Double currency Units ("DCU"), also called Double Currency Notes ("DCN") or Double Currency Investments ("DCI"), are a form of short term bonds that have an embedded option allowing the issuer to redeem the bond including the coupon in an alternative currency. In compensation for taking that risk, the holder of a DCU is entitled a higher than normal coupon. In a nutshell, a DCU is a short-term currency investment, in which the initial investment is redeemed in the currency that weakened against another.
In essence, a DCU is nothing else than a fully-funded short-put option on an alternative currency. As such, with most DCU’s maturing one or two months after being issued, they can be considered as short-term currency investments, rather than having a bond-like character. These instruments fit investors who are indifferent over holding either the reference or the alternative currency. As with other instruments, which embed a short option, a good time to invest is when volatility is high and expected to decrease, or when the currency pair is expected to move sideways. A special attention is to be taken as to the smile. The smile denotes the observed fact that out-of-the-money options feature a higher volatility than at-the-money options, for a given maturity. Unlike in equities, where the out-of-the money call options are usually “cheaper” than out-of-the-money put options (that’s why in equity jargon the term “smile” has been replaced by “skew”), the smile in the major currencies is quasi-symmetrical. The higher the smile, the more premium a seller of puts or calls gets when choosing an out-of-the-money strike.
The DCU has two components: one money-market investment in the reference currency and one short put option on the alternate currency. The money market’s interest and the option’s premium together form the coupon. Two scenarios are possible at maturity: either the alternate currency stayed strong (i.e. remained over the strike of the short put) and the invested notional is redeemed in the investment currency along with the coupon, or it weakened past the strike and the product is redeemed in the alternate currency, along with the coupon. In other words, the investor ends up with the weaker of the two currencies. Hence, the advice mentioned above not to invest in such a product if the investor cannot live with the risk of his notional being converted in the alternate currency.
Imagine a global investor whose reference currency is the EUR but who also holds assets in the USA and Asia. He is bearish the EUR, thinking that the USD exchange rate could strengthen against the EUR. In addition, the EUR/USD volatility is currently high, because of a trade dispute between the European Union and the USA. Since the short-term interest rates in USD are very low at the moment (3-month LIBOR rate at 0.5% p.a.), the investor would like to enter a EUR/USD double currency unit. His target yield and investment horizon are 6% p.a. and 1 month respectively. He has EU 400k to invest. These are the product data:
- Notional: EUR 400’000.00
- EUR/USD spot: 1.4650 (1 EUR buys 1.4650 USD)
- Coupon: 6% p.a. (equals to 0.5% over 1 month)
- Strike: 1.4900 USD per 1 EUR (equals to 101.70% of spot)
With this structure, the investor will keep his EUR as long as the USD doesn’t weaken by more than 1.4900 per USD. (scenario 1) If the EUR/USD were to close above that level at maturity, the product would be redeemed in USD, converted at 1.4900 USD per 1 EUR, along with the coupon of 6% p.a (scenario 2). The coupon is paid in any case. In scenario 1, the investor ends up with EUR 402'000.00. In scenario 2, the investor ends up with USD 598'980.00.
In the hypothetical case presented above, the 6% p.a. target coupon resulted in a strike being set 1.7% out-of-the-money. That means that the conversion risk is lowered when comparing to a strike that would be set at-the-money. An at-the-money strike would have resulted in a far higher coupon (akin to 12% p.a.), but the conversion risk would be much higher as well.
- Use DCU’s only if you are relatively indifferent as to holding either your reference or the alternate currency.
- Favour DCU’s over Term deposits when the volatility between the currency pair is high or expected to decrease or if you expect a sideways trending exchange rate. If you are using DCUs to increase the return of an otherwise lower money-market rate, make sure that you would not view a conversion in the other currency as a loss.
- Do actively select the strike. Setting an out-of-the-money strike will lower considerably the chances of conversion.
- Do consider the reinvestment risk. Of course, 12 times a one-month DCU will yield higher coupons (higher premiums) than a single1-year DCU. However, that assumes you can strike the 12 DCU’s at the same level over and over, or that you are right 12 times in a row. Both are unlikely in reality.
- Don’t use DCU’s when the risk of being converted in the alternate currency is too high.
- Don’t use DCU’s in a systematic way on the same currency pair. You will make several (or even a lot) of small gains, but ultimately a major event can annihilate all the gains you have made and more. So really use the DCU only if the first point of the Do’s above is fulfilled.
- Knock-in (Appearing) / Knock-out (Disappearing) DCU: Additional barriers are set that activate or deactivate the DCU.
- Triple currency Unit: a third currency is added to the structure and the investor is delivered the worst performing currency in case it ends in-the-money. Not necessarily recommendable, as few investors are indifferent as to holding either of three currencies.