Boosting dollar returns during euro strength

Background: An 'FX tarn' with conversion is a popular tool to boost the return on a US dollar deposit in a slightly bullish euro environment. By using this tool, the capital is redeemed as soon as one conditional coupon is paid. If the condition is never met, the holder gets the right but not the obligation to sell its US dollars against the euro at 1.00.

Problem: A European exporter is structurally long US dollars, and would like to earn an enhanced interest rate while still having the potential to convert those dollars into euros at an attractive level if the opportunity presents itself.

Solution: The client enters into an FX tarn with conversion. This structure is a five-year hybrid deposit which pays a coupon of:

• 4% at the end of the first year (fixed coupon)

• 6.5% at the end of the second year if the euro/dollar spot at that time is higher than the initial spot (spot at the time of the trade). If this coupon is paid, 100% of the dollar notional is redeemed to the client at the end of year two and the structure terminates. Otherwise, no coupon is paid on year two.

• 12% at the end of the third year if the euro/dollar spot at that time is higher than the initial spot and no coupon has been paid on year two.

If this coupon is paid, 100% of the dollar notional is redeemed to the client at the end of year three and the structure terminates. Otherwise, no coupon is paid on year three.

• 15% at the end of the fourth year if the euro/dollar spot at that time is higher than the initial spot and no coupon has been paid on years two and three. If this coupon is paid, 100% of the dollar notional is redeemed to the client at the end of year three and the structure terminates. Otherwise, no coupon is paid on year four.

• 22% at the end of the fifth year if the euro/dollar spot at that time is higher than the initial spot and no coupon has been paid on years two, three and four. If this coupon is paid, 100% of the dollar notional is redeemed to the client at the end of year five and the structure terminates.

If no conditional coupon has been paid on years two, three, four or five, the client gets the right but not the obligation to sell its dollars into euros at the end of year five at 1.00.

Analysis

This type of deposit gives clients with a mildly bullish euro/dollar view over the medium term, an opportunity to earn an attractive rate of return. The deposit is redeemable at year-end in years two to five. The condition for redemption is that the investor has received a conditional coupon. This condition is satisfied on the first coupon date where the euro/dollar rate is greater than or equal to the initial spot.

On the other hand, if euro/dollar is below the initial spot on each coupon date later than year one, the investor achieves a total return of 4% over a period of five years and can convert their dollar liquidities into euros at 1.00 or better (if the final spot is lower than the parity).

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