Are Dual Currency Deposits Really Worth It?
By Chad Creveling, CFA and Peggy Creveling, CFA
A chance to earn significantly higher interest rates on your deposits with the only downside being that you might be converted to a currency you could probably use anyway is pretty appealing, particularly given the paltry yields offered on cash these days. That’s what dual currency deposits promise.
The typical pitch for one of these products emphasizes the chance of earning higher interest rates on low-yielding deposits. Meanwhile, the potential risks (costs) of a possible currency conversion are glossed over with all the ways you could use the converted currency, such as for travel, business or education expenses.
As touted on one major bank’s website, with dual currency deposits you get:
- A higher guaranteed interest rate compared to regular deposits
- A chance to diversify your currency holdings
- A hedge against foreign exchange fluctuations
- An enhanced rate of return with short-term tenors of typically 3-6 months
It sounds pretty good—you get higher interest rates and there’s no real downside. At least that’s the marketing pitch. But is it really that simple?
What Are Dual Currency Deposits?
Dual currency deposits (DCDs) are foreign-currency-linked deposits that allow you to potentially earn more interest than normal-time deposits. In return for the higher interest, you give the bank the right to repay your deposit in either the base (initial) currency or the linked (new) currency at maturity depending on the foreign exchange movements between the currency pair during the deposit holding period. Conversions to the new currency by the bank are done at a predetermined FX rate, not the actual FX rate (spot rate) at the end of the holding period.
What you’ve done in effect is “sell” a put option to the bank for the additional interest rate (premium) you receive on the DCD compared to what you would receive on a standard-time deposit. This put gives the bank the right to convert you to the new currency at a predetermined FX rate depending on where the exchange rate between the relevant currency pair ends up at the deposit maturity.
What most people don’t realize is that they swapped the safety of their “plain vanilla” deposit for the risk of a foreign-exchanged linked derivative product. The payoff they receive depends on whether the exchange rate at the beginning of the deposit finishes above or below the conversion (strike) rate specified in the contract. In effect, they’ve become short-term currency speculators.
Why Would the Bank Want to Do This?
Basically, a bank offers dual currency deposits in order to make a profit (as well as for internal hedging purposes). The bank pays you a premium (the increased interest rate) for the put (the right to convert the currency) you sold them. You could have also sold this put in the secondary options market and gotten a higher premium. The bank effectively takes the put option you’ve sold them and sells it on at a higher price in the secondary options market. The difference is the bank’s profit. If used for internal hedging purposes, the DCD is cheaper for the bank than purchasing the put in the secondary options market.
The bank’s profit could be upwards of 10% of your initial deposit. For those inspired to do it yourself, the trade could easily be replicated at lower cost with a margin FX account with one of the online Forex Trading Platforms
Here’s an Example from a Leading Bank’s Website:
The bank is offering a 3-month AUD/USD dual currency deposit product. The base (initial) currency is the USD and the linked currency is the AUD. The interest rate (based on the USD amount) is 7% accrued daily based on a 360-day year. The conversion rate (the predetermined FX rate to exchange to the linked currency) is 0.96 (1.00 AUD = 0.96 USD). A 3-month USD time deposit at the same bank is yielding roughly 0.5% annualized. Assume you put USD 50,000 on deposit.
7% looks pretty good. That’s a 6.5% increase over what you could earn on the 3-month USD time deposit with the same bank. Let’s look at the potential scenarios.
The AUD/USD exchange rate finishes at 0.9734 above the conversion rate of 0.96. In this case, since the AUD strengthened against the USD relative to the conversion rate, your principal and Are Dual Currency Deposits Really Worth It? Written by Chad Creveling, CFA, and Peggy Creveling, CFA interest will be repaid in USD. The interest rate calculation would be: USD 50,000*7.00%*90/360) = USD 875. It doesn’t matter how high the AUD/USD finishes, you only ever receive USD 875, which is USD 813 over what you would have earned on the standard USD time deposit. Your total proceeds after 3 months are USD 50,875.
In this case, assume the AUD/USD exchange rate finishes at .9350. The AUD has weakened against the USD and since the ending FX rate is less than the conversion rate of 0.96 agreed to in the contract, you will be converted to the weaker currency, which is the AUD. You still receive the interest rate payment of USD 875, but your principal has been converted and returned to you in AUD at the conversion rate of 0.96. The amount you receive is USD 50,000/0.96 = AUD 52,083.33.
At current exchange rates (now .9350), your AUD 52,083.33 is worth only USD 48,697 (AUD 52,083.33*0.9350 = USD 48,697.91). Adding back the USD 875 in interest received, your net loss is USD 428.
This doesn’t seem so bad, but the bank chose this relatively benign scenario for a reason. In this case, the AUD only weakened by 2.60% relative to the conversion rate, but worse outcomes occur more often than most people realize.
Short-term currency movements are extremely volatile and impossible to predict. The daily volatility of the AUD/USD currency pair over the past 3 months has averaged 1.22%. This converts to a volatility of 9.68% over 3 months. What this means roughly is that two-thirds of the time the currency will end up in a range +/- 10% from the starting FX rate over the 3-month deposit period. The other one-third of the time the range will be even wider.
Remember the exchange rate only has to weaken by 1.63% relative to the conversion rate (0.96) to wipe out your increased interest earnings. Based on the statistics above, it’s clear there is a large chance of experiencing a significant loss.
The reason DCDs can be a losing proposition is that even assuming that half the time the rate finishes above the conversion rate and half the time below, you only ever receive USD 875, no matter how high the rate goes. Meanwhile, there is no limit to the loss you can bear.
It’s this asymmetric payoff that makes DCDs a losing bet over the long run. You can “win” several rounds of deposits, and then have all your gains and more wiped out in just one poor round. Kind of like gambling.
Here’s What Many People Fail to Understand:
- Despite retaining the word “deposit” in the product, you have traded the safety of a deposit for the risk of a derivative product and have effectively become a short-term currency speculator.
- The depositor always receives the weaker currency. If your initial currency weakens beyond the pre-determined exchange rate during the deposit period, you won’t get converted. If the linked currency weakens, you will be converted to the linked currency.
- The exchange rate used to convert the base (initial) currency to the linked (new) currency is not the spot (current) FX rate. The rate used is set in the DCD contract and will always be less than the spot rate.
- The depositor takes on asymmetric risk. The upside is limited to the additional interest rate received, while the downside is theoretically unlimited. During the financial crisis, currencies such as the AUD fell as much as 30% against the SGD, leaving AUD/SGD dual currency depositors with substantial losses.
- Currencies are extremely volatile and impossible to predict, particularly in the short-run, even by Forex professionals. You may “win” several rounds of deposits, but the asymmetric nature of the bet means that losing even one round can wipe out all previous gains leaving you with a net loss.
- Assuming there is no real loss on a conversion to the linked currency since you “needed the currency anyway” makes no more sense than saying there is no loss when you travel to foreign country and get ripped off at the airport exchanging money.
The next time someone offers you a dual currency deposit product, you may want to think twice.