HSBC's knock-out buffer notes linked to basket of three currencies offer cost-efficient access

By Emma Trincal

New York, March 28 - HSBC USA Inc.'s 0% knock-out buffer notes due April 16, 2013 linked to a basket of three currencies provide easy and cost-efficient access to a specific trade that may have been difficult to reproduce in other ways, sources said.

But the high volatility of the currency markets lead some to question whether the downside protection is adequate.

The equally weighted basket include the Korean won, the Mexican peso and the Russian ruble, according to an FWP filing with the Securities and Exchange Commission.

A knock-out event occurs if the basket level on April 9, 2013 has fallen by more than 15% relative to the initial level.

If a knock-out event occurs, the payout at maturity will be par plus the basket return, with full exposure to losses.

Otherwise, the payout will be par plus the basket return, subject to a contingent minimum return of at least 6.75%. The exact contingent minimum return will be set at pricing.

Hard to replicate

"If the basket falls but not by more than 15%, you get this 6.75% bump-up. That's definitely attractive," said Clemens Kownatzki, an independent currency and options trader in Los Angeles.

"I'm sure some institutions may have exposure to these three currencies and that some people would find this basket interesting."

The fees are 1%, according to the prospectus.

"It's not huge considering that it would be difficult to get that particular exposure and payout with an option trade," he said.

"You could use vertical spreads to reduce the cost of the premium, but it would still be expensive."

In a vertical spread, an option trader buys and sells an option on the same underlying but at different strike prices.

Paul Weisbruch, vice president of options sales and trading at Street One Financial, said mimicking the trade in a different format would be possible but complex.

"There are so many layers between the downside protection, the knock out, the various scenarios. ... It would be very complex to put all those pieces together," he said.

"You could say that this note is one way to enact that strategy in one trade as opposed to accessing different markets, putting together multi-leg trades and dealing with different commission levels. So I guess it would serve the purpose of simplicity."

Downside risk

The structure offers a chance to outperform the underlying basket if the final basket level declines by less than the knock-out buffer amount of 15%, according to the prospectus.

Investors would also outperform the underlying for any growth below the minimum contingent return.

But should the knock-out event occur, investors may lose up to 100% of their initial investment, the prospectus warned.

"What concerns me with this is the downside," said Kownatzki. "The 15% soft buffer makes me uncomfortable.

"Some currencies like the euro are not quite as volatile. Emerging market currencies are extremely volatile."

In 2008, the Russian ruble fell 37% against the dollar, the Mexican peso dropped 34% and the Korean won declined by 33%, he noted, saying that the decline occurred in the scope of five or six months.

"Granted, 2008 was a once-in-a-lifetime event. But you never know," he said.

"In 2011, we had a similar although milder move. The Korean won dropped over 15% and the Mexican peso fell by about 18%. So I don't think the 15% is enough to protect you.

"In theory, you could hedge the risk in futures or options. But it's not going to be cheap. Is it worth hedging that since it might defeat the purpose of the upside?

"I don't take these bets where I don't have a back door. And one year is a long time in the financial world."

The notes (Cusip: 4042K1C84) are expected to price Friday and settle April 9.

Minimum denominations are $10,000.

HSBC Securities (USA) Inc. is the underwriter with J.P. Morgan Securities LLC as dealer.

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