Hello and welcome to this instalment of “Derivatives Demystified.”
Today I want to talk about a specific type of structured deposit. Structured meaning that we attach derivatives (or in this case specifically option contracts) to a deposit to enhance the rate that can be earned.
Let’s consider a 12-month ZAR fixed deposit with a quoted annual effective interest rate of 9.20%. Say you deposit ZAR100,000,000. If you hold the deposit for the entire 12-month period, you expect to get ZAR109,200,000* back.
I know that the only way to earn more, is to risk more.
I’m a very conservative investor. I’m happy to assume a relatively small amount of risk to have the opportunity to earn 10.7% instead of 9.2%. When I say assume a small amount of risk I mean I definitely want at least my ZAR100,000,000 back. I think a 10.7% return over 1-year will be a good success, better than most local equity portfolios.
I have been thinking there is a very good chance that USDZAR will trade above 17.05 at the end of the year. My worries about electricity, inflation, politics and mismanagement pop op at least once a week. Despite my very best physical and mental exercises to control worries and I sometimes think ZAR can never strengthen again. And then I become hopeful and think maybe ZAR can strengthen (a little bit). I don’t want to get involved in trading derivatives and opening forex accounts, so I ask Investec if they can help.
They say, yes, it just so happens that such a structured deposit exists:
If USDZAR trades above 17.05 at the end of 1 year, you earn 10.7%
If USDZAR trades between 15.2257 and 17.05 at the end of 1 year, you earn between 0% and 10.7%, as represented in the graph
If USDZAR trades below 15.2257 at the end of 1 year, you earn 0%
How do they do this? So they pay me 9.2% on my fixed deposit of ZAR100mio. And they buy a 17.05 USD put option in USD5,865,102-64** and simultaneously sell a 15.2257 USD put option in USD6,567,842-53*** from me. By trading these options they secure an additional 1.5%**** of yield, and also guarantee that I don’t lose more than my capital investment*****. We don’t trade the derivatives outright, but embed the potential profit and losses in the deposit payout.
*ZAR100,000,000 (principal) + ZAR9,200,000 (interest of 100,000,000 x 0.092)
**ZAR100,000,000 / 17.05 strike
***ZAR100,000,000 / 15.2257 strike
****I earn ZAR1,500,000 1-year forward premium from the put spread
*****I can lose a maximum of ZAR10,700,000 = USD5,865,102.64*(17.05-15.2257)
Thank you for reading! Next week I’ll share a structured currency deposit idea for the more aggressive risk takers among us! By assuming more risk, also expect more return!
Source: Investec Corporate and Institutional Banking