JPMorgan’s $50 million gears on Stoxx seen as unique given size, FX twist

By Emma Trincal

New York, May 3 – JPMorgan Chase Financial Co. LLC’s $50.49 million of 0% capped gears due June 28, 2024 linked to the Euro Stoxx 50 index converted into U.S. dollars appeared to be an “unconventional” trade, a market participant said.

The fundamentals of the structure were simple: three times the index exposure up to a 25.03% cap and no downside protection, according to a 424B2 filing with the Securities and Exchange Commission.

What was unique was the conversion of the initial value denominated in euros (the underlying currency) into U.S. dollars at maturity.

The initial value was based on the euro/dollar exchange rate of 1.10435 on the trade date.

Investors in the securities will therefore have composite economic exposure to the performance of the Euro Stoxx 50 index as well as the performance of the euro relative to the U.S. dollar.

No quanto

“Very unusual. You get the currency exposure,” said the market participant.

Almost all structured notes linked to a foreign index denominated in a foreign currency remove the FX exposure using quanto options, he said.

“With quanto, even though the underlying is in euros, you just look at the price move in U.S. dollar terms. There is no conversion. It’s as if the trade was in dollars even though the underlying is in a foreign currency.”

The quanto option uses a fixed exchange rate that removes the exchange rate risk, he explained.

“You take the percentage price move in the foreign index and you apply it to par. That’s it,” he said.

ETF and exchange rate

Traditional foreign index-linked notes are not the only products shielding U.S. investors from currency risk.

Exchange-traded funds tracking international indexes are also currency neutral but in a different way, he explained.

“There is no FX exposure with notes linked to ETFs tracking international indices. And it’s not because of quanto. You don’t use quanto. You don’t have to because the ETF has already done the conversion,” he said.

“If it’s listed on a U.S. exchange and trading in U.S. dollars, the conversion is already happening.”

This made JPMorgan’s $50.49 million deal on the Euro Stoxx 50 index quite “unconventional,” he noted.

Unlike a quanto trade, the underlying index will be converted at maturity in U.S. dollars to calculate the payout.

“It’s a cross asset approach in a note. Your return is based on the local stock market and the exchange rate,” he said.

“It’s a double play on the euro zone.”

Twice bullish

Given the formula, investors buying the notes should be bullish twice – on the stock index and on the euro relative to the U.S. dollar.

The currency “leg” of the trade can have a decisive impact.

If for instance, the euro weakens relative to the U.S. dollar, investors may lose some or all of their investment, even if the underlying has increased in value, according to the prospectus.

But the currency exposure works both ways. Investors may also take advantage of a stronger euro.

As an example, if the underlying finishes flat but the exchange rate rises from 1.10 on the trade date to 1.32 at maturity, investors will pocket a 20% gain solely attributable to the FX component.

Individual investors

The market participant was surprised by the size of the deal.

“I think I know who they sold the deal to, but why? I’m not sure,” he said.

“It’s definitely a retail deal. It’s slightly more than one year, just enough to give you long-term capital gains. Only retail investors care about that; institutions don’t. And also, the fee is so high, it screams retail.”

He was referring to the 2% fee disclosed in the prospectus, which is the equivalent of 1.71% per annum.

“I can’t think of why they would offer that to retail investors,” he said.

The pricing was not a factor, he said.

“It’s just puzzling, especially such a big deal.”

Endangered species

Another reason to be “puzzled” was the well-established reluctance of retail investors to buy notes involving currency conversions.

Pure FX-linked notes have nearly vanished from the U.S. market. In 2013, issuers priced $600 million of them in 127 deals, according to data compiled by Prospect News. Last year, only eight came out totaling a meager $8 million, and this year, only $7 million were priced in two trades.

“Individual investors don’t like those currency plays. It’s too complex. That’s one of the reasons issuers remove the exchange rate risk with quanto options even though they still need to hedge it for themselves. Most of the time retail investors only want the exposure to the local stock market.”

Euro bull

Ed Moya, senior market analyst at Oanda, said that being bullish on the euro was probably a safer bet than having an upbeat view on European equities.

“The inflation picture in the euro zone is still troubling. That’s why many predict more rate hikes in Europe,” he said.

The euro zone’s refinancing rate is now at 3.75% while the Federal Reserve just increased the Fed Funds rate to a target range of 5%-5.25% on Wednesday.

“Obviously, they’re trailing the U.S. With more hikes to come in the euro zone, the euro is likely to appreciate,” he said.

Equity risks

On the equity front, however, Moya said he would be more cautious.

“Energy is still a big headwind. Europe remains subject to significantly higher natgas prices. That could have a negative impact on the economy,” he said.

Valuations in the European equity market were another concern.

“The rally in European stocks may be overextended,” he said.

Since an October low to a recent high last week, the Euro Stoxx 50 index has jumped 55%.

“A lot of that has been priced in. I would be hesitant to be a bull on the Euro Stoxx right now,” he said.

The notes are guaranteed by JPMorgan Chase & Co.

UBS Financial Services Inc. and J.P. Morgan Securities LLC are the agents.

The notes settled on Friday.

The Cusip number is 48130Y438.

© 2015 Prospect News.
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