Saturday, December 29, 2012

To invest in foreign currencies or not ??

Do not be surprised if you are already exposed to foreign currencies, even though you haven't made a conscious decision to dabble in it! 
Even if you buy a stock that is listed in Singapore, all of the company's revenue could come from other countries. Take, for instance, Global Logistics Properties, the company which was listed on the Singapore Exchange owns, manages and leases 296 properties within 122 integrated parks. Its network is spread across 25 major cities in China and Japan. Most of (the company's) income comes from Japan and China . . . (and it) doesn't have any property in Singapore, despite being priced in Singapore dollars. As such, the company's bottom line is affected by market sentiment, economic performance and natural disasters affecting those two countries.

But what about investors who wish to be directly exposed to FX? There are a couple of options available:

Dual currency deposit

A dual currency deposit (DCD) is a derivative instrument which combines a money market deposit with a currency option to provide a (potentially) higher yield than what is available for a standard deposit.

How does it work?

1. The base currency is deposited for a pre-determined term, from a week to a few months.
2. A specific exchange rate between the two currencies (the strike price) is agreed upon. These two currencies are known as the base currency and the alternative currency.
3. The return you get on your deposit depends on the market movement of the exchange rates between the two currencies, i.e. the investor is obligated to exchange an agreed amount of the base currency for the alternative currency at the strike price when the alternative currency weakens beyond the pre-agreed price.

Factors affecting return:
Investment tenor: A longer investment period translates into higher returns.
Strike price: The further away the strike price is from the current price, the lower the return. In other words, the higher the chance of the investor getting the alternate currency, the higher the investor's returns.
Volatility of currency pair: Currency pairs with higher volatility will reap higher returns.

What are the risks?
Foreign exchange risk: Apart from the inherent risks involved when dealing with FX, investors should be aware of potential losses when converting currencies. When the maturity proceeds are returned in the alternative currency and subsequently converted back to the base currency, a loss may be experienced due to movements in currency exchange rates. These losses may offset any interest earned on the deposit.

Liquidity risk: Investors are essentially locking in their money for the tenure of the deposit as penalties are enforced if withdrawal is made prior to maturity.

No guarantees: This is a non-principal guaranteed product, which means investors may lose part of their principal sum. This may happen especially when the investor ends up holding the alternative currency.

Credit risk: As this is an investment product, it is not protected by the Monetary Authority of Singapore's guarantee on saving deposits.
Foreign currency fixed deposits The foreign currency fixed deposit (FCFD) is similar to the Singapore dollar fixed deposit in that a sum of money is deposited with the bank for a fixed tenure and at a fixed interest rate. The main difference is that this deposit is denominated in a foreign currency.

Factors affecting returns:

Investment tenor: A longer investment period translates into higher returns.

The interest rate is calculated based on prevailing foreign currency market interest rates, and is adjusted to accommodate the bank's costs, risks associated with the product, and the bank's profit margin. The interest rate quoted at the start of the term is fixed for the entire tenure.

Volatility of currency pair: Generally, an investor has to be confident that the target currency will appreciate in order to ensure positive returns. Alternatively, ensure that you have a sufficiently long investment horizon to ride out exchange rate fluctuations.

Bonds are issued by corporations or governments from around the world. Some banks here offer foreign bonds in an international currency.

Such investments can be attractive, especially compared to local bonds. However, as this requires conversion to a foreign currency, it is a good proposition only as long as the Singapore dollar does not appreciate substantially against that currency.

Who should enter the tiger's den? 
Broadly speaking, these investment alternatives are suitable for investors who:
Have sufficient funds to withstand the loss of capital in the event that the currency option is exercised;

Understand forex risks;

Don't mind holding an alternative currency.

Finally, an investor should be aware that currency exchange rates can be influenced not only by the monetary policies of his own country's central bank but also the monetary policies of trading partners. Market sentiment, economic performance and even natural disasters can play a role in shifting currencies up or down relative to the currencies of other countries.
The Asian proverb, 'You cannot catch a tiger cub unless you enter the tiger's den', holds true. If you decide to dabble in FX, however, make sure you have a firm grasp of the market and its accompanying risks. If otherwise, do not go into this "money making" option while your knowledge of the risk is low and you do not wish to get your pocket burnt.

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