Yen May Rise to 13-Year High on Derivatives, RBS, SocGen Say

By Stanley White

Nov. 12 (Bloomberg) -- The Japanese yen may return to a 13- year high as banks that sold derivatives linked to the currency are forced to hedge payments to investors.

Securities companies need to purchase the currency to hedge as much as $100 billion related to so-called power reverse dual currency notes, which may push it to 80 per dollar by year-end, according to Societe Generale SA, France's second-largest bank. Royal Bank of Scotland Group Plc, Britain's fifth-largest bank, says hedging may push the currency to 85 against the greenback.

The yen has already rallied 14 percent versus the dollar this year due to a reversal in so-called carry trades, purchases of higher-yielding assets funded with the lower-yielding yen. Further gains may crimp Japanese exporter earnings as a global financial crisis threatens to halt growth in the world's second- largest economy.

``Hedging on PRDCs is one reason for the yen to rise, and there are still some positions left,'' said Masafumi Yamamoto, head of foreign exchange strategy for Japan at Royal Bank of Scotland in Tokyo and a former Bank of Japan currency trader. ``Japanese authorities should be wary of the potential impact this will have.''

Japan's currency rose to 90.93 per dollar on Oct. 24, the strongest since August 1995, as a seizure in credit markets and losses on mortgage derivatives prompted investors to pare carry trades. It last traded at 97.74 versus the dollar as of 12:29 p.m. in Tokyo.

PRDC Issuance

Toyota Motor Corp., the world's second-largest automaker, and Canon Inc., the world's largest camera maker, slashed profit forecasts in the past month as demand slows and a stronger yen erodes the value of sales. Japanese gross domestic product rose an annualized 0.1 percent in the three months ended Sept. 30, after contracting 3 percent in the second quarter, economists predicted a Cabinet Office report will show Nov. 17.

PRDCs are over-the-counter securities that combine exchanges of interest-rate payments with options that grant the right to buy and sell currencies. Derivatives are contracts whose value is derived from stocks, bonds, currencies and commodities.

The notes, which typically have a duration of 25 years or more, became popular among Japanese institutional investors in the mid-1990s as they offered higher yields than Japanese government debt, according to Terry Belton, global head of fixed income and foreign exchange strategy in New York at JPMorgan Chase & Co.

In only the first six months of 2003, issuance of PRDCs reached more than $9 billion, with investors almost entirely Japanese, according to a Bank of England report on the structured note market.

The securities pay a fixed coupon the first year and then pay coupons that rise when Japan's currency depreciates and fall when the yen appreciates against the dollar.

Hedge Buying

The sellers have the right to cancel the PRDCs should coupons rise above a certain level. Banks don't have the option to terminate the notes should coupons fall. Now that the yen is rising, banks are left with 25 years or more of coupon payments that they have to hedge by buying the yen. This could cause yen gains to accelerate ``very quickly,'' according to David Deddouche, a Paris-based foreign-exchange strategist at Societe Generale.

Hedging demand may not subside for another one to two years, said Takeharu Miki, currency options manager at Bank of Tokyo- Mitsubishi UFJ Ltd., a unit of Japan's biggest publicly listed lender.

``These structured notes are limited to institutional investors,'' Miki said. ``There's not much risk for the buyers of PRDCs. There's more risk for the sellers, because of the hedging when the yen appreciates.''

To contact the reporter on this story: Stanley White in Tokyo at swhite28@bloomberg.net