I was reading an article enticingly entitled “Boost Your Returns” in the latest issue of SmartMoney magazine.  My eyes skimmed down to a section on certificates of deposit.  I like CD’s.  They’re FDIC insured and provide a small but certain return.

CD’s as derivatives

But, whoa, not these CD’s.  The SmartMoney article is about CD’s that are indexed to various assets.  One highlighted CD is pegged to the value of BRIC currencies.  If the value of the foreign currencies rise, I receive an interest rate that is a portion of this growth.  If the currencies fall, relative to the dollar, then I receive no interest, but I do get the principal back at the end of the term.   Huh?  Why would I want to do this?  What does the average person know about the Brazilian real, Russian ruble, Indian rupee, or Chinese renminbi?  And by average, of course, I mean me.

I spend an inordinate percentage of my sparse free time reading about all things financial, but I don’t have an inkling of where these currencies are going. Sure the BRIC economies are staged for growth, but what do I know about the internal politics of each country?  If the Indian finance minister overestimates the need for rupees and prints too many, that will reduce their value.  Likewise, another Russian adventure into Georgia could result in a worldwide embargo, devaluing the ruble.

Why on earth would I want the return on my CD pegged to such a risky quantity?  CD’s are where you put your money when you want to preserve the principal and have access to it, should you need it in an emergency.  Sure you might pay a small interest penalty for early withdrawal, but at least you can get it out (unlike the structured versions).

Other investment options

If you really want a “piece of the action” in the BRIC nations, it would make a lot more sense to take part of your investments that are allocated for long-term risky growth and invest it in BRIC equities, through mutual funds or ETF’s.

If you really want to mimic the convoluted CD’s structure, you can do the following.  You could instead put your money into a conventional bank CD.  Ally Bank usually has good rates.  You take the money that the CD will pay out in interest, and use it to purchase currency options.  To simulate the BRIC version, you’ll have to buy four options — one for each currency.  The options should expire at the same time that the CD matures and should be for the same exchange rate that they are today.  Then when your CD matures if the currencies are worth more than today, you’ll be able to buy them cheaply.  And, better yet, you can get out of your CD at any time (with a potential interest penalty).  Bonus #2:  you can trade or exercise your options at any time — not just at the CD maturity.  If you sense tension along the Pakistani border, you can cash in your option on rupees.

Who should invest in structured CD’s

No one that I can think of.  Seriously.  No one.

Why do we need to turn something simple and easy to understand into a complex derivative.  Haven’t we lived through this nightmare before?  Remember how delightfully dowdy mortgages morphed into the CDO that ate Manhattan?

Full disclosure: I have an account at Ally Bank. I do not own currency options or BRIC-specific mutual funds or ETF’s. I do not own structured CD’s (nor do I plan to).

Tags: BRIC, CD's, certificate of deposit, derivatives

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