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The Beauty of Currency ETFs

You could then put your 2000 reals in a Brazilian bank, earn 200 reals interest, and one-year later, exchange them back for $1,100.

Since you locked in the exchange rate in the future, you were able to make a risk-free trade. Essentially, you put American dollars into a Brazilian bank for one year by completely eliminating currency risk. This is a textbook example of arbitrage.

Traders (now high speed computers) will execute these trades over and over until the risk-free profit disappears. The purchase of reals today will push up the spot price, such that $1 buys less than 2 real. The buying of dollars in the future will raise the future price of dollars. Investors will have to pay more for real today and get less in return when they switch back one year from now. In this way, the profit opportunity is closed.

Furthermore, interest rates could change to make the profit disappear. If everyone is switching from dollars to reals today, the U.S. interest rate may increase and the interest rate in Brazil may fall.

The benefit of these contracts is that they allow a foreign investor to approximate the return of a money market fund in a foreign currency, thanks to the implied yield that is calculated into the contract. In some cases, where arbitrage is easier to conduct, this gets very close to the actual rate of interest in a country.

Through August, almost every currency ETF in WisdomTree's lineup that was in existence before 2009 has outperformed the currency itself, thanks to the implied yields in the forward contracts.

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