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Making Sense of FX Yield Enhancement Products

The concern about the Federal Reserve “tapering” (i.e. reducing the amount of quantitative easing) has caused the demand for traditional yield investments such as REITs, bonds and bond funds to wane in recent months.

At the same time, massive funds exiting emerging markets and geopolitical uncertainty in the Middle East have led to increased volatility in the forex and equity markets. Where then to put your money if you are still looking for yield?

The Dual Currency Investment (DCI) is a forex structured product designed to provide yield and is commonly available to investors. You can easily find information on DCI at DBS, OCBC and UOB websites.

Let’s use a hypothetical example to illustrate how a DCI works.

The AUDSGD exchange rate was around 1.28 in early March. Assuming an investor puts SGD 50,000 into a DCI with the following terms:

Alternative currency: AUD

Tenor: 3 months

Strike price: AUDSGD = 1.24

Coupon = 5%p.a.

On the maturity date 3 months later, there are 2 possible scenarios:

(1) if the spot AUDSGD is higher than 1.24, the investor will get back his principal plus coupon in SGD;

(2) if the spot AUDSGD is lower than 1.24, the investor will be repaid his principal plus coupon in the alternative currency AUD converted at the strike price

AUDSGD-chart

At the time of initiating the trade, the risk-reward payoff may appear appealing; after all, the AUDSGD had hardly traded below the 1.24 level the prior year and the 5%p.a. return looked enticing in the ultra low interest rate environment. An investor may even think that getting converted to AUD might be good as the AUD deposit rate is a few times higher than that of SGD deposit rate. Furthermore, the AUD may appreciate and can be converted to more SGD in future.

On hindsight, the investor would likely not have entered into the above DCI trade. Looking at the above chart, the investor will be repaid in AUD on maturity (scenario 2). And if he had held on to the AUD till now, he would have lost a further 6% in SGD terms on the exchange rate (current 1.165 vs 1.24 conversion rate) in a span of 3 months!

The average daily turnover of the forex market is estimated to be USD 4 trillion dollars and it is a 24-hour market where participants including central banks and hedge funds, make full use of leverage and exotic derivatives to trade. I doubt retail investors (like myself) have access to the necessary tools and knowledge vis a vis the professional investors to understand and manage the risks in this extremely volatile forex market.

If I buy into a yield product, my objectives would typically be to achieve a stable return with some income generation. Can a forex structured product such as DCI effectively meet the needs of a yield investor? I don’t think so. Maybe P2P investments make more sense?