What is a Dual Currency Deposit?
A Dual Currency Deposit (or DCD) is a financial instrument structured to help a depositor take advantage of relative differences in two currencies. It allows a bank customer to make a deposit in one currency, and withdraw the money in a different currency if it is advantageous to do so. The DCD combines a cash or money market deposit with a foreign exchange option. Because of the currency risk, dual currency deposits offer higher interest rates.
- Dual currency deposits are a structured investment product.
- They combine a deposit and a currency option.
- These instruments expose a depositor/investor to risk and reward in the currency markets.
How a Dual Currency Deposit Works
Despite its name, a dual currency deposit is not a deposit in the sense that capital is at risk. A dual currency deposit is a structured product composed of a fixed deposit and an option. So the dual currency deposit is a derivative with a combination of a money deposit and a currency option. The investor will use this product in hopes of capturing higher yields from better interest paid by one currency compared to the other, and by relative changes in currency. However, it is also true that the investor must be ready to accept higher risks that those same changes in currency work unfavorably.
After currency repatriation, the moment with the deposit is withdrawn back, it is possible for the investor to get back less than the initial investment, even after interest is factored in. Therefore, it is better to think of it as an investment product with all associated risks.
These products are also known as a dual currency product or a dual currency instrument.
DCDs are typically short-term products for investors desiring exposure to two currencies. The principal is not a protected investment product. Both parties must agree to terms including investment amounts, currencies involved, maturity, and strike price. Interest is earned in the originating currency, but the principal has the possibility of payment in the second currency, should the counterparty exercise the option. In essence, this is a deposit that creates a foreign exchange rate risk for the investor, not unlike that of a currency swap.
Example of a Dual Currency Deposit
The selling point for dual currency deposits is the chance to earn significantly higher interest rates. The risk for the investor is the investment may be converted to a different currency if the counterparty chooses to exercise their option. If that currency is one the investor does not mind holding, then it is not a substantial risk to take. However, the risk is that the investment may still need to be converted back to the home currency at a future date with a less favorable exchange rate. The investor can choose to hold these funds in the foreign currency in hopes that the exchange rate will eventually move to their favor, or exchange them immediately, perhaps at a loss, to free up the funds for future trades.
If an investor lives in country B but knows that short-term interest is more favorable in country A, they will prefer to invest their money in country A where they may realize better earnings. However, if the investor feels the exchange rate for country A's currency will move against them over the life of the deposit, the investor may hedge against that risk with a dual currency deposit option. At maturity, the counterparty will repay the investor in their home currency. The downside, of course, is if the exchange rate moves in the opposite direction, it would be more profitable to remain in the currency of Country A and repatriate the funds after the deposit matures.
While the investor still receives the same amount contracted in the deposit contract, essentially creating a floor under its value, a problem arises when it is time to repatriate those funds. The exchange rate may be even less favorable than at the outset of the deposit, and the investor will receive less than they might have otherwise received, maybe even less than the amount invested.