Sunday, November 23, 2008

The Debts of the Lenders: The End of the Carry Trade Part 6 (PRDCs and Japanese bond markets)

Power Reverse Dual Currency bonds are a type of structured bond that were created by Japanese market makers to take advantage of the arbitrage opportunities between low domestic interest rates and higher rates overseas.

They are structured in such a way that when a certain exchange rate level is breached, for example Y95 in dollar/yen, the coupon disappears but the note is still valid. Unfortunately for the Japanese market makers, these instruments amount to DE FACTO SHORT POSITIONS on the yen. The money managers are now faced w/the prospect of either buying yen on the spot market (hideously expensive) or buying yen calls. In either case the Japanese bond desks are being forced to contribute to the further unwinding of the carry trade. This in turn will result in only more bearishness for global equities markets.

Potentially, the Japanese government COULD step in to buy all those bad bonds. But the cost would be astronomical, time consuming (months to plan and weeks to implement), and extremely complicated to oversee. And that is just speaking from the domestic angle. Foreign traders would also have to be consulted or else the ripple effects of policy decisions in Tokyo would quickly make their way felt in global markets. Don't believe me? Just look at how well the US government's TARP program has been implemented.