Thursday, August 12, 2010

Invest in Foreign Currency

Some people invest in foreign currency deposits to enjoy a higher interest rate. They stand the risk of exposure to foreign currency loss. A foreign currency that pays a higher interest rate is likely to be a weaker currency, so this risk can be quite real.

For example, Australian and New Zealand dollars paid a high interest rate during most of the past three years. When the currency weakened in late 2008, it dropped by almost 30% within two months. Some people who invested on leverage had to close their position and lost 50% to 100% of their capital sum.

For those who are luckier, they did not earned that much. This is due to the high cost (as reflected in a large spread) of converting from Singapore dollars to the foreign currency and back. The spread can be as high as 1%.

If the difference in interest rate is 4% per annum, and you invested for 3 months to earn 1% extra, this can be totally wiped out by the spread. Why take so much risk for so little gain?

Read my FAQ on "Invest in Foreign Currency" in www.tankinlian.com (Ask Mr. Tan), to learn about this risk and the potential pitcalls.

2 comments:

michael13 said...

Warren Buffett said: "Not sure, don't touch".

JRT said...

It really makes no sense to let the banks invest foreign currency for you. Any gains, the bank takes a large cut from you. All losses, you bear the full brunt (plus all the management fees, administrative fees and the spread)

So to the banks, left or right, they win

Foreign currency is very lucrative and very fast moving. If you have extra cash to burn, buy (and sell) foreign currency in the spot market. You also pay the spread to the broker but certainly much lesser than the bank. Eg, EURUSD spread can be as low as 2 pips, which is US$0.0002 only. Other than this, you pay no other commission, management fees, administrative fees etc, and you also get to earn the interest that is likewise offered by the bank

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