The Beauty of Currency ETFs

NEW YORK ( TheStreet) -- WisdomTree Dreyfus Chinese Yuan Fund ( CYB) 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) and Indian Rupee ETF ( ICN).

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.

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.

Of course, that's not always the case. The Emerging Currency ( CEW), a basket of several emerging market currencies, hasn't had as much gain over the spot price due to negative implied yields on the Israeli shekel, Chilean peso, and Taiwan dollar. Traders expect those currencies to appreciate and have bid up the forward price. Currently, the CYB also has a slightly negative implied yield of 0.4%.

Finally, the forward contracts settle by an exchange of the difference in the value of these contracts. WisdomTree rolls these contracts monthly and uses five or six counterparties to minimize counterparty risk. WisdomTree charges 0.45% annually for the single emerging market currency ETFs and 0.55% for CEW.

The other major currency ETF issuer is Rydex CurrencyShares, which deposits the underlying currency with J.P. Morgan. Rydex's offerings are limited to the major currencies available to foreigners, so the only comparable funds are the WisdomTree Dreyfus Japanese Yen ( JYF) and CurrencyShares Japanese Yen ( FXY); WisdomTree Dreyfus Euro ( EU); and CurrencyShares Euro ( FXE). The returns for these ETFs have been similar; WisdomTree charges 0.35% versus 0.40% for CurrencyShares; CurrencyShares has hundreds of millions in assets in FXE and FXY versus about $10 million in EU and JYF.

Investing in currencies carries risk, and emerging market currencies carry more risk than average. Central banks are flooding the globe with currency to fight the financial crisis, and the chances of a major accident are not small. However, for investors who want to invest in emerging market currencies, the WisdomTree products work as advertised. You can check their holdings on the WisdomTree Website.

-- Written by Don Dion in Williamstown, Mass.
At the time of publication, Dion does hold positions in any of the equities mentioned.

Don Dion is president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.