Aspects of Structured Products: Interest Rates

Nick Fentem, FICC Structuring

June 2007
Executive Summary

► Introduction

► FICC Structuring

► ILS Market

► Market Development

► Three Example IR Structures

► Major Markets

► Potential blueprint for ILS market

► Example USD IR Structures

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FICC Structuring

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FICC Structuring

FICC Structuring

Interest Rate Commodity FX Hybrid

1st Generation Barrier Option, TWB, Bets, Quantos Interest Rate

2nd Generation Faders, Range Accruals, Passport Options

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3rd Generation Outside Barriers, Sliding Strikes, Monte Carlo

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ILS Market – Rate

► Swap Market has developed rapidly

► In 2002 Swap Market existed out to five years

► In 2007 Swap Market out to 20 years

► ILS Interest Rates currently lower than USD – driven by the difference in short term rates

6.5

5.5

4.5

3.5

3
0 5 10 15 20
Maturity
ILS Swap Rate USD Swap Rate

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ILS Market – Rate History

► Market Conditions

► Market rallied significantly from the third quarter of 2006

► Sharp sell off over the past month, mirroring major markets with accompanied steepening of the curve

6.5

5.5

4.5

3.5

3
Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07
5yr Swap 3m Telbor

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ILS Structures – Multicallable

► Rationale

► Receive enhanced yield in return for taking duration risk

► Example Terms

Maturity 15 years

Coupon 6.40% annual Act/365

Call Issuer has the right to call at par after 1 year and every year thereafter

► Pick up vs. fixed rate bond in excess of 50 bps

► Risk – rates fall quickly, bond is called and funds can only be reinvested at lower rates

► Duration of bond falls as rates fall – “negative convexity”

► Breakeven interest rate level for call option is below 6.40% due to multiple call rights

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ILS Structures – Range Accrual

► Rationale

► Receive enhanced coupon as long as Telebor-3M remains within a range

► Example Terms

Maturity 5 years

Coupon 6.5% * n / N annual Act/365

n number of calendar days in a period where Telbor3m < Barrier

N total number of calendar days in a period

Barrier Year 1: 5%, thereafter increasing 0.50% each year

► Pick up vs. fixed rate bond in excess of 100 bps

► Risk – rates rise quickly above Barrier level leading to reduced coupon payout

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ILS Structures – Range Accrual

► Pricing / Risk Factors

► Level of Barrier relative to Telbor-3M rates implied by the forward curve

► Levels of cap volatility

► If rates are at or below rates implied by the forward curve then 6.5% coupon will be received for whole life

8.000

7.000

6.000

5.000

4.000

3.000

2.000

1.000

0.000
Jun- Sep- Dec- Mar- Jun- Sep- Dec- Mar- Jun- Sep- Dec- Mar- Jun- Sep- Dec- Mar- Jun- Sep- Dec- Mar-
07 07 07 08 08 08 08 09 09 09 09 10 10 10 10 11 11 11 11 12
Fwd Rate Barrier

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ILS Structures – Steepener

► Rationale

► Receive coupons linked to the steepness of the curve

► Curve is flatter on a forward basis, high coupon levels achievable if curve remains steep

► Example Terms

Maturity 5 years

Coupon max[ 8 * (CMS10 – CMS2), 0] annual Act/365

CMSn n-year ILS Swap Rate

► If the spread remains at current level of 88 bps coupon will be in excess of 7%

► Breakeven spread at 67.5 bps

► Risk – curve flattens

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ILS Structures – Steepener

► Pricing / Risk Factors

► Primary factor – level of Spread between 10y and 2y rates implied by the forward curve

► Levels of Swaption volatility & Implied Correlation between the rates impact value of the coupon floor at zero

Fwd Spread
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11
-0.1
Fwd Spread
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Major Markets

► Developed Swap Market in Longer Maturities

► 30y rate is now one of Benchmarks with liquidity available out to 50 years

► Demand for high duration assets, especially from Insurance Co’s / Pension Funds leads to inverted curves at very long end

6.5

5.5

4.5

3.5

3
0 10 20 30 40 50
USD Swap Rate EUR Swap rate

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Major Markets

► Developed Option Markets

► High liquidity for options both for long-dated expiries and for long-dated underlyings

► Broker screens for Vanilla Options out to 30y Expiry / 30y Underlying

► Also different Option volatilities quoted different strikes – “skew / smile”

► Current USD Vol Surface

Expiry/Ulying 1Y 2Y 3Y 4Y 5Y 7Y 10Y 12Y 15Y 20Y 25Y 30Y

1M 7.3 14.5 15 16.3 17.6 17.4 17.1 16.8 16.4 16 15.8 15.6
3M 9.4 12.5 14.3 15 15.7 15.5 15.2 14.85 14.5 14.1 14 14
6M 10.8 12.5 13.7 14.1 14.4 14.2 13.9 13.6 13.3 12.8 12.8 12.8
1Y 12.9 13.1 13.3 13.5 13.7 13.5 13.2 12.9 12.6 12.2 12.1 12
2Y 13.7 13.6 13.6 13.6 13.6 13.3 13 12.7 12.3 12.1 11.9 11.8
3Y 14.1 13.9 13.8 13.7 13.7 13.4 13 12.7 12.4 12.1 11.9 11.8
4Y 14.1 14 13.9 13.8 13.7 13.4 12.9 12.6 12.3 12 11.8 11.8
5Y 14.1 13.9 13.8 13.7 13.6 13.3 12.8 12.5 12.2 11.9 11.8 11.7
7Y 13.6 13.4 13.4 13.3 13.3 13 12.5 12.2 11.8 11.3 11.3 11.2
10Y 12.7 12.5 12.5 12.5 12.4 12.1 11.7 11.4 11 10.5 10.4 10.3
15Y 12 11.9 11.8 11.8 11.7 11.4 11 10.7 10.3 9.9 9.8 9.7
20Y 11.4 11.3 11.2 11.1 11 10.8 10.5 10.2 9.8 9.4 9.3 9.2
30Y 10.75 10.5 10.4 10.25 10.15 9.9 9.65 9.4 9.05 8.7 8.6 8.55

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USD Structures

► Three themes from ILS structures

► Call Features

► Range Accrual Format

► Coupons linked to Curve Steepness

► In highly liquid markets these themes can be combined

► Callable Range Accrual

► Range Accrual linked to curve Steepness

► Additional risk types also available

► Zero Coupon Format

► Path Dependent Coupons

► Target Redemption

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USD Structures – Callable Steepener

► Combine Risk Features

► Coupon Stream linked to curve steepness with enhanced yield from call features

► Example Terms

Maturity 5 Years

Coupon: Q1-Q2: 7.00 % , qtrly 30/360 unadj

Subsequently: 6 * (USD CMS30 – USD CMS 2) + 4.00%,

Cap/Floor: Each quarterly coupon is capped @ 9.00%, floored at 0.00%

Call: Issuer has right to call after 3 months and quarterly thereafter

► View: Curve steepening view on USD 30-2 CMS

► Exercise of call right will depend upon shape of forward curve on call date

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USD Structures – Callable Zero Coupon

► Zero Coupon Format

► Receive enhanced yield pickup from taking higher duration risk

► Example Terms

Maturity 30 Years

Issue Price 100%

Coupon 0%

Redemption: 900% (IRR 7.60%)

Call: Issuer has right to call at after 5 years and annually thereafter

Redemption at Call – equivalent to an IRR of 7.60%

► Pickup 160 bps vs. fixed rate bond

► View: Rates will remain Stable

► Duration will vary from 30 to 5 as rates change

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USD Structures – Callable Snowrange

► Memory Feature

► Receive enhanced yield pickup from linking coupons to previous coupons

► Example Terms

Maturity 10 Years

Coupon: Q 1: 10% * n/N quarterly, 30/360

Subsequently: Previous Coupon * n/N

n Number of days that USD 3M Libor < 7.00%

N Total number of days in Coupon Period

Call: Issuer has the right to call the note at par after three months and quarterly thereafter

► Pickup over 400 bps vs. fixed rate bond

► View: Mild bullish view on Libor over a long tenor. Has significant leverage which gives a high coupon even with a “safe” range on Libor

► Risk If rates rise sharply, coupon could be fixed at zero for rest of life irrespective of subsequent Libor move

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USD Structures – Range Accrual TARN

► TARN feature

► Trade called once sum of coupons reaches target level

► Example Terms

Maturity 5 Years

Coupon: 7.50% * n/N , quarterly, 30/360

n Number of days that 4.00% < USD 3M Libor < 6.00%

N Total number of days in Coupon Period

AutoCall : The note will automatically redeem when the total coupon paid under the structure reaches a sum of 11.25%
of the notional (ie earliest possible redemption in 1.5 years from the start date)

Global Cap sum of Coupons Paid will not exceed 11.25%

► Pick up will be lower than equivalent callable structure

► View: Range bound view on USD Libor over the next couple of years. Investor does not expect either an aggressive
tightening or easing from the Fed to get priced into short rates

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Conclusion

► Increasing liquidity of ILS Swap and Option markets has allowed a market in structured products to develop over the past year

► Major markets with greater liquidity in underlying markets offer a wider universe of IRD structured products

► As ILS markets develops further, we anticipate the full complement of USD IRD Structures to be replicated in ILS market

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