Tuesday, November 20, 2007

Selling a put option

When you invest in a Dual Currency Investment, you are selling a Put option. How does it work?

1. You place your money in fixed deposit in the foreign currency at an interest rate of x%
2. You give a put option to the bank to pass them the appreciation in the foreign currency for y%.
3. You take the risk of a fall in the foreign currency.

You get a total return of x% + y% from the investment. This is higher than the interest (x%) on the deposit in foreign currency.

Are you getting the correct price (y%) for the put option? Quite likely, you are getting much less than the true price for the option.

For example, if the value of the put option is 2% (i.e. to compensate you for the risk), you may be offered only 0.5%. The remainder (i.e 1.5%) goes towards the expenses and profit of the bank.

As you are not familiar with the correct price of the put option, it is best that you avoid this type of investment completely.

1 comment:

Anonymous said...

Thanks for explaining how a put option works in a dual currency investment (DCI).

I seem to think that a DCI provides some cushion for currency depreciation but places a limit on the upside.

If 2 people invest in the same foreign currency at time 0 - one converts his S$ into the foreign currency immediately to be placed in a time deposit, while the other enters into a DCI striking a few hundred pips below the spot rate.

Let's say at time 1, the foreign currency depreciates to a level that is below the strike price set by investor 2. He would have got the foreign currency at a lower exchange rate compared to investor 1 and suffer less loss.

However, if the foreign currency appreciates, investor 1 would have gained more than investor 2, as the latter would not get converted into the foreign currency and would have earned only the interest component but not the currency appreciation on his investment.

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