One of the hallmarks of the financial meltdown currently going on in the US were the securities that promised high returns in dollar terms for minimal risk. You could get apparently AAA, basically risk-free investments, that yielded 10% per annum. The argument then, was that they had done all the necessary risk mitigation to guarantee such a result. Obviously in hindsight this was not the case as most of those AAA securities turned out to be worthless.

So flash forward about a year and I get in my inbox an invitation to invest a minimum of $50,000 in a fund guaranteed to return the equivalent of 19% a year over a three year period. Now I basically ignored it, figuring that it was a Madoff in the making. However I heard my colleagues talking about it, and decided to take a closer look. It actually is a pretty good transaction however it is not "guaranteed" or "risk free"

So the transaction is basically this - FSDH an independent capital market player with its hands in a lot of things in the Nigerian market wants to offload a portion of its holdings of the GT Bank Eurodollar bond (it may be the entire stake, I don't know). However it also wants to leave itself the possibility of making some significant upside. So it comes up with a "win-win" transaction.

The GT Bank bond is convertible - basically it can become shares. So FSDH says that if you give us your money for three years, we will pay you all the interest that GT Bank pays us. After three years we will turn the loan into shares, sell those shares and pay you a certain amount.

Sounds like a great deal, GT Bank is definitely going to be in existence in three years, so where is the risk? Well there are two risks. The first is obviously that GT Bank may not be in existence in three years - highly unlikely but still possible. The second risk is around the conversion.

FSDH has commited to a conversion amount. The way convertibles work is that there is an agreed price at which the loan converts into shares. Now FSDH is planning on selling those new shares and paying you cash. However if the price of GT Bank is less than the conversion price, they may not be able to pay you the amount they commited to pay you.

FSDH is taking the view that GT Banks share price will be higher in three years and that they will be able to sell the shares for more than the amount they promised you and keep the excess, thus making money twice on the transaction. After all you are paying them a premium on what they paid for the bonds in the first place.

As I said it is a win-win transaction for both people, though it does have quite a bit of market risk (with regards to GT Bank's share price) and obligor risk (with regards to FSDH). In addition to there might be significant exchange rate risk depending on the value of the naira at the end of the three years.

As I said at the start, it is a good transaction but not for the faint hearted. Still it is good to see derivative financial products of this nature being produced in our market. Our financial development countinues apace. Now if only the stock market will stop misbehaving then we will all be alright ;)