Currently interest rates offered by banks on foreign currency bank accounts are low, especially relative to what can be earned by having the funds held in a rand bank account.
Some banks do offer products that enable you to earn a higher interest rate on your foreign currency funds. One such product is called a Dual Currency Deposit or DCD. It is what is termed a structured investment product that combines a traditional deposit with a foreign exchange option contract.
The basic terms are that the bank will offer you a higher-than-normal interest rate if you are prepared to receive the funds back at maturity in either the foreign currency or rands at a predetermined exchange rate.
Let’s take a look at an example where the foreign currency is US dollars (USD):
Assuming the interest rate available on a standard 30 day USD deposit is 4.72%, the bank is willing to offer you 5.75%, provided you are willing to receive your funds back in rands (ZAR) at an exchange rate of R18.35. This is based on a spot exchange rate of R17.40.
If at maturity, the spot exchange rate is below R18.35 the initial deposit amount will be returned in USD. But if the spot exchange rate at maturity is above R18.35 the initial deposit amount will be returned in ZAR, converted at the R18.35 exchange rate.
What you have effectively done is sell the bank an option to buy USD from you at an exchange rate of R18.35 in 30 days’ time. For this the bank is willing to pay you a “premium” in the form of the higher interest rate.
Why would they be willing to do this? Because, if the spot exchange rate in 30 days’ time is R18.50, for example, they would be able to buy the USD from you at R18.35 and sell it in the market at R18.50, making a R0.15 profit (less the value of the premium they offered you for 30 days). In this example the premium would amount to R0.0009 per USD and your deposit would then be returned in ZAR at the R18.35 exchange rate together with the interest earned.
However, if the spot exchange rate is R18.00 in 30 days’ time, there would be no value to the bank to exercise the option as they would be buying the USD at a higher rate than they could buy it in the market. So, they would simply return the deposit to you in USD plus the interest earned.
Taking advantage of this product would only make sense from a risk perspective if you were willing to receive the deposit back in either USD or ZAR at the agreed conversion rate. There may be circumstances where it would make sense, but it is critical that you have a full understanding of your total risk profile beforehand.
At wauko we ensure that we obtain a through understanding of our clients’ business and their risk profile before recommending what financial instruments to make use of in their cash flow management function.
Do you need assistance with evaluating what instruments to use in your cash management function? Contact Dale Petersen on 021 819 7802 or at dpetersen@wauko.com to connect with us.
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