structured products10

Structured Products – Part 5: Structured Products in Turkey

(Part of Master Thesis: Kocyigit, Eren, “The Use Of Retail Structured Products And Their Applications In Turkey”, Istanbul Bilgi University, 2010)

RETAIL STRUCTURED PRODUCTS IN TURKEY

In the previous chapters, definition, composition, types, advantages & disadvantages of retail structured products and their applications in different regions were examined.

In this chapter the applications of retail structured products in Turkey will be analyzed. Chapter will start explaining the current situation about the retail structured products and their applications in Turkish market. Then types of retail structured products will be analyzed in 2 main categories; structured funds (Capital Protected/Capital Guaranteed Funds) and structured deposits.

In funds section, Capital Protected/Capital Guaranteed Funds (CP/CG funds) will be examined. In structured deposits section, types of structured deposits will be examined according to their underlying instruments.

In the final section of the chapter; the future of retail structured products in Turkey will be analyzed. At this section, conditions that influence development of structured products in positive and negative manner will be discussed.

5.1. Current Situation of Retail Structured Products in Turkey

Retail Structured Products are quite new instruments for Turkish market. Because of some reasons they were introduced to Turkish market later then the other markets. Of course there can be lined up a lot of reasons for this argument but the following 3 reasons can be considered as the major reasons.

  • High interest rates: Because of high interest rates in Turkey, investors tended to seek return in time deposits of the banks and government bonds.
  • Risk averse investors: As a result of higher return opportunity with moderate risk, investors’ behaviors became more moderate.
  • Late integration of financial system: Till 2005 Turkish financial markets could be considered as far away from globalization.

Although there were more negative situations against the development of retail structured products in Turkish financial market, structured products started to take place in the market day by day and started to become important among the retail investors.

Especially decreasing interest rates and globalization of Turkish financial system influenced this development in a positive manner. Because of decreasing interest rates, risk appetites of the retail investors started to increase and they started to seek alternative investment vehicles. At this point; structure products are introduced to the retail investors by financial institutions. In addition to that; globalization of Turkish financial system also provided a suitable climate for these products to be offered by the financial institutions. Experienced financial institutions in retail structured products, like Fortis, Unicredit, BNP Paribas, Citibank and ING started to operate in Turkish financial market. Especially know-how of these financial institutions hastens the process of introducing structured products to Turkish retail investors.

Compared to the markets in Europe, America and Asia, Turkey is in the primary stage of the period that the other regional markets have already passed. It is not possible to talk about million numbers of products issued or billion volumes of products sold like European Market. Turkish financial system just started to present retail structured products.

Next section will analyze the most common types of retail structured products in Turkish financial system.

5.2. Types of Retail Structured Products in Turkey

According to the characteristics of Turkish financial market, retail structured products were composed basically in 2 different forms.

  1. Structured products that are formed as funds: Structured funds (Capital Protected/Guaranteed Funds – CP/CG Funds)
  2. Structured Products that are formed as deposits: Structured deposits

Firstly structured funds (CP/CG funds) will be analyzed.

5.2.1. Structured Funds (Capital Protected/Guaranteed Funds – CP/CG Funds)

First of all; there are 2 different types of structured funds in Turkey:

  • Capital Protected (CP) Funds:
  • Capital Guaranteed (CG) Funds:These 2 funds can be categorized as ‘capital protected products’ according to the structured products’ categorization of this study. They are called ‘funds’ because of their collection method of capital from investors.

    There are some similarities and differences between mutual funds and these funds;

• Both in mutual funds and CP/CG funds, capital is collected by pooling money from investors.

Mutual funds don’t have a maturity; CP/CG funds do have certain maturities like 6 months, 1 year, 2 years and etc…
Mutual funds are managed dynamically by a fund manager within the investment period. But in CP/CG funds; a capital protected product is structured with certain features (maturity, underlying instrument, etc…) and till maturity investment strategy of this product is never changed by fund manager.

Investors can participate to mutual funds every day, but they can participate to CP/CG funds within certain periods which are usually called public offering periods.
In CP/CG funds there is a commitment or guarantee for the protection of the capital, but in mutual funds there is not.

5.2.1.1. Definition of CP/CG Funds

As it is told in the previous sections, there are 2 types of structured funds; capital protected (CP) and capital guaranteed (CG) funds.

CP funds are the funds; that are structured in an appropriate investment strategy with best effort in order to provide full or partial protection to the initial investment.

CG funds are the funds; in an appropriate investment strategy with the guarantee of a guarantor in order to provide full or partial protection to the initial investment.

Operating process of CP and CG funds are the same. The only difference between them is; in CG funds there is a guarantee of a guarantor in order to provide part or full capital protection; however, in CP funds, there is not a guarantor and protection of initial investment is provided by best effort. The guarantor of the CG funds can be the financial company who issues the fund or a third party like a bank, insurance company and etc…

In the following chapters, CP funds and CG funds will be considered together as a single product as CP/CG funds since their composition and operating process is the same.

5.2.1.2. Composition and Operating Process of CP/CG Funds in Turkey

CP/CG funds are composed of 2 products;

  • Government Bonds: This part provides the capital protection
  • Options: This part provides possible yield that can be generated fromthe performance of an underlying instrument.

    Figure 5.1 shows the components of a basic CP/CG fund

Screen Shot 2015-02-15 at 10.15.46

Figure 5.1: Components of Structured Funds (CP/CG Funds)

Left side of the figure represents the composition just after public offering period; at the beginning of investment period. Right side of the figure represents the composition after investment period.

As can be seen from figure 5.1; in addition to the management cost taken by the issuer, there are 2 main components of these funds;

The fund’s bond component: Government bonds, treasury bills or reverse repo contracts are located in these funds in order to provide the capital protection feature. They are chosen according to their maturities and interest rates to fit the desirable capital protection rate (full or partial) at the end of these funds’ maturities. Generally, in these funds 100% capital protection is available, but sometimes the rate of protection may be lower (for example %90).

The fund’s option component: Besides protecting the capital, CP/CG funds also aim to generate a return. This is referred to as the fund’s performance, in order to achieve this capital gain; CP/CG funds buy options (‘KBC Capital Protected Funds’ 2002). Option part of these funds determines the real characteristics of the product, like its risk level, payoff profile, underlying asset and etc… According to the amount and the type of options that are used in these funds, risk level of these funds changes. The payoff of these funds is also determined by the payoff of the options that are located in these funds.

In addition to the components of CP/CG funds, there are some features that should be considered in order to analyze the operating processes of these funds (‘Akbank T.A.S. B Type %100 Capital Protected Sixth Mutual Fund Fact Sheet’ 2009).

a. Target of the fund: First of all, all the CP/CG funds should have a target in order to try providing a return to their investors. If the investor’s expectation is matching with the fund’s target, than the investor should invest in this fund. According to the target of the funds, suitable options are tried to be found from market. Target of the funds can be based on several expectations like; a rise or fall in the prices of the underlying, a sideway movement in the prices of the underlying, a rise or fall in the volatility of the prices of the underlying and etc… According to these expectations different option types can be used. These options types can be standard vanilla options or exotic options according to the fund’s target. (See Appendix A for most common types of exotic options that are used in CP/CG funds)

b. Underlying asset(s) of the fund: The performance of CP/CG funds depends on the change in the value of the underlying asset(s) like stock market indices, shares, interest rates, commodities or currencies (‘KBC Capital Protected Funds’ 2002). These funds track the performance of the underlying asset(s) by buying an option that was issued on this asset(s).

c. Term of the fund: Term (maturity) of CP/CG funds depend on the risk-free interest rate (interest rate of government bonds) in the market. Since Turkish risk-free rates are higher than European risk- free rates, in Turkey terms of these products are mostly 6 months, 1 year or maximum 2 years where in Europe average terms of these funds are between 2 and 6 years.

d. Participation Ratio of the fund: Every option that is located in CP/CG funds has a price. In these funds; the capital that are collected from investors are used in 2 parts; one part for bond component and remaining part for option component. Ratio of the capital that is reserved for option component to the option price gives us the participation rate.

In order to give an example;

Let’s say 1.000.000 TL is collected from investors. By the fund manager 900.000 TL is invested into government bond and 100.000 TL invested into an option. Let’s say the call option is in European style (gives the option buyer exercise right only at the end of maturity), underlying instrument of TRY/USD exchange rate and cost of this option is 200.000TL for 1.000.000TL. At this time participation rate for this fund is calculated as 100.000/200.000 = 0.5 = %50

If the option was a more expensive option, let’s say an American style option (gives the option buyer exercise right anytime during the maturity), than the price of the option would be more expensive, let’s say 250.000 TL. And the participation rate will decrease to 100.000/250.000 = 0.4 = %40

Participation ratio is determined just after the public offering period and depends on the price of the option bought. Participation ratio doesn’t change after it is determined.

e. Capital protection ratio of the fund: Most of CP/CG funds have % 100 capital protection, but also they can have partial capital protection like %90, %80. Due to the market conditions, the value of a CP/CG fund can be below its initial investment within its investment period. That’s because capital protection is valid only at the end of the maturity.

f. Management fee of the fund: Management costs of CP/CG funds are charged from their investors under the name of management fee. In Turkey this fee is mostly charged between %2 and %2.5 (annual) from the invested capital. This fee contains registration fee, audit fee, custody fee and other expenses that are paid by the fund. Capital protection will not be affected from this fee. This management fee will be considered at the set up process of the fund and the capital protection strategy will be structured accordingly.

g. Purchase period of the fund: CP/CG funds can only be purchased between some certain periods that are named public offering periods. These periods are mostly 1, 2 or 3 weeks long.

h. Penalty/Redemption fee of the fund: In CP/CG funds, investors can sell their fund share before maturity by paying a high-cost fee. This fee’s name is penalty or redemption fee. In Turkey it is mostly charged %2 from the whole investment (Not only from the gain, from the whole investment). Unlike management fee, this fee doesn’t go into issuers pocket but transferred to the fund to increase the return of the fund for the investors who will wait till maturity

i. Redemption frequency of the fund: Although holders of CP/CG funds have redemption opportunity before the end of maturity by being charged of high cost fees, there are some restrictions for this redemption. Unlike mutual funds, in CP/CG funds, investors cannot sell their share anytime they want. In Turkey prices of most of the CP/CG funds are determined twice a month and investors can sell their shares twice a month according to these prices.

j. Minimum Participation: Minimum participation limit shows the minimum amount of money that can be invested on a CP/CG fund. It differs from bank to bank but mostly 1.000 TL in Turkey.

k. Tax: In Turkey 10% withholding tax is applied to CP/CG funds’ option part only if option part generates a return at the end of the maturity.

In order to examine the operating process of the CP/CG funds following example is given:

Name: XYZ fund
Capital Gain Target: To generate a return that depends on a rise of IMKB 30 level, when starting date and maturity date are compared
Capital Protection Target: %100 Capital protected
Underlying: IMKB 30 Index
Term: 6 months (180 days)
Participation Ratio: %80
Public Offering Period: 17.05.2010 – 27.05.2010
Started Date: 28.05.2010
Maturity Date: 23.11.2010
Management Fee: %2 Annual
Redemption Frequency: Twice a month, every 5th and 15th working day Penalty Fee: %2.5
Tax: %10 withholding tax
Minimum Participation: 1.000 TL

In Turkey all the CP/CG funds operate under the rules of Capital Markets Board of Turkey; that’s why operating process of this example is tried to be examined under the rules of Capital Markets Board of Turkey by using (‘Türkiye İş Bankası A.Ş. Koruma Amaçlı Şemsiye Fonu’na Bağlı B Tipi %100 Anapara Korumalı Sekizinci Alt Fon İzahnamesi’ 2009)

Before investment period, establishing the product:

First of all; within public offering period that is between 17.05.2010 and 27.05.2010, money will be collected from the investors who are willing to invest in this fund. In other words investors who expect a rise of IMKB 30 level, (when 28.05.2010 and 23.11.2010 are compared) and also want capital protection in their investment can participate in this product within public offering period.

After the capital is collected from the investors (with a minimum participation value of 1.000 TL in this example) fund manager set up the capital protection strategy which best suits the target of the fund. While establishing the strategy fund manager seek for best products both in option component and bond component.

In this fund the bond component that consists of government bonds, treasury bills or reverse repo contracts will be set in order to generate the best risk-free rate of return in 6 months. More return on this risk free part means, higher amount of capital is reserved for option part. Higher amount of capital for option part means, higher participation rate. Higher participation rate means higher return for investors.

For the option part, fund manager seeks the best suitable option to fit this product with the best price. For this example; the fund manager will ask the price of a vanilla call option that is written on IMKB 30, with strike price of 28.05.2010’s spot IMKB 30 level, and maturity of 180 days (17.05.2010 – 27.05.2010) to different financial institutions to obtain the best price for this option style. Option with a low price mean higher participation rate. Higher participation rate means higher possible return to the investors.

After obtaining best suitable products for both bond and option parts, investments are made and the participation ratio is determined (%80 in this example). The IMKB 30 level on the start date is observed (28.05.2010 in this example). And then investment period of the fund starts.

During the investment period:

Before the end of maturity, investors can sell their shares by accepting a penalty fee (%2.5 of their whole investment in this example). They can sell their shares only from the prices that are determined in specific dates (every 5th and 15th working day in this example). If these days fall on a holiday then price of following working day is taken into account.

The fund’s price is determined by adding the value of the assets that are in the fund’s portfolio and deducting the expenses of the fund from this amount. In other words; during the investment period fund price will be determined as;

Price of Bond Component + Price of Option Component – Expenses

  • Price of bond component can be determined from the exchange market (Turkish bond market).
  • Price of option component can be determined by obtaining the bid price of the same option from the same counterparty. This obtained price is tested by option pricing models like Black & Scholes model (see section 3.4 for Black & Scholes model).
  • Expenses: represents the management fee and other expenses if the management fee doesn’t contain them. (Expenses like registration fee, audit fee, custody fee and other expenses that are paid by the fund.)

After the investment period: Calculating the fund’s performance with possible scenarios:

The funds value at the maturity date can be calculated as the following formula;

Screen Shot 2015-02-15 at 10.19.52

First scenario: If at the end of maturity IMKB 30 level will be above its initial level then;

Let’s say on the started date (28.05.2010), level of the IMKB will be 57.350 and at maturity date (23.11.2010) level of the IMKB will be 65.330 and 1.000 TL is invested to this fund;

Calculated Return= (65.330/57.350) – 1 = ~ 0.14
Fund’s Share Value of Investor= 1.000 x (1+ (0.14 x 0.8)) = 1112 TL 1112-1000= 112 (gross return from the fund)
112 – (112*(0.1(tax))) = 100.8 (reel return from the fund)

Investor will invest 1000 at the beginning and get 1100.8 at the end of 6 months if this scenario happens. This means about %10 return (reel) in 6 months, in other words %20 in a year.

Second scenario: If at the end of maturity IMKB 30 level will be below its initial level then;

Let’s say on the started date (28.05.2010), level of the IMKB will be 57.350 and at maturity date (23.11.2010) level of the IMKB will be 55.000 and 1.000 TL invested to this fund.

At this point because of the capital protection feature of the fund, the investor will get %100 of his/her initial investment although IMKB30 level decreases about %4 in 6 months.

5.2.1.4. Advantages & Disadvantages of CP/CG Funds in Turkey

As it can be analyzed from the previous sections, popularity of CP/CG funds is increasing in Turkey. Despite the market conditions, advantages of the CP/CG funds are quite important on this development.

CP/CG funds have advantages such;

  • CP/CG funds can generate a higher return than the deposits and bonds according to the performance of the underlying of the fund.
  • CP/CG funds enable the investors to access a higher return possibility by protecting their initial investements (‘Fortis Portföy: Anapara Koruma Amaçlı Fonlarda Bilmeniz Gereken 10 Şey’ 2007). In other words by investing in these funds, investors get a chance to reach higher returns than traditional investments while their initial investments are protected. This feature can be considered as the most important feature of these funds and attracts risk averse investors to invest in these funds.
  • CP/CG funds provide easy access to different kinds of instruments from all over the world in an easier and cheaper way. These funds give chance to retail investors to invest in barely found instruments.
  • CP/CG funds provide diversification in the portfolios of the investors in an easier and cheaper way. Since these funds can have hundreds of underlying instruments like shares, indices, commodities, equities, foreign currencies and etc… they enable the investors to diversify their portfolio.Although CP/CG funds have these attractive features and advantages, at the same time they involve some disadvantages and risks such as;
  • Compared to the deposits, CP/CG funds have longer maturities starting from 6 months to 2 years. Since Turkish investors get used to shorter maturities; maturities of these funds are seemed so long for them.
  • Altough interest rates of TL deposits decreased from %20 levels to %10 levels in Turkey, these rates can still be considered as high opportunity costs.
  • Unlike usual mutual funds, in CP/CG funds, investors couldn’t sell their shares anytime they want. Also they should pay a high cost penalty fee in order to sell their shares before maturity.
  • Option component of CP/CG funds are more complex compared to the instruments usual mutual funds are investing in. Sometimes investors can have diffulties to understand the investment strategy of a CP/CG fund especially if the fund’s option components is an exotic option.

In addition to these disadvantages, CP/CG funds are subject to following risks during their investment period (‘Türkiye İş Bankası A.Ş. Koruma Amaçlı Şemsiye Fonu’na Bağlı B Tipi %100 Anapara Korumalı Sekizinci Alt Fon İzahnamesi’ 2009)

  • Market Risk: Unexpected fluctuations in interest rates, commodity prices, equity prices and other financial asset’s prices affect the value of the fund during the fund’s investment period.
  • Interest Rate Risk: Since fund’s bond component is evaluated by the values of government bonds, treasury bills and reverse repo contracts unexpected fluctuations in interest rates of these fixed income securities affect the price of the fund during the fund’s investment period.
  • Counterparty Risk: In these funds, there is an option part and in this part, an option contract is bought from another financial institution on OTC market. Default of this option issuer means, that institution cannot fulfill its liabilities about this option contract.
  • Exchange Rate Risk: Unexpected fluctuations in exchange rates affect the value of the fund during the fund’s investment period.
  • Concentration Risk: If the fund is investing in a specific instrument with a specific maturity, fund can be subject to concentration risk.
  • Legal Risk: After the public offering period, fund is subject to legal risk if the regulations of these funds are being changed.

 

5.2.1.5. Taxation of CP/CG Funds in Turkey

CP/CG funds are subject to %10 withholding tax, if at the end of the maturity option part of the fund generated return. These funds are subject to %10 withholding tax from the amount of return generated by the option component. If option component didn’t generate return, these funds are not subject to any tax.

5.2.1.6. Things to be Considered Before Investing In CP/CG Funds

CP/CG funds can have very different compositions and features, that’s why an investor should consider if the structured fund is fitting in with his/her risk appetite, financial situation and market expectation. When choosing a structured fund, an investor should consider the followings;

  • Conditions required for capital protection and the portion of that protection.
  • Participation ratio
  • CP/CG funds are riskier than usual time deposits so the investors should determine whether they have the risk appetite for the fund they are choosing.
  • CP/CG funds are in a more complex composition than usual time deposits and mutual funds, so investors should understand the underlying and payoff mechanism of the fund they want to invest (‘Türkiye’de Anapara Koruma Amaçlı ve Anapara Garantili Fonlar’ 2008).
  • Capital protection feature of these funds is valid only at the maturity. Investors could sell their shares within the maturity but they have to pay penalty fees. Investors should be aware of these fees and they should invest in these funds if they have sufficient savings.

5.2.2. Structured Deposits

Another popular and well-known type of structured products in Turkish financial system is structured deposits. These products are structured by deposit banks.

Following sections will firstly define structured deposits and explain their main features and composition. Then most common types of structured deposits in Turkey will be detailed with given examples. In the remaining part of the section; advantages & disadvantages of structured deposits and things should be considered by an investor before investing in structured deposits will be analyzed.

5.2.2.1. Definition, Composition and Types of Structured Deposits

A structured deposit can be defined as a structured product that is composed of a deposit plus another financial product (mostly an option contract) where the return is depending on the performance of some underlying asset(s) (‘Making Sense of Structured Deposits’ 2008).

Figure 5.5 shows composition of a structured deposit.

Screen Shot 2015-02-15 at 10.36.10

As can be seen from Figure 5.5; structured deposits are composed of a time deposit account in any currency and an option contract that is written on any underlying asset. The underlying asset can be a single share, basket of shares, index, basket of indices, commodities, equities, currencies, interest rates and etc…Combination of these 2 components structures a structured deposit account that is in any currency, depending on any instrument.

The basic difference of structured deposits and time deposits is; in time deposits the return is fixed but in structured deposits it varies. Possible return of structured deposits depends on their risk levels, riskier structured deposits provide higher return possibility and vice versa.

When structured deposits are compared to CP/CG funds;

  • Structured deposits are more accessible than CP/CG funds because these funds can be bought in predetermined public offerings periods, but structured deposits can be bought anytime from deposit banks.
  • Structured deposits are more tailor-made than CP/CG funds. That’s because maturities of CP/CG funds are fixed by the fund manager before their public offering period; however, maturities of structured deposits can vary from weeks to months according to demands of the investors.
  • Like CP/CG funds, structured deposits can provide full or partial capital protection.
  • Composition of structured deposits is similar to composition of CP/CG funds. In structured deposits, there is a deposit component instead of a bond component and rest of the product is composed of an option contract written on any underlying asset.Structure deposits can be classified in 2 different forms;
    • According to their underlying asset: According to their underlying assets, these products be classified as; bond linked, FX(foreign exchange) linked, stock market linked, commodity linked, single stock linked, hedge fund linked, equity linked deposits.
    • According to their capital protection feature: According to their capital protection feature, these products can be classified as; deposits with capital protection feature and deposits without capital protection feature. In capital protected deposits, capital protection can be full or partial.

Since structured deposits are tailor-made products operating processes of these deposits change from product to product. Operating processes of most common types in Turkey will be examined later in this study (in section 5.2.2.3).

5.2.2.2. Structured Deposits in Turkey

In this section, structured deposits are categorized according to information collected from web sites of deposit banks that are operating in Turkey.

The volume of structured deposits in Turkey cannot be determined because these products aren’t listed on an exchange market and traded between investors and banks on OTC markets.

It can be told that; 4 major types of structured deposit are standing in the forefront when all the banks that are operating in Turkey are analyzed.

a. Foreign Exchange(FX)-Linked Structured Deposits

FX-linked structured deposits are the most popular type among the banks and investors. Investors can obtain higher returns in FX-linked deposits compared to usual time deposits by undertaking exchange rate risk. FX-linked deposits can be structured between any currency pairs. In Turkey most popular FX-linked deposits are structured in USD-TRY, USD-EURO and EURO-USD currency pairs. Also these deposits can be structured with different option types and offer different payoff features according to these option types. In Turkey most popular FX-linked structured deposits with different option types are; Dual Currency Deposit (DCD), Range Accrual, Double No Touch and Wedding Cake. Operating processes, compositions and features of these products will be analyzed in the next section with examples. Lastly; these products can be with or without capital protection feature.

b. Stock Market-Linked Structured Deposits

These products aren’t as popular as FX-linked deposits. They are mostly linked to IMKB30 or IMKB100 indices and generate returns to their investors according to the performances of these indices. These types of structured deposits are mostly offered for the investors who cannot undertake a risk to invest in the stock market directly but would still like to obtain return on stock market movements. These products can be with or without capital protection feature.

c. Bond-Linked Structured Deposits

These deposits are structured in order to generate extra return from the price movements of Turkish government bonds, treasury bills and Eurobonds. These products can be with or without capital protection feature.

d. Commodity-Linked Structured Deposits

Thus far, only a few banks offered this type of structured deposits. Gold was the most popular commodity among banks. Like the other types of structured deposits; these products can be with or without capital protection feature.

5.2.2.3. Most Common Types of Structured Deposits in Turkey

In this section most popular structured deposits which are DCD, Range Accrual, Double No Touch and Wedding Cake will be analyzed. As it is told in the previous section, there is not a reliable data about the volume of these products sold in Turkey. However, if these 4 products are compared with each other; DCD is leading the first place in recognition, popularity and volume sold. This is mostly because, DCD is a less complex and easier accessible product (with lower minimum participation limit) compared to other 3 products.

In Turkey, these 4 products firstly introduced to private banking customers (high net-worth individuals) because they have high minimum participation limits (approximately 100.000 $). However, recently retail customers of the banks started to open DCD accounts because minimum participation limit of DCD was lowered by the banks (till 10.000$ in some banks). On top of all this, downtrend in interest rates of time deposits (especially TL time deposits) led an increase in number and volume of DCD accounts opened.

Remaining part of the study will be examining these 4 products, starting from DCD.

a. DCD (Dual Currency Deposit)

aa. Definition, Main Characteristics and Features of DCD

Dual Currency Deposit (DCD) is the most popular type of structured deposit in Turkey. DCD can be defined as a transaction between an investor and a bank and consisting of a time deposit and an option contract. In this option contract the bank pays a premium to the investor for the FX option he/she has sold to the bank. In exchange of this premium, the investor gives the bank a right to buy a specified currency (TL, USD, EURO, GDP and etc) at a predetermined price (strike price). This option contract is combined to a time deposit account so the bank secures the deposit amount as collateral and the investor earns interest for his/her deposit within the maturity of the option contract. The premium of the option contract is given to the investors as an extra interest to their time deposit accounts. In every DCD there is a principal currency in which the original investment is hold and there is an alternative currency which is chosen by the investor ‘to play against the bank’ (Chorafas 2007).

In every DCD transaction following features are found;

  • A principal currency that the deposit account of the investor is held in (mostly called base currency)
  • An exchange rate of a currency pair composed of base currency and another currency
  • An option contract that’s is written on this exchange rate (call option for base currency, put option for other currency)
  • Strike price (exercise price)
  • MaturityOther important features of DCDs are;
    • Like time deposits, DCDs cannot be cashed before their maturity without any penalty. Cancellation before their maturity reduces interest earned to zero and can lead a loss in principal invested (‘HSBC Dual currency Deposit Product Fact Sheet 2009’).
    • In usual option contracts, premium is paid at the beginning of the maturity. However, most of the banks pay the premium of DCD at the end of the maturity as an extra interest to the deposit account.
    • In DCD transactions, European options are used that’s why options can be exercised only at the maturity.
    • In DCD transactions, different minimum participation limits are applied by the banks in Turkey varying from 10.000 to 500.000 USD or equivalent currencies.

Most popular types of DCDs in Turkey are;

  • USD Call / TL Put DCD: This type is structured on a USD time deposit. Investor holds USD and sells the bank a right to buy USD at a predetermined strike price. Strike price is chosen at a higher USD/TL rate from the spot rate.
  • TL Call / USD Put DCD: This type is structured on a TL time deposit. Investor holds TL and sells the bank a right to sell USD at a predetermined strike price. Strike price is chosen at a lower USD/TL rate from the spot rate.
  • EURO Call / TL Put DCD: This type is structured on a EUR time deposit. Investor holds EUR and sells the bank a right to buy EUR at a predetermined strike price. Strike price is chosen at a higher EUR/TL rate from the spot rate.
  • TL Call / EURO Put DCD: This type is structured on a TL time deposit. Investor holds TL and sells the bank a right to sell EUR at a predetermined strike price. Strike price is chosen at a lower EUR/TL rate from the spot rate.
  • USD Call / EURO Put DCD: This type is structured on a USD time deposit. Investor holds USD and sells the bank a right to sell EUR at a predetermined strike price. Strike price is chosen at a lower EUR/USD rate from the spot rate.
  • EURO Call / USD Put DCD: This type is structured on a EUR time deposit. Investor holds EUR and sells the bank a right to buy EUR at a predetermined strike price. Strike price is chosen at a higher EUR/ USD rate from the spot rate.In all these DCD types; loss of principal is possible and investors undertake exchange rate risks in order to obtain higher returns than usual time deposits. That’s why DCDs can be defined as first–class instruments and they are suitable for the investors who are looking to increase their return and prepared to take a degree of exchange rate risk (Credit Suisse:

Money Market Transactions 2006’). This exchange rate risk is exist due to differentiation of foreign exchange types subject to market conditions and this risk is undertaken by the investor (depositor) since the investor is in option writer position in these transactions. (‘BDDK Dual Currency Deposit Hakkında Basın Duyurusu’ 2010).

If an investor wants to participate in a DCD transaction first of all he/she should choose a currency pair (for example USD/TL). Then investors should nominate one of these currencies as base currency and the other as alternate currency. Once the investor has selected currency pair, base currency and alternate currency he/she must choose strike price and buffer value (difference between strike and spot price). Here buffer value shows the permissible appreciation/depreciation value of the base currency against the alternate currency. Finally investor chooses investment amount and investment term (maturity) (‘Citibank: Dual Currency Accounts 2006’).

To give a case in point; let’s consider an investor has an amount of Z USD. This investor expects a rise in USD/TL rate and he/she expects this rise till a specific rate (X) USD/TL, within a specific maturity (Y) days. At this time, this investor can participate in a USD Call / TL Put DCD with a strike price of (X) USD/TL and maturity of (Y) days. Investor may think USD/TL rate will not go above (X) USD/TL (strike price), or even if it does he/she finds it acceptable to convert his/her Z USD to TL at an exchange rate of (X) USD/TL after (Y) days.

In the following part, numerical examples of USD Call / TL Put and TL Call / USD Put DCDs can be found.

ab. USD Call / TL Put – TL Call / USD Put DCD Examples

In this part numerical examples of USD Call / TL Put and TL Call / USD Put DCD transactions will be presented. Rates and prices used in these numerical examples are average prices that can be found in the market at 22th March 2010.

aba. USD Call / TL Put DCD Example

In the following table a USD Call / TL put type of DCD transaction can be found.

Table 5.2: USD Call / TL Put DCD Example

USD Call / TL Put

Date: 22.03.2010

Transaction Amount

100.000 USD

Underlying

USD/TL

Spot Price

1,5385

Strike Price

1,5525

Maturity

1 month – 30 Days

Deposit (%)

2,00 (gross)

Premium (%)

8,00 (gross)

Table 5.2 shows a DCD transaction that occurs between an investor and a bank. At 22.03.2010, an investor with 100.000 USD principal sells the bank a right to buy USD at 1,5525 after 1 month (30 days). In exchange for this, bank gives the investor %8,00 (gross) interest to his/her principal as premium. In addition; by participating to this DCD transaction investor earns %8,00 (premium) + %2,00 (1 month TL deposit interest rate) = %10,00 gross interest to his/her principal. In other words; normally with this amount of principal, investor could earn %2,00 (gross) interest by investing in a usual time deposit; however, by undertaking the USD/TL exchange rate risk, investor could earn %10,00 (gross) interest.

At maturity 2 scenarios can happen; First scenario; if after 30 days, USD/TL rate is below the strike price (1,5525) for example 1,5500; the bank will not use its right to buy USD from 1,5525 because USD can be found cheaper than 1,5525 in the market. The investor’s 100.000 USD principal will be protected as 100.000 USD and the investor will earn %10,00 (gross) interest to his/her principal.

At the end of the DCD transaction gross amount of interest earned by the investor will be;

Screen Shot 2015-02-15 at 10.24.46

(100.000 x (0,08 + 0.02)) / 365 * 30 = ~ 822 USD

If the investor didn’t participate to this DCD transaction and invest 100.000 USD in 30 days time deposit, he/she could earn;

(100.000 x 0,02) / 365 * 30 = ~ 164 USD

As an overview; at the end of the transaction, investor earns 822 USD for 100.000 USD he/she invests in DCD for 1 month. That means; investor earns about 658 USD more than time deposit in 30 days by undertaking the USD/TL exchange rate risk. Since taken risk doesn’t come true at the end of the maturity, investor obtains 658 USD extra return by investing in DCD instead of investing in usual time deposit.

Second scenario if after 30 days, USD/TL rate is at or above the strike price (1,5525), for example 1,5700; the bank will use its right to buy USD from 1,5525 because in the market USD/TL is above 1,5525 (more expensive). The investor’s 100.000 USD principal will be converted to TL from 1,5525 exchange rate. At this point; the investor will earn %10,00 (gross) interest to his/her principal, but at the end of the maturity his/her principal is converted to TL with an unfavorable exchange rate for the investor.

At the end of the DCD transaction, gross amount of interest earned by the investor will be;

(100.000 x 0,10) / 365 * 30 = ~ 822 USD Investor’s principal loss will be;
(1,5700 – 1.5525) * 100.000 = 1.750 USD In total investor will be making a loss of 1.750 – 822 = 928 USD

Investor earns about 822 USD in 30 days by undertaking USD/TL exchange rate risk. Furthermore, at the end of the maturity an amount of 1.750 USD principal loss occurs because the risk undertaken by the investor comes true. At the end of the transaction, investor losses 928 USD in total for 100.000 USD he/she invested in DCD for 1 month.

In this example; breakeven point (the price at which a DCD transaction produces neither a gain nor a loss) is;

1,5525 + ((100.000 x 0.10)/365*30) / 100.000 = ~ 1,5607

In other words; if the market price is ~ 1.5607 at the end of DCD’s maturity, the investor will be at break-even point for that DCD transaction.

Figure 5.6 shows the payoff graph of a USD Call / TL Put DCD example. In this figure x axis of the graph represents the market price of the underlying exchange rate and y axis of the graph represents profit/loss amount that is made by the investor according to the different market prices of exchange rate. Also in the graph (b) is equal to TL time deposit interest rate and (a) is equal to DCD premium.

dual currency deposit example

Source: Isbank

Figure 5.6: Payoff Graph of USD Call / TL Put DCD Example

As can be seen from Figure 5.6; till strike price, investor earns a fixed amount of profit that is equal to DCD premium plus time deposit interest rate. At the prices above strike price, since the risk undertaken by the investor comes true, investor starts to lose money in every rise in the exchange rate. Till breakeven point; total interest taken by the investor (DCD premium + deposit interest rate) compensates total loss occurred, but after breakeven point; investor starts to lose from his/her principal investment.

abb. TL Call / USD Put DCD Example

In the following table a TL Call / USD put type of DCD transaction can be found.

Table 5.3: TL Call / USD Put DCD Example

TL Call / USD Put

Date: 22.03.2010

Transaction Amount

100.000 TL

Underlying

USD/TL

Spot Price

1,5385

Strike Price

1,5300

Maturity

1 month – 30 Days

Deposit (%)

8,75 (gross)

Premium (%)

5,25 (gross)

Table 5.3 shows a DCD transaction that occurs between an investor and a bank. At 22.03.2010, an investor with 100.000 TL principal sells bank the right to sell USD at 1,5300 after 1 month (30 days). In exchange for this, bank gives the investor %5,25 (gross) interest to his/her principal as premium. In addition, by participating to this DCD transaction; investor earns %5,25 (premium) + %8,75 (1 month TL time deposit interest rate) = %14,00 gross interest to his/her principal. In other words; normally with this amount of principal investor could earn %8,75 (gross) interest by investing in usual deposit; however, by undertaking the USD/TL exchange rate risk, investor could earn %14,00 (gross) interest.

At maturity 2 scenarios can happen;

First scenario, if after 30 days, the USD/TL rate is above the strike price (1,5300), for example 1,5350; the bank will not use its right to sell USD from 1,5300 because in the market bank can sell USD above 1,5300. The investor’s 100.000 TL principal will be protected as 100.000 TL and the investor will earn %14,00 (gross) interest to his/her principal.

At the end of the DCD transaction gross amount of interest earned by the investor will be;

Screen Shot 2015-02-15 at 10.26.01

(100.000 x (0.0875 + 0.0525)) / 365 * 30 = ~ 1.150 TL

If the investor didn’t participate to this DCD transaction and invest 100.000 TL in 30 days time deposit, he/she could earn;

(100.000 x 0,0525) / 365 * 30 = ~ 431 TL

As an overview; at the end of the transaction, investor earns 1.150 TL for 100.000 TL he/she invests in DCD for 1 month. That means; investor earns about 719 TL more than time deposit in 30 days by undertaking the USD/TL exchange rate risk. Since taken risk doesn’t come true at the end of the maturity, investor obtains 719 TL extra return by investing in DCD instead of investing in usual time deposit.

Second scenario; if after 30 days, the USD/TL rate is at or below the strike price (1,5300) for example 1,5150; the bank will use its right to sell USD from 1,5300 because in the market USD is below 1,5300. The investor’s 100.000 TL principal will be converted to USD from 1,5300 exchange rate. At this point; the investor will earn %14,00 (gross) interest to his/her principal, but at the end of the maturity his/her principal is converted to USD with an unfavorable exchange rate for the investor.

At the end of the DCD transaction gross amount of interest earned by the investor will be;

(100.000 x (0,0875 + 0.0525)) / 365 * 30 = ~ 1.150 TL

Investor’s principal loss will be; (1,5300 – 1.5150) * 100.000 = 1.500 TL In total investor will be making a loss of 1.500 – 1.150 = 350 TL

Investor earns about 1.150 TL in 30 days by undertaking USD/TL exchange rate risk. Furthermore, at the end of the maturity an amount of 1.500 TL principal loss occurs because the risk undertaken by the investor comes true. At the end of the transaction, investor losses 350 TL in total for 100.000 TL he/she invested in DCD for 1 month.

In this example breakeven point (the price at which a DCD transaction produces neither a gain nor a loss) is;

1,5300 – ((100.000 x 0,14) / 365 * 30) / 100.000 = ~ 1,5185

In other words; if the market price is ~ 1.5185 at the end of DCD’s maturity, the investor will be at break-even point for that DCD transaction.

Figure 5.7 shows the payoff graph of a TL Call / USD Put DCD example. In this figure x axis of the graph represents the market price of the underlying exchange rate and y axis of the graph represents profit/loss amount that is made by the investor according to the different market prices of exchange rate. Also in the graph (b) is equal to TL time deposit interest rate and (a) is equal to DCD premium.

dual currency deposit example

Source: Isbank

Figure 5.7: Payoff Graph of TL Call / USD Put DCD Example

As can be seen from Figure 5.7 till strike price; investor earns a fixed amount of profit that is equal to DCD premium plus deposit interest rate. At the prices below strike price since the risk undertaken by the investor comes true, investor starts to lose money in every fall in the exchange rate. Till breakeven point, total interest taken by the investor (DCD premium + deposit interest rate) compensates total loss occurred, however after breakeven point investor starts to lose from his/her principal investment.

In other types of DCDs; (EURO Call / TL Put, TL Call / EURO Put, USD Call / EURO Put, EURO Call / USD Put) the operating process is the same with the examples above.

ac. Taxation of DCD

In Turkey; taxation of DCD transaction can be considered in 2 parts;

Deposit Part: %15 withholding tax is applied to the deposit part of DCD.

Option Part: If investor obtains a return from option part of the DCD at the end of the maturity, then %10 withholding tax will be applied to the option part of the DCD. If investor makes a loss from option part of the DCD (capital loss exceeds the premium earned from option) at the end of the maturity, then a tax exemption will be occurred and no tax is applied to the option part of the DCD.

ad. Different Risk Levels of DCD

DCD transactions with the same underlying currency pair and option type may involve different risk levels. For example; in the USD Call / TL Put DCD example of this section, strike price is set to 1,5525 and maturity is set to 1 month. For the same amount of principal (100.000 USD), for the same underlying currency pair (USD/TL) and for the same option type (USD Call / TL Put DCD), risk level of this DCD transaction can vary according to different strike prices and maturities;

• Different maturities for the same strike price: If the maturity is determined shorter than 1 month for this DCD transaction, then risk level of the DCD will decrease so the investor will get lower premium from this DCD transaction. If the maturity is determined longer than 1 month, risk level of DCD will increase so the investor will get higher premium from this DCD transaction.

Figure 5.8 shows this relationship between risk level/premium amount of DCDs and their maturity, when the underlying currency pair and option type of these DCDs are the same.

dual currency deposit risk

Figure 5.8: Maturity & Risk Level/Premium Relationship in DCD

As can be seen from Figure 5.8; for DCD transactions with the same underlying currency pair and option type, maturities of these DCD transactions determine their premium amount and risk level. Longer maturities lead higher risk levels and higher premium payments, shorter maturities lead lower risk levels and lower premium payments to the investors.

• For the same maturity different strike prices; If the strike price is determined at a price above 1,5525 , risk level of this DCD will decrease so the investor will get lower premium from this DCD transaction. If strike price is determined at a price below 1,5525 , risk level of the DCD will increase so the investor will get higher premium from this DCD transaction.

Figure 5.9 shows this relationship between risk level/premium amount of DCDs and their strike price, when the underlying currency pair and option type of these DCDs are the same.

dual currency deposit risk premium

Figure 5.9: Strike Price & Risk Level/Premium Relationship in DCD

As can be seen from Figure 5.9; for DCD transactions with the same underlying currency pair and option type, strike prices of these DCD transactions determine their premium amount and risk level. Closer strike prices from spot price lead higher risk levels and higher premium payments, farther strike prices from spot price lead lower risk levels and lower premium payments to the investors. In other words; Distance of the strike price from the spot rate is determined by the investor’s risk appetite (‘RBC: Dual Currency Deposit’ 2009).

ae. Contrary Bank Transaction of DCD

Entire banks operating in Turkey hedge their risks resulting from DCDs by making ‘contrary bank transactions’. In a contrary bank transaction; bank operates in the middle of a DCD investor and a third party (a bank or any other financial institution). Bank buys DCD’s option contract from the investor of this DCD and sells this option contract to a third party. In this contrary bank transaction bank tries to earn commissions without undertaking exchange rate risk.

dual currency deposit

 

Figure 5.10: Contrary Bank Transaction

Figure 5.10 shows a contrary bank transaction of a bank to hedge its risk resulting from a DCD transaction. In the figure ABC option contract represents the option part of this DCD transaction.

As can be seen from Figure 5.10; bank operates in the middle between an investor and a third party for an ABC option. Bank buys this ABC option from the investor and pays X amount of premium and sells this ABC option to a third party and gets Y amount of premium. Difference between Y and X shows the commission earned by the bank from this DCD transaction consisting of an ABC option.

In this example; minimum amount of an ABC option that can be sold to a third party affects the minimum amount of capital that is needed by the investor to participate in a DCD transaction consisting of this ABC option. At this point; the bank can buy this ABC option from one investor or from more than one investor. If the bank buys this ABC option from only one investor; then the minimum amount of capital that is needed by the investor to participate in a DCD transaction consisting of this ABC option will be higher, (around 100.000 USD if banks operating in Turkey and their counterparties are considered).

Bank BUY ABC OPTION – PAYS X USD Investor

Bank SELL ABC OPTION – GETS Y USD Third Party

If the option part of a DCD is sold to one investor, then it can be told that; this DCD is tailored for a specific investor. Mostly in this kind of DCD transactions; firstly bank contacts with the investor and gets the demands of the investor about DCD’s strike price and maturity. Then the bank contacts with a third party and obtains a premium according to strike price and maturity determined by the investor. After this process; bank offers the investor a premium which is equal to the difference between the premium obtained from a third party and bank’s commission. If investor accepts this premium, DCD transaction will occur.

At the same time, it is possible for the same bank to buy this ABC option from more than one investor. At this point the minimum amount of capital that is needed by the investor to participate in a DCD transaction consisting of this ABC option can be lowered. For example; let’s assume minimum 100.000 USD capital is needed to sell ABC option to a third party. Bank can raise this 100.000 USD from one investor or 10 different investors at an amount of 10.000 USD.

If the option part of a DCD is sold more than one investor, firstly the bank will obtain a premium for selling ABC option to a third party and then according this premium the bank will find investors to include a DCD consisting of this ABC option. In this method; unlike tailoring a DCD to a specific investor, a predetermined DCD is sold to many investors in order to lower the minimum participation limit.

In Turkey; minimum participation limits to DCD transactions differ from bank to bank and vary from 10.000 to 500.000 USD because of these different raising capital methods.

In the following part of the section other popular types of structured deposits will be analyzed.

b. Range Accrual

It is a %100 capital protected structured deposit where the investor determines a specific range (band) with upper and lower limits for the underlying exchange rate for a specific maturity. Within this maturity; investor earns premium when the exchange rate stays in the range that is determined by the investor. For each day the exchange rate stays in the range, an interest is earned by the investor. For the days that exchange rate stays out of the range, investor doesn’t earn any interest. This product is %100 capital protected because in worst scenario; within the maturity exchange rate doesn’t stay in the range in a single day. At this time; the investor earns no interest but takes his/her principal back at the end of the maturity.

Composition of Range Accrual is; deposit + range accrual style option. Interest that is paid to the investor for the days that exchange rate stays in the range is equal to the premium of range accrual option.

Range Accrual can be considered as a less risky product than DCD for the investors, because a loss in the principal is possible in DCD; however, in Range Accrual principal investment is %100 protected. Risk level of Range Accrual can be determined according to the investor’s risk appetite. If the investor is risk averse the band of Range Accrual will be wider; if the investor risk appetite is higher band will be narrower.

In Turkey, minimum participation limit for Range Accrual is higher than DCD, about 1.000.000 USD. Range Accrual is usually structured on TL, USD and EUR deposits for USD/TRY, EUR/TRY, EUR/USD exchange rates with maturities differing from one to six months. Premium earned by Range Accrual is subject to %10 withholding tax in Turkey.

Operating process of a typical Range Accrual product can be examined by the following example in Table 5.4 (Numbers on the table do not reflect real market data; they are simulated for this example).

Table 5.4: USD/TL Range Accrual Example

USD/TL Range Accrual

Date: 22.03.2010

Transaction Amount

1.000.000 USD

Underlying Exchange Rate

USD/TL

Spot Price

1,5385

Determined Range

1,5200 – 1,5500

Maturity

1 month

Premium (%)

10,00 (gross)

During the transaction Market Deposit Rate for 3 months USD deposit is %2,00 (gross)

Table 5.4 shows a Range Accrual transaction that occurred between an investor and a bank. At 22.03.2010, an investor with 1.000.000 USD participates a Range Accrual transaction with underlying exchange rate of USD/TL and determines 1,5200 – 1,5500 range for 1 month (30 days). The investor deposits his/her 1.000.000 USD to the bank for 1 month and earns %10,00 interest from his principal for each day that exchange rate stays in the range determined by the investor.

At the end of the maturity investor earns [Principal x Premium Rate x T / 365] where T represents number of days that exchange rate stays in the range.

For this example investor earns; [1.000.000 x 0,10 x T /365], where T represents number of days that exchange rate stays in the range.

Let’s assume 2 different scenarios will happen at the end of this Range Accrual’s maturity.

Scenario 1: Let’s assume the exchange rate moves like in Table 5.5 and stays 17 days in the range.

Screen Shot 2015-02-15 at 16.30.08

Table 5.5: USD/TL Range Accrual Example: 1st Scenario

At the end of the maturity investor will earn from this Range Accrual transaction;

[1.000.000 x 0,10 x 17 /365] = ~ 4657 USD

Investor would earn [1.000.000 x 0,02 x 30 /365] = ~ 1.643 USD (gross) if he/she has chosen usual USD time deposit instead of Range Accrual deposit.

Scenario 2: Let’s assume the exchange rate moves like in Table 5.6 and stays 0 days in the range.

range accrual

Table 5.6: USD/TL Range Accrual Example: 2nd Scenario

At the end of the maturity investor will earn from Range Accrual transaction;

[1.000.000 x 0,10 x 0/365] = 0 USD

Investor would earn [1.000.000 x 0,02 x 30 /365] = ~ 1.643 USD (gross) if he/she has chosen usual USD time deposit instead of Range Accrual deposit.

c. Double No Touch

Double No Touch is a kind of structured deposit that has very similar characteristics with Range Accrual. In Double No Touch, investor also determines a range and earns premium (interest) when the exchange rate stays in this range. However, the only and the basic difference between Double No Touch and Range Accrual is; if the exchange rate moves out of the range (any day once or many times) through the maturity, the investor couldn’t earn any premium.

At the end of the maturity 2 possible outcomes can happen for Double No Touch;

1) The exchange rate stays in the range all the days through the maturity, so investor earns premium for these days.

2) Theexchangeratemovesoutoftherange(onceormanytimes) through the maturity, so investor doesn’t earn any premium.

Other characteristics of Double No Touch deposits are the followings;

  • It is a %100 capital protected product.
  • Composition of Double No Touch is; deposit + range accrual knocked-out style option. Interest that is paid to the investor for the days that stays in the range is equal to the premium of this knocked- out style option.
  • If DCD and Double No Touch are compared about their risk levels undertaken by their investors; Double No Touch is a less risky product than DCD. That’s because a loss in the principal is possible in DCD at the end of the maturity; however, in Double No Touch principal is %100 protected.
  • If Range Accrual and Double No Touch are compared about their risk levels undertaken by their investors; Range Accrual is a less risky product than Double No Touch. That’s because of the Double No Touch’s knocked-out feature. For this reason, for the same exchange rate range and maturity; the premium of Double No Touch is always higher than the premium of Range Accrual.
  • Risk level of Double No Touch can be determined according to the investor’s risk appetite. If the investor is risk averse the band will be wider; if the investor risk appetite is higher, band will be narrower.
  • In Turkey minimum participation limit for Double No Touch is higher than DCD, starting from 1.000.000 USD.
  • Double No Touch deposits are usually structured on TL, USD and EUR deposits for USD/TRY, EUR/TRY, EUR/USD exchange rates with maturities that are differ from one to six months.
  • Premium earned by a Double No Touch deposit is subject to %10 withholding tax in Turkey.Operating process of a typical Double No Touch product can be examined by the following example in Table 5.7

    Table 5.7: USD/TL Double No Touch Example

USD/TL Double No Touch

Date: 22.03.2010

Transaction Amount

1.000.000 USD

Underlying Exchange Rate

USD/TL

Spot Price

1,5385

Determined Range

1,5200 – 1,5500

Maturity

1 month

Premium (%)

20,00 (gross)

During the transaction Market Deposit Rate for 3 months USD deposit is %2,00 (gross)

Table 5.7 shows a Double No Touch transaction between an investor and a bank. At 22.03.2010, an investor with 1.000.000 USD participates a Double No Touch transaction with the underlying exchange rate of USD/TL and determines 1,5200 – 1,5500 range for 1 month (30 days). Within 1 month; the investor deposits his/her 1.000.000 USD to the bank and will earn %20,00 interest to his/her principal for 1 month if the exchange rate stays in the range all the days during the maturity. However, if the exchange rate moves out of the range just even a single day, investor will not get any premium and will get his/her principal back at the end of the maturity.

At the end of the maturity; investor earns,

[Principal x Premium Rate x T / 365]

if the exchange rate stays all the days in the range through maturity. In this formula, T represents number of days that the exchange rate stays in the range.

For this example; investor earns,

[1.000.000 x 0,20 x T /365]

if the exchange rate stays all the days in the range through maturity. T represents number of days that the exchange rate stays in the range.

Let’s assume 2 different scenarios will happen at the end of this Double No Touch’s maturity.

Scenario 1: Let’s assume the exchange rate moves like in Table 5.8 and stays 17 days in the range.

 Double No Touch

Table 5.8: USD/TL Double No Touch Example: 1st Scenario

At the end of the maturity investor earns nothing from this Double No Touch transaction, because the exchange rate has moved out from the range within the maturity.

Investor would earn [1.000.000 x 0,02 x 30 /365] = ~ 1.643 USD (gross) if he/she has chosen usual USD time deposit instead of Double No Touch deposit.

Scenario 2: Let’s assume the exchange rate moves like in Table 5.9 and stays 30 days (the entire maturity) in the range.

 Double No Touch

Table 5.9: USD/TL Double No Touch Example: 2nd Scenario

At the end of the maturity investor will earn from this Double No Touch transaction;

[1.000.000 x 0,20 x 30/365] = ~ 16.438 USD (gross)

Investor would earn [1.000.000 x 0,02 x 30 /365] = ~ 1.643 USD (gross) if he/she has chosen usual USD time deposit instead of Double No Touch deposit.

d. Wedding Cake

It is a %100 capital protected structured deposit where the investor determines 3 ranges (bands) with 3 upper and lower limits for the underlying exchange rate for a specific maturity. Payoff graphs of these deposits look like ‘wedding cake’ (see Figure 5.11) because of their tiered payoff profile, and that’s why they are called wedding cake deposits (‘RBC Wedding Cake Deposit’ 2009). Within the maturity investor of a wedding cake deposit earns different interests (premiums) for the days that the exchange rate stays in different ranges. Investor earns a premium with respect to first range (inner range) when the exchange rate stays in the first range during the maturity. Investors earns a premium with respect to second range (middle range), when the first range is breached through second range, but second range isn’t breached through third range during maturity. Investors deserves a premium with respect to third range (outer range), when the second range is breached through third range, but third range isn’t breached through outer rates. If third range is breached through outer rates, investor gets only his/her principal without any premium. (A breach occurs when the exchange rate reaches the band level on either side)

At the end of the maturity only one premium rate is applied to the investor’s account and this premium will be the premium of widest range that is reached within the maturity by the exchange rate. For example for a 90 days Wedding Cake; if the exchange rate stays 15 days in first, 15 days in second, 15 days in first, 16 days in second, 13 days in third, 14 days in second and 2 days in first respectively, at the end of the maturity the premium that will be applied to the investor’s account will be the third range’s premium for 90 days period. Although the exchange rate stayed for 32 days in first range, 45 days in second range and 13 days in third range as total, third rage’s premium is applied for 90 days because during the maturity third range was the widest range that is reached by the exchange rate.

Figure 5.11 shows payoff graph of a wedding cake deposit. In this figure x axis of the graph represents the market price of the underlying exchange rate and y axis of the graph represents the premiums that is paid to the investors according to the different ranges.

Wedding Cake

Source: Isbank

Figure 5.11: Wedding Cake Payoff Graph

As can be seen from Figure 5.11; as the bands are widening, their premium rate is lowering. First range is the narrowest range with the highest premium rate. Third range is the wider range with the lowest premium rate. At the exchange rates that are out of the 3rd range, premium rate is equal to zero.

Other characteristics of Wedding Cake deposits are the followings;

  • This product is also %100 capital protected, because in the worst scenario the outer range is breached by the exchange rate within the maturity and at this time the investor earns no interest but takes his/her principal back at the end of the maturity.
  • If DCD and Wedding Cake is compared about their risk levels that are undertaken by their investors; Wedding Cake is a less risky product than DCD because of its capital protection feature. Risk level of Wedding Cake can be determined according to the investor’s risk appetite. If the investor is risk averse the bands will be wider; if the investor risk appetite is higher bands will be narrower
  •  In Turkey minimum participation limit of Wedding Cake products is higher than DCD, starting from 1.000.000 USD. These deposits are usually structured on TL, USD and EUR deposits for USD/TRY, EUR/TRY, EUR/USD exchange rates with maturities that are differ from three to six month. Premium earned by Wedding Cake product is subject to %10 withholding tax in Turkey.

Operating process of a typical Wedding Cake product can be examined by the following example in Table 5.10 (Numbers on the table do not reflect real market data, they are simulated for this example)

Table 5.10: USD/TL Wedding Cake Example

USD/TL Wedding Cake

Date: 22.03.2010

Transaction Amount

1.000.000 USD

Underlying Exchange Rate

USD/TL

Spot Price

1,5385

Determined Ranges

First Range

1,5200 – 1,5500

Second Range

1,5000 – 1,5700

Third Range

1,4800 – 1.5900

Maturity

3 months

Premiums (%)

1,5200 – 1,5500

18,00 (gross)

1,5000 – 1,5700

7,00 (gross)

1,4800 – 1.5900

1,00 (gross)

During the transaction Market Deposit Rate for 3 months USD deposit is %2,00 (gross)

Table 5.10 shows a Wedding Cake transaction between an investor and a bank. At 22.03.2010, an investor with 1.000.000 USD participates to a Wedding Cake transaction with the underlying exchange rate of USD/TL and determines 3 ranges for 3 months (90 days). The ranges and premiums given to these ranges are determined as; 1,5200 – 1,5500 (%18,00 gross), 1,5000 – 1,5700 (%7,00 gross), 1,4800 – 1,5900 (%1,00 gross).

At the end of the maturity investor earns;

[Principal x Premium Rate x T / 365]

Where; T represents number of days that the exchange rate stays in the ranges. Premium Rate refers the widest range’s premium that is reached within the maturity by the exchange rate.

Let’s assume 4 different scenarios will happen at the end of this Wedding Cake’s maturity.

Scenario 1: Let’s assume the exchange rate moves like in Table 5.11.

Wedding Cake

Table 5.11: USD/TL Wedding Cake Example: 1st Scenario

Since widest range that is reached by the exchange rate is 1st range and its premium is %18; at the end of the maturity investor will earn from this Wedding Cake transaction;

[1.000.000 x 0,18 x 90 /365] = ~ 44.383 USD (gross)

Investor would earn [1.000.000 x 0,02 x 90 /365] = ~ 4.931 USD (gross) if he/she has chosen usual USD time deposit instead of Wedding Cake deposit.

Scenario 2: Let’s assume the exchange rate moves like in Table 5.12.

Wedding Cake

Table 5.12: USD/TL Wedding Cake Example: 2nd Scenario

Since widest range that is reached by the exchange rate is 2nd range and its premium is %7; at the end of the maturity investor will earn from this Wedding Cake transaction;

[1.000.000 x 0,07 x 90 /365] = ~ 17.260 USD (gross)

Investor would earn [1.000.000 x 0,02 x 90 /365] = ~ 4.931 USD (gross) if he/she has chosen usual USD time deposit instead of Wedding Cake deposit.

Scenario 3: Let’s assume the exchange rate moves like in Table 5.13.

Wedding Cake deposit

Table 5.13: USD/TL Wedding Cake Example: 3rd Scenario

Since widest range that is reached by the exchange rate is 3rd range and its premium is %1; at the end of the maturity investor will earn from this Wedding Cake transaction;

[1.000.000 x 0,01 x 90 /365] = ~ 2.466 USD (gross)

Investor would earn [1.000.000 x 0,02 x 90 /365] = ~ 4.931 USD (gross) if he/she has chosen usual USD time deposit instead of Wedding Cake deposit.

Scenario 4: Let’s assume the exchange rate moves like in Table 5.14.

Wedding Cake deposit

Table 5.14: USD/TL Wedding Cake Example: 4th Scenario

Since the exchange rate breached all the ranges during the maturity, investor couldn’t earn any premium. At the end of the maturity investor will earn from this Wedding Cake transaction;

[1.000.000 x 0 x 90 /365] = 0 USD (gross)

Investor would earn [1.000.000 x 0,02 x 90 /365] = ~ 4.931 USD (gross) if he/she has chosen usual USD time deposit instead of Wedding Cake deposit.

5.2.2.4. Advantages & Disadvantages of Structured Deposits in Turkey

Popularity and use of structured deposits are increasing in Turkey. Despite the market conditions, the advantages of these products are quite important on this development. Structured deposits have advantages such;

  • If structured deposits are compared to time deposits; structured deposits can generate higher returns than time deposits according to the performance of the underlying assets.
  • If structured deposits are compared with structured funds; they can be bought anytime and they do not have public offerings periods like structured funds.
  • Some of the structured deposits (Range Accrual, Double No Touch, Wedding Cake and etc…) enable the investors to access a higher return possibility by protecting their initial investments.
  • Structured deposits can be tailored according to the investor’s demand and risk appetite. Structured deposits can be available in different maturities, risk levels and underlying instruments subject to investor’s needs and demands.
  • Unlike structured funds, structured deposits don’t have an annual management fee or front end fees.
  • Structured deposits provide easy access to different kinds of instruments across the world in an easier and cheaper way.
  • Structured deposits provide diversification in the investors’ portfolios in an easier and cheaper way. Since structured deposits can have hundreds of underlying instruments like shares, indices, commodities, equities, foreign currencies and etc… they enable the investors to diversify their portfolio.Although structured deposits have these attractive features and advantages, at the same time they have some disadvantages such as;
    • Composition of the structured deposits is more complex than usual time deposits. Different option strategies can be used in order to establish a structured deposit. That’s why sometimes composition of a structured deposit can be hard to be understood by the investors.
    • Some of the structured deposits like DCD can lead a loss in the investor’s principal.
    • Structured deposits must be hold till their maturity by their investors in order to earn the return that is subject to these structured deposits. That can lead a liquidity problem for the investor because some of the structured deposits can have a maturity higher than 1 year.

5.2.2.5. Taxation of Structured Deposits in Turkey

Structured deposits are subject to 2 taxes in Turkey;
• Deposit Part: %15 withholding tax is applied to the deposit part of structured deposits if deposit part generates any return to the investor.
• Option Part: %10 withholding tax will be applied to the option part, if investor obtains a return from option part of the structured deposit at the end of the maturity. However, a tax exemption will occur and no tax is applied to the option part of structured deposit if investor is making a loss from option part of the structured deposit (capital loss exceeds the premium earned from option) at the end of the maturity.

5.2.2.6. Things to Be Considered By the Investors Before Investing In Structured Deposits:

Since structured deposits can have very different compositions and features; an investor should consider the followings before choosing a structured deposit.

  • Structured deposits are riskier products than usual time deposits so the investors should determine whether they have the risk appetite for the structured deposit they are choosing.
  • Structured deposits are in more complex compositions than usual time deposits so investors should understand the compositions and main features of the structured deposits before investing.
  • Return of structured deposits can be obtained by their investors at the end of their maturities. Any full or partial redemption before the final maturity date may adversely affect the value of the investment and result in a substantial loss for the investors when structured deposits are the issue (‘Structured Deposits – Information for Investors’ 2009). That’s why investors should consider that they can obtain the return which is subject to structured deposits only at the end of the maturity and investors should organize their financial position according to that.

5.3. Conditions Regarding the Development of Retail Structured Products in Turkey

In the previous sections, structured funds (CP/CG Funds) and structured deposits are analyzed within the context of Turkish market. In this section, conditions that are influencing the development of retail structured products in positive and negative manner will be looked in detail.

5.3.1. Conditions Influencing the Development of Retail Structured in Positive Manner

As it is conveyed in the previous sections, structured products have been developing in the Turkish market in the form of structured deposits and funds. Further development of those will be influenced by many parameters. After studying the recent structure of these products in detail; it can be told that the conditions which are probable to influence the development of structured products in positive manner are as follows;

a. Decline in Interest Rates of Time Deposits

A decline in the interest rates of time deposits affects the use of structured products among retail investors in the positive direction.

Table 5.15 shows investment breakdown of Turkish investors in 2009/12.

Table 5.15: Turkish Investors’ Investment Breakdown

Investors’ Investment Breakdown (Million TL) – 2009/11

Volume

%

TL Deposits

287.950

48%

TL Demand Deposits

49.387

8%

TL Time Deposits

238.563

39%

FX Deposits

138.833

23%

FX Demand Deposits

30.679

5%

FX Time Deposits

108.154

18%

Participation Bank Funds

25.954

4%

Bonds/Bills

64.804

11%

Eurobonds

5.201

1%

Mutual Funds

31.409

5%

Repo

3.634

1%

Pension Funds

8.796

1%

Common Stocks

38.781

6%

Total Volume

605.362

100%

Source: The Association of Capital Market Intermediary Institutions of Turkey

As can be seen from table 5.15; investing in time deposits can be evaluated as the most popular investment among Turkish investors because the share of time deposits in all instruments is %57 (%39 TL, %18 FX). It can be told that; with %57 share of deposit, Turkey has a high share in deposit compared to Europe. For example in Switzerland (a market recognized as one of the most developed in Europe), the deposit share of the retail investors is %33.3 in March 2010 (‘SSPA Market report for Structured Products’ 2010).

Due to the higher share of time deposits relative to other investments; investing in time deposits can be considered as the benchmarks of Turkish retail investors.

Since investing in time deposit is a benchmark for Turkish retail investors, opportunity cost of these investors is interest rates of mentioned tools. That’s why interest rates of TL/USD/EUR time deposits and their past movements should be examined in order to analyze the use of structured products in Turkey.

Figure 5.12 shows the average interest rates of TL/USD/EUR time deposits with a maturity of 1 month at most. In this table, TL rates are dating back at 1985 but USD and EUR rates are dating back at 2000. Average TL interest rates of time deposits belonging to 2001 aren’t included in this figure since throughout that year, the increased recorded %7021 in average because of the 2001 financial crisis.

try interest rates

Figure 5.12: Up to 1 Month Average TL/USD/EUR Deposit Interest Rates

As can be seen from Figure 5.12; both TL and FX time deposit interest rates started to decline after 2000. Especially in 2002; opportunity cost of investing in alternative products in FX currency reached to a tolerable level for the FX investors. That’s why usage structured products in FX currency like USD or EUR Call DCDs increased earlier then usage of those in TL form. Opportunity cost of investing in alternative products in TL was always higher than investing in FX products, but especially in 2005, it decreased to a relatively tolerable level. Because of this reason, usage structured products in FX currency like TL Call DCDs and CP/CG funds started to increase after 2005.

In the future; lower interest rates of TL and FX time deposits will lead to a more demand and interest in structured products and vice versa.

b. Financial Globalization

As the global players of the financial world, Fortis, Unicredit, BNP Paribas, Citibank and ING initiated their operations in Turkey, they also brought their know-how and expertise about structured products at the same time. All of these institutions were already familiar with the marketing and designing of structured products.

Without any doubt, the experience of these institutions in structured products influences the development of structured products in a positive way.

c. Heightened Competition

Since a lot of global players familiar with structured products know- how have entered Turkish market, the competition in Turkish financial system is unprecedentedly more severe than ever which in return forces all pawns in the market to seek to improve their products and discover new ones in order to survive the competition; on the other hand, it results in an increase in product diversity and recognition of structured products among investors in Turkish market.

To conclude, heightened competition setting effects the development of structured products in a positive manner.

d. Extensive branch network;

Since structured products are complex instruments; they should be introduced to the investors face to face and for this purpose an extensive branch network is needed. At 31.12.2009 according to the data that is taken from The Banks Association of Turkey (TBB); in Turkish Banking system 45 banks are operating in 9.036 branches with 172.403 employees. According to this data it can be told that Turkey has an extensive branch network in banking system.

Turkish extensive branch network with 9.036 influences the development of structured products in positive manner.

In addition to these conditions; also following conditions are influencing the development of structured products in Turkey in positive manner (‘Société Générale: Capital Guaranteed Funds’ 2008);

  • Turkish individual investors have confidence in local financial institutions.
  • There is an increase in sophisticated needs of investors.
  • More amount of time is being started to be spent in the financial planning activities at the corporate and the individual level.

5.3.2. Conditions Influencing the Development of Retail Structured in Negative Manner

In Turkey; although conditions influence the development of structured products positively, there may be others that have a negative impact on the development of structured products as such;

a. Conservative / Risk Averse Investors

The biggest problem facing the development of structured products is perhaps the characteristics, knowledge and risk appetite of Turkish investors. They have become conservative and risk averse investors because of high interest rates and financial instability. Furthermore, their knowledge regarding structured products is not sufficient to invest in them. That’s why in comparison with the investors in EU and USA; their characteristics, risk appetite and knowledge do not suit the desirable investor profile necessary for structured products. That can be considered as a situation that has a negative impact upon development of structured products in Turkey.

b. Complexity of Products

When the composition, payoff and other features of structured products are compared with traditional investments like bonds and deposits; structured products are more complex products than other products in the market. As explained above; knowledge of Turkish investors is not enough to understand these complex products. That’s why complexity of these products influences the development of structured products in negative manner.

c. High Interest Rates Compared To Other Structured Products Market

Although interest rates (O/N, deposit, bond, policy) have been in a decreasing trend since 2004 in Turkey, those rates are still above normal levels compared to other regional markets which are already developed in structured products (Europe, North America and Asia & Pacific). To conclude; it can be told that in Turkey interest rates are still above normal levels.

Since the policy interest rates determined by Central Banks affect other interest rates in the market (O/N, bond, deposit); in Figure 5.13, policy interest rates of Turkey and some important countries in structured products sector are compared. In the figure policy interest rates of March 2010 are used.

Policy Interest Rates
Figure 5.13: Policy Interest Rates

As can be seen from the Figure 5.13; most developed countries in structured products (EU countries, Switzerland, UK, USA, Hong Kong) have policy interest rates that are equal to or less then %1 when policy interest rates at March 2010 are considered. Figure shows; Turkey has a higher policy interest rate (% 6,50) compared to the countries that are developed in structured products.

High interest rates mean high opportunity costs and high opportunity costs means a deterrent effect for the investors against investing in structured products. That’s because relatively high level of interest rates in Turkey influences the development of structured products in negative manner.

d. Nonexistence of Organized Markets

In Turkey there is not an exchange market for structured products. In structured deposits; the transactions are occurring between investors and banks on OTC markets. Also there is not an organized market for structured funds; investors participate to these funds within the public offerings periods by applying to the banks.

Nonexistence of organized markets leads some problems for the investors and the banks. These problems are listed below:

  • Nonexistence of organized markets leads lack of secondary markets for the structured products. Without secondary markets liquidity problems for structured products arise in Turkey. Illiquidity can be determined as a deterrent effect to the investors for investing in structured products.
  • Nonexistence of organized markets leads lack of product diversity for the structured products. In European markets, especially in German structured products market, existence of exchange traded markets leads the product issuers to issue hundreds of new products in each day with different variations, maturities and underlying instruments (‘Market Report for Structured Products’ 2010). That’s why product diversity is occurred in these markets. Product diversity leads an increase in the investors’ attention to structured products. Conversely, lack of product diversity leads a loss of interest to structured products for the investors.
  • Nonexistence of organized markets leads lack of pricing transparency for the structured products. Without exchange markets, price of the structured products are determined by the banks. In these markets, investors cannot check whether the product is fairly priced or not. This leads lack of confidence for the investors about the prices of structured products and a loss of interest in these products.
  • Nonexistence of organized markets leads lack of performance tracking platform for the structured products. Without exchange markets, performance of structured products cannot be tracked each day. This lack leads a loss of interest in structured products for the investors.As can be realized from all these reasons, nonexistence of organized markets in Turkey influences the development of structured products in negative manner.

    e. Lack of Legal Infrastructure and Legislation

    There are deficiencies in the legal infrastructure and legislation of structured products in Turkey because they are quite new instruments for the market. This situation, on the other hand, does have a negative effect on the development of those structured products when both banks and investors are considered.

  • From the banks’ perspective; to structure these products with deficiencies in legal infrastructure and legislation will be harder in operating process.
  • From the investors’ perspective; investors will be doubtful to invest in these products because of their deficiencies in legal infrastructure and legislation.

Lack of legal infrastructure and legislation influences the development of structured products in negative manner.

f. Being Without Government Guarantee

In Turkey; investors compare the structured products with the bank deposits or government bonds. Since government bonds are debt instruments that are issued by the government and a portion of bank deposits are under the guarantee of government, being without government guarantee influences the development of structured products in negative manner.

g. Instability of The Turkish Economy;

Turkish economy can still be considered as unstable, because in Turkey, even unimportant social, economic and political events have a significant power of affecting rates and prices in financial system. This situation causes on investors behalf, avoiding of alternative investments such as structured products.

Instability of Turkish Economy influences the development of structured products in negative manner.

e. Other problems;

In addition to the problems mentioned above following problems also influences the development of structured products in negative manner.

  • The banks don’t have educated staff in order to introduce and advertise structured products to the investors.
  • The banks don’t have sufficient technical infrastructure for the operating process of structured products. (This is true especially for structured deposits)