An examination of the performance of currency-linked structured notes (1990--2000)

Structured notes are a result of financial innovation and engineering and have had a significant impact in international financial markets. This study examines the economics of the structured note market, i.e. the factors influencing demand and supply for structured notes and the factors that have led to the development of the structured note market. The main focus of the study is on currency-linked structured notes, which are a plain-vanilla debt security with an embedded derivative linked to an exchange rate. Leading determinants of demand for structured notes are the ability to create customized exposure for investors, to give access to markets where investors cannot participate due to regulatory constraints, to achieve enhanced portfolio and risk management, and to achieve enhanced yield. The main reasons why issuers prefer structured notes to conventional plain-vanilla securities are to achieve lower funding cost, to manage risk, and to circumvent regulatory constraints. Investors' demand far currency-linked notes is mainly dominated by the search for higher return, especially when returns in domestic currency are relatively lower. This study examine the performance of currency-linked notes in terms of yield earned by the investors as compared to yield on a benchmark to determine whether currency-linked notes result in enhanced yield for investors as suggested in the literature. Performance of currency-linked notes issued by supra-nationals institutions with AAA credit ratings between 1990 and 2000 is compared against benchmark consisting of plain-vanilla bonds issued by supra-nationals. The study finds support in favor of the hypothesis that actual yield is higher than the yield on the benchmark. The findings were consistent with the expectation that actual yield will be higher than the yield on the benchmark and the reason for the additional yield may be attributed to the additional risks inherent in currency-linked notes.