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Foreign-denomination CDs carry risk

Greg McBrideMix together record-low interest rates and a falling dollar, and investors inevitably look, or are told to look, overseas. Among the latest alternatives gaining attention are foreign-denominated certificates of deposit. These are CDs that are issued by a bank in the United States, and thus protected by FDIC insurance, but denominated in a foreign currency.

Don't be fooled by the sales pitch of higher overseas interest rates, with the added bonus of capital gains as the dollar declines. These investments are indeed FDIC-insured, but this does not equate to a risk-free investment like regular domestic CDs backed by the U.S. dollar. Why? Currency risk.

Currency risk is the risk that the dollar appreciates vs. the currency of choice between the time you invest and the time the CD matures. While investors are lured by the upside of capital gains should the dollar depreciate, the risk also exists that the dollar may strengthen, eliminating the earnings from the higher interest rate the investor initially pursued.

The dollar has declined substantially over the past year, falling more than 20 percent against the euro, and nearly 20 percent against the New Zealand dollar. But that is water under the bridge to anyone considering a foreign-denominated CD now. All that matters is how the dollar performs on a relative basis between the time you invest and the time the CD matures.

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The risk can easily outweigh the return.

Let's look at an example using a one-year CD denominated in New Zealand dollars paying 4.75 percent APY. What would happen if the dollar should appreciate by 5 percent in the next 12 months against the New Zealand dollar, reversing but a portion of the overall decline seen in the past year? The attractive 4.75 percent return on the CD is more than given back by the currency appreciation, generating a loss of 0.25 percent before the impact of transaction costs. The exchange into and out of a foreign currency generates transaction costs for the investor, as a spread exists between the exchange rate a bank offers to buy and sell a currency.

The appeal of foreign-denominated CDs has been rising as U.S. interest rates and the dollar have declined. But the phenomenon may be short-lived. A case can be made for the dollar actually rising in the year to come.

While the U.S. economy is not expanding at a blistering pace by any means, it is much further along the road to recovery than many foreign counterparts, such as Japan and much of Europe. The dollar's fall has accelerated as foreign investors have sold U.S. assets, weary of the anemic economy and low interest rates. But an improving economic environment contributes to stronger stock market performance, creating -- rather than reducing -- demand for dollars.

Further, many foreign central banks are actively cutting interest rates in waging their own battles against economic stagnation and fears of deflation. The European Central Bank cut rates by 50 basis points on June 5, partly in an effort to boost a sagging economy and partly to slow the rapid rise of the euro that is hurting European exporters.

The ebb and flow of exchange rates is a current any would-be investor in foreign-denominated CDs must account for.

This is not to suggest that foreign-denominated CDs are a bad investment option, but they can be if used improperly. Investing in a certificate of deposit denominated in a foreign currency is placing a bet on the performance of two currencies, the home currency and the overseas currency, over time. The value of an investor's account at maturity is impacted by the performance of either currency relative to the other.

The folly is if these investments are perceived, or presented as, an alternative to the CD you would find at any local bank. The CDs offered by your local institution offer a risk-free return, provided that the account balance remains within the confines of FDIC insurance limits. But as demonstrated by the aforementioned currency risk, foreign-denominated CDs are not risk-free and thus are not alternatives to the low-yielding CDs so prevalent here at home. If anything, they are an alternative to other international investments or a supplement to other risky asset classes, such as stocks, corporate bonds, real estate or precious metals.

Greg McBride is a financial analyst for Bankrate.com.

For advice regarding your specific situation, please e-mail one of Bankrate.com's Q&A experts or visit the Personal Finance Advice channel on Bankrate.com.

 
-- Posted: June 6, 2003
     
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