How can you invest in non-convertible currencies?

	Currencies Unplugged Merk Mutual Funds sheds light on key concepts relating to the currency market. Can any currency be converted into any other currency? The Archive: Read Currencies Unplugged

Non-convertible currencies, as the name implies, are currencies that cannot be readily exchanged for another currency, generally as a result of government restrictions. The Chinese yuan (CNY) is a well known non-convertible currency. The Chinese authorities do not allow convertibility, in part, as a means to facilitate the managed exchange rate of the yuan (the currency peg).

Non-convertible currencies are not freely traded in the traditional spot or forward currency markets. Rather, investors can replicate an investment in a non-convertible currency using non-deliverable forward (NDF) contracts. An NDF acts like a forward contract for non-convertible currencies, allowing investors to gain exposure to currencies they otherwise would not be able to invest in. Rather than delivering the underlying currency at expiration (as may be the case in a traditional forward currency contract), any profit or loss is settled by making a net payment in a convertible currency, such as the U.S. dollar (USD).

As an example, say an investor enters into a NDF to purchase 1 million CNY in a month’s time at an exchange rate of 6.85 USD/CNY (6.85 CNY to buy 1 USD – click here for an explanation of how currencies are quoted). In a month’s time assume the CNY appreciates to 6.80 USD/CNY. The investor will therefore receive a profit of USD$1,073.42 [(1,000,000/6.80) – (1,000,000/6.85)].

The Merk Asian Currency Fund has historically gained exposure to non-convertible Asian currencies by entering into NDF contracts for currencies including: CNY, Indian Rupee (INR), Indonesian Rupiah (IDR), Korean Won (KRW), Malaysian Ringgit (MYR), Philippines Peso (PHP), Taiwan Dollar (TWD), Thailand Baht (THB). The notional value of these contracts is typically fully collateralized with U.S. T-Bills or other money market instruments.

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