Merrill Lynch's collateralized FX obligation (CFXO) structure is the subject of quite a bit of chatter.
The attention granted to the structure, which is rated by Standard & Poor's and is currently being marketed globally, generally follows the line of thinking applied to the handful of rated market risk structures that have recently come to the market, such as the commodity credit obligation (CCO) and constant proportion debt obligation (CPDO).
While some sources tout its innovation, diversification and yield benefits, others say the structure lures investors with ratings but ultimately locks them into difficult-to-model market risk. In the case of the CFXO, one source said an investor might be better suited to simply purchasing OTM options instead of paying a fee for the exposure packaged inside an illiquid structure.
Yet, the ability to sell rated currency risk to institutional investors (who often require ratings to hold a security) is what is achieved with the CFXO structure, Merrill said. "The beauty of being able to assign ratings to default swaps referencing prices, commodity spot prices (or index values) and FX rates is that it is
easier for credit investors to assess the risk of such instruments," Merrill Lynch analysts wrote in a research report.
The firm earlier this month announced it was set to launch the CFXO. Credit Agricole Asset Management will manage the deal, which is being offered in all major currencies with a five-year maturity and in notes rated triple-A to triple-B, along with equity. As the deal is being offered across the capital structure, investors can choose either leveraged or subordinated FX exposure.
The move is part of a growing trend of capturing various economic risks within CDOs or CDO-like structures.
In general, the CFXO structure, modeled after a synthetic CDO, essentially uses swaps to reference the risk of a portfolio of currency-linked options. While S&P rated the Merrill/Credit Agricole CFXO, Derivative Fitch, which recently released rating criteria for the structures, is also looking at the deals.
The CFXO essentially bets on the volatility of a given basket of currencies by triggering a payment upon a certain level of appreciation or depreciation. While some isolate the risk of a given currency appreciating against another, such as the U.S. dollar, some of the deals in the works include such currency bets on multiple benchmarks, such as the U.S. dollar and the euro. These structures generally have a five-to-seven-year average life and reference a portfolio of roughly 25 options on the appreciation or depreciation of roughly 12 to 15 currencies, according to Fitch.
Most of the deal proposals utilize American-style triggers, which are tested for breaches daily throughout a structure's life.
Barclays Capital in June of 2006 closed a roughly $100 million offering of Everest I - the first-ever managed CCO deal and only the second deal backed entirely by commodity trigger swaps to be publicly rated.
The transaction priced some 100 basis points wider than most new issue CDOs, the deal's arrangers said. Everest referenced a portfolio of 100 commodity trigger swaps - similar to credit default swaps. The deal had a five-year life and an S&P AA+' weighted average rating.
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