead to losses.
1. Exchange rate fluctuations
A common hot money vehicle is the purchase of esoteric currencies (such as in the case of Bitcoin or perhaps investing in the Thai baht) or even mainstream currencies in the presence of uncertain market conditions.
2. Interest rates
Fluctuating interest rates or market rates are common interest rate vehicles. A bank, for example, may apply a hot-money strategy when they offer exceedingly high interest rates to borrowers with low credit scores.
3. Capital controls
In China, protectionary policies against foreign investments were implemented in recent years. The policies made it harder for direct foreign investment in the Chinese capital market.
Investing in Hot Money
As evidenced in the examples above, hot money is not for the risk-intolerant. Such investments require a great deal of market knowledge, sound financial acumen and, ultimately, luck. There are, however, certain methods an investor can apply to increase their chances of generating high returns.
Conducting enough research
An investor should always perform as much research as possible. There is no downside to possessing more information, other than perhaps the cost and effort needed to get them. Good information and research is the differentiator between hot money and a reckless investment.
While hot money investments benefit from larger asset bases, taking advantage of larger upside and lower transaction fees and starting small allows investors to get a feel for the nuances of the investments. Hot money arbitrage is quite different compared to long-term investing.
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