Beware if you are approached to invest in Dual Currency Deposit (DCD). Don't be fooled by the seemingly high interest rate. Such deposits are highly speculative, and you may suffer substantial loss in your investment should the currency rate goes against you.
Watch out! A dual currency deposit (DCD) is not a deposit. It is actually a derivative instrument that is inherently speculative in nature. “While it promises interest rate over and above the traditional time deposit, consumer must face the risk of suffering a loss on the original investment due to foreign exchange rate fluctuations and the conversion of the Principal Amount from the Deposit Currency to the Payment Currency at maturity”. (Quoted from the fine print of an international bank). Aiyoyo! What does that mean????
When you invest in a DCD, you are giving the bank the right to repay you at a future date (at maturity) in the alternate/linked currency instead of the base currency in which your initial investment was made regardless of whether you wish to be repaid in the alternate currency at that time. Here’s how it works:
Initial Investment Amount : SGD100,000
Tenor : 1 month
From : Apr 6, 2010
To : May 6, 2010
Expiry Date : May 4, 2010
Interest Rate : 3.5% P.A.
Interest Amount : 287.67
Strike/Conversion Rate : 1.2650
Scenario 1 (SGD weakens against AUD)
On maturity, the prevailing spot rate (1.275)
is higher than the conversion rate (1.265)
Expected proceeds (Principle + Interest) in SGD
SGD100,000 + (SGD100000 x 3.5% p.a. x 30/365)
= SGD100,287.67
Investment Return
SGD100,287.67 – SGD100,000
= Profit of SGD287.67
Scenario 2 (AUD weakens against SGD)
On maturity, the prevailing spot rate (1.255)
is lower than the conversion rate (1.265)
Expected proceeds (Principle + Interest) in AUD
(Base on the conversion rate of 1.2650)
(SGD100,287.67/1.265)
= AUD79,278.79
Investment Return
(converted based on the spot rate of 1.255)
(AUD79,278.79 x 1.255) – SGD100,000
= Loss of SGD505.12
In the event that AUD appreciates, your return on the DCD investment is SGD287.67 or 0.2877% (3.5% x 30/365). Had you gone ahead to invest in AUD directly, your total gain will most likely be much higher since you get to keep the gain from the appreciation of AUD on top of the interest earned. If AUD fall, you must bear the full currency exchange loss and take delivery of AUD at the rate of 1.26500, instead of being able to buy AUD at 1.255 (which is cheaper) in the open market. Is this a sound investment?
The return is capped at the interest promised in the contract. If the AUD strengthens, banks get to keep the upside gain in the currency appreciation but if AUD depreciates, customer must bear full loss on the investment sum when compared with the amount of the base currency initially invested. Clearly, this is a bias investment tool.
If you are willing to take the currency risk, you are probably better off investing in the foreign currency directly. Why bear the unlimited downside risk in DCD and give up the upside gain to the bank for a mere compensation of 0.2877% interest?
Most bank customers are not aware of the underlying Foreign Exchange (FX) option. When you signed up a DCD, you are effectively selling an FX option to the bank, which gives them the right to exercise the option, to pay your deposit back in alternate/linked (or the weaker) currency. In the above example, you are selling a "put” option – an AUD put against SGD to the bank for a return of 0.2877% (3.5%/annum) for your SGD deposit. The interest earned is actually the option premium. If you have a difficulty understanding how it works, don’t worry, many don’t either. Just say NO if your bank offers you any complicated investment idea that you cannot or do not understand. Remember, the higher interest rate offers under the DCD account may not cover you sufficiently for the potential FX loss; neither does it pay you the potential FX gained for undertaking the currency risk. The bottom line is DO NOT SIGN ANYTHING YOU DON"T UNDERSTAND. DON’T enter if you have no clues about the directional view of the currency pair.
