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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5 5 4.5 6 5.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 4 3.5 3 0 ILS Swap Rate 5 USD Swap Rate 4 10 Maturity 15 20 .

5 5 4. mirroring major markets with accompanied steepening of the curve 7 6.5 4 3.ILS Market – Rate History ► Market Conditions ► Market rallied significantly from the third quarter of 2006 ► Sharp sell off over the past month.5 3 Jun-06 Jul-06 5yr Swap Aug-06 Sep-06 3m Telbor Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 5 .5 6 5.

40% due to multiple call rights 6 .ILS Structures – Multicallable ► Rationale ► Receive enhanced yield in return for taking duration risk ► Example Terms Maturity Coupon Call 15 years 6. 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. fixed rate bond in excess of 50 bps ► Risk – rates fall quickly.40% annual Act/365 Issuer has the right to call at par after 1 year and every year thereafter ► Pick up vs.

ILS Structures – Range Accrual ► Rationale ► Receive enhanced coupon as long as Telebor-3M remains within a range ► Example Terms Maturity Coupon n N Barrier 5 years 6.50% each year ► Pick up vs.5% * n / N annual Act/365 number of calendar days in a period where Telbor3m < Barrier total number of calendar days in a period Year 1: 5%. fixed rate bond in excess of 100 bps ► Risk – rates rise quickly above Barrier level leading to reduced coupon payout 7 . thereafter increasing 0.

000 2.Dec10 10 Mar11 Jun11 Sep11 Dec11 Mar12 .Dec08 08 Mar09 Jun09 Sep09 8 Dec.000 7.000 5.Dec.000 3.000 0.000 Jun.Sep.000 1.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.Mar09 10 Jun10 Sep.000 6.000 4.Mar07 07 07 08 Fwd Rate Barrier Jun08 Sep.5% coupon will be received for whole life 8.

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 Coupon CMSn 5 years max[ 8 * (CMS10 – CMS2). 0] n-year ILS Swap Rate annual Act/365 ► 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 9 .

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

5 5 4.5 3 0 USD Swap Rate 10 EUR Swap rate 11 20 30 40 50 .5 6 5.5 4 3.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.

7 12.6 30Y 15.7 11 10.4 4Y 16.3 9.3 13.9 9.1 15.8 12.6 15.7 9.3 9.2 8.9 12.4 15.5 9.3 10.2 10.3 10.3 12.1 13.3 8.3 10.2 9.4 12.8 9.1 12.5 9.1 14.7 13.4 13.5 12.8 11.4 10.8 11.7 13.5 13.4 15Y 16.1 12 11.8 13.1 14.3 9.5 13.2 13.4 12.9 13.4 8.9 13.6 12.9 12.75 2Y 14.7 13.5 13.7 25Y 15.4 10.6 13.4 13.8 13.9 14 13.2 10.6 12.3 12.15 7Y 17.9 10Y 17.4 14.1 11.8 11.7 11.9 11.8 12 11.5 14.4 10.7 14.1 10.8 11.3 12.2 12.1 11.4 12.4 10.8 9.7 10.8 11.8 12.6 12.6 13.7 14.9 13.5 12.5 13.4 11.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 1M 3M 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y 15Y 20Y 30Y 1Y 7.6 13.6 13.85 13.1 13.5 12.3 13 12.7 12 11.2 11.5 11.3 12.55 12 .7 13.4 13.7 13.7 13.9 13.65 12Y 16.3 13.5 11.7 11 10.9 11.1 12.2 13 13 12.3 12.2 13.6 12.6 14 12.5 11.3 15 14.5 11.6 13.8 12.8 11 10.8 9.7 12.9 11.2 11.8 14 12.25 5Y 17.4 9.8 11.8 12.3 13.8 14.05 20Y 16 14.1 13.9 11.5 3Y 15 14.8 11.8 13.

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 13 .

00%. qtrly 30/360 unadj Subsequently: 6 * (USD CMS30 – USD CMS 2) + 4.00 % .00%. Cap/Floor: Call: Each quarterly coupon is capped @ 9. floored at 0.00% 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 14 .USD Structures – Callable Steepener ► Combine Risk Features ► Coupon Stream linked to curve steepness with enhanced yield from call features ► Example Terms Maturity Coupon: 5 Years Q1-Q2: 7.

60% ► Pickup 160 bps vs.USD Structures – Callable Zero Coupon ► Zero Coupon Format ► Receive enhanced yield pickup from taking higher duration risk ► Example Terms Maturity Issue Price Coupon Redemption: Call: 30 Years 100% 0% 900% (IRR 7. fixed rate bond ► View: Rates will remain Stable ► Duration will vary from 30 to 5 as rates change 15 .60%) Issuer has right to call at after 5 years and annually thereafter Redemption at Call – equivalent to an IRR of 7.

coupon could be fixed at zero for rest of life irrespective of subsequent Libor move 16 . Has significant leverage which gives a high coupon even with a “safe” range on Libor ► Risk If rates rise sharply.USD Structures – Callable Snowrange ► Memory Feature ► Receive enhanced yield pickup from linking coupons to previous coupons ► Example Terms Maturity Coupon: 10 Years Q 1: 10% * n/N quarterly. 30/360 Subsequently: Previous Coupon * n/N n N Call: Number of days that USD 3M Libor < 7. fixed rate bond ► View: Mild bullish view on Libor over a long tenor.00% Total number of days in Coupon Period Issuer has the right to call the note at par after three months and quarterly thereafter ► Pickup over 400 bps vs.

50% * n/N . quarterly.25% of the notional (ie earliest possible redemption in 1. 30/360 Number of days that 4.00% < USD 3M Libor < 6.00% Total number of days in Coupon Period The note will automatically redeem when the total coupon paid under the structure reaches a sum of 11.5 years from the start date) 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 17 .USD Structures – Range Accrual TARN ► TARN feature ► Trade called once sum of coupons reaches target level ► Example Terms Maturity Coupon: n N AutoCall : Global Cap 5 Years 7.

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 18 .

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