Foreign Currency Fixed Deposit (FCFD) is a fixed investment instrument in which a specific sum of money that is poised to earn interest is deposited into a bank.
Although fixed deposits have virtually no risk, foreign currency fixed deposits introduce an element of exchange rate risk because investors must exchange their currency into the target currency and then convert it back again once the term is over.
The money deposited in an FCFD earns interest but comes with some currency exchange risk.
Money in an FCFD account can’t be withdrawn until the fixed term is up.
Investors use FCFD accounts to diversify or hedge against foreign currency movements.
A foreign currency fixed deposit is a type of time deposit issued by banks to investors who would like to keep foreign currency for future use or hedge against foreign currency fluctuation. The money deposited in the FCFD account cannot be withdrawn until the agreed fixed term has expired.
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, depositors must make sure that they do not need that money for the entire duration of the term. If an investor withdraws the funds prior to maturity, an early withdrawal penalty would apply, which is often steep and set at the discretion of the bank. The early redemption of a foreign currency fixed deposit will very likely result in the partial loss of the principal sum due to the combined effects of the redemption charges and bid-ask spread charges.
There are a number of reasons why an FCFD investment appeals to certain investors. Investors who want some diversification to their portfolios may opt for FCFDs in another currency. Companies looking to hedge against foreign exchange movements may use the FCFD as a hedging tool. For such companies, an FCFD is used to facilitate cross-currency swaps. Investors who want exposure to a target currency because they invest abroad, have children studying in a given country, or conduct business in another country may invest in FCFDs.
An FCFD can be invested in in two ways–opening a local account that offers deposits in the foreign currency that the investor would like to gain exposure to or opening an account in the foreign country itself. Interest rates, minimum deposits, tenure periods, and available currencies vary from bank to bank.
For example, A Canadian investor who has CAD dollars but wants to hold U.S. dollars can deposit USD into a US dollar-denominated FCFD paying a higher interest rate than a local Canadian savings account. To do this, the investor will have to purchase US dollars from the issuing bank using his Canadian dollars. After the US dollars are purchased, they are deposited into the FCFD.
USD/CAD is quoted as 1.29 from an FCFD issuing bank. An investor that wants to deposit $100,000 will buy USD at the rate of 1.29 from the bank by selling CAD 129,000. The $100,000 is deposited in the FCFD account for one year and earns an annual interest of 1.5%. After the tenure ends, the USD is sold for CAD at the prevailing foreign exchange rate offered by the issuing bank.
Investors who do not expect foreign exchange rates to move against them will typically use an FCFD. However, all FCFD investors face foreign exchange risk given that if there is an adverse movement in the exchange rate, the transaction costs and exchange rate difference might negate any excess interest returns or even put the investor in losses.
Following our example above, at the end of the term, the investor earns 1.5% x $100,000 = $1,500. However, the bank is only willing to purchase USD at a rate of 1.21. This means that the investor will receive Canadian dollars worth $101,500 x 1.21 = CAD 122,815. As you can tell, this amount is below the investor’s original investment amount of CAD 129,000.