Question

Suppose you want to buy a US dollar deposit with Korean won but would like to be certain about the number of Korean won it will be worth at the end of a year.

Q. How can you avoid exchange rate risk by buying a US dollar deposit?

Answer 1

Whwn we buy a US dollar deposit, it in turn gives us a certain rate of interest on it. For example, a US dollar deposit may give an yearly interest of somewhere between 2-4%.

Lets say one USD is equal to 1000 Won today. If we are going to buy 100 USD, we will need 100000 Won. If we book that as a US dollar deposit for one year, and if it gives us an interest of 4%, it means we will get back 104USD at the end of the year. Now assume that Won appreciated a little and now 1 USD is equal to 980 Won only. So at the end of the year, we will get back 104*980= 101920 Won. Notice that the Wons we got back is still more than what we invested initially, even though the Won actually appreciated (which is bad for us). This is because of the 4% interest we got on the US dollar deposit.

So, we can see that due to the interest we get on the US dollar deposit, we avoid some of the exchange rate risk. Of course, if the Won had appreciated by some 10% or so, then our interest would've only covered a part of it.