Deutsche Bank's digital return notes tied to Chilean peso designed for Latin American bulls

By Emma Trincal

New York, Dec. 12 - JPMorgan in its upcoming sale of Deutsche Bank AG, London Branch's 0% digital return notes due Dec. 27, 2013 linked to the Chilean peso relative to the dollar is jumping in the bullish bandwagon on Latin American currencies, sources said. However, the deal is priced for risk-takers, sources said, given the barrier-type of downside protection.

If the currency finishes above the initial level, the payout at maturity will be par plus the digital return of 14%, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the currency falls by up to 15% and will be fully exposed to all losses if the currency falls below the 85% trigger level.

"This is not a bad trade fundamentally because the Chilean peso story has not been given enough attention. The fundamentals of Chile are good, it's based on copper and it's the same positive story as in Mexico. Now the real question is risk and liquidity," a currency strategist said.

The new Eldorado

Marc Chandler, global head of currency strategy at Brown Brothers Harriman, said that these types of deals reflect a general bullish momentum toward Latin American countries in both equities and currencies markets.

"I do tend to like the Chilean peso," he said.

"This is a thematic topic. People in recent years have been fascinated with China, Asia. But the competitive environment is changing."

Agents, especially HSBC, but also Goldman Sachs and JPMorgan have sold notes tied to the Mexican peso relative to the dollar this year. But the Chilean peso has not been used so far this year as an underlier, according to data compiled by Prospect News.

"We're noticing a bullish interest in Latin American currencies," said Chandler. "There is investor optimism around the Mexican peso and bulls in this currency benefit from a greater transparency than in Chile. Mexican futures contracts are very transparent while Chile is a much smaller market.

"But the Chilean peso is attractive too. It has strengthened relative to the US dollar this year."

For Chandler, the market sentiment is tied to positive fundamentals in Latin America.

Citing a study from the Boston Consulting Group, he said that Chinese wages are about to exceed Mexican wages soon.

"Chinese labor cost increases are eating up China's competitive advantage, making the Americas more attractive to foreign capital and manufacturing," he said.

"A sign of this shift from Asia to the Americas was visible with Apple's recent decision to relocate some of its production lines back into the U.S.

"Latin America, North America are now becoming the competitive places," he said.

Alternative trade

But Chandler said that he would use the notes to express a bullish view on the Chilean peso because of the downside risk.

"The 14% digital upside on this deal for one year is good. The Chilean peso versus the dollar is up 9.53% so far this year," he said.

"But the 85% barrier with a strike at the initial price, that, I don't really like it.

"If you're a fixed-income investor you can also get the yield in addition to the currency appreciation. For the one-year Chilean Treasury, you're looking at a 6.5% yield.

"As an alternative trade, I would do something plain vanilla like combining the purchase of a Chilean government bond with a long currency exposure. I would buy the Treasury bills to get this 6.5% yield and I would use it as a buffer. I would get my return around 9% from the currency appreciation. Overall I would get the same upside potential but with a much better protection, one that strikes beyond the 6.5% decline not at the initial price. I would use the yield as a buffer and if I break that level, at least I would have that cushion," he said.

Tail risk

A structurer said that the upside in the form of a digital payout was very appealing.

"I think it's quite good although the downside is higher than the upside," this structurer said.

"You do get this enhanced return with the digital coupon. If the Chilean peso is up by only 1% you get 14%, so that's not bad. Who wouldn't like it?"

He agreed that yield-hungry investors are flocking to Latin America emerging markets.

"There is a bullish theme around this region. The Mexican peso is doing well. Yields in those countries are higher relative to the U.S.," he said.

But the notes are not designed for risk-adverse investors, he said.

"We've seen JPMorgan offering these digital payouts in currency deals quite often. I assume it's for their private bank clients. We don't do this because we can't risk too much with our own clients," he said.

"We haven't seen a 15% decline of the Chilean peso versus the U.S. dollar since 2008. But who knows with local risk?

"It's an OK trade. But for conservative clients, it wouldn't work.

"They sold a knockout. But if the currency drops by 40%, what do you tell your clients? There's too much of a reputational risk for us," he said.

A buffer would have been preferable to a barrier, said the structurer. But it would have made the 14% digital nearly impossible to price.

"It just wouldn't have worked. What's enticing in this deal is the coupon. People are bullish on this currency. If you had offered them a 10% or less coupon for a one-for-one after 15%, I don't think it would have been as exciting," he said.

For the currency strategist, FX volatility levels have dropped so much that in the next 12 months, the risk associated with the notes could be substantial.

"We could see a significant correction at a time when vols. are so low. I'm not sure it's appropriate for individual investors to sell some tail risk in an environment of ultra low volatility, unless of course, you know what you're doing. Somehow, it reminds me of the structures sold before 2008 that burnt so much money."

The notes will price on Friday and settle on Dec. 19.

The Cusip number is 25152RAR4.

JPMorgan Chase Bank, NA and J.P. Morgan Securities LLC are the placement agents.

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