Forex deposits - Risky or Exciting?

MARKET MANIAC

There has been much fanfare "" and appropriately so "" surrounding Reserve Bank of India's (RBI's) recent dictum, under which Indian residents are permitted to invest upto $ 25,000 a year in international markets.

While this opening out of the capital account is more than welcome, and certainly timely, the immediate opportunities available are fraught with risk, which, in all likelihood, most investors are not fully aware of.

First out of the gate (as usual), Citibank and ICICI Bank are offering excellent LIBOR plus returns on short-term deposits on several global currencies.

Given that domestic deposits earn just 3.5 per cent for upto 90 days, while returns on currencies such as the Aussie dollar are in excess of 6 per cent, there has been a lot of interest in these vanilla products. Press reports indicate that Citi mopped up over $ 1 million on the first day itself.

In addition to the high interest, the deposit also provides a potential "" and possibly substantial "" additional gain if the currency appreciates against the rupee. Over the past three months, the Aussie dollar has appreciated by more than 9.5 per cent against the rupee.

Thus, if it repeats its behaviour over the next three months, a three-month Aussie dollar deposit (at 6.30 per cent) would end up earning a huge return of nearly 45 per cent (on an annualised basis).

Sterling appreciated by even more "" nearly 12.5 per cent over the past three months; thus, if sterling does a repeat performance, a sterling deposit (at 4.30 per cent) would provide a return of nearly 55 per cent (again, annualised).

For the record, the euro rose by 9.5 per cent, while the dollar fell by about 0.5 per cent against the rupee over these same three months. Clearly, these are exciting opportunities.

But "" and there's always a but, isn't there "" the flip side of opportunity is risk, and it is certainly possible that rather than continuing to rise further against the rupee, any of these currencies could actually fall quite sharply against the rupee, resulting in not just a reduced return, but a loss of capital.

Quite simply, if (say) sterling fell by just 1 per cent against the rupee over three months, which could happen if it fell by that much against the dollar and the rupee stayed more or less steady against the dollar, the deposit would end up more or less breaking even (and at a loss compared to a similar tenor rupee deposit).

[Note that a 1per cent loss over three months, works out to a 4 per cent loss on an annualised basis, which is about equal to the 4.3 per cent return being offered by sterling deposits.] If sterling fell by 2 per cent over three months, the deposit would actually lose money.

Now, nobody "" other than God "" really knows what will happen to sterling (or any other currency) against the dollar over the next three months.

And given that few, if any, of us have a disturbance-free connection with God, the best we can do is develop statistical estimates of what could happen, based on what has happened. One of these methodologies, which are widely used in financial analysis, is called value at risk (Var).

The Var of an exposure provides a measure of the probability of loss on an investment exceeding a particular amount. There are several different methodologies for calculating Var and, although none of them are sacrosanct, the very same banks that are offering customers these deposits use Var to decide how much of an exposure they are comfortable with.

Now, using a fairly standard methodology to calculate Var for USD/GBP tells us that there is a 5 per cent chance that the USD/GBP rate could move adversely by more than 1.45 per cent between today and tomorrow. Note, I said between "today and tomorrow".

Assuming that RBI continues to maintain its tight hold on the rupee, this means that your sterling deposit could lose part of its capital between today and tomorrow. Sure, it could return to profit the next day or the day after; or, of course, it could continue to lose even more money.

If, for instance, the dollar completely reverses itself and gains back the 12.5 per cent it lost against the pound over the past three months "" an unlikely contingency, to be sure "" your sterling deposit of, say, five lakh would be worth about 4.5 lakh after three months, even after including the attractive interest being paid!

Now, my intention is not to put you off foreign currency deposits. Rather, it is to highlight the risks involved. In my view, these deposits are really more useful for someone who has foreign currency expenses coming up "" say, a holiday in Europe "" rather than as an investment vehicle, certainly in their current plain vanilla form.

Of course, commercial banks are scurrying to put together structured deposits, which would at least protect your capital, and these would certainly be welcome, as they would allow depositors to take a lower risk bet on global markets.

And, no doubt, in reasonably short order, there would be an even wider spectrum of global products available, some with more aggressive risk profiles, permitting, for instance, Indian residents to use leverage to try to improve their returns.

An even better fall-out of these would be that once resident investors got a taste of structured products, there would be renewed pressure on the Securities and Exchange Board of India to liberalise the domestic markets.

Hedge funds, here we come!

jamal@mecklai.com