A power reverse dual currency swap (also known as a PRDC swap) is similar to an interest rate swap, whereby each party exchanges payments based on a predetermined payment schedule on a predefined notional amount in a single currency.
The main difference is in how the interest rate paid by the structured coupon (also known as the PRDC leg) is determined.
In SDX Interest Rates this leg is fixed. That is, the interest rates of both currencies are fixed for each coupon at the inception of the trade. For each currency the same fixed rate can be used for all coupons or you can set a different fixed rate for each coupon. You do this in the Coupon Structuring window, which is accessed by clicking the Coupon Structuring button.
The interest rate paid by this leg is calculated as follows:
Min(MaxCoupon, Max(MinCoupon, secondary currency fixed rate * FX FWD/initial spot - main currency fixed rate))
Where:
MinCoupon (which cannot be set to less than zero) guarantees a positive cash flow for the receiver of this leg.
MaxCoupon caps the coupon that can be paid by this leg.
The cap is an al setting.
FX FWD is either the FX forward rate for a future fixing or the actual FX spot on a historical fixing.
Spot is the initial spot at the time the deal was entered into.
Accordingly the coupon on the PRDC leg depends on what happens in the FX market.
The other leg is always based on a predefined floating rate.
There are two styles of PRDC swap, the difference between them being in whether the swap can be terminated (or called). In a:
Non-callable style PRDC swap the swap cannot be called.
Bermudan style of PRDC swap one of the parties has the right but not the obligation to terminate the PRDC swap on any of the predefined call dates during the life of the swap.
In a callable PRDC swap the right to cancel the swap early always belongs to the payer of the PRDC leg (also known as the swap issuer). The swap issuer will generally call the instrument when the main currency weakens, an event that will result in a higher coupon for the PRDC leg.
Why Enter into a PRDC?
The power reverse dual currency swap (or PRDC) is a very common structured product which was designed as a yield enhancement instrument for JPY investors. That is, the investor (the party who receives the PRDC leg) will expect to receive a higher yield than that currently available in the market. It is exclusively an investor product, and is principally traded in USD/JPY, EUR/JPY and AUD/JPY.
An investor who wants to take a view against the current FX forward curve of some JPY-related currency pairs (e.g., AUD/JPY or USD/JPY) and who also believes that the JPY interest rates will not rise sharply may enter into a PRDC swap to receive an enhanced yield in comparison with a vanilla swap that is denominated in JPY or the cross currency swap.
Most PRDCs are structured in such a way that the first coupon is fixed at a high rate, which is obviously attractive to the investors, and in such a way that the coupons rise as the domestic/foreign exchange rate depreciates. However, it comes with a higher risk for the investor, i.e., that they are then exposed to a long period (often between 15 to 30 years) of low coupons, sometimes close to 0%, if the secondary currency does appreciate against the main currency.
Accordingly, the investor will be looking to get the large fixed coupon in the 1st year and for the note to then be called.