Foreign Currency Investments, Foreign Denominated CDs, Foreign Currency Trading, Futures Accounts   Foreign Currency Investments, Foreign Denominated CDs, Foreign Currency Trading, Futures Accounts 
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Foreign Denominated CDs

Home > Foreign Currency Investments > Foreign Denominated CDs

Foreign Currency Investments, Foreign Denominated CDs, Foreign Currency Trading, Futures Accounts
With record-low interest rates and a falling dollar, investors invariably look, or are told to look, overseas. One of the latest alternatives gaining attention is foreign-denominated certificates of deposit. These will be CDs that are issued by a bank in the United States, and are thus protected by FDIC insurance, but denominated in a foreign currency.

Don't be taken in by the marketing pitch of higher overseas interest rates and the added bonus of capital gains as the dollar falls. These investments are FDIC-insured, but this does not mean it is a risk-free investment like regular domestic CDs backed by the U.S. dollar. The reason is Currency Risk.

Currency risk is the risk that the dollar gains vs. the currency chosen between the time you invest and the time the CD matures. Investors are lured by the upside of capital gains if the dollar depreciates. But the risk exists that the dollar may strengthen, cutting the earnings from the higher interest rate the investor initially pursued.

The dollar has declined substantially over the past year. But that is immaterial to anyone considering a foreign-denominated CD now. What matters is how the dollar performs on a relative basis between the time you invest and the time the CD matures.

The risk may outweigh the return
Here’s an example using a one-year CD denominated in New Zealand dollars paying 4.75 percent APY. What would happen if the dollar appreciates by 5 percent in the next 12 months against the New Zealand dollar, reversing only a part of the overall decline seen in the past year? The 4.75 percent return on the CD is more than given back by the currency appreciation, leaving you with a loss of 0.25 percent before the impact of transaction costs. The exchange into and out of a foreign currency attracts transaction costs for the investor, as a spread exists between the exchange rate a bank offers to buy and sell a currency.

The attraction of foreign-denominated CDs has been rising as U.S. interest rates and the dollar have declined. But the phenomenon may be short-lived.

While the U.S. economy is not expanding at a great pace, it is much further along the road to recovery than many foreign counterparts, such as Japan and Europe. The dollar's decline has accelerated as foreign investors have sold U.S. assets, weary of the anemic economy and low interest rates. But an improving economic environment leads to stronger stock market performance, creating -- rather than reducing -- demand for dollars.

Also, many foreign central banks are actively cutting interest rates in waging their own battles against economic stagnation and fears of deflation. The European Central Bank cut rates by 50 basis points recently, partly in an effort to boost a sagging economy and partly to slow the rapid rise of the euro that is hurting European exporters.

The ebb and flow of exchange rates is a current any would-be investor in foreign-denominated CDs must take into account.

This does not mean that foreign-denominated CDs are a bad investment option, but they can be if used incorrectly. Investing in a certificate of deposit denominated in a foreign currency is placing a bet on the performance of the two currencies over time. The value of an investor's account at maturity is dependent on the performance of either currency relative to the other.

It may be harmful if these investments are perceived, or presented as, an alternative to the CD you would find at any local bank. The CDs offered by local institutions give a risk-free return, provided that the account balance remains within the confines of FDIC insurance limits. But foreign-denominated CDs are not risk-free and thus are not alternatives to the low-yielding CDs available at home. Mostly, they are an alternative to other international investments or a supplement to other risky asset classes, such as stocks, corporate bonds, real estate or precious metals.

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