It is important to note that a TARN (or Target Accrual Redemption Note) is not in itself an independent product, but rather that it exists as an additional feature added on to an existing product. That existing product is actually a strip of structures. The add-on part is that there is always a target redemption condition (or cap) added to the payout of the underlying structures.
The fixing dates for the TARN are the expiry dates of the underlying structures. If on any fixing date before the product’s end expiry date the target redemption condition imposed on the payout is reached, the entire product is redeemed. That is, the rest of the product (including both legs of all remaining structures) ceases to exist. However, any positive payout (profits) or negative payout (losses) accumulated before the knock out event still need to be received/paid.
So as in a regular Inverse Floater Swap , in an inverse floater TARN the structured (or TARN leg) pays a coupon calculated as Fixed rate - Floating index * Gearing.
The main differences between a regular inverse floater swap and the TARN version are as follows:
The second leg is always based on a floating rate.
As a result of the TARN add-on, as soon as the total coupon amount paid by the payer of the TARN leg exceeds a specified target amount, the swap ends.
There are two styles of inverse floater TARN, the difference between them being in whether the instrument can be terminated (or called) before the expiry date. In a:
Non-callable style inverse floater TARN the instrument cannot be called.
Bermudan style of inverse floater TARN (also known as a callable inverse floater TARN), the payer of the TARN leg has the right but not the obligation to terminate the instrument on one or more predefined fixing (or termination) dates during the life of the instrument.
Advantages of an Inverse Floater TARN
Like an inverse floater swap, an inverse floater TARN offers a high interest rate in exchange for a small risk (i.e., that the interest rate index will rise above the fixed rate during the term of the swap). Furthermore, this risk can be negated by defining a minimum coupon payout for the inverse formula leg.
The primary advantage of the TARN version is that it offers the buyer a better-than-market rate in exchange for the fact that the earning potential is limited by the cap. Furthermore, if you enter into the callable version of the inverse floater TARN, the receiver of the TARN leg will receive an even higher premium to compensate for the risk that the TARN leg payer will cancel the swap as the floating rate moves in an unfavorable direction.
Pricing an Inverse Floater TARN in SDX Interest Rates
You price an inverse floater TARN in SDX Interest Rates in the same way as you would price an inverse floater swap (see Pricing an Inverse Floater Swap in SDX Interest Rates). However, you must also define:
Whether the instrument has a TARN add-on or not.
If the instrument has a TARN add-on, you must also define the maximum return (or cap), specified as a percentage of the notional. As soon as the total of coupons paid by the payer of the TARN leg exceeds this value, the swap ends.
Whether the instrument is callable or non-callable.
It is also important to note that:
If the instrument is callable, by default the system sets the call dates to match the start dates of the underlying coupons using the call frequency.
In the Callable Dates and Fees window (accessed by clicking the Call Dates button in the pricing page) you can then edit the notice dates, and also cancel any of the automatically scheduled call dates. For more information on working in this window, see Working in the Callable Dates and Fees Window.
The fixed rate to be used in the calculation of the TARN leg coupon payments is displayed as the Market Rate in the results area. The value of this result is calculated so as to ensure a zero NPV for the swap. You can specify your own value, in which case the NPV will be non-zero.