A family of complex debt instruments, referred to as \u201ccallable LIBOR exotics\u201d [1], are available to investors who
wish to enhance the yield on their portfolios. As discussed in the June 2005 FINCAD newsletter, one such
instrument is a \u201ccallable range accrual note\u201d. This instrument is priced in the FINCAD XL v9 product, along with
other exotic instruments such as callable range accrual swaps, callable capped floaters (both notes and swaps),
callable inverse floaters (both notes and swaps), and callable snowballs. Each of these instruments has a
complicated coupon that depends on floating interest rates, with multiplicative factors, additive spreads, and caps
and floors. Investors in these instruments are therefore exposed to interest rate risk. In addition, these instruments
contain embedded Bermudan-style call and/or put options. The instrument issuer (e.g., a bank) is long the call
option, which exposes the investor to re-investment risk. To compensate the investor for these risks, the issuer
offers a high initial coupon and sets an initial lock-out period during which the call option cannot be exercised. If
the investor predicts movements in interest rates correctly, then the high coupon will persist after the initial period
and the investor will obtain an above-market yield, at least until such time as the issuer calls back the note. If the
investor does not predict movements in interest rates correctly, then the investor may get stuck with a long-dated
instrument that pays little or no coupon over its life.

Snowballs (also referred to as callable snowballs or callable inverse snowballs) are somewhat different from range
accruals, capped floaters, and inverse floaters because snowballs are \u201cpath-dependent\u201d instruments. The current
coupon is given by the previous coupon plus a spread minus a floating interest rate, floored at 0%. In this way, the
coupon builds upon previous coupons, much like a snowball that accumulates snow and grows as it rolls along the
ground. For example, the first 2 coupons in a 10-year semi-annual snowball might be fixed at an above-market
rate of 6.5%. The remaining coupons, i = 3 to 20, are given by Ci = Ci-1 + 2% \u2013 6-month Libor setting in arrears.
If 6-month LIBOR consistently fixes at a small value (e.g., < 2%), then the snowball coupons grow over time. If 6-
month LIBOR consistently fixes at a larger value (e.g., > 2%), then the snowball coupons decrease over time. For
a very large fixing of 6-month LIBOR (e.g., 9%), the snowball can immediately melt all the way down to the floor of
0%.

Methods for the valuation of interest rate derivatives include closed-form solutions, lattice methods (e.g., trees),
and Monte Carlo simulations. Closed-form solutions are typically only available for the simplest of interest rate
derivatives (e.g., European exercise and a simple coupon). The features of snowballs that impact the choice of
valuation method include: (1) the coupon is path-dependent; (2) rates can set in advance or in arrears; and (3)
early exercise is possible (i.e., there are multiple call/put dates). The path-dependent feature means that one must
know about past coupons in order to determine the current coupon. This suggests that valuation is best
accomplished using a (forward-looking) Monte Carlo method, rather than a (backward-looking) tree-based
method. Rates setting on arbitrary dates (in advance or in arrears) are also more easily handled by a Monte Carlo
method than a tree-based method. However, the early exercise feature means that one must know about the
future in order to determine the value of holding the option as opposed to exercising early. The Bermudan
exercise feature is more easily handled by a (backward-looking) tree-based method than a (forward-looking) Monte
Carlo method.

The choice of an interest rate model for valuing an interest rate derivative is driven by the instrument features and
the valuation method. The LIBOR Market Model (LMM) is a popular model because the modeled quantities are
the market-observed forward rates, and the LMM is consistent with the market-standard approach for valuing caps
using Black\u2019s formula. The LMM is well-suited to Monte Carlo methods, and Bermudan exercise can be handled in
a Monte Carlo method using the Least Squares Monte Carlo (LSMC) algorithm proposed by Longstaff and
Schwartz [2]. The FINCAD snowball valuation functions use the LMM and LSMC.

The first step in the snowball valuation is to calibrate the LMM. The liquid calibration instruments in the interest
rate market are caps and European swaptions. The implied volatilities of caps contain information on the volatilities
of forward rates. The implied volatilities of swaptions contain information on both the volatilities and correlations of
forward rates. Snowballs are sensitive to both the volatilities and correlations of forward rates. Therefore, one
could choose to calibrate the LMM to both caps and swaptions or to swaptions alone. For example, the LMM could
be calibrated to liquid European swaption data, with swaption expiries corresponding to snowball rate fixing dates,
and swap floating leg rate terms corresponding to snowball rate terms. Alternatively, the LMM could be calibrated
to liquid cap data alone, with caplet expiries corresponding to snowball rate fixing dates, and caplet rate terms
corresponding to snowball rate terms. This calibration would capture the volatilities of the forward rates that
underlie the snowball, while the correlations between forward rates could be set based on historical data.
Calibration is a topic in the September 2005 FINCAD newsletter. Workbooks are available in the FINCAD XL v9
product for calibration of various interest rate models including the LMM.

The second step is to define a path of dates for the Monte Carlo simulation. These dates define a set of periods over which forward rates are evolved according to the LMM. Path dates include important instrument dates, such as rate fixing dates, coupon payment dates, and exercise dates. Given the paths of forward rates and a set of possible exercise dates, the LSMC algorithm is used to estimate the optimal exercise date for each path. Given the optimal exercise dates, the callable snowball is priced on each path. The price of the callable snowball is the average price over all paths.

The LSMC algorithm estimates the optimal exercise strategy by estimating an option\u2019s \u201ccontinuation\u201d and
\u201cexercise\u201d values on exercise dates. The continuation value is the value of the embedded option assuming the
option is not exercised immediately. The exercise value is the value of the option resulting from immediate
exercise. For snowballs, computations of the continuation and exercise values require nested Monte Carlo
simulations, which are computationally expensive. The LSMC algorithm is a \u201cdimension-reducing\u201d algorithm.
Instead of running nested Monte Carlo simulations of forward rates on each path, the LSMC algorithm regresses
the path-specific continuation values and exercise values over all paths against a small number of functions of
simple variables that are observable on the exercise date (e.g., a swap price and a forward rate). The exercise
strategy found by the LSMC algorithm is typically a sub-optimal exercise strategy (at best, the optimal exercise
strategy), so a lower bound on the value of the embedded option is obtained. Therefore, the LSMC algorithm
gives an upper bound for the price of the callable snowball because the investor is short the call option.

The choice of regression variables affects how closely the LSMC algorithm approximates the optimal exercise
strategy [1, 2]. The FINCAD snowball pricing functions provide a choice between two sets of regression variables:
either the 0th and 1st moments of the interest rate curve (i.e., the level and slope of the interest rate curve,
represented by a swap price per unit notional and a forward rate) or the sums of the random factors used to evolve
each forward rate. In the case of snowballs, the swap price and forward rate are expected to be the best choice
for regression variables because they are financially meaningful and significantly change in value when
continuation is optimal vs. when immediate exercise is optimal.

For payment purposes, Business Days are NY and LDN Business Days. For the purpose of the delivery of the notice, Business Days are NY, LDN, and TARGET Business days. For the purpose of the Reference Index, Business Days are LDN Business Days.

First we calibrate the LIBOR Market Model using co-terminal semi-annual European swaptions that expire on 5- Sep-2000, 5-Mar-2001, 5-Sep-2001, \u2026, 3-Mar-2005 such that the forward rates underlying the swaptions are the same forward rates that underlie the snowball (i.e., 6-month LIBOR forward rates that fix 7 business days before the end of coupon periods, which are on the 14th day of September and March). We use the FINCAD function aaCalibrateSwaption2_LMM to obtain calibrated values of the LMM volatility and correlation parameters.

Second, we generate the Monte Carlo path dates using the FINCAD function aaCallSnowball_LMM_fs_tbl. The
generated dates and the LMM parameters are input into the FINCAD function aaCovarMatGen2_LMM to generate
a forward rate-forward rate covariance matrix.

Finally, the covariance matrix and the snowball details are input into the FINCAD function aaCallSnowball_LMM_fs
to get the price of the snowball. Using 10000 Monte Carlo paths, the 95% confidence interval for the price of the
callable snowball is [88.26, 88.38] per 100 notional. An example spreadsheet showing this last step is given in the
Figure below. Recall that this price range is an upper bound on the price. The upper bound approaches the true
price as the exercise boundary estimated by the LSMC algorithm approaches the optimal exercise boundary.