All power to PRDC notes
Forex structured products
The rise of the PRDC since it first appeared in 1995 is intimately related to the search for yield enhancement during the long bull run, which began in 1990, in Japanese government bonds, a period that saw 10-year swap rates decline from 3.50% to 1.15% today. As its name implies, the original PRDC note was a leveraged version of the common reverse dual note, an investment denominated in yen and guaranteeing par redemption in that currency while paying coupons in another, higher-yielding currency. As yen yields continued to decline, investors turned towards the leveraged version of this product to maintain a target current yield. The increased leverage was applied to the coupon only – by increasing sensitivity to changes in the forex index as well as by lengthening maturities – while the principal itself remained free of forex risk. Although there are many variations on the basic PRDC note, the distinguishing feature of almost all variations is the coupon structure:
While the coupon formula may appear unconventional, the underlying economics are simple. The investor receives a fixed amount of foreign currency (usually dollars) and pays a fixed amount of yen. Since the coupon is always floored at zero (so the coupon can never be negative), the investor is effectively long a call on the foreign currency and short a put on the yen. Moreover, the degree of leverage in the transaction increases with a higher A% as well as with a reduction in the forex strike. Therefore, for the same current coupon, a formula with a small spread between A% and B% and a low forex strike is more leveraged than one with a wide spread between A% and B% and a higher forex strike.
There are many reasons for the PRDC note’s enduring popularity. First, the PRDC note is a mechanism for earning foreign – in effect higher – rates of interest on a yen principal-guaranteed investment. Investors pick up the interest rate differential between yen and the foreign currency, while the redemption amount is not at risk from forex movements. While there is residual credit exposure to the issuer, investors typically choose only the highest-rated entities in order to minimise the credit view implicit in the structure.
In addition, investors in Japan are comfortable with the view that the yen will not strengthen dramatically during the (variable) life of the note. Effectively, investors take a view that the forex forwards imply a greater degree of strengthening in the yen than will be realised.
Nearly all PRDC notes traded today incorporate a call feature, a forex knock-out or both. Consequently, the average 30-year PRDC note is viewed as a substantially shorter-duration investment than suggested by the long maturity. In practice, PRDC investors aim to earn the high non-call coupon (usually one or two years) and then have the note called or triggered. In effect, the average PRDC note becomes a short-term note yielding Libor plus 300 basis points or more and incorporating the tolerable risk of a near-term strengthening of the yen. By incorporating the possibility of early redemption, callable/trigger PRDC notes also require less of a long-term forex view on the part of the investor.
The PRDC note market has benefited from the virtuous circle stemming from increasing volumes and liquidity. As volumes have grown, dealers have implemented increasingly sophisticated pricing and risk management tools, which, in turn, frequently enable tighter pricing. One example of this is the move in the past two years from one-factor (stochastic forex and static interest rates) toward multi-factor pricing of capped callable structures. Moreover, increased trading volumes have also improved liquidity in underlying hedge markets, notably long-dated forex volatility, which has reduced parameter-driven pricing disparities across financial institutions.
On the investor side, the PRDC note has benefited from increased acceptance and familiarity with the product, and solid performance for much of the period since 1995. Despite its many variations and custom-made nature, the PRDC note is regarded increasingly as a vanilla instrument – investors are familiar with the performance under different forex scenarios and with the call dynamics.
As the PRDC note has evolved from a highly exotic, custom-made product into the most liquid structured product in the Japanese market, with a corresponding increase in investor sophistication, so variations in the PRDC note have coalesced around a widely accepted ‘menu’ of features. In addition to the basic payout profile, the design of a specific PRDC note trade involves choosing a combination of features from the following palette, and virtually all PRDC notes traded today are combinations of these building blocks:
- Choice of forex strikes/coupon spread for coupon determination. The forex strike, in combination with the coupon rate spread (A% – B% above) determines the yen coupon for a given forex level. Investors may choose fixed strikes or a step-down/step-up pattern, effectively varying the overall magnitude of forex risk and the time-dependent pattern of forex risk exposure. For example, an investor may choose a high initial forex strike (for instance, $1=¥125) which steps down rapidly over time if the note is not called or triggered.
- Cap structures. The coupon may be capped at a fixed level or incorporate a step-up/step-down pattern. Moreover, the cap level need not be dependent on the underlying coupon formula. For example, a coupon formula such as:
15% × (dollar/yen)/120 – 10%
capped at 5% may specify that the 5% cap be paid whenever the dollar/yen rate exceeds $1=¥115 and not $1=¥120 as implied by the coupon formula. In other words, in most cases, the formula would pay 5% whenever the dollar/yen rate exceeds $1=¥120. However, in this case, there is a ‘switch’ event, where the coupon jumps to the 5% cap rate when the underlying forex rate is fixed above the pre-specified trigger of $1=¥115. This feature is often referred to as a ‘digital cap’. An extension of the digital cap is a ‘quasi-PRDC note’ structure in which the standard coupon formula is replaced with a ladder of strikes, each corresponding to a specific coupon. For example, dollar/yen levels of $1=¥100, 110, 120 and 130 might be associated with coupons of 1%, 2%, 3% and 4%.
- Callable/trigger variations. Callable PRDC notes have been traded since 1997 and trigger knock-out versions since 1999. The former provide the greater yield pick-up, but investors bear the uncertainty surrounding the exact market circumstances that would cause the note to be called. For a given PRDC note structure, the call boundary – the set of market parameters that determine a call event – is primarily a function of the forex rate and, to a lesser extent, yen and dollar interest rates. However, the exact levels at which the note is called will vary also with other market factors. For example, a substantial increase in long-dated Japanese interest rate volatility will raise the forex rate at which a capped PRDC note is called.
The trigger knock-out addresses this concern by specifying a fixed foreign exchange rate (or step-down forex schedule), which will cause the note to redeem early. The impact on pricing is ambiguous: a high trigger level, for example a dollar/yen rate level of $1=¥150, will cause the note to knock out at a time when running coupons are large. Here, the trigger acts in a similar fashion to a call feature, and the headline coupon will be correspondingly enhanced. Conversely, a low trigger will cause the note to redeem early when the coupon is low and the benefit of this ‘quasi-put’ to the investor results in a more conservative coupon formula today.
In addition to the standard par trigger or call, some structures incorporate an early redemption bonus. For instance, if the note is triggered or called, then the redemption value will exceed par by a pre-specified margin. And it is possible to combine both call and trigger features in a single note, either simultaneously or consecutively. For example, a PRDC note may have a one-year non-call period, followed by a five-year callable period, followed by a 24-year callable and trigger knock-out period.
- Yield-enhancing additions. For investors seeking additional yield, it is possible to link the note redemption amount to the forex rate prevailing at maturity. This is done either in forward or option form. In the former case, the redemption amount is expressed in the foreign currency and converted at a strike determined today. At maturity, this amount is paid in yen by converting at the then-prevailing forex spot rate. Practically, the redemption formula appears as: Par × forex at maturity/strike.
The yield enhancement arises both from the fact that ultra-long dated forex forwards are substantially lower than spot levels and that, in a callable structure, the call option amounts to a forex option on the principal amount of the note. To the extent that the investor believes forex at maturity will exceed the forward level, it is possible to generate additional value to pass on in the form of a higher coupon. In the option case, the same methodology is used, but here the redemption in yen is capped at par. In other words, the investor will not benefit if the forex rate at maturity is greater than the strike rate.
Much development effort in the dealer community in the past two years has revolved around improving risk and pricing systems for these combinations. A few years back, the redemption link was offered for bullet or callable structures only. Today, swap dealers are able to manage the greater risk inherent in knocking out a large redemption value, so that higher risk combinations such as a foreign exchange knock-out redemption-linked PRDC note with a high redemption strike are offered.
In 2002, investors have been able to choose a capped PRDC note with a step-down forex strike, a five-year call period and a redemption forward link. In practice, the most popular combinations utilise step-up caps, step-down foreign exchange strikes with a multi-call and/or trigger feature, and no redemption link. The combination of features will determine: the initial coupon spread and early running yield; the evolution of risk (whether the risk is back-ended to pay a larger coupon today); the expected duration of the note (if the risk is back-ended, the note is less likely to be called and expected duration will go up); and the degree of risk and hedging cost to the swap dealer, which will, in turn, affect pricing.
In 2002, the PRDC note market has seen increased participation from the dealer community, with corresponding pressure on margins. In addition, the tenor of PRDC notes has increased in response to a continuing decline in yields. There’s also been a move toward Australian dollar and euro-linked coupons as US dollar yields have declined.
While there has been only piecemeal innovation in the PRDC note market in the past year – mostly pricing new risk variations – the dealer and pricing environment has changed more dramatically. Specifically, there has been a marked increase in the number of swap dealers offering complex PRDC note variations priced using the latest models. Previously, it was not unusual for one or another dealer to demonstrate a distinct edge in a particular PRDC note variant, usually a newer structure.
Given the slower pace of innovation in the past year, it is now common to find up to 20 dealers able to price a specific PRDC note variant, with a corresponding decline in margins. This pressure on margins is exacerbated by the auction process, which serves as the main channel for foreign dealers to participate in the PRDC note market. Traditionally, domestic securities houses have sourced demand for the PRDC note then put the structured hedge out to competitive tender. With greater participation in this process, spreads on some products have declined to almost zero, while more exotic variants are frequently won by the dealer with the most aggressive correlation assumptions.
As the number of dealers has increased and in light of the difficult credit environment in 2002, the role and cost of credit lines of long-dated medium-term note (MTN) issuers to swap dealers is becoming a source of competitive advantage. Given the long maturity of the PRDC note, the structured swap between dealer and MTN issuer is highly credit-sensitive, as reflected in differential funding levels according to the perceived credit risk of the swap provider. So in a crowded field, both the existence of lines to the more popular issuers and the dealer’s credit standing are becoming sources of competitive differentiation.
A corollary of increased dealer participation in the PRDC note market is the greater liquidity in long-dated forex volatility markets. The majority of today’s PRDC notes have 30-year tenors, with forex vega risk predominating in the 10-year to 15-year part of the volatility curve (this is a function of any call/trigger features, as well as foreign exchange and coupon spreads). As a result, liquidity has gradually but steadily increased in the past year and it is now possible to find two-way markets in 10-year dollar/yen volatility, whereas previously five-year was considered the upper bound for liquidity. In turn, as long-dated volatility becomes more actively traded, bid/offer spreads on PRDC notes will continue to decline and variation in pricing across dealers is also expected to diminish.
Meanwhile, the continuing decline in Japanese yields has caused investors to move into ever-longer structures. As recently as a year ago, 20-year maturities still represented the most liquid segment of the PRDC note market, and it was not uncommon to see 15-year structures. Today, 25-year and 30-year maturities represent between 80% and 90% of traded PRDC notes, and some houses have begun to show 35-year maturities. Generally, investors have a specific current yield target when purchasing PRDC notes, and note maturities vary with prevailing long-dated yields to meet this target.
The value in PRDCs is driven predominantly by the interest differential between the yen and any number of foreign currencies. So, as the yield gap narrows, the economics of the transaction become less compelling. Since hitting a high of 4.1% in March this year, the spread between 30-year US dollar and Japanese yen swap rates has declined 110 basis points, and this decline has reduced investor demand in dollar/yen-linked PRDCs in favour of currencies such as Australian dollar and the euro. While exact numbers are difficult to come by, JP Morgan’s experience is that Australian dollar structures account for approximately 40% of transactions executed today, against 20% one year ago. Euro-linked transactions have increased from almost nothing one year ago to 10% of the total today, with the remainder accounting for the traditional US dollar-linked structures.
In the past seven years, the PRDC note has become the standard for yield-enhanced structured investments in the Japanese market. The long tenor and substantial interest rate spread between the yen and other currencies provide significant yield-enhancement at a tolerable risk – reflation in the Japanese economy leading to a stronger yen and higher Japanese rates – for Japan-based investors. In light of increasing liquidity, improved trading technology, a continued low-yield environment, a firm dollar/yen rate and increasing familiarity with this product among investors, it is clear that the PRDC note will continue to occupy a leading role in the Japanese structured product market in 2003.
Jason Sippel and Shoichi Ohkoshi are vice-presidents, investor derivatives marketing, at JP Morgan in Tokyo
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