The dollar is sinking like a stone, and savvy investors are looking for ways to profit from its troubles. Exchange-traded funds based on the values of various foreign currencies have made it much easier for those who want to bet on the direction of the U.S. dollar.

In the past, betting on moves in foreign currencies wasn't so easy. You could use futures contracts, but that often required opening a separate brokerage account. In addition, futures involve large amounts of currency -- a single futures contract controls 125,000 euro, or 12.5 million yen. Those amounts are larger bites than many investors wanted to take.

Other options were equally unattractive. Companies such as American Express (NYSE:AXP) and Wells Fargo (NYSE:WFC) will let you buy relatively small amounts of foreign currency. But transaction costs are relatively high, and the currency you buy doesn't generate any interest.

Enter the ETF
When currency ETFs became available in late 2005, they offered a much easier way for average investors to play the currency market. The concept of the CurrencyShares Trusts is simple: Take investors' dollars and buy foreign currency with them. So each share of the CurrencyShares Euro Trust (NYSE:FXE) represents 100 euro, while the CurrencyShares Japanese Yen Trust (NYSE:FXY) holds 10,000 yen per share. By choosing how many shares to buy, investors can easily get as little or as much foreign-exchange exposure as they want.

Currency ETFs have gained in popularity for many reasons. The most obvious is that they've performed extremely well in light of the dollar's fall. The Euro Trust, for example, has gained more than 18% in the past 12 months, while the Canadian Dollar Trust (NYSE:FXC) is up nearly 25% so far this year. But they also pay dividends based on foreign interest rates -- the Euro Trust currently pays 3.77%, while the Australian Dollar Trust (NYSE:FXA) pays 6.13% and the British Pound Trust (NYSE:FXB) offers 5.43%.

Safety or speculation?
As an investment, currency ETFs have two very different risk profiles. On one hand, they closely resemble savings accounts; the ETFs hold cash and invest it with banks to get interest. So when measured in the appropriate foreign currency, your shares are unlikely to gain or lose much value -- a share worth 100 euro now will probably be worth 100 euro next month or 10 years from now. That distinguishes these ETFs from foreign bonds, whose value moves up and down even in local currency terms.

If you're measuring performance in U.S. dollars, floating exchange rates add a speculative flavor to currency ETFs. While that has been highly beneficial recently, it could quickly turn against fund investors if the dollar rebounds. These funds can be extremely volatile -- in just the past week, for instance, the Canadian Dollar Trust has fallen 5% from its recent highs.

What to do
In general, diversification is useful. So just as owning foreign stocks in your portfolio can give you exposure to high-growth areas of the world, having some of your short-term savings invested in foreign currency can protect you if the dollar falls.

But the one thing you shouldn't count on if you invest in currency ETFs is for their high returns to continue indefinitely. Even a small bounce in the dollar's value could cause you to lose money in these funds. If you're looking for a sure thing, currency ETFs definitely aren't the answer. But if you understand the risks, buying currency ETFs with a small fraction of your cash holdings may play a useful role in your portfolio.

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