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Invest Style

A complex product for playing or hedging currencies

For high-net worth investors only

A complex product for playing or hedging currencies

BY LARRY MacDONALD

Globe Investor Magazine Online, April 29, 2009


If your portfolio holds cash that's earning next to nothing at today's microscopic interest rates, you might be tempted by the 4- to 10-per-cent interest rates offered by the Double Currency Units, or DOCU, family of structured products.

They are distributed in Canada by UBS Bank (Canada), a subsidiary of Swiss financial conglomerate UBS AG.

"Growth has been exponential since the DOCU family was introduced in 2000," said Susanne Alexandor, an investment specialist at UBS Bank (Canada). "UBS and its international subsidiaries now place approximately two thousand DOCU products a day with clients worldwide." But DOCUs are not for everybody. They are sold only to accredited investors and require a minimum investment of $250,000. UBS Bank (Canada) raises the bar further: their account minimum is $2-million.

UBS financial advisers tailor DOCUs to the needs of individual clients. Maturities of up to 12 months are available (interest rates are quoted on a per-annum basis). Other options can be selected as well. See the sidebar for more product information.

Here is how they work. Standard DOCUs combine the purchase of money-market investments with the sale of currency call options. Their higher returns result from adding the income received from the call options to the income earned from the money-market investment.

Got your thinking cap on? Let's explain how they work in a little more detail with an example. Following the explanation, the risks are summarized.

Assume a hypothetical investor selects a standard DOCU: i) with a maturity of one month, ii) denominated in Canadian dollars, and iii) paying 5 per cent on a per-annum basis. The embedded currency call option is based on the Canadian-U.S. dollar exchange rate. The amount invested is $1-million.

At time of purchase, the spot exchange rate is $1.26 (Canadian) per one U.S. dollar. The DOCU investor believes the exchange rate will not close below $1.2375 (Canadian) when the DOCU matures, so they fix this as the strike price on the call option. On expiration date, there would be two possible outcomes.

1. If the exchange rate closes above the strike price of the call option, the DOCU investor will receive capital invested plus a per-annum return of 5 per cent (0.4166 per cent for the month). This works out to $1,004,167 (Canadian), or in other words a profit of $4,167.

2. If the exchange rate closes at or below the strike price of the option, the DOCU investor will receive capital invested plus earnings in U.S. dollars, converted at $1.2375 (Canadian) strike price. This works out to $811,366 (U.S.).

Many investors do not mind receiving the second currency (U.S. dollars in the above example) because they have a need for it. They may be planning to visit or live in the country of the second currency, or otherwise are receptive to diversifying their wealth across different currencies.

Investors with no need for the second currency may not want to buy a standard DOCU if they believe there is a chance they could end up with the second currency. In the event it is received, converting it back to the DOCU currency reduces returns because it now buys fewer units. Indeed, the return could be negative.

In the example above, let's say the exchange rate closes at $1.2222 (Canadian) when the DOCU matures. The holder receives $811,366 (U.S.) and converts it back at $1.2222 to get $991,891 (Canadian). This amount is obviously less than the original $1-million invested, so there has been a loss.

What are the risks? As noted above, the investor does not know the currency of payment and could experience a capital loss depending on currency preferences and movements. In addition, DOCUs are issued as the unsecured debt of UBS and therefore come with credit risk. UBS's long-term credit is currently rated A+ (Fitch), Aa2 (Moody's) and A+ (Standard & Poor's).

Presumably, accredited investors with investment accounts of $2-million or more are sophisticated enough to understand complex structured products. Still, several financial advisers expressed concern that some investors may not fully understand what they are buying.

"This is one complicated product," remarked Warren MacKenzie, president of Second Opinion Investor Services. "I've studied options but I do not claim to understand how to price the risks in this product."

Preet Banerjee, senior vice-president with Pro-Financial Asset Management, shares this view. "I'm worried that these products will be pitched to investors who do not understand them," he said.

Another point raised is that there is no liquidity. DOCUs have to be held to maturity; they can't be sold or bought midway through their term. "There is no secondary market for these securities," noted Mr. Banerjee.

Richard Croft, president of R.N. Croft Financial Group Inc., wonders "whether the return compensates adequately for the risk." Investors are being asked to take on currency risk in exchange for an annual return between 4 and 10 per cent.

According to his calculations, an investor can earn substantially more from a "homemade DOCU" constructed by purchasing a bank guaranteed investment certificate and selling currency call options trading on the Philadelphia Stock Exchange. That's because the premiums received on publicly traded call options are higher than the premiums on the over-the-counter call options embedded in the DOCU product.

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