PRDC Notes

A financial institution that buys structured notes may, before a purchase, need to check a PRDC note's coupon formula, zero floor, and early cancellation, and to look at profit and loss and valuation as exchange rates and interest rates move.

Yen redemption with an exchange-rate coupon

A PRDC note is a structured note made by embedding several coupon swaps in a reverse dual currency bond (a bond whose principal is redeemed in yen and whose coupon is denominated in a foreign currency) to raise the coupon. The Bank of Japan's material calls this form a power reverse dual (PRD) note and explains that the coupon rate changes with the exchange rate on each interest payment date¹. Power Reverse Dual Currency (PRDC) covers the payments and valuation of a PRDC as a derivative.

Consider a fictional example with a face value of 100 yen, a term of 15 years, and Company C as the issuer. The terms and figures are the example values in the Bank of Japan's material.

Power Reverse Dual Currency (PRDC) calls the side that receives the PRDC coupon the "receiver" and the side that pays it the "payer." In this bond, the issuer of the bond is the receiver, and the swap counterparty (the dealer) is the payer. Below, the terms are issuer of the bond, investor, and swap counterparty.

Figure description

This redraws the figure in the Bank of Japan's material, leaving out the arranger and the cover transactions. The investor pays Company C the principal in yen. Company C pays the investor "USD 5%×3," and the investor pays Company C "JPY 4.8%×2." Company C receives "USD 5%×3" from the swap counterparty. It pays the counterparty "JPY 4.8%×3." The figure shortens the counterparty to "Swap party." Two flows are left out: Company C's redemption of the principal in yen at maturity, and the payment of premiums. Redemption is at the redemption price in the table.

In the figure, "USD 5%×3" is three payments of 5%, or 15%, and "JPY 4.8%×2" is two payments of 4.8%, or 9.6%. These correspond to the 15% and 9.6% in the coupon formula of the example².

How the coupon rate is set

With $S$ as the exchange rate on the interest payment date (yen per dollar), the coupon rate is set by the following formula¹.

$$C = \max\left(15\% \times \frac{S}{123} - 9.6\%,\ 0\right)$$

This is the same as taking the face value of 100 yen converted at 123 yen, about USD 0.81, multiplying it by the 15% dollar coupon, converting to yen at the exchange rate on the payment date, and subtracting 9.6% in yen³. Because the foreign-currency rate is multiplied by the exchange rate, the coupon grows as the yen weakens. While $S$ is at or below 78.7 yen (call it $K$), the value of the formula is 0 or less, and the zero floor sets the coupon rate at 0%³.

Consider a fictional example that moves the exchange rate in the formula of the example. At 123 yen, the coupon rate is 5.4%, the difference between the dollar 15% and the yen 9.6%. Each 1 yen the yen weakens raises the coupon rate by about 0.122 percentage points³.

Figure description

While the exchange rate on the payment date is at or below 78.7 yen, the coupon rate stays flat at 0%. Above 78.7 yen, it rises by about 0.122 percentage points for each 1 yen the yen weakens. It is about 2.6% at 100 yen, about 5.4% at 123 yen, and about 9.9% at 160 yen. The vertical axis is the coupon rate on the face value.

Payments on the swap and options

In the figure in the Bank of Japan's material, Company C receives "USD 5%×3," denominated in a foreign currency, from the swap counterparty and pays "JPY 4.8%×3" in yen². Because the coupon it pays the investor is set by the exchange rate, Company C exchanges those payments with the swap counterparty. The zero floor is a guarantee the investor buys from Company C. As the other side of that guarantee, the figure draws an arrow for Company C buying a currency option from the swap counterparty².

The early-cancellation right runs the other way. The investor sells the right to Company C, and Company C buys it. The investor receives a premium for it¹.

What the investor receives when the exchange rate moves

Because the coupon grows when the yen weakens and shrinks when it strengthens, what the investor receives changes a great deal with the exchange rate. The Bank of Japan's material shows a five-year-remaining scenario calculation in an example where a financial institution holds 10 billion yen of face value. The main scenario is the case where the forward exchange rates at the time the material was written are realized. The stress scenario is the case where the yen strengthens at about twice the current pace (about 4% a year)⁴.

This table is a scenario calculation in the 2019 material, not current market values. The coupon rates are the values of the example formula with the exchange rates put in⁴. The denominator in the material's formula is written as 113 yen in some tables, but the values shown match a calculation with 123 yen⁵.

The material takes the viewpoint of the financial institution that invested. It looks at the difference from the funding cost (the forward rate of 1-year LIBOR) as the "interest margin." LIBOR is a benchmark rate whose publication ended at the end of September 2024, and this calculation uses the benchmark of that time. On top of the lower coupons, higher interest rates raise the funding cost and also lower the value of the bond⁴.

The case that favors the investor is the one where the exchange rate moves as in the main scenario and interest rates do not change, and the valuation is above 10 billion yen. The case that disfavors the investor is the one where a rise in interest rates and a stronger yen come together, and the valuation is below 10 billion yen and the interest margin in year 5 turns negative. The "total of 5 years' coupons" is the cumulative cash flow in the material minus the principal of 10 billion yen⁴.

Risks that remain with the investor

The investor in a PRDC note remains exposed to five risks. The first is a continuing strong yen. When the exchange rate is at or below 78.7 yen, the coupon is zero. In the stress scenario (a stronger yen at about twice the current pace), the coupon rate in year 5 falls to 0.03%. Because the term is long at 15 years, a prolonged period of a strong yen means a long period of receiving low coupons¹.

The second is that the issuer can cancel early. In the example, the issuer can cancel every six months, and once the bond is cancelled the investor receives no further coupons. The investor receives a premium for selling this right¹.

The third is the issuer's credit risk. The example sets the redemption price at 100 yen. Even if the exchange rate moves, the yen amount of the principal does not change, but redemption assumes that the issuer can pay. If the issuer's management or financial condition worsens, payments of principal or interest may be delayed or become impossible⁷.

The fourth is that the bond is hard to sell midway. Market liquidity is quite low for many structured products, and a sale to the selling firm is not always possible. The material asks institutions to assume that the actual sale price may be well below the theoretical price⁸.

The fifth is a fall in valuation. As the table under the exchange-rate scenarios shows, a rise in interest rates alone lowers the present value from 10.33 billion yen to 9.84 billion yen⁴.

What to check before buying

The Bank of Japan's material asks a financial institution, before buying a structured product, to analyze its structure, identify stress events, set scenarios, and grasp the effect on its business. For the price the selling firm shows, the material asks institutions either to calculate the theoretical price themselves or to obtain prices from several dealers and check whether the price is reasonable⁹. Whether there is a way to sell or hedge when a risk materializes is also an item to check⁸.

Rules on sales or solicitation to individuals are not covered on this page. The rules on selling structured notes in Japan are covered in What Are Structured Products?.

Notes

1. Center for Advanced Financial Technology, Financial System and Bank Examination Department, Bank of Japan, "仕組商品投資のリスク把握と管理" (Understanding and managing the risks of investing in structured products, in Japanese; published July 31, 2019), page 4, "（1）ＰＲＤ（power reverse dual）債" (1. PRD (power reverse dual) bonds). The terms of the example (coupon formula, redemption price, term, zero floor, multi-callable) are in the same place. ↩ ↩² ↩³ ↩⁴ ↩⁵

2. The same material, page 5, the figure "基本的な仕組み［PRD 債］" (Basic structure [PRD note]). The correspondence to 15% and 9.6% is a calculation from the number of payments in the figure. ↩ ↩² ↩³

3. Calculation from the formula in the example. $K$ is 123 × 9.6 ÷ 15 ≈ 78.7 yen, and per 1 yen the coupon rises by 15 ÷ 123 ≈ 0.122%. USD 0.81 is a rereading of the formula, not an explanation in the material. ↩ ↩² ↩³

4. The same material, the tables "③ＰＲＤ債（残存5年の例）" (3. PRD note (example with 5 years remaining)) on page 25 (main scenario), page 27 (interest rates rise 1 percentage point), and page 28 (interest rates rise 1 percentage point and the yen strengthens), and the exchange rate scenario on page 26. The total of the coupons is the cumulative cash flow in the tables minus the principal of 10 billion yen. ↩ ↩² ↩³ ↩⁴ ↩⁵ ↩⁶ ↩⁷

5. The same material: the formulas on pages 5, 25, and 27 are written with 113 yen, and the formula on page 28 with 123 yen. For year 1 on page 25, 15% × 96 ÷ 123 − 9.6% ≈ 2.11%, which matches the table. A calculation with 113 yen gives about 3.14%, which does not match. ↩

6. The same material, page 15, "（1）シナリオ分析の重要性" (1. The importance of scenario analysis). ↩

7. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (What are the features and risks of Nikkei Stock Average-linked notes?, in Japanese), page 3, "発行者の信用リスク" (Issuer's credit risk). The material explains Nikkei Stock Average-linked notes and says there is a risk that payments of principal or interest may be delayed or become impossible because of a change in the financial condition of the issuer of the bond. ↩

8. Center for Advanced Financial Technology, Financial System and Bank Examination Department, Bank of Japan, "仕組商品投資のリスク把握と管理" (Understanding and managing the risks of investing in structured products, in Japanese), page 30, "（１）購入前の検討（続き）" (1. Examination before purchase (continued)). ↩ ↩²

9. The same material, page 29, "（１）購入前の検討" (1. Examination before purchase). ↩