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# Target redemption notes Example 7.

5% USD Target Redemption Index Linked Deposit (issued by Bank of East Asia, 2004) Selling points - Enjoy potentially higher returns with Index Linked Deposit 100% principal protection plus 7.5% guaranteed coupon return over a maximum of 5-year investment period. 1st year annual coupon is guaranteed at 6.5% (very juicy), payable semi-annually. The remaining coupon rate of 1% will be based on the LIBOR movement. The inverse oater formula is max{7% 2 6-month LIBOR (in arrears), 0} However, the total coupon received will not shoot beyond the target rate of 7.5%. If the coupon payment accrued during the deposit period is less than the target rate, then the remaining amount will be paid at maturity.

Early termination Once the accumulated coupon payment reached the target rate, the deposit will be terminated automatically. Worst scenario The deposit is held for 5 years until maturity so that the annual return for the deposit is only 1.5% per annum. Market background The US Fed policy makers voted unanimously to keep the Fed Fund Rate unchanged at 1% on 28 October 2003, the lowest level in the past 45 years. They had indicated that the interest rate would remain at a low level for a considerable period. Potential risk If the 6-month LIBOR rises beyond 3.5% one year afterwards and never come down again. The deposit is then held for 5 years until maturity.

Valuation approach The note value is given by the sum of present value of all potential future cashows. Since the termination date is uncertain, the cashow on the coupon date tk , k = 1, 2, . . . , K, is stochastic. N L(r, tk ; ) PtT Ak ck ccap notional amount -period LIBOR at time tk (with dependence on interest rates) value of unit-par discount bond at time t with maturity date T accumulated coupon amount up to coupon date tk coupon payment received at tk target coupon cap rate

## Inverse oater formula

N max{f mL(r, tk ; ), 0}

k

Ak = N
j=1

## max{f mL(r, tk ; , 0},

Ak N ccap.

Coupon payment received at tk ck = min(max(N ccap Ak1, 0), N max{f mL(r, tk ; , 0}) Dene a stopping time tk of hitting the target rate, the index k is a positive integer satisfying 1 k K such that k = sup{k|Ak1 < N ccap}. Implicitly, we have ck = 0 when k k K.

The pricing model resembles an Asian barrier option, where the knock-out feature depends on the path dependence variable A (running accumulated coupon sum).

## t k r(u) du + e t K r(u) du max(N c = Ne cap AK , 0) K

+
k=1

t k r(u) du ck e

k Note that e t r(u) du is the discount factor over the period [t, tk ].

The rst term represents the par payment at the knock-out date tk . When k = K, the note survives until maturity. The last term represents the sum of cash ows received at all coupon dates and maturity date tK . The second term represents the payo of a European put option at tK with dependence on the stochastic quantity AK . When the accumulated coupon payments have not reached the target cap rate at maturity, the remaining amount of the target coupon is paid out (in additional to the par) at maturity.

Modeling of the interest rate uncertainty Interest rate eect enters as (i) discount factor (ii) calculation of coupon payment (dependence on the LIBOR rate) One factor short rate model would imply full correlation of all future LIBOR rates. However, the use of a short rate model with more factors would make numerical valuation cumbersome. In reality, interest rate uctuations occur by jump, say, decision made by the US Federal Reserve Board. The simple diusion models cannot capture such eect.

Equity target redemption notes SG Product 10-year fund that is 100% capital guaranteed Pay a juicy xed coupon of 10% in the rst year For Year Two, the coupon payment is referenced to the average performance of the 6 worst stocks in a basket of 24 blue-chip stocks. max{0, 10% + 0.5 average performance of the 6 worst stocks} From Year Three onwards, the investor gets the better of the previous years coupon or the payout formula. Once the aggregate coupon payments reaches or exceeds 20%, the fund terminates with full payment of the coupon for that year.

## Worst scenario: 10-year fund with total coupon of 20%

Blending equity and rates Design products that have both equity and xed-income risk. The equity and xed-income markets typically oset each other during economic downturns, therefore hedging the investor against excessive downside in one market.

Examples 1. A note that automatically switches between a bond and equity index once the initial index reaches a certain barrier. 2. Combination of an equity range accrual and a LIBOR range accrual, with the coupon dependent on the number of days in an observation period where both indexes are within the range.