How to profit from currency movements

The US dollar is near the lowest level in its history compared with a basket of other major currencies. So far this year, the greenback is down 13% against the Japanese yen and 8% against the euro, as the US Federal Reserve continues slashing interest rates amid fears that America is already in recession. With things likely to get worse before they get better, there's little sign of respite for the dollar.

So how can you profit from currency movements? The classic solution is to spreadbet (and subscribers can read more about this in the supplement that comes with this issue). But if that's a little too risky for your tastes, you might want to look at a currency fund instead.

Currently, you can buy eight major currency exchange-traded funds (ETFs), including the euro (FXE), sterling (FXB), yen (FXY) and Swiss franc (FXF). Designed to track the underlying currency's movements against the dollar, they are one of the simplest ways of playing the forex game, and with management fees of 0.4% a year, among the cheapest.

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However, spotting an opportunity, several banks have launched funds tracking more exotic currencies. The latest is Morgan Stanley, with the launch of Market Vectors-Chinese Renminbi/USD ETN (NYSE Arca:CNY) and Market Vectors-Indian Rupee/USD ETN (NYSE Arca:INR). Each is designed to track the performance of the S&P Total Return Index in each currency; the renminbi version was up 8% in 2007.

If you don't want to bet on a specific currency's performance, but think the dollar will keep falling, there are three options open to you: the ProFunds Falling US Dollar (FDPIX), Rydex Weakening US Dollar 2X Strategy (RYWDX) and Direxion Dollar Bear 2.5x Fund (DXDDX).

ProFunds rises as the dollar falls against a basket of currencies. The latter two are a tad more complex in that they use leverage to boost returns. The Rydex funds is leveraged to a multiple of two, meaning you should gain or lose twice as much as the ProFunds fund. The Direxion fund is even more risky, with a leverage of 2.5.

These are all worth investigating. But one of our favourites is the PowerShares DB G10 Currency Harvest Fund (DBV), which uses futures contracts to take long positions in the three highest-yielding currencies of the G10 countries, and shorts the three with the lowest. Using this strategy between 1994 and 2007 would have turned $10,000 into $51,754, compared to $41,986 made from investing in the S&P 500 and $15,826 from US treasury bills.

Do be aware that all the above funds are listed in America and are therefore denominated in dollars, meaning there is a currency risk in buying them in sterling. However, given that the outlook for the pound is also pretty grim right now, with the UK facing many of the same woes as America (see: Britain follows America into recession), we think this is a reasonable risk to take.