Foreign-denomination CDs carry risk
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.
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
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
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
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