Hongkongers like their foreign-currency investment products. They like their Australian dollar fixed deposits, their local currency Asian bond funds and their Singapore dollar real estate investment trusts. The investment story is basic. Interest rates are higher in markets such as Australia, Indonesia, Malaysia and India, compared with Hong Kong (see right sidebar). A three-year Malaysian government bond in ringgits yields three per cent, compared with 0.22 per cent for a Hong Kong government bond in the local currency, for example. People can also make money on the currency appreciation. If people have the view that a given currency is on the rise, they might hope for the double boost of extra yield and gains on the foreign exchange. This has been an attractive story in recent years. In the aftermath of the 2008-09 credit crisis, Asian economies stood as global pillars of growth, and regional currencies rose in value against the so-called G3 currencies (the yen, euro and US dollar). The trend is unwinding with the US dollar showing strength this year, but an investor who bought many of the popular regional yield currencies in 2009 would be sitting on gains today (see chart). Interest rates and yields are high in many of the regional markets, certainly compared with Hong Kong's next-to-zero deposit rates. So what's stopping investors from piling into, for example, Australian government bonds? The short answer is currency risk. Foreign exchange rates can be volatile, which spells risk for the investor who, when it's over, wants to convert the investment back into Hong Kong dollars. The relationship between interest rates and foreign exchange is messy. High yields seen in a given currency could suggest that inflation is on the rise - a reason not to buy the local bonds. Or the yields could be drawing offshore money into the market, a positive for the currency and bond prices. High interest rates in a given country could also be interpreted as a sign a country's economy is healthy, which is also positive for the currency. Or it could be a sign that the central bank is about to cut interest rates, which is bad for bond prices. And so on ... A high yield is no guarantee of positive returns, which is why people do not automatically invest in the currency with the best yield. 'Not many high-yield currencies are attractive; for example, the outlook for the [Indian] rupee is not positive,' says Marc Lansonneur, regional head of investment teams, Societe Generale Private Banking (Asia-Pacific). He points to the yuan traded in Hong Kong (abbreviated CNH) as a good counter-example. Yields on yuan bonds, such as dim sum instruments, are low. But the investments are popular, as the outlook on yuan appreciation is still mildly positive. The currency bet is favourable even if the yields are tiny. One might assume there is a relationship between yield and currency risk, that investments denominated in currencies with the highest depreciation risk might compensate by offering a higher yield. But this is not the case. 'If I am earning 1 per cent on a US-dollar bond, I could buy an equivalent Australian dollar bond that yields 5 per cent. You might think a 4 per cent yield difference reflects how much I would expect the Australian dollar to depreciate over the life of the bond. But the market never works that way,' says Adam Tejpaul, head of investments at J.P. Morgan Private Bank. Tejpaul cites research that has found that high-yielding currencies tend to appreciate over the long run. Ultimately, he says, fund flows drive foreign exchange markets. Interest rates can influence fund flows, but they are just one variable. For example, for many years before the credit crisis, professional traders were borrowing yen to invest in Australian bonds. Because Australian lenders paid investors more in interest than the Japanese banks charged for lending, investors made easy money on the difference. For a long time, investors also profited from the Australian dollar appreciation, because of so much money flowing into the currency. This 'carry trade' unravelled when the global credit crisis hit, and investors abandoned small-market currencies for the safety of the US dollar, euro and yen instruments. The Aussie dollar went to a high of 98 cents against the US dollar, in July 2008, then fell to 60 cents in October that year, resulting in large losses to foreign investors on their Australian dollar bonds. The Australian dollar's gyrations in that period were not driven by people's expectations of inflation or their view about the soundness of the Australian economy (the textbook reasons for currency moves). They were driven by massive, unified fund flows as global investors all piled into the same carry trade and then all exited at the same time. Hongkongers holding an Australian dollar fixed deposit at the time would have been mystified - and very unhappy - about that outcome. 'If you invested in the Australian dollar in 2008 at the top, six months later, you would have been in big trouble,' says Lansonneur. That is how currency moves can easily wipe out yield gains. A UBS report on emerging market currencies shows that foreign currency returns dominate the overall returns an investor makes on local currency bonds. In eight of the past 10 years, currency fluctuations had the biggest impact on bond returns. The currency moves can be positive or negative, but they tend to be large and volatile. (See chart.) Therefore, you need to be fundamentally comfortable with owning a large volume of the target currency should the exchange rate drop dramatically. 'It's not for novices, or for people blindly following what they read in the newspaper. Most foreign-exchange transactions are speculative,' says Edward Lam, head of foreign exchange advisory for north Asia, Deutsch Bank Private Wealth Management. That said foreign-currency-denominated investments offer diversification. Once a person decides to invest outside the realm of Hong Kong/US dollars, a world of investment choices opens up. Furthermore, every portfolio needs a certain level of risk to increase returns. A small allocation to local-currency products can balance out a portfolio that is too heavy in safe, low-return instruments. 'You need to take a view on the currency. You need to ask: 'How does it add to my portfolio?'' says Manpreet Singh Gill, senior investment strategist for Standard Chartered Bank, of such products.