The WisdomTree Dreyfus Emerging Currency (NYSEArca: CEW) accesses “non-deliverable” forward (NDF) exchange contracts, and the fund captures the broad and sudden shifts of investor sentiments in the emerging currencies market, writes Rakesh Saxena for Seeking Alpha.

CEW fund provides access to the short-term money market in the emerging markets without encumbering investors with possible settlement risks. It is noted that only those comfortable with foreign exchange risks should be investing in this type of fund. (More on currency investing in our special report).

Potential traders should also note that NDF contracts incorporate interest rate differentials and speculative orders, which means that during stressful times in the financial markets, the exchange rates available in the NDF market are more accurate than the official quotes from emerging market banks.

NDF contracts are essentially outright forward exchange contracts with profits and losses adjusted between two counterparties based on the difference between the contracted and spot rate on the contract maturity date. (More on forward contracts can be found here).

Why is a basket of currencies beneficial?

• Emerging markets can be volatile; currency basket ETFs can give you broad exposure to a range of currencies and mitigate your overall risk. (More on emerging markets here).
• They are lower-correlating assets. The currencies in emerging markets generally move independently  of other domestic investments and alternative asset classes, such as commodities.
• They’re another way to access the overall growth of a currency category; in this case, emerging markets.

For more information on world currencies, visit our currency category. Or take a look at our ETF currency guide for currency ETF selections.

• WisdomTree Dreyfus Emerging Currency (NYSEArca: CEW): up 5.9% since inception; currencies include Mexican peso, Brazilian real, Chilean peso, South African rand, Polish zloty, Israeli shekel, Turkish new lira, Chinese yuan, South Korean won, Taiwanese dollar, Indian rupee

Max Chen contributed to this article.

Because of government restrictions, capital controls and sometimes liquidity issues, WisdomTree applies currency contracts, or non-deliverable forwards, and U.S. dollar-denominated short-term government and commercial paper in its foreign currency funds, writes Don Dion for TheStreet.

A forward contract is an agreement to exchange currencies at a predetermined rate at a specific time. The benefit is that the contracts allow foreign investors to gauge the return of a money market fund in a foreign currency. (Read our currency special report).

WisdomTree uses forward contracts to reflect foreign currency holdings in its Chinese, Brazilian and Indian currency ETFs. Its Japanese yen and euro ETFs hold short-term yen  and euro debt. WisdomTree’s currency ETFs have been outperforming the underlying currency thanks to implied yields in forward contracts.

• WisdomTree Dreyfus Chinese Yuan Fund ETF (NYSEArca: CYB): up 1.8% year-to-date
• WisdomTree Dreyfus Brazilian Real Fund ETF (NYSEArca: BZF): up 35.7% year-to-date
• WisdomTree Dreyfus Indian Rupee (NYSEArca: ICN): up 9.5% year-to-date
• WisdomTree Dreyfus Japanese Yen Fund ETF (NYSEArca: JYF): up 0.5% year-to-date
• WisdomTree Dreyfus Euro Fund ETF (NYSEArca: EU): up 8.6% year-to-date

Interest rates are a major determinant in forex prices. For example,  country “X” has a higher interest rate than country “Y,” and a person from country “Y” purchases a forward contract to exchange currency “Y” back to currency “X” at 2-to-1 in one year. A person would lock in the exchange rate in the future and would profit from the higher interest rate with no risk – this is known as arbitrage. Traders would then buy up the foreign currency until the exchange rate no longer overcompensates for the higher foreign interest rates.

Potential currency traders should note that trading in currencies includes risks, and trading in emerging market currencies carries even more risk. Have a strategy when you invest.

For more information on foreign currencies, visit our currency category.

Max Chen contributed to this article.

The Forex Market

The foreign exchange market, also known as the forex market, is the largest market in the world. In 2007, for example, it garnered $3.2 trillion worth of transactions each day. It’s the quiet giant of finance and dwarfs all other capital markets worldwide.

Unlike most other trading, such as futures, stocks or options, forex trading doesn’t happen on an exchange. It’s not controlled by any governing body, has no central exchange and there are no clearing houses involved guaranteeing trades. It’s a global network, made up of banks, corporations and individuals. The forex is also the most liquid market – there are always ready and willing buyers and sellers for the currency someone is seeking to trade.

The vast majority of currency trading is done bank-to-bank, and when each party enters into an agreement, they both take on the counterparty risk of the other. They’re not only competitors, but they’ve got to cooperate, as well.

There’s no actual buying and selling in the currency market – only trading, hence the need for cooperation.

Exchange traded funds (ETFs) have made entering this market much easier than it used to be. Prior to the launch of currency-related ETFs in 2005, the forex was a challenging market for individual investors to gain access to. Many investors might find this simplified access appealing, especially when you’re talking about a market that’s open 24 hours a day. If you’ve been eager to play this market, there are a rapidly growing number of opportunities to play the currency markets in the form of both ETFs and exchange traded notes (ETNs), which we’ll detail later.

Currency Basics

When entering the currency market, much of the focus is on the eight major currencies, which give you the best over- or under-valued opportunities. The eight major countries that make up the currency trading market are the United States, the Eurozone (Germany, France, Italy and Spain), Japan, United Kingdom, Switzerland, Australia, Canada and New Zealand.

There are many, many more currencies beyond the eight majors, such as the Brazilian real, Polish zloty and Hungarian forint.

Some of the key points to consider when you’re investing in currencies are:

• When trading currencies, yield drives return. Every currency has a yield.
• The forex allows huge leverage; often as high as 100:1 – which means that you can control $10,000 worth of assets with as little as $100 of capital. Remember, leverage works both ways, though.
• Since currency values never stay the same, the carry trade became a popular theory. Carry traders hope to earn not only the interest rate differential between the two currencies, but also look for their positions to appreciate in value. We’ll discuss this in more detail in the next section.
  
• Interest rates matter – a lot. Becoming familiar with the economics of the country in which the currency you are trading holds will help you understand when inflation is looming and when opportunity is knocking.

In currency markets, there’s always a bull somewhere. Why? The foreign exchange market is all about opposites and all about relativity. As one currency gains value, another has to be losing.

Dan McCabe, CEO at Next Investments, points out that one of the biggest advantages to investing in currencies is that it’s a great way to get non-U.S. dollar exposure.

“As an investor, I have nearly all my stuff in U.S. dollars. When I want to buy something, it’s often foreign-made. If I don’t have a hedge for the fact that the U.S. dollar may depreciate, I’m just losing my buying power on the world stage.”

For example, have a look at this five-year chart of the euro vs. the U.S. dollar. For the last three years, the euro steadily gained before falling off mid-way through 2008:

This means that as the euro gained strength, perhaps tourism in Europe suffered as Americans couldn’t afford to go over there and spend as much. But on the flip side, it likely brought tourists over here who were itching to spend and find bargains. Currency is all about relationships, and a currency being either weak or strong doesn’t necessarily mean it’s bad or good.

McCabe sees currencies as more of a buy-and-hold hedge instead of getting caught up in trading. “You’d rather just come in, buy it and put it away and look at it like a foreign money market account,” he says.

The Carry Trade

One of the most popular ways for institutional investors to play currencies is with the carry trade. Putting it simply, the carry trade involves borrowing currencies from countries with low interest rates and investing it in high interest rate countries. The strategy aims to take advantage of the wide spread in interest rates between certain currencies.

As of June 24, some interest rates for various currencies were:

• Australian Dollar, 3%
• New Zealand Dollar, 2.5%
• Euro, 1%
• U.S. Dollar, 0.25%
• Japanese Yen, 0.1%

You can track these interest rates at Daily FX.

With these interest rates in mind, an investor utilizing the carry trade would want to buy Australian dollars with the much lower-yielding Japanese yen, which is one of the most popular carry trade combinations around.

The carry trade isn’t a risk-free strategy, though. One of the biggest risks is if the exchange rate devalues by more than the average annual yield. If you’re using leverage, your losses could be even greater.

ETFs have simplified the carry trade for retail investors. The PowerShares DB G-10 Currency Harvest (DBV) tracks the interest rates of the U.S. dollar, euro, Japanese yen, Canadian dollar, Swiss franc, British pound, Australian dollar, New Zealand dollar, Norwegian krone and the Swedish krona. DBV looks at the three-month interest rates of the G10 currencies and goes long on the three with the highest rates and short on the three with the lowest. The ETF seeks to capitalize on the trend that the currencies with high interest rates generally tend to rise in value relative to currencies that have low interest rates.

Currency Risks

McCabe points out that currencies are non-correlated assets. “The risk you have oftentimes is performance vs. the underlying currency you’re purchasing in.”

As an example, assume that $1 equals 1 yen. If the dollar increases in value, you might get 1 yen for 90 cents – great if you’re traveling to Japan when this happens. However, it’s not so great if you have an asset priced in yen that you bought when dollars and yens were of equal value.

The flip side also works: if the dollar falls against various currencies, you stand to make money on assets based in those currencies if you bought them before the dollar weakened.

When searching for currencies to invest in, McCabe looks at the country behind it. Political upheaval can wreak havoc on a currency.

“I would look for a stable country with strong jurisprudence and rule of law…a country you believe is going to be stable, in case of turmoil.”

Why Use ETFs Instead?

Investing in currencies on your own, without an ETF, can be an arduous task. The currency market is one that never closes. Twenty-four hours a day, trillions and trillions of dollars in trades are taking place. You could find yourself sitting up in the middle of the night, waiting for a key signal to pounce on a trade.

That probably doesn’t sound like the average retail investor’s idea of a good time.

There are now two options for exchange traded currency investing: ETFs and exchange traded notes (ETNs).

Two key differences between currency ETFs and ETNs are:

1. Currency ETNs (like all ETNs) are backed by the full faith and credit of the issuer. If the issuer goes under, you have to get in line with all the other creditors. It’s a small risk, but it’s one to keep in mind.
2. Currency ETNs linked to a single currency are treated like debt for federal tax purposes, according to a 2007 IRS ruling. It means that any interest is taxable to investors, even though the interest is reinvested and not paid out until the ETN is sold or upon maturity of the contract. It also means that investors can’t elect capital gains treatment.

Not all exchange traded currency products are structured in the same way, either.

McCabe points out that it’s wise to be aware of what makes currency products different from one another. For example, Rydex’s CurrencyShares funds are grantor trusts – they hold the actual currency.

The interest earned on them is accrued on a daily basis and reinvested monthly. This reinvested interest is then reflected in the fund’s net asset value (NAV).

On the other hand, PowerShares‘ currency ETFs, PowerShares DB US Dollar Bullish Fund (UUP) and PowerShares DB US Dollar Bearish Fund (UDN), hold futures contracts and are registered as open-ended ETFs. Any gains from futures contracts are subject to 60/40 tax treatment, in which 60% of the gains are long-term, 40% are short-term.

In the bullish fund, the futures contracts are designed to be long on the U.S. dollar against the euro, yen, pound, canadian dollar, Swedish krona and Swiss franc. The bearish fund is designed to be short on the U.S. dollar against those currencies.

WisdomTree’s currency income ETFs invest in either non-U.S. moey market securities, or in a combination of money market instruments designed to provide exposure to non-U.S. money market securities or rates. They are not money market funds. They seek to give investors current income reflective of foreign money market rates available to U.S. investors, as well as exposure to changes in the value of a specific currency relative to the U.S. dollar.

Market Vectors‘ currency ETNs are senior, unsecured debt securities that give exposure to the exchange rate between U.S. dollars and foreign currencies. The underlying indexes are also affected by movements in interest rates in the country of the underlying currency and that of the United States’.

Market Vectors and ProShares also have some double long and double short ETNs for investors looking to enhance their exposure. They aim to double the daily performance of a specific currency. Know the risks of short and leveraged funds before you invest, however. They aren’t for everyone.

Barclays’ iPath currency ETNs measure the relative values of two currencies. In the EUR/USD fund, for example, when the euro rises against the U.S. dollar, the fund increases, and vice versa. The provider also has a currency carry ETN, iPath Optimized Currency Carry (ICI), that seeks to capture the returns potentially available from a carry trade. The pool of currencies the index may apply its strategies are known as the “G10″ currencies, which includes the U.S. dollar, euro, Japanese yen, Canadian dollar and Swiss franc.

How to Choose

At this point, there are enough ETNs and ETFs targeting currencies that investors have a whole range of choices when it comes to figuring out how they want to play them. When choosing currency ETFs, consider the differences between the available funds, how they access currencies and their tax treatment. In short, know what you own.

Perhaps one of the easiest ways is via a broad basket of currencies, which help spread out the risk and lessen the blows a volatile stock market can deliver. Some examples:

• Barclays Global Emerging Market Strategy [GEMS] Asia 8 Index ETN (AYT)
• Barclay’s iPath Optimized Currency Carry Exchange Traded Note (ICI)
• PowerShares DB G10 Currency Harvest Fund (DBV)
• WisdomTree Dreyfus Emerging Currency Fund (CEW)

There are a number of single-currency funds available, as well, along with a number of others that are in registration:

• PowerShares DB US Dollar Bullish Fund (UUP)
• PowerShares DB US Dollar Bearish Fund (UDN)
• CurrencyShares Australian Dollar Trust (FXA)
• WisdomTree Dreyfus Brazilian Real Fund ETF (BZF)
• CurrencyShares British Pound Sterling Trust (FXB)
• iPath GBP/USD Exchange Rate ETN (GBB)
• CurrencyShares Canadian Dollar Trust (FXC)
• Market Vectors – Chinese Renminbi/USD ETN (CNY)
• WisdomTree Dreyfus Chinese Yuan Fund ETF (CYB)
• CurrencyShares Euro Trust (FXE)
• iPath EUR/USD Exchange Rate ETN (ERO)
• WisdomTree Dreyfus Euro Fund ETF (EU)
• Market Vectors – Indian Rupee/USD ETN (INR)
• WisdomTree Dreyfus Indian Rupee Fund (ICN)
• CurrencyShares Japanese Yen Trust (FXY)
• iPath JPY/USD Exchange Rate ETN (JYN)
• WisdomTree Dreyfus Japanese Yen Fund ETF (JYF)
  
• CurrencyShares Mexican Peso Trust (FXM)
• CurrencyShares Russian Ruble Trust (XRU)
• CurrencyShares Swedish Krona Trust (FXS)
• CurrencyShares Swiss Franc Trust (FXF)
  

There are also leveraged funds, which enable investors to maximize the movements of a particular currency. The following funds all double exposure by 200%:

• ProShares Ultra Yen ETF (YCL)
• ProShares UltraShort Yen ETF (YCS)
• ProShares Ultra Euro ETF (ULE)
• ProShares UltraShort Euro ETF (EUO)
• Market Vectors Double Long Euro ETN (URR)
• Market Vectors Double Short Euro ETN (DRR)

In registration include CurrencyShares for Hong Kong, Singapore and South Africa, as well as WisdomTree funds for the Czech koruna, Chilean peso, Israeli Shekel, the Russian ruble and many more.

Read the disclaimer, as Tom Lydon is a board member of Rydex Funds.

For more stories on currencies, visit our currency ETF category. For more special reports, view our special report page.

It was during 2008 when the global financial crisis intensified and the dollar’s six-year decline against the euro and other top-performing currencies reversed their trends, reports Patrick Lane for Economist.

But there are currencies out there that are faring quite well against the dollar. The yen is one, but that is overlooking the fact that Japan’s economy is a bit shaky. The slowdown of exports probably won’t reverse the the upward trend of the Chinese yuan. The central banks in Frankfurt, Germany, and London have a little bit more room for increased rate cuts and are likely to take advantage of it.

In previous years, large volumes of cash from the United States and Japan and found their way into the E.U. and emerging-market currencies, but the money will eventually return. Current slowing economies has shown that investors are snuggling safely in U.S. Treasury notes.

Some currencies could be facing some risk, though. They include the Indian rupee, South Korean won, Brazilian real, and “most” east European currencies. Most vulnerable currencies belong to countries whose banks, companies, and households owe short-term debt denominated in foreign currency, the most conscious being the Icelandic krona.

• PowerShares DB USD Index Bullish (UUP): up 4.9% in 2008

• India is adding interest rates and tax cuts announced earlier this month to make up for their declining output and exports, indicating a deeper slowdown than expected. The economy will slow but not at a rapid pace, giving the government time to shore up, reports Nipa Piboontanasawat and Kartik Goyal for Bloomberg.
• Inflation also stands above “acceptable” levels, according to the country’s central bank, making monetary policy management more difficult. The Reserve Bank of India cut the repurchase rate by 1%, to 6.5%, earlier this month. It’s the third cut since October, say Kartik Goyal and Arijit Ghosh for Bloomberg.
• The rupee is coming off one-month highs, but it’s still feeling stronger after rate cuts by the Federal Reserve, reports Swati Bhat for Reuters. Foreign institutional investors have been net buyers of about $440 million of Indian shares in December, but they’ve dumped a net $13.2 billion in 2008.

• WisdomTree Dreyfus Indian Rupee Fund (ICN): down 5.2% since May 22 inception

• WisdomTree India Earnings (EPI): down 53.5% since Feb. 26 inception

• PowerShares India (PIN): down 49.3% year-to-date

Carl Delfeld for ETF XRAY writes how the attack is another burden on India and how increased tension with Pakistan and the disputed Punjab region may be a more pressing matter compared to economic growth.

As India is affected by a global credit crunch and rupee’s decline, most economists have cut India’s GDP growth in half for 2008 and 2009. The Sensex, India’s leading stock market index, has been diminished by half its worth since January as foreign investors funnel billions out of the country.

• The India rupee ETF WisdomTree Dreyfus Indian Rupee Fund (ICN) is currently down 9.1% since its May 22 inception.

• PowerShares India Portfolio (PIN) is down 58.1% since its March 5 inception

Delfeld predicts that India’s economy may drop even further and the best point of entry into India markets is in three to six months’ time.

Then there are optimists who think relations have matured to a point between India and Pakistan where the two countries will shrug off incidents caused by unsavory elements such as terrorists or extremists who disapprove of peace and cooperation between the two countries, according to Cherian Thomas for Bloomberg.

It is said that Bombay Stock Exchange rose on the first trading day after attacks – it was business as usual and there seemed to be no signs of panic among investors. As long as relations with Pakistan do not falter after the attacks on Mumbai, India’s economy may be poised to outperform expectations.

Market strategists are calling the latest market fluctuations a perfect environment for the actively managed ETF to show their strengths, allowing investors a chance to intervene if their money begins to shrink, reports David Bogoslaw for BusnessWeek.

The definition of an actively managed ETF has yet to be set in stone, but the Securities and Exchange Commission (SEC) says it is not seeking to track the return of a particular index, rather, selecting securities that are consistent with the ETF’ss objectives and policies.

The biggest challenge in gaining the popular following for active management with ETFs is that the general backlash in the financial industry against quantitative models, due to the losses they incurred for clients. It has lead analysts to believe they may be too complicated for the general investing public.

If actively managed funds stay clear of the weaker areas of the market, they can outperform an index since stock prices do track earnings strength, says Bogoslaw. And remember – they’re cheaper than mutual funds, one of their biggest selling points.

Actively managed ETFs are going to be treated like mutual funds, and most providers seem to understand that investors are largely going to wait for some long-term performance numbers before they dive in.

Some active ETFs, all of which launched this year:

• PowerShares Active AlphaQ Fund (PQY)
• PowerShares Active Alpha Multi-Cap Fund (PQZ)
• PowerShares Active Low Duration Fund (PLK)
• PowerShares Active Mega Cap Fund (PMA)
• WisdomTree Dreyfus Chinese Yuan Fund (CYB)
• WisdomTree Dreyfus Indian Rupee Fund (ICN)
• WisdomTree Dreyfus Brazilian Real Fund (BZF)
• WisdomTree Dreyfus Euro Fund (EU)

The rupee was knocked down by losses in stocks after worries about problems in the global financial sector as well as heavy demand for the U.S. dollar, Reuters reports. Meanwhile, Indian shares fell more than 3% today, to their lowest close in two months as investors braced themselves for more fallout from the latest in the U.S. financial crisis.

In better news, inflation fell for a third consecutive week last week – a signal that the Central Bank’s three interest rate increases are serving their purpose. Kartik Goyal for Bloomberg reports that wholesale prices rose 12.1% during the last week in August. India’s industrial output for July rose 6.5% from the year before, consistent with a slowing economy and high inflation and interest rates.

Reuters reports that while the numbers are positive, they’re still consistent with a slowing economy. According the one economist’s view, the bottom has not yet been reached.

• PowerShares India (PIN), down 26% since March 5 inception
• WisdomTree India Earnings (EPI), down 30.8% since Feb. 26 inception
• Market Vectors Rupee/USD ETN (INR), down 9.1% since March 18 inception
• WisdomTree Dreyfus Indian Rupee (ICN), down 4.5% since May 22 inception

Murray Coleman for IndexUniverse acknowledges that it has been a short period of time and that three months cannot really be viewed as a valid data set.

However, it’s encouraging when it comes to actively managed funds, because many questions about them centered around how they were going to do in the absence of back-tested data. But these positive first three months could draw investors toward active ETFs.

Many investors see a few advantages for actively managed ETFs. For example, the PowerShares Active Alpha Multi-Cap Portfolio (PQZ), selects from a pool of the 2,000 largest stocks by market-cap size. This allows for flexibility in making updates of up to three stocks per week. This gives an advantage over indexing funds which are essentially stuck in a group of stocks.

Through Aug. 1, PQZ had lost only 5.9% over the past three months, while the average mulit-cap core mutual fund lost 9.2% over this same period. David O’Leary, chief investment officer at AER Advisors, says their ability to eliminate lagging stocks when needed has been key this year.

Some actively managed ETFs include:

• PowerShares Active Alpha Multi-Cap (PQZ): down 6.9% over the past month; $7 million assets
• Bear Stearns Current Yield (YYY), up .2% over the past month; $51 million assets

WisdomTree has also launched four new currency ETFs that are classified as actively managed by the Securities and Exchange Commission (SEC). The funds seek to earn current income reflective of money market rates available to U.S. investors.

These four funds are:

• WisdomTree Dreyfus Chinese Yuan Fund (CYB), down 1.5% over the past month; $219 million assets
• WisdomTree Dreyfus Indian Rupee Fund (ICN), up 5.8% over the past month; $10 million assets
• WisdomTree Dreyfus Brazilian Real Fund (BZF), up 3.0% over the past month; $107 million assets
• WisdomTree Dreyfus Euro Fund (EU), down 1.4% over the past month; $21 million assets