Currency Linked Investment – Forex movement has huge impact

I posted two articles on 9 and 22 May 2008 on Currency Linked Investments (CLI) which explained the mechanics of this type of investment product.

 

The interest rate for CLI is attractive when compared with the rate you can get from plain vanilla Singapore dollar fixed deposits, hence the draw to this investment.

 

When investing in this product you have to handle the risk of foreign currency (forex) movement which out-weighs the interest rate receivable, if the forex moved in opposite direction from what you have expected.

 

To illustrate what I mean by way of example:

 

Assuming you have placed Australian dollar A$150,000 for 2 weeks at interest rate of 5.5% per annum.

 

You have also contracted with the bank to convert to Singapore dollar in 2 weeks time at strike forex rate of A$1 = S$1.027 if Singapore dollar weakens against Australian dollar (i.e. A$1 > S$1.027)

 

At the time of contract, you believed that Australian dollar will not rise so quickly against Singapore dollar, since Australian dollar had been trading at below S$1 for a long while.

 

But your expectation turned out to be wrong. Australian dollar strengthened to A$1= S$1.0532. Hence you are converted to S$ at agreed strike rate of A$1 = S$1.027. You have lost the chance of converting at higher forex rate to the tune of:

 

(1.0532 -1.027) x A$150,000 = S$3,930

 

This amount can hardly be covered by the 5.5% p.a. interest earned for 2 weeks:

 

14/360x 5.5% x A$150,000 = A$320.83 = S$329.49 at conversion rate of 1.027.

 

It is better off if you stay invested in Australian dollar fixed deposits and convert at exchange rate of 1.0532. On top of that, you would have earned some interest in 2 weeks, though the interest rate would be lower for A$ fixed deposit of 2.6% p.a.

 

CLI as an investment product is somewhat risky during a climate of volatile exchange rates. The illustration shows a movement in forex rate can cause a huge impact on gains or loss of your investment. Interest rate to be earned on the investment will not be sufficient to cover this loss or foregone opportunity to profit.

 

Written on 3/25/2009 10:40 AM

 

Copyright © 2009, the author known as LKT in Singapore.

 

The material presented is intended to be general and written in layman’s language as much as it is possible. The author shall not be liable for any direct or consequential loss arising from any use of material written. Please seek professional advice from your financial advisor or financial institutions on material written covering financial matters.

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