The Beauty of Currency ETFs

NEW YORK (TheStreet) -- WisdomTree Dreyfus Chinese Yuan Fund(CYB Quote) uses forward contracts to replicate holding foreign currency in many of their foreign currency ETFs.

Although forward contracts can be confusing at first, these funds are straighter forward than they appear and come much closer to matching their target than commodity ETFs. The Japanese yen and euro ETFs are the exceptions in that they hold short-term yen- and euro-debt.

I recently discussed the difference between commodity and currency ETFs after the Wall Street Journal published a confusing article on CYB.

Due to government restrictions and capital controls, and in some cases liquidity, WisdomTree uses currency contracts known as non-deliverable forwards, along with U.S. dollar denominated short-term government and commercial paper.

Besides CYB, there are several others, including the Brazilian Real ETF(BZF Quote) and Indian Rupee ETF(ICN Quote).

A forward contract is an agreement to exchange currencies for a given rate at a specific future date. It states at what price currency X will be exchanged for currency Y.

Interest rates are a major factor in determining this price and the best way to show this is with an example. Say the interest rate in Brazil is 10% and the interest rate in the U.S. is 1%. Also, two reals can be exchanged for $1 today, and the exchange rate in a one-year forward contract is the same. You have 1000 dollars.

If this were the scenario, you could exchange $1,000 dollars for 2000 reals today, and buy a forward contract to exchange reals back to dollars at 2-to-1 in one year's time.