Someone asked me which is better – foreign currency fixed deposits or dual currency? What is dual currency? In the example below is a real dual currency product with the example figures taken from its marketing materials:
Example: The based currency is SGD and the alternate currency AUD. Currently the spot rate is 1.2200 SGD/AUD. The strike price selected is 1.2150. The tenor is 1 month and the interest rates guaranteed 8%pa.
Current Spot rate = 1.220
Strike price = 1.2150
Two days prior to the maturity date this is what happens:
Spot rate = 1.2250
SGD/AUD is now at 1.2250 (i.e. SGD weakens against the AUD). Since this is above the strike price, you get the original principal + 1 month interest all in SGD. This is: SGD 100,000 * (1 + 8%/12) = $100,667.
Scenario 2. Spot rate = 1.2050
SGD/AUD is now at 1.2050 (i.e. SGD strengthens against the AUD). Since this is below the strike price, you will receive the AUD equivalent of the principal + interest at exchange rate of the STRIKE PRICE. This is 100000/1.2150 * (1+8%/12)= AUD 82,853. This is equivalent to 82853*1.2050=$99,838 which is a lost of $162.
Let’s analyszed the above for Scenario 1. When the AUD appreciates against the SGD, the gain which the investor enjoys is capped at 8%pa. This is fine to me as long as there is some downward protection – is there? Consider Scenario 2. AUD depreciates against the SGD causing the spot rate below the strike price and as a result the investor is forced to receive the AUD at the strike price. Since spot rate is below strike price, there is a lost due to the exchange rate differential. If the spot rate is much much lower than the strike price, it just means that there is UNLIMITED downward lost (well, the worst case lost is 100% when spot rate is 0.00 which is theoretically not possible).
For Scenario 2, receive in Aussie dollar = [100000/Strike Price](1+r)
Converts to SGD equivalent = AUD*Spot Rate = 100000(1+r)*SpotRate/Strike Price
Gain = (1+r)*SpotRate/StrikePrice.
Breakeven = Gain = 1
(1+r)*SpotRate/StrikePrice = 1
SpotRate = StrikePrice/(1+r) = 1.2150/(1+8%/12) = 1.2070
This means that if the spot rate drops below 1.2070, there will be capital lost.
From the above mathematics, it can be seen that such an instrument like dual currency offers limited gain but large losses (maximum 100%). The gain and lost potential is not in favor of the client. If what is not in favor of the client, it is than in favor of the product manufacturer. An investment is only fair if it fulfills the following quality:
- Unlimited potential gain but limited losses OR
- Limited gain but downward protection
So is dual currency meant for everybody? There are two ways which the dual currency is marketed:
- Dual currency is often marketed as allowing investor to express their currency views. So if the investor feels bullish in AUD, he or she will buy into this idea and in the above example will get 8%pa of interest. But there is a problem, if the client is bullish in AUD, why not just buy into a plain vanilla AUD fixed deposit? At least the upside is unlimited. For dual currency, there is no downside protection which is the same as the AUD fixed deposit. Thus, a person who is bullish in a particular currency shouldn’t be using the dual currency!
- Dual currency is often marketed to people who are neutral to both the base and alternative currency. This is really silly. If a person is neutral to both currencies – which means currency exchange risk is immaterial – than is it not more appropriate to just place the money in plain vanilla fixed deposit of the currency that yields the highest interest rates? Why bother about strike price and spot rates and nonsense?
25 March 2008 addition: Apparently I heard dual currency is selling like hotcakes. Yet oh why oh is this so when the product is so lousy? It is really a amazing to know that salespeople can sell such lemons so easily. An investment product which cap the upside but causes a investor full currency exposure at the downside is to me a crazy deal.
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