What Is a Targeted Accrual Redemption Note?
Let me explain what a targeted accrual redemption note, or TARN, really is. It's an exotic derivative that ends when the limit on coupon payments to you, the holder, gets reached.
These TARNs stand out because they're prone to early termination. If the coupons add up to a set amount before the settlement date, you get a final payment of the par value, and that's the end of the contract.
Key Takeaways
- A targeted accrual redemption note (TARN) is an index-linked derivative with a target cap.
- The cap is the maximum amount of accumulated coupon payments you can receive.
- Once that cap is hit, the note terminates automatically.
- FX-TARNs link to currency indexes instead of equities.
Understanding Targeted Accrual Redemption Notes (TARNs)
At its core, a TARN is an index-linked note with a fixed number of coupons that make up the target cap. When you hit that cap, the note terminates, and you get the par value paid back. This setup often includes an appealing initial coupon, plus the chance to recover your par value quickly.
An index-linked note combines a fixed-income investment with potential extra returns based on an equity index like the S&P 500. Beyond that, TARNs are like inverse floating-rate notes, where the benchmark could be something like Euribor.
You can also think of TARNs as path-dependent options: as the end-user, you're essentially buying a strip of call options while selling a strip of put options with double the notional value of the calls. The contract might have a knock-out provision that ends it if the benchmark hits a certain level.
A common type is the foreign exchange TARN, or FX-TARN, where counterparties swap currencies at a preset rate on specific dates. The amount exchanged depends on whether the rate is above or below a fixed forward price.
Valuation of Targeted Accrual Redemption Notes (TARNs)
Valuing TARNs isn't straightforward because the redemption depends on the coupons you've received so far. Once the knock-out level is reached, the investment stops, and you get the principal back. From your perspective as an investor, a strong initial coupon rate followed by quick capital return is the best scenario. But if the indexed rates don't perform well, you could be locked in longer, watching the time value of your money diminish what started as an attractive short-term play.
Normally, a note's value is the present value of par and coupon payments. With TARNs, though, not all coupons are guaranteed, so you can't just do a straight present value calculation. Instead, you need to simulate interest rate volatility to figure the odds of hitting the knock-out level based on the note's terms. If the benchmark is volatile, valuing the TARN accurately becomes even tougher.
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