New products for the FX basket

Since late last year, risk appetite has returned among private banking and mass retail buyers of structured products. As the market bounces back, those who structure foreign exchange (FX)-based products anticipate a period of growth in 2010 and 2011.

At the more sophisticated ultra high-net-worth (HNW) end of the market, investors often put on short-term trades with a specific view on a given currency pair, and volatility in the dollar, yen, euro and sterling have all created opportunities.

In the mass retail segment, the outlook is more medium-term and products based on sudden currency movements such as those precipitated by the Greek fiscal crisis are less popular. Instead, retail investors tend to prefer a strong macroeconomic story such as that of the emerging economies of Brazil, Russia, India and China (the BRICs), which are outpacing the US and Europe and putting upward pressure on their currencies.

Certainly, the structured products market remains story driven and after buying products that they did not fully understand in 2005 and 2006 (such as accumulators), many investors are looking for simplicity and transparency, while arrangers are looking for good liquidity in the underlying and highly developed derivatives markets so they can manage their own risk exposure.

Page-long mathematical equations on term sheets are unlikely to generate much demand, either with HNWs or with the client advisors at private banks, who provide the distribution channels for structured products arrangers. Clear and simple pay-offs with a good underlying story are in fashion and plays on currency movements fit into this.

"FX was a big winner during the financial crisis and took business away from other asset classes such as equities," says James Davison, head of FX structuring for Europe at BNP Paribas in London. "The start of this year has seen some reversal of this trend, but demand for FX structured products is still good, given the overall increase in risk appetite, and we are seeing strong demand for products linked to baskets of FX as a way for investors to express a view on a big-picture story such as emerging markets or commodities."

Emerging market focus

BRIC currencies remain a popular way to play emerging markets, but private banking and retail investors are increasingly looking at other currencies such as Turkish lira, Indonesian rupiah and Malaysian ringgit.

"A growing number of investors are also switching from playing the emerging markets currencies story against the US dollar to playing it against the euro or the yen," says Mr Davison. "There is a widespread belief that the yen will underperform this year, as it looks likely to once again be adopted as a funding currency for the carry trade."

"The retail market is driven by simple pay-outs with a strong story and last year interest rate products such as floored floaters were very popular," says Tamas Korchmaros, head of FX index and investor products, currency structuring, at RBS global banking and markets in London. Floored floaters are structured products offering capital protection at maturity, plus periodical coupon payments linked to the three-month Euribor rate.

"Investors already feel comfortable with these products, so we are introducing extra elements such as FX for yield pick-up," says Mr Korchmaros.

RBS has a strong position in the German and Austrian retail markets following its acquisition of ABN Amro, and recently launched a five-year euro-denominated 2.25% floored floater for those markets, which gives a pay-off based on a basket of commodity currencies expected to appreciate versus the US dollar, especially as its power as the global reserve currency wanes.

In addition to the minimum 2.25% coupon, the investor will receive a pay-off on the maturity date based on the performance of the Australian dollar, Brazilian real, New Zealand dollar, Norwegian krone, Russian rouble and South African rand, all versus the US dollar. The notes are listed on the Frankfurt Stock Exchange free market.

"Last year there was a lot of risk aversion, but since the end of 2009 we have seen a return of risk appetite and the outlook for commodity currencies is a strong story," says Mr Korchmaros. "We are also seeing demand for products such as baskets of emerging markets currencies versus a dollar, euro and yen basket."

Georg von Wattenwyl, head of financial products advisory and distribution at Bank Vontobel in Zurich, says: "We offer clients very short-term products [in respect to] where they or their advisor have a strong opinion on where a currency such as the euro or dollar is headed over a period of a few weeks and these products can be highly tailored via our deritrade platform.

"These are shorter-term products, but in the market for structured products with a two or three-year tenor, investors are looking for a strong story, such as commodity currencies, or emerging markets currencies gaining in value versus G-10 currencies," he adds.

For example, the Vontobel unit on an 'eight Asian currencies' basket offers 100% capital protection, and pays out based on the performance (versus the US dollar) of a basket comprising the Chinese yuan, Indonesian rupiah, Indian rupee, South Korean won, Thai baht, New Taiwan dollar, Singapore dollar and Malaysian ringgit.

The deritrade platform at Bank Vontobel allows the client advisor to tailor products to the exact specifications of the client by entering parameters such as the amount of capital protection, tenor, underlyings and pay-off. In addition to a wide range of equities, the platform also includes various currency pairs, including Swiss franc-US dollar, US dollar-Canadian dollar, euro-Japanese yen and new Turkish lira-US dollar.

A growing number of banks are investing in similar electronic platforms, giving client advisors much more flexibility, where previously they had to either offer products off the shelf, or phone in requests for pricing on a pay-off requested by a client.

UBS also has a well-developed platform, where starting at only $50,000 client advisors can put together structured products, including a range of commodities and currency pairs.

Marc Honegger, global head of the fixed income, commodities and currencies (FICC) structured flow group at UBS Investment Bank in Zurich

Sticking point

Although there is growing demand for tailored products among private banking accounts, in the HNW and mass retail segment many investors still tend to stick with a few well-established stories, and products based on BRIC themes are extremely popular.

And following 12 months of slow sales right across the structured products industry in the wake of the September 2008 collapse of Lehman Brothers, strong flows have been seen into BRIC-based structured products.

Investors have become more willing to take on risk in the search for yield. This was first seen in the bond markets, where private banking accounts were prominent on many new issues. Structured products arrangers were quick to attempt to tap into this risk appetite with new products and plays on FX have grown as a way to generate yield.

An FX pay-off is viewed as a good way to get BRIC exposure. According to Société Générale, investors looking for diversification on emerging markets are increasingly interested in FX products.

Société Générale has noted that there is a strong correlation between equity and currencies in BRIC countries, much more so than for developed markets' currencies.

"Since late last year, we have seen a lot of demand for emerging markets products," says Marc El-Asmar, head of structured products sales for Europe at Société Générale Corporate and Investment Banking in London.

"In addition to equities, investors are looking for exposure to emerging markets through FX and we have had a lot of interest in products which give a leveraged play on baskets of emerging markets currencies," he adds.

For example, Société Générale has seen strong interest in a five-year product with a pay-off based on a call on a BRIC basket. It gives investors 100% capital protection at maturity, plus a 410% leveraged play on the appreciation of a basket of the four BRIC currencies versus the US dollar. The product is wrapped in a euro medium-term note.

The capital protection feature only holds at maturity, so during the life of the product it can have values in secondary lower than the initial investment level.

Capital protection is still a critical component of structured products, which presents arrangers with a challenge in a very low interest rate environment as the bonds used to provide the capital protection leave very little over to buy the options needed to create the pay-off. One solution is for investors to accept a cap on their return, which will make the trade cheaper to put on. Another is to give up some of their capital protection, although most products currently being marketed remain in the 95% to 100% range for capital protection.

Outside of the simpler BRIC basket, or other currency plays, there are also demands for dynamically managed portfolios of currency trades, including those executing carry trades between currency pairs with a sizeable interest rate difference. Some of these products were being launched two years ago, but the unfolding of the financial crisis, accompanied by global asset sell-offs and the unwinding of various carry trades, prevented them from gaining much traction.

Now that the markets have settled down, algorithmic plays on carry trades are becoming a staple of the FX structured products business.

"Algorithmic strategies have gained a lot of traction over the past year, not only in FX but also for commodities and fixed income-based structured products," says Marc Honegger, global head of the fixed income, commodities and currencies (FICC) structured flow group at UBS Investment Bank in Zurich. "They were initially targeted at the ultra-high-net-worth client segment, but are now also available to retail accounts via tracker certificates."

For example, the UBS V10 Strategy is a diversified algorithmic carry-trade strategy based on the G-10 currencies. Long and short positions are monitored on a daily basis, and once a pre-defined volatility threshold is exceeded, a long carry can be changed to a short carry. This aims to address one of the basic problems associated with carry trades, namely that in periods of rising risk aversion the trade may no longer work and significant losses may be incurred unless the trade is rapidly reversed.

"In the current market, investors are looking for uncorrelated and highly transparent products and since the algorithmic model is pre-defined and the rules are made available, it is a glass box rather than a black box," says Andre Meyer, head of the FICC structured flow group for wealth managers and Intermediaries in Europe, the Middle East and Africa at UBS Investment Bank in Zurich.

"In recent months we have had a lot of requests for structured products looking to diversify portfolios and gain access to risk," says Peter Billington, deputy global head of FX trading at Commerzbank in London. "Investors move very quickly from one story [such as yield plays] to another, and the crisis in Greece focused attention on the euro-dollar and directional plays. We have also been seeing a lot of attention on sterling-yen and euro-yen."

"Investors want simple pay-offs, mostly linear," adds Enrico Ferrante, head of FX structuring at Commerzbank in London. "One popular product is based on target options, where the investor has a series of options that can be exercised as long as the cumulative pay-off does not breach a certain level. This knock-out on the intrinsic value makes the trade cheaper to put on."

Andre Meyer, head of the FICC structured flow group for wealth managers and Intermediaries in Europe, the Middle East and Africa at UBS Investment Bank in Zurich

Push for diversification

Overall, the big drop in equities during the global financial crisis focused more attention on correlation, and institutional investors are looking to increase their exposure to commodities or FX in order to achieve greater diversification in their portfolios.

Although expert at managing equities and bonds, many institutions have little expertise in currency trading and are more likely to outsource this component. As a result, arrangers of highly tailored FX strategies, or widely available structured products ,such as those based on based on automated dynamically managed strategies, see plenty of growth ahead of them in 2010 and 2011.

And in the mass retail space, FX trades are growing in acceptance alongside the more traditional equity plays in the BRIC and other emerging economies.