Using Derivatives for Enhanced Yield
In recent years, a relatively low interest rate environment has encouraged savers and investors to examine alternative investment products in search of more attractive returns than are generally available from fixed-term interest-bearing deposits.
This has prompted the banking community to work towards the introduction of a wide range of structured products, whose returns are dependent not on simple interest rates, but on the performance of an underlying-market, such as a stock market index, or a commodity price.
The wide range of derivatives now traded in the financial markets has proved ideal for building the foundations of many of these products. Indeed it is often possible to create a structure whose return can be enhanced whichever way the underlying market moves.
Investors can now choose from deposits whose returns depend on:
- The rise in an individual stock or equity.
- The rise in a market index, such as the Dow or the Nikkei.
- The movement in an exchange rate.
- The price of a commodity such as precious or base metals.
Investment structures can even be created that are 'market-neutral', where it is possible to create conditions in which a return can be obtained even if there is little or no movement in the underlying market. Examples of some of the more unusual offerings might include returns based on an exchange rate staying within a pre-agreed range or a stock market index neither rising nor falling by more than ten per cent. These are often referred to as 'path dependent structures, as the final return from the investment depends mainly on an underlying market performance.
Most of these investments are created using various derivatives, although the customer has no risk exposure to the derivative itself. This is borne by the bank. In each case, the depositor's initial capital will be returned in full, whatever the resulting payout.
Many of the structured deposits illustrated here are derived from 'Digital' (also known as 'Binary') options where a pre-agreed multiple of the initial premium is payable if the pre-determined market conditions are achieved.
FX Touch Deposit
The most basic form of this investment vehicle involves a simple exchange rate scenario.If a certain pre-agreed exchange rate trades
at any time during the lifetime of the option, an enhanced return is paid on the investor's kinds.If the agreed rate never trades,a
minimum return is paid.This could be as low as zero, but the enhanced return, if payable, will always be higher than the corresponding
market rate for a Fixed term deposit in that currency.
FX Range/ Double No Touch Deposit
A slightly more complex version of the FX Touch Deposit, which pays an enhanced return if an exchange rate remains at all times within a range between two pre-agreed levels.
For example, spot EUR/USD is 1.2150. Current 3-month USD money market deposit is 3.50%. If EUR/USD remains between 1.1750 and 1.2550 for the next three months, an enhanced return of 5.75% is paid to the investor.
FX Tower Deposit
This is similar to a FX Range Deposit, but with a series of ranges. In the example above, there might also be additional enhanced returns of, for example, 7.25% if a range between 1.1850 and 1.2450 remains unbroken, and a return of 8.50% if a range between 1.1950 and 1.2350 is also unbroken. If all three ranges are broken, the return is zero, with a repayment of initial capital only.
Dual Currency Investment ('DCI')
This is another investment product that offers the possibility of a higher return than is available for current money market rates.
The most unusual feature of a DCI is that repayment maybe made at the bank's discretion in a different currency from the one originally chosen by the customer. The exchange rate applied to this conversion is agreed prior to the outset of the investment, but is normally set at a favourable rate for the investor compared to the current spot level. The closer the conversion rate is set to the current spot rate, the better the enhanced return will be.
The DCI is most suitable for investors who seek not only an attractive return for their funds, but who also have an underlying requirement to purchase the second currency at an attractive rate compared to current spot levels.
Range Accrual Deposit
This product provides the investor with an enhanced return if a related market (for example three-month USD LIBOR) remains within a pre-determined range.
The term 'accrual' refers to the enhanced amount increasing on a day-by-day basis provided the market rate remains within the range. A 'nil' return is achieved on any days that the market is outside the range.
Ratchet Deposit
This is a deposit whose return depends on the level of interest rates for the PREVIOUS deposit period.
For example, a customer might receive the hi9her of either the previous interest rate for the corresponding period, or a return based on the difference between a pre-agreed figure and the current rate.
Capital-Protected Equity Linked Deposit
This is a slightly different structure, as it is based on the performance of an underlying stock market index, or even an individual stock or basket of stocks.
It can be structured to produce an enhanced return if a stock rises, or if the price falls, or if a basket of stocks remains within a pre-agreed percentage range of the initial level.
The initial capital investment is always guaranteed, and the deposit will be structured to ensure that, where there is an enhanced payout, it is always higher than the comparable return from a conventional deposit.
Target Redemption Note ('TARN')
The TARN represents a more complex structure, and can be seen as more of a long-term investment vehicle, but it is possible to create some very attractive returns if market conditions are suitable. This investment would not be suitable for a client who may require access to the funds prior to the maturity date.
The initial capital invested into a TARN structure is guaranteed by Emirates NBD.
A typical TARN structure would offer investors a very high return in the first 1 or 2 years, followed by a return based on the per¬formance I behaviour of an underlying market. This could be anything ranging from a basket of equities (or equity index), to a series of exchange rates or even the shape of the interest yield curve. Each investment has a 'gross target retum.'
Once this return has been achieved the initial deposit is returned to the client in full .and the client is free to reinvest the funds elsewhere.
Unlimited returns based on the upside movements of, for example, twenty major international equities through synthetic investment structures also represent a relatively low risk exposure to stock markets. This is in contrast to simply purchasing the equities individually, in which case there is unlimited risk to capital if there is a fall in the share price.
