Dual Currency Options

Some may have heard this, some may not. Some think of this as a high risk product, to me it is safer than equities with a guaranteed interest which is quite high.

Dual currency options is a short term product, from 1 week to 3 months. It is usually done in big amounts by priority/private customers. As this is a classified as a high risk and complicated product, most aunties and uncles do not understand the mechanism.

How does it work? Basically, you are selling an currency option to the bank, whereby the bank pays you the premium for it. It usually comes in 1 week, 2 weeks, 1 months, or 3 months for you to choose. We will pair your SGD with an alternate currency, say NZD. When it matures, you either get back SGD or NZD, whichever currency is weaker. At the same time, you gain the premium.

Let's assume NZD/SGD current spot is 1.04, we pair SGD $100,000 with NZD at the strike rate of 1.03 for 1 month, yield 10% pa. This means that if NZD/SGD > 1.03 after 1 month, then you get back SGD $100,000 + 10%pa interest = SGD $100,833. If NZD/SGD <= 1.03, ie your money is "striked" at the rate of 1.03, which means you get back NZD $97,087 + 10%pa interest = NZD $97,896. For both cases, you are guaranteed to get 10% pa interest, So no matter what currency you got back, you still earn effectively 10% pa for that period you put in. The buffer for this case is 100 pips because you strike it at 1.0300 against the current spot at 1.0400. If you select your buffer as 50 pips, that means you will strike at 1.0350 against the current spot at 1.0400. 50 pips is more risky than 100 pips, because it is nearer to the spot rate.

So how would we make a loss? Loss is made if NZD falls beyond your strike price. In the previous example, my strike price is 1.0300 against current spot 1.0400. One month later if spot drops to 1.0172, my placement gets converted to NZD, which I'll be getting NZD $97,896. When the spot is 1.0172, it means that my NZD would be worth (NZD $97,896 X 1.0172) SGD $99,583 which means I lost SGD $417 even after 10% pa interest. However, if one month later spot drops only to 1.0236, my NZD will be worth (NZD $97,896 X 1.0236) SGD 100,208 which means I still make a net gain of SGD $208 despite the drop in NZD beyond my strike price. To add on, technically speaking trading dual currency options is really not as risky as equities. With spot at 1.04, strike at 1.03, yield at 10%pa, you can afford to have the spot to drop to 1.0215, which is the breakeven point. Hence, there is a buffer of total 185 pips from the spot.

Pls see table illustration below:

				If Reconverted to	Interest
	NZD/SGD	At Maturity		Base CCY SGD	(p.a.)
	1.0414	100,833.33	SGD	N.A.	10.00%
	1.0409	100,833.33	SGD	N.A.	10.00%
Current Spot Rate:	1.0400	100,833.33	SGD	N.A.	10.00%
Strike Price:	1.0300	100,833.33	SGD	N.A.	10.00%
	1.0257	97,896.44	NZD	100,416.67	5.00%
	1.0236	97,896.44	NZD	100,208.33	2.50%
Breakeven point:	1.0215	97,896.44	NZD	100,000.00	0.00%
	1.0172	97,896.44	NZD	99,583.34	-5.00%
	1.0130	97,896.44	NZD	99,166.67	-10.00%

The yellow region indicates we get back SGD 100,833, while the green region indicates we get back NZD 97,896, with the margin at the strike price 1.0300. From this table, you may think that the upside potential is limited. It is true because you are getting back in base currency, SGD. But with 10%pa, I don't think anyone should complain about it. The good thing is that it provides enough cushion if the market goes against you.

The grandest thing about dual currency is that you will buy the currency cheaper than current spot. Back to the example, if I approach the bank teller to place NZD FD, she would sell me at 1.06 given the current spot is only 1.04. If I buy from the banker through dual currency, I can buy much cheaper at 1.03 and still make a gain of 10%pa upfront. You do the math.