February 26, 2008

Capital Protected Note in EUR

Last month, my boss gave me a note. The note outlined a structured product call Capital Protected Note (CPN). My boss was very excited over the product and asked me what I think.

The CPN works like this :

"The CPN enables you to participate in the positive development of an equally weighted currency basket composed of a selection of 5 emerging currencies (BRL, RUB, IDR, INR, ARS) against USD while remaining invested in EUR."

If the basket of currency falls, you get 101.50% of your capital upon maturity. If it appreciates, you get 117%.

Once I saw such structure, I immediately know that the bank is trying to rip the customers off. The bank do it by several ways, but before I get to that, I need to break down the components of the structure.

1) The bank take your EUR which has a higher interest rates compared to the USD. They than hedge it buy doing a currency swap, whereby the interest rate differential is in their favor. In this way, no risk of the EUR/USD exchange rate is hedged and therefore there is no risk for the bank. They than tell the customer that the customer can invest in EUR without any EUR/USD risk, which in actual fact, the customer lost out!. The estimated lost to the customer is about 0.50% on this component.

2) The bank than go and buy what we call a "basket option" of the 5 currencies. Specifically, the bank buys a USD put against the 5 currencies. A basket option is cheaper than if the bank were to buy USD put against each individual currency because as a basket, there is diversification and offsetting of the volatility. The is the second component that the bank rip customer of without telling them.

3) Because the USD interest rate is very low and the basket currencies are of high interest rate currencies, the USD put is very cheap. So what the bank does is to take the customers' money, use a small portion to buy option, and than invest the balance into instrument like FD or T-Bills. The yield from FD and T-Bills will be more than enough to cover the cost of the option and thus making the structure "capital protected". The bank than charge a "management fee" of 1%.

The customer, like my boss, were trailed by such products because they do not understand how it was structures and how it can be done cheaply by themselves.

However, I feel very sad after I showed my boss how we can structured the same product at a lower cost and also avoiding paying the bank 1% management fee. My boss, who is initially very excited with the product, lost interest just because I show him I can structured it. He must be thinking if I can structured it, than the product must be not very complex and thus do not want to invest in such simple product.




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5 comments:

Ninje said...

That's brilliant man! Keep them coming. It's fascinating to read how you engineer these structured products.

weirdo san said...

Hi Pal,

It's been quite some time that I have last visit your site. Hope you still rem me. This thing you wrote abt the CPN i dont really quite understand.

Anyway, just to let you know. I failed my CFA!! =~(

You should write more if you have the time. Its really excite me reading such stuff! Keep it up

tifosikrishna said...

Hi, very nice explanation of the product.

Thanks.

What I don't understand is that how the bank agrees to pay 17% if basket of currencies appreciates?

I understand that the bank has bought a PUT option in USD against the basket, but the point is, on exercise, the option should be adequately in-the-money to pay 17% back to the customer.

I also understand the of the 17%, some of the interest expense can be borne by the interest the deposits ea rns via T-bills, but will it always add up to a minimum 17%?

sorry, if the question is so naive..

regards
krishna.

icecold1967 said...

Hi Krishna,

Actually it is my fault that I did not write clearly.

Actually the product pays "up to 17%", not pay 17% if the basket of currencies appreciate.

Therefore, if the basket of currencies go nowhere, than you may get 0%.

tifosikrishna said...

icecold,

Now it is clear.

Thanks and keep posting on some of the interesting products that you come across.

I have bookmarked your URL and hope to visit on a regular basis.

regards
krishna.