In May, both Merrill Lynch and JPMorgan divulged that they were going to launch foreign exchange linked credit obligations. Ostensibly, CFXOs look little different from existing FX products. What sets them apart is that they will be rated, which could well attract a lot of fresh investors into the industry.
As JPMorgan explained in a research note it issued in April, the building blocks of CFXOs are FX default swaps, where a barrier is set a certain percentage away from the prevailing spot rate when the deal is transacted. The default event occurs when the barrier is breached, making it essentially the same as a one-touch option.
Merrill was the first to announce that it was launching a CFXO and, at the time of writing, it was able to provide more details of its product than JPMorgan. Its CFXO will be managed by Crédit Agricole Asset Management and will consist of a basket of currencies. "The CFXO will have 10 currency pairs at any one time, and it will have one-to-five event triggers on each pair," says Nicolas Rabeau, co-head of global rates exotics trading and global head of hybrids trading at Merrill Lynch.
He adds that a small portion of the fund – 10% to 30% – will be allocated to emerging market currencies. "The manager can play an active role in taking profits or losses. Crédit Agricole is an experienced manager," he says.
Tim Owens, global head of currency and commodities solutions at JPMorgan, agrees that having an active manager is something that could add to the popularity of the products. "The trend in CDOs is to have an active manager. You could have static products, left for the lifetime of the trade, but investors seem to prefer actively managed products where managers can add or remove components. They provide greater comfort," he explains.
Just as with CDOs, CFXOs will be broken into separate tranches – equity, mezzanine and senior – which will be rated by agencies, such as Standard & Poor’s. The tranches have different risk profiles and so they carry different ratings. The equity investors agree to take the first losses in the portfolio; the mezzanine investors are only exposed if the equity tranche is wiped out and finally the senior investors are only at risk if the losses in the portfolio take out the two previous tranches. Because there is a greater probability that the equity will lose money, they are compensated by receiving a higher coupon.
The triggers in Merrill’s CFXO are Asian, meaning that any default event will be based on the average rate of the currency over the product’s lifetime. Although JPMorgan was unable to provide full details of its product, it is believed that the triggers of its CFXO will be American-style. If a barrier is breached, part of a tranche will be knocked out immediately, resulting in no further coupon payments and the loss of the original capital. JPMorgan’s initial product will comprise a bigger basket of currencies, with more focus on the emerging markets.
"Emerging market investors typically will have a view on both the credit and currency. They do have some correlation. It’s natural for them to look at both," says Owens. "Investors in credit in emerging markets get paid an enhanced yield for risk. What we’ve done is say why not take currency risk in the same manner. You get a high coupon but if a trigger is breached, you may not get any more coupons or the initial investment back. What makes these more palatable is the ability to invest in a basket of a more diversified pool of risk, which can be tranched into different categories." In other words, there are tranches to satisfy various risk appetites.
Early indications are that there is going to be substantial demand for CFXOs. Merrill expects that its first CFXO will attract between €500 million and €1 billion in funds, and other banks will be watching closely. Hopes are high that a secondary market will develop. "We believe that this is a significant step in the development of FX, which will see it develop into a very broad asset class. We see a lot of demand and we think that it’s good that the first one launched will bring such a well-rounded structure to the market. Obviously others will follow," concludes Atanas Bostandjiev, managing director and head of structured rates and FX marketing EMEA at Merrill Lynch.