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PRDC Notes: Currency and Rate Exposure and Issuer Call Decisions

Article Quant Q&A · Author: Bruce Wayne
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Summary

The document discusses power reverse dual-currency notes through a Yen investor’s exposure to a Brazilian real and Yen-linked payoff. One explanation frames the investor as long the real forward, or equivalently as holding exposure to the real spot and a real fixed-rate bond while short a Yen fixed-rate bond. This helps connect the coupon structure to foreign exchange and interest rate risk.

The issuer’s early call decision is described as depending on whether market moves have favored the investor, including real appreciation, lower real rates, or higher Yen rates. Bermudan exercise models must account for currency and rate dynamics and their correlations, with later call dates potentially exercised when the deal is less favorable to the investor. A second reply offers a contrasting, less product-specific view based on funding and resale considerations. The discussion is informal and does not provide a valuation model, calibration method, or detailed treatment of the coupon formula.

Key ideas

  • A Yen investor in the described note has exposure to the real through forward-linked coupons and maturity cash flows.
  • The real forward exposure can be viewed as a combination of spot and two currency bond positions.
  • Issuer call incentives can change with the exchange rate and interest rates in both currencies.
  • Bermudan call exercise analysis depends on modeled currency and rate dynamics, including correlations.
  • The replies differ in framing and do not provide a complete pricing procedure.

Tags

ForexFixed incomeOptionsDerivatives pricing
Full text
# FX: PRDC (Power Reverse Dual-Currency Notes): key risks and callability


# FX: PRDC (Power Reverse Dual-Currency Notes): key risks and callability












Can anyone tell me more about PRDC products. I've heard it is a popular product among Japanese investors. One popular product is the 10Y BRL/JPY paying a coupon of 20%*PerfFX-15% with callable options for the bank. I am a bit confused about the sensitivities (fx and rates), from my understanding the client thinks the BRLJPY forward is too low so he is long the forward => short BRL rate and long JPY rate. Correct? What about the correlation between fx spot and rates? It is confusing for me. Also, every year the bank can call the product. How does the trader decide if he should call it back or not? Thanks for your help

## Answer by dm63 (score 2)

https://quant.stackexchange.com/a/32385

In your example, the buyer of the PRDC security is a Yen-based investor who gets long the BRL on a forward basis, on each coupon date and on the final maturity date. Because BRL is a lot cheaper forward than spot, the investor gets a high coupon for taking this risk. You can think of the risk taken by the investor in 2 ways, either (a) long the BRL forward or (2) long the BRL spot + long a BRL fixed rate bond + short a Yen fixed rate bond. These are equivalent.

The dealer usually had an option to mature the bonds early. They will do this if the trade is moving sufficiently in the investor's favor: either spot BRL has appreciated , or BRL rates have gone down , or Yen rates have gone up, or some combination. As with any Bermudan option , the early options will only be exercised if the markets have moved heavily in the investor's favor. The later options require to be less 'in the money' to be exercised. The models used to determine exercise are complex , containing the dynamics of the fx rate and the two rate markets, and their correlations.

## Answer by rupweb (score 0)

https://quant.stackexchange.com/a/32398

Per my FX / MM training the relationship between FX and rates is built into the forward when the price is agreed. Your PRDC uses whatever the 10 year interest rates are for BRL and JPY on trade date. There isn't any other "correlation" because once the forward price is set then the cash flows are set for value date, with some percentage collateral upfront (like a premium).

I am not directly familiar with PRDC but it sounds like if the investor is long the BRL/JPY then in 10 years time he will be giving X JPY to take Y BRL. If he is short, then he'll be taking X JPY for giving Y BRL. The risk today is how much do the future cash flows cost compared to structuring the PRDC as a set of money market deposits / loans in BRL / JPY over 10 years? That will presumably involve variable underlying interest rates on both currencies, and then the FX risk is the final spot deal to get the PnL currency in 10 years time. Whereas the forward locks in all those variables today!

The same data has to underwrite a decision whether to "call back" the deal. It would be about the rates available in depos / loans on the 2 currencies, and the interest rate differentials, and then the FX spot rate for maturity. I would say the trader doesn't call back anything but resells it if various PnL risks are breached on his side, or if the client doesn't post margin.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.