A currency option bond is a security that offers returns in multiple currencies. The holder of a currency option bond can choose the currency in which they would like to be paid. The feature extends to both the coupon payments and the principal payment.
An American manufacturer issues a 5-year USD/GBP bond. Each bond is issued at $100 and is repaid $100 or £80. The annual coupon is $5 or £4. The currency option bond gives the bondholder the right to receive the principal and interest payments in either USD or GBP.
The exchange rate and the coupon rate are fixed at the time of purchase. Therefore, the exchange rate remains $1= £0.80 through the bond’s lifetime. This bond is known as a 5% USD/GBP bond. Such a currency option bond allows the investor to hedge against exchange rate risk. Consider the following:
The USD depreciates against the GBP from $1 = £0.80 to $1 = £0.75. An investor holding the 5% USD/GBP bond specified above would prefer to receive his interest payments in GBP. An investor would rather receive £4 (which is now worth $5.55) than $5. If the exchange rate remains unchanged until maturity, the investor would ask to be reimbursed £80 (worth $106.67).
The USD appreciates against the GBP from $1 = £0.80 to $1 = £0.85. An investor holding the 5% USD/GBP bond specified above would prefer to receive his interest payments in USD. An investor would rather receive $5 than £4 (which is now worth $4.71). If this exchange rate remains unchanged until maturity, the investor would ask to be reimbursed $100.
Advantages of Currency Option Bonds
A currency option bond allows investors to hedge against exchange rate risk. To compensate for the reduced risk, the interest rate on a currency option bond is always lower than the interest rate on any of the single currency bonds that make up the currency option bond. For example, the American manufacturer analyzed in the example above must be paying an interest rate greater than 5% on both its 5-year USD bond and its 5-year GBP bond.
An investor sacrifices the higher return of a single currency bond but gains the ability to hedge against exchange rate risk. In practice, the currency option bonds available to retail investors come with short maturity durations (usually limited to a few months).
Valuation of a Currency Option Bond
The value of a 5-year 5% USD/GBP bond at $1 = £0.80 depends on the value of a straight 5-year 5% USD bond and the value of an option to swap a 5-year 5% GBP bond at a fixed exchange rate of $1 = £0.80.
The value of a 5-year 5% USD/GBP bond at $1 = £0.80 is the sum of the value of a straight bond and the value of a currency option.
Practical Example of a Currency Bond Valuation
An American manufacturer issues a 1-year 5% USD/GBP currency option bond at $1 = £0.80. The bond is sold for $100 and pays an interest of $5 or £4. The current exchange rate is $1 = £0.80. If the USD appreciates, an investor would prefer the principal to be reimbursed in USD, and if the USD depreciates, an investor would prefer the principal to be reimbursed in GBP.
A 1-year USD bond provides a return of 8% and a 1-year GBP bond gives a return of 9%. A 1-year put USD at $1 = £0.80 is priced at $0.01. The currency option bond specified can be replicated by a straight 1-year USD bond redeemed at $100 with a 5% interest rate plus an option to exchange $105 for £84.
The currency option bond issued by the American manufacturer is overpriced. The correct interest rate of a fair currency option bond would be given by the following formula:
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