How are banks able to offer high interest rates on foreign currency fixed deposits?

The bank can offer you the local interest rate on a foreign currency, which might be a lot different than your home interest rate. The bank can do this on a no-win no-lose basis, less a commission or fee they charge you, by using the forward currency market to hedge the future conversion of the foreign currency back into your home currency.

So, suppose you have dollars $1,000, and the foreign currency is the franc, currently at a spot rate of 2.0000 francs per $ (which is a price of 50c per franc). Also, suppose the home/dollar interest rate is 5% p.a. and the foreign/franc interest rate is 12% p.a. Your temptation is to invest your $1,000 in Franc-land to earn 12%.

Now, the forward foreign exchange market, once hedged against currency risk, works to produce a forward exchange rate that is related to the current spot rate in the exact inverse of the relative interest rates. To see this, consider the following, assuming no bid-to-offer spreads in all rates:- You approach a bank to convert a future cash receipt of Fr2,240 back into dollars, in one year's time. The current spot rate is 2.0000Fr/$ and interest rates are 12% in Franc-land, and 5% at home. The bank says "fine", and calculates the forward rate by hedging its exposure as follows:- The bank looks at your future franc sum of Fr2,240 and works out that with interest rates at 12% p.a. it should borrow Fr2,000 today to guarantee producing a debt of Fr2,240 in one year's time, which can be repaid by using your future franc receipt, that you would give to the bank in exchange for dollars. Now, in borrowing Fr2,000 today, the bank would not simply borrow francs and do nothing else. It will hedge its currency risk by converting the francs it had just received from the bank it had borrowed them from, into dollars at today's spot rate of Fr2.0000 per $, producing $1,000 ... which it will not simply sit on, but will invest at 5%, producing a sum of $1,050 in one year's time. So, in one year's time the bank will have guaranteed a cash inflow from you in francs of Fr2,240, which it will use to pay off its franc loan, and a cash inflow of $1,050, which it will return to you. So, given these transactions that the bank would enter into in order to guarantee a rate at which to convert your future francs, the bank says that the one-year forward rate it is prepared to quote you today, for guaranteed future settlement is Fr2,240/$1,050 = 2.1333. You notice that this is today's spot rate of 2.0000, multiplied by 1.12 and divided by 1.05. This is how forward rates/prices are set, by simple no-arbitrage profit/loss.

So, let's look at the outcome. You provide the bank with $1,000 and the bank guarantees to give you back Fr2,240 divided by Fr/$2.1333 = $1,050. Now, this is exactly the amount you would have got back had you invested at home, i.e. 5%.

Now, this is a hedged transaction for you and the bank and so you and the bank cannot win/lose (except for the bank's commission or fee). However, for you, you could decide not to ask the bank for a one-year guaranteed forward rate, choosing instead to leave your currency risk open. If the exchange rate moved in your favour, to below Fr2.1333/$ then you would receive more than 5% in home currency terms, BUT, if the exchange rate moved against you, you could receive less than 5% in home currency terms.

So, this is how the bank can offer you an enticing-sounding interest rate, but with hedging it is no different than home interest rates. If you choose to leave yourself un-hedged, you could be better off, or worse off !