FT Alphaville has already cautioned about the chaotic effects the Japanese crisis is having on variance swaps. But here’s another potential (derivatives) spillover.
It’s the effect on “Power Reverse Dual Currency Notes” also known as PRDCs.
(H/T Sean Corrigan of Diapason Commodities)
These are somewhat complex derivatives designed to pay out foreign interest rates to investors in their own domestic currencies. Unsurprisingly, they have always been pretty popular in Japan due to the country’s low interest rate environment.
Their popularity, however, did turn out to bite some investors in the face.
As the FT reported back in 2008:
Power-reverse dual currency bonds are the latest instruments to cause concern. PRDCs, which have been principally issued in Japan, are long-dated bonds, usually with a maturity of about 30 years, with coupons linked to movements in a foreign currency such as the US or Australian dollar.
If the yen weakens against the relevant currency, the coupon rises. The product is “callable”, meaning once the purchaser receives a certain return the issuer can cancel the deal. But just as deleveraging has created domino effects in numerous other asset classes, there are signs that volatility in the foreign exchange markets is starting to affect PRDC trades. That threatens to exacerbate the swings in the dollar/yen rate to a degree that could wrong-foot many investors inside and outside Japan.
Now, the opposite of the desired effect is happening (again).
Yen strength is seeing the coupons decline.
As the FT observed, PRDCs have always been structured to eliminate coupons when certain exchange rate levels are breached. The note, though, remains valid.
They explained at the time thus:
These trigger levels were not much of a concern when the yen was weak. But the volatility of the yen and its strong appreciation has left the swap houses, which have the hedging risk and pay out the coupons, with an urgent need to re-hedge.
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With the appreciation of the yen, market makers were left with the longer-term problem of managing the residual risk of their foreign exchange exposure to the currency options embedded in the PRDCs. This left them with massive short positions in the yen, which were amplified as the currency strengthened. This meant they had either to buy yen calls – options which entitle an investor to buy the yen against another currency – or simply hedge their positions by buying the yen in the spot market.
And it’s not just against the US dollar where we see the problem.
The most pronounced effect is actually against the Australian equivalent.
Note the difference in scale between the dollar/yen cross-rate move and the Aussie/yen cross-rate move:
Yen strengthening against the dollar, meanwhile, also lengthens the duration of the PRDC and forces sellers to receive 30-year fixed-rate cash flows via 30-year swaps.
And presto, here follows the effect on the US 30-year swap spread too:
Of course, as Risk had reported previously, the 2008 effect did teach investors some lessons, and appetite for PRDCs has since fallen off a cliff. That said, for those left outstanding, the convexity effect could by now be multiplying the hedging need.
In that case, the following points raised by Risk remain applicable:
Due to the one-sided nature of the flow on the yen swap curve, re-hedging this exposure can be an expensive exercise.
“Rather than paying high fixed-yen coupons and receiving fixed dollars for two to three years, issuers have been forced to re-hedge their positions to paying fixed dollars and receiving fixed yen for 30 years,” says Carrillo, who says the subsequent scramble for new hedges has been so widespread it has not just flattened the yen swap curve, but actually caused an unusual inversion in 20–30-year forward buckets.
“For a period of time, the collective re-hedging that was done across the market actually brought 30-year swap rates sharply below those of comparable Japanese government bonds (JGBs),” he says, referring to the October 10, 2008 moment when 30-year JGB asset swap spreads inverted to about +55 basis points, their widest point in history.
Essentially, the Japanese 30-year swap spread (usually negative) went unusually positive at the time– a move which coincided with the US 30-year swap spread going negative.
This time the effect on Japanese swap spreads hasn’t been quite as great, although they did go briefly positive again:
Related links:
New menace casts shadow over Japan’s FX horizon – FT
Storm over Japan bonds show Bank worries were prescient - FT
How JGBs roasted some big investors’ pinkies – FT Alphaville