Are foreign currency fixed deposits safe?

In today's low interest rate regime in Singapore, many retail investors are looking around for fixed deposits that give a higher return than savings and they are asking the question,

"Are foreign currency fixed deposits safe?"

What is a foreign currency fixed deposit (FCFD)?
[Source http://www.investopedia.com/terms/f/FCFD.asp]

Investopedia defines an FCFD to be "a fixed investment instrument in which a specific sum of money with an agreed upon time and interest rate is deposited into a bank. Although fixed deposits have virtually no risk, foreign currency fixed deposits introduce an element of risk because investors must exchange their currency into the target currency and then covert it back again once the term is over

When foreign currency fixed deposits are larger and longer in duration, they receive much higher interest rates. An FCFD can be a very useful and safe way to invest your money. However, you must make sure that you do not need that money for the entire duration of the term."

We understand fixed deposits
Most of us understand what fixed (time) deposits are. They are a deposit with a bank but for a specified period of time, usually 3 months to 12 months, at a interest rate fixed at the start of the tenure. Fixed deposits typically pay a higher interest than savings because your money is kept by the bank for a fixed period of time and most banks would levy a penalty in terms of forgone interest or even administrative charges if you wish to withdraw the fixed deposit before maturity.

FCFD introduces exchange rates
Now what happens with a foreign currency fixed deposit is that we introduce another variable, which is the exchange rate.

Therefore, a FCFD now has two elements:
1) Interest Rate
2) Exchange Rate

How does it work - An example
Assuming USD (US dollar) to SGD (Singapore Dollar) is 1.5 and USD Foreign Currency (FC) deposit pays 4% interest for 1 yr.

Now for you to get the 4% interest at the end of 1 year in SGD, the interest rate would have to be the same at 1 USD : 1.5 SGD. But in reality, the exchange rates go up and down all the time.

In addition, let's say you want to deposit SGD 10,000 into a 1 year FC, assuming now the exchange rate is SGD/USD is 1.5, when you invest, the bank converts your SGD into USD, say at 1.55 (because the banks will make a spread over the exchange rates) so you already lost 3.3% in value. So now you have USD 6,453.61 earning 4%.

Your interest may be less than FCFD rate if SGD appreciates
After 1 yr, your USD 6.453.61 at 4% earns =USD 258.06 interest, if you decide to withdraw capital and interest, it will be USD 6,711.75. When you exchange that back to SGD, assuming that SGD has strengthened against the USD to say, 1.4. So when you translate back your USD 6,711.67 to SGD, it becomes SGD 9,396.34!

If you play around with the interest rates, so long as the SGD strengthens to below 1.49 (> 4%) against the USD, you will lose the benefit of the higher interest rates. So it that is the additional currency risk you bear when you deposit in FC fixed deposits. Of course, the converse is true, if SGD weakens, then you will make 4% interest plus exchange gain!

Risk of FCFD
The example above shows that FCFD comes with a higher risk because exchange rates can go up or down. In general, if you do not need the fixed deposit and can let it renew without exchanging it back to SGD, then you are not affected by the variation in exchange rates. In general, where the SGD appreciates against the foreign currency that your FCFD is in, then there is a high chance of the increase in SGD exchange rate to a point that it erodes or even causes a loss to the value of the FCFD when the amount is changed back to SGD.

It is a double-edged sword and adds an element of risk that investors should review carefully before investing in such products.

Be well and prosper.