Now you PRDC them...

Power-reverse dual-currency notes proved a bonanza for dealers when markets were tame, but risk-managing the product has become a drain on resources and cash in recent years. As a result, some firms have decided to exit the market. Mark Pengelly investigates

Power-reverse dual-currency (PRDC) notes have represented something of a Trojan horse for dealers. The hybrid structures have been popular for more than a decade among a wide range of Japanese investors, from regional banks to pension funds. In simple terms, the product constitutes a carry trade in which investors receive coupons based on foreign currency interest rates on a yen-denominated principal amount. As the yen remained weak relative to the dollar, dealers generated a huge amount of PRDC business, making giant profits from issuing and hedging the products for Japanese clients and counterparties. But as with the legendary wooden horse, these books later expelled a horde of troublesome Greeks.

Since market volatility struck in 2008, these exposures have made books much tougher to hedge. Consequently, dealers admit to having suffered losses over the past two years. “The market has had a tough 2008 and 2009. Just about everyone who has a substantial position has lost money,” confirms a London-based exotics head at a major US dealer.   

Many smaller market participants looked to exit the business during 2009. At the height of the product’s popularity, dealers say there were up to 20 banks pricing PRDCs. Now, dealers believe only a handful of banks remain serious about the business. The most high-profile recent disposal came in early 2009, when American International Group’s financial products unit sold a $7 billion PRDC book, which was largely absorbed by Deutsche Bank. Deutsche did not respond to requests for comment on the matter. Other firms have also been able to cherry-pick attractive portfolios. BNP Paribas, for instance, took on a substantial number of trades from two AAA-rated international banks in mid-2009.

“A few years ago, a large number of banks came into the business and that led to a pricing of risk in the market that became quite aggressive. Over the past two or three years, there’s been a clear decline in customer demand, but there’s also been a clear decline in the number of banks involved,” says a London-based head of foreign exchange structuring at a large European bank. Until the subprime mortgage crisis hit in mid-2007, PRDC issuance regularly topped $10 billion a year. Much of this business has now disappeared, say dealers.

Why have PRDCs proven so debilitating? The products caught on in the mid-1990s and quickly gained attention from Japanese investors facing low domestic interest rates. Although the bulk of PRDC notes offered exposure to US dollars, Australian dollars also became popular – particularly as US interest rates fell between 2001 and 2003, say dealers.

To maximise the returns on offer, the products are extremely long-dated. By buying the note, investors are effectively taking the view the yen will not appreciate in line with levels implied by the forward curve. If the target currency stays high relative to the yen, investors receive juicy coupons. If the yen appreciates, the note is principal-protected, but investors could face as much as 30 years with no coupon payments.

In their most popular form, the Bermudan callable PRDC, issuers also bear the right to call the note on each coupon date. This selling of call options back to dealers souped up the available return that could be made on the notes. Provided the yen remained steady or depreciated, investors were able to earn enhanced coupons until the products were called by dealers. This usually occurred at the first available opportunity, typically during the first or second year of the trade.

For Japanese investors, the risk and return inherent in the product had lasting appeal, say traders: while they were exposed to the risk of a sudden appreciation in the yen, such a move could signal the end of recession and better returns on investments elsewhere. For the most part, when PRDCs were called, much of the cash returned to investors would be immediately reinvested in further PRDCs, creating a continuous cycle of profits for issuers.

But having fallen as low as ¥123.94 to the dollar in June 2007, the yen appreciated strongly during 2008 and 2009. By January 20, 2010, it traded at ¥91.21 to the dollar. Coupon payments on PRDCs usually reference levels close to spot, meaning many trades struck in recent years at around ¥100–120 to the dollar will be underwater.

On the face of it, issuers should be pleased they no longer have to pay high coupons to investors. But PRDCs are fiendishly difficult to risk-manage. Their hybrid nature requires dealers to pay close attention to interrelated exposures to foreign exchange rates, interest rates, currency volatility, basis risk and correlation. Making things trickier, all banks are similarly positioned in what is frequently a one-way market.

In simple terms, as the yen appreciates and the expected maturity of the products lengthens, dealers develop a short position in long-dated currency volatility. Typically, banks will use swaps or forwards to hedge this exposure. “As the yen weakens, a normal foreign exchange trader would need to pay fixed on long-dated yen swaps to hedge the interest rate exposure created by such a move. On the other hand, when the yen strengthens against the dollar, you need to receive in long-dated yen swaps,” explains one London-based PRDC trader.

If the yen appreciates past the point at which no coupons are paid on the PRDC note, dealers need to offload their hedges as the product’s payout cannot get any lower. However, if the yen weakens again and recrosses the strike, dealers need to buy back their hedges at an elevated level. In this way, hedging the products dynamically can mean dealers are buying high and selling low. Because the expected maturity of the note can change depending on how likely it is to be called, banks’ exposures to vega – or their sensitivity to changes in volatility – have a variable duration. Meanwhile, dealers are typically forced to hedge in short-dated maturities due to liquidity constraints, giving them additional basis risk, say bankers.

Another, more intractable problem is cross-gamma. Cross-gamma is the rate of change in the delta of one exposure in response to a change in another underlying. In the case of PRDCs, it refers to the effect a change in interest rates has on the delta of a dealer’s currency exposure, and vice versa. “A change in dollar/yen affects the delta you have to changes in dollar rates. So if dollar rates change and dollar/yen doesn’t move, how much would your dollar/yen delta change? That’s your cross-gamma. And if everything moves in tandem, you get a lot of cross-gamma, which is quite an interesting thing to manage,” says the London-based PRDC trader.

This cross-gamma effect stung dealers badly in late 2008. As the yen strengthened towards the end of the year, 10-year interest rate swap levels declined in a highly correlated fashion (see figure 1). This created a nightmare for dealers, says PK Sinha, New York-based director of interest rates and foreign exchange structuring at BNP Paribas. “When dollar/yen collapses, vols go much higher and Treasury yields also collapse, there is a vicious cycle where you get longer and longer dollar/yen and you continue to get longer and longer yields,” he says.

Although the phenomenon caused hefty losses for dealers, this exposure is virtually impossible to hedge. “The problem with the cross-gamma is that it’s basically unhedgeable because there’s no product that cleanly takes the risk away from you,” says Sinha.

Even some of the more liquid instruments used to hedge PRDC exposures such as basis swaps and foreign exchange options have become less liquid since the onset of the crisis. This has caused market players to suffer through an increase in hedging costs. “With the lack of liquidity in some of the hedging instruments we’ve seen in the past couple of years, a lot of the small players have suffered,” remarks Tim Sillitoe, London-based head of hybrids trading at Royal Bank of Scotland (RBS).

This is likely to be a particular issue at smaller firms without access to liquidity internally, adds the London-based exotics head at a major US dealer. “A lot of people have been very exposed to the spread they’ve had to pay to hedge these books. These books are very volatile in terms of positions, and hedges require a lot of rebalancing. For the smaller players with no access to good internal liquidity, this has proved to be quite expensive,” he says.

Bankers say hedging PRDCs requires a substantial commitment to infrastructure and a high tolerance for risk, especially during periods of market stress. With little cash coming in the door from new issuance, it’s not surprising smaller players have decided to sell their books, suggests the London-based foreign exchange structuring head: “Risk like this requires resources. If it’s not a business where you’re seeing much customer flow, you may well decide it does you better to exit,” he says.

Notwithstanding this, some dealers remain committed to PRDCs – a fact demonstrated by the market that exists for legacy books. So, what can dealers learn from their mistakes? They agree that investing in modelling and infrastructure is critical, as valuing PRDCs is no easy task. “There are many components to working out where the mark may be and there are significant differences across the market,” says BNP Paribas’ Sinha. This is especially true during market turmoil, he adds.

Dealers contribute valuations to London-based data provider Markit’s Totem service, which provides consensus pricing estimates for PRDCs. Demonstrating the difficulty of valuing the products, discrepancies in pricing led JP Morgan to call for a meeting of participating dealers during early 2009, according to a source familiar with the matter. Markit declined to comment on the issue.

An important component in pricing PRDCs is correlation, something suspected of being responsible for a large part of recent losses. “Some of the houses that got in the business built up a portfolio that was marked off correlations that were too low. As correlation in the market increases, you end up with a situation where you’ve got to re-mark your book higher, but if you do that, you’re going to face a substantial loss,” says RBS’s Sillitoe.

Ten years ago, realised correlation between 10-year swap rates and dollar/yen spot rates traded at around 0%, dealers note. By January 20, 2010, realised correlation between 10-year swaps and dollar/yen spot rates had hit 65%, according to Bloomberg. Banks with sizeable PRDC books may have exposures of $2 million–5 million per 1% of correlation, estimate some market participants. “The lesson for me is that you have to keep using the most sophisticated model you can. You always have to keep challenging all the assumptions in your model, and you have to be ready to re-mark and take some pain whenever you think it’s right to do so,” says Sillitoe.

In addition to being vigilant about risks such as correlation, dealers also need to remain cognisant of one-way exposures, says Ani Banerjee, a multi-asset exotics trader at Citi in London: “If you are a smart dealer, you have to understand that when you do the trade, the market is structurally the same way around.” This means pricing trades correctly from day one, he says.

Some banks have attempted to offload the more exotic risks associated with their PRDC books via instruments such as correlation swaps. This plays to a desire by relative-value participants such as hedge funds to access markets that appear skewed and do not reflect fair value – a trend that allowed dealers to buy back correlation from hedge funds in the form of correlation swaps, for example. But in a stressed market, they run the risk that hedge fund counterparties may not be able to make good on these trades. In fact, since the subprime mortgage crisis broke out in mid-2007, dealers believe the failure of exotic hedges with beleaguered clients has been yet another source of losses for PRDC books.

Banerjee says the failure of dynamic hedging strategies during periods of market turmoil means dealers need to use a more scenario-based approach towards hedging PRDCs. “Minimising first-order Greeks doesn’t work in a high-covariance environment like the fourth quarter of 2008. The better approach would be to shift to a scenario-based methodology, where you have a grid of your profit and loss and Greeks over a wider range of scenarios,” he says.

Could lingering PRDC exposures continue to cause problems for dealers? While markets have recently stabilised and realised volatility has decreased, bankers warn any future market tremors could cause another wave of losses. With many PRDC notes having been struck at around ¥100–120 to the dollar, legacy exposures won’t disappear until the dollar appreciates again. Equally, a flurry of new PRDC issuance is unlikely while investors remain underwater. That’s not to mention decreasing interest rate differentials, which have diminished the returns available on carry trades. The federal funds target rate remained at 0.25% on January 20, just 15 basis points above the Bank of Japan’s main policy rate of 0.1%.

If PRDCs do make a comeback, dealers believe it will be in a different form. In particular, bankers are sceptical any new trades will bear maturities of as long as 30 years. Some traders say the cheapness of local equities compared with global rivals has caused more Japanese investors to consider taking views on the Nikkei 225 index, for example. Areas of recent activity include auto-callables, Nikkei and interest rate hybrids and other, simpler structures in currencies and rates.

Others believe carry to be a more enduring theme. Sinha at BNP Paribas says the bank has seen renewed interest in PRDC-type structures over the past few months, although not on the scale of previous years. But instead of Australian or US dollars, the business has gravitated towards emerging markets. “The business that has traditionally been in dollar/yen or Australian dollar/yen is probably expanding into other currencies where you get a bit more carry. Japanese investors are always looking at some avenue to gain yield enhancement. And the best way of doing that is to get exposure to a high-yielding currency,” he says. While they involve different currencies, the techniques used for hedging and trading emerging-market PRDCs are similar to those used for trades involving Australian or US dollars. Nonetheless, with lower liquidity in emerging market rates, both hedging costs and the estimation of certain pricing parameters are likely to be more difficult, dealers note.

Whether or not this activity ever reaches the heights seen before recent market ructions, one thing is certain: PRDC hedging will continue to have a widely felt effect on the market. Discussing the impact of the move in late 2008, Citi’s Banerjee points to the widening of the dollar/yen cross-currency basis, the widening of the dollar basis, the widening of the yen rate basis, negative yen forward rates and extreme steepening of risk reversals in dollar/yen and Australian dollar/yen. While all of these moves are not exclusively attributable to the notes, at least 65% of the moves in dollar/yen and Australian dollar/yen were attributable to PRDC hedging activity, he claims. It is little wonder the products continue to be a popular talking point for market participants.