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Dual Currency Deposits – Do You Know You Have Become the Insurer?

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Dual Currency Deposits – Do You Know You Have Become the Insurer? S T R A T E G I C INVESTMENTS Dual Currency Deposits – Do You Know You Have Become The Insurer? By Eng Tiang Chuan Avoided like the plague during the financial crisis, structured products are reviving like green shoots after a long awaited rain. Dual Currency Deposits in particular, have been really popular. Depositors may not have understood the risks involved. Structured products earned a bad name after version is diverted away to the possible uses or Conversion Rate which is the pre-agreed the Minibond saga in 2008. Many investors of the new currency, for example, using it for exchanged rate. were badly burnt during the worst financial a holiday, paying for children’s education or crisis in living memory. Not all structured for business. Not explained are the risks in- Put-option buyers generally have a bear- products are bad. However, a big number volved in this type of structured product. ish view or wish to protect their holdings. To of investors did not understand the risks in- By entering into the Dual Currency protect the position, a put-option is bought volved and were shocked to see their invest- Deposit, the depositor has actually sold a and the option premium paid to the put-op- ments turn into waste paper during the crisis. Put-Option to the bank. There are different tion seller. The put-option allows the option While some structured products are variations of the structure available. Before buyer to sell the asset at a pre-determined easily identifiable, others have been mis- explaining how one type of DCD structure price (strike price) if the asset price drops as taken for having the low risk nature of plain works, let’s take a look at the terms used in anticipated. The put-option seller, having vanilla deposits. Dual Currency Deposits the structured products: collected the option premium, thus has the (DCD) are highly popular yet greatly misun- obligation to buy the asset from the option derstood. Numerous investors were shocked • Put-Option – A right, but not the obliga- buyer at the pre-determined price. when told that their deposits had suffered tion, to sell an underlying asset at a pre- In a DCD, the bank is the option buyer huge losses along with the many other in- agreed price at a pre-determined date. and the depositor is the option seller. The vestments when they thought that deposits • Put-Option Seller – The party that has sold bank will typically sell the put-option bought were supposed to be low risk. Many deposi- the Put-Option. Has the obligation to buy from the depositor in the secondary options tors went ahead with the deposits without the underlying asset at the pre-agreed market or use it for internal hedging. If the realizing they have actually entered into a price and date. option is sold in the secondary market, part derivative contract. • Put-Option Buyer – The party who has of the option premium collected from the A well-encountered sales pitch for DCD bought the Put-Option. open market is passed to the put-option would typically emphasize the higher inter- • Option Premium – The price of the option. seller in the form of the higher interest. The est potential compared to a normal deposit. • Strike Price – The pre-agreed price. In a bank takes the rest of the premium as earn- Attention on the scenario of currency con- DCD, the strike price is called the Strike Rate ings. If the option is used for internal hedg- 40 ISSUE 15 INVEST JUN/JUL 10 ing, the bank is able to buy the put-option ance contract (put-option). case scenario. However, if the insured event cheaper than what is available in the market. When the option structure is applied occurs, ie, the exchange rate of the alternate A simpler way of looking at the arrange- to the DCD, the depositor becomes the in- currency drops versus the base currency, the ment is through an insurance perspective. surance company who sells the insurance depositor has to pay the life insured the base The put-option seller is the insurer. The put- policy to the bank who is the life insured. currency (which is the stronger currency) and option buyer is the insurance buyer look- In exchange, the bank pays an insurance take the alternate currency (which is now the ing for insurance protection (to protect his premium for the protection. The insured weaker currency). The exchange rate is the investment position). The insurance buyer event is the drop in exchange rate versus strike rate which is pre-determined. The fol- (put-option buyer) pays an insurance pre- the base currency. When nothing happens, lowing figures illustrate how the DCD works. mium (option premium) to the insurance the depositor will pocket the insurance pre- company (put-option seller) for the insur- mium and pay out nothing. This is the best At The Start of Dual Currency Deposit Sell Put Option (Insurance) to Bank to protect against drop in exchange rate of AUD vs SGD. The exchange rate, called the strike rate, is fixed in advance. Depositor Bank (Insurer) (Life Insured) Holds the Base Holds the Alternate Currency eg, SGD Currency eg, AUD At Maturity of Dual Currency Deposit Exchange Rate of AUD/SGD is Above Strike Rate Ie, AUD strengthen against SGD Bank Pays Premium for Put Option (Insurance) in the form of higher interest Depositor Bank (Insurer) (Life Insured) Holds the Base Holds the Alternate Currency eg, SGD Currency eg, AUD YOUR INVESTMENT INSPIRATIONS 41 At Maturity of Dual Currency Deposit Exchange Rate of AUD/SGD is Below Strike Rate Ie, AUD weaken against SGD The Bank takes delivery of the Base Currency (SGD) Bank Pays Premium for Put Option (Insurance) in the form of higher interest Depositor takes delivery of the Alternate Currency (AUD) at the pre-determined exchange rate, in effect, taking less than Depositor Bank what the current exchange rate (Insurer) (Life Insured) would have provided Holds the Base Holds the Alternate Currency eg, SGD Currency eg, AUD As many DCD depositors found out, curren- bers where risks are spread out. For the the Minibond holders made. Do not assume cies such as the Australian dollar dropped as DCD Depositor, there is no risk pooling. that there will be another round of compen- much as 30% against the Singapore dollar He bears all the risks. A single big currency sations. Don’t become an Insurer if you are during the crisis. Many depositors were con- movement against him could cause huge not ready to be one. verted to the weaker currency at easily 20% damage. to 30% higher exchange rate, thus suffering • An equity investor is compensated with the big losses even after the higher interest rate. upside by taking on the risk of downside Written By: Eng Tiang Chuan There are a few points that DCD deposi- movement. In fact, theoretically, there is tors have to take note: unlimited upside (share price goes up and Eng Tiang Chuan is a Chartered Financial up) and limited downside (share price goes Consultant with PromiseLand Independent. • The depositor always receives the weaker to zero). In the case of a DCD, for a limited He is licensed by the Monetary Authority of currency (beyond the strike rate). Should upside (higher interest), the depositor takes Singapore to provide financial advice. the Alternate Currency (eg, AUD) appreci- on a much higher downside risks (huge ate against the Base Currency (eg, SGD), the currency movement). The depositor effec- Email: [email protected] depositor still holds on to weaker currency tively becomes the Insurer for the currency Tel: 6505 4100 (SGD). In the event the Alternate Currency fluctuations. Website: http://www.ifa-sg.com depreciates against the Base Currency • When promoting the DCD, the relation- beyond the strike rate, the depositor is left ship manager would typically emphasize Although every reasonable care has been with the weaker Alternate Currency (eg, the uses for the currency should there be taken to ensure the accuracy of the infor- AUD). a conversion. Is there really a need for the mation contained in this article, the author • The exchange rate used for converting to currency or is the ‘need’ just a marketing cannot be held liable for any errors, inaccu- the Alternate Currency is not the spot (cur- gimmick? racies, and / or omissions however caused. rent) exchange rate. The conversion takes • Deposits are low risk savings. If the deposi- This article represents the personal views of place at a disadvantageous rate which tor needs or wants a low risk product, a DCD the author and is for information only and was decided in advance. Depositors could is definitely not for them. does not constitute an offer or solicitation suffer huge loses being forced to convert at of any purchase. Any advice herein is made the higher rate strike rate. In order words, Despite the lessons from the Lehman Mini- on a general basis and does not take into ac- the depositor can convert currencies at the bond fiasco, Dual Currency Deposits are still count the specific insurance and investment current exchange rate which is much lower. aggressively peddled to depositors. Carry- objective of any specific persons or groups of • With a DCD, the depositor effectively be- ing an inappropriate name with the word persons. The reader may wish to seek advice comes an Insurer. Insurance works on the ‘Deposit’, non-discerning depositors could from a financial adviser before purchasing. basis of risk pooling and law of large num- again be making the same mistakes that 42 ISSUE 15 INVEST JUN/JUL 10.
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