“You’ve seen some fairly large moves in the Japanese interest rate markets, with widening basis swap levels, which has been due to the dollar/yen falling and banks scrambling to hedge positions they have due to these products,” said Bilal Hafeez, global head of foreign exchange strategy at Deutsche Bank in London.
PRDCs have been popular for more than 10 years among Japanese regional banks and buy-and-hold investors keen to express the view that the yen will not strengthen to the level implied by the forward curve.
In the most popular structure, Bermudan callable PRDCs, the investor swaps yen Libor for dollar Libor on a yen notional. After an initial fixed-rate period, the coupon payments are leveraged and highly sensitive to changes in foreign exchange rates. If the dollar strengthens against the yen, coupons increase, but dealers hold a series of call options they can exercise to limit the upside for investors. These notes have typically been called at the earliest opportunity by dealers.
However, if the yen appreciates to a certain level (often ¥100 to the dollar), coupon payments drop to a floor of 0%. The notes are less likely to be called, and the investor risks holding a zero-coupon note until maturity – which could be as long as 30 years.
While an appreciating yen is beneficial for dealers as they do not have to pay coupons, they are affected by changes in the expected maturity of their exposures, forcing them to adjust their hedges. “As it becomes apparent these structures are not going to get called, clients are increasingly underwater and banks have to hedge some of the risk they have in these products,” explained Mark Barnes, London-based head of currency options at Royal Bank of Scotland.
One of the most noticeable signs of dealer hedging has been in the yen-dollar basis swaps market, particularly for longer maturities, added Barnes. “It’s had a decent-sized impact on the market.”
Following the yen’s strengthening to below the ¥100 level on March 14, the cost of yen-dollar basis swaps has been driven upwards. Thirty-year yen-dollar basis swaps shot up to 56 basis points on March 18, having traded at 6.57bp on February 29. In comparison, five- and 10-year yen-dollar basis swaps peaked at 34bp and 50bp on March 18, respectively, from 4.06bp and 6.31bp on February 29.
“I think this is a result of people who have PRDCs on their books hedging some of their swap risk, as it becomes apparent these structures are not going to get called,” said Barnes.
New PRDC structures have been less prevalent over the past two years given rising interest rates in Japan, but dealers would still have to manage legacy positions held from earlier deals. Deutsche Bank has estimated the size of the PRDC market to be around $30 billion.
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