Long Dated FX products

Dr. Sebastián del Baño Rollin

Global Head FX and Equity Quantitative Research

Quantitative Research October 2002

 Overview

1. Long dated FX products

2. The Power Reverse Dual Currency Note
3. Modelling of long dated FX products
4. The impact of the volatility smile
5. Some market considerations

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 Long Dated FX products

„ Recent years have witnessed a significant increase in the demand for long
dated FX products
„ Corporates with substantial FX exposures typically will consider FX swaps (a
strip of forwards). They will also often add extra features to the contract:
z Cancellability clauses held by either the bank or the corporate
z Other exotic features to cheapen the structure
„ Investors wishing to place capital in high yield currencies
z Emerging markets
z Yen investors (USD or AUD)

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 The Power Reverse Dual Currency Note (PRDC)

„ Designed as a yield enhancement instrument for Yen investors

z Investor swaps Yen LIBOR by Dollar LIBOR paid on a Yen notional
z This is offset by some exposure to USDJPY risk
„ Typically maturities around 30Y
„ Very popular product in the past. On lower USD rates market is now shifting
towards AUD

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 The Power Reverse Dual Currency Note (PRDC)

„ Examples:
1. Investor receives string of forwards with maturities 1Y, 2Y, …, 30Y
2. Investor receives string of USD call / JPY Put options pays string of JPY
LIBOR payments
3. Trigger PRDC. Yield can be enhanced with a substantial first coupon
(typically around 4%). This is offset by a discrete USDJPY knock out
clause.
4. Callable PRDC. Yield can be enhanced with a substantial first coupon
(typically around 4%). This is offset by a callability clause on the Bank.
„ Investor hopes a PRDC will be called/triggered in 1Y to collect a substantial
return on a JPY investment.

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 The Power Reverse Dual Currency Note (PRDC)

USDJPY

1Y 2Y 3Y 4Y Time

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 The Power Reverse Dual Currency Note (PRDC)

USDJPY

1Y 2Y 3Y 4Y Time

Customer receives 4% coupon

Bank can decide to cancel deal

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 The Power Reverse Dual Currency Note (PRDC)

USDJPY

1Y 2Y 3Y 4Y Time

K1
Customer receives payout of USD Call/ JPY Put
Bank can decide to cancel deal

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 The Power Reverse Dual Currency Note (PRDC)

USDJPY

1Y 2Y 3Y 4Y Time

K1

K2

Customer receives payout of USD Call/ JPY Put

Bank can decide to cancel deal

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 Modelling of long dated FX products

„ A fundamental observation

−rf T
Vega = S T N (d1)e ≈α T
− rd T
Rhod = KTN (d 2)e ≈ βT

„ Thus, intuitively, vol risk is relevant for the shorter maturities and interest rate
risk for longer maturities

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 Modelling of long dated FX products

„ To value and hedge long dated FX trades we need to consider the impact of
stochastic interest rates
„ Example: Amin Jarrow (1991) price a vanilla option in a Black Scholes model
enriched with HJM dynamics for the interest rates
z Main result is that implied vol is the volatility of a string of forwards to the
maturity of the option
z This forward volatility will include the volatility of spot, volatilities of interest
rates and correlations between spot/domestic rate/foreign rate.

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 Modelling of long dated FX products

„ The Amin Jarrow model can be used to value PRDC’s. Important aspects of
the implementation:
z Choice of a particular HJM rate model: Hull-White, Vasiceck, BGM, …
z Estimation of correlations: spot rate/domestic rate/foreign rate. How does
one manage the correlation risk (correlation will also move with time…)
z Effects of the volatility smile

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 The impact of the volatility smile

„ Ideally one would want a stochastic volatility model coupled with stochastic
interest rate models to be able to value and hedge the impact of the smile
„ This is unrealistic: too many parameters, calibration problems, speed issues,
…
„ In practice one often analyses the Vega profile of the PRDC to see where in
strike space is our vol exposure

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 The impact of the volatility smile

USDJPY

1Y 2Y 3Y 4Y Time
Bank will cancel deal if spot is above a
certain level

Bank is short this strike

K1

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 The impact of the volatility smile

USDJPY

1Y 2Y L1 3Y 4Y Time
Bank is long this strike

Bank is short this strike

K1

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 The impact of the volatility smile

USDJPY

1Y 2Y L1 3Y 4Y Time
Bank is long this strike

Bank is short this strike

K1

This is a Risk Reversal position: Bank is long high side vol and short low side vol

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 The impact of the volatility smile

„ A risk reversal is typically a zero cost structure under the Black Scholes model
assumptions.
„ If we value this risk reversal under the smile we’ll obtain the smile value
corresponding to the second year leg of the PRDC

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 Some market considerations

„ Why is the PRDC marketable

z USD/JPY interest rate differential is (was) very negative. Forward is very
low. We can offer very profitable strike schedule.
z USDJPY was not perceived to be following the forward. Difference
between risk neutral measure and real world measure means a structure
can look very profitable with a high likelihood (with risk) whereas the value
of the hedged position be flat (without risk)
„ Limitations of mathematical modelling
z The PRDC market is one sided. All banks are hedging the same long
dated vol positions. Supply/demand effects determine the shape of the
long dated USDJPY smile. This does not respond to USDJPY rate
dynamics and poses difficult problems to the mathematical modelling of
spot.

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 Disclaimer

The information in this document is intended to provide you with a summary of potential transaction structures and terms and conditions that may or may not lead to transactions being entered into between us. It is not
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