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# Structured Rates Manual

Private Investor Products

Introduction

Interest rate linked structured notes, whose payoffs depend on future interest rates, have been very popular in recent years with Private Investors. The appeal of structured products lies in their ability to deliver highly customised returns for investors, consistent with their unique investment objectives. This manual highlights the range of structured rate products and intends to provide private wealth managers and their clients with a selection of different investment opportunities, which enables one to express specific views on any future interest rate development. All structures can be in either note or swap form. Included in the manual is a consideration of the investor’s view versus his risk appetite. While structured rate products are flexible instruments by nature and almost every product can be structured to suit the investor’s risk appetite, some products will appeal more to the conservative investor while other products suit investors with a strong view or a more aggressive attitude. Most notes are sold in principal protected form, whereby only the coupon is at risk. It is also possible to generate more upside potential by structuring the product so that (part of) the notional is at risk. Views on absolute interest rate levels and relative differences between interest rates can be expressed through interest rate linked structured notes.

**Key Advantages of Structured Rate Products
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Highly Customised: Structured rate products are tailored to fit investors’ unique requirements. They create riskreturn profiles that would normally be inaccessible to the private investor. Enhanced Yield: By expressing a view and accepting a certain risk, investors can achieve higher returns on their investments than they would receive with traditional products. Convenience: The use of structured rate products allows particular risk-return payoffs that can be difficult or expensive to create in the markets available to the investor.

Potential Clients

> > > > > Private Investors Asset Managers Private Banks Corporates Insurance Companies and Pension Funds For any additional information regarding structured rate products, please contact your local sales representative. 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.

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Table of Contents

**Methodology Building Blocks Credit Linkage FX Linkage/Quanto Risks Product Map Product Descriptions Floaters
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Floating Rate Note CMS/CMT Linked CMS Spread: > Steepener Note (Leveraged CMS Spread Note) > Flattener Note > Digital CMS Spread Note > CMS Spread Range Accrual > Minimum Coupon Spread Note > CMS Spread Inverse Floater Ratchet: > Ratchet Note > Normal Capped Floater

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**Features (and their most popular variants)
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Snowball: > Snowball Note (Ladder Note) > Resetting Snowball > SnowRange Note > Snowbear Note (Reverse Snowball) > Snow TARN > Thunderball Callable: > Bermudan Callable Note > Callable Zero Coupon Note > Callable Inverse Floater Target Redemption (TARN) > Guaranteed Inverse Floater TARN > Guaranteed Ladder Inverse Floater TARN > Guaranteed Capped Floater TARN > Guaranteed Fixed Range Accrual TARN > Guaranteed SnowRange TARN > Hybrid Coupon TARN Multi Index > Double Digital Note > Linear Trigger Note > Dual Range Note > Dynamic Cap Note 29

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32 34 36 38

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Range Accruals

Range Accrual: > Normal Range Accrual (lower or upper boundary) > Callable Range Accrual > Corridor Range Accrual > Double Range Accrual > CMS Spread Range Accrual > Minimum Coupon Range Accrual > Floating Range Accrual > Step-up Coupon Range Accrual > Variable CMS Range Accrual One Look: > One Look Digital Note > Multi Look Note 23

Other Products

Volatility Note Bond Discount Note 45 46 48 49 52 54 56 58 60 63 66 67

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Appendix Most Popular Products Structured Note Market Turbo Certificates Interest Rate Models Modelling Processes Yield Curve Considerations Glossary Disclaimer Contacts

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Callable Notes have an unknown maturity (the issuer holds the option of early redemption). in order to exploit the value of the curve. the structure benefits from increasing rates. Vega. Description of Product This section explains in more depth the mechanics of the structure. The “shock” to the level and slope was standardised across products. but less than implied by the forwards. Investors should also be aware of some basic concepts. for maturities displaying positive delta. Considered are a parallel upward and downward shift and a steepening and a flattening. it is important for investors to realise that it is relative to the forward curve. it does provide investors with an idea of ways in which the product can be tailored to meet their specific needs. Variations Here a summary of some of the more popular variations on the basic product is given. which are summarised in this section. Sensitivity to Rate Moves The Delta Profile indicates the yield curve view of the structure. dependence on more than one index (Multi Index). Furthermore. Nevertheless. Common risks include (but are not limited to): coupon risk. reinvested at the six month interest rate in six month’s time (the 6 month forward rate). attempts to categorise and classify them will always be open to debate. Market View The Market View outlines in more detail the view on interest rates which is expressed through the product. Coupon payments can be capped (increasing the participation but maximising the upside). the payoff can be quantoed. for example. investors can add features to their “basic product” Occasionally. and the redemption structure. Importantly. When considering the market view expressed by a structure. Minimum IRR (Lifetime Floor). the market view is expressed in relation to the implied forwards. he should actually take a bullish position. or FX Linkage (see Building Block: FX Linkage: Quanto). The sensitivity to yield curve movements is summarised diagrammatically for the product specified in the example. To enhance returns. reinvestment risk (arising from callability). or the notional can amortise or accrete. Again. a one year interest rate will give the same return as the current six month interest rate. that they become products in their own right. most products can be customised so as to fit a different rate view. different ways and linked to an endless variety of indices. Although the focus is primarily on the basic structure. capped and floored (also known as a corridor). If the investor believes that the rates will rise. and the potential rate views it may suit. mark-to-market risk. Almost all structured rate products can have the following extra features: Callability. with most structures there is enormous scope for customisation. forward curves are a graph of forward rates versus maturities. In general. These include: the importance of the Forward Curve. the fixing of the index can be in arrears (a few business days before the coupon payment date) as opposed to normal fixing in advance.Methodology Building Blocks Summary All product profiles have been generated and presented using a standardised and rigorous procedure. and Correlation. how the coupon is determined. Automatic Redemption (as soon as a certain coupon is reached: Lifetime Cap: TARN). consideration of possible Yield Curve Movements. features are so popular . The larger the delta for a maturity. and indicates the kind of inputs which affect the profile. investors should be aware of the huge potential each product has for customisation. floored (guaranteeing a minimum coupon). Also Consider This final section suggests alternative structures which investors should consider. Forward Curves Forward rates are the interest rates between any two future periods implied by the current yield curve. Target Redemption Notes automatically redeem as soon as an aggregate coupon level is reached (TARN). Different risks apply to different products. and principal risk (if not capital guaranteed). or only accrue if certain conditions are met (as in the Range Accrual structure). there are still inherent risks. allowing the reader to gain a greater understanding of how it works. the Delta Profile of a note. which graphically depicts the interest rate sensitivity that the specific example has. the more impact the interest rate change has on the mark-to-market of the structure. In order to form the “basic product” the coupon can be tailored in many . Summary Given the highly flexible nature of structured products. Product Summary The Product Summary provides a snapshot of the main features of the basic product. certain basic “building blocks” apply to all structured products. relevant to all products. Just as the yield curve is a graph of interest rates versus maturities. Note also that the steepening/ flattening scenarios were driven by rate movements at both ends of the yield curve (as opposed to a bullish or bearish steepening/flattening – see Basic Concepts) and that changes in the structure may change the sensitivity to rate moves. So today’s 1 year rate and today’s 6 month rate imply what the 6 month rate will be in 6 months time. Additionally. It is worth noting that the Summary only describes the basic product. For example. and for maturities displaying negative delta. Zero Coupon Notes deliver all accrued interest with the notional at maturity. Coupon/Payoff Profile The payoff is designed in such a way that it optimally expresses the view of the investor. floating. Perhaps the most important aspect of this section is the Delta Profile. based on their market view. such as the coupon/payoff profile. The delta profile is constructed by shifting one rate at a time by 1 basis point (keeping all other rates constant) and re-valuing the structure. Whilst the list can never be exhaustive. inverse floating. The delta shows the change in the position’s value resulting from a basis point change in the underlying interest rate. The product is broken down into its constituent parts. or formula-driven coupon. Features Risk Even though most (but not all) products are capital guaranteed. They are constructed under the principle that. Path Dependency (via the Snowball family). it is also possible to structure the note such that (part of) the notional is at risk. The layout of the product profiles is as follows: Example Basic details of one possible structure are given. Credit Linkage (see Building Block: Credit Linkage). Although most structures are capital guaranteed. the structure benefits from falling rates. an expectation of decreasing rates will only be profitable if rates fall by more than implied by the forward curve. Redemption Structure Structured notes can also be classified by their redemption profile: normal “Bullet” notes have the full notional paid back at maturity. The investor can choose between a (contingent) fixed. optional features/enhancements. Investors who take bearish portfolio positions when they expect yields to rise (but who ignore the forward rates) may find that their positions generate a below-market return despite their rate forecast being correct. An investor should only take a bearish position if he expects rates to rise more than implied by the forward rates. 6 7 . thus broadening the scope of indices available for the investor to express a view on (see Building Block: FX Linkage).

Delta Profile of a Range Accrual Maturity Maturity Upward Shift Yield Bearish Flattening Yield Bearish Steepening Maturity Maturity Maturity Maturity 1 0 Curve Flattening Hence. Curvature: It covers most other movements. Bullish Flattening Yield Yield Bullish Steepening Delta Profile An investor’s structured note position is clearly subject to interest rate risk. it is easy to see the yield curve view that the position expresses. the investors structure changes in value. and short term rates rise (by a lesser amount) Yield Slope: A change in the Slope of the yield curve occurs when long term yields and short term yields become closer together (a curve flattening). the more in line they move. the position can be subject to the interest rate risk across all maturities. Changes in the Level of the Yield Curve Downward Shift Yield Yield Changes in the Slope of the Yield Curve Curve Flattening Yield Yield Changes in the Curvature of the Yield Curve Increased Curvature Yield Yield Vega Another important indicator of the risk of a structure is its Vega. the overall interest rate view expressed by this position is of a yield curve flattering. From this. or a bearish flattening (when driven by a rise in short term yields). Delta -1 -2 Positive delta at shorter maturities implies that the structure will benefit from rising short term rates Negative delta at longer maturities implies that the structure will benefit from falling long term rates Maturity Curve Flattening Maturity 8 9 . A curve flattening can be either a bullish flattening (when the flattening is driven by a fall in long term yields). not just the rates that their coupon is directly referenced to. which is simply how “curved” the yield curve is. Maturity Curve Steepening Decreased Curvature Maturity Maturity Maturity Correlation Correlation is the degree to which one variable fluctuates in line with another variable. Similarly. Level: A change in the Level of the yield curve is represented by a parallel shift. Hence. Volatility is a key parameter in the pricing of derivatives and changes in volatility changes the value of a structure. and the sensitivity to this risk is measured by delta. Movements and changes in shape can be split into three components: level. increased curvature is represented by a more “humped” yield curve. Correlation risk is the risk that due to a change of correlation between two indices. The structure will benefit most if long term rates fall. The higher the correlation between two variables. or when short term yields and long term yields become further apart (a curve steepening). This type of movement explains the vast majority of yield curve movements. which shifts yields at every maturity up or down by the same amount. the position’s Delta Profile maps out the interest rate sensitivity across all maturities.Yield Curve Movements Investors’ primary concern lies with yield curve movements and changes in shape. which measures the structure’s sensitivity to volatility. a steepening can be bullish (when driven by a fall in short term yields) or bearish (when driven by a rise in long term yields). Driven largely by the level of uncertainty over future rate movements. However. slope and curvature. because this is what determines their returns.

5 days a week. finally closing on Friday at 16:30 EST (21:30 GMT) in New York. the volatility of the underlying forward value. For example. which is the value of the defaulted Reference Entity’s bond adjusted for Swap Multiple Names Instead of single name exposure.it is the risk that one party owing money to another party. The investor “insures” the counterparty against default. reducing the exposure on one single name. or files for Chapter 11 protection. the investor has to pay an amount equal to the losses incurred on holding debt of the defaulted company. the CDS ceases to exist. Leverage can also be increased or decreased using a synthetic (CDO) structure. these economic factors are themselves influenced by the level and volatility of FX. ABN AMRO now offers investors the possibility to enhance returns by incorporating an element of FX risk. Small changes in the FX rate can have significant effects on (for example) imports and exports. inflation. In case of default (called a Credit Event). Quantos are attractive. Hence. the structure is not principal guaranteed. trade and investment flows. or 20:00 GMT.Yield Enhancement Yield Enhancement Building Blocks – Credit Linkage Building Blocks – FX Linkage/Quanto Summary While most structures are designed to provide exposure to interest rates only. Credit Linkage can be applied to any structure. growth. Rationale FX Linkage (Multi Index) Demand for additional yield is the main driver behind the growing popularity of FX linked interest rate hybrids and other exotic structures. without being exposed to the associated FX risk. However. Sunday) and then moves around the globe through the various trading centres. Key parameters are the forward value of the underlying. placed under administration.2001. By adding a second constraint. > Instead of exposure on a single index (for example 6 months EURIBOR). may not pay. The investor has mark-to-market exposure to credit spread movements. domestic currency. with daily trading volumes in excess of 1. In the event of default the investors’ note will be redeemed at zero and receive the recovery value (if any) adjusted for swap unwind costs. Credit derivatives are a class of financial products designed to isolate the credit risk of an entity. because they shield the purchaser from FX fluctuations. the yield can further be enhanced. on an occurrence of a Credit Event with respect to the Reference Entity. investors can benefit from steep curves in other markets. Euro. In note form (called a Credit Linked Note. After this. Another possibility is the quanto mechanism. Foreign Exchange In terms of trading volume. the note will be redeemed at zero and the investor will receive the Recovery Amount. Companies have de-leveraged significantly following the excesses of 1999 . the spot and forward exchange rates. The basic building block is the Credit Default Swap (CDS). thus avoiding potential FX risk. a structured note paying a fixed rate which is enhanced by Credit Linkage may be switchable into a “credit only” note with a fixed or floating coupon payment. The currency exchange market is a true 24-hour market. while receiving flows in their Switchable A Credit Linked structure is usually not callable. or vice versa. but the payoff depends on an index denominated in Currency B (for example 6 months USD LIBOR). so is the perceived risk (as expressed in the credit spread). For structures involving the sale of options. These events are known as Credit Events. Trading begins Monday morning in Sydney (corresponding to 15:00 EST. the investor can opt for linkage to a (linear) basket of Reference Entities. such as the US Dollar. Examples > A note is denominated in Currency A (say Euros). which can be made switchable (rather than callable). a quanto contains an embedded currency forward with a variable notional amount (“quanto” stands for quantity adjusting option). affecting potential future growth. Essentially. In other words. Regular Premium Income Credit Events In the context of credit derivatives. This is called a Quantoed note. Credit Derivatives Whilst the credit derivatives market has been in existence since the early 1990’s. Payment upon default Summary Whilst most structures in this manual are designed to provide exposure to interest rates only. and the correlation between the forward value of the underlying and the forward FX rate. The Swap unwind costs represent the mark-to-market value of the embedded (and in this manual described) interest rate swap. giving an investor regular income in exchange for the credit risk of a third party. Risks A bet on multiple indices will increase the probability of a below-market or zero payout. In the long run. unwind costs. and (implied) recovery rates high. the payoff depends on a second index as well (for example the EUR/USD exchange rate). CLN). the FX market is by far the world’s largest and most liquid market. Although credit spreads are historically low. Investor CDS Counter Part Rationale Demand for additional yield is the main driver for the growing popularity of credit linked interest rate hybrids and other exotic structures. Japanese Yen. three events are described as defaults: bankruptcy. with the payoff in currency B. the quanto mechanism allows investors (who “sell” volatility) to benefit from high implied volatility (at inception) of indices in foreign currencies. FX levels are determined by real economic factors such as interest rates. with the payoff in another. Even central banks and governments find it increasingly difficult to affect the exchange rates of the most liquid currencies. The payoff is determined by a variable measured in one currency. an investor can take advantage of the expected levels of many indices in almost any given currency. or increase the leverage by using a First-To-Default (FTD) basket. failure to pay and restructuring. Canadian Dollar or Pound Sterling. ABN AMRO now offers investors the possibility to enhance returns by incorporating an element of credit risk. pays a coupon in Currency A and redeems in Currency A. with dealers in every major time zone. but switchable. default rates are low. Risk By embedding exposure on a Reference Entity. without assuming FX risk or needing to enter into a Cross Currency Swap. the volatility of the forward FX rate. The quanto mechanism suits investors with the view on an index denominated in a certain currency (or investors who want to use the value in a particular index) but who want to receive the payoff in another currency. Swiss Frank. Under normal circumstances this volume makes it impossible for individuals or companies to affect FX rates. Credit risk is a familiar concept . 10 11 . This is called a Multi Index Note. Quanto A quanto or cross-currency derivative is an instrument involving two currencies.5 trillion USD. Bankruptcy: where the Reference Entity becomes insolvent. which can broaden the scope of indices available for the investor to express a view on. With a quanto derivative an exposure can be on an index in currency A. such as a corporation. Failure to Pay: where the Reference Entity defaults on interest or principal payments due on its debt. it is only since 1999 that the market has really taken off. Restructuring: where the Reference Entity restructures the terms of its debt to the disadvantage of the debt holders.

Where this happens the investor may have to reinvest into another structure with less advantageous conditions in the market. when investing in a note. Lower Rates Interest Rate Risk Interest rate risk is the risk that the value of the structure changes due to a change in the absolute level of interest rates. Client’s Attitude to Risk Client’s View Aggressive >Multi Index Note > Step-Up Lower Boundary Range Accrual > One Look Note > Snowbear Note > Lower Boundary Range Accrual TARN > Geared CMS Note > Turbo Short Bond Future > Corridor Range Accrual > SnowRange Note > Target Redemption Note > Bond Discount Note > Snowball > One Look Note > Callable Inverse Floater > Multi Index Note > Upper Boundary Range Accrual > One Look Note > Leveraged Inverse Floater > SnowRange Note > Thunderball & Snowball > Target Redemption Note > Multi Index Note > Snow TARN > Turbo Long Bond Future > Leveraged Steepener Note > Digital CMS Spread Note > One Look Note (on CMS) > Multi Index Note > Leveraged Flattening Note > Target Redemption Note > SnowRange Note > Digital CMS Spread Note > Multi Index Note Medium Conservative > Ratchet Note > Floating Lower Boundary Range Accrual > CMS Linked Note > Capped Floater > Minimum Coupon Range Accrual > Floating Rate Note > Capped CMS Note > (Callable) Range Accrual > (Callable) Zero Coupon Note > Callable Note > Ratchet Note > Normal Bond > Minimum Coupon Range Accrual Reinvestment Risk If the note is callable the issuer has the right to redeem the structure early. Stable Rates Market Risk Market risk can impact all asset classes. credit risk. Over time the MtM of an investment may be positive or negative due to all the above elements. Risk in this context entails two essential components: exposure (to potential loss) and uncertainty (over expected returns). A downgrade of the issuer will negatively affect the markto-market of the investment. These are closely related but are considered separately to give a deeper insight. Some assets are highly liquid and have low liquidity risk (like a stock of a public traded company). Furthermore. the inherent risks may not be obvious. the investor is exposed to a change in the credit quality of the issuer. Asset allocation and diversification can be applied to minimise this risk. but it is important to Note that at maturity redemption is at the pre-agreed level (mostly Par). Common risks include (but are not limited to) market (interest rate) risk. Over the life of the transaction.Risks Product Map Summary Although risk is a generally understood concept. the investor is exposed both to the movement of the underlying as well as to the credit quality of the issuer. > Callable Zero Coupon Note > Normal Bond > Upper Boundary Range Accrual > Upper Boundary Range Accrual > Callable Inverse Floater > Bermudan Callable Note > Bond Discount Note > Minimum Coupon Range > Resetting Snowball Accrual > Multi Look Note > (Callable) Zero Coupon Principal Risk Principal risk. corresponding changes in the value and volatility may negatively affect the value of the investment. it is useful to define what it means for a buyer of a structured rate product. while other assets are highly illiquid (such as property). Credit Risk Credit risk is the risk that a loss will be experienced because of a default by the counterparty (issuer). can be divided into: 1) risk of the issuer defaulting (this aspect is covered in credit risk) and 2) the possibility to structure the note such that (part of) the notional is at risk. the coupon is usually conditional upon specific levels. Higher Rates > Floating Lower Boundary Range Accrual > Floating Range Accrual > Multi Look Note Liquidity Risk Liquidity risk is the risk that arises from the difficulty of selling an asset or note. creating the exposure sought by the investor. Under certain market conditions a structured note might be difficult to offset either because the unwind costs are relative high or because it is difficult to find a counterparty. mark-to-market risk and coupon risk) are the outcome of the different risk types. in the shape of the yield curve or in any other interest rate relationship. Due to economic changes or other events that impact the market. in the difference between two rates. A high coupon will be paid if the embedded view proves to be correct. In the event of Steepening > CMS Spread Range Accrual > Digital CMS Spread Note > Dynamic Cap Note Mark-to-Market Risk The mark-to-market (MtM) of an investment is its value at a specific moment. the investor might either receive a fraction of the notional (the “recovery rate”) or lose the full notional invested (worst case scenario). a default. > CMS Spread Range Accrual > CMS Linked Note > Minimum Coupon Spread Note > Dynamic Cap Note Flattening > CMS Spread Range Accrual > Digital CMS Spread Note > CMS Spread Range Accrual > Minimum Coupon Spread Note 12 13 . Backtests or forward projections are not a guarantee of realizing the projected coupons. The value of an investment is dependent on the value of the underlying asset and its variability (volatility). > Corridor Range Accrual > Callable Range Accrual > Bond Discount Note > Callable Zero Coupon Note > Resetting Snowball > Multi Look Note Coupon Risk In a structured rate product. the risk of losing (part of) the notional. Structured rate products often contain “plain vanilla” or highly exotic embedded options. liquidity risk and reinvestment risk. barriers or triggers. and other less obvious factors such as volatility and correlation. The credit quality of an issuer is reflected by its rating as assigned by rating agencies and by its credit spread in the market. Some risks (principal risk. As each structured product is unique. a below market or even zero coupon will accrue if the view proves to be (partly) incorrect.

04 Description of Product An FRN is similar to a vanilla interest rate swap. Risks A decrease in rates or a smaller increase than implied by the forwards will result in an opportunity loss versus a fixed coupon security. on the coupon payment date). The fixing of the floating interest payment is normally in advance (i. The cash flows are exchanged at the end of each interest period. 2 business days before the start of the coupon period) and the payment in arrears (at the end of the coupon period.e. the investor gives the notional to the issuer and in return receives floating interest payments. in a normal FRN the first coupon is already fixed. The 5 year negative delta seems large but is very small on an absolute basis. Example: Floating Rate Note Currency Maturity Coupon ABN Receives EUR 5 years 6M EURIBOR + 3bps. -0. 0. based on a pre-agreed amount. These notes are also known as Floaters. In an FRN. So. An FRN is a note whose interest rate is periodically adjusted according to the interest rate of a specified short term index. with the floating rate fixing a few days before the coupon payment date.a.e. the sensitivity to interest rate moves is minimal.02 -0. likes the note to trade around Par regardless of interest rate movements). As expected for a floating instrument.06 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y In the graph the delta profile of the 5 year FRN shows the interest rate sensitivity of the structure. term and conventions. an agreement between two counterparties to swap a floating interest rate for a fixed interest rate (or vice versa).00 Delta -0. rather than at the start of the coupon period > It is possible to construct an Inverse Floater variant if rates are expected to decrease Also Consider > CMS linked Note > Capped Floater > Ratchet Note 14 15 .Attitude to Risk: Conservative Floating Rate Note (FRN) Summary A Floating Rate Note (FRN) suits an investor with the view that interest rates will go up. or who wants to be protected against rising interest rates.02 0. Sensitivity to Rate Moves An FRN has no significant sensitivity to curve moves. 30/360 Notional Delta Profile of 5Y FRN Market View An FRN suits an investor with the view of increasing rates (or higher future rates than implied by the forwards) or an investor who does not want delta exposure on the yield curve (i. The investor is therefore hedged against the consequences of rate moves. s. Variations > The coupon can be capped to increase the participation or add a spread above the floating rate (Capped Floater) > The coupon can be floored to guarantee a minimum coupon > A Corridor can be constructed which minimises and maximises the coupon > The fixing can be in arrears.

Hence. the note may trade below par during the life of the transaction. Convexity measures the curvature in the relationship between bond prices and their yields. The delta profile of the CMS Linked Note is shown the graph. the structure benefits from rising rates for current maturities of eleven years or more. since the participation level is different (82. A steepening of the yield curve will be positive for the structure.Attitude to Risk: Conservative Attitude to Risk: Conservative CMS/CMT Linked Note Summary A CMS Linked Note suits an investor with the view that the yield curve will steepen. However. the deltas have a slightly different weighting and could result in some (although limited) parallel shift exposure. Example: CMS Linked Note Currency Maturity Coupon ABN receives EUR 10 years 82. which is periodically reset. The benefits of convexity cause more convex bonds to have higher prices and consequently lower yields. increasing the participation level in the CMS but limiting the upside > The CMS coupon can be floored. The coupon payment in a CMS Linked Note is referenced to a constant maturity swap rate. if rates fall their price rises by more. A CMS Linked Note is especially attractive in a flat yield curve environment. the structure benefits from a steepening of the yield curve.5% of the 10 year versus 100% of the 6-months). The 10Y delta is negative as the note is a 10Y structure and the 10Y delta represents the notional as in any floating rate instrument. It is the longer dated yields which reflect the implied 10Y constant maturity rate. guaranteeing a minimum payment. Conversely. Upward Shift Yield Yield Curve Flattening Maturity Maturity Risks A Flattening of the curve will have a negative impact on the mark-to-market of the structure. the CMS Linked Note enables investors to gain a floating exposure to a longer term rate. whereby the investor profits from a decline in a specified CMS rate > Steepener Note > CMS Spread Range Accrual with CMS coupon 16 17 . Although the coupon payment will benefit from an increase in the indexed (long term) rate. 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. Market View CMS Linked Notes suit investors with the view that the yield curve will steepen. the structure benefits from falling rates for current maturities of ten years or less. A parallel shift will have limited impact. A parallel shift will have limited impact. the mark-tomarket effect of the parallel upward (downward) shift is small as the funding costs (i. Also possible is a Constant Maturity Treasury (CMT) which is referenced to a particular maturity US Treasury. When transacted in note form. By referencing to longer term constant maturity swap rates (typically between 2 and 30 years). if the curve shape doesn’t change. A flattening of the yield curve will be negative for the structure. The investor profits from an increase in volatility due to the convexity adjustment (the investor is said to be “long Vega”). Also Consider Variations > The CMS coupon can be capped.50% of the 10Y CMS 6M EURIBOR or Notional Sensitivity to Rate Moves Overall. 4 0 Downward Shift Yield Yield Curve Steepening Delta -4 -8 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 20Y Maturity Maturity Description of Product A Constant Maturity Swap is a floating-for-floating interest rate swap. exchanging a LIBOR Rate for a particular swap rate. Bonds with high convexity perform better if rates change. The CMS Linked Note is attractive when the forward swap curve is flat as it will increase the participation level (or gearing) in the longer dated rate.e. if rates rise their price falls by less. the short term rate) increases (decreases) as well. Parallel shifts should not have too much of an impact as the underlying swap is floating-for-floating.

which accrues a high coupon for every day the difference between two indices stays above a certain strike. and the client receives coupons for days when the curve is not inverted. giving a positive effect on the mark-to-market of the structure (the investor is said to be “long” correlation). If the curve becomes steeper.00% with a value of the structure close to a Zero Coupon Note). flattening and stable curve view. the investor prefers rates to go down). with many investors betting against an inversion of the EUR yield curve. because they will get a higher yield pick-up (since lower correlation makes it more likely for the structure to breach the range). Once the option sold becomes in-the-money the investor prefers correlation to decrease. A parallel shift upwards will normally be negative for the structure as the coupon is fixed. Here the investor receives a high fixed coupon minus the (leveraged) difference between 2 indices. In general. Variations > The structure can leverage on a steepening of the curve (Steepener Note) by paying a coupon of X times (10Y – 2Y) > The structure can leverage on a flattening of the curve (Flattener Note) by paying a coupon of X – (Y times (10Y – 2Y)) > The CMS Spread Range Accrual Note (see example) accrues a day’s worth of coupon for every day the CMS spread fixes within a predefined range > A Digital CMS Spread Note pays a certain coupon if the CMS Spread meets a predefined condition. Higher volatility of the spread at inception will increase the coupon. As the investor is basically long the 10Y CMS and short the 2Y CMS. This is currently a popular trade in the market. correlation is important. If an investor expects a steepening of the curve. a Flattener (similar to an Inverse Floater) will be attractive. 30/360 Number of days (10Y CMS . which the investor obviously prefers to go up as it increases the probability of a positive curve. The effect of a slope move depends on the relative level of the curve. the investor prefers high correlation (if the option he sold is still out-of-the-money) because the likelihood of the spread between the two indices breaching the range would be lower. In a Flattener the investor buys the cap on the long term rate. although part of the delta is the notional effect as it is a 20 year note. The investor only achieves an above market return if the curve steepens more than implied by the forwards. when buying a CMS Spread Range Accrual (assuming the investor sells out-of-the-money options). the investor profits significantly. Although the structure obviously likes the curve to stay positive sloping (and a steepening of the curve increases the probability of receiving the coupon). After trading. In a CMS Spread Range Accrual the client sells a series of daily Digital CMS Spread Floors. Downward Shift Yield Yield Curve Steepening Market View CMS Spread Notes suit investors with the view that a chosen spread will remain relatively unchanged. a note paying a multiple of the difference between 2 indices may be appropriate (for example: 8 x (10Y – 2Y)). become bigger or become smaller than that implied by the forwards for the index. Another alternative is a CMS Spread Range Accrual. As the structure has a fixed (range accrual) coupon. The payoff depends on the difference between two indices and can suit a steepening. Maturity Maturity Upward Shift Yield Yield Curve Flattening Delta Profile of a CMS Spread Range Accrual 20 0 Delta Maturity Maturity -20 Risks 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 20Y 25Y 30Y -40 An adverse movement of the curve can result in a below market or zero coupon structure (worst case scenario: annual coupons of 0. The interesting part is the positive delta in 25 year and 30 year. Also Consider > Target Redemption Notes (if expecting a flatter curve) > CMS Note (if expecting a steeper curve) 18 19 . and if the investor’s view is digital by nature (i. If the investor’s view is of a flattening curve. the positive delta in year 30 is explained as the 10Y CMS rate in year 20. making it more likely that the curvature will move back in his favour. investors prefer low correlation at inception. When transacted in note form. Current forward rates imply that 2Y rates will exceed 10Y rates in 2018. In the Steepener the investor buys the cap on the short term rate.10% x N/M) annual. the negative delta in year 20 is expected (i.e. ABN AMRO would receive a day’s worth of coupon for every day the curve is inverse. The effect of a slope move depends on the relative level of the curve.e. and receives a higher coupon if the curve flattens. Description of Product In a Steepener or Flattener structure the investor is in effect buying a series of caps to ensure the coupon he receives is floored at zero. Since two indices are involved. the note may trade below par during the life of the transaction.2Y CMS) > 0 Total Number of Days 6M EURIBOR or Notional Sensitivity to Rate Moves A parallel shift downwards will normally be positive for the structure as the coupon is fixed. CMS Spread Notes can therefore be used in different interest rate environments. The sensitivity to curve flattening and steepening is more complex. the more leverage is possible.Attitude to Risk: All Attitude to Risk: All CMS Spread Note Summary A CMS Spread Note suits an investor with a view on the curvature and slope of the yield curve. otherwise the investor (typically) receives a 0% coupon > CMS Spread Notes can be done in inverse floater format In the graph the delta profile of the CMS Spread Range Accrual is shown. the investor thinks the curve will not invert) the CMS Spread Range Accrual is an attractive option. The flatter the curve. Example: CMS Spread Range Accrual Currency Maturity Coupon N M ABN Receives EUR 20 years (5. a steepening of the curve also increases the probability that the fixed (range accrual) coupon will be below the market rate and hence have a negative impact on the mark-to-market of the structure.

for year 2: 4.30% Sensitivity to Rate Moves A parallel shift downwards or a flattening of the yield curve will normally be positive for the structure.65% 4. Yield 1 0 Delta -1 Maturity Yield Delta Profile of a Ratchet Cap Coupon 4.40% 4. the note may trade below par during the life of the transaction. The exposure to 5 year rates is mainly the fact that it is a 5 year structure and partly the fact that as the investor has sold caps.00%.00% 5.e. The options sold therefore become more inthe-money.50% 5. in which case the coupon will lag a normal Floating Rate Note and need several periods of stable rates in order to catch up again.5% > Capped CMS > Capped Floater 4.65% 5. The structure suits an investor with the view that rates will rise. Hypothetical Interest Rate Scenario and Ratchet Coupon In the graph the delta profile of the Ratchet Note is shown.5% 1st fixing 2nd fixing 3rd fixing 4th fixing 5th fixing 6th fixing 7th fixing 8th fixing Variations > Different underlying indices are possible.60% 4.5% Also Consider Interest Rate 5. reducing the value of the swap. qu 30/360 25bps per quarter 3M USD LIBOR or Notional A hypothetical interest rate scenario Coupon Ratchet cap 1st fixing 2nd fixing 3rd fixing 4th fixing 5th fixing 6th fixing 7th fixing 8th fixing 6M USD LIBOR + 40bps 25bps per quarter 6M USD LIBOR fixing 4.e. In a scenario of rapidly increasing rates the note will under perform a normal Floating Rate Note. Upward Shift Curve Steepening Maturity -2 -3 In the above example it is obvious that a modest increase in rates will result in an above market coupon. Downward Shift Yield Yield Curve Flattening Market View The Ratchet Note suits an environment with steep yield curves and high volatility (at inception) which allows a substantial yield pick up to be achieved.80% 5.40% 5.90% 5. Description of Product A Ratchet Note is an instrument in which each successive coupon is capped in some way by the previous coupon payment.15% Maturity Maturity A parallel shift upwards or a steepening of the yield curve will normally be negative for the structure. although some indices (for example. a maximum increase of 25bps per fixing) a normal coupon cap can be applied (i. Example: Ratchet Cap Currency Maturity Coupon Ratchet cap ABN receives USD 5 years 3M USD LIBOR + 40bps. 6. For the successive caplets the strike is reset on predetermined roll dates. The level at which the strike is set is dependent on earlier strikes and fixings. the coupon cap for year 1 is 4.25% etc) Coupon 6M $L Fixing 20 21 .00% 4. The main risk for the investor is therefore a scenario in which rates spike up very quickly. The main feature is the fact that the jumps in the strike level are restricted to a certain maximum (i.90% 6. which is capped. 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y Risks A spike in interest rates could result in a below-market coupon. As expected.15% 5. the strike is not allowed to jump by more than 25bps). the investor prefers the short term rate to go up slightly. but that large and quick increases in rates (as perhaps implied by the forwards) will not materialise. The Ratchet Note is basically a note in which the investor sells a string of caplets for which only the first caplet strike is set.90% 6. As a result.25% 4. an increase in the 5 year rate (which is the present value of the 3 month forwards) indicates an increase in short term rates. When transacted in note form. A Ratchet Note pays a floating rate coupon that is only allowed to increase by a certain amount per period. the investor prefers 5 year rates to decrease (slightly).e.5% 3.Attitude to Risk: Conservative Attitude to Risk: Conservative Ratchet Note Summary A Ratchet Note suits an investor with the view that rates will go up but by less than implied by the forwards. CMS indices) tend to have less steep forwards > Instead of a ratchet cap (i.

e.25% Market View Range Accruals work in different rate scenarios: if future rates are expected to be higher than implied by the forwards. etc. and the higher the coupon will be. a corridor (Corridor Range Accrual). volatility is an important element.25% = 7 . the more value the options will have. based upon preagreed conventions (i. the full coupon will be paid: 360/360 x 7 . a rate move as implied by the forwards or a specific path as expected by the investor. the 10Y in 1Y. If after the trade the implied volatility increases (decreases) the mark-to-market of the swap will decrease (increase). an upper boundary only. the coupon is: 187/360 x coupon of (for example) 7 . and on pre-agreed dates. one for each day of the accrual period. otherwise a below-market coupon accrues (usually 0%).e. For each day the investor is correct he accrues one day’s worth of coupon. weekly. Corridor Range Accruals suit a stable rate environment. floating (Floating Range Accrual) or step-up (Step-Up Coupon Range Accrual). Daily is the most common > Range accruals can be made (Bermudan) callable (and most are in order to achieve yield enhancement): Callable Range Accruals > The structure can have a minimum coupon (Minimum Coupon Range Accrual) > The structure can have a different reference index every year (i. The investor sells these options in return for an above-market coupon. FX. Most of these options will have out-of-the-money strikes and the higher the volatility at inception. a lower boundary only range accrual is a suitable and yield enhancing structure. stepup or step-down barriers > The frequency with which the index is observed can be daily. The structure can also be dependent on two indices (Double Range Accrual) > The coupon can be fixed. By making the structure callable. a receiver swaption is the right > The index can be LIBOR. an Upper Boundary Range Accrual works. The investor prefers high volatility at inception as this will enhance his coupon. the investor has sold ABN AMRO the option to call the structure (redeem early) at a pre-determined level (usually 100%) on pre-determined dates through the life of the note.Attitude to Risk: All Range Accruals (RA) Summary A Range Accrual suits an investor with the view that an index will stay within (or outside) a given range. the investor is exposed to swaption volatility. beginning at a future date for a pre-agreed amount. Variations Description of Product A simple Range Accrual is basically a strip of digital options. Many Range Accruals are made Bermudan Callable to enhance the coupon.25% = 3. to receive the fixed rate). or the spread between 2 indices (CMS Spread Range Accrual). The option sold to ABN AMRO is a Receiver (Range) Bermudan Swaption. Since the client sells the options. If the structure is Bermudan Callable. For each period the coupon is determined by counting the number of days the reference index stays within the range versus the number of days in that period. A Step Up Coupon Range Accrual works well in a steep forward curve environment > It is possible to have a lower boundary only. The buyer of the Receiver Bermudan Swaption has the right to exchange a stream of floating interest rate payments for a stream of fixed interest rate payments (in this case a range accrual payment). CMS.76% > If all days are within the range. the 9Y in 2Y etc): Variable CMS Range Accrual 22 23 . If future rates are expected to be lower. Assume for reasons of simplicity the note has a maturity of 1-year (consisting of 360 days): > If 187 days are within the range. monthly.

Attitude to Risk: All Attitude to Risk: All Example 1: Callable Corridor RA Currency Maturity Coupon ABN receives Ref index Range Callable USD 5 years 7 . Floating CMS Spread RA Payoff Profile 5 4 A parallel shift upwards or a steepening of the yield curve will normally be negative for the structure.2Y CMS) > 0 3M USD LIBOR or Notional Sensitivity to Rate Moves A steepening of the yield curve will be positive for the structure.0 1 0 2005 Coupon 2009 2013 10yr Swap 2017 2021 10yr-2yr 2025 -0. Yield Yield -2 Downward Shift Curve Flattening Maturity Maturity In the graph above the delta profile of the example Floating CMS Spread RA is shown.5 Also Consider > SnowRange Note > Multi Index Note > Bermudan Callable Note 24 25 .5 Maturity Maturity Delta Profile of Floating CMS Spread RA 20 Oct 05 Upper Oct 06 Oct 07 3M Forwards Oct 08 Oct 09 Lower Oct 10 10 A flattening of the yield curve will be negative for the structure.5 3 2 0. The delta profile shows that the client profits from a curve flattening. When the structure is callable.00% coupon and a value of the structure close to the value of a Zero Coupon Note). which will “only” affect a single coupon payment. The structure is sensitive to absolute changes in rates and implied volatility.00% Quarterly 3M USD LIBOR Forwards against Specified Boundaries 6.5. the investor profits from a curve steepening and increase in the longer dated rates. The exposure to 15 year rates is partly the representation of paying the short term floating rate in the swap.Y2: 3.70%) 3M USD LIBOR – 11bps or Notional 3M USD LIBOR Y1 .5 Example 2: Floating CMS spread RA Currency Maturity Coupon ABN receives USD 15 years 10Y CMS + 35bps IF (10Y . 0 Maturity -10 Maturity -20 1Y 3Y 5Y 7Y 9Y 11Y 13Y 15Y 17Y 19Y 25Y Risks An unanticipated move of the chosen reference index can result in a low coupon or zero coupon structure (worst case scenario: all fixings outside the range. 2.25% x N/M. A parallel shift will have limited impact. it is far more important for the value of the structure that the longer dated rates moves in the investors favour than the 3 month spot rate.5 Interest Rate 4.00% . 1.5 3.5 Upward Shift Yield Yield Curve Flattening Delta Profile of 5Y Callable Corridor RA 1 Delta 0 Delta In this graph the 3 month USD LIBOR forward interest rate is shown versus the chosen boundaries in above mentioned example.00% . the note may trade below par during the life of the transaction. Downward Shift Yield Yield Curve Steepening 5. Upward Shift Yield Yield Curve Steepening When transacted in note form. Note that according to the forwards the coupon is paid in full. As expected.0 -1 Sensitivity to Rate Moves 2W 1M 2M 3M 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y A parallel shift downwards or a flattening of the yield curve will normally be positive for the structure.6. resulting in a 0. The delta profile depicts the interest rate sensitivity of the structure. the investor is exposed to reinvestment risk. which the investor prefers to decrease. qu 30/360 (5Y = 4.Y5: 3. It is clear that the investor wants longer dated rates to go down: since the longer dated rates are basically the present value of a string of forwards. 10yr-2yr Spread Maturity Maturity 0. Part of this is the notional effect: it is a 15-year trade. Interest Rate In the graph above the delta profile of the example 5 year Corridor Callable Range Accrual is shown. A parallel shift will have limited impact.50% Y3 .

a value of the structure close to the value of a Zero Coupon Note). which the investor likes to go up. if the single fixing is outside the range no payment will take place.23%) 0. Delta Profile of 1Y Digital Note on 10Y CMS 4 Yield Yield Market View A parallel shift downwards or a flattening of the yield curve will normally be negative for the structure. Example: One Look (Digital) Note Currency Maturity Coupon EUR 1 year 5. even if the investor is correct for 99% of the time. If on the other hand the index is on the “wrong” side. If the reference index is at the right side of the fixing for the investor. the investor receives a significant above-market coupon. There is no difference of being “just right” or “really right” The . Also. the investor prefers volatility to be low. swap rates. At time of trading. they can receive an above-market coupon dependant upon a fixing above a certain strike. the degree that the option is in or out-of-the-money doesn’t matter.00% if 10Y EUR CMS fixes at or above 3. the single fixing can still be outside the range. Upward Shift Yield Yield Maturity Curve Steepening Maturity ABN receives A One Look Note suits any interest rate environment.60% at maturity (10Y Euro spot = 3.6bps or Notional Sensitivity to Rate Moves A parallel shift upwards or a steepening of the yield curve will normally be positive for the structure. the negative delta in year one can be explained as the notional effect. FX. structure can be designed to be sensitive to the path taken. commodities or double indices (i. the investor prefers volatility to move up so the possibility that the fixing will be positive for him increases somewhat. Description of Product In a One Look Note the investor sells a European digital option (where the payout is either a fixed cash amount or nothing at a predefined date) to the issuer. The payout of a One Look Note is digital: if the view proves to be correct a fixed cash amount will be paid. One Look Notes are well suited for short term views. The note may trade below par during the life of the transaction. the path followed by the index is irrelevant. an out-of-the-money option is profitable for him. Downward Shift Curve Flattening 2 Delta Maturity Maturity 0 Risks An adverse movement of the reference index can result in a zero pay out (worst case scenario: a 0. After inception the volatility preference all depends on the movement of the index relative to the position of the investor. As the note is a one year structure. every fixing is a digital payout regardless of the path and previous fixings) > A normal One Look Note is 3-months up to 1-year. The main exposure is to the 10 year rate at the end of year one (the 11 year rate). the coupon payment can be contingent upon a fixing within a predefined corridor. the investor prefers the volatility to be high so he receives more upfront premium. Notice that as the investor has sold the option. Overall the investor prefers the curve to steepen. If correct. a Multi Look Note can be structured (i. Also Consider Bond Discount Note Normal Fixing Start Observation Period Payment Date 26 27 .Attitude to Risk: Aggressive Attitude to Risk: Aggressive One Look Digital Note Summary A One Look Note suits an investor with a short term view on an index. here the fixing is in arrears (postponed until the end of. a fixing below a certain strike level would result in the fixed payoff. With knock-in and knock-out options a coupon payoff can be structured which will have a zero payout if a certain barrier is breached or pays out at the moment a certain barrier is hit.e. As the fixing is digital. Whilst a normal swap fixes at the beginning of (or typically a few days before) the observation period.00% if 10Y EUR CMS fixes below 3. Fixing-in-arrears In-arrears Fixing -2 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y Variations > Instead of a One Look.e. In a One Look Note only the fixing counts. If rates are expected to decline. exposure on two indices) are possible The graph above shows the exposure of the note to the 11 year interest rate and the 1 year rate. payments take place at the end (see graph below). In either case.60% 3M EURIBOR . If an investor expects rates to be stable.00% coupon and if multiple fixings. Most of the time investors sell nearthe-money digital options. or a few days before the end of the observation period). but with multiple fixings a longer maturity is possible > Instead of a short term interest rate index. If the investor expects interest rates to go up.

75%. a Snowball The most popular Snowball is the inverse floating variant. it is possible to construct the Snowball in such a way that the payout benefits from an increase in rates (called a Reverse Snowball or Snowbear) > A Lifetime Cap can be added to construct a Target Redemption Note variant (Snow TARN) > A very popular structure is the Callable SnowRange. which will increase the Fixed Rate or Gearing. floored at 0% Semi annually 6M EURIBOR or Notional 28 29 . CMS. FX or the spread between 2 indices > Instead of speculating on a decrease in rates via the Inverse Floater variant. s. The coupon payoff from a Snowball is sensitive to changes in the shape of the yield curve and volatility curve. the client sells a call option to ABN AMRO at par and buys a series of caps with a moving strike as the coupons are floored at zero. features of a Snowball are the inverse floater part (in the form of: Fixed Rate – (X x Floating Rate)). it is possible to designed for investors who believe that the yield curve is 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. In a Snowball. the cap the investor bought is at 7% (because otherwise the coupon could become negative).Y7: (Previous coupon + 2. the Bermudan Swaption.12M EURIBOR in arrears).a. Variations > The index can be LIBOR. the snowball itself (Previous Coupon + Inverse Floater) and if callable. Example 1: Snowball Description of Product The Snowball is also known as a “Ladder” The main . adding value (leverage) as a Thunderball for an investor with a specific view. 30/360 Y2 . the 3M USD LIBOR in-arrears]. Currency Maturity Coupon Callability ABN receives EUR 7 years Y1: 5. The cap is equal to the previous coupon + fixed amount. The structure works best in a steep yield curve environment. future coupons rely on past coupons. They generate a significant yield pick.50% . allowing the coupon to accumulate by referring back to the previous coupon. As coupon formula is [(Gearing x Previous Coupon) – the Snowball feature refers back to the previous coupon. Suppose the previous coupon is 5% and the fixed amount is 2% (making the coupon formula: Previous coupon + 2% . This structure is known coupon is path dependent by nature.> It is possible to leverage the previous coupon so the up by betting against the forward curve with leverage.Attitude to Risk: Aggressive Snowball (Ladder) Note Summary A Snowball Note suits an investor with the view that interest rates will remain within a pre-defined band or (with the most popular structures) decrease (or increase less than implied by the forward) over time. This Market View product is a combination of a Range Accrual. and a Bermudan Swaption (see example 2) > To reduce the path dependency risk. In other words.6M EURIBOR (in arrears)). The Snowball should be seen as a feature which can be embedded in many structures.

50% x 360/360 = 3. the coupon is determined by counting the number of days within the range versus the number of days in that period. This effect is enhanced as a result of the effects of gearing and the path dependent nature of the coupons. the coupon at the end of year one will be: 7 . The path dependent nature of Snowball structures can result in a below-market coupon or even zero coupon despite the view of the investor being correct for most of the time (i. Downward Shift Yield Yield Curve Flattening Maturity Maturity A parallel shift upwards or a steepening of the yield curve will normally be negative for the structure. the investor prefers rates to decrease. Snowball Payoff Profile 6 M Range Callability ABN receives USD 5 years 6M: 7 . As expected.00% x 180/360 = 3. Interest Rate 4 2 0 Oct 05 Oct 06 Oct 07 Oct 08 Oct 09 Oct 10 Oct 11 Oct 12 Coupon 6M Forward In a SnowRange. Upward Shift Yield Yield Maturity Curve Steepening Maturity 30 31 .00%: If in year 1 all days are within the range. Risks The structure is sensitive to absolute changes in rates and implied volatility.00%.00% coupons during the life of the note and a value of the structure close to the value of a Zero Coupon Note.50% . even if the investor is continuously correct in the subsequent periods. Callable SnowRange SnowRange Payoff Profile 12 Also Consider > Target Redemption Note > Callable Range Accrual -1. The coupon payment is therefore highly path dependent.6.0 1M 3M 6M 9M 12M 15M 18M 21M 2Y 3Y 4Y 5Y 6Y 7Y 8Y Currency Maturity Coupon N In the previous graph the delta profile of the example Snowball structure is shown. future payouts will always be equal at best or lower than the previous coupon.00% Semi annually 3M USD LIBOR or Notional 6 3 Oct 05 Coupon Oct 06 Oct 07 Upper Oct 08 6M Forward Oct 09 Oct 10 Lower SnowRange Coupon Calculation Assume for reasons of simplicity a period of 3-years (consisting of 3 x 360 days) and an initial coupon of 7 . Sensitivity to Rate Moves A parallel shift downwards or a flattening of the yield curve will normally be positive for the structure.5 Interest Rate 0.0 Delta 9 -3.Attitude to Risk: Aggressive Attitude to Risk: Aggressive Delta Profile of a Snowball Note 1.50%. the new coupon would be 3.00% x 360/360 = 7 . If in year 3 all days are back in the range again. the note may trade below par during the life of the transaction. a flattening curve will generate a positive mark-to-market for the investor. multiplied by the previous coupon. The worst case scenario is 0.e. Suppose in year 2 only 180 days are within the range: the new (now maximum) coupon for the note is 7 .00% x N/M Thereafter: (Prev coupon + 0.5 As expected. the timing of being right is very important: the most risk is early in the life of the note).50%. once a coupon is reduced due to a period of fixings outside the range. The advantage of a SnowRange over a normal Callable Range Accrual is the additional pick up in yield if the view proves to be correct.50%) x N/M number of days 6M USD LIBOR is within range total number of days 3. When transacted in note form.

This embedded option in the note shortens the duration of the note and leads to negative convexity: when yields fall. an increase in implied volatility will decrease the mark-to-market value of the structure. The yield pick-up of a Callable Note over the fixed rate depends on several factors. that the long term rates will not rise as quickly as the 5YNonCall6M. Currency Maturity Coupon ABN receives Callable EUR 10 years 3. beginning at a future date for a pre-agreed amount and based upon pre-agreed conventions. If he expects rates to go up. The investor sacrifices a known duration of a normal bond for a higher yield and uncertain duration of a Bermudan Callable Note. 5YNC2Y) forwards suggest or expects rates to be stable. As expected. giving the buyer the right to exchange a stream of floating interest rate payments for a stream of fixed interest rate payments. -2 If interest rates move up. The embedded Bermudan option allows the investor to achieve a coupon pick-up in return for the risk of early redemption. the likelihood of the note being called increases. In the graph above the delta profile is shown. Investors are essentially selling swaption volatility and prefer high volatility at inception of the trade as this will enhance their coupon. the main sensitivity is to 10 year interest rates. This is a Step-Up Callable Note determined dates through the life of the note. volatility and steepness of the forward curve generally increase the yield pick-up. -3 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y Risks An increase in rates can result in a mark-to-market loss (the note will trade below par).55%. Upward Shift Curve Steepening Maturity Delta Profile of a 10Y Callable Note 0 -1 Delta Description of Product In a Callable Note. As the investor has sold an option. thereafter semi-annual Maturity Yield Market View A parallel shift upwards or a steepening of the yield curve will normally be negative for the structure. Investors > The coupon structure can step up (for example in an achieve a pick-up over the equivalent reference rate by environment where the curve is very steep: as the step selling ABN AMRO the option to call the structure (redeem up is in line with the forward rates it increases the option early) at a pre-determined level (usually 100%) on prevalue). s. If interest rates move down.e. The option sold is a Bermudan Swaption. the investor is exposed to reinvestment risk.a 30/360 (10Y ref rate 3. Higher maturity. a decrease in implied volatility will increase the value of the structure (and also increase the probability of being called). A decrease in the 10 year rate will increase the mark-to-market value of the structure. he will prefer a floating rate instrument. meaning that he sold the right (but not the obligation) to redeem the notes at 100% on any given call date. If interest rates fall and the structure is called. For this the investor is compensated by an option premium. The structure is sensitive to changes in volatility. the duration falls too as it becomes more likely that the call will be exercised. A Bermudan Callable Note suits an investor with the view > The number of calls and the first call is flexible (i. the investor sells a call option with a strike at 100% to the issuer.Attitude to Risk: Conservative Attitude to Risk: Conservative Bermudan Callable Note Summary Variations Sensitivity to Rate Moves A parallel shift downwards or a flattening of the yield curve will normally be positive for the structure. The reason behind the Bermudan Callable Note’s popularity is the fact that most investors prefer uncertainty in maturity over uncertainty in yield. as with any fixed rate instrument (an opportunity loss).23%) 6M EURIBOR – 11bps or Notional NC12M. the probability that the note will be called decreases (assuming constant volatility). he will buy a fixed rate security. Example: Bermudan Callable Note Downward Shift Yield Yield Curve Flattening Maturity Maturity Yield A Bermudan Callable Structure is most attractive if the investor believes that the market will be relatively stable or that rates will rise less than implied by the forwards. which will be paid in the form of a higher coupon. If the investor expects rates to go down. Also Consider > Callable Zero Coupon Note > Callable Range Accrual with a “wide” range 32 33 .

If rates are stable or increase less than implied by the forwards the Zero will outperform the benchmark.e. the investor loses its Zero Coupon Note could be the desire to defer tax on principal and will receive the unknown recovery value. A popular variant is the Zero Accreting Swap. the likelihood of the note being called increases and the investor will have had an above market IRR but has to reinvest in a lower yield environment. Philips or is that a Zero Coupon Note will generally have a higher BMW). high interest rate sensitivity) and the investor is not exposed to reinvestment risk. interest until a later date. in which an annual coupon is paid. the investor is still exposed to reinvestment risk. As the name suggests coupons are not paid during the life of the note. Downward Shift Yield Yield Curve Flattening Maturity Maturity Yield 0 -1 Delta -2 Maturity Yield Delta profile of a 10Y Callable Zero Coupon Note A parallel shift upwards or a steepening of the yield curve will normally be negative for the structure. The yield of a Callable Zero Coupon the market will be relatively stable or that the forwards will look more attractive relative to a non Callable Zero imply that rates will not rise by too much. If the investor Coupon if the curve is relative flat after the first call date believes rates will decrease a Normal (Non Callable) Zero > Zero Accreting Swaps where the notional over which an Coupon is a well suited product as it has a duration equal annual coupon is paid increases > To enhance the yield. but over an accreting notional. As expected. A decrease in the 10 year rate will increase the mark-to-market value of the structure. Risks Zero Coupon Notes have a duration equal to its maturity and therefore have mark-to-market high interest rate sensitivity. For this the investor is compensated by an option premium. When the Zero Coupon Note is made callable. Also Consider Bermudan Callable Note 34 35 .75% (10Y rate 3. In the graph above the delta profile is shown. If rates increase. It replicates the normal zero coupon structure. the investor sells a call option to the issuer. In this case the investor sells default protection yield than a coupon bearing note in an upward sloping on the selected entity for which he receives a premium. Example: Callable Zero Coupon Note Currency Maturity IRR Call ABN receives EUR 10 years 3. the non-callable Zero Coupon can to its maturity (i. Another reason for buying a If the underlying entity defaults.Attitude to Risk: Medium Conservative Attitude to Risk: Medium Conservative Callable Zero Coupon Note Summary A Callable Zero Coupon Note suits an investor who expects rates to be stable. If rates decrease. which will be paid in the form of an enhanced fixed internal rate of return (IRR). meaning that the investor has sold the right (but not the obligation) to redeem the note at a predetermined level and call date. the duration falls too as it becomes more likely that the call will be exercised. and paid at maturity. Description of Product In a Callable Zero Coupon Note. The embedded option in the note shortens its duration and leads to negative convexity: when yields fall. A yield pick-up over the equivalent reference rate is achieved by selling ABN AMRO the option to call the structure (redeem early) at a pre-determined level on pre-determined dates throughout the life of the note. The IRR will be higher when the Swaption volatility at inception is higher. In a Callable Zero Coupon the This is a Credit Linked Zero Coupon Note investor sacrifices a known duration of a straight zero coupon bond for a higher yield and uncertain duration. The IRR of a Callable Zero Coupon Note therefore depends on the shape of the curve and volatility. Upward Shift Curve Steepening Maturity -3 Market View Variations -4 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y A Callable Zero structure is most attractive for an investor > Zero Coupon Notes can be callable or non-callable (with who does not need a regular cash flow. the relative mark-to-market of a Zero will suffer as the fixed IRR will be lower than the prevailing market rate. and believes that no reinvestment risk). The option sold is actually a Receiver Bermudan Swaption. but are automatically reinvested at a fixed annual rate of return. annual afterwards 6M EURIBOR -11bps or Notional Sensitivity to Rate Moves A parallel shift downwards or a flattening of the yield curve will normally be positive for the structure. The advantage be linked to a preferred credit (for example GE. but lowers the credit risk for the investor on the counterparty.26%) NC1Y. or has the view that the long term rate will not rise as quickly as implied by the forwards. the main sensitivity is to 10 year interest rates. yield curve environment.

The structure is sensitive to absolute changes in rates and implied volatility.00% coupons and a value of the structure close to the value of a Zero Coupon Note). If the structure is callable the investor is exposed to reinvestment risk.(2 x 6M EURIBOR). By choosing the extent of leverage the investor can express his risk appetite. leverage is possible by subtracting a multiple of the index from a higher fixed rate. which therefore floats inversely with the chosen index. The most commonly used indices are short-term interest rates like 6-month EURIBOR or 3-month USD LIBOR. (a multiple of) the index is subtracted from a fixed amount. he prefers swaption volatility to be high at inception (the investor is selling volatility). FX or the spread between 2 indices > 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. CMS. To support the view that the market is overestimating the future fixings. Example: Callable Inverse Floater Currency Maturity Coupon ABN receives Callable EUR 10 years 11. Downward Shift Yield Yield Curve Flattening Market View The Inverse Floater suits an investor with the view that a certain index will decrease or stay low while the forward for that index is upward sloping. Payoff Profile of a Callable Inverse Floater 6 5 Interest Rate 4 Also Consider > Target Redemption Note (since most Target Redemption Notes are Inverse Floaters) > Snowball Oct 05 Coupon Oct 07 Oct 09 6M Forward Oct 11 Oct 13 Oct 15 3 Variations > The index can be LIBOR.49%) 6M EURIBOR .Attitude to Risk: Medium Aggressive Attitude to Risk: Medium Aggressive (Callable) Inverse Floater Summary An Inverse Floater suits an investor with the view that a certain index will stay low while the forward for that index is upward sloping. Investors generally floor the coupons at zero by buying a series of caps with a strike equal to the fixed amount divided by the leverage. The lower the index resets. The coupon structure of an Inverse Floater is a fixed rate minus a particular index. -3 Description of Product An Inverse Floater is the opposite of a normal Floating Rate Note: rather than receiving the index. whereby in arrears fixing will take extra advantage of a steep yield curve 2 36 37 .35% . the note may trade below par during the life of the transaction. As the investor sells the option. the investor prefers rates to decrease over all maturities. As expected. If the structure is Bermudan Callable. but also increases the probability of reaching the worst case scenario: a 0. the higher the coupon. -4 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y In the graph above the delta profile of the Callable Inverse Floater is shown. When transacted in note form.00% coupon.11bps or Notional Semi annual Sensitivity to Rate Moves A parallel shift downwards or a flattening of the yield curve will normally be positive for the structure. the investor has sold a Bermudan Swaption to the issuer meaning that he sold the right (but not the obligation) to redeem the notes at 100% on any given call date. Upward Shift Yield Yield Maturity Curve Steepening -1 Maturity Delta -2 Risks An unanticipated upward move of the chosen reference index can result in a low coupon or zero coupon structure (worst case scenario: 0. Higher leverage provides greater potential upside. (At time of pricing 10Y Euro = 3. Maturity Maturity Delta Profile of a Callable Inverse Floater 0 A parallel shift upwards or a steepening of the yield curve will normally be negative for the structure.

50% . The most almost any coupon type that exists for a traded market popular structures are the Guaranteed Inverse Floater index (a short term index such as LIBOR. Downward Shift Yield Yield Curve Flattening Maturity Maturity Yield > The TARN is available in those currencies where ABN AMRO operates underlying vanilla cap/floor and swaption portfolios (in most currencies up to 10-years. In other words. a swap rate and the Guaranteed Ladder Inverse Floater. Although the TARN can be seen as a feature (and implemented in many products). structure has a minimum IRR).XX% . most structures are floored at zero.Y5: [13. 0] subject to aggregate cap level of the case if his view proves to be correct) as the rate of Y. the note may trade below par during the life of the transaction. The TARN automatically redeems when the total sum of the paid out coupons equals a designated target level (the Lifetime Cap) and therefore has by definition an unknown duration.YY% return is known per possible redemption date and decreases > Guaranteed Ladder Inverse Floater (GLIF): The coupon with time.XX% . If interest rates and volatility fail to rise or fall as much as implied by the forward curve then the duration of the trade can change significantly.g. 0] up to boundary only). Currently. in USD and Market View Yen up to 12-years and in Euro up to 15-years) The TARN coupon structure can take several forms. with in the worst case the final coupon (if the structure has a lifetime floor. 0] up to the lifetime cap level Description of Product > Guaranteed Capped Floater (GCF): The coupon pays The product derives its name from its embedded life time (Floating Index + spread) capped at X.a. e. Max [X. as in the most popular structures. 30/360 Y2 . With the Guaranteed Fixed Range Accrual variant the barriers can be defined in such a way that the > Guaranteed Inverse Floater (GIF): The coupon pays investor profits from increasing rates (by having a lower Max [Fixed Rate – (gearing x floating index).(2 x 6M USD LIBOR in arrears)] 3M USD LIBOR – 11bps or Notional 10% Sensitivity to Rate Moves A parallel shift downwards or a flattening of the yield curve will normally be positive for the structure. It is of course or an FX rate coupon). Risks The coupon payoff from target redemption structures is sensitive to changes in the shape of the yield curve and volatility curve. pays Max [Previous coupon + X. and and a variant of the GLIF once this target is reached. in most structures the lifetime cap is the lifetime floor: at maturity the final coupon pays any remaining unpaid portion of the lifetime cap/floor (so the Delta Profile of a GIF TARN 2 Maturity Yield Variations ABN receives Lifetime Cap A parallel shift upwards or a steepening of the yield curve will normally be negative for the structure. due to its popularity we will describe TARNs as a separate product.(2 x 6M USD of the product to be as short as possible (which will be LIBOR in arrears). Interest Rate 5 4 Also Consider > SnowRange Note > CMS Spread Note (Flattener) Oct 05 Coupon Oct 06 Oct 07 6M Forward Oct 08 Oct 09 Oct 10 3 38 39 . the structure automatically > Hybrid Coupon: combines any of the coupon types redeems. As most of the LIBOR based target redemption described structures can potentially result in a negative coupon for a particular coupon period as well. in an upward sloping curve environment more “risk” is on the “higher rates” side.00%. decrease over time (or increase less than implied by the forwards). Although an increase in volatility also increases the probability of lower rates. the investor prefers these rates to go down as the in-arrears fixing is like a digital: a fixing at a level which will result in auto redemption or a fixing which will result in a continuation of the structure. Obviously. but in > The TARN payout may be a coupon bearing instrument or 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. As such the product has an unknown duration. the investor wants the duration the lifetime cap level. When transacted in note form. The sum of all coupons paid over the life > The Guaranteed SnowRange (GSR) combines the GFRA of the transaction will be equal to the Lifetime Cap. The converse holds true for decreases in volatility. s. the uncertainty of this product lies in the timing of the final payment and maturity.(gearing x floating index). Upward Shift Curve Steepening Maturity 0 Delta -2 -4 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y In the graph above the delta profile of the Guaranteed Inverse Floater TARN is shown. otherwise no coupon at all) on the maturity date of the note. The TARN has an unknown duration by nature.Attitude to Risk: Aggressive Attitude to Risk: Aggressive Target Redemption Note (TARN) Summary A TARN suits an investor with the view that interest rates will remain within a pre-defined band. Also. As the structure has possible automatic redemption in years 2 and 3.XX% and subject cap (sometimes referred to as the aggregate cap or minto the lifetime cap max cap) and sets an absolute limit on the aggregate > Guaranteed Fixed Range Accrual (GFRA): Fixed Rate x amount of coupon that will be paid over the lifetime of N/M (see Range Accruals) the structure. ABN AMRO offers the possible to structure the TARN such that it profits from an following coupon types within the TARN structure: increase in rates. GIF TARN Payoff Profile 6 Possible outcomes for a few volatility scenarios given the GIF version An increase in volatility increases the probability of higher interest rates and thus a decrease in expected coupon payout which would result in a lengthening of the duration. or. Example: Inverse Floater TARN Type Currency Maturity Coupon Guaranteed Inverse Floater TARN USD 5 years Y1: 6.

YY% > Linear Trigger Option. Since the investor usually sells out-of-the-money options.Attitude to Risk: Aggressive Attitude to Risk: Aggressive Multi Index Note Summary A Multi Index Note suits an investor with a specific view on multiple markets or indices. Low correlation increases the likelihood that the two indices will breach a certain constraint. After trading.XX% AND 10Y USD CMS fixes above Y. the structure profits from increasing rates and a steepening of the curve. Also Consider > Hybrid Coupon TARN > Dynamic Cap Sensitivity to Rate Moves A parallel shift upwards or a steepening of the yield curve will normally be positive for the structure. As expected. Consequently. Description of Product Multi Index Products have payoffs which depend on multiple interest rates.00% if 3M USD LIBOR fixes below X. correlation is a consideration. Upward Shift Yield Yield Maturity Curve Steepening Maturity A parallel shift downwards or a flattening of the yield curve will normally be negative for the structure.6.CMS 2Y > 0. if correlation increases. > Dual Range Option: the investor will receive a fixed or floating payoff if 2 conditions are met. Therefore the note becomes less risky for the investor. since it is a 5-year note. An example is the Double Digital Option Note in which the digital payoff depends on two boundaries and two indices. In the graph above the delta profile of the Double Digital Range Accrual is shown.50% x N/M number of days CMS 2Y > 4.120. and therefore the upfront pick-up for the investor is higher. the likelihood of the two indices breaching a certain rule falls.50% . For example the client receives 9.5 -5. multiple underlying indices or a combination of the two. the note may trade below par during the life of the transaction. he prefers volatility to be high at inception but to decrease over time. Example: Double Digital Range Accrual Currency Maturity Coupon N M ABN receives USD 5 years 9.50% AND CMS 10Y . since they move more in line. In general.00).5 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 20Y Risks A bet on multiple indices will result in a higher probability of receiving a zero coupon. The investor is exposed to more complex (and less observable) sensitivities. The negative delta in year 5 is partly due to the notional effect. Variations > Different underlying indices are possible such as (quantoed) money market rates.XX% x N/M for all days 3M USD LIBOR is within (2. Downward Shift Yield Yield Curve Flattening Maturity Maturity 40 41 .00 .00% coupons and a value of the note close to the value of a Zero Coupon Note.5 0.00%) AND USD/JPY is within 90. Market View Multi Index Notes are designed for investors looking for additional yield pick-up and/or have a very specific view on multiple indices and want to leverage this.0 Delta -2. By making the payoff dependent on two indices instead of one an investor can achieve a significant above-market yield if his view proves to be correct.0 -7. The worst case is a consecutive breach of one of the barriers resulting in 0. For example the client receives a coupon of X. as an out-of-the-money option with decreasing volatility has a smaller likelihood of becoming in-the-money. the investor prefers the correlation to be low at inception and increase over time as most investors prefer selling out-of-the-money options.00% Total number of days 3M USD LIBOR or Notional Delta Profile of a Double Digital Range Accrual 5. When transacted in note form.0 2. which will have a positive effect on the mark-to-market of the structure (the investor is said to be “long” correlation). For example the client receives USD 10Y CMS + 35bps if (10Y CMS . swap rates and FX rates > Double Digital Option: the digital pay-off depends on 2 boundaries and 2 indices.2Y CMS) > 0.

This variable strike cap can be added to a structure in order to finance the extra leverage sometimes sought.00%. and the investor generally profits if the curve steepens or a spread widens (in the case of a spread on 2 rates in 2 different currencies) and the 3rd reference rate shifts upward. He prefers low volatility at inception to reduce the cost of the floor. or a leveraged difference between 2 indices (for example: 10 x (10Y CMS – 2Y CMS)). when the curve is flat (or the 42 43 .Y2: 8. in current market conditions the floor will be expensive to finance > A fixed rate can be added to the leveraged Spread (for example Min (3M + 1.00% (always in note format). the investor buys a spread option to floor the structure. increasing the leverage over the spread or margin over the single index > A flattening view can be accommodated. plus a spread (for example: 3M USD LIBOR + 100bps). The advantage of a dynamic cap over a fixed cap in a parallel upward shift is therefore obvious: a parallel upward shift won’t impact the absolute coupon level.00% + 5 x (10Y – 2Y)) > A Dynamic Floor can be structured (for example Max (3M – 1. Selling the variable cap enables the investor to finance the leverage on the Spread. but prefers high volatility after trading. floored at 0.00% Thereafter : Min [3M USD LIBOR + 1. it is “dynamic” .00%. for example 8 x (10Y – 2Y).00% 3M USD LIBOR or Notional -10 EDH7 EDU7 EDH8 4Y 6Y 8Y 10Y 12Y 14Y This graph shows the delta profile of the Dynamic Cap. Delta Profile of a Dynamic Cap 5 A steepening of the yield curve will be positive for the structure. The structure is often floored at 0. For example. the structure benefits from a steepening of the curve. When transacted in note form. Although the structure has limited parallel shift exposure. > A guaranteed minimum coupon can be achieved. an intra-curve or inter-curve) and a view on the absolute level of interest rates. the cap is at 3M USD LIBOR + 100bps. as it raises the likelihood that the spread will widen. Sensitivity to Rate Moves Overall. Maturity Yield Variations A flattening of the yield curve will be negative for the structure. The parallel shift exposure is limited but correlates with the steepness of the curve. but slightly positive for the structure if it is combined with a steepening of the curve. The parallel shift exposure is limited but correlates with the steepness of the curve. although this decreases the upside > The absolute coupon can be capped. 10 x (10Y CMS – 2Y CMS)] floored at 0. However. Downward Shift Curve Flattening Maturity Risks The main risk will be with the underlying payoff which is capped by the dynamic cap (worst case scenario: 0. So instead of having a cap fixed at 7 . As expected.e. hence. and is a variant of the well known spread option. the floor at 0. spread between the 2 rates in 2 different currencies is low) the dynamic cap investor is long volatility on the spread at inception.00% coupons and a value of the structure close to the value of a zero coupon bond). Also Consider > CMS Spread Note > Multi Index Note ABN receives Description of Product The dynamic cap product is an enhancement of the 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). Upward Shift Yield Yield Curve Steepening 0 Delta -5 Maturity Maturity Yield Market View Selling a dynamic cap gives the investor both a relative rate view (i. The structure is more attractive when at inception the forward curve is flat. Typically. A steepening of the curve implies higher forward rates and thus a higher forward cap. 2. The structure overall has a slightly negative delta due to the notional effect.Attitude to Risk: Medium Conservative Attitude to Risk: Medium Conservative Dynamic Cap Note Summary A dynamic cap suits investors with a view on the slope of the yield curve or on the difference between 2 rates in different currencies. A structure with a fixed cap would have a higher negative delta.00%. The variable cap depends on one of the 2 indices in the spread or a third index. 6 x (10Y – 2Y)).00%. if a curve shifts upwards and also steepens. a parallel upward shift will be slightly negative for the structure due to the notional effect. The high negative delta in year 5 is partly due to the notional effect: it is a 5 year trade. An example payout is a note which pays the minimum of a weighting times an index. Furthermore. A Flattening of the curve will have a negative impact on the mark-to-market of the structure. the investor profits from a steepening of the curve. The coupon therefore depends on the minimum of 2 payoffs: the leveraged difference between 2 indices and an index plus a margin.00% Example: Dynamic Cap Currency Maturity Coupon USD 5 years Y1 . the dynamic cap strike increases and avoids a negative impact on the payout of the steepening as opposed to a fixed cap. the note may trade below par during the life of the transaction. Without the dynamic cap the leverage would have been lower.00% and the fixed element in the cap.

reset at-the-money every year. A major advantage of the Volatility Note is the fact that the investor can play the absolute variation of an index.25% if |10Y CMS in arrears . the note may trade below par during the life of the transaction. In the graph above the delta profile of the 10 year digital Volatility Note is shown. Otherwise no coupon is paid > The note can be constructed as an inverse floater. two indices can be used Example: 10Y Digital Volatility Note Yield Maturity Upward Shift Yield Yield Curve Flattening Maturity Maturity Risks Currency Maturity Coupon EUR 10 years 5. The investor is therefore said to be “long Vega”: he profits from an increase in volatility. without having to take a view on the direction of the index. The note can also be used as a hedge for long term bond investors whose portfolios have natural negative volatility.YY%. Downward Shift Yield Maturity Curve Steepening Variations > The Volatility Note can be made digital: if Index X in arrears – Index X fixes at or above Y. the higher the payout will be.40%. A Volatility Note pays a coupon which is linked to the absolute variation of an index over a set period of time. Also Consider (One Look or Multi Look) Digital Note 44 45 . annual 30/360 Fixing Annual. which the investor obviously likes to increase. The investor takes advantage of any movements of the index. A steepening will normally be positive as it signals rising (thus changing) yields. A flattening of the yield curve or an upward shift will normally be negative for the structure. profiting from a decrease in volatility > Instead of one index.Attitude to Risk: Medium Volatility Note Summary The Volatility Note suits an investor with the view that the volatility of a particular index will go up.00% coupons with the value of the structure close to the value of a Zero Coupon Note). Sensitivity to Rate Moves A parallel shift downwards will normally be positive for the investor as the relative value of the fixed coupon increases. The more variation. The longer maturity buckets indicate a preference for increasing rates which is logical as the 11 year rate can be seen as the 10 year rate 1 year forward. the investor receives a fixed coupon. When transacted in note form. Delta profile of a 10Y Volatility Note 5 0 Delta -5 -10 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 20Y Market View A Volatility Note suits an investor with the view that the volatility of an index will go up. 2 bd before coupon payment ABN Receives 6M EURIBOR + 8bps or Notional A decrease in volatility will result in a below-market or zero coupon (worst case are consecutive 0. Description of Product A Volatility Note paying an annual coupon of (gearing x the absolute change of an index) is similar to being long a string of cash-settled one-year swaption straddles.10Y CMS| > 0. The negative delta in year 10 is the notional effect: it’s a 10-year note. Overall the investor prefers a steepening of the curve. without the complexity of managing a rolling option position.

Downward Shift Yield Yield Curve Flattening Maturity Maturity A parallel shift upwards or a steepening of the yield curve will normally be negative for the structure. because with a large fall in rates he would prefer to buy the underlying bond. and the bond does not have too many accrued days of interest. paid as an above-market coupon.50%. or the coupon can be based on the investor’s strike preference > Instead of government bonds the investor can select a corporate bond. If rates increase the probability of the strike being triggered at the maturity date increases. A Bond Discount Note is also known as a Bond Reverse Convertible. Description of Product With a BDN.75% (3M EURIBOR at 2.25% 2015 100.Attitude to Risk: Medium Attitude to Risk: Medium Bond Discount Note Summary A Bond Discount Note (BDN) suits an investor with the view that a reference bond (typically a government bond) will stay above a certain strike level (a certain price). A BDN is mostly a short term play. If at maturity the option is in-the-money. The structure is not capital guaranteed. The delta profile shows that the sensitivity is obviously to the long rate. As the structure involves selling a put option. High volatility at inception is positive for the investor as the option sold has more value and therefore increases the coupon. the underlying bonds are delivered “dirty” (with accrued interest). the investor will receive his coupon.50% (at time of pricing 100. therefore reducing the number of deliverable bonds per denomination.50%. A parallel shift downwards or a flattening of the yield curve will normally be positive for the structure. the investor sells a put option on a bond with a certain strike to the issuer. The investor receives his money back if the fixing is at or above the strike (the preferred scenario: cash settlement) or receives the underlying bonds at a higher price than the spot price of that bond (bond delivery. but settlement will be in bonds: the investor receives a number of the reference bonds instead of his money back.71%) Delta Profile of a Bond Discount Note 2 Risks A fall in the price of the underlying bond can result in delivery of the bond at a higher price than the present market price (not a capital guaranteed structure). there is some mark-to-market sensitivity to volatility. the investor receives the coupon and the note will be settled in cash (the investor receives his money back). 0 Delta Also Consider -2 One Look Digital Note -4 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y Market View The buyer of a BDN should have the (short term) view that rates stay stable or decrease slightly (or increase less than implied by the forwards).17%) Nether 3. Hence the upfront premium will be lower. This would reduce the Participation Level. Sensitivity to Rate Moves If fixing is at or above 100. resulting from a fixing below the strike). A relatively high coupon and accrued interest leads to a relatively higher dirty price. Variations > The maturity can range from 3-months up to 2-years in all currencies and government bonds for which ABN AMRO operates an option market > The strike can be based on a certain coupon requirement. Upward Shift Yield Yield Maturity Curve Steepening Maturity 46 47 . obliging the investor to buy the underlying bond at a predetermined price and date if the buyer of the option (in this case ABN AMRO) wishes to sell. For this the investor is compensated by an option premium. If rates decrease the price of a fixed income instrument will increase so the probability of delivery of the underlying bond will decrease (as the spot price will move away from the strike price). If fixing is below 100. In order to maximise the coupon it is important for the BDN that the reference bond’s coupon is not too high. By selecting a corporate bond the maturity has a maximum of 6-months > It is possible to structure a BDN in which bond delivery is the preferred scenario and cash settlement the non preferred one (for example cash settlement at a lower level than 100%) > This structure is also very popular on FX (called DCD’s: Dual Currency Deposits) or Equity (Reverse Convertibles) Example: Bond Discount Note Currency Maturity Coupon Underlying Strike EUR 3 months 4.

However. Source: mtn-i. 130 different structure variations have been issued compared to 163 in all of 2005. Despite the difficult market conditions. the traditional pay-offs still remain the most trusted and hence most popular. with a wide and growing variety of structures. The standard CMS Linked MTN (where returns are based on a constant maturity swap reference rate) decreased in popularity but was still heavily represented in the market. 48 49 . The graph above shows the breakdown of the most popular MTNs with a CMS underlying element. the growth has been largely driven by investors positioning themselves for a steepening of the yield curve. In the first quarter of 2006. This structure allows investors to accrue above market returns for every day the spread between two reference rates fixes within a defined range. at 6% of YTD 2006 Interest Rate linked MTN issuance. the progression made within interest-rate linked MTNs has been significant. when almost 25% of all MTN’s were CMS-linked to some extent. CMS structures still have a large market share (11% of YTD MTN issuance). 2006 1st Semester Interest Rate Linked MTN Split Range Accrual Standard CMS Linked Callable Zero coupon CMS Spread Range Accrual Bermudan Callable Accreting Zero Flipper Fixed Rate Callable Fixed Rate Step-Up Callable Inverse FRN European Callable Capped Floating Rate Note Target Redemption Note Others 22% 12% 8% 6% 5% 5% 4% 4% 3% 3% 2% 2% 2% 22% 2006 1st Semester CMS Breakdown Standard CMS Linked 54% CMS Spread Range Accrual 25% CMS Spread 10% CMS Volatility Linked 4% CMS Linked Range Accrual 4% CMS Linked Quanto 2% CMS Linked Target Redemption 1% Source: mtn-i. and of course heavy curve flattening on both sides of the Atlantic has meant this share has more than halved to 11% YTD 2006.com. down from 21% in 2005 (by USD equivalent value). making up 12% of interest rate linked issuance YTD 2006. The numerous innovative structures developed within the sector have diversified investors’ interests. As mentioned.Appendix Most Popular Products Most Popular Products Structured Note Market Turbo Certificates Interest Rate Models Modelling Processes Yield Curve Considerations Summary Interest Rate linked MTNs still hold the major share of the structured MTN market. The change in clients’ views since the period of short-end interest rate hikes. a popular structure has been the addition of leverage to the CMS Spread Note: a note offering above market returns if the investor’s view on the spread between two swap rates proves correct. CMS Structures The CMS structure has been hugely popular in the past few years. These are digital structures and are usually structured to allow investors to position themselves for non-inversion or steepening of the yield curve. with particularly explosive growth in 2005. In recent years. CMS Spread Range Accruals remained popular. This said.com.

See graph. notably those that combine interest rate plays with inflation exposure. Innovation is clearly the driving factor behind the market. it makes flexibility and responsiveness crucial for market participants. Innovation With H1 06 interest rate-linked MTN sales down by USD 51bn on H1 05 and the Euro and US dollar yield curves uninspiring. have gained market share in 2006 so far. compared to 19% in 2005 and back up to 24% in 2006 YTD (by USD eqv. Added to the speed of product takeup. Interest Rate Linked Product Innovation 200 104% Contribution of Top 10 Structures 150 Product Variations 90% 100 75% 50 0 2001 2002 2003 2004 2005 Q1 2006 60% Source: mtn-i. leading to concern about rates breaking out of the predefined range. the contribution of the ten most popular structures to total IR-linked issuance has shown a steady decline since 2002. In 2004. In just the first eight weeks of 2006 hybrid issuance had already overtaken 2005’s volume. The standard version remains a popular structure. Callable & Cumulative Callable MTNs are notes where the issuer has the option of early redemption. Main Callable Structures . flippable and target redemption. the overall change in activity in the MTN market can be attributed to market conditions that affect the risk appetite of investors. HICPx). The demand was further lowered by continuing USD weakness. whereby the payout of each coupon is “path dependent” – reliant on the level of the previous coupon. Similarly. In summary. USD Range Accrual issues have fallen. rate structure buyers seemed to have moved away from some of the heavily structured IR-linked instruments that were popular in 2005. accounting for 10% of overall MTN issuance YTD in 2006.5% of all issuance had a cumulative element. The interest rate-linked MTN market has responded by delivering bespoke solutions to investor demands and has adapted its offering to the changing rate markets. The Zero Coupon Callable Note is finding its place in the market due to the higher IRR on offer. In 2005. Within Interest-Rate linked MTNs alone. 4. This underlines the emergence of an important new product tailored to a specific set of risk preferences. The majority pay a floating rate plus a spread capped at a multiple of the HICPx and floored at 0%. Similarly. USD issuance accounted for 80% of all Range Accruals in 2004.com. as well as issuers delaying issuance until there is more confidence in the market. falling to 1. The main conclusion to be drawn from the graph below is that relatively vanilla structures.Range Accrual Notes The standard Range Accrual structure accrues interest for every day that the reference rate fixes within a predefined range. fixed rate issues now look more attractive after a period of rate hikes in Europe and the US. 50 51 . 67% in 2005 and now down to 33% YTD 2006. value). Hybrid products on the other hand have seen a significant increase in volume. 130 different structures have been issued during the first quarter of 2006 and the fast-paced and bespoke nature of the market means this figure is sure to reach 200 by year end. 2006 (1st semester) 10 % of Intrest-Rate Linked MTNs 8 6 4 2 0 Floating Rate 2005 European H1 2006 Bermudan Fixed Rate Zero Coupon Source: mtn-i. the number of product variations issued per year has risen from 42 in 2001 to 163 in 2005. 31% of all Interest Rate Linked MTNs were callable. there has been a fall in activity of cumulative structures. Furthermore. Investor demand for USD denominated issues has fallen amidst the prolonged Fed Funds tightening cycle. made possible through the higher yield curve environment. Many of these structures tend to exploit the behaviour of the forward EURIBOR curve versus the forwards for Eurozone Harmonised Index of Consumer Prices (excluding tobacco.9% in the first half of 2006 (by value).2005 vs.com. such as the fixed rate and zero coupon callables. The range accrual feature is increasingly used in more exotic varieties: for example cumulative coupon.

a revival in simple callable structures has emerged. followed by a slight downturn thereafter. but. particularly for Asian investors. commodity linked MTNs have not taken off (only USD 1. appetite for these and other inflation-linked structures should continue to be strong with continuing inflation fears in both Europe and the US. Commodity. The largest ever FX-linked MTN was an Asian currency basket. Pure inflation sales were dominated by HICPx (Eurozone) and UK RPI. equity linked structures have gained in market share. with a strong pickup in issuance over Q4 2005. the inflation capped FRN accounted for most of these. The inflation capped FRN has been the year’s major development. Fund. structured Medium Term Note (MTN) issuance appears to be strong in 2006 with year-to-date issuance of USD 94bn. 2005 saw extremely strong issuance in the first quarter. Hybrid. Indian rupee. This was also the case at the start of 2006. Ratchet Notes. Strong issuance at the start of the year is a trend that is often observed. Market Sectors Interest Rate Linked issues continue to dominate the structured market at 48% of YTD new issuance (USD 45bn). In particular. This trend towards relatively straightforward structures is expected to continue in the near future. 52 53 . for the first time. Indonesian rupiah and Korean won. Q2 06 has begun with leveraged cross-market differential notes referencing local and pan-European inflation. This has greatly enhanced investment possibilities. As could be expected in an environment of booming equity markets. Investors are once again looking for real returns through inflation linked products. FX-linked MTNs showed a significant sales surge with almost a four-fold increase from USD 1. Polish inflation also featured. The Credit-linked MTN market has shown one of the strongest recoveries at the start of the year.4bn in Q4 05 to close to USD 5bn in Q1 06.1bn of new issuance in the first semester). Having said this. Capped FRNs and zero accreting notes have also been gaining in popularity. interest rate linkers still dominate the issuance with a market share of 48%. Another factor that might drive the market is the continued development of hybrid structures linked to multiple assets and markets. perhaps surprisingly. Outlook Interest rate linkers look set to remain the dominant asset class. 60% 60 Issuance 40% 30 20% 0% Q2 01 Q2 02 Q2 03 Q2 04 Q2 05 Q2 06 0 Interest Rate Linked Equity and Equity Index Linked Currency Linked Other (Credit. whilst the most dominant currencies were the Chinese renminbi. B o nd Linked) Total Issuance Source: mtn-i. CMS-linked structures have so far been less popular than in 2005. brought on primarily by the severe flattening of the yield curve. Structured MTN Market Size 80% 90 USD Equivalent in USD bn The high returns observed in stock markets have led to increasing equity linkage (22% of YTD deal volume).Structured Note Market Summary Although lower than last year’s record figures. Issuance doubled from H2 05 to almost USD 21bn in H1 06. Spanish and. Japan’s departure from the zero interest rate policy offers new opportunities. Amid investor uncertainty about market direction. despite difficult bond market conditions. This supply was driven by investor appetite for exposure to emerging market currencies. although the difficult environment for CMS based structures has also shifted the focus to different asset classes. Lastly. amid strong investor appetite and fresh issuer funding targets. It is a simple yield enhancing structure that exploits the correlation between the forward EURIBOR curve versus the forward HICPx curve. The recent Euro strength has also led to an increase in Euro issuance (50% of the market) and a decline in USD denominated structures (29%). showing a significant increase from 14% in 2005.com. The rebound in volume in Q1 06 to USD 5bn equalled that across all of 2005. Innovative hybrid inflation products drove more than 50% of Q1 06 sales in this asset class. 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.

54 55 . which can never be smaller than zero. Turbos on bond futures are defined by their underlying future. The stop-loss level is determined by ABN AMRO. If he expects sharply rising long term interest rates in Japan for instance. however. Depending on market circumstances. and is largely dependent on the volatility of the underlying market.a..14 EUR 106.2 (Price of Underlying/Price of Turbo) 1. the Turbo ceases to exist and ABN AMRO unwinds the position. A 1 EUR increase in the price of the underlying contract should lead to a 1 EUR price increase of the relevant Turbo (not accounting for fees). This means that no interest is charged over the financing level. T-Bond > Japan: JGB Risks > Turbos are highly leveraged investments. the financing level is adjusted to account for the price difference between the two futures contracts and any costs incurred during rolling. the investor will then receive the residual value of the Turbo. This allows an investor to match the duration of his bond portfolio with a required amount of Turbos. BUXL > United States: T-Note. ABN AMRO periodically rolls the underlying contract. 2006 116. Because the underlying is a future (not a physical asset) in this case. Bund. Equally. The price of a Turbo is equal to the difference between the market price of the underlying future and the financing level of the Turbo. he can choose to buy a Turbo Long or Turbo Short.66 EUR 9. the management fee does accrue over this amount. which means that buyers risk losing their entire invested capital. Because Turbos always reference the first maturing futures contract. the price of the next maturing future will not be the same as the price of the current future. an investor who anticipates declining long term rates in Europe can choose to buy a Turbo Long on the Bund future.27 EUR 12. The stop-loss level is slightly above the financing level in the case of a Turbo Long. Example Type Current Underlying Future Price of Underlying Financing Level Stop-Loss Level Fair Value Turbo Leverage Management Fee Turbo Long Euro-Bund Future Sep. On a roll date. their interest rate sensitivity is relatively constant. accrued daily over the Financing Level Market View An investor can use Turbos to take an aggressive view on a certain bond market. the financing level and stop-loss level. > An interest rate hedge using Turbos may not be perfect. > A stop-loss event will result in the position being unwound and the investor receiving the residual value.Turbo Certificates Summary Turbo Certificates (“Turbos”) are delta-one investment instruments which give investors leveraged exposure to an underlying bond future. Description of Product A Turbo is designed to offer one-for-one exposure to the price changes of the underlying future. To keep the price of the Turbo constant during the rolling process. ABN AMRO does not physically have to “lend” money to the structure.80 EUR 104. he can buy a Turbo Short on the JGB future. as it will for example not necessarily protect against changes in slope of the yield curve. Equally. If the underlying future hits the stop-loss level. Underlyings Turbos Long and Short are currently offered on the following Bond Futures: > Europe: BOBL. which is dependent on market circumstances and could be zero. and slightly below the financing level in the case of a Turbo Short. Depending on whether the investor has a bullish or bearish view on interest rates in certain maturities and geographic regions.5% p. The financing level can be seen as the amount of money that ABN AMRO has to contribute to buy the underlying above the premium paid by the investor. Schatz. Turbos can be used to hedge interest rate risk in a bond portfolio. As Turbos will always reference the first maturing futures contract. but it is easy to implement and requires little capital outlay. The hedge achieved in this way will never be perfect.

numerous models have been developed to simulate the fluctuations of the yield curve. a stochastic differential equation describes the yield curve. Parallel shifts are possible and steepening or flattening as well only when the relative shift along the curve varies in the same direction. a procedure that randomly samples changes in market variables by running the model repeatedly (10. Moreover. An extension of Vasicek is the Hull-White model that correctly reproduces the initial entire yield curve and incorporates time dependant mean reversion. models the entire yield curve by. Jarrow and Morton suggest several functional forms for the volatility of the term structure. by virtue of being arbitrage-free. who were amongst the first to publish it. The values of these securities are closely related to the shape and the apparently random movements of the term structure. its standard formulation is based on unobservable instantaneous rates. The model is characterised by the exact specification of the spot rate dynamics through time. as traded in the market. HJM models require the use of a Monte Carlo Simulation. Common Themes Underlying all three generations of models. in contrast to the spot rate approach. minute or even a day). This choice was due to a combination of mathematical convenience and numerical ease of implementation. The first generation of models developed were generally spot rate based. the term structure. however valuing these vanilla instruments is useful primarily for calibration. The LIBOR specification of these models is also known as the Brace-GatarekMusiela (BGM). Market Models The motivation for the development of market models arose from the fact that. since the formulation of this category of model allows a decoupling between the two. Ideally the model is capable of providing an analytical formula for these vanilla instruments. The event being modeled (the fluctuation of interest rates) is much more complex than the movements of an index price and so three generations of interest rate models have evolved. They have the advantage when calibrating to their associated vanilla product (i. market models are based on observable rates in the market and hence readily price-standard instruments. The simplest short rate models are rarely used in practice as they have few parameters and no ability to calibrate to the entire yield curve. The match to the market Black pricing formula (1976) for option prices makes calibration of market models very simple. the prices of caps/floors and swaptions are required (very liquid securities). The second generation models comprise the Heath-Jarrow-Morton (HJM) models which attempted to model the forward curve directly. By construction. it must be calibrated to the market. Mean reversion is the tendency to revert back to some long-run average level over time. Heath. These rates are therefore fundamentally different from actual forward LIBOR and swap rates. After specifying these volatilities and correlations. Each is distinguished by different methods of constructing the effective volatility function which determines its use in practice. Each forward rate has a time dependent volatility and time dependent correlation with the other forward rates being evolved. Conclusion The three generations of interest rate term structure models. Therefore. Short Rate Models By short rate here. The later model engineered by Vasicek is more common in this category as it incorporates the concept of mean reversion. Besides matching the initial yield curve. An important feature of the HJM model is that it permits interest rate volatility to change across time: though it is difficult for the user to specify how volatility changes through time. The latest generation are market models. such as letting volatility exponentially dampen. Forward Rate Models The Heath. as given. it is the rate that is observed for the shortest-term loans starting at a certain point. where the Black-Scholes framework is universally accepted to determine the price of derivative products. the HJM methodology directly models the entire term structure of forward rates. volatility and correlation. but otherwise a very efficient numerical algorithm is necessary. The evolution of modelling has come about through differing ways of describing the yield curve (using spot or forward rates) and the complexity of adjustments for time.e. Market models can be used to price any instrument whose pay-off can be decomposed into a set of forward rates. Unlike other asset classes as equities and foreign exchange. although the HJM framework is theoretically appealing. Spot and forward models must derive the appropriate calibrating quantities from market observable rates. To use any model for pricing. The HJM model permits more than one factor to influence the forward rates: it can have more than one source of volatility. borrowing now and repayment after a small time interval (i.Interest Rate Models Background In the last twenty years interest rate sensitive products have become increasingly popular. and is commonly used for exotic interest rate derivatives such as a Bermudan Swaption and a Callable Range Accrual. used to price options for other asset classes. a second. The quoted implied Black volatilities can directly be inserted in the model. a LIBOR model for cap products) in allowing a separate fitting to volatility and correlation. it gives the model characteristics similar to the Black-Scholes model. it is pulled back to that average and vice versa for lower rates. Due to the time dependency and flexibility.e. Jarrow & Morton (HJM) model. the model is computationally intensive although it allows for more sophisticated and consistent pricing. The basic model implies that all rates move in the same direction over a short time interval. meaning that it decreases proportionally with time. an instrument can be priced using Monte Carlo simulation to evolve the forward rates. in small time stages. BGM attempts to model the forward rate curve starting with market observable forward rates. and requires knowledge of the volatility of the underlying.000 or more) and taking the average result. The real use of the model is to value more exotic options such as Bermudan Swaptions. 56 57 . This model still leads to explicit formulas and can be used to analytically price caps and floors. are equivalent mathematically and are all within the general HJM framework. but not all by the same amount. It takes the price of the underlying asset. in which the entire yield curve is specified by a single variable. The value of a derivative is simply the replica costs and therefore independent of the risk appetite of the investor. By taking the initial forward rate curve as given. avoiding the numerical fitting procedures that are needed for the spot rate or forward rate models. That is if rates are observed much higher than the long-run average. The first generation proposed to model the interest rate directly starting with the nearest maturities (short end): the short rate models. The essential assumption of believing the markets to be arbitrage-free and complete (all risks can be hedged out) allows the market price of risk to be removed. changes to the forward curve. no such agreement exists with regard to interest rate modelling.

An extension to this idea introduces a Markov process. Asset prices. the random variable is the product of the driving variable. who at each point of time can take one step to the right with a given probability p or one step to the left with probability 1-p. In other word it has “no memory”: the asset price path leading to its current value has absolutely no influence or effect on what the next asset price movement will be. As discussed. If the whole pub were to attempt the same walk. and the square root of the time interval. It is still randomly generated > the annual volatility needs to be carefully chosen but conforms to a normal distribution with a mean of 0 (drift) > the Wiener process provides the basis for the random and a standard deviation of 1 (variance). the number will be between +1 and -1. the asset price) is relevant for predicting its next value. The “random walk” of asset prices includes a number of simple assumptions combined together: the price is derived from the previous one but does not affect the result (Markov) > the annual expected return should depend on the risk of Wiener Process A Wiener process puts a mathematical probability and range the return on the asset constraint upon the driving variable. This means that about nature of the price two-thirds of the time. we expect to see each number an equal number of times. are often assumed to follow Brownian motion. The simplest random walk is a path constructed according to the following rules: > there is a starting point > the distance from one point in the path to the next is a constant (constant footsteps) > the direction from one point in the path to the next is chosen at random. Any variable whose value changes over time in an uncertain way is said to follow a stochastic process: the variable is neither completely determined nor completely random as it contains an element of probability. Historical asset prices are not of any use in predicting future prices. to avoid overcomplicating the process. 58 59 . though might see a “6” rolled four times in a row. the numbers will be between two standard deviations of the zero and 99 percent of the time. and no direction is more probable than another (the drunkard is just as likely to slump to the left as to the right) 100% 70% 0 20 40 60 80 100 The industry-standard GBM (Geometric Brownian Motion) equation relates the new asset price to the old one through a time dependent term and a random variable. or one standard deviation around the average of zero. The simulation runs the model repeatedly (often 10. in this case. the model describes geometric Brownian motion which is the basis of the Black-Scholes model. a number of models have been associated with the process driving the numbers. A Monte Carlo simulation of the stochastic process is required to sample the random driving variable and derive the price chart. Stochastic processes can be classified as discrete or continuous time. It has a deterministic element (the expected return/drift) and a random term (which is more or less important dependent on the volatility). About 95 percent of the time. The same breakdown can be applied to the variable that the process is modelling. The Random-Walk Process The foundation for asset price modelling is the “Random Walk” It is the intuitive idea of taking successive steps in . an understanding of the variable (price) is first required. The Wiener process develops the principle to asset pricing such that prices do not move by a constant amount in a given period but are influenced by a driving variable: a > number generated to influence the relative price shift. like molecules. For any random walk. which is an extension of the ideas discussed on where a “drunkard” might end up after some time on their walk home.e. The example of rolling a dice at regular time intervals shows that rolling a “6” three times in a row does not mean a 6 will not be rolled again.e. the underlying variable can take any value within a certain range. in option terms. A discrete-time process is one where the value of the variable can only change at certain fixed points in time. An individual walker strays further away from the intended straight line with time. therefore it is impossible to produce consistently superior returns through technical analysis. Conclusion When pricing derivative products. intuitively it is quite unlikely. described above. In a continuous-variable process. More technically speaking. For this reason numerous models have attempted to model price movements to value derivative instruments. An important result that follows is the deviation from the intended straight line (variance) of a random walk increases linearly with time. the price chart will vary considerably each occasion the model is run. the asset price. It is called a random walk because it can be thought of as an individual (drunkard) aiming to walk on a straight line to a chosen destination. which is a particular kind of stochastic process. This means that after a large number of sequential throws (with a “fair” dice). The value of a derivative is the value today (present value) of all expected discounted cash flows. a random direction for modelling stochastic processes. receiving the expected payout conditional upon the option being in the money). each aiming to go straight across. When simplified for the Wiener process.Modelling Processes Background The pricing of any derivative product is dependent on the (expected) future price of the underlying asset. whereas in a discrete-variable process. In practice. however. conditional on receiving the cash flow (i. Suppose we draw a line some distance from the origin of the walk to the intended end point. If the model were to be adapted for continuous time. multiples of a cent) and changes can be observed only when the exchange is open.000 times) and takes the average result. a Markov process is consistent with the “weak” form of the efficient market hypothesis. Its property is that only the current value of the dependent variable (i. The graph below shows eight random walks of 100 time steps. every point in the domain will be crossed a number of times almost surely. they will be between three standard deviations of zero. When modelling asset price movements over a period. an understanding of the modelling behind the underlying asset pricing is essential. The expected discounted cash flow is basically the probability of receiving the cash flow times the expected payout. Essentially a model uses the volatility and expected return at each time interval and the amount by which the price moves is determined by the random number. the average position away from the line would indeed be on the line at each point. asset prices are restricted to discrete values (e. Due to the characteristic of the Markov process. whereas a continuous-time process allows for a change at any time. It is simple in the sense that the walker makes discrete fixed movements of constant lengths at specified time intervals.g. The motion analyzed is called a Simple Random Walk. only certain discrete values are possible. 8 random walks aiming to go straight across 130% The Processes To understand how asset prices can be modelled. the return to the holder of the stock in a small period of time is normally distributed and the returns in two nonoverlapping periods are independent.

Supply Side Factors Central Bank monetary policy is arguably the most important determinant of the yield curve. certainly in the short term. Typical shapes of the curve include: “Normal” (upward sloping). and an array of structured products makes it possible to link returns to any view on the future movements of the curve. they also contain a risk premium. and the debate over which theory explains these movements continues. giving the yield curve an upward bias. For example. An upwards sloping yield curve environment reflects the expectations that interest rates will rise. whereas borrowers prefer to borrow for longer periods. it is possible that there may be an impact on the slope as well: a rate tightening cycle would have a larger impact on short term interest rates. Its shape and absolute level are of vital importance to investors. the Market Segmentation Theory does not allow for any switching between “segments” (areas of the yield curve). Supply and Demand 90-95% of yield curve movements are accounted for by parallel shifts in the curve. a change in householder preference for current (over future) consumption has been consistently shown to induce a large and persistent shift of the yield curve level. Similarly.Yield Curve Considerations Summary The Yield Curve. The main shortfall of this theory is that no consideration is given to the inherent risk associated with investing for longer maturities. Expectations of higher inflation. the yield curve effects of a sharp oil price shock. The Liquidity Preference Theory proposes that investors prefer to retain liquidity by holding short term securities. and flattening the curve. This is because these type of shocks move output and inflation expectations in opposite directions. A flat yield curve may signal uncertainty. For example. Biased Expectations Theory: This theory suggests that whilst the forward rates do reflect interest rate expectations. the forward rates (interest rates between two future dates) implied by the yield curve are pure expectations of future interest rates. and “Inverse” (downward sloping). pushing prices up. The direct effect of Central Bank rate movements is to alter supply conditions at the very short end of the yield curve. a shift of corporate borrowing preferences between fixed and floating rate terms can alter the supply conditions at either end of the yield curve. the 2001 halt in US Treasury 30 year issuance created a shortage at the long end of the yield curve. pushing yields down. Borrowers’ maturity preference changes can alter the slope of the yield curve. “Flat” (horizontal). Where parallel shifts express current rate moves. slope and curvature. this increased supply in an increasingly global market would induce investors to demand higher yields. Eventually. and hence a steeper yield curve. Hypothetical Yield Curves Normal Yield Yield Maturity Inverted Maturity Flat Yield Yield Maturity "Humped" Maturity There are three dominant theories which attempt to explain the term structure of interest rates: 60 61 . Market Segmentation Theory: Like the Preferred Habitat Theory. the supply and demand factors influencing the yield curve environment warrant consideration: Demand Side Factors Growth and Inflation Expectations are key drivers at the long end of the yield curve. a flat curve implies that interest rates will stay broadly constant. Expectations of declining economic conditions and correspondingly lower future interest rates can lead to a shift by investors into longer maturity. Main Theories The main considerations of the yield curve are its level. Worth noting is that the effect of demand and inflationary shocks is not always straight forward. and the yield curve effect depends on whether the output or inflation response is dominant. this theory suggests that different market participants have differing maturity preferences. Although the main effect would be a parallel shift in the yield curve. The Preferred Habitat Theory agrees that a risk premium is reflected in forward rates. changing its slope or curvature. resulting in a parallel shift of the curve. This flattening could be compounded by the lagged effect a rate hike might have on inflation: lower long term (not short term) inflation expectations putting downward pressure on long term interest rates. However. often linked to economic growth. or a technology driven supply shock are not as clear. the slope is about expectations of future moves. Pure Expectations Theory: According to this theory. relative to short term rates. and a downward sloping curve implies falling interest rates. Government Finances can also affect the shape of the yield curve. However. this theory suggests that investors and borrowers have different maturity preferences. and therefore the yield in any segment is independent of other sections of the curve. However. yields down. driving them higher than less sensitive long term rates. also known as the Term Structure of Interest Rates. expectations of rapid economic expansion may lead to a steepening of the curve. is the relationship between yields and maturities for a given security. However. “safe haven” securities. The curve may also be “humped” (see graph below). and leading to an inverted yield curve. Conversely. as a result of the increased demand for capital. will lead to an expected rise in nominal interest rates. and the willingness to borrow for longer maturities. and are willing to switch away from their “preferred habitat” maturity if sufficiently rewarded. Most market participants agree that this theory offers a rather dubious explanation of the yield curve. Sustained budget deficits require increased government borrowing to fund them.

Arrears – observation and fixing of the underlying rate at the end of the coupon period as opposed to the start of the coupon period. Convexity – a measure of the curvature in the relationship between price and yield. Collar (or Corridor) – a combination of an interest rate cap and interest rate floor. Credit Default Swap (CDS) – an agreement whereby one party (the protection buyer) pays the other party (the protection seller) a fixed periodic premium for a certain tenor. Amortisation – a decrease of notional amount throughout the life of a structure in a predetermined way. Bonds with high convexity perform better if rates change. 62 63 . restructuring and failure to pay. Credit Event – an event which triggers payment in a Credit Default Swap. Collateralized Debt Obligation (CDO) – a way of repackaging credit risk by dividing a pool of securities or financial assets into tranches. not the issuer’s. Cross Currency Swap – the exchange of principal and interest in one currency for the equivalent in another currency at an exchange rate fixed at inception. The emergence of structured notes has given borrowers the flexibility of raising finance in maturities they would not have otherwise considered. and if they follow a highly transparent monetary policy. Bullet – an obligation that must be paid in a single lump sum at the end of its term. Main Determinants of the Yield Curve Yield Accretion – an increase of notional amount throughout the life of a structure. Clean Price – the price of a bond which does not include accrued interest. at a predetermined price. and investors would require a smaller liquidity premium. Central Bank Monetary Policy Expectations of Future Monetary Policy Inflations Expectations and Convexity Bias Maturity Barrier Options – options where the payoff depends on whether the underlying asset’s price reaches a certain level during a certain observation period. Convexity increases strongly with maturity and is of great influence at the long end of the curve. These tranches have different risk and return profiles. Countries with large foreign currency reserves resulting from current account surpluses are major buyers in the government bond markets. and other financial institutions have led to increased demand (and correspondingly lower yields) at the longer end of the yield curve. The interest rate cap can be thought of as a series of caplets which exist for each period the cap agreement is in existence. In “rates” it means a rise in yields (a fall in price). A change in their preference over the maturity or currency of their purchases can have a major impact on the shape of the yield curve. Cap – an option that provides a payoff when a specified interest rate is above a certain strike level. Conclusion Whilst numerous factors are clearly relevant in shaping the term structure of interest rates. essentially redistributing the risk from the underlying portfolio. If the Central Bank has strong inflation fighting credentials. Negative convexity means that as market yields decrease. The convexity bias therefore tends to lower yields at the long end of the curve. investors have an increasingly important influence on the supply and demand dynamics at a given point on the yield curve. Bearish – a view that an asset or underlying index will fall. the graph below summarises the main determinants of the different parts of the curve. Bermudan Option – an option that allows for exercise at certain discrete predetermined times during its life. In “rates” it means a fall in yields (an increase in price). insurance companies. Callable – the option but not the obligation for the issuer to redeem a security prior to its stated maturity. duration decreases as well. then the yield curve may be flatter than it otherwise would. preference). Foreign Central Bank purchases of government bonds have a significant effect on the shape of the yield curve. Convexity measures the curvature in the relationship between bond prices and their yields. This is because concerns about future growth would outweigh inflationary worries.Glossary Convexity Bias is a factor which influences the long end of the yield curve. Currency Forward – A forward contract in the forex market that locks in the price at which an entity will buy or sell a currency on a future date. the more sensitive the duration is to changes in yield. Credit Spread – the yield spread between risk free securities and others that are identical in all respects except for credit quality. Common examples are bankruptcy. Central Bank Reputation is also important. Through the process of “reverse inquiry” (whereby an issuance is driven by the investor’s. if rates fall their price rises by more. Financial Innovation can also affect the shape of the yield curve. The protection seller makes no payments unless a specified credit event occurs on a predefined reference entity. The greater the convexity. if rates rise their price falls by less. Callable securities will exhibit negative convexity at certain priceyield combinations. Caplet – one component of an interest rate cap. Bullish – a view that an asset or underlying index will rise. American Option – an option that allows for exercise at any time during its life. because of the reduced uncertainty about future rate changes. Correlation – a statistical measure describing the degree of dependence between the fluctuations of two variables. The benefits of convexity cause more convex bonds to have higher prices and consequently lower yields. Regulatory Changes such as recent moves towards closer asset/liability matching amongst pension funds.

Exotic – structured products which are more complex than the derivatives usually traded on an exchange. Volatility – the annualised standard deviation of an asset’s return. Spot Price – the current market price for an asset or index. The greater the duration. Hedge Fund – a discretionarily managed portfolio of investments that uses strategies such as leverage. for a call option when the spot price is higher than the strike price. Out-of-the-money – an option is said to be out-of-themoney when its intrinsic value is zero. This means that the mark-to-market price of a bond will be negatively impacted by an increase in interest rates. Swaption – the option to enter into a swap.g. and zero (or “low payout”) otherwise. Floorlet – one component of a floor. It shows the change in the option’s value resulting from a small change in volatility of the underlying index. the product is generally automatically redeemed. Strike Price – the predetermined price for which the underlying asset/index may be purchased or sold by the investor upon exercise of the derivative contract. Knock-in Option – a type of barrier option which only comes into existence if a certain barrier is hit. e. In-the-money – an option is said to be in-the-money when its intrinsic value is positive. A loss will occur if the spot price is close to the strike price at expiration of the options. Derivative – a financial contract whose price and cash flows are dependent upon one or more underlying assets. Implied Volatility – the future volatility of an instrument’s price estimated from derivatives currently traded in the market. the greater the sensitivity to interest rate movements. When this level is reached. Vega – a measure of an option’s sensitivity to volatility. Floor – an option that provides a payoff when a specified interest rate is below a certain strike level. the buyer gains the right but not the obligation to enter into a specified swap agreement with the counterparty on a specified future date. they are generally traded over the counter. Mark-to-market (MtM) – the act of recording the price or value of a security to reflect its current market value rather than its book value. Digital (or Binary) – a derivative product for which the payout is a fixed cash amount (“high payout”) if the investor’s view proves to be correct. Straddle – an option strategy primarily used to profit from an increase in volatility. such as interest rates. Historical Volatility – the volatility of a financial instrument actually realised over a given period in the past. First-To-Default Basket (FTD) – provides multiple name exposure in a CLN. but also in case of structures with some possibility of fixed coupons such as embedded caps and floors this effect will be displayed. long. It is a measure of the variability of the asset price. Notional – the cash amount over which the pay-off of a derivative or structured product is calculated. Forward Rate – the interest rate for a future period of time implied by the rates prevailing in the market today. Yield – the annual rate of return for a security. Swap – an agreement between two parties to exchange defined cash flows over a period of time. As opposed to vanilla products. Sensitivity – the magnitude of a financial instrument’s reaction to changes in underlying factors.Delta – a measure of the sensitivity of a derivative to changes in its underlying asset or index. (Modified) Duration – the measure of the price sensitivity of a fixed-income security to an infinitesimal change in yield. not just its final value. for a call option when the spot price is lower than the strike price.g. Notional Effect – Apart from pure floating rate bonds. Quanto – a derivative in which the relevant performance of the underlying asset or index is paid out in a foreign currency. Vanilla – the most basic version of a derivative contract. Hybrid – a derivative product that depends on the performance of two or more underlying assets or indices. Lifetime Cap – the maximum cumulative coupon amount that an investor in for instance a Target Redemption Note can earn. because an equivalent investment will pay a higher coupon in this situation. 64 65 . The interest rate floor can be thought of as a series of floorlets which exist for each period the floor agreement is in existence. Knock-out Option – a type of barrier option which ceases to exist if a certain barrier is hit. It involves buying a call and a put with the same strike price and expiration date. Dirty Price – the price of a bond which includes the accrued interest. short and derivative positions with the goal of generating above market returns at an acceptable level of risk. Underlying Asset – the asset or index upon which the value and pay-off of a derivative contract is based. Internal Rate of Return (IRR) – the discount rate that makes the net present value of future cash flows equal to zero. Participation level (gearing) – the percentage of the price change of the underlying index/asset that the buyer of a derivative contract is exposed to in relation to that contract’s notional amount. The biggest notional effect is displayed in case of fixed rate bonds. each bond displays the notional effect. Path Dependent – a feature for a derivative whereby the payoff depends on the whole path followed by the underlying variable. Par Value – the face value of a fixed-income asset. In exchange for an option premium. European Option – an option that can only be exercised at the end of its life. Structured Note – a debt obligation that contains a derivative component to achieve a specific risk/reward profile. Yield curve – the relationship between yields and maturities for a given security (also known as the Term Structure). Leverage – the use of derivatives or borrowed capital to increase notional exposure to an investment. e. Forward Curve – a graph of forward rates for different maturities. An investor in a CLN with a FTD feature runs full principal risk in case of a credit event on any of the names in the underlying basket.

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