Power Reverse Dual Currency Note - Hedging

Hedging

A plain vanilla PRDC is exposed to the movements in interest rates, FX, volatility (on both interest rates and fx), correlation and basis. Those risks are hedged with interest rate swaps in each currency to reduce interest rate risk, interest rate swaptions in each currency to reduce interest rate volatility exposures, FX Options to reduce FX volatility exposures and Basis swaps to reduce basis risk. Correlation exposure can be partially hedged with correlation swaps.

While such hedges are theoretically possible, there are a lot of practical difficulties, largely due to the following situation. The owners of the PRDC notes, usually retail investors, don't hedge their risks in the market. Only the banks, which are all short the notes, actively hedge and rebalance their positions. In other words, if there is a significant move in FX, for example, all the PRDC books will need the same kind of FX volatility rebalancing at the same time. The note holders would be the natural counterparty for the hedge, but they don't take part in this market (similar to buyers of portfolio insurance in 1987). This situation often creates "one way markets" and sometimes liquidity squeeze situations in long term FX volatilities, basis swaps or long end AUD interest rate swaps.

The volume of PRDC notes issued has been so large that the hedging and rebalancing requirements far exceed the available liquidity in several key markets. However every model is derived under the assumption that there is sufficient liquidity - in other words, they are potentially mispricing the trades because in this market, a few of the key standard Black–Scholes assumptions (such as zero transaction cost, unlimited liquidity, no jumps in price) break down. No active secondary market ever existed for PRDC and banks usually mark their books to some consensus level provided by an independent company. Anecdotal evidence indicates that nobody would show a bid anywhere close to that consensus level.