Banks pull out of PRDC market

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LONDON – Losses and increasing hedging costs have forced many smaller firms out of the power-reverse dual currency (PRDC) business, say dealers, leaving a rump of major banks operating in the market.

One high-profile withdrawal was AIG’s financial products unit, which sold a $7 billion PRDC book in early 2009. The book was largely absorbed by Deutsche Bank. The bank did not respond to requests for comment on the matter.

Issuing and hedging PRDCs for Japanese investors provided dealers with bumper profits before the financial crisis. But market gyrations and increases in hedging costs have caused losses for a broad range of market participants.

“The market has had a tough 2008 and 2009. Just about everyone who has a substantial position has lost money,” observes a London-based exotics head at a major US dealer.

These losses have propelled the exit of many smaller banks from the market over the past year, adds a London-based head of foreign exchange structuring at a large European bank. “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," he said. "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."

The market has had a tough 2008 and 2009. Just about everyone who has a substantial position has lost money

At the height of the product’s popularity, dealers say there were up to 20 banks pricing PRDCs. Now, only a handful of banks remain serious about the business, say bankers.

In addition to Deutsche Bank, other firms have also been able to cherry-pick attractive portfolios. For instance, BNP Paribas took on a substantial number of trades from two AAA-rated international banks in mid-2009.

In simple terms, PRDCs constitute a carry trade in which foreign currency interest rates are paid on a yen-denominated notional amount. If the target currency stays high relative to the yen, investors receive juicy coupons – typically for a period of one or two years before the notes are called. However, if the yen appreciates, investors could face as much as 30 years with no coupon payments. Although the bulk of PRDC notes offer exposure to US dollars, Australian dollars are also popular.

But the strength of the yen over the past two years has left many trades under water. The yen reached ¥123.94 to the dollar in June 2007. By January 26, 2010, it had closed at ¥89.66 to the dollar, according to Bloomberg. Coupon payments on PRDCs usually reference levels close to spot, so many trades would have been conducted at pre-crisis levels of ¥100–120 to the dollar.

Before the outbreak of the subprime mortgage crisis, annual PRDC issuance regularly topped $10 billion a year. Much of this sprung from investors putting money back into the products, as older notes were swiftly called by issuers. However, with many investors facing little chance of coupons in the near future, issuance has dropped to a fraction of former levels.

A lack of cash from new issuance means it is 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 might well decide it does you better to exit,” he says.

The hybrid and long-dated nature of PRDCs makes them particularly nettlesome for dealers. The products give banks negative convexity to movements in the USD/JPY spot rate, as well as cross-gamma exposures, which are difficult or impossible to hedge, dealers say. These effects made periods including late-2008 especially problematic for banks hedging PRDC books.

Meanwhile, poorer liquidity in basis swaps and foreign exchange options has also played a role, speculates Tim Sillitoe, London-based head of hybrids trading at Royal Bank of Scotland. “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,” he said.

An important factor in pricing PRDCs is correlation. Ten years ago, realised correlation between 10-year swap rates and USD/JPY spot rates traded around 0%, dealers note. By January 20, 2010, realised correlation between 10-year swaps and USD/JPY spot rates had hit 65%, according to Bloomberg. Banks with sizeable PRDC books could have exposures of $2 million–5 million per 1% of correlation, estimate some market participants.

Sillitoe believes this might have been another factor behind 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."

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