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The global market in foreign exchange (forex) has mushroomed in recent years because of governments’ policies of deregulation of the financial industry in many countries. As investment capital flows more easily around the world, the demand for foreign currency has increased, both from businesses and individual investors.
The forex market is highly volatile, but does not necessarily entail very high risk – having foreign currency needs is the key to risk reduction. Many asian investors do have foreign currency needs because of their connections with the United States, Australia, and neighbouring countries in the region. The main reason to trade in foreign currencies is to obtain a better return than you would in an ordinary bank deposits in your own currency. If your main cash holdings are in a currency that you expect to weaken, you can switch to another currency and reconvert at a later date. There are other, more speculative attractions : some currencies offer a much higher rate of interest than others, and sometimes exchange rate of a foreign currency changes dramatically. It may be possible to make substansial gains by currency trading, but this is a high-risk strategy. For most investors, it is safer to trade in the currencies that you actually use quite frequently in your daily life. Premium accounts are an excellent way to participate in the forex markets in controlled way that is appropriate for your circumstances and personal attitude towards risk.
The typical premium transaction works like this :
You deposit a sum of money in the currency of your choice, called your ‘base’ currency. Usually this will be the currency in which you receive most of your income. There is a minimum sum required most of your income. There is a minimum sum required to open the account.
In consultation with your customer relationship manager, you plan your investment play.
You sell a ‘call option’ on your base currency against another currency of your choice. Selling a ‘call option’ means that you sell the bank the right – but not the obligation – to purchase an agreed sum of money in your base currency on an agreed future date. If the bank decides to exercise the option, it will pay you in the alternative currency you select at the exchange rate you agree at the outset.
You wait for the option to expire. Meanwhile, your cash deposit earns interest.
When the option expires, the bank decides whether or not to exercise its option to exchange your money. Its decision will normally be based on how the exchange rate has moved in the meantime (the current rate is called the ‘spot’ rate) if the agreed exchange rate is in the bank’s favour, it will exercise the option and convert your money. Depending on the difference between the agreed rate and the spot rate, this may mean that both you and the bank make a small profit.
If the bank does not exercise its option, then your deposits remains in your base currency, but you earn a better interest rate than normal for the period because the bank pays you an ‘option premium’ (this is a fee for the option you sold). To make things easier to calculate, the bank includes the option premium in the interest rate it quotes you at the outset. (Martin)
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