Dual Currency Deposits (DCD)

5 mins read

Dual Currency Deposits (DCD) are structured products that allow an investor to earn an increased interest rate as compared to the base rate that would be earned on a regular fixed term currency deposit. Besides the enhanced interest rate, the product is designed so that the principal amount to be received at maturity is tied to the movement of the exchange rate on a selected currency pair. The DCD therefore, based on the expectation that a given base currency will appreciate against a selected alternate currency, may be used as a vehicle to convert an invested base currency amount into the alternate currency amount at a pre-defined exchange rate. The pre-defined exchange rate is known as the conversion rate or the strike rate.

The enhanced yield on the DCD is in lieu of the customer’s higher exposure to foreign exchange risk arising from having effectively written a currency call option on the base currency investment. This option gives the counterparty to the transaction the right to exchange the invested base currency amount for the selected alternate currency at the maturity date (also known as the decision date) if the strike rate is breached.

Foreign exchange risk that impacts the value of DCDs can arise from a number of factors such as political & government events, the performance of capital markets, economic conditions, movement in interest rates, etc.

On the creation date of the instrument, the customer selects the tenor, the currency pair, the base currency of the investment, the alternate currency to which the investment may be converted and the conversion rate. Based on the selection a corresponding enhanced yield is assessed that is set for the duration of the security. In general, the closer the strike rate is to the current spot/ forward rate the higher will be the yield offered on the product.

At expiry, the customer will receive the enhanced interest applicable to the base currency amount. In addition and provided the conversion rate is breached, the investment amount will be converted to the desired alternate currency amount.

DCD risk-return profile

The risks involved in this product include:

• The risk of a loss of capital investment in the base currency. This occurs if the conversion option was effected at maturity, the base currency appreciation continues into the future and if the investment, now converted to the alternate currency is converted back to the base currency.
• The risk that the investment amount will be converted at a less favourable rate than desired by the customer. Conversion is based on whether or not the strike rate is breached on the maturity date, for which there is no guarantee. If the base currency has not appreciated in relation to the alternate currency such that the conversion rate is not breached at maturity, the investment will not be automatically converted to the alternate currency. If the purpose was to benefit from the switch to the alternate currency amount at a preferred rate, that objective would not be fulfilled. The customer would need to approach the open market for currency conversion at a rate that could be less favourable compared to the strike rate. For this reason, the DCD product is not considered a hedge for currency requirements.

The enhanced yield of a DCD is an obvious advantage of investing in a DCD product. The conversion option is more complicated to evaluate. The advantages or disadvantages of this option are based on customer’s objectives. As the conversion rate is usually set above the current spot rate, if breached the conversion may be considered as an opportunity to receive a better rate than those currently available on the creation date. Alternatively, if the base currency continues to appreciate, the set conversion rate can be viewed as a disadvantage of having to forgo a more favourable market rate. Further as mentioned earlier if the customer wants to convert the amount back to the base currency he may have to suffer a capital loss over his initial investment.

If the conversion rate is not breached, the disadvantage for customers whose intended purpose was to receive the alternate currency amount is that they would now have to obtain the amount from the market at rates less favourable that their selected conversion rates. On the other hand, the option not being exercised may be considered an advantage by the customers as it means the preservation of base currency capital amount.

Examples – Brexit and DCD returns

We look at a few hypothetical examples of DCDs below. The examples are structured to illustrate how the Brexit event of 24-June-2016 would have impacted the payoff profiles of such investments.

Let us assume that the creation dates for these instruments is 24-March-2016. The tenor selected by the client is 3 months, i.e. maturity date or decision date is 24-June-2016 which incidentally happens to be the date on which Brexit referendum results are to be announced. On 24-March-2016 the spot and 3-month forward exchange rates for the currency pairs USD-JPY, USD-EUR and USD-GBP are given below. The strike rates selected by the client are also mentioned. In general, the strike rates are set above the current spot/ forward exchange rates:

The base currency in all three transactions is assumed to be USD. The investment amount is USD 50,000 for each investment. The second currency in the currency pair is the alternate currency in the structure product respectively.

If the customer had invested the amount in a regular fixed term currency deposit, let us assume that they would have earned a rate of interest equivalent to the 3-month USD LIBOR of 0.632% per annum. In this stylized setting, the enhanced yields offered on all three DCDs is 2% p.a., regardless of currency pair selected.

As USD is the first currency in the currency pairs, the principal amounts invested will be converted to the alternate currency if the spot exchange rate for the concerned currency pair is greater than or equal to the strike rate at maturity.

The following are the spot exchange rates at maturity:

While the strike rate was breached for the USD-GBP DCD product on the maturity date, this was not the case for USD-JPY or USD-EUR.

Under all transactions:

• The client receives an enhanced interest rate of USD 252.05 [50000*0.02*92/365]
• Compare this to an interest income of USD 79.65 [50000*0.00632*92/365] if they have opted to invest in the regular fixed term currency deposit.

Example # 1 – USD-JPY – Strike not breached/ Conversion not exercised

• The client receives the original invested amount of USD 50,000.
• If they immediately went to the open market to convert the amount to the desired alternate currency, they would receive JPY 5,140,000 [50,000*102.8]
• Compare this to the more favourable amount of JPY 5,640,000 [50,000*112.8] if the strike rate had been breached.
• On the other hand, as the conversion was not exercised the client has not suffered a loss in base currency principal amount and instead has made a 2% gain on his initial investment.

Example # 2 – USD-EUR – Strike not breached/ Conversion not exercised

• The client receives the original invested amount of USD 50,000.
• If they immediately went to the open market to convert the amount to the desired alternate currency, they would receive EUR 44,730 [50,000*0.8946]
• Compare this to the more favourable amount of EUR 44,750 [50,000*0.8950] if the strike rate had been breached.
• Again, as the conversion was not exercised the client has not suffered a loss in base currency principal amount and instead has made a 2% gain on his initial investment.

Example # 3 – USD-GBP – Strike breached/ Conversion exercised

• The client receives a principal amount of GBP 35,500 [50,000*0.7100].
• If the client’s situation has changed such that he requires US dollars at this point in time instead of the alternate currency amount, he would be compelled to go to the market to convert the amount back to USD. If the USD-GBP spot rate is unchanged at 0.7178, the customer will receive USD 49,456.67 in principal amount.
• Total proceeds including interest received in base currency would amount to USD 49,708.73.
• The client, therefore, has suffered a capital loss of $291.27 (-2.31%) on the initial USD investment.
• He would have been better off selecting the regular fixed term currency deposit to invest in as in that case his investment value would have been USD 50,079.65.