10 Year JPY Callable Reverse Floater Note
Mar 15, 2006
Recently, a Japanese bank sold the following reverse floater to a large Japanese insurance company. The selling and the buying of the note was apparently inspired by the recent changes in the Bank of Japan's policy of quantitative easing. (We saw quite a few reverse callable floater swaps in 2003 and 2004 (mostly 5 year ones) on USD Libor from banks all over Asia, but this is the first structured note that we have seen in the last year and a half using callable reverse floaters on JPY Libor.)
Notional Amount |
JPY 10 billion | |
Start Date |
April 1, 2006 | |
Maturity |
March 31, 2016 | |
Coupon |
1.25%
Max { ( 1.25% - 6M JPY Libor ) , 0 }
Max { ( 1.50% - 6M JPY Libor ) , 0 }
Max { ( 1.75% - 6M JPY Libor ) , 0 }
Max { ( 2.50% - 6M JPY Libor ) , 0 } | Year 1
Year 2
Year 3
Year 4
Year 5-10 |
Call Option |
The bank has the right to call this note after paying accrued interest at the end of 1 Year and every annual payment date thereafter. |
The first year's coupon is high as compared to short term Japanese Yen rates (1y JPY Libor) but from year 2 onwards the coupon is tied to a floating rate equal to the six month Libor. The bank is betting that the rates in Japan will go up significantly over the long run and the investor who buys this note will have to have a view that the JPY short term rates will not go up significantly from its current level over the next ten years. This may or may not be a very tenable view.
The biggest drawback of the note, from the point of view of the investor, is that there is a Bermudan option embedded in the note. The bank can call the note back every year after year 1, i.e. the investor is selling a 10 year Bermudan call option to the bank. This is a long term option and therefore the call needs to priced in properly and that could well make the first year's coupon much higher than what it is. Investors should pay attention to this call option and whether it has been priced into the coupon. Selling a 10 year call option could prove to be very risky and therefore should command a high premium. We would recommend using a binomial framework with a CIR (Cox-Ross-Rubinstein) or Hull-White tree to price the 10 year bermudan call.
Actually, embedding a call option in a structured swap or a note is the oldest trick in the book and investors should be wary of this fact.
The buyer of the note, the investor, must do an IRR (internal rate of return) analysis on the note both with and without the call option attached and make a comparison with the risk free rate. Such an analysis is important for making a decision as to whether to buy this note or not. It is a long term note and only an IRR analysis will tell whether it is worth buying this note or not. For doing the IRR analysis a MC simulation is the best way to go whereby JPY forward Libor rates are simulated. Also, like any structured note, a volatility duration (vega) analysis should also be done at the outset to properly characterize the risk of the note. A simple duration analysis is not adequate to capture all the risks of such a note.
Disclaimer: Risk Latte Company and Team Latte does not vouch for the veracity of the details mentioned above and nor does it guarantee the accuracy of any fact, figures and analysis. The above is presented solely for educational purposes.
  
Any comments and queries can be sent through our web-based form.
|
a d v e r t i s e m e n t
