November 12, 2005

Currency Speculation Made Easy

WHILE EXPLORING the wonders of the Internet recently, I stumbled across Boston Gal’s Open Wallet, a very useful personal-finance blog that has a bunch of interesting links and posts. For instance, I learned that I can now spend my spare change on, thanks to the good people at Coinstar. Extreme.

Also quite interesting was a post which the site’s author, who cleverly goes by the name of “Jane Dough,” wrote about an Internet bank offering certificates of deposit denominated in foreign currencies. In short, these products (“Currency CDs”) let one speculate on the currency markets while also, in most cases, earning interest on one’s FDIC-insured deposit. Jane, in noting the Mexican peso CD offers a 6.75 pc annual interest rate, asks for her readers’ thoughts on the idea and also asks whether a weakened dollar would make a Currency CD a better or worse investment. So, Jane, here you go.

I suppose I’d start by saying this appears to be a pretty complicated product, and as such, one would want to tread very cautiously before investing in it: reading up on the prospectus, making sure one knows about associated fees, restrictions, and so on. Furthermore, because currency markets are inherently risky, one ought only consider investing in such a thing if one had plenty of other money set aside.

That said, my gut reaction is that if one is looking for an investment to hedge against a fall in the dollar, there are plenty of other stores of value – real estate, precious metals, etc. – in which one could put one’s money. Still, in certain circumstances, I could see someone investing in a Currency CD. That’s provided the investment was minimal (no more than 1 pc of one’s worth, tops) and one’s net worth was more than sufficient to withstand the potential loss of the entire investment. But more on that in a bit.

First, though, there’s the question of the risk-reward one runs with the thing.

Let’s say, for instance, that Jane wanted to buy a three-month, $10,000 Currency CD denominated in Mexican pesos (MXN). At a recent exchange rate, that would mean Jane would have 107,310 MXN in her possession. If the peso was absolutely stable, three months from now Jane would have 109,120 MXN, based on the CD’s 6.75 pc annualized interest rate. That's a profit of 1,810 MXN.

Now, in Mexico, 1,810 MXN is enough to buy a really, really nice dinner for four, including vino tinto y propina. But of course, the real question is whether the pesos would be worth as much or more as they were when Jane bought the CD. If they were (i.e., the dollar weakened) she’d be golden. If they’re not (i.e., the dollar strengthened), she’s in trouble – and hopefully not like all the investors in history whom the peso has burnt in a particularly wretched way.

However, let’s say the Mexican peso was remarkably stable, and there was no currency fluctuation at all. Jane would still have that 1,810 MXN/ US$168.75 profit. Sounds great, right? Well, yeah, but not as great as you might think. After all, remember the opportunity cost that went along with investing the money in the first place.

The same bank which offers the Currency CDs also offers standard CDs in U.S. dollars. These have absolutely no currency risk, and in addition, have about as little practical risk as one can get. Among these standard CDs is a three-month CD, and that recently paid an annualized 4.06 pc. On a quarterly basis, that would provide Jane with a payment of $101.50 in interest for each $10,000 she put into a certificate.

So let’s examine the two options. With the three-month standard CD, one would earn $101.50 in interest on a $10,000 certificate. With the three-month Currency CD in MXN, and assuming no valuation changes, one would earn $168.75 in interest on a $10,000 certificate, a difference of $67.25. That’s a difference of just over $20 per month.

For $20, I think it’d be a better bet to take the standard CD, just so one wouldn’t have the urge to constantly check the latest exchange rates, wonder about developing geopolitical trends, or what not.

However, there is one limited circumstance in which I could see one putting money into an extremely sound foreign currency via a Currency CD, and that’s as a hedge against general societal malaise or utter economic disaster. The idea would be that one could use the money to get through the trouble and then have some start-up cash for when things turned around. Still, in my mind that’s the type of thing only the rich ought consider, and even then, as a very minute portion of one’s portfolio. For the rest of us, there are better places to put our money.

As for Jane’s second question, she asks whether a weakened dollar would make a Currency CD more attractive. The short answer is no. That’s because it doesn’t matter where the dollar starts, only where it finishes. The dollar could weaken further against the currency in question, or it could strengthen. That expected future valuation should be the only driver in one’s thinking.

Posted by Benjamin Kepple at November 12, 2005 10:39 AM | TrackBack