Morgan Stanley cuts volatility on currency-linked notes with diverse basket, adviser says

By Kenneth Lim

Boston, July 27 - A currency-linked note by Morgan Stanley lowers the underlying volatility by placing a wide range of currencies into a basket, an investment adviser said.

Morgan Stanley plans to price a series of zero-coupon principal-protected notes due Feb. 28, 2013 linked to a basket of nine currencies.

The basket has a 70% weighting in developed market currencies and a 30% weighting in emerging market currencies. The developed market portion is equally weighted among the Australian dollar, British pound, Canadian dollar, euro, Japanese yen and Swiss franc. The emerging market portion is equally weighted among the Brazilian real, Chinese renminbi and Indian rupee. The basket value will increase if the currencies appreciate relative to the U.S. dollar.

At maturity, investors will receive par plus 120% to 140% of any gain in the index. The exact participation rate will be set at pricing. Investors will receive at least par.

Spreading the risk

The composition of the basket struck the adviser as particularly wide-ranging.

Such a basket will have a lower volatility compared to one that is just linked to fewer currencies, the adviser said.

"It's a little like creating an index on the U.S. dollar," the adviser said.

While lower volatility can be a positive feature in non-principal-protected products, it might not be ideal when the principal is safe.

"You actually want volatility to be on the higher side if it's principal protected because your downside is already covered," the adviser said. "There's no cap on the upside here, so it's even better if your volatility is high because you have a lot more potential on the upside and very little risk on the downside."

But pining for better volatility on this product is probably not realistic, the adviser said.

"It's probably how they can protect the principal and do away with the cap," the adviser said. "You have to give some to take some."

With the low underlying volatility, investors are most likely to have a modest return, the adviser said.

"It shouldn't be a surprise," the adviser said. "An average CD is currently offering maybe 3% per annum. If you're not taking that much more risk, you're probably not going to get a much better return."

Safe exposure

The product could be attractive to cautious investors who think that the value of the U.S. dollar is going decline.

"Investors who want to gain some exposure to foreign currency or want to have a bit of an inflation hedge but don't want to take on too much risk," the adviser said. "It's a principal-protected note, so it's relatively lower risk than the principal-at-risk products, and you have a chance to potentially get a better return on your investment than money market."

Investors who want to use the product as a currency hedge might find better value in more targeted products, the adviser added.

"You probably don't have investments in all nine currencies," the adviser said. "If you're looking for a true hedge, you'd probably want to find something that's just one or two currency pairs."

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