July 12, 2007

Why I never place Foreign Currency Fixed Deposit Part II

In my previous posting, I shard with the reader the cost of placing foreign currency deposit (FCD) and how the banks rip the customers off by giving them a wide spread.
Many readers thus wonder how can they place a FCD in an efficient and cheap manner.

The way we professionals do it is by way of foreign exchange forwards, whereby we get the same risk and reward exposure but yet in a cheap and efficient manner.
In order to illustrate how the professionals do it, let us walk through an example of a customer who go by the conventional way of buying the foreign currency and placed it into the fixed deposit.

Let us assume that the customer walk into a bank and wanted to place a USD fixed deposit of USD100,000 for 6 months. The bank will sell the USD to this customer at a rate of 1.5235. So the customer needs to pay the bank :

USD100,000 x 1.5235 = SGD152,350

The customer placed the USD100,000 with the bank, whereby the bank will pay the customer an interest rate of 4.745% for 6 months. The interest the customer will received at the end of 6 mths is :

USD100,000 x 4.745% x 183 days/360 days = USD2,412.04

The principal plus interest the customer has at the end of the 6 months period is therefore :

USD100,000 (principal) + USD2,412.04 (interest) = USD102,412.04

Now, assuming that the USD/SGD exchange happens to remains the same as it is, and the customer decided to convert the USD back into SGD, he will then receive :

USD102,412.04 x 1.5105 = SGD154,693.39

The profit for the customer is thus SGD154,693.39 – SGD152,350 = SGD2,343.39

Now, a professional fx trader will go by the FX forward market by going to a futures trading house to do the transaction. This is how he does it.

He will buy a fx forward of USD100,000 at an all-in forward rate of 1.4963. This fx contract will mature only 6 mths later, which is essentially the same as the 6 mth deposit.

Now fast forward to six months later. Again, assuming the USD/SGD rate remains unchanged, the spot rate is 1.5155, and the professional trader than “square-off” his position by selling away the USD100,000.

The profit the fx trader so thus USD100,000 x (1.5155- 1.4963) = SGD1,920

Because the trader is only entering a FX contract, he still has the SGD152,350 with him, which he will than placed it in a SGD 6 mth fixed deposit with the bank. Please note that because the fx trader need to place a margin with the futures house, he will not have the full SGD152,350, but a reduced amount of SGD142,350 (the SGD10,000 is for the margin). He placed the SGD at 1.70% as follow :

SGD142,350 x 1.70% x 183 days / 365 = SGD1,213.29

The fx trader total profit is thus SGD1,920+SGD1,213.29= SGD3,133.29
Compared the customer’s profit of SGD2,343.39 with the fx trader’so profit of SGD3,133.29, the difference is a whopping SGD789.90, or 33% difference.


Marisa y Dory said...

Qué lío de números! No me enteré de nada chico, jajaja!!!


Teodoro said...

You are invited to visit my new blog. Go to this link if you want to knew it: André Benjamim Thank you. Embrace.

W.Medeiros said...

God bless you!

W.Medeiros said...

God bless you!

Maj Bloodloss said...

Out of curiosity, when you enter into an FX contract, what is the consideration paid/held for the futures trading house?

On a separate note, is the 10% margin determined by the trader or set by the house?

icecold1967 said...

Hi maj bloodloss,

When you open an account with the futures ouse, they required an initial amount. The minimum is around SGd5000. Normally, the margin for fx is around 2-4% of the notional amount. Therefore, to trade a contract of say USD100,000 , the margin is about 2k-4k, but one must be mindful that if the market starts to move against you, the maintaince margin will increase.

Maj Bloodloss said...

Hi icecold1967,

Thanks for the reply. So there's a possibility of a margin call if the maintenance margin is hit?

icecold1967 said...

Yes, there is this possibility of margin call. But to put things into perspective, instead of putting the full USD100,000 and convert it into AUD for example, you are just putting up a small margin. At the end of the day, you risk is the same regardless of the route you take (being placing a fx deposit or through FX forward contract). The only difference is that the cost of the latter is lower.