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Why foreign CDs rarely pay off

By Claes Bell · Bankrate.com
Tuesday, February 5, 2013
Posted: 3 pm ET

With rates on certificates of deposit in the U.S. stuck in the mud, it's understandable to look at CD rates overseas and get a little jealous. EverBank, which allows U.S. customers to invest in foreign-denominated CDs, lists the six-month rate on a Brazilian CD as 2.8 percent, nearly 17 times the average rate for a six-month CD in the U.S.

In fact, there are several foreign-denominated CDs listed on the site that put American CDs to shame when it comes to yields. There's only one problem: Eventually, you'll have to bring those yields, and your principal, back to the U.S. to spend. (EverBank foreign-denominated CDs are insured by the Federal Deposit Insurance Corp., but that doesn't include currency fluctuations). Those who attempt to benefit from high foreign yields will likely find themselves back to square one, thanks to an economic theory called covered interest rate parity, or CIRP.

The theory of covered interest rate parity holds that in countries like ours that allow money to be moved in or out freely, any advantage in deposit yields you can earn will be directly offset by depreciation of the currency. That means that if you bought one of those high-earning Brazilian six-month CDs, when you went to convert those Brazilian reals back to dollars at maturity, you'd find that reals had declined enough in value relative to the dollar to bring your earnings back to about what they would have been on a U.S. six-month CD.

The reason this usually holds is because of something called arbitrage. Arbitrage is the practice of buying an asset in one market and instantly reselling it in another market to achieve a riskless return.

To illustrate, say you work at a place where people really, really like one brand of chocolate chip cookie. The only place you can buy them nearby is at the company cafeteria, where they go for $1 apiece. You need a little extra cash, so on your day off, you go to Costco and buy a bunch of the same cookies for 50 cents apiece and resell them at work.

Things are great at first, but as you sell more and more cookies, the cafeteria is forced to cut its prices to compete, and suddenly people are only willing to pay 75 cents for a cookie. Eventually, one of your coworkers decides to start doing the same thing, and sells his cookies for 60 cents. At that point, everyone gets caught up in a price war until nobody's earning much more than the 50 cents per cookie that Costco is selling them for, plus maybe transportation costs.

The same thing happens in international finance. When even the smallest arbitrage opportunity pops up, deep-pocketed investors who specialize in that sort of thing pounce on it repeatedly, using huge sums of money, until the price differences in the two markets are gone. Most likely, if there was an opportunity to earn a bunch of riskless profits by putting cash in foreign CDs, those arbitrageurs would flood the banks with so much money that it would drive rates down to the level where there was nothing more to be gained. In other words, your CD deposits are the cookies, and the arbitrageurs are your copycat coworkers. Good luck making a nice profit with them around.

What do you think? Have you ever invested in foreign CDs? Tell us about your experience!

Follow me on Twitter: @ClaesBell.

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