The Dual Currency deposit is one of the most popular payoffs within Foreign Exchange (FX) linked structured products around the world. While FX options and OTC derivatives are very widely used for hedging and speculative purposes, FX linked structured products comprise a relatively small part of the overall market dwarfed by the dominating position of equities.
Some FX linked structured products mimic their equity counterparts, for example a medium dated principal protected product whose underlying is a basket of currencies (often emerging markets) against another (more established) currency. The return is typically a participation in the performance of the basket if it strengthens against the single currency.
A unique currency proposition
The Dual Currency deposit however is a product that does not really have an equivalent in any other asset class and thus is a true FX play. Its other distinguishing feature is that it does not “feel” like a structured product. It is popular in many countries, with one of the most active being Mexico. FX is a particular focus in Mexico due to the relationship of the country and currency with the US and US Dollar. Dual Currency deposits are issued very regularly by entities active in Mexico such as BBVA Bancomer and Santander.
One typical product issued in December 2020 has its reference currency of US Dollars (USD) and pays interest at a rate of 5.15% p.a. equivalent over its five week maturity (very short maturities are typical for Dual Currency deposits). All Dual Currency deposits also have an alternate currency, in this case the Mexican Peso (MXN). Typically, if the alternate currency weakens beyond the strike level then the investor gets their principal back in this alternate currency. Usually, the strike is set at a level which represents a few percent depreciation by the alternate currency, 2.8% in this example.
The initial level of USD/MXN, the relevant currency pair was 19.84 and the strike level set at 20.40. Therefore, if the investment is converted to the alternate currency the notional will be converted at the strike FX rate.
Hoping for currency stability
These are the common features, a high level of interest (compared to the reference currency in particular) and a slightly out-of the-money strike which will only get exercised against the investor if the alternate currency depreciates significantly. The investor is hoping that the alternate currency stays flat or up against the reference currency.
From a Mexican investor’s perspective, they hold what starts out as a USD investment and with a high rate of interest. If the currency does not move much then the investor will be happy and generally the alternate currency can weaken a little before exercise occurs. In this case the investor receives back their principal back in MXN having “sold” US dollars at a level more favourable than where the FX struck.
Typical product features
Economically, this product is essentially a reverse convertible (as used in equity stock and index products) where a high rate of interest is earned and the investor takes principal risk. In the case of an equity reverse convertible this is simply calculated as a reduced principal return, whereas for a Dual Currency Deposit it is presented as a return in a different currency.
Dual Currency Deposits tend to have very short maturities of a month or less compared to the Equity Reverse Convertibles which are usually between three and twelve months. This is a combination of the fact that normally FX volatility is lower than equity volatility and the perceived need to set the strike a few percent out of the money to absorb small fluctuations. The yield that could be offered under longer maturities for a currency pair would not be very attractive as the put option sold would have insufficient premium.
From the investment bank’s perspective, hedging is straightforward as it involves a short dated vanilla FX put option which is generally very liquid. Therefore, this product is generally very competitively priced as it would have to be since such a short maturity would not support a higher margin. Banks expect high volume flow business to make this product pipeline profitable and an active FX desk is a necessity.
The popularity of this product stems from the high rate of interest, the convenience of continual re-investment and the risk-reward profile. Investors often feel that they understand currency movements and certain behavioural finance factors can come into play about the perceived strength of the domestic currency, or not viewing an investment as loss making that ends up being paid out denominated in your home currency.
Other countries where the Dual Currency deposit is popular include Malaysia and Hong Kong, where similar currency themes are popular. They are also frequently seen in Switzerland although in that market Gold and Silver often take the role of reference currency, with the alternate currency being Swiss Francs or US Dollars. The two precious metals alongside the two important currencies have competed over decades to be accepted as safe havens and investors may well relish the opportunity of earning high rates of interest and as a worst case end up being paid back in a currency that they still view as strong even if it has declined in value. Source for all product references is www.structuredretailproducts.com.
Because Dual Currency deposits typically allow for a couple of percent decline in the alternate currency, a gradual slide in the FX over a one-year period might not trigger many losses and leave the investor happy with the interest earned. The hidden enemy of this product as for many principal at risk products is volatility and the occasional big depreciation that could prove costly.
In conclusion, an interesting construction outside the equity sphere that allows investors to earn interest while taking risk they will probably feel comfortable with.
A version of this article has also appeared on www.structuredretailproducts.com
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