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Private Investor Products
Introduction
Interest rate linked structured notes, whose payoffs Key Advantages of Structured Rate
depend on future interest rates, have been very popular Products
in recent years with Private Investors. The appeal of
structured products lies in their ability to deliver highly Highly Customised: Structured rate products are tailored
customised returns for investors, consistent with their to fit investors’ unique requirements. They create risk-
unique investment objectives. return profiles that would normally be inaccessible to the
private investor.
This manual highlights the range of structured rate products
and intends to provide private wealth managers and their Enhanced Yield: By expressing a view and accepting a
clients with a selection of different investment opportunities, certain risk, investors can achieve higher returns on their
which enables one to express specific views on any future investments than they would receive with traditional
interest rate development. All structures can be in either products.
note or swap form.
Convenience: The use of structured rate products allows
Included in the manual is a consideration of the investor’s particular risk-return payoffs that can be difficult or
view versus his risk appetite. While structured rate products expensive to create in the markets available to the investor.
are flexible instruments by nature and almost every product
can be structured to suit the investor’s risk appetite, some Potential Clients
products will appeal more to the conservative investor
while other products suit investors with a strong view or > Private Investors
a more aggressive attitude. > Asset Managers
> Private Banks
Most notes are sold in principal protected form, whereby > Corporates
only the coupon is at risk. It is also possible to generate > Insurance Companies and Pension Funds
more upside potential by structuring the product so that
(part of) the notional is at risk. Views on absolute interest For any additional information regarding structured rate
rate levels and relative differences between interest rates products, please contact your local sales representative.
can be expressed through interest rate linked structured
notes. Pieter-Reinier Maat
Head of Financial Market Products
Sven Haefner
Global Head of PIP Products
This Structured Rates Manual ("Manual") is designed to help distributors of financial products identify an investment approach and product range that
could generally suit their clients. The Manual is intended as a summary only and the information contained therein is not intended to be exhaustive.
The information provided is for general consideration only and the Manual in no way constitutes investment advice or a recommendation from ABN
AMRO Bank N.V.. Distributors should ensure that investors are fully aware of the risks involved in the purchase of investment products and should
comply with all prevailing law. This material is for information purposes only and is not intended as an offer or solicitation with respect to the purchase
or sale of any particular security. Past performance is not a guarantee of future performance. For further disclaimer information please see page 66
of this Manual.
2 3
Table of Contents
Glossary 63
Disclaimer 66
Contacts 67
4 5
Methodology Building Blocks
6 7
Yield Curve Movements Changes in the Slope of the Yield Curve Changes in the Curvature of the Yield Curve Vega
Investors’ primary concern lies with yield curve Another important indicator of the risk of a structure is
Curve Flattening Curve Steepening Increased Curvature Decreased Curvature
movements and changes in shape, because this is its Vega, which measures the structure’s sensitivity to
Yield
Yield
Yield
Yield
what determines their returns. Movements and changes volatility. Volatility is a key parameter in the pricing of
in shape can be split into three components: level, slope derivatives and changes in volatility changes the value
and curvature. of a structure.
Level: A change in the Level of the yield curve is Maturity Maturity Maturity Maturity Correlation
represented by a parallel shift, which shifts yields at Correlation is the degree to which one variable fluctuates
Bullish Flattening Bullish Steepening
every maturity up or down by the same amount. Delta Profile in line with another variable. The higher the correlation
Yield
Yield
An investor’s structured note position is clearly subject between two variables, the more in line they move.
This type of movement explains the vast majority of yield to interest rate risk, and the sensitivity to this risk is Correlation risk is the risk that due to a change of correlation
curve movements. measured by delta. However, the position can be subject between two indices, the investors structure changes in
to the interest rate risk across all maturities, not just the value.
Changes in the Level of the Yield Curve Maturity Maturity rates that their coupon is directly referenced to. Hence,
the position’s Delta Profile maps out the interest rate
Downward Shift Upward Shift Bearish Flattening Bearish Steepening
sensitivity across all maturities. From this, it is easy to
Yield
Yield
Yield
Yield
see the yield curve view that the position expresses.
0
Slope: A change in the Slope of the yield curve occurs Similarly, a steepening can be bullish (when driven by a
Delta
-1
when long term yields and short term yields become fall in short term yields) or bearish (when driven by a rise
closer together (a curve flattening), or when short term in long term yields). -2
yields and long term yields become further apart (a curve Positive delta at shorter maturities implies that the structure will benefit Maturity
from rising short term rates
steepening). A curve flattening can be either a bullish Curvature: It covers most other movements, which is Negative delta at longer maturities implies that the structure will benefit
flattening (when the flattening is driven by a fall in long simply how “curved” the yield curve is. Driven largely from falling long term rates
term yields), or a bearish flattening (when driven by a rise by the level of uncertainty over future rate movements, Curve Flattening
Yield
Hence, the overall interest rate
in short term yields). increased curvature is represented by a more “humped” view expressed by this position
yield curve. is of a yield curve flattering.
The structure will benefit most if
long term rates fall, and short term
rates rise (by a lesser amount)
Maturity
8 9
Yield Enhancement Yield Enhancement
Summary Summary
While most structures are designed to provide exposure unwind costs. The Swap unwind costs represent the Whilst most structures in this manual are designed to domestic currency, thus avoiding potential FX risk.
to interest rates only, ABN AMRO now offers investors mark-to-market value of the embedded (and in this provide exposure to interest rates only, ABN AMRO now Quantos are attractive, because they shield the purchaser
the possibility to enhance returns by incorporating an manual described) interest rate swap. offers investors the possibility to enhance returns by from FX fluctuations.
element of credit risk. Credit Linkage can be applied to incorporating an element of FX risk. Another possibility
any structure, which can be made switchable (rather than Payment upon default is the quanto mechanism, which can broaden the scope Foreign Exchange
callable). of indices available for the investor to express a view on. In terms of trading volume, the FX market is by far the
Investor CDS Counter Part With a quanto derivative an exposure can be on an index world’s largest and most liquid market, with daily trading
Rationale in currency A, with the payoff in currency B, or vice versa. volumes in excess of 1.5 trillion USD. Under normal
Regular Premium Income
Demand for additional yield is the main driver for the Hence, an investor can take advantage of the expected circumstances this volume makes it impossible for
growing popularity of credit linked interest rate hybrids levels of many indices in almost any given currency, individuals or companies to affect FX rates. Even central
and other exotic structures. Although credit spreads are without being exposed to the associated FX risk. banks and governments find it increasingly difficult to
historically low, so is the perceived risk (as expressed in the Credit Events affect the exchange rates of the most liquid currencies,
credit spread). Companies have de-leveraged significantly In the context of credit derivatives, three events are Rationale such as the US Dollar, Japanese Yen, Euro, Swiss Frank,
following the excesses of 1999 - 2001, default rates are described as defaults: bankruptcy, failure to pay and FX Linkage (Multi Index) Canadian Dollar or Pound Sterling. The currency exchange
low, and (implied) recovery rates high. restructuring. These events are known as Credit Events. Demand for additional yield is the main driver behind the market is a true 24-hour market, 5 days a week, with
growing popularity of FX linked interest rate hybrids and dealers in every major time zone. Trading begins Monday
Switchable Bankruptcy: where the Reference Entity becomes other exotic structures. By adding a second constraint, morning in Sydney (corresponding to 15:00 EST, or 20:00
A Credit Linked structure is usually not callable, but insolvent, placed under administration, or files for the yield can further be enhanced. GMT, Sunday) and then moves around the globe through
switchable. For example, a structured note paying a Chapter 11 protection. the various trading centres, finally closing on Friday at
fixed rate which is enhanced by Credit Linkage may Quanto 16:30 EST (21:30 GMT) in New York. In the long run, FX
be switchable into a “credit only” note with a fixed or Failure to Pay: where the Reference Entity defaults on A quanto or cross-currency derivative is an instrument levels are determined by real economic factors such as
floating coupon payment. interest or principal payments due on its debt. involving two currencies. The payoff is determined by interest rates, growth, inflation, trade and investment
a variable measured in one currency, with the payoff flows. However, these economic factors are themselves
Credit Derivatives Restructuring: where the Reference Entity restructures in another. Key parameters are the forward value of influenced by the level and volatility of FX. Small changes
Whilst the credit derivatives market has been in existence the terms of its debt to the disadvantage of the debt the underlying, the spot and forward exchange rates, in the FX rate can have significant effects on (for example)
since the early 1990’s, it is only since 1999 that the market holders. the volatility of the forward FX rate, the volatility of the imports and exports, affecting potential future growth.
has really taken off. Credit derivatives are a class of financial underlying forward value, and the correlation between
products designed to isolate the credit risk of an entity, Multiple Names the forward value of the underlying and the forward FX Examples
such as a corporation. Credit risk is a familiar concept - it Instead of single name exposure, the investor can opt for rate. Essentially, a quanto contains an embedded currency > A note is denominated in Currency A (say Euros), pays a
is the risk that one party owing money to another party, linkage to a (linear) basket of Reference Entities, reducing forward with a variable notional amount (“quanto” stands coupon in Currency A and redeems in Currency A, but
may not pay. The basic building block is the Credit Default the exposure on one single name, or increase the leverage for quantity adjusting option). The quanto mechanism the payoff depends on an index denominated in Currency
Swap (CDS), giving an investor regular income in exchange by using a First-To-Default (FTD) basket. Leverage can suits investors with the view on an index denominated B (for example 6 months USD LIBOR). This is called a
for the credit risk of a third party. The investor “insures” also be increased or decreased using a synthetic (CDO) in a certain currency (or investors who want to use the Quantoed note.
the counterparty against default. In case of default (called structure. value in a particular index) but who want to receive the > Instead of exposure on a single index (for example 6
a Credit Event), the investor has to pay an amount equal payoff in another currency. For structures involving the months EURIBOR), the payoff depends on a second
to the losses incurred on holding debt of the defaulted Risk sale of options, the quanto mechanism allows investors index as well (for example the EUR/USD exchange rate).
company. After this, the CDS ceases to exist. In note By embedding exposure on a Reference Entity, the (who “sell” volatility) to benefit from high implied volatility This is called a Multi Index Note.
form (called a Credit Linked Note; CLN), on an occurrence structure is not principal guaranteed. In the event of (at inception) of indices in foreign currencies, without
of a Credit Event with respect to the Reference Entity, default the investors’ note will be redeemed at zero assuming FX risk or needing to enter into a Cross Currency Risks
the note will be redeemed at zero and the investor will and receive the recovery value (if any) adjusted for swap Swap. In other words, investors can benefit from steep A bet on multiple indices will increase the probability of a
receive the Recovery Amount, which is the value of the unwind costs. The investor has mark-to-market exposure curves in other markets, while receiving flows in their below-market or zero payout.
defaulted Reference Entity’s bond adjusted for Swap to credit spread movements.
10 11
Risks Product Map
12 13
Attitude to Risk: Conservative
Delta
-0.02
interest rate movements). The investor is therefore hedged
against the consequences of rate moves. -0.04
14 15
Attitude to Risk: Conservative Attitude to Risk: Conservative
Yield
Yield
Delta
of the yield
market effect of the parallel upward (downward) shift curve will be
-4 positive for
is small as the funding costs (i.e. the short term rate) the structure.
A parallel
increases (decreases) as well. A CMS Linked Note is shift will have
limited impact.
especially attractive in a flat yield curve environment. -8
6M 9M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 20Y Maturity Maturity
Yield
Yield
A Constant Maturity Swap is a floating-for-floating interest The delta profile of the CMS Linked Note is shown the of the yield
curve will be
rate swap, exchanging a LIBOR Rate for a particular swap graph. The 10Y delta is negative as the note is a 10Y negative for
the structure.
rate. By referencing to longer term constant maturity structure and the 10Y delta represents the notional as in A parallel
shift will have
swap rates (typically between 2 and 30 years), the CMS any floating rate instrument. It is the longer dated yields limited impact.
Linked Note enables investors to gain a floating exposure which reflect the implied 10Y constant maturity rate. Maturity Maturity
to a longer term rate. The investor profits from an increase Hence, the structure benefits from rising rates for current
in volatility due to the convexity adjustment (the investor is maturities of eleven years or more. Conversely, the
said to be “long Vega”). Convexity measures the curvature structure benefits from falling rates for current maturities Risks
in the relationship between bond prices and their yields. of ten years or less. A Flattening of the curve will have a negative impact on
Bonds with high convexity perform better if rates change; the mark-to-market of the structure.
if rates fall their price rises by more, if rates rise their
price falls by less. The benefits of convexity cause more When transacted in note form, the note may trade below
convex bonds to have higher prices and consequently par during the life of the transaction.
lower yields.
Also Consider
Variations > Steepener Note
> The CMS coupon can be capped, increasing the > CMS Spread Range Accrual with CMS coupon
participation level in the CMS but limiting the upside
> The CMS coupon can be floored, guaranteeing a
minimum payment, but decreasing the participation
> A corridor can be constructed to minimise and maximise
the CMS coupon
> It is possible to construct an inverse floater variant, whereby
the investor profits from a decline in a specified CMS rate
16 17
Attitude to Risk: All Attitude to Risk: All
Summary Description of Product Example: CMS Spread Range Accrual Sensitivity to Rate Moves
A CMS Spread Note suits an investor with a view on In a Steepener or Flattener structure the investor is in A parallel shift Downward Shift Curve Steepening
downwards will
Yield
Yield
the curvature and slope of the yield curve. The payoff effect buying a series of caps to ensure the coupon he Currency EUR normally be
positive for the
depends on the difference between two indices and receives is floored at zero. In the Steepener the investor Maturity 20 years structure as the
coupon is fixed.
can suit a steepening, flattening and stable curve view. buys the cap on the short term rate. In a Flattener the Coupon (5.10% x N/M) annual, 30/360 The effect of
investor buys the cap on the long term rate. In a CMS N Number of days (10Y CMS - 2Y CMS) > 0 a slope move
depends on the
Market View Spread Range Accrual the client sells a series of daily M Total Number of Days relative level of
the curve. Maturity Maturity
CMS Spread Notes suit investors with the view that a Digital CMS Spread Floors. ABN AMRO would receive a ABN Receives 6M EURIBOR or Notional
A parallel shift Upward Shift Curve Flattening
chosen spread will remain relatively unchanged, become day’s worth of coupon for every day the curve is inverse, upwards will
Yield
Yield
normally be
bigger or become smaller than that implied by the forwards and the client receives coupons for days when the curve Delta Profile of a CMS Spread Range Accrual negative for the
structure as the
for the index. CMS Spread Notes can therefore be used in is not inverted. Since two indices are involved, correlation coupon is fixed.
20
different interest rate environments. If an investor expects is important. In general, when buying a CMS Spread Range The effect of
a slope move
a steepening of the curve, a note paying a multiple of the Accrual (assuming the investor sells out-of-the-money depends on the
relative level of
difference between 2 indices may be appropriate (for options), investors prefer low correlation at inception, 0 the curve. Maturity Maturity
example: 8 x (10Y – 2Y)). If the curve becomes steeper, because they will get a higher yield pick-up (since lower
Delta
the investor profits significantly. The investor only achieves correlation makes it more likely for the structure to breach
-20
an above market return if the curve steepens more than the range). After trading, the investor prefers high correlation Risks
implied by the forwards. The flatter the curve, the more (if the option he sold is still out-of-the-money) because An adverse movement of the curve can result in a below
leverage is possible. If the investor’s view is of a flattening the likelihood of the spread between the two indices -40 market or zero coupon structure (worst case scenario:
curve, a Flattener (similar to an Inverse Floater) will be breaching the range would be lower, giving a positive 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 20Y 25Y 30Y annual coupons of 0.00% with a value of the structure
attractive. Here the investor receives a high fixed coupon effect on the mark-to-market of the structure (the investor close to a Zero Coupon Note).
minus the (leveraged) difference between 2 indices, and is said to be “long” correlation). Once the option sold In the graph the delta profile of the CMS Spread Range
receives a higher coupon if the curve flattens. Another becomes in-the-money the investor prefers correlation Accrual is shown. As the structure has a fixed (range When transacted in note form, the note may trade below
alternative is a CMS Spread Range Accrual, which accrues to decrease, making it more likely that the curvature will accrual) coupon, the negative delta in year 20 is expected par during the life of the transaction.
a high coupon for every day the difference between two move back in his favour. Higher volatility of the spread at (i.e. the investor prefers rates to go down), although part
indices stays above a certain strike. This is currently a inception will increase the coupon. of the delta is the notional effect as it is a 20 year note. Also Consider
popular trade in the market, with many investors betting The interesting part is the positive delta in 25 year and > Target Redemption Notes (if expecting a flatter curve)
against an inversion of the EUR yield curve. Current Variations 30 year. As the investor is basically long the 10Y CMS > CMS Note (if expecting a steeper curve)
forward rates imply that 2Y rates will exceed 10Y rates > The structure can leverage on a steepening of the curve and short the 2Y CMS, the positive delta in year 30 is
in 2018, and if the investor’s view is digital by nature (i.e. (Steepener Note) by paying a coupon of X times (10Y – 2Y) explained as the 10Y CMS rate in year 20, which the
the investor thinks the curve will not invert) the CMS > The structure can leverage on a flattening of the curve investor obviously prefers to go up as it increases the
Spread Range Accrual is an attractive option. (Flattener Note) by paying a coupon of X – (Y times (10Y – 2Y)) probability of a positive curve. The sensitivity to curve
> The CMS Spread Range Accrual Note (see example) flattening and steepening is more complex.
accrues a day’s worth of coupon for every day the CMS
spread fixes within a predefined range Although the structure obviously likes the curve to stay
> A Digital CMS Spread Note pays a certain coupon if the positive sloping (and a steepening of the curve increases
CMS Spread meets a predefined condition; otherwise the probability of receiving the coupon), a steepening of
the investor (typically) receives a 0% coupon the curve also increases the probability that the fixed
> CMS Spread Notes can be done in inverse floater format (range accrual) coupon will be below the market rate and
hence have a negative impact on the mark-to-market of
the structure.
18 19
Attitude to Risk: Conservative Attitude to Risk: Conservative
Ratchet Note
Summary Example: Ratchet Cap A hypothetical interest rate scenario Sensitivity to Rate Moves
A Ratchet Note suits an investor with the view that rates Downward Shift Curve Flattening
A parallel shift
Yield
Yield
will go up but by less than implied by the forwards. A Currency USD Coupon 6M USD LIBOR + 40bps downwards or
a flattening of
Ratchet Note pays a floating rate coupon that is only Maturity 5 years Ratchet cap 25bps per quarter the yield curve
allowed to increase by a certain amount per period. Coupon 3M USD LIBOR + 40bps, qu 30/360 6M USD LIBOR fixing Coupon will normally be
positive for the
Ratchet cap 25bps per quarter 1st fixing 4.00% 4.40% structure.
Market View ABN receives 3M USD LIBOR or Notional 2nd fixing 4.25% 4.65% Maturity Maturity
The Ratchet Note suits an environment with steep yield 3rd fixing 4.60% 4.90%
curves and high volatility (at inception) which allows a Delta Profile of a Ratchet Cap 4th fixing 4.80% 5.15% Upward Shift Curve Steepening
A parallel shift
Yield
Yield
upwards or
substantial yield pick up to be achieved. The structure 5th fixing 5.00% 5.40% a steepening of
1
suits an investor with the view that rates will rise, but 6th fixing 5.50% 5.65% the yield curve
will normally be
that large and quick increases in rates (as perhaps implied 0
7th fixing 5.90% 5.90% negative for the
structure.
by the forwards) will not materialise. The main risk for the 8th fixing 6.30% 6.15%
investor is therefore a scenario in which rates spike up Maturity Maturity
Delta
-1
very quickly, in which case the coupon will lag a normal In the above example it is obvious that a modest increase
Floating Rate Note and need several periods of stable -2 in rates will result in an above market coupon. In a scenario Risks
rates in order to catch up again. of rapidly increasing rates the note will under perform a A spike in interest rates could result in a below-market
-3 normal Floating Rate Note. coupon.
Description of Product 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y
A Ratchet Note is an instrument in which each successive Hypothetical Interest Rate Scenario and Ratchet Coupon When transacted in note form, the note may trade below
coupon is capped in some way by the previous coupon In the graph the delta profile of the Ratchet Note is par during the life of the transaction.
6.5%
payment. The Ratchet Note is basically a note in which shown. As expected, the investor prefers the short term
the investor sells a string of caplets for which only the rate to go up slightly. The exposure to 5 year rates is Also Consider
first caplet strike is set. For the successive caplets the mainly the fact that it is a 5 year structure and partly the 5.5% > Capped CMS
Interest Rate
strike is reset on predetermined roll dates. The level at fact that as the investor has sold caps, an increase in the > Capped Floater
which the strike is set is dependent on earlier strikes 5 year rate (which is the present value of the 3 month
4.5%
and fixings. The main feature is the fact that the jumps forwards) indicates an increase in short term rates, which
in the strike level are restricted to a certain maximum (i.e. is capped. The options sold therefore become more in-
the strike is not allowed to jump by more than 25bps). the-money, reducing the value of the swap. As a result, 3.5%
20 21
Attitude to Risk: All
Summary
A Range Accrual suits an investor with the view that an to receive the fixed rate), and on pre-agreed dates. By
index will stay within (or outside) a given range. For each making the structure callable, the investor is exposed to
day the investor is correct he accrues one day’s worth of swaption volatility. The investor prefers high volatility at
coupon, otherwise a below-market coupon accrues inception as this will enhance his coupon. For each period
(usually 0%). the coupon is determined by counting the number of
days the reference index stays within the range versus
Market View the number of days in that period. Assume for reasons of
Range Accruals work in different rate scenarios: if future simplicity the note has a maturity of 1-year (consisting of
rates are expected to be higher than implied by the forwards, 360 days):
a lower boundary only range accrual is a suitable and yield
enhancing structure. If future rates are expected to be > If 187 days are within the range, the coupon is: 187/360 x
lower, an Upper Boundary Range Accrual works. Corridor coupon of (for example) 7.25% = 3.76%
Range Accruals suit a stable rate environment, a rate > If all days are within the range, the full coupon will be
move as implied by the forwards or a specific path as paid: 360/360 x 7.25% = 7.25%
expected by the investor.
Variations
Description of Product > The index can be LIBOR, CMS, FX, or the spread
A simple Range Accrual is basically a strip of digital options, between 2 indices (CMS Spread Range Accrual). The
one for each day of the accrual period. The investor sells structure can also be dependent on two indices (Double
these options in return for an above-market coupon. Since Range Accrual)
the client sells the options, volatility is an important element. > The coupon can be fixed, floating (Floating Range
Most of these options will have out-of-the-money strikes Accrual) or step-up (Step-Up Coupon Range Accrual). A
and the higher the volatility at inception, the more value Step Up Coupon Range Accrual works well in a steep
the options will have, and the higher the coupon will be. If forward curve environment
after the trade the implied volatility increases (decreases) > It is possible to have a lower boundary only, an upper
the mark-to-market of the swap will decrease (increase). boundary only, a corridor (Corridor Range Accrual), step-
Many Range Accruals are made Bermudan Callable to up or step-down barriers
enhance the coupon. If the structure is Bermudan Callable, > The frequency with which the index is observed can be
the investor has sold ABN AMRO the option to call the daily, weekly, monthly, etc. Daily is the most common
structure (redeem early) at a pre-determined level (usually > Range accruals can be made (Bermudan) callable (and
100%) on pre-determined dates through the life of the most are in order to achieve yield enhancement): Callable
note. The option sold to ABN AMRO is a Receiver (Range) Range Accruals
Bermudan Swaption. The buyer of the Receiver Bermudan > The structure can have a minimum coupon (Minimum
Swaption has the right to exchange a stream of floating Coupon Range Accrual)
interest rate payments for a stream of fixed interest rate > The structure can have a different reference index every
payments (in this case a range accrual payment), beginning year (i.e. the 10Y in 1Y, the 9Y in 2Y etc): Variable CMS
at a future date for a pre-agreed amount, based upon pre- Range Accrual
agreed conventions (i.e. a receiver swaption is the right
22 23
Attitude to Risk: All Attitude to Risk: All
Example 1: Callable Corridor RA 3M USD LIBOR Forwards against Specified Boundaries Example 2: Floating CMS spread RA Sensitivity to Rate Moves
6.5 Downward Shift Curve Steepening
Currency USD A steepening
Yield
Yield
Currency USD of the yield
Maturity 5 years 5.5 Maturity 15 years curve will be
positive for
Coupon 7.25% x N/M, qu 30/360 (5Y = 4.70%) Coupon 10Y CMS + 35bps IF (10Y - 2Y CMS) > 0 the structure.
Interest Rate
A parallel
ABN receives 3M USD LIBOR – 11bps or Notional 4.5
ABN receives 3M USD LIBOR or Notional shift will have
limited impact.
Ref index 3M USD LIBOR
3.5 Maturity Maturity
Range Y1 - Y2: 3.00% - 5.50% Delta Profile of Floating CMS Spread RA
Y3 - Y5: 3.00% - 6.00%
2.5 20 Upward Shift Curve Flattening
Callable Quarterly A flattening
Yield
Yield
Oct 05 Oct 06 Oct 07 Oct 08 Oct 09 Oct 10 of the yield
curve will be
Upper 3M Forwards Lower 10 negative for
Delta Profile of 5Y Callable Corridor RA the structure.
A parallel
shift will have
Delta
1 0
In this graph the 3 month USD LIBOR forward interest limited impact.
-20
1Y 3Y 5Y 7Y 9Y 11Y 13Y 15Y 17Y 19Y 25Y
-1 An unanticipated move of the chosen reference index can
Sensitivity to Rate Moves result in a low coupon or zero coupon structure (worst
In the graph above the delta profile of the example case scenario: all fixings outside the range, resulting in a
-2
Downward Shift Curve Flattening
A parallel shift Floating CMS Spread RA is shown. As expected, the 0.00% coupon and a value of the structure close to the
Yield
Yield
2W 1M 2M 3M 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y downwards or
a flattening of investor profits from a curve steepening and increase in value of a Zero Coupon Note).
the yield curve
will normally be the longer dated rates. The exposure to 15 year rates is
positive for the
In the graph above the delta profile of the example 5 year structure. partly the representation of paying the short term floating The structure is sensitive to absolute changes in rates
Corridor Callable Range Accrual is shown. The delta profile rate in the swap, which the investor prefers to decrease. and implied volatility.
depicts the interest rate sensitivity of the structure. It is Maturity Maturity
Part of this is the notional effect: it is a 15-year trade.
clear that the investor wants longer dated rates to go down: Upward Shift Curve Steepening When the structure is callable, the investor is exposed to
A parallel shift
Yield
Yield
since the longer dated rates are basically the present value upwards or Floating CMS Spread RA Payoff Profile reinvestment risk.
a steepening of
of a string of forwards, it is far more important for the the yield curve
will normally be 5 1.0
value of the structure that the longer dated rates moves negative for the When transacted in note form, the note may trade below
in the investors favour than the 3 month spot rate, which structure.
4 par during the life of the transaction.
will “only” affect a single coupon payment. The delta profile 0.5
10yr-2yr Spread
Maturity Maturity
Interest Rate
3
shows that the client profits from a curve flattening. Also Consider
2 > SnowRange Note
0.0
> Multi Index Note
1
> Bermudan Callable Note
0 -0.5
2005 2009 2013 2017 2021 2025
24 25
Attitude to Risk: Aggressive Attitude to Risk: Aggressive
Yield
Yield
view on an index. If correct, the investor receives a followed by the index is irrelevant. Also, the degree that Currency EUR upwards or
a steepening of
significant above-market coupon. The payout of a One the option is in or out-of-the-money doesn’t matter. There Maturity 1 year the yield curve
will normally be
Look Note is digital: if the view proves to be correct a is no difference of being “just right” or “really right”. The Coupon 5.00% if 10Y EUR CMS fixes at or above positive for the
fixed cash amount will be paid; if the single fixing is structure can be designed to be sensitive to the path 3.60% at maturity (10Y Euro spot = 3.23%) structure.
outside the range no payment will take place. taken. With knock-in and knock-out options a coupon 0.00% if 10Y EUR CMS fixes below 3.60% Maturity Maturity
payoff can be structured which will have a zero payout if ABN receives 3M EURIBOR - 6bps or Notional
Market View a certain barrier is breached or pays out at the moment a A parallel shift
Downward Shift Curve Flattening
Yield
Yield
downwards or
A One Look Note suits any interest rate environment. If an certain barrier is hit. Most of the time investors sell near- Delta Profile of 1Y Digital Note on 10Y CMS a flattening of
the yield curve
investor expects rates to be stable, the coupon payment the-money digital options. At time of trading, the investor will normally be
4
can be contingent upon a fixing within a predefined corridor. prefers the volatility to be high so he receives more negative for the
structure.
If the investor expects interest rates to go up, they can upfront premium. After inception the volatility preference
receive an above-market coupon dependant upon a fixing all depends on the movement of the index relative to the 2 Maturity Maturity
above a certain strike. If rates are expected to decline, a position of the investor. If the reference index is at the
Delta
fixing below a certain strike level would result in the fixed right side of the fixing for the investor, the investor prefers
0
Risks
payoff. One Look Notes are well suited for short term views. volatility to be low. If on the other hand the index is on An adverse movement of the reference index can result
the “wrong” side, the investor prefers volatility to move in a zero pay out (worst case scenario: a 0.00% coupon
Description of Product up so the possibility that the fixing will be positive for -2 and if multiple fixings, a value of the structure close to
In a One Look Note the investor sells a European digital him increases somewhat. Notice that as the investor has 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y the value of a Zero Coupon Note).
option (where the payout is either a fixed cash amount sold the option, an out-of-the-money option is profitable
or nothing at a predefined date) to the issuer. Whilst a for him. The graph above shows the exposure of the note to the As the fixing is digital, even if the investor is correct for
normal swap fixes at the beginning of (or typically a few 11 year interest rate and the 1 year rate. As the note is a 99% of the time, the single fixing can still be outside the
days before) the observation period, here the fixing is in Variations one year structure, the negative delta in year one can be range.
arrears (postponed until the end of, or a few days before > Instead of a One Look, a Multi Look Note can be explained as the notional effect. The main exposure is to
the end of the observation period). In either case, structured (i.e. every fixing is a digital payout regardless the 10 year rate at the end of year one (the 11 year rate), The note may trade below par during the life of the
payments take place at the end (see graph below). of the path and previous fixings) which the investor likes to go up. Overall the investor transaction.
> A normal One Look Note is 3-months up to 1-year, but prefers the curve to steepen.
Fixing-in-arrears with multiple fixings a longer maturity is possible Also Consider
> Instead of a short term interest rate index, swap rates, Bond Discount Note
In-arrears Fixing
FX, commodities or double indices (i.e. exposure on two
indices) are possible
26 27
Attitude to Risk: Aggressive
Summary Variations
A Snowball Note suits an investor with the view that > The index can be LIBOR, CMS, FX or the spread
interest rates will remain within a pre-defined band or between 2 indices
(with the most popular structures) decrease (or increase > Instead of speculating on a decrease in rates via the
less than implied by the forward) over time. The Snowball Inverse Floater variant, it is possible to construct the
should be seen as a feature which can be embedded in Snowball in such a way that the payout benefits from an
many structures, allowing the coupon to accumulate by increase in rates (called a Reverse Snowball or Snowbear)
referring back to the previous coupon. In other words, > A Lifetime Cap can be added to construct a Target
future coupons rely on past coupons. Redemption Note variant (Snow TARN)
> A very popular structure is the Callable SnowRange. This
Market View product is a combination of a Range Accrual, a Snowball
The most popular Snowball is the inverse floating variant, and a Bermudan Swaption (see example 2)
designed for investors who believe that the yield curve is > To reduce the path dependency risk, it is possible to
relatively steep and that forward rates overestimate the structure a Resetting Snowball. In this structure the
increase in spot rates in the future or expect rates to stay coupon resets automatically at predetermined dates
stable or decrease. They generate a significant yield pick- > It is possible to leverage the previous coupon so the
up by betting against the forward curve with leverage. As coupon formula is [(Gearing x Previous Coupon) –
the Snowball feature refers back to the previous coupon, the 3M USD LIBOR in-arrears]. This structure is known
coupon is path dependent by nature, adding value (leverage) as a Thunderball
for an investor with a specific view. The structure works
best in a steep yield curve environment. Example 1: Snowball
28 29
Attitude to Risk: Aggressive Attitude to Risk: Aggressive
Delta Profile of a Snowball Note As expected, a flattening curve will generate a positive SnowRange Payoff Profile Also Consider
mark-to-market for the investor. This effect is enhanced > Target Redemption Note
1.5 12
as a result of the effects of gearing and the path > Callable Range Accrual
dependent nature of the coupons.
0.0 9
Interest Rate
Callable SnowRange
Delta
-1.5 6
Currency USD
Maturity 5 years
-3.0 Coupon 6M: 7.00% x N/M 3
1M 3M 6M 9M 12M 15M 18M 21M 2Y 3Y 4Y 5Y 6Y 7Y 8Y Oct 05 Oct 06 Oct 07 Oct 08 Oct 09 Oct 10
Thereafter: (Prev coupon + 0.50%) x N/M
N number of days 6M USD LIBOR is within Coupon Upper 6M Forward Lower
The coupon payment is therefore highly path dependent; Suppose in year 2 only 180 days are within the range:
2
once a coupon is reduced due to a period of fixings outside the new (now maximum) coupon for the note is 7.00%
the range, future payouts will always be equal at best or x 180/360 = 3.50%. If in year 3 all days are back in the
lower than the previous coupon, even if the investor is range again, the new coupon would be 3.50% x 360/360
0 continuously correct in the subsequent periods. The = 3.50%.
Oct 05 Oct 06 Oct 07 Oct 08 Oct 09 Oct 10 Oct 11 Oct 12
advantage of a SnowRange over a normal Callable Range
Coupon 6M Forward Accrual is the additional pick up in yield if the view proves Risks
to be correct. The structure is sensitive to absolute changes in rates
Sensitivity to Rate Moves and implied volatility.
Yield
downwards or
a flattening of result in a below-market coupon or even zero coupon
the yield curve
will normally be despite the view of the investor being correct for most of
positive for the
structure.
the time (i.e. the timing of being right is very important:
the most risk is early in the life of the note). The worst
Maturity Maturity
case scenario is 0.00% coupons during the life of the
Upward Shift Curve Steepening note and a value of the structure close to the value of
A parallel shift
Yield
Yield
30 31
Attitude to Risk: Conservative Attitude to Risk: Conservative
Yield
Yield
downwards or
forwards suggest or expects rates to be stable. Investors > The coupon structure can step up (for example in an a flattening of
the yield curve
achieve a pick-up over the equivalent reference rate by environment where the curve is very steep: as the step will normally be
positive for the
selling ABN AMRO the option to call the structure (redeem up is in line with the forward rates it increases the option structure.
early) at a pre-determined level (usually 100%) on pre- value). This is a Step-Up Callable Note
determined dates through the life of the note. Maturity Maturity
Yield
Yield
upwards or
a steepening of
A Bermudan Callable Structure is most attractive if the Currency EUR the yield curve
will normally be
investor believes that the market will be relatively stable Maturity 10 years negative for the
or that rates will rise less than implied by the forwards. If Coupon 3.55%, s.a 30/360 (10Y ref rate 3.23%) structure.
the investor expects rates to go down, he will buy a fixed ABN receives 6M EURIBOR – 11bps or Notional Maturity Maturity
rate security. If he expects rates to go up, he will prefer a Callable NC12M, thereafter semi-annual
floating rate instrument. The embedded Bermudan option
allows the investor to achieve a coupon pick-up in return Delta Profile of a 10Y Callable Note If interest rates move up, the probability that the note
for the risk of early redemption. The investor sacrifices a will be called decreases (assuming constant volatility).
0
known duration of a normal bond for a higher yield and If interest rates move down, the likelihood of the note
uncertain duration of a Bermudan Callable Note. being called increases. As the investor has sold an
-1 option, an increase in implied volatility will decrease
Description of Product the mark-to-market value of the structure; a decrease in
Delta
32 33
Attitude to Risk: Medium Conservative Attitude to Risk: Medium Conservative
Summary Description of Product Example: Callable Zero Coupon Note Sensitivity to Rate Moves
A Callable Zero Coupon Note suits an investor who In a Callable Zero Coupon Note, the investor sells a call Downward Shift Curve Flattening
A parallel shift
Yield
Yield
expects rates to be stable, or has the view that the long option to the issuer, meaning that the investor has sold Currency EUR downwards or
a flattening of
term rate will not rise as quickly as implied by the forwards. the right (but not the obligation) to redeem the note at a Maturity 10 years the yield curve
will normally be
A yield pick-up over the equivalent reference rate is achieved predetermined level and call date. For this the investor is IRR 3.75% (10Y rate 3.26%) positive for the
by selling ABN AMRO the option to call the structure compensated by an option premium, which will be paid Call NC1Y, annual afterwards structure.
(redeem early) at a pre-determined level on pre-determined in the form of an enhanced fixed internal rate of return ABN receives 6M EURIBOR -11bps or Notional Maturity Maturity
dates throughout the life of the note. As the name suggests (IRR). The option sold is actually a Receiver Bermudan
Upward Shift Curve Steepening
coupons are not paid during the life of the note, but are Swaption. The IRR will be higher when the Swaption Delta profile of a 10Y Callable Zero Coupon Note A parallel shift
Yield
Yield
upwards or
automatically reinvested at a fixed annual rate of return, volatility at inception is higher. The embedded option a steepening of
0 the yield curve
and paid at maturity. A popular variant is the Zero Accreting in the note shortens its duration and leads to negative will normally be
Swap, in which an annual coupon is paid, but over an convexity: when yields fall, the duration falls too as it negative for the
structure.
-1
accreting notional. It replicates the normal zero coupon becomes more likely that the call will be exercised. The
structure, but lowers the credit risk for the investor on IRR of a Callable Zero Coupon Note therefore depends Maturity Maturity
Delta
-2
the counterparty. on the shape of the curve and volatility.
-3 If rates increase, the relative mark-to-market of a Zero
Market View Variations will suffer as the fixed IRR will be lower than the prevailing
A Callable Zero structure is most attractive for an investor > Zero Coupon Notes can be callable or non-callable (with -4 market rate. If rates are stable or increase less than implied
who does not need a regular cash flow, and believes that no reinvestment risk). The yield of a Callable Zero Coupon 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y by the forwards the Zero will outperform the benchmark.
the market will be relatively stable or that the forwards will look more attractive relative to a non Callable Zero If rates decrease, the likelihood of the note being called
imply that rates will not rise by too much. If the investor Coupon if the curve is relative flat after the first call date In the graph above the delta profile is shown. As increases and the investor will have had an above market
believes rates will decrease a Normal (Non Callable) Zero > Zero Accreting Swaps where the notional over which an expected, the main sensitivity is to 10 year interest IRR but has to reinvest in a lower yield environment.
Coupon is a well suited product as it has a duration equal annual coupon is paid increases rates. A decrease in the 10 year rate will increase the
to its maturity (i.e. high interest rate sensitivity) and the > To enhance the yield, the non-callable Zero Coupon can mark-to-market value of the structure. Risks
investor is not exposed to reinvestment risk. The advantage be linked to a preferred credit (for example GE, Philips or Zero Coupon Notes have a duration equal to its maturity
is that a Zero Coupon Note will generally have a higher BMW). In this case the investor sells default protection and therefore have mark-to-market high interest rate
yield than a coupon bearing note in an upward sloping on the selected entity for which he receives a premium. sensitivity.
yield curve environment. Another reason for buying a If the underlying entity defaults, the investor loses its
Zero Coupon Note could be the desire to defer tax on principal and will receive the unknown recovery value. When the Zero Coupon Note is made callable, the
interest until a later date. In a Callable Zero Coupon the This is a Credit Linked Zero Coupon Note investor is still exposed to reinvestment risk.
investor sacrifices a known duration of a straight zero
coupon bond for a higher yield and uncertain duration. Also Consider
Bermudan Callable Note
34 35
Attitude to Risk: Medium Aggressive Attitude to Risk: Medium Aggressive
Yield
Yield
a certain index will stay low while the forward for that Currency EUR downwards or
a flattening of
index is upward sloping. The coupon structure of an Maturity 10 years the yield curve
Inverse Floater is a fixed rate minus a particular index, Coupon 11.35% - (2 x 6M EURIBOR). will normally be
positive for the
which therefore floats inversely with the chosen index. (At time of pricing 10Y Euro = 3.49%) structure.
Yield
Yield
upwards or
certain index will decrease or stay low while the forward Delta Profile of a Callable Inverse Floater a steepening of
for that index is upward sloping. To support the view that the yield curve
will normally be
0
the market is overestimating the future fixings, leverage negative for the
structure.
is possible by subtracting a multiple of the index from a -1
higher fixed rate. Higher leverage provides greater potential Maturity Maturity
-2
worst case scenario: a 0.00% coupon. By choosing the extent Risks
of leverage the investor can express his risk appetite. -3 An unanticipated upward move of the chosen reference
index can result in a low coupon or zero coupon structure
Description of Product -4 (worst case scenario: 0.00% coupons and a value of the
6M 9M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y
An Inverse Floater is the opposite of a normal Floating structure close to the value of a Zero Coupon Note).
Rate Note: rather than receiving the index, (a multiple of)
the index is subtracted from a fixed amount. The lower In the graph above the delta profile of the Callable The structure is sensitive to absolute changes in rates
the index resets, the higher the coupon. The most Inverse Floater is shown. As expected, the investor and implied volatility.
commonly used indices are short-term interest rates like prefers rates to decrease over all maturities.
6-month EURIBOR or 3-month USD LIBOR. Investors If the structure is callable the investor is exposed to
generally floor the coupons at zero by buying a series of Payoff Profile of a Callable Inverse Floater reinvestment risk.
caps with a strike equal to the fixed amount divided by
6
the leverage. If the structure is Bermudan Callable, the When transacted in note form, the note may trade below
investor has sold a Bermudan Swaption to the issuer 5
par during the life of the transaction.
meaning that he sold the right (but not the obligation) to
Interest Rate
redeem the notes at 100% on any given call date. As the 4 Also Consider
investor sells the option, he prefers swaption volatility to > Target Redemption Note (since most Target Redemption
be high at inception (the investor is selling volatility). 3 Notes are Inverse Floaters)
> Snowball
Variations 2
Oct 05 Oct 07 Oct 09 Oct 11 Oct 13 Oct 15
> The index can be LIBOR, CMS, FX or the spread
between 2 indices Coupon 6M Forward
> The leverage can be set at a level which suits the risk
appetite of the investor
> Inverse floaters can be made (Bermudan) callable
(Callable Inverse Floater Note)
> The index can fix in advance or in-arrears, whereby in arrears
fixing will take extra advantage of a steep yield curve
36 37
Attitude to Risk: Aggressive Attitude to Risk: Aggressive
Yield
Yield
will remain within a pre-defined band, or, as in the most an unknown duration. If interest rates and volatility fail to Type Guaranteed Inverse Floater TARN downwards or
a flattening of
popular structures, decrease over time (or increase less rise or fall as much as implied by the forward curve then Currency USD the yield curve
will normally be
than implied by the forwards). The TARN automatically the duration of the trade can change significantly. In other Maturity 5 years positive for the
redeems when the total sum of the paid out coupons words, the uncertainty of this product lies in the timing Coupon Y1: 6.00%, s.a. 30/360 structure.
equals a designated target level (the Lifetime Cap) and of the final payment and maturity. Y2 - Y5: [13.50% - (2 x 6M USD LIBOR Maturity Maturity
therefore has by definition an unknown duration. Although in arrears)]
Upward Shift Curve Steepening
the TARN can be seen as a feature (and implemented in Variations ABN receives 3M USD LIBOR – 11bps or Notional A parallel shift
Yield
Yield
upwards or
many products), due to its popularity we will describe > The TARN is available in those currencies where ABN Lifetime Cap 10% a steepening of
the yield curve
TARNs as a separate product. AMRO operates underlying vanilla cap/floor and swaption will normally be
portfolios (in most currencies up to 10-years, in USD and Delta Profile of a GIF TARN negative for the
structure.
Market View Yen up to 12-years and in Euro up to 15-years)
2
The TARN coupon structure can take several forms, but in > The TARN payout may be a coupon bearing instrument or Maturity Maturity
general the payout is designed to take advantage of stable zero coupon and the coupon structure can be applied to
or lower rates than implied by the forwards. The most almost any coupon type that exists for a traded market 0 Possible outcomes for a few volatility scenarios given
popular structures are the Guaranteed Inverse Floater index (a short term index such as LIBOR, a swap rate the GIF version
Delta
and the Guaranteed Ladder Inverse Floater. It is of course or an FX rate coupon). Currently, ABN AMRO offers the An increase in volatility increases the probability of higher
-2
possible to structure the TARN such that it profits from an following coupon types within the TARN structure: interest rates and thus a decrease in expected coupon
increase in rates. With the Guaranteed Fixed Range Accrual payout which would result in a lengthening of the duration.
variant the barriers can be defined in such a way that the > Guaranteed Inverse Floater (GIF): The coupon pays -4 The converse holds true for decreases in volatility. Although
6M 9M 1Y 2Y 3Y 4Y 5Y 6Y
investor profits from increasing rates (by having a lower Max [Fixed Rate – (gearing x floating index), 0] up to an increase in volatility also increases the probability of
boundary only). Obviously, the investor wants the duration the lifetime cap level, e.g. Max [X.XX% - (2 x 6M USD lower rates, in an upward sloping curve environment more
of the product to be as short as possible (which will be LIBOR in arrears), 0] subject to aggregate cap level of In the graph above the delta profile of the Guaranteed “risk” is on the “higher rates” side.
the case if his view proves to be correct) as the rate of Y.YY% Inverse Floater TARN is shown. As the structure has
return is known per possible redemption date and decreases > Guaranteed Ladder Inverse Floater (GLIF): The coupon possible automatic redemption in years 2 and 3, the Risks
with time. pays Max [Previous coupon + X.XX% - (gearing x investor prefers these rates to go down as the in-arrears The coupon payoff from target redemption structures is
floating index), 0] up to the lifetime cap level fixing is like a digital: a fixing at a level which will result sensitive to changes in the shape of the yield curve and
Description of Product > Guaranteed Capped Floater (GCF): The coupon pays in auto redemption or a fixing which will result in a volatility curve.
The product derives its name from its embedded life time (Floating Index + spread) capped at X.XX% and subject continuation of the structure.
cap (sometimes referred to as the aggregate cap or min- to the lifetime cap The TARN has an unknown duration by nature, with in the
max cap) and sets an absolute limit on the aggregate > Guaranteed Fixed Range Accrual (GFRA): Fixed Rate x GIF TARN Payoff Profile worst case the final coupon (if the structure has a lifetime
amount of coupon that will be paid over the lifetime of N/M (see Range Accruals) floor, otherwise no coupon at all) on the maturity date of
6
the structure. The sum of all coupons paid over the life > The Guaranteed SnowRange (GSR) combines the GFRA the note.
of the transaction will be equal to the Lifetime Cap, and and a variant of the GLIF
once this target is reached, the structure automatically > Hybrid Coupon: combines any of the coupon types 5 When transacted in note form, the note may trade below
Interest Rate
redeems. As most of the LIBOR based target redemption described par during the life of the transaction.
structures can potentially result in a negative coupon for 4
a particular coupon period as well, most structures are Also Consider
floored at zero. Also, in most structures the lifetime cap > SnowRange Note
is the lifetime floor: at maturity the final coupon pays any 3 > CMS Spread Note (Flattener)
Oct 05 Oct 06 Oct 07 Oct 08 Oct 09 Oct 10
remaining unpaid portion of the lifetime cap/floor (so the
Coupon 6M Forward
38 39
Attitude to Risk: Aggressive Attitude to Risk: Aggressive
Delta
Market View > Linear Trigger Option. For example the client receives -2.5 The investor is exposed to more complex (and less
Multi Index Notes are designed for investors looking for USD 10Y CMS + 35bps if (10Y CMS - 2Y CMS) > 0. observable) sensitivities.
-5.0
additional yield pick-up and/or have a very specific view > Dual Range Option: the investor will receive a fixed or
on multiple indices and want to leverage this. An example floating payoff if 2 conditions are met. For example the -7.5 When transacted in note form, the note may trade below
is the Double Digital Option Note in which the digital client receives a coupon of X.XX% x N/M for all days 3M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 20Y par during the life of the transaction.
payoff depends on two boundaries and two indices. USD LIBOR is within (2.50% - 6.00%) AND USD/JPY is
within 90.00 - 120.00). In the graph above the delta profile of the Double Digital Also Consider
Description of Product Range Accrual is shown. As expected, the structure > Hybrid Coupon TARN
Multi Index Products have payoffs which depend on Example: Double Digital Range Accrual profits from increasing rates and a steepening of the > Dynamic Cap
multiple interest rates, multiple underlying indices or curve. The negative delta in year 5 is partly due to the
a combination of the two. Consequently, correlation Currency USD notional effect, since it is a 5-year note.
is a consideration. In general, the investor prefers the Maturity 5 years
correlation to be low at inception and increase over time Coupon 9.50% x N/M Sensitivity to Rate Moves
as most investors prefer selling out-of-the-money options. N number of days CMS 2Y > 4.50%
Upward Shift Curve Steepening
Low correlation increases the likelihood that the two AND CMS 10Y - CMS 2Y > 0.00% A parallel shift
Yield
Yield
upwards or
indices will breach a certain constraint, and therefore the M Total number of days a steepening of
the yield curve
upfront pick-up for the investor is higher. After trading, ABN receives 3M USD LIBOR or Notional will normally be
positive for the
if correlation increases, the likelihood of the two indices structure.
breaching a certain rule falls, since they move more in
line. Therefore the note becomes less risky for the investor, Maturity Maturity
which will have a positive effect on the mark-to-market of Downward Shift Curve Flattening
A parallel shift
Yield
Yield
the structure (the investor is said to be “long” correlation). downwards or
a flattening of
Since the investor usually sells out-of-the-money options, the yield curve
will normally be
he prefers volatility to be high at inception but to decrease negative for the
over time, as an out-of-the-money option with decreasing structure.
40 41
Attitude to Risk: Medium Conservative Attitude to Risk: Medium Conservative
Yield
Yield
the yield curve
in different currencies, and is a variant of the well known spread at inception. He prefers low volatility at inception will be positive
for the structure.
spread option. This variable strike cap can be added to a to reduce the cost of the floor, but prefers high volatility 0 The parallel shift
exposure is limited
structure in order to finance the extra leverage sometimes after trading, as it raises the likelihood that the spread but correlates with
Delta
the steepness of
sought. So instead of having a cap fixed at 7.00%, the cap will widen. the curve.
-5 Maturity Maturity
is at 3M USD LIBOR + 100bps; hence, it is “dynamic”.
The coupon therefore depends on the minimum of 2 Variations A flattening of
Downward Shift Curve Flattening
Yield
Yield
payoffs: the leveraged difference between 2 indices and > A guaranteed minimum coupon can be achieved, although -10 the yield curve
will be negative
EDH7 EDU7 EDH8 4Y 6Y 8Y 10Y 12Y 14Y
an index plus a margin. this decreases the upside for the structure.
The parallel shift
> The absolute coupon can be capped, increasing the exposure is limited
Market View leverage over the spread or margin over the single index This graph shows the delta profile of the Dynamic Cap. but correlates with
the steepness of
the curve.
Selling a dynamic cap gives the investor both a relative > A flattening view can be accommodated. However, in As expected, the investor profits from a steepening of Maturity Maturity
rate view (i.e. an intra-curve or inter-curve) and a view on current market conditions the floor will be expensive to the curve. The structure overall has a slightly negative
the absolute level of interest rates. For example, if a curve finance delta due to the notional effect, the floor at 0.00% and
shifts upwards and also steepens, the dynamic cap strike > A fixed rate can be added to the leveraged Spread (for the fixed element in the cap. A structure with a fixed cap Risks
increases and avoids a negative impact on the payout of example Min (3M + 1.00%, 2.00% + 5 x (10Y – 2Y)) would have a higher negative delta. The high negative The main risk will be with the underlying payoff which is
the steepening as opposed to a fixed cap. Selling the > A Dynamic Floor can be structured (for example Max (3M delta in year 5 is partly due to the notional effect: it is capped by the dynamic cap (worst case scenario: 0.00%
variable cap enables the investor to finance the leverage – 1.00%, 6 x (10Y – 2Y)), floored at 0.00% a 5 year trade. coupons and a value of the structure close to the value
on the Spread. An example payout is a note which pays of a zero coupon bond).
the minimum of a weighting times an index, plus a spread Example: Dynamic Cap Sensitivity to Rate Moves
(for example: 3M USD LIBOR + 100bps), or a leveraged Overall, the structure benefits from a steepening of the A Flattening of the curve will have a negative impact on
difference between 2 indices (for example: 10 x (10Y CMS Currency USD curve. Although the structure has limited parallel shift the mark-to-market of the structure.
– 2Y CMS)). Without the dynamic cap the leverage would Maturity 5 years exposure, a parallel upward shift will be slightly negative
have been lower, for example 8 x (10Y – 2Y). The structure Coupon Y1 - Y2: 8.00% for the structure due to the notional effect, but slightly When transacted in note form, the note may trade below
is often floored at 0.00% (always in note format), and the Thereafter : Min [3M USD LIBOR + positive for the structure if it is combined with a steepening par during the life of the transaction.
investor generally profits if the curve steepens or a spread 1.00%, 10 x (10Y CMS – 2Y CMS)] of the curve. A steepening of the curve implies higher
widens (in the case of a spread on 2 rates in 2 different floored at 0.00% forward rates and thus a higher forward cap. The advantage Also Consider
currencies) and the 3rd reference rate shifts upward. ABN receives 3M USD LIBOR or Notional of a dynamic cap over a fixed cap in a parallel upward > CMS Spread Note
shift is therefore obvious: a parallel upward shift won’t > Multi Index Note
Description of Product impact the absolute coupon level. The structure is more
The dynamic cap product is an enhancement of the attractive when at inception the forward curve is flat.
spread option structures capped at a fixed rate: the
investor is selling a variable cap on a spread of 2 rates
(single or multi-currency). The variable cap depends
on one of the 2 indices in the spread or a third index.
Typically, the investor buys a spread option to floor the
structure. Furthermore, when the curve is flat (or the
42 43
Attitude to Risk: Medium
Volatility Note
Delta
-5
Market View
A Volatility Note suits an investor with the view that the
volatility of an index will go up. The investor takes advantage -10
1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 20Y
of any movements of the index, without having to take a
view on the direction of the index. The note can also be In the graph above the delta profile of the 10 year digital
used as a hedge for long term bond investors whose Volatility Note is shown. The negative delta in year 10 is the
portfolios have natural negative volatility. notional effect: it’s a 10-year note. The longer maturity
buckets indicate a preference for increasing rates which is
Description of Product logical as the 11 year rate can be seen as the 10 year rate
A Volatility Note paying an annual coupon of (gearing x 1 year forward, which the investor obviously likes to increase.
the absolute change of an index) is similar to being long a Overall the investor prefers a steepening of the curve.
string of cash-settled one-year swaption straddles, reset
at-the-money every year. The investor is therefore said to Sensitivity to Rate Moves
be “long Vega”: he profits from an increase in volatility. A
A parallel shift Downward Shift Curve Steepening
major advantage of the Volatility Note is the fact that the downwards will
Yield
Yield
normally be
investor can play the absolute variation of an index, without positive for the
investor as the
the complexity of managing a rolling option position. relative value of
the fixed coupon
increases. A
Variations steepening will
normally be positive
Maturity Maturity
> The Volatility Note can be made digital: if Index X in as it signals rising
(thus changing) yields.
arrears – Index X fixes at or above Y.YY%, the investor Upward Shift Curve Flattening
Yield
Yield
A flattening
receives a fixed coupon. Otherwise no coupon is paid of the yield
> The note can be constructed as an inverse floater, curve or an
upward shift
profiting from a decrease in volatility will normally
be negative for
> Instead of one index, two indices can be used the structure.
Maturity Maturity
Example: 10Y Digital Volatility Note
Risks
Currency EUR A decrease in volatility will result in a below-market or
Maturity 10 years zero coupon (worst case are consecutive 0.00% coupons
Coupon 5.25% if |10Y CMS in arrears - 10Y with the value of the structure close to the value of a Zero
CMS| > 0.40%, annual 30/360 Coupon Note). When transacted in note form, the note
Fixing Annual, 2 bd before coupon payment may trade below par during the life of the transaction.
ABN Receives 6M EURIBOR + 8bps or Notional
Also Consider
(One Look or Multi Look) Digital Note
44 45
Attitude to Risk: Medium Attitude to Risk: Medium
the strike (the preferred scenario: cash settlement) or or the coupon can be based on the investor’s strike Also Consider
Delta
receives the underlying bonds at a higher price than the preference One Look Digital Note
-2
spot price of that bond (bond delivery, resulting from a > Instead of government bonds the investor can select a
fixing below the strike). A BDN is mostly a short term play. corporate bond. By selecting a corporate bond the maturity
has a maximum of 6-months -4
Market View > It is possible to structure a BDN in which bond delivery 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y
The buyer of a BDN should have the (short term) view is the preferred scenario and cash settlement the non
that rates stay stable or decrease slightly (or increase preferred one (for example cash settlement at a lower The delta profile shows that the sensitivity is obviously
less than implied by the forwards), because with a large level than 100%) to the long rate. If rates decrease the price of a fixed
fall in rates he would prefer to buy the underlying bond. > This structure is also very popular on FX (called DCD’s: income instrument will increase so the probability of
Dual Currency Deposits) or Equity (Reverse Convertibles) delivery of the underlying bond will decrease (as the
Description of Product spot price will move away from the strike price).
With a BDN, the investor sells a put option on a bond Example: Bond Discount Note
with a certain strike to the issuer, obliging the investor If rates increase the probability of the strike being
to buy the underlying bond at a predetermined price and Currency EUR triggered at the maturity date increases.
date if the buyer of the option (in this case ABN AMRO) Maturity 3 months
wishes to sell. For this the investor is compensated by Coupon 4.75% (3M EURIBOR at 2.17%) As the structure involves selling a put option, there is
an option premium, paid as an above-market coupon. In Underlying Nether 3.25% 2015 some mark-to-market sensitivity to volatility.
order to maximise the coupon it is important for the BDN Strike 100.50% (at time of pricing 100.71%)
that the reference bond’s coupon is not too high, and the Sensitivity to Rate Moves
bond does not have too many accrued days of interest. If fixing is at or above 100.50%, the investor receives the
Downward Shift Curve Flattening
This would reduce the Participation Level. If at maturity coupon and the note will be settled in cash (the investor A parallel shift
Yield
Yield
downwards or
the option is in-the-money, the underlying bonds are receives his money back). If fixing is below 100.50%, the a flattening of
the yield curve
delivered “dirty” (with accrued interest). A relatively high investor will receive his coupon, but settlement will be in will normally be
positive for the
coupon and accrued interest leads to a relatively higher bonds: the investor receives a number of the reference structure.
dirty price, therefore reducing the number of deliverable bonds instead of his money back.
bonds per denomination. Hence the upfront premium will Maturity Maturity
be lower. High volatility at inception is positive for the Upward Shift Curve Steepening
A parallel shift
Yield
Yield
investor as the option sold has more value and therefore upwards or
a steepening of
increases the coupon. A Bond Discount Note is also the yield curve
will normally be
known as a Bond Reverse Convertible. The structure is negative for the
not capital guaranteed. structure.
Maturity Maturity
46 47
Appendix Most Popular Products
48 49
Range Accrual Notes Innovation Interest Rate Linked Product Innovation
The standard Range Accrual structure accrues interest for The main conclusion to be drawn from the graph below With H1 06 interest rate-linked MTN sales down by USD
200 104%
every day that the reference rate fixes within a predefined is that relatively vanilla structures, such as the fixed rate 51bn on H1 05 and the Euro and US dollar yield curves
Product Variations
2006 so far. The Zero Coupon Callable Note is finding its 90%
The range accrual feature is increasingly used in more place in the market due to the higher IRR on offer, made instruments that were popular in 2005. Hybrid products 100
exotic varieties: for example cumulative coupon, flippable possible through the higher yield curve environment. on the other hand have seen a significant increase in
75%
and target redemption. Similarly, fixed rate issues now look more attractive after volume, notably those that combine interest rate plays 50
a period of rate hikes in Europe and the US. with inflation exposure.
USD Range Accrual issues have fallen. USD issuance 0 60%
2001 2002 2003 2004 2005 Q1 2006
accounted for 80% of all Range Accruals in 2004, 67% in Similarly, there has been a fall in activity of cumulative In just the first eight weeks of 2006 hybrid issuance had
Source: mtn-i.com.
2005 and now down to 33% YTD 2006. Investor demand structures, whereby the payout of each coupon is “path already overtaken 2005’s volume. This underlines the
for USD denominated issues has fallen amidst the prolonged dependent” – reliant on the level of the previous coupon. emergence of an important new product tailored to a
Fed Funds tightening cycle, leading to concern about rates In 2005, 4.5% of all issuance had a cumulative element, specific set of risk preferences. Many of these structures
breaking out of the predefined range. The demand was falling to 1.9% in the first half of 2006 (by value). tend to exploit the behaviour of the forward EURIBOR
further lowered by continuing USD weakness. curve versus the forwards for Eurozone Harmonised
In summary, the overall change in activity in the MTN Index of Consumer Prices (excluding tobacco; HICPx).
Callable & Cumulative market can be attributed to market conditions that affect The majority pay a floating rate plus a spread capped
Callable MTNs are notes where the issuer has the option the risk appetite of investors, as well as issuers delaying at a multiple of the HICPx and floored at 0%.
of early redemption. In 2004, 31% of all Interest Rate issuance until there is more confidence in the market.
Linked MTNs were callable, compared to 19% in 2005 The interest rate-linked MTN market has responded by
and back up to 24% in 2006 YTD (by USD eqv. value). delivering bespoke solutions to investor demands and
has adapted its offering to the changing rate markets.
Main Callable Structures - 2005 vs. 2006 (1st semester)
Innovation is clearly the driving factor behind the market.
10
Within Interest-Rate linked MTNs alone, the number of
% of Intrest-Rate Linked MTNs
50 51
Structured Note Market
Summary
Although lower than last year’s record figures, structured The high returns observed in stock markets have led to FX-linked MTNs showed a significant sales surge with
Medium Term Note (MTN) issuance appears to be strong increasing equity linkage (22% of YTD deal volume), showing almost a four-fold increase from USD 1.4bn in Q4 05
in 2006 with year-to-date issuance of USD 94bn. 2005 saw a significant increase from 14% in 2005. Issuance doubled to close to USD 5bn in Q1 06. This supply was driven
extremely strong issuance in the first quarter, followed by from H2 05 to almost USD 21bn in H1 06. by investor appetite for exposure to emerging market
a slight downturn thereafter. Strong issuance at the start currencies. The largest ever FX-linked MTN was an Asian
of the year is a trend that is often observed, amid strong Investors are once again looking for real returns through currency basket, whilst the most dominant currencies
investor appetite and fresh issuer funding targets. This inflation linked products. The rebound in volume in Q1 06 were the Chinese renminbi, Indian rupee, Indonesian
was also the case at the start of 2006, with a strong pick- to USD 5bn equalled that across all of 2005. Innovative rupiah and Korean won.
up in issuance over Q4 2005. As could be expected in an hybrid inflation products drove more than 50% of Q1 06
environment of booming equity markets, equity linked sales in this asset class. In particular, the inflation capped The Credit-linked MTN market has shown one of the
structures have gained in market share. Having said this, FRN accounted for most of these. It is a simple yield strongest recoveries at the start of the year, but, perhaps
despite difficult bond market conditions, interest rate enhancing structure that exploits the correlation between surprisingly, commodity linked MTNs have not taken off
linkers still dominate the issuance with a market share of the forward EURIBOR curve versus the forward HICPx curve. (only USD 1.1bn of new issuance in the first semester).
48%. The recent Euro strength has also led to an increase Pure inflation sales were dominated by HICPx (Eurozone)
in Euro issuance (50% of the market) and a decline in and UK RPI. Spanish and, for the first time, Polish inflation Outlook
USD denominated structures (29%). also featured. Q2 06 has begun with leveraged cross-market Interest rate linkers look set to remain the dominant
differential notes referencing local and pan-European asset class, although the difficult environment for CMS
Structured MTN Market Size inflation. based structures has also shifted the focus to different
asset classes. Amid investor uncertainty about market
80% 90
direction, a revival in simple callable structures has
USD Equivalent in USD bn
60%
emerged. Ratchet Notes, Capped FRNs and zero accreting
60 notes have also been gaining in popularity. This trend
Issuance
Market Sectors
Interest Rate Linked issues continue to dominate the
structured market at 48% of YTD new issuance (USD
45bn), although it is lower than in 2005 as investors’
interest has shifted to a wider variety of asset classes in
a difficult interest rate environment. CMS-linked structures
have so far been less popular than in 2005, brought on
primarily by the severe flattening of the yield curve.
52 53
Turbo Certificates
Summary Example
Turbo Certificates (“Turbos”) are delta-one investment The price of a Turbo is equal to the difference between
instruments which give investors leveraged exposure to the market price of the underlying future and the financing Type Turbo Long
an underlying bond future. Depending on whether the level of the Turbo. The financing level can be seen as the Current Underlying Future Euro-Bund Future Sep. 2006
investor has a bullish or bearish view on interest rates in amount of money that ABN AMRO has to contribute to Price of Underlying 116.80 EUR
certain maturities and geographic regions, he can choose buy the underlying above the premium paid by the investor. Financing Level 104.14 EUR
to buy a Turbo Long or Turbo Short. Turbos on bond futures Because the underlying is a future (not a physical asset) Stop-Loss Level 106.27 EUR
are defined by their underlying future, the financing level in this case, ABN AMRO does not physically have to Fair Value Turbo 12.66 EUR
and stop-loss level. “lend” money to the structure. This means that no Leverage 9.2 (Price of Underlying/Price
interest is charged over the financing level; however, of Turbo)
Market View the management fee does accrue over this amount. Management Fee 1.5% p.a., accrued daily over
An investor can use Turbos to take an aggressive view on the Financing Level
a certain bond market. If he expects sharply rising long The stop-loss level is slightly above the financing level in
term interest rates in Japan for instance, he can buy a the case of a Turbo Long, and slightly below the financing Underlyings
Turbo Short on the JGB future. Equally, an investor who level in the case of a Turbo Short. If the underlying future Turbos Long and Short are currently offered on the
anticipates declining long term rates in Europe can hits the stop-loss level, the Turbo ceases to exist and following Bond Futures:
choose to buy a Turbo Long on the Bund future. ABN AMRO unwinds the position. Depending on market
circumstances, the investor will then receive the residual > Europe: BOBL, Schatz, Bund, BUXL
Equally, Turbos can be used to hedge interest rate risk in value of the Turbo, which can never be smaller than zero. > United States: T-Note, T-Bond
a bond portfolio. Because Turbos always reference the The stop-loss level is determined by ABN AMRO, and is > Japan: JGB
first maturing futures contract, their interest rate sensitivity largely dependent on the volatility of the underlying market.
is relatively constant. This allows an investor to match the Risks
duration of his bond portfolio with a required amount of As Turbos will always reference the first maturing futures > Turbos are highly leveraged investments, which means
Turbos. The hedge achieved in this way will never be perfect, contract, ABN AMRO periodically rolls the underlying that buyers risk losing their entire invested capital.
as it will for example not necessarily protect against changes contract. On a roll date, the price of the next maturing
in slope of the yield curve, but it is easy to implement and future will not be the same as the price of the current > A stop-loss event will result in the position being
requires little capital outlay. future. To keep the price of the Turbo constant during the unwound and the investor receiving the residual value,
rolling process, the financing level is adjusted to account which is dependent on market circumstances and could
Description of Product for the price difference between the two futures contracts be zero.
A Turbo is designed to offer one-for-one exposure to the and any costs incurred during rolling.
price changes of the underlying future. A 1 EUR increase > An interest rate hedge using Turbos may not be perfect.
in the price of the underlying contract should lead to a 1
EUR price increase of the relevant Turbo (not accounting
for fees).
54 55
Interest Rate Models
56 57
Modelling Processes
Background
The pricing of any derivative product is dependent on More technically speaking, a Markov process is consistent Suppose we draw a line some distance from the origin of The industry-standard GBM (Geometric Brownian Motion)
the (expected) future price of the underlying asset. When with the “weak” form of the efficient market hypothesis. the walk to the intended end point. For any random walk, equation relates the new asset price to the old one through
modelling asset price movements over a period, a number Historical asset prices are not of any use in predicting every point in the domain will be crossed a number of times a time dependent term and a random variable. When
of models have been associated with the process driving future prices; therefore it is impossible to produce almost surely. The graph below shows eight random walks simplified for the Wiener process, the random variable is
the numbers. Asset prices, like molecules, are often consistently superior returns through technical analysis. of 100 time steps, each aiming to go straight across. the product of the driving variable, described above, and
assumed to follow Brownian motion, which is an extension the square root of the time interval. Essentially a model
of the ideas discussed on where a “drunkard” might end Stochastic processes can be classified as discrete or An important result that follows is the deviation from the uses the volatility and expected return at each time interval
up after some time on their walk home. continuous time. A discrete-time process is one where intended straight line (variance) of a random walk increases and the amount by which the price moves is determined
the value of the variable can only change at certain fixed linearly with time. An individual walker strays further away by the random number. It has a deterministic element
The value of a derivative is the value today (present points in time, whereas a continuous-time process allows from the intended straight line with time. If the whole pub (the expected return/drift) and a random term (which is
value) of all expected discounted cash flows. The expected for a change at any time. The same breakdown can be were to attempt the same walk, the average position away more or less important dependent on the volatility). Due
discounted cash flow is basically the probability of receiving applied to the variable that the process is modelling, in from the line would indeed be on the line at each point. to the characteristic of the Markov process, the price
the cash flow times the expected payout, conditional on this case, the asset price. In a continuous-variable process, chart will vary considerably each occasion the model is
receiving the cash flow (i.e. in option terms, receiving the the underlying variable can take any value within a certain 8 random walks aiming to go straight across run. A Monte Carlo simulation of the stochastic process
expected payout conditional upon the option being in the range; whereas in a discrete-variable process, only certain is required to sample the random driving variable and
130%
money). For this reason numerous models have attempted discrete values are possible. In practice, asset prices are derive the price chart. The simulation runs the model
to model price movements to value derivative instruments. restricted to discrete values (e.g. multiples of a cent) and repeatedly (often 10,000 times) and takes the average
changes can be observed only when the exchange is open. result. If the model were to be adapted for continuous
The Processes 100% time, the model describes geometric Brownian motion
To understand how asset prices can be modelled, an The Random-Walk Process which is the basis of the Black-Scholes model. As discussed,
understanding of the variable (price) is first required. Any The foundation for asset price modelling is the “Random the return to the holder of the stock in a small period of
variable whose value changes over time in an uncertain Walk”. It is the intuitive idea of taking successive steps in time is normally distributed and the returns in two non-
way is said to follow a stochastic process: the variable is a random direction for modelling stochastic processes. It 70% overlapping periods are independent.
0 20 40 60 80 100
neither completely determined nor completely random is called a random walk because it can be thought of as
as it contains an element of probability. The example of an individual (drunkard) aiming to walk on a straight line The motion analyzed is called a Simple Random Walk. It is Conclusion
rolling a dice at regular time intervals shows that rolling to a chosen destination, who at each point of time can simple in the sense that the walker makes discrete fixed When pricing derivative products, to avoid overcomplicating
a “6” three times in a row does not mean a 6 will not be take one step to the right with a given probability p or movements of constant lengths at specified time intervals. the process, an understanding of the modelling behind the
rolled again, however, intuitively it is quite unlikely. This one step to the left with probability 1-p. The Wiener process develops the principle to asset pricing underlying asset pricing is essential. The “random walk”
means that after a large number of sequential throws such that prices do not move by a constant amount in a of asset prices includes a number of simple assumptions
(with a “fair” dice), we expect to see each number an The simplest random walk is a path constructed given period but are influenced by a driving variable: a combined together:
equal number of times, though might see a “6” rolled according to the following rules: number generated to influence the relative price shift. > the price is derived from the previous one but does not
four times in a row. > there is a starting point affect the result (Markov)
> the distance from one point in the path to the next is a Wiener Process > the annual expected return should depend on the risk of
An extension to this idea introduces a Markov process, constant (constant footsteps) A Wiener process puts a mathematical probability and range the return on the asset
which is a particular kind of stochastic process. Its property > the direction from one point in the path to the next is constraint upon the driving variable. It is still randomly generated > the annual volatility needs to be carefully chosen
is that only the current value of the dependent variable chosen at random, and no direction is more probable but conforms to a normal distribution with a mean of 0 (drift) > the Wiener process provides the basis for the random
(i.e. the asset price) is relevant for predicting its next value. than another (the drunkard is just as likely to slump to and a standard deviation of 1 (variance). This means that about nature of the price
In other word it has “no memory”: the asset price path the left as to the right) two-thirds of the time, the number will be between +1 and -1,
leading to its current value has absolutely no influence or one standard deviation around the average of zero. About
or effect on what the next asset price movement will be. 95 percent of the time, the numbers will be between two
standard deviations of the zero and 99 percent of the time,
they will be between three standard deviations of zero.
58 59
Yield Curve Considerations
Yield
in forward rates. However, this theory suggests that pressure on long term interest rates, relative to short the yield curve effects of a sharp oil price shock, or a
investors and borrowers have different maturity preferences, term rates. technology driven supply shock are not as clear. This is
and are willing to switch away from their “preferred because these type of shocks move output and inflation
habitat” maturity if sufficiently rewarded. Government Finances can also affect the shape of the expectations in opposite directions, and the yield curve
Maturity Maturity yield curve. Sustained budget deficits require increased effect depends on whether the output or inflation response
Flat "Humped" Market Segmentation Theory: Like the Preferred Habitat government borrowing to fund them. Eventually, this is dominant.
Yield
Yield
Theory, this theory suggests that different market increased supply in an increasingly global market would
participants have differing maturity preferences. However, induce investors to demand higher yields, resulting in a
the Market Segmentation Theory does not allow for any parallel shift of the curve.
switching between “segments” (areas of the yield curve),
Maturity Maturity
and therefore the yield in any segment is independent Borrowers’ maturity preference changes can alter the
of other sections of the curve. Most market participants slope of the yield curve. For example, the 2001 halt in US
There are three dominant theories which attempt to agree that this theory offers a rather dubious explanation Treasury 30 year issuance created a shortage at the long
explain the term structure of interest rates: of the yield curve. end of the yield curve, pushing prices up, yields down,
and flattening the curve. Similarly, a shift of corporate
borrowing preferences between fixed and floating rate
terms can alter the supply conditions at either end of the
yield curve, changing its slope or curvature.
60 61
Glossary
Convexity Bias is a factor which influences the long end Conclusion Accretion – an increase of notional amount throughout Collar (or Corridor) – a combination of an interest rate
of the yield curve. Convexity measures the curvature in Whilst numerous factors are clearly relevant in shaping the life of a structure. cap and interest rate floor.
the relationship between bond prices and their yields. the term structure of interest rates, the graph below
Bonds with high convexity perform better if rates change; summarises the main determinants of the different parts American Option – an option that allows for exercise at Collateralized Debt Obligation (CDO) – a way of re-
if rates fall their price rises by more, if rates rise their of the curve. any time during its life. packaging credit risk by dividing a pool of securities
price falls by less. The benefits of convexity cause more or financial assets into tranches. These tranches have
convex bonds to have higher prices and consequently Main Determinants of the Yield Curve Amortisation – a decrease of notional amount throughout different risk and return profiles, essentially redistributing
lower yields. Convexity increases strongly with maturity the life of a structure in a predetermined way. the risk from the underlying portfolio.
Yield
and is of great influence at the long end of the curve. The
convexity bias therefore tends to lower yields at the long Arrears – observation and fixing of the underlying rate at Convexity – a measure of the curvature in the relationship
end of the curve. the end of the coupon period as opposed to the start of between price and yield. The greater the convexity, the
the coupon period. more sensitive the duration is to changes in yield. Callable
Central Bank Reputation is also important. If the Central Central Expectations Inflations securities will exhibit negative convexity at certain price-
Bank of Future Expectations
Bank has strong inflation fighting credentials, and if they Monetary Monetary and Convexity Barrier Options – options where the payoff depends on whether yield combinations. Negative convexity means that as
Policy Policy Bias
follow a highly transparent monetary policy, then the the underlying asset’s price reaches a certain level during a market yields decrease, duration decreases as well.
Maturity
yield curve may be flatter than it otherwise would. This is certain observation period.
because concerns about future growth would outweigh Correlation – a statistical measure describing the degree
inflationary worries, and investors would require a smaller Bearish – a view that an asset or underlying index will of dependence between the fluctuations of two variables.
liquidity premium, because of the reduced uncertainty fall. In “rates” it means a rise in yields (a fall in price).
about future rate changes. Credit Default Swap (CDS) – an agreement whereby
Bermudan Option – an option that allows for exercise at one party (the protection buyer) pays the other party (the
Foreign Central Bank purchases of government bonds certain discrete predetermined times during its life. protection seller) a fixed periodic premium for a certain
have a significant effect on the shape of the yield curve. tenor. The protection seller makes no payments unless a
Countries with large foreign currency reserves resulting Bullet – an obligation that must be paid in a single lump specified credit event occurs on a predefined reference entity.
from current account surpluses are major buyers in the sum at the end of its term.
government bond markets. A change in their preference Credit Event – an event which triggers payment in a
over the maturity or currency of their purchases can have Bullish – a view that an asset or underlying index will rise. Credit Default Swap. Common examples are bankruptcy,
a major impact on the shape of the yield curve. In “rates” it means a fall in yields (an increase in price). restructuring and failure to pay.
Regulatory Changes such as recent moves towards Callable – the option but not the obligation for the issuer Credit Spread – the yield spread between risk free
closer asset/liability matching amongst pension funds, to redeem a security prior to its stated maturity, at a securities and others that are identical in all respects
insurance companies, and other financial institutions predetermined price. except for credit quality.
have led to increased demand (and correspondingly
lower yields) at the longer end of the yield curve. Cap – an option that provides a payoff when a specified Cross Currency Swap – the exchange of principal and
interest rate is above a certain strike level. The interest rate interest in one currency for the equivalent in another
Financial Innovation can also affect the shape of the cap can be thought of as a series of caplets which exist currency at an exchange rate fixed at inception.
yield curve. The emergence of structured notes has given for each period the cap agreement is in existence.
borrowers the flexibility of raising finance in maturities they Currency Forward – A forward contract in the forex
would not have otherwise considered. Through the process Caplet – one component of an interest rate cap. market that locks in the price at which an entity will buy
of “reverse inquiry” (whereby an issuance is driven by the or sell a currency on a future date.
investor’s, not the issuer’s, preference), investors have an Clean Price – the price of a bond which does not include
increasingly important influence on the supply and demand accrued interest.
dynamics at a given point on the yield curve.
62 63
Delta – a measure of the sensitivity of a derivative to Forward Rate – the interest rate for a future period of Notional – the cash amount over which the pay-off of a Straddle – an option strategy primarily used to profit
changes in its underlying asset or index. time implied by the rates prevailing in the market today. derivative or structured product is calculated. from an increase in volatility. It involves buying a call and
a put with the same strike price and expiration date. A
Derivative – a financial contract whose price and cash Hedge Fund – a discretionarily managed portfolio of Notional Effect – Apart from pure floating rate bonds, loss will occur if the spot price is close to the strike price
flows are dependent upon one or more underlying investments that uses strategies such as leverage, long, each bond displays the notional effect. This means that at expiration of the options.
assets. short and derivative positions with the goal of generating the mark-to-market price of a bond will be negatively
above market returns at an acceptable level of risk. impacted by an increase in interest rates, because an Strike Price – the predetermined price for which the
Digital (or Binary) – a derivative product for which equivalent investment will pay a higher coupon in this underlying asset/index may be purchased or sold by
the payout is a fixed cash amount (“high payout”) if the Historical Volatility – the volatility of a financial situation. The biggest notional effect is displayed in case the investor upon exercise of the derivative contract.
investor’s view proves to be correct, and zero (or “low instrument actually realised over a given period in the past. of fixed rate bonds, but also in case of structures with
payout”) otherwise. some possibility of fixed coupons such as embedded Structured Note – a debt obligation that contains a
Hybrid – a derivative product that depends on the caps and floors this effect will be displayed. derivative component to achieve a specific risk/reward
Dirty Price – the price of a bond which includes the performance of two or more underlying assets or indices. profile.
accrued interest. Out-of-the-money – an option is said to be out-of-the-
Implied Volatility – the future volatility of an instrument’s money when its intrinsic value is zero, e.g. for a call Swap – an agreement between two parties to exchange
(Modified) Duration – the measure of the price price estimated from derivatives currently traded in the option when the spot price is lower than the strike price. defined cash flows over a period of time.
sensitivity of a fixed-income security to an infinitesimal market.
change in yield. The greater the duration, the greater the Par Value – the face value of a fixed-income asset. Swaption – the option to enter into a swap. In exchange
sensitivity to interest rate movements. In-the-money – an option is said to be in-the-money for an option premium, the buyer gains the right but not
when its intrinsic value is positive, e.g. for a call option Participation level (gearing) – the percentage of the the obligation to enter into a specified swap agreement
European Option – an option that can only be exercised when the spot price is higher than the strike price. price change of the underlying index/asset that the buyer with the counterparty on a specified future date.
at the end of its life. of a derivative contract is exposed to in relation to that
Internal Rate of Return (IRR) – the discount rate that contract’s notional amount. Underlying Asset – the asset or index upon which the
Exotic – structured products which are more complex makes the net present value of future cash flows equal value and pay-off of a derivative contract is based.
than the derivatives usually traded on an exchange. As to zero. Path Dependent – a feature for a derivative whereby
opposed to vanilla products, they are generally traded the payoff depends on the whole path followed by the Vanilla – the most basic version of a derivative contract.
over the counter. Knock-in Option – a type of barrier option which only underlying variable, not just its final value.
comes into existence if a certain barrier is hit. Vega – a measure of an option’s sensitivity to volatility. It
First-To-Default Basket (FTD) – provides multiple name Quanto – a derivative in which the relevant performance shows the change in the option’s value resulting from a
exposure in a CLN. An investor in a CLN with a FTD Knock-out Option – a type of barrier option which of the underlying asset or index is paid out in a foreign small change in volatility of the underlying index.
feature runs full principal risk in case of a credit event ceases to exist if a certain barrier is hit. currency.
on any of the names in the underlying basket. Volatility – the annualised standard deviation of an asset’s
Leverage – the use of derivatives or borrowed capital to Sensitivity – the magnitude of a financial instrument’s return. It is a measure of the variability of the asset price.
Floor – an option that provides a payoff when a specified increase notional exposure to an investment. reaction to changes in underlying factors, such as interest
interest rate is below a certain strike level. rates. Yield – the annual rate of return for a security.
Lifetime Cap – the maximum cumulative coupon amount
Floorlet – one component of a floor. The interest rate that an investor in for instance a Target Redemption Note Spot Price – the current market price for an asset or Yield curve – the relationship between yields and maturities
floor can be thought of as a series of floorlets which exist can earn. When this level is reached, the product is index. for a given security (also known as the Term Structure).
for each period the floor agreement is in existence. generally automatically redeemed.
Forward Curve – a graph of forward rates for different Mark-to-market (MtM) – the act of recording the price
maturities. or value of a security to reflect its current market value
rather than its book value.
64 65
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