Dual-Currency Private Placements

Structuring a Transaction

In the late 1980s, the dual – currency private placement market emerged as a profitable way to channel capital

from Japanese life insurance companies to Western borrowers. The product gave Japanese investors the

protection of yen principal and possible currency gains from a foreign currency coupon, while offering

borrowers subordinated U.S. dollar LIBOR debt at competitive rates.

In the example detailed on the following pages, a Japanese investor purchases a ¥ 10 billion, 10-year

subordinated private placement with an annual coupon paid in Australian dollars; the borrower receives 10-

year U.S. dollars at six-month LIBOR. To synthesize the yen/Australian dollar placement and to transform it

into U.S. dollar LIBOR, the intermediary uses the currency swap market, the spot foreign exchange market,

and the Australian corporate bond market.

Although the transaction appears complex, in reality it can be reduced to three sets of cash flows. First is the

initial placement of ¥ 10 billion and the initiation of the currency swap transaction, a spot foreign exchange

transaction, and an Australian dollar bond portfolio investment. Second is the payment of interest. Third is the

exchange of cash flows at the end of the currency swap.

10 Year ¥ Billion
Placement with Australian
Dollar Coupon

Principal Amount: ¥ 10 billion

¥/US$ Exchange Rate: 129

¥/A$ Exchange Rate: 112.2

10-Year A$ Yield 14.73 %

10-Year yen zero-coupon/

US$ LIBOR Swap Rate 5.34 %

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1st. step: Initial Placement

The sales force of a London-based financial intermediary reports that a Japanese leasing company is willing

to invest ¥ 10 billion in a 10-year subordinated private placement. The funds must be placed with a well-

kown financial institution with a credit quality equivalent to the S&P rating single A. The leasing company is

willing to do the placement only if it can attain a yield of 5.52 %, but with the coupon paid in Australian

dollars.

Calculating this IRR on a yen-equivalent basis involves using an appropriate forward yen/Australian dollar

exchange rate to translate the Australian dollar coupons into the yen equivalents. The fact that the investor

uses a forward rate to evaluate the investment does not mean that he or she plans to hedge the coupon

payments. Hedging the coupon payments would defeat the purpose of investing in a dual-currency instrument.

However, the investor needs to translate the Australian dollar coupon into yen in order to estimate the

investment’s return in yen terms. For this, he or she needs a forward rate.

A key feature of this dual-currency structure is that at maturity the Japanese investor gets back the par value,

in yen, of his or her principal. This requires that the intermediary invest enough yen at the start of the

transaction to receive the par value at maturity.

This is done via a yen zero-coupon/U.S. dollar LIBOR swap. When the transaction is initiated, the

intermediary takes the borrower’s yen proceeds and swaps a portion of them for U.S. dollars, which are

passed on to the borrower. The rest of the yen are used to buy a portfolio of Australian bonds, which are used

to pay the Australian dollar coupon to the Japanese investor.

Application

The intermediary finds a counterparty willing to take the other side in a 10-year yen zero-coupon/U.S. dollar

LIBOR swap. The counterparty quotes an annual effective rate of 5.34 %. How many yen must the

intermediary invest in the swap to receive ¥ 10 billion in 10 years?

Answer:_______________

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Application

What amount, in millions of U.S. dollars, will the intermediary receive in the swap today?

Answer:_______________

Purchasing Australian Dollar Bonds

The intermediary now has U.S. dollars, which can be passed on to the borrower. Because the intermediary did

not invest the full ¥ 10 billion in the swap, a portion of the yen proceeds is left over. These yen can be

invested in Australian dollar bonds to provide the Australian dollar coupon payments that the Japanese

investor inquires.

Application

How much can the intermediary invest, in millions of Australian dollars, in an Australian dollar bond portfolio

to be used to pay the coupon?

Answer:_______________

Application

Now label the diagram below with the appropriate cash flows calculated in the previous application: the

initiation of the currency swap, the purchase of Australian dollars, and the investment in an Australian dollar

bond portfolio.

A$ bond Spot FX ¥ zero-coupon/

portfolio market US$ LIBOR
swap counterparty

A$ A$ ¥ US$ ¥

I n t e r m e d i a ry y

 US$  ¥

Japanese ¥

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 Leasing Company  Borrower

2nd. Step: Calculating the Coupon Payments

The intermediary will receive U.S. dollar LIBOR from the borrower every six months; this payment will be

passed on to the swap counterparty. The intermediary will also receive an annual Australian dollar payment

from the bond portfolio. These payments are received once a year for 10 years, with the final payment

depleting the portfolio. They will be passed on to the borrower, who will pay the leasing company.

Application

What will be the amount of the Australian dollar coupon payment?

Answer:_______________

Application

Now fill in the amounts of interest payments in the chart below.

A$ bond Spot FX ¥ zero-coupon/

portfolio market US$ LIBOR
swap counterparty

 

I n t e r m e d i a ry

 

Japanese
Leasing Company  Borrower

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3rd. step: Repayment of Principal

The final stage of the transaction is the repayment of principal. The borrower repays the U.S. dollar principal,

the intermediary passes this on to the swap counterparty. The swap counterparty, in return, makes a payment

of ¥ 10 billion to the intermediary. This payment is passed on to the borrower, who in turn pays it to the

leasing company. These cash flows are diagrammed below.

Application

Now fill the amount of the principal redemption cash flows.

A$ bond Spot FX ¥ zero-coupon/

portfolio market US$ LIBOR
swap counterparty

 

I n t e r m e d i a ry

 

Japanese
Leasing Company  Borrower

Comparison to Alternative Investment

The Japanese investor demands a yen-equivalent yield on the dual-currency placement of at least 5.52 %. To

find the yen-equivalent yield, the investor must translate the Australian dollar coupon payments into yen and

calculate an IRR (Internal Rate of Return).

The logical exchange rates to use when translating the coupon payments are a series of 10 forward

yen/Australian dollar rates. Although the market for long-dated forward Australian dollars is illiquid, quotes

do exist. Even if the quotes did not exist, the investor would have to assume some future exchange rate to

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compare the dual-currency instrument with a straight yen investment. Again, the investor does not intend to

hedge the Australian dollar coupon. The forward rates are simply used to evaluate the investment in yen

terms.

If the dual-currency instrument provides the borrower with a competitive U.S. dollar LIBOR rate while

yielding more than the investor’s yen benchmark, the intermediary can take as profit the excess yield of the

dual-currency instrument. This profit can be taken in any combination of the three parts of the transaction: the

yen zero-coupon/U.S. dollar LIBOR currency swap, the spot exchange of yen for Australian dollars or the

Australian dollar coupon payment.

Application

Complete the table to find the IRR on the dual-currency private placement. Using the payment figure

calculated in the 5th Application, fill in the amount of the Australian dollar coupon. Then, using the forward

rates supplied in the table, calculate the yen-equivalent cash flows of the dual-currency instrument.

Period Yen Australian Forward Yen

Principal dollar coupon rate equivalent

0 ____ ____
1 ____ 104.50 ____
2 ____ 97.33 ____
3 ____ 90.65 ____
4 ____ 84.43 ____
5 ____ 78.63 ____
6 ____ 73.24 ____
7 ____ 68.21 ____
8 ____ 63.53 ____
9 ____ 59.17 ____
10 ____ ____ 55.11 ____

IRR = ____

The difference between the Japanese investor’s benchmark of 5.52 % and the yen-equivalent IRR of the dual-

currency issue is ______ %. This is the amount the bank can take as profit.

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