Power Reverse Dual-Currency Note Basics and Beyond

A Power Reverse Dual-Currency Note (PRDC) is a type of investment product that can provide a regular income stream. It's essentially a loan to the issuer, which is usually a corporation or a bank.

The issuer repays the loan with interest, and in some cases, the interest is paid in a different currency than the loan itself. This can be beneficial for investors who want to hedge against currency fluctuations.

The PRDC market is relatively small compared to other investment products, but it can offer attractive returns for investors who are willing to take on a bit more risk.

A power reverse dual-currency note is a long-dated FX product that aims to enhance yield for yen investors.

It's based on the USD/JPY interest rate differential, where investors swap yen LIBOR for dollar LIBOR with payment defined in terms of a notional amount denominated in yen.

This type of note pays a foreign interest rate in the investor's domestic currency, which can be enhanced by taking advantage of the interest rate differential between the two currencies in question.

The power feature added to this note implies higher initial coupons, with coupons rising as the domestic/foreign exchange rate depreciates.

However, this power feature also brings about a higher degree of risk for the investor, so they often place a digital cap on the rate to lock it once it hits a certain threshold.

PRDC notes have very long maturities, up to 30 years, which can be beneficial for investors looking for a long-term investment opportunity.

In practice, PRDC notes are used to enhance yield for yen investors by leveraging the interest rate differential between the USD and JPY.

Investors typically swap yen LIBOR for dollar LIBOR, with payment defined in terms of a notional amount denominated in yen.

This approach can result in higher initial coupons that rise as the domestic/foreign exchange rate depreciates, but also increases the risk for the investor, who may need to place a digital cap on the rate to lock it once it hits a certain threshold.

Hedging is a crucial aspect of PRDCs, as they are exposed to various risks such as interest rates, FX, volatility, correlation, and basis. A plain vanilla PRDC is hedged with interest rate swaps in each currency to reduce interest rate risk.

The owners of PRDC notes, usually retail investors, don't hedge their risks in the market, leaving only banks to actively hedge and rebalance their positions. This creates a situation where banks are forced to rebalance their hedges at a loss, often daily.

Investment banks hedging PRDC risks have a short cross-gamma position between FX volatility, interest rate, and FX, making them vulnerable to market volatility. In a volatile market, the hedger for a PRDC note is expected to pay more coupons on a PRDC note, forcing them to rebalance their hedges.

The volume of PRDC notes issued has been so large that the hedging and rebalancing requirements far exceed the available liquidity in several key markets. This leads to "one way markets" and liquidity squeeze situations in long-term FX volatilities, basis swaps, or long-end AUD interest rate swaps.

The lack of an active secondary market for PRDCs means that banks usually mark their books to a consensus level provided by an independent company, but nobody would show a bid anywhere close to that consensus level. Anecdotal evidence suggests that this can lead to mispricing of trades due to broken assumptions in models.

In the PRDC market, the buyer of the security is a Yen-based investor who gets long the BRL on a forward basis, on each coupon date and on the final maturity date.

The investor takes on the risk of a cheaper BRL forward price, but is rewarded with a higher coupon for taking this risk. This risk can be thought of in two ways: long the BRL forward, or long the BRL spot + long a BRL fixed rate bond + short a Yen fixed rate bond.

The dealer has the option to mature the bonds early if the trade is moving sufficiently in the investor's favor. This means they will exercise the option if spot BRL has appreciated, or BRL rates have gone down, or Yen rates have gone up, or some combination.

The forward price of the PRDC is set based on the 10 year interest rates for BRL and JPY on trade date, and the cash flows are set for value date with some percentage collateral upfront.

The investor's risk today is how much do the future cash flows cost compared to structuring the PRDC as a set of money market deposits / loans in BRL / JPY over 10 years.

During the subprime mortgage crisis, PRDC notes were at the center of market attention. Investment banks hedging the risks for PRDC structured note issuers had a short cross-gamma position between FX volatility, interest rate, and FX.

In a volatile market, investment banks were forced to rebalance their hedges at a loss, often daily. This led to increased market volatility in FX skew, long-dated FX volatility, long-dated Japanese Yen, and Australian dollar interest rate, especially during the last quarter of 2008.

The depreciation of the yen sparked new growth in PRDCs, as Japanese investors bet on further depreciation of their national currency.

The subprime mortgage crisis was a time of great turmoil in the markets, and PRDC was no exception. Investment banks were forced to rebalance their hedges at a loss, often daily, due to the short cross-gamma position between FX volatility, interest rate, and FX.

In a volatile market, the hedger for a PRDC note was expected to pay more coupons as FX spot went up. This led to a higher likelihood of the hedger calling the note, reducing the expected duration.

The hedger had to partially unwind the hedges done at the inception of the PRDC note, which resulted in additional costs. For example, the hedge would have to pay swaps in the foreign currency.

FX spot moving in a correlated fashion with the foreign currency swap rate increased the hedger's costs. As FX spot went up, the hedger would need to pay a higher swap rate, and receive a lower swap rate as FX spot went down.

The increased market volatility in FX skew, long-dated FX volatility, long-dated Japanese Yen, and Australian dollar interest rate was a direct result of the hedging activities. This was particularly evident in the last quarter of 2008.

The depreciation of the yen is sparking a revival in power-reverse dual currency notes, also known as PRDCs.

Japanese investors are turning to PRDCs, betting on the further depreciation of their national currency.

The yen has lost around 10% this year and is currently trading at 127 to the US dollar.

This has led to an increase in PRDC investment, with treasurers seeking to boost yields amid higher rates.

CFOs are facing tough questions about the impact of exchange rates on foreign revenues.

A power reverse dual-currency note, or PRDC, is a type of long-dated FX product that aims to enhance yield for yen investors.

PRDC notes are based on the USD/JPY interest rate differential, allowing investors to swap yen LIBOR for dollar LIBOR with payment defined in terms of a notional amount denominated in yen.

These notes have very long maturities, often up to 30 years, which can provide a higher degree of flexibility for investors.

The power feature of PRDC notes implies higher initial coupons, with coupons rising as the domestic/foreign exchange rate depreciates.

However, this feature also brings about a higher degree of risk for the investor, so they often place a digital cap on the rate to lock it once it hits a certain threshold.

Investment banks hedging the risks for PRDC structured note issuers will have a short cross-gamma position between FX volatility, interest rate, and FX, which can lead to rebalancing their hedges at a loss.

In a volatile market, the hedger for a PRDC note is more likely to call the note, reducing the expected duration of the note, and forcing them to partially unwind the hedges done at the inception of the PRDC note.

PRDC models are used to price power reverse dual-currency notes. A PRDC model is essentially a formula that calculates the interest rate of a note.

These models take into account various factors, including the underlying asset's volatility, the correlation between the two currencies, and the note's notional amount.

In a PRDC model, the investor pays a coupon in currency c1 and receives a coupon in currency c2, but with a twist.

The investor receives the coupon in currency c2 at a rate that's adjusted by the current FX rate, compared to the FX rate at the deal's inception. This gives the investor an option to receive cash flows that resemble a Bermudan-style FX option.

The cash flows in a PRDC model are always guaranteed to be positive for the investor, making it a relatively safe investment. This is because the swap house is essentially selling a series of currency options with a floating rate as a premium.

The payoff is calculated using a formula that takes into account the FX rates, the coupon, and the number of periods (n). It's a complex calculation, but essentially it's MAX(N(FXt/FX0)r1t - r2t(N-1), 0), where FXt is the FX rate at time t, FX0 is the initial FX rate, and r1t and r2t are the interest rates.

The model used to price PRDCs has evolved over time. Popular choices for interest rate factors include the Hull-White model, Black-Karasinski model, and extended Cheyette Model.

These models are chosen for their speed and efficiency. In fact, the Hull-White model is a popular choice for its simplicity and ease of implementation.

For FX models, dealers often opt for Dupire-type local volatility models, stochastic SABR Volatility Models, or models that allow mixing of the two. These models provide a more accurate representation of FX price movements.

In recent years, the industry-standard LIBOR market model has become the go-to choice for pricing PRDCs. This model offers a more sophisticated approach to pricing, taking into account the complexities of interest rate and FX markets.

Here are some of the popular models used for pricing PRDCs:

A power reverse dual-currency note is a long-dated FX product that aims to enhance yield for yen investors.

It's based on the USD/JJPY interest rate differential, allowing investors to swap yen LIBOR for dollar LIBOR.

The payment is defined in terms of a notional amount denominated in yen, making it a foreign interest rate paid in the investor's domestic currency.

This type of note has very long maturities, up to 30 years, which is a significant departure from traditional investment products.

The power feature of the note implies higher initial coupons, with coupons rising as the domestic/foreign exchange rate depreciates.

However, the power feature also brings about a higher degree of risk for the investor, requiring a digital cap on the rate to lock it once it hits a certain threshold.