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A deposit rate is the interest rate that a financial institution pays you for depositing your cash with them. Deposit rates are typically quoted annually, so, if the GBP rate is 2%, you would expect to earn 2% interest if you held GBP in a deposit account for a year.
If your business operates in multiple currencies, deposit rates are definitely something to be aware off. Deposit rates (and interest rates in general) vary from one currency to another. If you’ve just received a payment in a foreign currency, you might earn more interest if you keep it in a foreign currency account rather than changing it immediately into your own currency. Similarly, if you have spare cash in your business, you might choose to hold it in the currency that is paying the higher interest rate.
However, it’s not quite that straightforward. While you are holding a deposit in a foreign currency, exchange rates are changing. For example, if you decide to put your cash in a USD account rather than a GBP account, to earn more interest, you might find that the USD/GBP exchange rate goes down (USD weakens), offsetting some or all of the extra interest you earned. Of course, the opposite could also happen…
These differences in interest rates are something that currency traders try to exploit via what are known as “carry trades”. They borrow money in a currency with a low interest rate, use the money to buy a currency with a high interest rate, earn interest on that currency and pocket the difference between the interest paid and the interest earned.
For example, imagine you borrow £8,000 at an interest rate of 1%. The GBP/USD exchange rate (or Cable) is 1.25. and you can earn 2% interest on a US dollar deposit. You exchange your pounds, getting $10,000. After a year, you should have $10,200 ($10,000 plus 2% interest) in your USD account.. If (and it’s a big if…) exchange rates are the same, you can change your dollars back into pounds, giving you £8160. You’ll need only £8080 (£8000 plus 1% interest) to repay your original loan, so you make a profit of £80.
Of course, things are never that simple. Both exchange rates and interest rates/deposit rates change all the time. The key is to understand that both are important and inter-related, and you’ll need to consider both when planning your currency strategy.
- The most common carry trade is known as the Yen carry trade and involves exchanging Japanese Yen for a high-yielding currency, typically the Australian Dollar, Brazilian Real, or Turkish Lira. Since 2016, Japan’s central bank has been running negative interest rates, making borrowing Yen extremely cheap
- Uncertainty, concern, and fear can cause investors to unwind their carry trades. The 45% sell-off in currency pairs such as the AUD/JPY and NZD/JPY in 2008 was triggered by the Subprime turned Global Financial Crisis.
- A dramatic example of the Implications of a carry trade was the peso carry trade that came in 1994 and became known as the “Tequila Crisis”. Struggling with a high current-account deficit and hyperinflation, Mexico pegged the peso to the U.S. dollar in 1988 – but when the U.S. raised interest rates, the Mexican currency could not keep the peg and a surge in capital outflows led to a crash.
Want to know more?
- The anomaly that causes currencies with higher interest rates to appreciate instead of depreciate is known as the “forward premium puzzle”. This academic paper takes a detailed look at the issue and attempts to explain the possible reasons for it.
- This entry from our hedging glossary dives deeper into Yen carry trades
Assure Hedge’s perspective
“Understanding deposit rates, and interest rates more broadly, is fundamental for anyone with a business that operates in more than one currency. Even relatively small movements in interest rates can have a huge impact on exchange rates and, in turn, on your bottom line.”
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DISCOVER OTHER CONCEPTS IN OUR CURRENCY HEDGING GLOSSARY
At the money
At the money is a term used in options trading.
The base currency is the first currency shown in a foreign exchange quotation.
A collar is a hedging strategy that helps you manage your foreign exchange risk by limiting your exposure to currency fluctuations to within a certain range.