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A major U.S bank has recently issued Target Accrual Redemption Note (TARN) on reverse CMS (Constant Maturity Swap). This product pays a coupon indexed on a reverse, capped and floored CMS until the sum of coupon payments reach a target objective.
Analysis by PRICING PARTNERS
Product description:
This product pays a coupon whose performance is directly linked to the 10Y swap rate using the coupon on reverse CMS. More specifically, the coupon is given by the formula 12% – 2* CMS10Y floored at 2% and capped at 8%, or Min[8% ; Max(2% ; 12% – 2* CMS10Y)].
The coupons are paid until the sum of coupon payments reach 30%. As soon as the sum of coupon payments exceeds 30% on a payment date, the last coupon is adjusted so that the sum makes exactly 30%. The structure is automatically cancelled, and the nominal is repaid at par. In addition, if at maturity, the sum of coupon payments did not reach 30%, an additional coupon is paid, in order to reach 30%.
Product Features :
| Issuer | Banque d’investissement américaine |
| Currency | EUR |
| Product type | TARN |
| Underlyings assets | CMS10Y |
| Exposure period | 10 years (January 2010 – January 2020) |
| Key features | 1-Leveraged position on CMS10Y (Bet on CMS10Y to remain below a given level) 2-Automatic cancellation as soon as the sum of coupons reach 30% |
Cash Flow example:
In this simple example, we provide the value of the underlying swap. This underlying swap receives the coupon of TARN and pays the floating leg (in our case, the 6-month Euribor) until the sum of coupon payments reach 30%.
The cash flow table
In this scenario, the value of the swap is near zero, indicating that the note should be issued to 100.
Pricing & Risks :
Ignoring the plight RNA, this product would be a simple reverse CMS capped and floored. A proper pricing of coupon depends on good modeling CMS options (which can be successfully replicated by a combination of swaptions). The condition RNA adds a risk of smile, as the strike is implicit Fortent RNA-dependent stochastic coupons paid successively. The product price is by using a model markov fonctional “which allows a proper consideration of the smile.
It should be noted that the TARN condition makes the operation look more attractive because the operation is canceled when the sum of paid coupon reaches 30%.
The study of the Greek shows that the product is very sensitive to the moves of interest yield curve. The volatility risk, measured by the Vega is not negligible, since the movements of the volatility surface have impacts on both coupons of reverse CMS and the TARN condition.
Strategy returns table :
In this example, the probability of reverse CMS returns to be between 2.5% and 5% is 75%.
The probability to be between 5% et 7.5% is 15%, and the one to be below 2.5% is lower than 10%.
Performance analysis:
| Sharpe ratio | 37.62% |
| Delta | 2.00% |
| Vega | 0.59% |
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