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
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2 Answers
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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.
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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.
