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.

26 comments:

Anonymous said...

Thanks for your post. How do one invest in FC FD without going through the bank to prevent any rip-off?

icecold1967 said...

Hi Anonymous,

For foreign currency FD, to get the same exposure, one can open a margin fx account with brokerages houses like Phillips, CIMB futures, Saxo markets etc. to do it. Those are FX margin trading, but one can use those instrument to get the same exposure as FC FD at a much cheaper cost as illustrated in my previous posting.

tifosikrishna said...

Hi, your explanation was very lucid. Thanks.

In your example, it is case of customer selling a PUT option, is this how the product is sold always?

Are there any DCD where customer buys a CALL option along with the product? If yes, at what rate compared to the normal time deposit, they are sold?

regards
krishna

icecold1967 said...

Hi Krishna,

Normally bank structure the DCD in this way so that they can attrack customers by selling them the "high deposit rate".

If they structured a call product, the interest rate not only may be very low, it may even be that the customer has to pay the bank for the call option.

Therefore it will than be a hardsell for the bank.

As far as I am aware, I have not see product by the bank for the customer to buy a call option. However, what I am saying is a structure product you see in the mass retail market, of course, if you happen to be a private banking customer, they can structure any product for you.

tifosikrishna said...

icecold,

Thanks for your reply. In fact, as you had rightly said, all the DCD that I have seen till date (issued by different banks) are with SELL of an option for the customer.

However, i stumbled upon an example (posted below) which looked different to me, Can you have a look and let me know how it can be structured to meet the pay-off.

A typical example of this would be a Malaysian Ringit DCD at, say 7% for 6 months with an embedded FX OTC option for the full Ringit maturity amount at the maturity date against USD. This would ensure that if the Ringit depreciated against the USD during the life of the contract (actually more likely to be depreciated more than a certain amount) then the USD value would be maintained. The actual payout would be in Ringit either way, but the USD equivalent purchasing power of the Ringit amount would be protected by increasing the amount of Ringits paid if the USD has strengthened significantly.

icecold1967 said...

Hi Krishna,

From what you mentioned, it seems too good to be true. Therefore i am not sure if I miss out anything.

The deposit rate for MYR for 6 mth now is about 3.30%. The spot rate for USDMYR is around 3.2200. Therefore if I understand you correctly, you can placed a MYR deposit say of MYR100,000, and the USD equivalent is USD31,055.90. If MYR depreciate, say to 3.30, than you get back MYR102,484.47 plus interest of MYR3,509.59. If MYR appreciate, you still get back MYR100,000 plus interest of MYR3,509.59? I think this is too good to be true, so unless I am missing something, or I did not understand your description fully, I would like to make such DCD as well.

Maybe you would like to email me the website of any pdf brochure you have to my email account. Without seeing the full product description, it is difficult for me to comment on how this is structure.

tifosikrishna said...

Icecold,

Thanks for your quick response. I am afraid i have misled you. I work for a banking software product company and i took this example out a internal literature available, i guess the figures used may not be in line with actual market.

I don't have anymore material than what i have posted previously. I wanted your expert opinion on how you view the product.

From your post, i see that you concur with my view of the product.

Thanks.
krishna.

irvan said...

Hi icecold,

So by buying dual currency deposit, are we selling the bank naked put option? Does that means the potential downside is unlimited?

icecold1967 said...

Hi Irvan,

In short, the answer is "yes" to both you questions. However, for your query on the "unlimited risk", that is in theory only. In real life, it may not be that "unlimited". For example, if you place a AUD/SGD dual currency deposit, and AUD fell against SGD at you get exercise at strike say 1.27. Effectlively you buy AUD at rate 1.27 against SGD. Will AUDSGD goes to zero? I will say the chance of that happening is zero. So there may not be "unlimited" risk in that sense. Can AUDSGD goes to 1.00? Yes of course. But if you were to place a straight foreign currency deposit at the current spot rate, if that happen, you still suffer the same loss(or infact more losses)than the dual currency deposit since the current spot rate is higher than your strike price.

Squirrel said...

Hi icecold,

I am a retiree with all my savings in USD. Recently I have been placing my savings in DCD with CAD and AUD, mainly to earn a better return than standard deposit. The upsurge of the greenback in the past few days had me worried, especially after reading this article in Daily FX:
http://www.dailyfx.com/story/bio1/U_S__Dollar_Could_Rally_Further_1218233634424.html

though as a layman I could hardly understand what it meant, it sounded bad news for me. I have some DCD expiring next week and I know I'll receive the deposit in AUD and CAD for sure. In the past when that happened, based on my banker's advice and the market expectation of a weaker USD, I would simply reverse the link i.e. AUD or CAD as base currency with USD at a strike same as what I got them for. Everytime I was able to get back the USD without loosing on the exchange but made gains on interest. So far so good, however this time may be different. In view of what the article says, i.e. market expects the US bank rate will go up 144bps (btw, what does that mean?) and the exchange rate will continue upward as well. What is your advice for me at this stage? Should I buy back the USD right away and stop investing in DCD? or Should I continue my former strategy of reversing the link? When do I know when I should or should not invest in DCD?

icecold1967 said...

Dear Squirrel,

Thanks for your comments.

As usual, before I begin, I have to say that what I written is purely my personal view, and I will not be responsible for any losess incurred by anybody that follow my views and comment.

144 basis point is the jargon in money market which means 1.44%. In money market, 1 basis point is 0.01%.

if I understood you correctly, what you did is that you place a DCD (i.e. selling AUD put against USD). If the AUD fall below the strike, you get exercised and is left with AUD, you then sell a AUD call at the same strike. When the correction for AUD is over and AUD reversed back to the uptrend, your AUD call get exercised again, Therefore your USD amount remain the same, but you gain more (as compared to a straight USD deposit only) from the DCD.

You are worried now that this time may be different. I think your banker has done a good job so far from you, and maybe you would also ask your banker again for his advise.

As my my own view, it will difficult for me to give any advice since I do not know at what strike your AUD DCD is, what portion of this DCD constitute your asset allocation, what is your risk tolerance etc.

Take for example, if your AUD strike is at 0.96, it may hardly worth anything to sell AUD call at that strike. Also, if the DCD is the only asset you own, than you are taking a very high risk in the currency bet, as a bad bet will wipe out a susubstantial portion of your funds. How much risk are you willing to tolerate if AUD continues to fall before you decide enough is enough? So you see, without all this information, it is really difficult for me to make any suggestion.

As for my personal view onthe market, I think that since AUD has fall such a long way, a technical bounce is imminent, but the extent of the rebounce and the timing may be short, probably last for a few weeks, and up to 0.93-0.96. So in short, I think the AUD will stay weak against the USD for the short to intermediate term.

However, in the long term (say 3-5 years), I think the USD will underperfomance all major currencies.

So whether you should just buy back your USD and stop or continue to invest in DCD will be a personal call depending on your own risk tolearnace and time horizon.

Squirrel said...

Hi icecold,

Thank you for your valuable advice and insight. I can now have a more effective discussion with my banker.

Squirrel

shikha gupta said...

Thank you for the insight..It was really helpful

Nicolas said...

Hi icecold,
thanks for the interesting article.
I was wondering about the "naked put" wording though.

Let's say a customer is buying a DCD in USD against EUR.
The client is selling a put to the bank, which gives the possibility to the bank to buy USD (and pay for that in EUR) at maturity price.

Now the option seller (the customer) does have assets in USD to back the optino he sold to the bank.
So why is the put "naked"?

icecold1967 said...

Nicolas,

The option is naked because the customer will end up holding USD in your example. If it is a "covered" option, the customer would have a "short" positionin USD so that if the bank exercise the option, the customer get the USD from the bank, but can use it to cover his short USD position.

MaryWorth said...

Could you look at this interest rate quote and trade suggestion for a Dual Currency Deposit and tell me is my bank trying to take a major advantage of me or are they acting in my best interest?

Here is an example:
Deposit Currency: AUD
Alternate Currency: EUR
Invested Amount: AUD 100,000
Tenor: 1 week
Spot: 1.8440
Strike: (200 points) 1.8240
Interest: 6.15%p.a
Trade date: 24th April 2009
Start Date: 28th April 2009
Expiry Date: 30th April 2009 (where the contract expires)
Maturity Date: 5th May 2009 (where the funds are being credited into your Call account)
Therefore: (AUD100,000 * 6.15%)/360 * 7days = AUD119.58
On expiry should your EURAUD spot rate closes @ or below 1.8240 (strike price), you will receive AUD100,000 + AUD119.58 / 1.8240 = EUR 54,890.12
OR should it closes above 1.8240 (strike price), you will receive AUD100,000 + AUD 119.58 = AUD 100,119.58

icecold1967 said...

MaryWorth,

In this structure, you are effectively sellling an EUR put to the bank.

The bank pays you 6.15% or AUD119.58 based on AUD100,000 deposit. If you had just place the AUD100k into a time deposit based on interbank rate of about 3%, you get AUD58.33. This means that the bank is paying you 119.58-58.33= 61.24 for the option you sold.

Based on the parameters, I price the option from Bloomberg and the pricing is AUD350.

This mean that if one sell the EURAUD put, he should get AUD350. Even if we half the price, you should still be getting around AUD175....compared this to AUD61.24....well, the answer is obvious....

Anonymous said...

i personally benefit from my private bankers dci. at the end of the day its all about getting your view right and play the right range. yes bank makes a spread but there are also privileges with a banks such as information, security of your deposit etc, nothing is free. i think most importantly is are you making at the end of the day

icecold1967 said...

Never in my post did I mentioned that things should be free.

What I only say is that you can do it at a lower cost if you know how to do it yourself.

Sure, at the end of the day, if you make money from the advice of your private banker, that is good, but do not tell Ooi Hong Leong about it.... think he will get pissed of as he lost a billion because of his private banker...

Anonymous said...

I've been doing DCIs for 5 years and only now do I realise that banks actually make more than their clients (from MaryWorth's example).

Is it possible for the layman to learn how to sell a put option so one need not go through the banks? Where can we learn about forex options trading?

Thanks for any advice!

icecold1967 said...

Hi Anonymous,

It is possible by reading some books on option, but most book uses equity as example rather than fx, but the underlying principle is the same.

Having said that, it may be difficult for many people because of the jargon used in option.

Thee are brokerage house like Saxomarket that offer FX option. Alternatively, you can trade exchange traded FX option.

However, as option is effectively a derivative that "derive" from FX, one should be familiar with spot FX first before dealing in option.

Anonymous said...

Hi,

Thank you for your valuable post.

May I know what is the difference between DCI (Dual Currency Investment) and DCD (Dual Currency Deposit)?

icecold1967 said...

Hi,

I am not sure if there is any difference... it seems the same to me.

rose said...

I recently came across your blog and have been reading along. I thought I would leave my first comment. I don't know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.

Lucy

http://forextradin-g.net

icecold1967 said...

Hi Lucy,

Thks for your comments and I am glad that you like it.

It is unfortunate that I have not update my blog for a long time as I am runing out of topics to write on.

Maybe you can suggest topics of interest to you and I can than write on it.

CHeers

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