Dynamics of Long Dated FX Products - Power Reverse Dual Currency Notes
July 9, 2007
Let's revisit the topic of Power Reverse Dual Currency (PRDC) Notes once again. Again and again we are faced with queries from the readers of our site regarding this product. Most of them want to know more about the mechanics of this product; some are interested in detailed pricing models and how PRDCs can be priced. An interesting query has recently come from a reader who is keen on looking at vol models and vol surfaces for pricing PRDCs.
We cover PRDCs - in terms of pricing and product analysis - quite extensively in our training programmes. Here we will attempt - once again - to outline some very general features of the product.
What is a PRDC?
- A power reverse dual currency note (PRDC) is essentially a hybrid product with exposure to the underlying FX, the foreign interest rate (USD LIBOR) and domestic interest rate (JPY LIBOR);
- If we assume fixed interest rates then a PRDC note simply becomes a long dated FX derivative product which gives significant yield enhancement to investors. Typically, investors think of PRDCs as long dated FX products;
- A PRDC can be structured as a note or a swap;
- The product can be broken down into a series of call options on the underlying currency'
- Most PRDCs are Yen structures whereby the underlying currency (FX pair) is USD/JPY;
- PRDCs can be structured in a note form or a swap form;
In its most vanilla form a PRDC payoff can written as:
In the above payoff is the foreign interest rate and is the domestic interest rate.
How do we deconstruct a PRDC note or a swap?
- A PRDC note can be decomposed into a series of FX call options;
- Generally PRDC swaps are structured so that an investor of the note receives USD call / JPY put options and pays JPY LIBOR on the coupon dates;
- Typically, the first coupon is very high (around 4% to 5%) and it is sometimes offset by USD/JPY knock out trigger levels;
- Banks mostly have a callability clause attached to the note;
Risk Exposure of PRDC products:
- Since these are long dated FX products the investor has an exposure to the long term volatility of the FX options. This is captured by the vega of the options embedded in the note.
- Since these are hybrid products and if we keep the interest rates in the above payoff are kept floating - the way a swap would be structured - then given that these are long term products, typically 10, 20 and 30 years, one has to work with stochastic interest rates; hence there is significant interest rate risks built into the product;
- Moreover, given the payoff contains a series of call options going out far into future three is also a significant "rho" (interest rate) risks built into the option payoffs
So why would investors want an exposure to such a product? A few want to take exposure to long term volatility in the Dollar-Yen market. But most investors buy callable or triggered PRDCs to get a substantial yield in the first year and then hope that either the structure will be called back by the bank or knocked out.
Reference: Some of the above content is based on the work and presentation of Dr Sebastian del Bano Rollin (Royal Bank of Scotland , Quantitative Research)
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