This Rate-Booster Could Cost You a Fortune

Nothing's more frustrating than seeing your hard-earned money sitting in a savings account, gathering nothing but dust. Adventurous investors have discovered some interesting ways to get their money to work harder for them. But in doing so, they may be taking on risks they don't fully understand, and which could come back to bite them.

The best the world will offer
Most people know that countries around the world use different currencies. What you may not realize, though, is that those currencies carry different interest rates. Because most countries that have their own independent currencies set their own fiscal and monetary policies, market forces push interest rates up and down depending on local economic conditions. Even with a global economy, you can find some areas in which monetary policy is tight and others where it's relatively loose.

One popular way to try to profit from interest rate differences is known as the carry trade. This strategy involves taking money in a low-interest rate currency, as the U.S. dollar is right now, and exchanging it for a currency that offers higher interest rates. That way, you can earn substantial interest on your foreign currency, with the hope of then converting it back to U.S. dollars and reaping an overall profit.

In the past, it wasn't easy to set up a strategy like this. It's not like you can just go down to the local bank and ask for a euro-denominated savings account. But foreign exchange (aka forex) trading has become increasingly popular in recent years, with Citigroup (NYSE: C  ) and Goldman Sachs (NYSE: GS  ) having established partnerships with forex brokers geared toward individual investors.

Thanks to currency exchange-traded funds, implementing a carry trade is now easier than ever. Just look at how high the rates are for some countries' currencies:

Country/Region

ETF

Current Interest Rate or Portfolio Implied Yield

Australia

CurrencyShares Australian Dollar Trust (NYSE: FXA  )

3.94%

Brazil

WisdomTree Dreyfus Brazilian Real Fund (NYSE: BZF  )

8.71%

Mexico

CurrencyShares Mexican Peso Trust (NYSE: FXM  )

3.65%

South Africa

WisdomTree Dreyfus South African Rand Fund (NYSE: SZR  )

6.45%

Mix of Emerging Markets

WisdomTree Dreyfus Emerging Currency (NYSE: CEW  )

2.60%

Source: CurrencyShares, WisdomTree.

All of those rates certainly beat the pants off the average yields you'll find from U.S. banks. Lately, getting even 1% on your money has become increasingly difficult as the Fed shows nearly no signs of raising interest rates in the near future.

Rewards ... and risks
Currency ETFs are designed to be relatively safe. They tend to own either high-quality, short-term investments or foreign exchange futures and forward contracts that guarantee delivery of a certain amount of foreign currency at a given time. So once you buy shares of a currency ETF, you can be pretty comfortable that it's worth the corresponding amount of foreign currency.

But don't get the idea that your interest comes risk-free. Currency fluctuations can be extremely wild, as anyone who's watched the dollar's movements against the euro can attest.

From one perspective, though, it's been a long time since you've had such a good opportunity to buy currency ETFs. The share prices of these ETFs are tied to the currency exchange rate between the dollar and the respective currency. Because the dollar has advanced strongly in recent months against many currencies, your dollars can now buy more foreign currency than they could before.

The question is whether the dollar will keep rising or will fall back. If it keeps rising, then you risk losing more from adverse currency exchange fluctuations than you gain from the higher interest rates. But if the dollar reverses its trend and starts to drop, then you not only get the better interest but also some currency-related gains.

Know what you own
The carry trade may sound like free money, but it's actually a sophisticated strategy that is riskier than you might think. Even for experts in foreign exchange trading, the strategy isn't for the meek. But it can help you diversify an all-U.S. dollar portfolio. So if you decide that you can't handle watching your cash earn next to nothing, take a closer look at currency ETFs, but make sure you know what you're getting into before you buy.

Looking to go global with your investing? Let Fool Tim Hanson show you the way.

Fool contributor Dan Caplinger isn't afraid of Kaiser Soze, but the forex market commands his respect. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy doesn't need a money-changer to work wherever you do.


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