Dual Currency Deposit
Dual Currency Deposits (DCDs) are types of deposits that are linked to foreign currency interest rates. Therefore depositors stand to earn more interest from them than from normal deposits. The higher interest rate comes at the cost of giving the bank more freedom to repay your deposit in either the original currency or the linked currency at maturity, depending on the currency exchange rates between the two currencies during the intervening period.
A fixed FX rate is used by the bank for converting to the new currency, rather than the spot FX rate that would apply at the conclusion of the lock.
If you want a higher yield in one currency and are okay with the potential of getting your money back in a different currency at the conclusion of the deposit period, a Dual Currency Deposit (DCD) may be a good option for you.
Why do banks accept DCDs?
Essentially, a bank offers these accounts in order to benefit from them. As a result, the bank compensates you with higher interest rates for surrendering your right to potentially benefit from the currency conversion in the secondary market. You could have obtained a bigger premium by selling this put on the secondary options market.
Essentially, the bank buys the put option you sold to them and resells it in the secondary options market for a higher price. The bank's profit makes up the difference. Using the DCD for internal hedging saves the bank money over acquiring a put on the secondary market.
How it works
- A one-time cash deposit in a single currency is made for a predetermined period of time.
- An agreement is reached on the yield and the foreign exchange rate relative to the other currency. The exchange rate will be better than the current spot rate in most cases.
- The deposit and interest earned are refunded at maturity in the original currency or translated to the linked currency at the predetermined rate. At maturity, the amount of currency you get depends upon whether the DCD conversion rate is lower or higher than the market rate.
- You can indicate either the conversion rate or the yield you want, but not both.
When the conversion rate is closer to the current spot rate, it will result in a higher yield for the Dual Currency Deposit and vice versa.
A bank offers a DCD on the EURUSD pair for a period of three months. In this case, the euro is the base currency, while the US dollar is the linked currency. The annual interest rate is 5%, compounded daily over a year equivalent to 360 days. The exchange rate is 1 EUR=1.15 USD. The same bank's three-month USD time deposit pays about 1% per annum. Let's say you deposited USD $100,000.
Take a look at what could happen in each of the following situations.
Consider the following scenarios below.
At maturity, the EURUSD rate is at 1.25, which is higher than the initial rate of 1.15. Because the US dollar weakened against the euro, the bank will pay you your principal and the interest yield in USD. The earnings will be calculated as $100,000 X 5% * 90/360 = $1,250. Whatever the EURUSD exchange rate is, the bank will pay you $1,250. This is more than the $1,004 that you would have earned using a normal time deposit for a year. With the DCD, you will earn a total of $101,250 after just three months.
If the EURUSD exchange rate fell from the original 1.15 to 1.12 at maturity, you would be paid in euros, which is the "weaker" currency. You will still receive the $1,250 as interest, but the principal amount will be converted to EUR using the original conversion rate. Therefore, you will receive $100,000/1.15=EUR 86,956.
If we apply the current exchange rate of 1.12 to the EURUSD pair, your principal amount will be worth 86,956 X 1.12= $97,390. If you add the $1,250 earned in interest, you will end up with a net loss of $1,360.
Pros and cons of dual currency deposit
- There is a possibility of receiving an exchange rate that is much better than the current spot or forward exchange rates.
- They can earn you significantly higher returns in the form of interest than normal deposits.
- The conversion rate is better than the current spot rate when the deposit is made, but it may be worse at the time of expiration if it remains the same.
- In this case, the money is being held for a set period of time. Before the expiration date, it is not possible to withdraw or convert the funds without incurring additional fees.
- The currency you receive depends on whether the DCD conversion rate is lower or higher than the market rate when the DCD matures.
DCDs provide a good avenue for both banks and investors to hedge against currency fluctuations. It is possible to increase your returns by investing in a currency at a higher conversion rate, based on your investment preferences and view on currency exchange rates, as well as on the performance of the currencies themselves.
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