November 7, 2007

Dual Currency Deposit

My ex-colleague told me the other time that she just placed a dual currency deposit whereby she get a higher interest rate compared with a normal SGD fixed deposit. She asked for my view on this instrument. She is a little concerned after her colleague, who is a treasury manager working with her, told her that it is a risky investment.

To understand if this is a risky instrument, I told her that she need to understand how does it work. In a dual currency deposit as for her case, she has SGD and thus SGD is her base currency, and AUD is her alternate currency. By placing her SGD into a dual currency deposit, effectively she is selling a “put” option – an AUD put, to be specific against SGD. In return for this option that she sold, the bank “compensate” her by giving her a higher interest rate for her SGD deposit. Therefore, if the strike is at say 1.2500, and upon expiry if the AUDSGD rate goes below 1.2500 to say 1.2000, she will take delivery of the AUD at the rate of 1.2500, instead of being able to buy AUD at 1.2000 (which is cheaper). The question is than whether she thinks that the AUDSGD rate will be above 1.2500 when the deposit mature.

From the looks of it, I told her that the AUD will likely to strengthening against the SGD and thus she need not be overly concerned.

So as far as investor is concern, such instrument can enhance the yield because investor is selling a naked put option to the bank. As long as the investor understands what the dual currency deposit comprise of and the directional view of the currency pair, it is not as risky an instrument.

For me, I am more particular about the pricing of the product. The bank always priced this type of product in order to rip of the customers. So I went to a bank to ask them for a quotation for a dual currency deposit on NZD against USD to see how much the bank rip the customers off, and this is what I found:

Current spot NZD/USD: 0.7835
USD interest rate for 1 month: 16.5%
Strike: 0.7785
So you receive USD14,208.33 if you deposit USD1 million in the structure.

I than check the inter-bank rate for the option pricing for NZDUSD, and it is as follow:

As you can see, the premium for the option is 1.5687%. That is to say, if you sell a NZD put against the USD for USD1 million for 1 month, you can receive USD15,686.99. On top of that, you still have your USD sitting in the bank, and assuming you set aside USD100,000 as margin, your balance of USD900,000 should earn you interest. At a rate of say 4.5% for 1 month, it can earn you USD3,487.50.

Therefore, all in all, if you sell naked put option on the NZD put on margin, you can achieved the same risk payoff at a cheaper price. How much cheaper? Well, through the selling of naked put option plus the deposit, you received a total of USD19,174.49. The bank pays you USD14,208.33, and the difference is USD4,966.16.
on top of that, because the bank quoted me a spot NZDUSD rate which is 20 pips away from the interbank spot rate, that will cost me another USD2,000. So all in all, it is about USD6,966.16.

Of course, I am basing on USD1 million. If you work out base on USD100,000 it will be about 10% of it.