Marc Gerstein (Reuters.com) submits: Potential U.S. economic softness and the prospect of a weaker dollar may boost the appeal of foreign currency plays. Nowadays, it's getting a lot easier for the average investor to do that without having to deal with the margin risks often associated with futures trading. One approach would be to purchase one or more of the Rydex currency-based exchange traded funds, known as CurrencyShares Trusts and available to track the Euro (NYSEARCA:FXE), the British Pound (NYSEARCA:FXB), the Canadian Dollar (NYSEARCA:FXC), the Australian Dollar (NYSEARCA:FXA), the Swiss Franc (NYSEARCA:FXF), the Swedish Krona (NYSEARCA:FXS), or the Mexican Peso (NYSEARCA:FXM). Those attracted to a theme based on general global economic development, as opposed to the specific fundamentals impacting any of the aforementioned, and for the most part well developed, economies have another choice: Principal Protected Notes Linked to a Basket of Emerging Market Currencies (ECN) [often referred to collectively as BRIC] offered by Wachovia Corporation (WB-OLD).
The notes, which mature on April 6, 2008 but are in all other respects configured to trade as stock, do not offer direct investments in any currencies. Instead, they are derivatives in the sense that their returns are tied not just to the creditworthiness of the borrower, Wachovia, but also to the performance of some other asset. In this case, it's a "basket" of assets, namely, the Brazilian real, the Chinese yuan, the Indian rupee, and the Russian ruble.
Assuming one is willing to accept the credit risk associated with Wachovia, which has an A credit rating from Standard & Poor's, the other risks are surprisingly low. The worst-case scenario is a repayment by Wachovia of the $10.00-per-share face value with no interest. That would represent a 2.9 percent loss for those who buy at the current market price which, at $10.30 per share, includes a mild secondary-market premium.
That unfavorable outcome would occur if the value of the currency basket on the maturity date, calculated as the equally-weighted average appreciation rate [against the U.S. dollar] of the four currencies, winds up at or below zero.
Indeed, that would be the case if the note were to mature based on Tuesday's exchange rates.
The fact that the market price of the notes, $10.30, exceeds their $10.00 hypothetical here-and-now payoff value is partly a reflection of an inefficient market — the issue size is small, approximately $10 million, and trading volume tends to be low. But there's more.
For one thing, the upside opportunity is magnified to the extent that if the performance of the basket is positive, the payoff is calculated based on 155 percent of the appreciation. In other words if, on April 6, 2008, the average appreciation of the currency basket is 5 percent, the notes will be worth $10.775 [5 percent appreciation times a 155 percent participation rate equals 7.75 percent which, multiplied by $10.00 comes to $10.775]. If the basket appreciates 10 percent, the notes will be worth $11.55.
The other valuation consideration is, of course, tied to expectations for the basket currencies.
Many investors believe the Chinese yuan, specifically, is undervalued and is very likely to appreciate.
The other currencies tend to invite more debate.
For Russia, the Organization for Economic Co-operation and Development [OECD] expects inflation to moderate from 9.0 percent in 2006 to 8.5 percent in 2007 and 7.2 percent in 2008. That could lead to a rise in the ruble's exchange rate.
In Brazil, interest rate cuts are expected by the OECD to enhance real GDP growth through 2008. If that expectation pans out, the real may move higher; indeed, this is the only currency in the basket that is up at present.
India is the biggest question mark right now; its currency has been the worst performer since benchmark exchange rates were fixed. Recent reports of a widening trade deficit there may keep the rupee under pressure for a while.
Beyond specific developments in the countries whose currencies are included in the basket, financial developments in the United States are relevant since the dollar is the across-the-board reference currency. That may be the consideration that looms largest to most investors if we continue to see indications of dollar weakness in response to domestic economic trends, as well as ever-present talk of central bankers diversifying their currency holdings away from dollar-denominated assets.
To quantify some expectations, assume an investor would hope to achieve a 5.5 percent annualized return. That would be a healthy outcome considering the notes have a bit less than a year and a half to maturity, and compared to the approximately 5 percent yield on two-year U.S. corporate bonds. To achieve a 5.5 percent return here, based on a market price of $10.30, we'd need a final price of $10.87.
Factoring in the 155 percent upside adjustment factor built into the notes, we'd need to see the currency basket appreciate at least 5.62 percent. If, hypothetically, the rupee winds up 5 percent lower, the other three currencies would need to appreciate 9.15 percent on average to generate our target return.
If, in addition to a 5 percent depreciation in the rupee, we also see a 12 percent gain for the yuan, which would bring it to $8.86, that would leave us needing a 6.22 percent appreciation, on average, for the ruble and the real.
Price changes of such magnitude, while by no means easy to forecast, are well within the realm of possibility in the currency markets. Indeed, both the rupee and the real have experienced moves along those lines earlier this year. Looking ahead, though, future price shifts could just as easily pull the basket down. That's why the asymmetrical distribution of probabilities, 155 percent of any gain with a $190.00 floor to the downside, is so important here.
Disclosure: Author owns shares of ECN
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