Market Precognition

The goal of this blog is to PRE-RECOGNIZE next several moves in the market
I focus on trading the S&P emini futures and T-notes futures.
A loyal reader will begin to understand the themes, memes, and sentiment that leads the market.

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Johnny Hom

Sunday, August 19, 2007

Esoterica

From TheStreet.com:

Esoteric products like "Power Reverse Dual Currency Bonds" -- popular with Japanese retail investors -- "leave the system vulnerable to sharp price swings," Dow says. "It's hard for the Fed to get its hands around these things -- they don't know where the bodies are buried. The underlying economy looks good, but financial accidents can take on dimensions you never thought of. This is no time to be a hero."


QUESTION: Can anyone explain what "Power Reverse Dual Currency Bonds" are?

posted by Johnny @ 8:07 AM  

1 Comments:

  • At 9:50 AM, Blogger Lloyd Sakazaki said…

    In the Japanese structured bond market, dual currency bonds with JPY coupons and USD principal were developed in the late 1980s to offer a yield pick-up to yen-based fixed-income investors, taking advantage of higher U.S. interest rates. When the yen strengthtened versus the dollar in the 1990s, the dual currency bonds fell underwater and Japanese investors turned to "reverse" dual currency bonds, usually with USD coupons and JPY principal, which offered some current yield enhancement while protecting principal at 100% in yen.

    To offer additional coupon yield, bankers soon developed the "power" reverse dual currency bond, which uses JPY-USD options in place of fixed coupons. Essentially, the present value of the would-be fixed coupon stream is exploited to buy USD calls/JPY puts instead, giving a nominally enhanced coupon rate in JPY of the form:

    Leverage factor
    x max[(FXi/FXo - 1), 0] x 100%,

    where FXo is the strike in JPY/USD and FXi is the JPY/USD exchange rate at coupon date i. The coupon rate typically appears very attractive since JPY/USD forward rates are much lower than spot rates, due to the large interest rate differential between JPY and USD.

    Offhand, I do not know why these forex structured bonds would have such a dramatic impact on markets, unless retail and/or institutional investors have truly overdosed on them. With the power reverse dual and related esoterica (e.g., three-currency "chooser" bond, which was very popular in the late 1990s), the worst case usually is that an investor just receives no coupons (i.e., options expire worthless). So long as principal is protected in JPY, there seems to be little cause for alarm, unless the bonds have very long (10 years or longer) maturities.

    --Lloyd

     

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