JPMorgan's dual directional notes linked to Brazilian real use structure rarely seen in FX

By Emma Trincal

New York, May 14 - JPMorgan Chase & Co.'s 0% dual directional buffered review notes due June 4, 2015 linked to the performance of the Brazilian real relative to the dollar caught market participants' attention because absolute value or dual directional notes are mostly seen in equities, not in the currency-linked note market.

The notes will be called at par plus an annualized call premium of at least 17% if the currency has remained flat or appreciated relative to the dollar on any monthly review date. The exact call premium will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the notes are not called and the currency depreciates by up to the contingent buffer of 15%, the payout at maturity will be par plus the absolute value of the currency return.

If the currency finishes below the 85% barrier level, investors will be fully exposed to the decline.

This deal is the first one this year to use an absolute value type of payout in the currency asset class, according to data compiled by Prospect News.

So far, no currency-linked note has priced in this structure type. Among the 39 absolute return or dual directional note offerings to have priced so far this year, 33 were linked to equity indexes or equity exchange-traded funds, three to single stocks, two to a commodity-based underlying and one to a basket of stocks, according to the data.

Absolute return

"Your upside is capped, and you have unlimited exposure to the downside. That's not unusual for an autocall. But the interesting piece is that you can actually make money if the currency depreciates as long as it stays within the first 15% loss range," said Clemens Kownatzki, an independent currency and options trader.

"Brazil is a popular currency. There is plenty of exposure to be had.

"What I don't like is that the Brazilian real is also a very volatile currency.

"There have been several instances in the past when the real dropped by more than 15% in a single month.

"From an option perspective, it would be interesting selling volatility, but it would be very, very risky. I am not comfortable with it."

Highly volatile

Looking back to the 1990s, he said that the Brazilian real depreciated against the dollar by as much as 70% in January 1999. The year 2002 was extremely volatile as well, with the real "going crazy," he said. It was down 12% in June, then fell an extra 23% in July before moving back up 13% in August and falling again by 26% in September.

"People may think that it's a long time ago, but the real has had volatile moves lately as well. Last year it depreciated by 17% against the dollar," he said.

"It's an interesting note because you get a return whether the currency goes up or down at least to a point.

"However, I would find it problematic given the history of this currency. I wouldn't do it as a standalone trade. I would have to add some downside protection. This could be done with a lock-in forward or through an option trade, for instance buying an out-of-the money put at a strike 15% down."

A currency analyst at a sellside firm declined to comment on the deal but somewhat downplayed the risk.

"The odds of a large-scale depreciation of the real over one year have fallen as it is important for the central bank to control imported inflation," he said.

Attractive pricing

But a currency structurer said the pricing is very attractive possibly given the risk of depreciation as anticipated by the market, although this may not explain everything.

"The note if it appreciates or stays flat will pay a 17% digital coupon. If not, you're fully exposed. But here's the intriguing piece: the client gets a return if the depreciation is less than 15%. In that case, it's one-to-one in absolute terms. It's linear. Unlike the upside, it's not digital. Then you get the full exposure past the 15% level," he said.

"To be able to get 17% on the upside and up to 15% for part of the downside is very attractive. I have to say, I am not sure how they were able to price it so attractively on a one year. To some degree, it's because it's principal at risk. A lot of FX deals are principal at risk, but not all of them. We couldn't do it. We're more conservative. Obviously, when it's principal protected you don't get much funding. But here, they do. They're pretty big. They're one of the top FX issuers in structured notes, so they probably have the client base."

JPMorgan is by far the leading agent in currency-linked notes with $114 million sold so far this year in 19 deals, or 81% of the total year-to-date issuance volume in this asset class, according to data compiled by Prospect News. It is followed by Goldman Sachs (9% of the volume in seven deals) and Bank of America (one deal representing 4% of the volume).

"Another reason for the attractive pricing is probably the Brazilian real futures. Right now, based on the forwards, the market expects the real to depreciate by 10% in a year. It's still less than 15% though," he said.

The deal comes at a time when many emerging market currencies have appreciated against the dollar, he noted, including the real, which is up 10% year to date.

"This may or may not add more risk to the investor. It's hard to tell," he said.

J.P. Morgan Securities LLC is the agent.

The notes will price Friday and settle Wednesday.

The Cusip number is 48126N6M4.

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