Saturday, March 01, 2008

Currency investing (2) - ways and means

If I wish to invest on the basis of anticipated currency movements, what are the choices? There are several, each with their own advantages and disadvantages:

1. FX deposit. Simply ask your bank to convert some money into the currency of choice and place it on call or term deposit. It's simple, quick and easy. The risks are largely one dimensional (i.e. the FX fluctuations between the two currencies). The downside is that banks can be uncompetitive when it comes to FX spreads (the cost of conversion) and the interest rate you are offered will not be the best available.

2. FX structured deposit. This is essentially a deposit in one currency against which you write a out option in favour of the bank to convert to a second currency. If the currency stays above the strike price, you get back your money in the original currency together with a return which equals the interest on your deposit and the option premium. It's a good way to earn higher rates of interest so long as you are prepared to accept the second currency at or below the strike price if things move against you. Probably best to pair your local currency against a currency that you expect to appreciate if you want to do this.

3. Invest overseas. If you invest in another country, you are investing in the currency of that country as much as the asset (shares, property etc) that you buy. If you can find an attractive investment in a country whose currency you expect to appreciate, that gives you a degree of leverage.

4. Derivatives. You can buy or sell futures and options on a wide variety of currency pairs. The implied leverage and magnified volatility are not for everyone, but if you can accept the higher risks involved then the rewards can be correspondingly high.

5. Carry trade. This has been a favourite of investors for many decades. The idea is that you borrow money in one currency and invest it in an other currency. In order for this to work, the trade usually requires either an expectation of favourable currency movements between the pair of currencies you are working with or a yield differential or both. Borrowing yen to invest in high yielding Australian or New Zealand dollars as been a popular choice.

6. Offshore debt financing. Taking out a mortgage in yen to finance a property in Australia or New Zealand (where the interest rates are a lot higher) has been a widely used strategy. If the currency movements work in your favour you not only reduce your interest cost but may get a capital gain on the principal component of your mortgage.

To date, I have only done #1 and #3 and I am comfortable with both of those forms of investment. I am not terribly interested in speculating in FX derivatives due to a combination of personal time constraints and risk appetite. Likewise with #5. #2 is a derivative by any other name and, as I said above, I would only be interested in pairing HK$ against a currency I was very confident would appreciate against the HK$. (It would also help if I intended to make other investments in that second currency at some point in the future.) #6 effectively adds another layer of leverage to your investment. It's the sort of thing I would consider if I wished to buy a property in a country with high domestic interest rates but has little appeal in the shorter term.

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