Power reverse dual currency note
Encyclopedia
A dual currency note pays coupons in the investor's domestic currency with the notional in the issuer’s domestic currency. A reverse dual currency note (RDC) is a note which pays a foreign interest rate in the investor's domestic currency. A power reverse dual currency note (PRDC Note) or power reverse dual currency bond (PRDC Bond) is an exotic financial structured product
where an investor is seeking a better return and a borrower a lower rate by taking advantage of the interest rate
differential between two economies. The power component of the name denotes higher initial coupons and the fact that coupons rises as the domestic/foreign exchange rate depreciates. The power feature comes with a higher risk for the investor, which characterizes the product as leveraged carry trade. Cash flows may have a digital cap feature where the rate gets locked once it reaches a certain threshold. Other add-on features are barriers such as knockouts and cancel provision for the issuer.
) of the notes under their Euro Medium Term Note
program. Also heavily involved are PRDC swap hedgers - the major ones include JPMorgan Chase, BNP Paribas
, Deutsche Bank
, Goldman Sachs
, Credit Suisse
, Mizuho Securities, Nomura Securities Co.
, Daiwa Securities Capital Markets, Citigroup
, The Bank of Tokyo-Mitsubishi UFJ
, and Crédit Lyonnais
.
where
or Monte Carlo
models where one factor represents the short rate in currency1; the second factor the short rate in currency2; and the third factor the movement in the FX rate between currency1 and currency2.
Model choice
for the interest rate factors varies - for speed reasons, popular choices are Hull-White model
, Black-Karasinski model, and extended Cheyette model.
FX model choice also varies among houses - popular choices are Dupire local volatility
model, stochastic SABR Volatility Model
, or models which allow mixing of the two.
Note that some banks choose to use simplified models for reasons such as ease of hedging or speed.
, may take several minutes to produce.
, and basis risks. Those exposures are hedged with interest rate swap
s in each currency to reduce interest rate risk
, interest rate swaption
s in each currency to reduce interest rate volatility exposures, Currency Option
s to reduce fx volatility exposures and Basis swap
s to reduce basis risk
. Correlation exposure can be hedged with correlation swaps.
While such hedges are theoretically possible, there are a lot of practical difficulties, largely due to the following situation. The owner of the PRDC note, usually a retail investor, doesn't hedge his risks in the market. Only the banks, which are all short the note, actively hedge and rebalance their positions. In other words, if there is a significant move in fx, for example, all the PRDC books will need the same kind of fx volatility rebalancing at the same time. The note holders would be the natural counterparty for the hedge, but they don't take part in this market (similar to buyers of portfolio insurance in 1987). This situation often creates "one way markets" and sometimes liquidity squeeze situations in long term fx volatilities, basis swaps or long end AUD interest rate swaps.
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. However all pricing models work on the assumption that there is sufficient liquidity - in other words, they are potentially mispricing the trades because in this market, a few of the key standard Black–Scholes assumptions (such as zero transaction cost, unlimited liquidity, no jumps in price) break down. No active secondary market ever existed for PRDC and banks usually mark their books to some consensus level provided by an independent company. Anecdotal evidence indicates that nobody would show a bid anywhere close to that consensus level.
. By the nature of the trade, investment banks hedging the risks for PRDC structured note issuers will have a short cross gamma position between FX volatility, interest rate and FX. In a volatile market where market parameters move in large and correlated steps, investment banks are forced to rebalance their hedges at a loss, often daily.
In particular, when FX spot goes up, the hedger for a PRDC note is expected to pay more coupons on a PRDC note. Thus, the hedger is more likely to call the note, reducing the expected duration of the note. In this situation, the hedger has to partially unwind the hedges done at the inception of the PRDC note. For example, he would have to pay swaps in the foreign currency. If FX spot moves in a correlated fashion with the foreign currency swap rate (that is, foreign currency swap rate increases as FX spot increases), he would need to pay a higher swap rate as FX spot goes up, and receive a lower swap rate as FX spot goes down. This is an example of how the hedger of a PRDC note is short cross gamma.
This is the main driver behind the 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.
Structured product
In finance, a structured product, also known as a market linked investment, is generally a pre-packaged investment strategy based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuance and/or foreign currencies, and to a lesser extent, swaps...
where an investor is seeking a better return and a borrower a lower rate by taking advantage of the interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
differential between two economies. The power component of the name denotes higher initial coupons and the fact that coupons rises as the domestic/foreign exchange rate depreciates. The power feature comes with a higher risk for the investor, which characterizes the product as leveraged carry trade. Cash flows may have a digital cap feature where the rate gets locked once it reaches a certain threshold. Other add-on features are barriers such as knockouts and cancel provision for the issuer.
Market
The majority of investors are Japanese with 9 billion USD worth of notes issued 2003, with the issued notional increasing every year up till 2008 when it sharply declined. Major participants in the market include issuers (usually SupranationalsInternational financial institutions
International financial institutions are financial institutions that have been established by more than one country, and hence are subjects of international law. Their owners or shareholders are generally national governments, although other international institutions and other organisations...
) of the notes under their Euro Medium Term Note
Medium Term Note
A medium-term note is a debt note that usually matures in 5–10 years, but the term may be less than one year or as long as 50 years. They can be issued on a fixed or floating coupon basis...
program. Also heavily involved are PRDC swap hedgers - the major ones include JPMorgan Chase, BNP Paribas
BNP Paribas
BNP Paribas S.A. is a global banking group, headquartered in Paris, with its second global headquarters in London. In October 2010 BNP Paribas was ranked by Bloomberg and Forbes as the largest bank and largest company in the world by assets with over $3.1 trillion. It was formed through the merger...
, Deutsche Bank
Deutsche Bank
Deutsche Bank AG is a global financial service company with its headquarters in Frankfurt, Germany. It employs more than 100,000 people in over 70 countries, and has a large presence in Europe, the Americas, Asia Pacific and the emerging markets...
, Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
, Credit Suisse
Credit Suisse
The Credit Suisse Group AG is a Swiss multinational financial services company headquartered in Zurich, with more than 250 branches in Switzerland and operations in more than 50 countries.-History:...
, Mizuho Securities, Nomura Securities Co.
Nomura Securities Co.
is a wholly owned subsidiary of Nomura Holdings, Inc. , which forms part of the Nomura Group. It plays a central role in the securities business, the Group's core business. Nomura is a financial services group and global investment bank. Based in Tokyo and with regional headquarters in Hong Kong,...
, Daiwa Securities Capital Markets, Citigroup
Citigroup
Citigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...
, The Bank of Tokyo-Mitsubishi UFJ
The Bank of Tokyo-Mitsubishi UFJ
is the largest bank in Japan, which was established on January 1, 2006, with the merger of the Bank of Tokyo-Mitsubishi, Ltd. and UFJ Bank Ltd. The bank serves as the core retail and commercial banking arm of the Mitsubishi UFJ Financial Group....
, and Crédit Lyonnais
Crédit Lyonnais
Crédit Lyonnais is a historic French bank. In the early 1990s it was the largest French bank, majority state-owned at that point. Crédit Lyonnais was the subject of poor management during that period which almost led to its bankruptcy in 1993...
.
Payoff and cashflows
The investor pays a coupon times a fixed rate in currency c1 and receives a coupon times a fixed rate in currency c2 times current FX rate divided by the FX rate at the inception of the deal. However, the cash flows are always guaranteed to be positive for the investor. The investor, therefore, has the option to receive cash flows making the payoff similar to a Bermudan style FX option. The swap house is, thus, selling a series of Currency options with a floating rate as a premium; the rate is usually subtracted with a spread.where
Model
Pricing of PRDCs is usually solved by 3-factor grid/latticeLattice model (finance)
In finance, a lattice model can be used to find the fair value of a stock option; variants also exist for interest rate derivatives.The model divides time between now and the option's expiration into N discrete periods...
or Monte Carlo
Monte Carlo
Monte Carlo is an administrative area of the Principality of Monaco....
models where one factor represents the short rate in currency1; the second factor the short rate in currency2; and the third factor the movement in the FX rate between currency1 and currency2.
Model choice
Short rate model
In the context of interest rate derivatives, a short-rate model is a mathematical model that describes the future evolution of interest rates by describing the future evolution of the short rate, usually written r_t \,.-The short rate:...
for the interest rate factors varies - for speed reasons, popular choices are Hull-White model
Hull-White model
In financial mathematics, the Hull–White model is a model of future interest rates. In its most generic formulation, it belongs to the class of no-arbitrage models that are able to fit today's term structure of interest rates...
, Black-Karasinski model, and extended Cheyette model.
FX model choice also varies among houses - popular choices are Dupire local volatility
Local volatility
A local volatility model, in mathematical finance and financial engineering, is one which treats volatility as a function of the current asset level S_t and of time t .-Formulation:...
model, stochastic SABR Volatility Model
SABR Volatility Model
In mathematical finance, the SABR model is a stochastic volatility model, which attempts to capture the volatility smile in derivatives markets. The name stands for "Stochastic Alpha, Beta, Rho", referring to the parameters of the model. The SABR model is widely used by practitioners in the...
, or models which allow mixing of the two.
Note that some banks choose to use simplified models for reasons such as ease of hedging or speed.
Inputs
- Correlation constants between each factor. Those correlation parameters are usually estimated historically or calibrated to market prices
- FX volatilityVolatility (finance)In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
calibrated to fx options and user inputs - IRS volatilities of each currency calibrated based on IRS Swaptions and yield curves
- Yield curveYield curveIn finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...
of money marketMoney marketThe money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
rate1 and rate2 based on deposit rates, futuresFutures contractIn finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
prices and swap rateSwap rateSwap rate is the fixed rate that makes the market value of a given swap at initiation zero. They are the borrowing rates between financial institutions, usually with credit ratings of A/AA equivalent. Swap rates are calculated using the fixed rate leg of interest rate swaps. Swap rates form the...
s - Basis swap spread curves
- Spot FX rate
Computation
Unless PRDCs are broken down in separate parts and valued by replication (see: portfolio replication theories); values, such as the present valuePresent value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
, may take several minutes to produce.
Hedging
A plain vanilla PRDC is exposed to volatility, interest, fx, correlationCorrelation
In statistics, dependence refers to any statistical relationship between two random variables or two sets of data. Correlation refers to any of a broad class of statistical relationships involving dependence....
, and basis risks. Those exposures are hedged with interest rate swap
Interest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
s in each currency to reduce interest rate risk
Interest rate risk
Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
, interest rate swaption
Swaption
A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps....
s in each currency to reduce interest rate volatility exposures, Currency Option
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
s to reduce fx volatility exposures and Basis swap
Basis swap
A basis swap is an interest rate swap which involves the exchange of two floating rate financial instruments. A basis swap functions as a floating-floating interest rate swap under which the floating rate payments are referenced to different bases....
s to reduce basis risk
Basis risk
Basis risk in finance is the risk associated with imperfect hedging using futures. It could arise because of the difference between the asset whose price is to be hedged and the asset underlying the derivative, or because of a mismatch between the expiration date of the futures and the actual...
. Correlation exposure can be hedged with correlation swaps.
While such hedges are theoretically possible, there are a lot of practical difficulties, largely due to the following situation. The owner of the PRDC note, usually a retail investor, doesn't hedge his risks in the market. Only the banks, which are all short the note, actively hedge and rebalance their positions. In other words, if there is a significant move in fx, for example, all the PRDC books will need the same kind of fx volatility rebalancing at the same time. The note holders would be the natural counterparty for the hedge, but they don't take part in this market (similar to buyers of portfolio insurance in 1987). This situation often creates "one way markets" and sometimes liquidity squeeze situations in long term fx volatilities, basis swaps or long end AUD interest rate swaps.
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. However all pricing models work on the assumption that there is sufficient liquidity - in other words, they are potentially mispricing the trades because in this market, a few of the key standard Black–Scholes assumptions (such as zero transaction cost, unlimited liquidity, no jumps in price) break down. No active secondary market ever existed for PRDC and banks usually mark their books to some consensus level provided by an independent company. Anecdotal evidence indicates that nobody would show a bid anywhere close to that consensus level.
PRDC during Subprime Crisis
PRDC has been the subject of much attention in the market during the subprime mortgage crisisSubprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
. By the nature of the trade, investment banks hedging the risks for PRDC structured note issuers will have a short cross gamma position between FX volatility, interest rate and FX. In a volatile market where market parameters move in large and correlated steps, investment banks are forced to rebalance their hedges at a loss, often daily.
In particular, when FX spot goes up, the hedger for a PRDC note is expected to pay more coupons on a PRDC note. Thus, the hedger is more likely to call the note, reducing the expected duration of the note. In this situation, the hedger has to partially unwind the hedges done at the inception of the PRDC note. For example, he would have to pay swaps in the foreign currency. If FX spot moves in a correlated fashion with the foreign currency swap rate (that is, foreign currency swap rate increases as FX spot increases), he would need to pay a higher swap rate as FX spot goes up, and receive a lower swap rate as FX spot goes down. This is an example of how the hedger of a PRDC note is short cross gamma.
This is the main driver behind the 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.