You made a bank deposit in UK sterling that matures next December. The interest rate was 10% while home rates are only 4%. You thought you would be going to London at the end of the year, but now you cannot. The outlook for pounds is depreciation, but you will lose all of your interest if you break the deposit.
What can you do reduce your risk and what do you need to think about in deciding if you should?
Name three strategies to deal with this situation and tell which you think is best and why.
To reduce the risk associated with the bank deposit in UK sterling, there are a few strategies you can consider, along with some factors to think about when making your decision.
1. Wait until maturity: You can choose to wait until the deposit matures in December. By doing so, you will receive the full interest rate of 10%. However, there is a risk of currency depreciation, which might reduce the value of your deposit when converted back to your home currency.
2. Hedge your position: Another option is to use hedging strategies to mitigate the risk of currency depreciation. For example, you can engage in a foreign exchange forward contract or purchase currency options to lock in an exchange rate. This will protect the value of your deposit, but there might be additional costs associated with hedging.
3. Break the deposit and transfer funds: If you anticipate significant depreciation of the UK pound, you can choose to break the deposit before maturity and convert your funds back to your home currency. This way, you may minimize potential losses due to currency depreciation. However, breaking the deposit would mean forfeiting the interest earned until that point.
When deciding which strategy is best, you need to consider several factors:
1. Currency outlook: Assess the likelihood and extent of pound depreciation compared to your home currency. Consider economic indicators, central bank policies, and expert opinions to gauge the direction of the exchange rate.
2. Opportunity cost: Evaluate the potential gains or losses you might face if you break the deposit versus waiting until maturity. Calculate the difference between the interest earned and the potential exchange rate changes.
3. Risk tolerance: Consider your risk appetite and capacity to bear potential losses. If you prioritize capital preservation over earning interest, breaking the deposit might be a viable option, even if you forfeit some interest income.
Ultimately, the best strategy will depend on your specific circumstances and preferences. It is important to carefully evaluate the potential risks and rewards associated with each option and make an informed decision based on your individual situation. It may also be helpful to consult with a financial advisor for personalized advice based on your unique financial goals.