Higher rates see corporates reassess FX structured products

When it comes to deciding where to put their money, corporate treasurers tend to have a fairly simple palate. If they have excess foreign currency, the usual route involves placing it in bank deposit accounts where they can earn a steady interest rate.

While the rates offered on these accounts are far below what could be earned by putting the money into basic foreign exchange structured products, many companies have strict policies prohibiting them from doing so due to the products’ embedded optionality and the complex hedge accounting rules that apply to them.

But as interest rate differentials have made some currencies more expensive to hedge with FX forwards, many firms are reviewing their policies to include FX options as an alternative hedge. And as they become comfortable with options in general, it makes the use of structured products as an investment product more feasible.

Historically, one of the most popular FX structured products among sophisticated institutional investors has been the dual currency note (DCN).

As treasurers develop more of a taste for options, dealers hope they will venture into other capital- or yield-enhancing structures

DCNs, also known as dual currency deposits, are typically short-dated structures that feature a deposit currency and an alternative currency that stands in relation to it.

A bank would offer a higher-than-normal coupon to investors whereby they would receive either the foreign currency or the domestic deposit currency upon maturity at a predetermined exchange rate.

If the deposit currency weakens compared with the alternative, investors would get their principal back in the original currency. If the deposit currency appreciates beyond the set conversion rate at the time when the DCN expires, the bank would repay the principal to investors – as well as the coupon – in the alternative currency and at the prearranged conversion rate.

Essentially, investors fund the coupon by selling an embedded option to the counterparty at that improved strike.

Dealers say these types of short-dated structured note are starting to become popular with corporates as a yield-enhancing alternative for excess foreign cash. The idea is that if the corporate is agnostic about the currency it holds, or if it wants to sell down the alternative currency but has no set timeframe, it can earn some return instead of sticking it on deposit at a bank.

What’s surprising to some is that corporates are choosing to do it now instead of when interest rates were close to zero and they were earning almost nothing on their bank deposits.

Beyond investment products, dealers are also seeing corporates use optionality to limit their exposures on net investment hedges of foreign assets.

For example, if a UK company is hedging a physical US asset with a forward and the dollar appreciates against sterling, the balance sheet value of its asset has increased but its hedge has decreased in value. And when it comes to settling the hedge, the asset it is hedging doesn’t generate enough cash to fund the negative mark-to-market value.

Cap-loss forwards are an example of a product that can provide a way for corporates to limit the amount they would have to pay upon settlement.

The forward rate is set at-the-money to the strike and the option compensates from that point, capping the maximum loss for investors. If a corporate was exposed to euro/US dollar upside and spot was 1.00, for instance, the strike would be set at 1.10 and any losses would occur between 1.00 and 1.10. Once it moves beyond the strike, the profits from the call option would match the further negative moves from the forward.

As treasurers develop more of a taste for options, dealers hope they will venture into other capital- or yield-enhancing structures like target redemption forwards or FX autocallables. However, they may have to wait for corporates’ risk appetite to mature before they can digest such products.

Editing by Lukas Becker