JPMorgan links bearish notes to four currencies; narrow sweet spot, but possible hedge tool, adviser says

By Kenneth Lim

Boston, Nov. 12 - A series of partially principal protected bearish currency notes by JPMorgan Chase & Co. has a narrow "sweet spot" that increases the risk of underperformance, an investment adviser said.

JPMorgan plans to price zero-coupon 97% bearish principal protected notes due May 20, 2010 linked to a basket of four reference currencies relative to the U.S. dollar.

The basket comprises equal weights of the euro, the British pound sterling, the Swiss franc and the Japanese yen. The basket level increases if the currencies appreciate relative to the U.S. dollar.

At maturity, investors will receive $970 per $1,000 par note plus an additional amount. The additional amount will equal at least 1% for every 1% decline in the basket, subject to a maximum basket decline of 13%. If the basket ends at or above its initial level, the additional amount will be zero. The participation rate will be set at pricing.

Narrow sweet spot

The note works best if the basket falls within a narrow range, the investment adviser said.

"What strikes me is that you start out 3% underwater, so you need the basket to go down by 3% before you make back your principal," the adviser said. "So when you take that into account, you take part in any basket decline only from 87% to 97% of the initial value, so your sweet spot is only 10%.

"This is a currency product, so I expect the volatility is somewhat lower than an equity basket, but it's still quite a narrow range compared to some other products."

The narrow participation range increases the chance that investors could underperform less risky products, but the product is nevertheless relatively safe, the adviser said.

"Obviously as an investor you prefer having a wider range, but ultimately that's probably what you get for something that's almost principal protected," the adviser said. "Because so many assets are so volatile right now, principal protection, even 97% principal protection, costs more to offer. So investors who want that extra safety have to be aware that they'll have to give up something on the upside."

Possible hedge instrument

The adviser said the product could be used as a hedge for investors who are positively exposed to a weakening of the U.S. dollar.

"This could be useful in a situation where the investor has, let's say significant exposure to exporters, for example," the adviser said. "Exporters generally you'd expect them to do worse when the dollar appreciates, because it costs more to buy U.S. products if the dollar costs more. But this product can provide a hedge because it pays you more if the U.S. dollar goes up, and you only lose 3% if the dollar goes down.

"So if you have $100,000 invested in some exporters and you invest $100,000 in this product, if the dollar appreciates, you hope that whatever you lose on those exporters is offset by the gain in the exchange rates. If the dollar depreciates, you take 3% off your gains from the exporters. You're basically paying 300 basis points to possibly protect your principal on the other side."

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