Many investors buy foreign currency or securities tied to foreign currency as part of their investment portfolios. Buying foreign currency reduces the investor's dependence on the continued strength of the U.S. economy. However, despite the obvious benefit of diversifying a portfolio, there are many other pros and cons that people should seriously consider before buying foreign currency.
Exchange Rate Risk
If you buy foreign currency or investments such as certificates of deposit or government bonds issued in foreign currency, your investment gains value whenever the U.S. dollar weakens against the currency in which you invested. During a severe U.S. recession, your investment could significantly increase in value simply because the dollar becomes cheaper. However, foreign currency exchange works both ways and if the dollar strengthens, investments tied to foreign currency lose value. Many investors buy foreign currency from the developing world, and the exchange rates involving these currencies are very volatile, which can mean big gains or major losses for investors.
Investments And Yields
Some banks offer certificates of deposit issued in foreign currency, while brokerage firms sell national bonds issued by foreign governments. Every nation has a credit rating that impacts the amount the government must pay on its debts, including bonds. Major countries like the United States have high credit ratings, so debts tied to U.S. currency pay lower interest. Bonds and CDs issued by smaller nations pay much higher interest rates because these countries are viewed as a higher credit risk. Therefore, most foreign currency investments have higher yields than dollar-based securities. Also, most countries only issue bonds in increments of $100,000 or more and foreign currency CDs normally have higher minimum purchase requirements than dollar-based investments.
Cost Vs. Taxes
When you buy an investment such as a mutual fund or annuity, you often pay a commission in excess of 5 percent. Commissions on bonds issued in foreign currency are usually minimal, and you normally pay no fees to buy foreign currency in the form of a CD. However, while some bonds issued domestically, such as municipal bonds, pay a federal tax-free yield, earnings from investments in foreign currency are subject to federal and state taxation.
The Federal Deposit Insurance Corporation insures CDs issued in foreign currency up to the equivalent of $250,000 per account owner. However, the FDIC only insures you against losing money held in a CD in the event that your bank goes bankrupt and does not insure against losses of principal caused by currency fluctuations. Furthermore, the Securities and Investor Protection Corporation insures cash, in the form of U.S. dollars held in brokerage accounts at firms that go bankrupt. However, SIPC coverage does not extend to foreign currency held in brokerage accounts.