What is a Targeted Accrual Redemption Note?
An exotic derivative known as a targeted accrual redemption note (TARN) expires after the holder receives a certain number of coupon payments.
One aspect that sets target accrual redemption notes (TARN) apart is that they may be terminated early. The note holder gets a final payment of the par value, and the contract expires if the accumulation of coupons exceeds a predefined level before the settlement date.
Understanding Targeted Accrual Redemption Notes (TARNs)
A targeted accrual redemption note is an index-linked note with a predetermined number of coupons for the target cap. The note will be canceled with the par amount paid whenever the goal cap is met. Therefore, there is often a tempting initial discount and the chance to recover the par value quickly. A fixed-income investment combined with extra potential returns linked to a stock index’s performance, such as the S&P 500 index, is called an index-linked note.
TARNs are comparable to inverted floating-rate notes, where the benchmark may be LIBOR, Euribor, or a comparable rate, apart from these index-linked aspects. Another way to think about TARNs is path-dependent options, where the end-user essentially purchases a strip of call options and sells a strip of put options with a notional value twice that of the calls. A knock-out clause in the contract can state that it will end if the benchmark hits a certain threshold.
Common TARNs are foreign exchange TARNs, or FX-TARNs, in which counterparties exchange currencies on pre-arranged dates at a predetermined rate. Different currency amounts are traded depending on whether the rate is higher or lower than a predetermined forward price.
Targeted Accrual Redemption Notes (TARNs) valuation
Because the redemption schedules rely on the coupons collected so far, the value of targeted accrual redemption notes might take time. The investment ends, and the principal is returned once the knock-out level is achieved. An excellent initial coupon rate and an early return on capital are desirable outcomes in the eyes of investors. What was previously an appealing shorter-term investment may become unappealing due to the time value of money, however, if the indexed rates perform poorly.
A note’s value is typically determined by calculating the present value of the par and coupon payments. However, targeted accrual redemption notes are risky since not all coupon payments will be processed. Therefore, a TARN has to simulate interest rate volatility to determine the likelihood of triggering the knock-out threshold given the note’s terms instead of doing a linear calculation on the present value. It will inevitably be more challenging to appropriately evaluate TARNs linked to volatile benchmarks.
Conclusion
- A target cap is included in an index-linked derivative called a targeted accrual redemption note (TARN).
- The maximum amount of total coupon payments collected is called the cap.
- The message ends automatically when the limit is reached.
- Instead of stocks, FX-TARNS are correlated with a currency index.
