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 Japanese yen is gaining strength, which is putting exporters on guard because of the threat it poses. Strategist Fumiyuki Nakanishi said the dollar-yen rate and the performance of exporters would likely determine the Nikkei’s direction this week, with the ultimate goal of keeping the ratio above 1,000.

Many analysts and insiders say it is not “right” to deliberately weaken the yen through market intervention, report Colin Ng and V. Phani Kumar for The Wall Street Journal. The dollar-yen rate and the performance of exporters would likely determine the Nikkei’s direction this week.

In response, Japanese government bonds were higher as Tokyo shares dropped steeply. The stronger yen may hurt exporters, but ETF investors can capitalize in a few ways:

• CurrencyShares Japanese Yen (NYSEArca: FXY): down 0.42% year-to-date

• WisdomTree Dreyfus Japanese Yen (NYSEArca: JYF): up 0.6% year-to-date

For more stories about Japanese yen, visit our Japanese yen category.

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

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.

Japan might be helping to bail out the International Monetary Fund (IMF) to aid emerging markets, which makes one wonder if the country’s exchange traded funds (ETFs) will soon be ripe for some investment themselves.

Billions In Aid. The International Monetary Fund (IMF) has warned that there may not be enough money for any more bailouts within six to eight months, and Japan has offered to add $100 billion to the fund to go toward aiding emerging markets.

Dominique Strauss-Kahn said this weekend that the IMF needs more countries to follow the example of Japan. The problem is, no other countries have the money. The IMF is aware that most countries are about to go bankrupt this year, and Eastern Europe is hottest on their radar.

John Stepek for MoneyWeek reports that besides Japan, it is hard to see where the money will come from. Most of the world’s major economies are spending billions bailing out their own populations, never mind anyone else’s.

Other Bailouts Not Working Yet. Although countries such as the United Kingdom and the United States is getting billions poured in, the money does not seem to be doing them any good. The recession is looming deep for many countries and banks know this and are ready to hibernate. They are aware that as the recession grows, so does the number of people who wont pay you back.

Strong Yen. Although Japan is feeling the effects of the downturn due to falling export demand, the yen is strong enough to consider the other assets cheap. Assets in Brazil, Turkey and Mexico are where investors are looking to park their money.

And if the yen weakens this year – perhaps if the central bank intervenes to try to weaken the currency and help out exporters – then any Japanese investor holding overseas assets would see a nice boost to their value.

• iShares MSCI Emerging Markets (EEM): down 3.8% year-to-date

• iShares MSCI Japan Index (EWJ): down 4.7% over three months; down 13.7% year-to-date.

• WisdomTree Dreyfus Japanese Yen Fund (JYF) up 8.4% over three months; down 1% over one week

Carl Delfeld for ETF XRAY has quite a few reasons why he chose the CurrencyShares Japanese Yen Trust (FXY) as his latest pick of the week.

First of all, the Japanese yen is cheap in real trade-weighted terms, and has not seen lows like this since the 1980s. Better yet, Japanese banks are not displaying much correlation with the subprime lending that has taken the rest of the world by storm. Total write-downs by the local banks are at $17 billion, compared to an average of $500 billion around the world.

Although the yen does not have a high yield, it is acting like the other yieldless traditional store of value: gold. Gold hasn’t been serving that purpose very well this year, either. The yen is also the gateway to the “carry-trade” and Japanese retail investors hold positions in commodities and world currencies at around $300 billion.

On the downgrade of American International Group (AIG), the yen touched a two-year high against the euro. It also reached its highest point in five years against the New Zealand dollar, as a drop in stocks encourage investors to reduce their holdings of higher-yielding assets and pay back loans in the yen, report Ye Xie and Bo Nielsen for Bloomberg.

Trang Ho for Investor’s Business Daily also reports that overwhelming fear in the markets right now could also lead investors not just to the yen, but also the Swiss Franc. One analyst expects both currencies to appreciate between 5% and 7%, respectively, over the next two months.

The U.S. dollar could fall further against the yen as investors cover short positions against Japan’s currency.

The CurrencyShares Swiss Franc (FXF) gives exposure.

Also look for safe-keeping with WisdomTree Dreyfus Japanese Yen (JYF). FXY is up 5% year-to-date, FXF is up 0.8%, while JYF is down 1.1% since its May 22 inception.

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

ETFs have made it possible for the average investor to get exposure to the world’s currency markets – the largest financial market in the world. Before they came along, investors often had to use futures contracts that involved large amounts of currency.

The first fund launched in late 2005, and it opened up a whole new world for people looking to capitalize on the movements in the foreign exchange.

An excellent article on Investopedia addresses the top issues and questions people might ask about investing in currencies. Among the facts:

• Currencies are not traded on a regulated exchange, there is no central governing body and no arbitration panel to settle disputes. Self-regulation has been very effective, because participants must both compete and cooperate with one another.
• In the foreign exchange market, prices are quoted to the fourth decimal point.
• Technically, you are not buying or selling anything in the currency market. All trades exist as computer entries.
• Currencies are traded in pairs, and when a trade is made, one is always long on one, short on the other.

Not all currency ETFs are created alike. They do track a currency, or a basket of them, from around the world.

Rydex’s line of CurrencyShares are designed to hold cash and invest it with banks to get interest. WisdomTree’s line of Currency Income funds seek to earn current income reflective of the money market rates in the country for which the fund is named. They are not, however, “money market” funds.

ELEMENTS currency exchange traded notes (ETNs) are structured to track the performance of the U.S. dollar vs. the currency named in the fund. For example, if the currency in the fund’s name appreciates relative to the dollar, other things being equal, the value of the fund will increase. Market Vectors currency ETNs give exposure to the exchange rate of foreign currencies.

Note that ETNs differ somewhat from ETFs in their structure as well as tax treatment.

• WisdomTree Dreyfus Japanese Yen (JYF), down 4.8% since May 22 launch
• WisdomTree Dreyfus New Zealand Dollar (BNZ), down 5% since July 8 launch
• CurrencyShares Euro Trust (FXE), up 3.5% year-to-date
• CurrencyShares Mexican Peso Trust (FXM), up 12.2% year-to-date

• ELEMENTS Australian Dollar (ADE), down 3.4% since March 4 launch
• ELEMENTS Canadian Dollar (CUD), down 7.2% since March 18 launch
• Market Vectors Renminbi/USD (CNY), down 2.1% since March 17 launch
• Market Vectors Double Long Euro (URR), down 10.7% since May 22 launch
• PowerShares DB US Dollar Index Bullish (UUP), up 0.2% year-to-date

For full disclosure, some of Tom Lydon’s clients own shares of UUP.

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

But despite all the recent performance, today the dollar has taken a step back amid suspicion that its recent rally has been too quick to keep it up. Since hitting a record low in July, the U.S. dollar has gained 8.1%, report Ye Xie and Corell Eddings for Bloomberg.

On Friday, the greenback climbed to a two-year high against the British pound and the euro, reports David Ellis for CNN Money. The dollar’s recent rise is made more impressive when one considers that it’s happening amid global economic turmoil. The dollar climbed higher than a number of currencies this past month, most importantly, the euro.

ETFs affected by the movements in currencies:

• CurrencyShares British Pound Sterling (FXB), down 3.6% year-to-date
• WisdomTree Dreyfus Japanese Yen Trust (JYF), down 5.5% since May 22 inception
• CurrencyShares Euro Trust (FXE), up 2.7% year-to-date
• PowerShares DB US Dollar Index Bullish (UUP), up 1% year-to-date

For full disclosure, Tom Lydon’s clients own shares of UUP.

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

However, it is important to understand and know what to expect from currency ETFs before investing in them, as Anthony Welch for Index Universe explains.

Welch first points out that currency ETFs are not substitutes for money markets. Currency ETFs can and often do fluctuate in value, despite most of them paying monthly interest.

Similarly, currency ETFs are not substitutes for bonds. This is because bonds have a fixed date where an investor expects a return of principal. Meanwhile, currencies can decline for long periods of time and possibly never get back to the highs they once achieved. As a result, currencies are not something investors can buy and hold in the long run with a true degree certainty.

Currencies are also not similar to stocks. The currency market is enormous, being that currencies trade 24 hours a day and represent all the money in the world in a sense. Unlike most stocks, many currency traders have reasons to trade without the intention to make money, but rather to hedge risk.

Although currency ETFs are not like money markets, bonds, or stocks, they are very simple. Currency ETFs are nothing more than a relationship between two currencies, one of them usually being the U.S. dollar. These relationships fluctuate based on an extenuating number of circumstances ranging from interest rates, political climate and economic and GDP activity.

Some of the many Currency ETFs include:

• CurrencyShares Australian Dollar Trust (FXA), up 3.3% year-to-date
• CurrencyShares Euro Trust (FXE), up 4.2% year-to-date
• WisdomTree Dreyfus South African Rand (SZR), down 1% since July 8 inception
• WisdomTree Dreyfus Japanese Yen (JYF), down 4.5% since May 22 inception
• PowerShares DB US Dollar Index Bearish (UDN), up 1.9% year-to-date
• PowerShares DB US Dollar Index Bullish (UUP), down 0.4% year-to-date

For full disclosure, some of Tom Lydon’s clients own shares of UUP.

Read the disclosure, as Tom Lydon is a board member of Rydex Investments.