USDPHP dual currency option bond: A financial instrument for investment with applications for hedging

• Main Author: Camacho, Kashmirr Ibañez
• Format: text
• Language: English
• Published: Animo Repository 2016
• Subjects: Finance and Financial Management
• Online Access: https://animorepository.dlsu.edu.ph/etd_masteral/5187
• Institution: De La Salle University

The low interest rate environment provides a unique challenge to investors. To present investors with an alternative financial instrument, a USDPHP Dual Currency Option Bond (USDPHP DCOB) was proposed. This study explored how to price a USDPHP Dual Currency Option bond that gives the investor the ability to choose the currency in which he will receive the coupon payment at each coupon date. The dual currency option bond is intended to provide an alternative investment vehicle for corporations, retail investors and bond fund or portfolio managers interested to earn a fixed stream of income (i.e. the coupon payments) while taking advantage of the relative strength or weakness of a currency. It also provides an alternative avenue for an issuer to raise funds in the capital market. To price the USDPHP DCOB, concepts of bond valuation, FX forward pricing and options pricing were combined. A three-component pricing model was developed to make the computations more tractable: the FX Forward Pricing Model, the FX Option Pricing Model, and the Bond Valuation Model. An MS Excel Pricing Tool was also developed to help aid in pricing the USDPHP DCOB. The pricing tool incorporates the forecasts of the forward rates, scenario analysis on when an investor will elect to receive his proceeds in USD or in PHP, computations on duration to aid in hedging a bond portfolio, and a simulation tool to generate spreads. Interviews were also done to assess the viability of the demand for this product. Thoughts of potential investors from the investment banking side, trading side, reserve management side, and retail investor side were gathered. The assessment of the USDPHP DCOB from the interviews were positive, with all respondents seeing the potential in the product, agreeing with the price concession, and affirming the viability of the framework of the pricing model proposed. This study also looked at possible implementation procedures from an issuer, portfolio manager, retail investor and corporate investor perspective. Issues that were addressed from an issuer perspective were the sales proceeds and how they should be compensated for writing the embedded put option on USDPHP, and how to hedge the coupon payments that may be disbursed in USD or PHP. Issues for the portfolio manager that were addressed include how to earn an additional spread. The USDPHP DCOB’s possible performance as an investment vehicle in an actively managed bond portfolio was also explored by making use of scenario analysis and simulation analysis. On the retail side, four scenarios were explored on how the “finance-savvy” OFW can operationalize his investment in the USDPHP DCOB. Meanwhile, on the corporate investor side, the advantages of investing in the USDPHP DCOB instead of deposits were explored. The USDPHP DCOB also presented interesting applications for hedging. This study also explored how a portfolio manager can use the USDPHP DCOB to hedge duration risk and how a corporate investor can use the USDPHP DCOB to partially hedge a floating rate liability.