Not all currency exchange traded funds (ETFs) are created equal. Some hold the actual currency, for example, while others hold forward contracts to get the necessary exposure to the currency in question.
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 opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.