Power Reverse Dual Currency Note - PRDC During Subprime Crisis

PRDC During Subprime Crisis

PRDC has been the subject of much attention in the market during the subprime mortgage crisis. By the nature of the trade, investment banks hedging the risks for PRDC structured note issuers will have a short cross gamma position between FX volatility, interest rate and FX. In a volatile market where market parameters move in large and correlated steps, investment banks are forced to rebalance their hedges at a loss, often daily.

In particular, when FX spot goes up, the hedger for a PRDC note is expected to pay more coupons on a PRDC note. Thus, the hedger is more likely to call the note, reducing the expected duration of the note. In this situation, the hedger has to partially unwind the hedges done at the inception of the PRDC note. For example, he would have to pay swaps in the foreign currency. If FX spot moves in a correlated fashion with the foreign currency swap rate (that is, foreign currency swap rate increases as FX spot increases), he would need to pay a higher swap rate as FX spot goes up, and receive a lower swap rate as FX spot goes down. This is an example of how the hedger of a PRDC note is short cross gamma.

This was the main driver behind the increased market volatility in FX skew, long dated FX volatility, long dated Japanese Yen and Australian dollar interest rate, especially during the last quarter of 2008.