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
Highly Customised: Structured rate products are tailored
to fit investors’ unique requirements. They create risk-
return 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.

2 3
 Table of Contents

Methodology 6 Features (and their most popular variants)

Building Blocks 7 Snowball: 29
> Snowball Note (Ladder Note)
Credit Linkage 10
> Resetting Snowball
FX Linkage/Quanto 11 > SnowRange Note
Risks 12 > Snowbear Note (Reverse Snowball)
Product Map 13 > Snow TARN
> Thunderball
Callable:
Product Descriptions > Bermudan Callable Note 32
Floaters > Callable Zero Coupon Note 34
Floating Rate Note 15 > Callable Inverse Floater 36
CMS/CMT Linked 16 Target Redemption (TARN) 38
CMS Spread: 18 > Guaranteed Inverse Floater TARN
> Steepener Note (Leveraged CMS Spread Note) > Guaranteed Ladder Inverse Floater TARN
> Flattener Note > Guaranteed Capped Floater TARN
> Digital CMS Spread Note > Guaranteed Fixed Range Accrual TARN
> CMS Spread Range Accrual > Guaranteed SnowRange TARN
> Minimum Coupon Spread Note > Hybrid Coupon TARN
> CMS Spread Inverse Floater Multi Index 40
Ratchet: 20 > Double Digital Note
> Ratchet Note > Linear Trigger Note
> Normal Capped Floater > Dual Range Note
> Dynamic Cap Note 42
Range Accruals
Range Accrual: 23 Other Products
> Normal Range Accrual (lower or upper boundary) Volatility Note 45
> Callable Range Accrual Bond Discount Note 46
> Corridor Range Accrual
> Double Range Accrual
> CMS Spread Range Accrual
Appendix 48
> Minimum Coupon Range Accrual Most Popular Products 49
> Floating Range Accrual Structured Note Market 52
> Step-up Coupon Range Accrual Turbo Certificates 54
> Variable CMS Range Accrual
Interest Rate Models 56
One Look: 26
> One Look Digital Note
Modelling Processes 58
> Multi Look Note Yield Curve Considerations 60

Glossary 63
Disclaimer 66
Contacts 67

4 5
 Methodology
Summary
All product profiles have been generated and presented
using a standardised and rigorous procedure. The layout
of the product profiles is as follows:
Product Summary
The Product Summary provides a snapshot of the main
features of the basic product, how the coupon is determined,
and the potential rate views it may suit. It is worth noting
that the Summary only describes the basic product; with
most structures there is enormous scope for customisation.
Market View
The Market View outlines in more detail the view on
interest rates which is expressed through the product.
Although the focus is primarily on the basic structure,
most products can be customised so as to fit a different
rate view. Importantly, the market view is expressed in
relation to the implied forwards. An investor should only
take a bearish position if he expects rates to rise more
than implied by the forward rates. If the investor believes
that the rates will rise, but less than implied by the forwards,
he should actually take a bullish position. 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.
Description of Product
This section explains in more depth the mechanics of the
structure. The product is broken down into its constituent
parts, allowing the reader to gain a greater understanding
of how it works.
Variations
Here a summary of some of the more popular variations
on the basic product is given. Whilst the list can never be
exhaustive, it does provide investors with an idea of ways
in which the product can be tailored to meet their specific
needs, and indicates the kind of inputs which affect the
profile.
6 7
Example
Basic details of one possible structure are given. Perhaps
the most important aspect of this section is the Delta
Profile, which graphically depicts the interest rate sensitivity
that the specific example has. The delta shows the change
in the position’s value resulting from a basis point change in
the underlying interest rate. 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.
Sensitivity to Rate Moves
The Delta Profile indicates the yield curve view of the
structure. In general, for maturities displaying positive
delta, the structure benefits from increasing rates, and
for maturities displaying negative delta, the structure
benefits from falling rates. The larger the delta for a
maturity, the more impact the interest rate change has
on the mark-to-market of the structure. The sensitivity to
yield curve movements is summarised diagrammatically
for the product specified in the example. Considered are
a parallel upward and downward shift and a steepening
and a flattening. The “shock” to the level and slope was
standardised across products. 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.
Risk
Even though most (but not all) products are capital
guaranteed, there are still inherent risks, which are
summarised in this section. Different risks apply to
different products. Common risks include (but are not
limited to): coupon risk; reinvestment risk (arising from
callability); mark-to-market risk; and principal risk (if not
capital guaranteed).
Also Consider
This final section suggests alternative structures which
investors should consider, based on their market view.
Again, investors should be aware of the huge potential
each product has for customisation.
Building Blocks
Summary
Given the highly flexible nature of structured products,
attempts to categorise and classify them will always be
open to debate. Nevertheless, certain basic “building
blocks” apply to all structured products, such as the
coupon/payoff profile, optional features/enhancements,
and the redemption structure. Investors should also be
aware of some basic concepts, relevant to all products.
These include: the importance of the Forward Curve;
consideration of possible Yield Curve Movements; the
Delta Profile of a note; Vega; and Correlation.
Coupon/Payoff Profile
The payoff is designed in such a way that it optimally
expresses the view of the investor. In order to form
the “basic product”, the coupon can be tailored in many
different ways and linked to an endless variety of indices.
Coupon payments can be capped (increasing the participation
but maximising the upside), floored (guaranteeing a
minimum coupon), capped and floored (also known as a
corridor), or only accrue if certain conditions are met (as
in the Range Accrual structure). The investor can choose
between a (contingent) fixed, floating, inverse floating, or
formula-driven coupon. Furthermore, the payoff can be
quantoed, thus broadening the scope of indices available
for the investor to express a view on (see Building Block:
FX Linkage).
Features
To enhance returns, investors can add features to their
“basic product”. Occasionally, features are so popular
that they become products in their own right. Almost all
structured rate products can have the following extra
features: Callability; Path Dependency (via the Snowball
family); Automatic Redemption (as soon as a certain
coupon is reached: Lifetime Cap: TARN); Minimum IRR
(Lifetime Floor); dependence on more than one index
(Multi Index); Credit Linkage (see Building Block: Credit
Linkage); or FX Linkage (see Building Block: FX Linkage:
Quanto). Additionally, 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, in order to
exploit the value of the curve.
Redemption Structure
Structured notes can also be classified by their redemption
profile: normal “Bullet” notes have the full notional paid
back at maturity; Callable Notes have an unknown maturity
(the issuer holds the option of early redemption); Target
Redemption Notes automatically redeem as soon as an
aggregate coupon level is reached (TARN); Zero Coupon
Notes deliver all accrued interest with the notional at
maturity; or the notional can amortise or accrete. Although
most structures are capital guaranteed, it is also possible to
structure the note such that (part of) the notional is at risk.
Forward Curves
Forward rates are the interest rates between any two
future periods implied by the current yield curve. Just
as the yield curve is a graph of interest rates versus
maturities, forward curves are a graph of forward rates
versus maturities. They are constructed under the principle
that, for example, a one year interest rate will give the
same return as the current six month interest rate,
reinvested at the six month interest rate in six month’s
time (the 6 month forward rate). So today’s 1 year rate
and today’s 6 month rate imply what the 6 month rate
will be in 6 months time. When considering the market
view expressed by a structure, it is important for investors
to realise that it is relative to the forward curve. For example,
an expectation of decreasing rates will only be profitable
if rates fall by more than implied by the forward curve.
 Yield Curve Movements Changes in the Slope of the Yield Curve Changes in the Curvature of the Yield Curve Vega
Investors’ primary concern lies with yield curve Another important indicator of the risk of a structure is
Curve Flattening Curve Steepening Increased Curvature Decreased Curvature
movements and changes in shape, because this is its Vega, which measures the structure’s sensitivity to

Yield

Yield

Yield

Yield
what determines their returns. Movements and changes volatility. Volatility is a key parameter in the pricing of
in shape can be split into three components: level, slope derivatives and changes in volatility changes the value
and curvature. of a structure.

Level: A change in the Level of the yield curve is Maturity Maturity Maturity Maturity Correlation
represented by a parallel shift, which shifts yields at Correlation is the degree to which one variable fluctuates
Bullish Flattening Bullish Steepening
every maturity up or down by the same amount. Delta Profile in line with another variable. The higher the correlation

Yield

Yield
An investor’s structured note position is clearly subject between two variables, the more in line they move.
This type of movement explains the vast majority of yield to interest rate risk, and the sensitivity to this risk is Correlation risk is the risk that due to a change of correlation
curve movements. measured by delta. However, the position can be subject between two indices, the investors structure changes in
to the interest rate risk across all maturities, not just the value.
Changes in the Level of the Yield Curve Maturity Maturity rates that their coupon is directly referenced to. Hence,
the position’s Delta Profile maps out the interest rate
Downward Shift Upward Shift Bearish Flattening Bearish Steepening
sensitivity across all maturities. From this, it is easy to
Yield

Yield

Yield

Yield
see the yield curve view that the position expresses.

Delta Profile of a Range Accrual

Maturity Maturity Maturity Maturity 1 Curve Flattening

0
Slope: A change in the Slope of the yield curve occurs Similarly, a steepening can be bullish (when driven by a

Delta
-1
when long term yields and short term yields become fall in short term yields) or bearish (when driven by a rise
closer together (a curve flattening), or when short term in long term yields). -2
yields and long term yields become further apart (a curve Positive delta at shorter maturities implies that the structure will benefit Maturity
from rising short term rates
steepening). A curve flattening can be either a bullish Curvature: It covers most other movements, which is Negative delta at longer maturities implies that the structure will benefit
flattening (when the flattening is driven by a fall in long simply how “curved” the yield curve is. Driven largely from falling long term rates

term yields), or a bearish flattening (when driven by a rise by the level of uncertainty over future rate movements, Curve Flattening

Yield
Hence, the overall interest rate
in short term yields). increased curvature is represented by a more “humped” view expressed by this position
yield curve. is of a yield curve flattering.
The structure will benefit most if
long term rates fall, and short term
rates rise (by a lesser amount)

Maturity

8 9
 Yield Enhancement
Building Blocks – Credit Linkage
Summary
While most structures are designed to provide exposure
to interest rates only, ABN AMRO now offers investors
the possibility to enhance returns by incorporating an
element of credit risk. Credit Linkage can be applied to
any structure, which can be made switchable (rather than
callable).
Rationale
Demand for additional yield is the main driver for the
growing popularity of credit linked interest rate hybrids
and other exotic structures. Although credit spreads are
historically low, so is the perceived risk (as expressed in the
credit spread). Companies have de-leveraged significantly
following the excesses of 1999 - 2001, default rates are
low, and (implied) recovery rates high.
Switchable
A Credit Linked structure is usually not callable, but
switchable. For example, 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.
Credit Derivatives
Whilst the credit derivatives market has been in existence
since the early 1990’s, it is only since 1999 that the market
has really taken off. Credit derivatives are a class of financial
products designed to isolate the credit risk of an entity,
such as a corporation. Credit risk is a familiar concept - it
is the risk that one party owing money to another party,
may not pay. The basic building block is the Credit Default
Swap (CDS), giving an investor regular income in exchange
for the credit risk of a third party. The investor “insures”
the counterparty against default. In case of default (called
a Credit Event), the investor has to pay an amount equal
to the losses incurred on holding debt of the defaulted
company. After this, the CDS ceases to exist. In note
form (called a Credit Linked Note; CLN), on an occurrence
of a Credit Event with respect to the Reference Entity,
the note will be redeemed at zero and the investor will
receive the Recovery Amount, which is the value of the
defaulted Reference Entity’s bond adjusted for Swap
10
unwind costs. The Swap unwind costs represent the
mark-to-market value of the embedded (and in this
manual described) interest rate swap.
Payment upon default
Investor CDS Counter Part
Regular Premium Income
Credit Events
In the context of credit derivatives, three events are
described as defaults: bankruptcy, failure to pay and
restructuring. These events are known as Credit Events.
Bankruptcy: where the Reference Entity becomes
insolvent, placed under administration, or files for
Chapter 11 protection.
Failure to Pay: where the Reference Entity defaults on
interest or principal payments due on its debt.
Restructuring: where the Reference Entity restructures
the terms of its debt to the disadvantage of the debt
holders.
Multiple Names
Instead of single name exposure, the investor can opt for
linkage to a (linear) basket of Reference Entities, reducing
the exposure on one single name, or increase the leverage
by using a First-To-Default (FTD) basket. Leverage can
also be increased or decreased using a synthetic (CDO)
structure.
Risk
By embedding exposure on a Reference Entity, the
structure is not principal guaranteed. 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. The investor has mark-to-market exposure
to credit spread movements.
Yield Enhancement
Building Blocks – FX Linkage/Quanto
Summary
Whilst most structures in this manual are designed to
provide exposure to interest rates only, ABN AMRO now
offers investors the possibility to enhance returns by
incorporating an element of FX risk. Another possibility
is the quanto mechanism, 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, with the payoff in currency B, or vice versa.
Hence, an investor can take advantage of the expected
levels of many indices in almost any given currency,
without being exposed to the associated FX risk.
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. By adding a second constraint,
the yield can further be enhanced.
Quanto
A quanto or cross-currency derivative is an instrument
involving two currencies. The payoff is determined by
a variable measured in one currency, with the payoff
in another. Key parameters are the forward value of
the underlying, the spot and forward exchange rates,
the volatility of the forward FX rate, the volatility of the
underlying forward value, and the correlation between
the forward value of the underlying and the forward FX
rate. Essentially, a quanto contains an embedded currency
forward with a variable notional amount (“quanto” stands
for quantity adjusting option). 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. For structures involving the
sale of options, the quanto mechanism allows investors
(who “sell” volatility) to benefit from high implied volatility
(at inception) of indices in foreign currencies, without
assuming FX risk or needing to enter into a Cross Currency
Swap. In other words, investors can benefit from steep
curves in other markets, while receiving flows in their
domestic currency, thus avoiding potential FX risk.
Quantos are attractive, because they shield the purchaser
from FX fluctuations.
Foreign Exchange
In terms of trading volume, the FX market is by far the
world’s largest and most liquid market, with daily trading
volumes in excess of 1.5 trillion USD. Under normal
circumstances this volume makes it impossible for
individuals or companies to affect FX rates. Even central
banks and governments find it increasingly difficult to
affect the exchange rates of the most liquid currencies,
such as the US Dollar, Japanese Yen, Euro, Swiss Frank,
Canadian Dollar or Pound Sterling. The currency exchange
market is a true 24-hour market, 5 days a week, with
dealers in every major time zone. Trading begins Monday
morning in Sydney (corresponding to 15:00 EST, or 20:00
GMT, Sunday) and then moves around the globe through
the various trading centres, finally closing on Friday at
16:30 EST (21:30 GMT) in New York. In the long run, FX
levels are determined by real economic factors such as
interest rates, growth, inflation, trade and investment
flows. However, these economic factors are themselves
influenced by the level and volatility of FX. Small changes
in the FX rate can have significant effects on (for example)
imports and exports, affecting potential future growth.
Examples
> A note is denominated in Currency A (say Euros), pays a
coupon in Currency A and redeems in Currency A, but
the payoff depends on an index denominated in Currency
B (for example 6 months USD LIBOR). This is called a
Quantoed note.
> Instead of exposure on a single index (for example 6
months EURIBOR), the payoff depends on a second
index as well (for example the EUR/USD exchange rate).
This is called a Multi Index Note.
Risks
A bet on multiple indices will increase the probability of a
below-market or zero payout.
11
 Risks Product Map

Summary Client’s Attitude to Risk

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

12 13
 Attitude to Risk: Conservative

Floating Rate Note (FRN)

Summary Example: Floating Rate Note

A Floating Rate Note (FRN) suits an investor with the
view that interest rates will go up, or who wants to be Currency EUR
protected against rising interest rates. An FRN is a note Maturity 5 years
whose interest rate is periodically adjusted according to Coupon 6M EURIBOR + 3bps, s.a. 30/360
the interest rate of a specified short term index. These ABN Receives Notional
notes are also known as Floaters.
Delta Profile of 5Y FRN
Market View
0.02
An FRN suits an investor with the view of increasing rates
(or higher future rates than implied by the forwards) or an
0.00
investor who does not want delta exposure on the yield
curve (i.e. likes the note to trade around Par regardless of

Delta
-0.02
interest rate movements). The investor is therefore hedged
against the consequences of rate moves. -0.04

Description of Product -0.06

An FRN is similar to a vanilla interest rate swap, an 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y

agreement between two counterparties to swap a floating

interest rate for a fixed interest rate (or vice versa), based
on a pre-agreed amount, term and conventions. The cash
flows are exchanged at the end of each interest period. In
an FRN, the investor gives the notional to the issuer and
in return receives floating interest payments. The fixing of
the floating interest payment is normally in advance (i.e.
2 business days before the start of the coupon period) and
the payment in arrears (at the end of the coupon period,
on the coupon payment date). So, in a normal FRN the
first coupon is already fixed.
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, with the floating rate fixing a
few days before the coupon payment date, rather than at
the start of the coupon period
> It is possible to construct an Inverse Floater variant if rates
are expected to decrease
In the graph the delta profile of the 5 year FRN shows
the interest rate sensitivity of the structure. The 5 year
negative delta seems large but is very small on an
absolute basis. As expected for a floating instrument,
the sensitivity to interest rate moves is minimal.
Sensitivity to Rate Moves
An FRN has no significant sensitivity to curve moves.
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.
Also Consider
> CMS linked Note
> Capped Floater
> Ratchet Note

14 15
 Attitude to Risk: Conservative Attitude to Risk: Conservative

CMS/CMT Linked Note

Summary Example: CMS Linked Note Sensitivity to Rate Moves

A CMS Linked Note suits an investor with the view that
the yield curve will steepen. The coupon payment in a Currency
CMS Linked Note is referenced to a constant maturity Maturity
swap rate, which is periodically reset. Also possible is a Coupon
Constant Maturity Treasury (CMT) which is referenced to ABN receives
a particular maturity US Treasury.
Market View
4
CMS Linked Notes suit investors with the view that the
yield curve will steepen. Although the coupon payment
will benefit from an increase in the indexed (long term) 0
rate, if the curve shape doesn’t change, the mark-to-
Overall, the structure benefits from a steepening of the
EUR yield curve. Parallel shifts should not have too much of
10 years an impact as the underlying swap is floating-for-floating.
82.50% of the 10Y CMS However, since the participation level is different (82.5%
6M EURIBOR or Notional of the 10 year versus 100% of the 6-months), the deltas
have a slightly different weighting and could result in
some (although limited) parallel shift exposure. 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.
Downward Shift Curve Steepening
A steepening

Yield

Yield
Delta

of the yield
market effect of the parallel upward (downward) shift curve will be
-4 positive for
is small as the funding costs (i.e. the short term rate) the structure.
A parallel
increases (decreases) as well. A CMS Linked Note is shift will have
limited impact.
especially attractive in a flat yield curve environment. -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 flattening

Upward Shift Curve Flattening

Yield

Yield
A Constant Maturity Swap is a floating-for-floating interest The delta profile of the CMS Linked Note is shown the of the yield
curve will be
rate swap, exchanging a LIBOR Rate for a particular swap graph. The 10Y delta is negative as the note is a 10Y negative for
the structure.
rate. By referencing to longer term constant maturity structure and the 10Y delta represents the notional as in A parallel
shift will have
swap rates (typically between 2 and 30 years), the CMS any floating rate instrument. It is the longer dated yields limited impact.
Linked Note enables investors to gain a floating exposure which reflect the implied 10Y constant maturity rate. Maturity Maturity
to a longer term rate. The investor profits from an increase Hence, the structure benefits from rising rates for current
in volatility due to the convexity adjustment (the investor is maturities of eleven years or more. Conversely, the
said to be “long Vega”). Convexity measures the curvature structure benefits from falling rates for current maturities Risks
in the relationship between bond prices and their yields. of ten years or less. A Flattening of the curve will have a negative impact on
Bonds with high convexity perform better if rates change; the mark-to-market of the structure.
if rates fall their price rises by more, if rates rise their
price falls by less. The benefits of convexity cause more When transacted in note form, the note may trade below
convex bonds to have higher prices and consequently par during the life of the transaction.
lower yields.
Also Consider
Variations > Steepener Note
> The CMS coupon can be capped, increasing the > CMS Spread Range Accrual with CMS coupon
participation level in the CMS but limiting the upside
> The CMS coupon can be floored, guaranteeing a
minimum payment, 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, whereby
the investor profits from a decline in a specified CMS rate

16 17
 Attitude to Risk: All Attitude to Risk: All

CMS Spread Note

Summary Description of Product Example: CMS Spread Range Accrual Sensitivity to Rate Moves
A CMS Spread Note suits an investor with a view on In a Steepener or Flattener structure the investor is in A parallel shift Downward Shift Curve Steepening
downwards will

Yield

Yield
the curvature and slope of the yield curve. The payoff effect buying a series of caps to ensure the coupon he Currency EUR normally be
positive for the
depends on the difference between two indices and receives is floored at zero. In the Steepener the investor Maturity 20 years structure as the
coupon is fixed.
can suit a steepening, flattening and stable curve view. buys the cap on the short term rate. In a Flattener the Coupon (5.10% x N/M) annual, 30/360 The effect of
investor buys the cap on the long term rate. In a CMS N Number of days (10Y CMS - 2Y CMS) > 0 a slope move
depends on the
Market View Spread Range Accrual the client sells a series of daily M Total Number of Days relative level of
the curve. Maturity Maturity
CMS Spread Notes suit investors with the view that a Digital CMS Spread Floors. ABN AMRO would receive a ABN Receives 6M EURIBOR or Notional
A parallel shift Upward Shift Curve Flattening
chosen spread will remain relatively unchanged, become day’s worth of coupon for every day the curve is inverse, upwards will

Yield

Yield
normally be
bigger or become smaller than that implied by the forwards and the client receives coupons for days when the curve Delta Profile of a CMS Spread Range Accrual negative for the
structure as the
for the index. CMS Spread Notes can therefore be used in is not inverted. Since two indices are involved, correlation coupon is fixed.
20
different interest rate environments. If an investor expects is important. In general, when buying a CMS Spread Range The effect of
a slope move
a steepening of the curve, a note paying a multiple of the Accrual (assuming the investor sells out-of-the-money depends on the
relative level of
difference between 2 indices may be appropriate (for options), investors prefer low correlation at inception, 0 the curve. Maturity Maturity

example: 8 x (10Y – 2Y)). If the curve becomes steeper, because they will get a higher yield pick-up (since lower

the investor profits significantly. The investor only achieves
an above market return if the curve steepens more than
implied by the forwards. The flatter the curve, the more
leverage is possible. If the investor’s view is of a flattening
curve, a Flattener (similar to an Inverse Floater) will be
attractive. Here the investor receives a high fixed coupon
minus the (leveraged) difference between 2 indices, and
receives a higher coupon if the curve flattens. Another
alternative is a CMS Spread Range Accrual, which accrues
a high coupon for every day the difference between two
indices stays above a certain strike. This is currently a
popular trade in the market, with many investors betting
against an inversion of the EUR yield curve. Current
forward rates imply that 2Y rates will exceed 10Y rates
in 2018, and if the investor’s view is digital by nature (i.e.
the investor thinks the curve will not invert) the CMS
Spread Range Accrual is an attractive option.
correlation makes it more likely for the structure to breach
the range). After trading, 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, giving a positive
effect on the mark-to-market of the structure (the investor
is said to be “long” correlation). Once the option sold
becomes in-the-money the investor prefers correlation
to decrease, making it more likely that the curvature will
move back in his favour. Higher volatility of the spread at
inception will increase the coupon.
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; otherwise
the investor (typically) receives a 0% coupon
> CMS Spread Notes can be done in inverse floater format
Delta
-20
Risks
An adverse movement of the curve can result in a below
-40 market or zero coupon structure (worst case scenario:
1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 20Y 25Y 30Y annual coupons of 0.00% with a value of the structure
close to a Zero Coupon Note).
In the graph the delta profile of the CMS Spread Range
Accrual is shown. As the structure has a fixed (range When transacted in note form, the note may trade below
accrual) coupon, the negative delta in year 20 is expected par during the life of the transaction.
(i.e. the investor prefers rates to go down), although part
of the delta is the notional effect as it is a 20 year note. Also Consider
The interesting part is the positive delta in 25 year and > Target Redemption Notes (if expecting a flatter curve)
30 year. As the investor is basically long the 10Y CMS > CMS Note (if expecting a steeper curve)
and short the 2Y CMS, the positive delta in year 30 is
explained as the 10Y CMS rate in year 20, which the
investor obviously prefers to go up as it increases the
probability of a positive curve. The sensitivity to curve
flattening and steepening is more complex.
Although the structure obviously likes the curve to stay
positive sloping (and a steepening of the curve increases
the probability of receiving the coupon), 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.

18 19
 Attitude to Risk: Conservative Attitude to Risk: Conservative

Ratchet Note

Summary Example: Ratchet Cap A hypothetical interest rate scenario Sensitivity to Rate Moves
A Ratchet Note suits an investor with the view that rates Downward Shift Curve Flattening
A parallel shift

Yield

Yield
will go up but by less than implied by the forwards. A Currency USD Coupon 6M USD LIBOR + 40bps downwards or
a flattening of
Ratchet Note pays a floating rate coupon that is only Maturity 5 years Ratchet cap 25bps per quarter the yield curve
allowed to increase by a certain amount per period. Coupon 3M USD LIBOR + 40bps, qu 30/360 6M USD LIBOR fixing Coupon will normally be
positive for the
Ratchet cap 25bps per quarter 1st fixing 4.00% 4.40% structure.

Market View ABN receives 3M USD LIBOR or Notional 2nd fixing 4.25% 4.65% Maturity Maturity
The Ratchet Note suits an environment with steep yield 3rd fixing 4.60% 4.90%
curves and high volatility (at inception) which allows a Delta Profile of a Ratchet Cap 4th fixing 4.80% 5.15% Upward Shift Curve Steepening
A parallel shift

Yield

Yield
upwards or
substantial yield pick up to be achieved. The structure 5th fixing 5.00% 5.40% a steepening of
1
suits an investor with the view that rates will rise, but 6th fixing 5.50% 5.65% the yield curve
will normally be
that large and quick increases in rates (as perhaps implied 0
7th fixing 5.90% 5.90% negative for the
structure.
by the forwards) will not materialise. The main risk for the 8th fixing 6.30% 6.15%
investor is therefore a scenario in which rates spike up Maturity Maturity
Delta

-1
very quickly, in which case the coupon will lag a normal In the above example it is obvious that a modest increase
Floating Rate Note and need several periods of stable -2 in rates will result in an above market coupon. In a scenario Risks
rates in order to catch up again. of rapidly increasing rates the note will under perform a A spike in interest rates could result in a below-market
-3 normal Floating Rate Note. coupon.
Description of Product 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y

A Ratchet Note is an instrument in which each successive
coupon is capped in some way by the previous coupon
payment. 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. For the successive caplets the
Hypothetical Interest Rate Scenario and Ratchet Coupon When transacted in note form, the note may trade below
In the graph the delta profile of the Ratchet Note is par during the life of the transaction.
6.5%
shown. As expected, the investor prefers the short term
rate to go up slightly. The exposure to 5 year rates is Also Consider
mainly the fact that it is a 5 year structure and partly the 5.5% > Capped CMS

strike is reset on predetermined roll dates. The level at
which the strike is set is dependent on earlier strikes
and fixings. The main feature is the fact that the jumps
in the strike level are restricted to a certain maximum (i.e.
the strike is not allowed to jump by more than 25bps).
Interest Rate
fact that as the investor has sold caps, an increase in the > Capped Floater
5 year rate (which is the present value of the 3 month
4.5%
forwards) indicates an increase in short term rates, which
is capped. The options sold therefore become more in-
the-money, reducing the value of the swap. As a result, 3.5%

the investor prefers 5 year rates to decrease (slightly). 1st

fixing
2nd
fixing
3rd
fixing
4th
fixing
5th
fixing
6th
fixing
7th
fixing
8th
fixing
Variations
Coupon 6M $L Fixing
> Different underlying indices are possible, although some
indices (for example, CMS indices) tend to have less
steep forwards
> Instead of a ratchet cap (i.e. a maximum increase of
25bps per fixing) a normal coupon cap can be applied
(i.e. the coupon cap for year 1 is 4.00%, for year 2:
4.25% etc)

20 21
 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. For each
day the investor is correct he accrues one day’s worth of
coupon, otherwise a below-market coupon accrues
(usually 0%).
Market View
Range Accruals work in different rate scenarios: if future
rates are expected to be higher than implied by the forwards,
a lower boundary only range accrual is a suitable and yield
enhancing structure. If future rates are expected to be
lower, an Upper Boundary Range Accrual works. Corridor
Range Accruals suit a stable rate environment, a rate
move as implied by the forwards or a specific path as
expected by the investor.
Description of Product
A simple Range Accrual is basically a strip of digital options,
one for each day of the accrual period. The investor sells
these options in return for an above-market coupon. Since
the client sells the options, volatility is an important element.
Most of these options will have out-of-the-money strikes
and the higher the volatility at inception, the more value
the options will have, and the higher the coupon will be. If
after the trade the implied volatility increases (decreases)
the mark-to-market of the swap will decrease (increase).
Many Range Accruals are made Bermudan Callable to
enhance the coupon. If the structure is Bermudan Callable,
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. The option sold to ABN AMRO is a Receiver (Range)
Bermudan Swaption. 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), beginning
at a future date for a pre-agreed amount, based upon pre-
agreed conventions (i.e. a receiver swaption is the right
22
to receive the fixed rate), and on pre-agreed dates. By
making the structure callable, the investor is exposed to
swaption volatility. The investor prefers high volatility at
inception as this will enhance his coupon. 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. Assume for reasons of
simplicity the note has a maturity of 1-year (consisting of
360 days):
> If 187 days are within the range, the coupon is: 187/360 x
coupon of (for example) 7.25% = 3.76%
> If all days are within the range, the full coupon will be
paid: 360/360 x 7.25% = 7.25%
Variations
> The index can be LIBOR, CMS, FX, or the spread
between 2 indices (CMS Spread Range Accrual). The
structure can also be dependent on two indices (Double
Range Accrual)
> The coupon can be fixed, floating (Floating Range
Accrual) or step-up (Step-Up Coupon Range Accrual). A
Step Up Coupon Range Accrual works well in a steep
forward curve environment
> It is possible to have a lower boundary only, an upper
boundary only, a corridor (Corridor Range Accrual), step-
up or step-down barriers
> The frequency with which the index is observed can be
daily, weekly, monthly, etc. 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.e. the 10Y in 1Y, the 9Y in 2Y etc): Variable CMS
Range Accrual
23
 Attitude to Risk: All Attitude to Risk: All

Example 1: Callable Corridor RA 3M USD LIBOR Forwards against Specified Boundaries Example 2: Floating CMS spread RA Sensitivity to Rate Moves
6.5 Downward Shift Curve Steepening
Currency USD A steepening

Yield

Yield
Currency USD of the yield
Maturity 5 years 5.5 Maturity 15 years curve will be
positive for
Coupon 7.25% x N/M, qu 30/360 (5Y = 4.70%) Coupon 10Y CMS + 35bps IF (10Y - 2Y CMS) > 0 the structure.

Interest Rate
A parallel
ABN receives 3M USD LIBOR – 11bps or Notional 4.5
ABN receives 3M USD LIBOR or Notional shift will have
limited impact.
Ref index 3M USD LIBOR
3.5 Maturity Maturity
Range Y1 - Y2: 3.00% - 5.50% Delta Profile of Floating CMS Spread RA
Y3 - Y5: 3.00% - 6.00%
2.5 20 Upward Shift Curve Flattening
Callable Quarterly A flattening

Yield

Yield
Oct 05 Oct 06 Oct 07 Oct 08 Oct 09 Oct 10 of the yield
curve will be
Upper 3M Forwards Lower 10 negative for
Delta Profile of 5Y Callable Corridor RA the structure.
A parallel
shift will have

Delta
1 0
In this graph the 3 month USD LIBOR forward interest limited impact.

rate is shown versus the chosen boundaries in above -10

Maturity Maturity

0 mentioned example. Note that according to the forwards

the coupon is paid in full. Risks
Delta

-20
1Y 3Y 5Y 7Y 9Y 11Y 13Y 15Y 17Y 19Y 25Y
-1 An unanticipated move of the chosen reference index can
Sensitivity to Rate Moves result in a low coupon or zero coupon structure (worst
In the graph above the delta profile of the example case scenario: all fixings outside the range, resulting in a
-2
Downward Shift Curve Flattening
A parallel shift Floating CMS Spread RA is shown. As expected, the 0.00% coupon and a value of the structure close to the
Yield

Yield
2W 1M 2M 3M 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y downwards or
a flattening of investor profits from a curve steepening and increase in value of a Zero Coupon Note).
the yield curve
will normally be the longer dated rates. The exposure to 15 year rates is
positive for the
In the graph above the delta profile of the example 5 year structure. partly the representation of paying the short term floating The structure is sensitive to absolute changes in rates
Corridor Callable Range Accrual is shown. The delta profile rate in the swap, which the investor prefers to decrease. and implied volatility.
depicts the interest rate sensitivity of the structure. It is Maturity Maturity
Part of this is the notional effect: it is a 15-year trade.
clear that the investor wants longer dated rates to go down: Upward Shift Curve Steepening When the structure is callable, the investor is exposed to
A parallel shift
Yield

Yield

since the longer dated rates are basically the present value upwards or Floating CMS Spread RA Payoff Profile reinvestment risk.
a steepening of
of a string of forwards, it is far more important for the the yield curve
will normally be 5 1.0
value of the structure that the longer dated rates moves negative for the When transacted in note form, the note may trade below
in the investors favour than the 3 month spot rate, which structure.
4 par during the life of the transaction.
will “only” affect a single coupon payment. The delta profile 0.5

10yr-2yr Spread
Maturity Maturity

Interest Rate
3
shows that the client profits from a curve flattening. Also Consider
2 > SnowRange Note
0.0
> Multi Index Note
1
> Bermudan Callable Note
0 -0.5
2005 2009 2013 2017 2021 2025

Coupon 10yr Swap 10yr-2yr

24 25
 Attitude to Risk: Aggressive Attitude to Risk: Aggressive

One Look Digital Note

Summary Example: One Look (Digital) Note Sensitivity to Rate Moves

A One Look Note suits an investor with a short term In a One Look Note only the fixing counts; the path Upward Shift Curve Steepening
A parallel shift

Yield

Yield
view on an index. If correct, the investor receives a followed by the index is irrelevant. Also, the degree that Currency EUR upwards or
a steepening of
significant above-market coupon. The payout of a One the option is in or out-of-the-money doesn’t matter. There Maturity 1 year the yield curve
will normally be
Look Note is digital: if the view proves to be correct a is no difference of being “just right” or “really right”. The Coupon 5.00% if 10Y EUR CMS fixes at or above positive for the
fixed cash amount will be paid; if the single fixing is structure can be designed to be sensitive to the path 3.60% at maturity (10Y Euro spot = 3.23%) structure.

outside the range no payment will take place. taken. With knock-in and knock-out options a coupon 0.00% if 10Y EUR CMS fixes below 3.60% Maturity Maturity
payoff can be structured which will have a zero payout if ABN receives 3M EURIBOR - 6bps or Notional
Market View a certain barrier is breached or pays out at the moment a A parallel shift
Downward Shift Curve Flattening

Yield

Yield
downwards or
A One Look Note suits any interest rate environment. If an certain barrier is hit. Most of the time investors sell near- Delta Profile of 1Y Digital Note on 10Y CMS a flattening of
the yield curve
investor expects rates to be stable, the coupon payment the-money digital options. At time of trading, the investor will normally be
4
can be contingent upon a fixing within a predefined corridor. prefers the volatility to be high so he receives more negative for the
structure.
If the investor expects interest rates to go up, they can upfront premium. After inception the volatility preference
receive an above-market coupon dependant upon a fixing all depends on the movement of the index relative to the 2 Maturity Maturity

above a certain strike. If rates are expected to decline, a position of the investor. If the reference index is at the

Delta
fixing below a certain strike level would result in the fixed right side of the fixing for the investor, the investor prefers
0
Risks
payoff. One Look Notes are well suited for short term views. volatility to be low. If on the other hand the index is on An adverse movement of the reference index can result
the “wrong” side, the investor prefers volatility to move in a zero pay out (worst case scenario: a 0.00% coupon
Description of Product up so the possibility that the fixing will be positive for -2 and if multiple fixings, a value of the structure close to
In a One Look Note the investor sells a European digital him increases somewhat. Notice that as the investor has 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y the value of a Zero Coupon Note).
option (where the payout is either a fixed cash amount sold the option, an out-of-the-money option is profitable
or nothing at a predefined date) to the issuer. Whilst a for him. The graph above shows the exposure of the note to the As the fixing is digital, even if the investor is correct for
normal swap fixes at the beginning of (or typically a few 11 year interest rate and the 1 year rate. As the note is a 99% of the time, the single fixing can still be outside the
days before) the observation period, here the fixing is in Variations one year structure, the negative delta in year one can be range.
arrears (postponed until the end of, or a few days before > Instead of a One Look, a Multi Look Note can be explained as the notional effect. The main exposure is to
the end of the observation period). In either case, structured (i.e. every fixing is a digital payout regardless the 10 year rate at the end of year one (the 11 year rate), The note may trade below par during the life of the
payments take place at the end (see graph below). of the path and previous fixings) which the investor likes to go up. Overall the investor transaction.
> A normal One Look Note is 3-months up to 1-year, but prefers the curve to steepen.
Fixing-in-arrears with multiple fixings a longer maturity is possible Also Consider
> Instead of a short term interest rate index, swap rates, Bond Discount Note
In-arrears Fixing
FX, commodities or double indices (i.e. exposure on two
indices) are possible

Normal Fixing Start Observation Period Payment Date

26 27
 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. The Snowball
should be seen as a feature which can be embedded in
many structures, allowing the coupon to accumulate by
referring back to the previous coupon. In other words,
future coupons rely on past coupons.
Market View
The most popular Snowball is the inverse floating variant,
designed for investors who believe that the yield curve is
relatively steep and that forward rates overestimate the
increase in spot rates in the future or expect rates to stay
stable or decrease. They generate a significant yield pick- > It is possible to leverage the previous coupon so the
up by betting against the forward curve with leverage. As
the Snowball feature refers back to the previous coupon, the
coupon is path dependent by nature, adding value (leverage)
for an investor with a specific view. The structure works
best in a steep yield curve environment.
Description of Product
The Snowball is also known as a “Ladder”. The main
features of a Snowball are the inverse floater part (in the
form of: Fixed Rate – (X x Floating Rate)), the snowball
itself (Previous Coupon + Inverse Floater) and if callable,
the Bermudan Swaption, which will increase the Fixed
Rate or Gearing. In a Snowball, 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. The cap
is equal to the previous coupon + fixed amount. Suppose
the previous coupon is 5% and the fixed amount is 2%
(making the coupon formula: Previous coupon + 2% - 12M
EURIBOR in arrears), the cap the investor bought is at 7%
(because otherwise the coupon could become negative).
The coupon payoff from a Snowball is sensitive to changes
in the shape of the yield curve and volatility curve.
28
Variations
> The index can be LIBOR, CMS, FX or the spread
between 2 indices
> Instead of speculating on a decrease in rates via the
Inverse Floater 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. This
product is a combination of a Range Accrual, a Snowball
and a Bermudan Swaption (see example 2)
> To reduce the path dependency risk, it is possible to
structure a Resetting Snowball. In this structure the
coupon resets automatically at predetermined dates
coupon formula is [(Gearing x Previous Coupon) –
3M USD LIBOR in-arrears]. This structure is known
as a Thunderball
Example 1: Snowball
Currency EUR
Maturity 7 years
Coupon Y1: 5.75%, s.a. 30/360
Y2 - Y7: (Previous coupon + 2.50% - 6M
EURIBOR (in arrears)), floored at 0%
Callability Semi annually
ABN receives 6M EURIBOR or Notional
29
 Attitude to Risk: Aggressive Attitude to Risk: Aggressive

Delta Profile of a Snowball Note As expected, a flattening curve will generate a positive SnowRange Payoff Profile Also Consider
mark-to-market for the investor. This effect is enhanced > Target Redemption Note
1.5 12
as a result of the effects of gearing and the path > Callable Range Accrual
dependent nature of the coupons.
0.0 9

Interest Rate
Callable SnowRange
Delta

-1.5 6
Currency USD
Maturity 5 years
-3.0 Coupon 6M: 7.00% x N/M 3
1M 3M 6M 9M 12M 15M 18M 21M 2Y 3Y 4Y 5Y 6Y 7Y 8Y Oct 05 Oct 06 Oct 07 Oct 08 Oct 09 Oct 10
Thereafter: (Prev coupon + 0.50%) x N/M
N number of days 6M USD LIBOR is within Coupon Upper 6M Forward Lower

In the previous graph the delta profile of the example range

Snowball structure is shown. As expected, the investor M total number of days SnowRange Coupon Calculation
prefers rates to decrease. Range 3.50% - 6.00% Assume for reasons of simplicity a period of 3-years
Callability Semi annually (consisting of 3 x 360 days) and an initial coupon of
Snowball Payoff Profile ABN receives 3M USD LIBOR or Notional 7.00%:
6
In a SnowRange, the coupon is determined by counting If in year 1 all days are within the range, the coupon at
the number of days within the range versus the number the end of year one will be: 7.00% x 360/360 = 7.00%.
4 of days in that period, multiplied by the previous coupon.
Interest Rate

The coupon payment is therefore highly path dependent; Suppose in year 2 only 180 days are within the range:
2
once a coupon is reduced due to a period of fixings outside the new (now maximum) coupon for the note is 7.00%
the range, future payouts will always be equal at best or x 180/360 = 3.50%. If in year 3 all days are back in the
lower than the previous coupon, even if the investor is range again, the new coupon would be 3.50% x 360/360
0 continuously correct in the subsequent periods. The = 3.50%.
Oct 05 Oct 06 Oct 07 Oct 08 Oct 09 Oct 10 Oct 11 Oct 12
advantage of a SnowRange over a normal Callable Range
Coupon 6M Forward Accrual is the additional pick up in yield if the view proves Risks
to be correct. The structure is sensitive to absolute changes in rates
Sensitivity to Rate Moves and implied volatility.

Downward Shift Curve Flattening

A parallel shift The path dependent nature of Snowball structures can
Yield

Yield

downwards or
a flattening of result in a below-market coupon or even zero coupon
the yield curve
will normally be despite the view of the investor being correct for most of
positive for the
structure.
the time (i.e. the timing of being right is very important:
the most risk is early in the life of the note). The worst
Maturity Maturity
case scenario is 0.00% coupons during the life of the
Upward Shift Curve Steepening note and a value of the structure close to the value of
A parallel shift
Yield

Yield

upwards or a Zero Coupon Note.

a steepening of
the yield curve
will normally be
negative for the
When transacted in note form, the note may trade below
structure. par during the life of the transaction.
Maturity Maturity

30 31
 Attitude to Risk: Conservative Attitude to Risk: Conservative

Bermudan Callable Note

Summary Variations Sensitivity to Rate Moves

A Bermudan Callable Note suits an investor with the view > The number of calls and the first call is flexible (i.e.
Downward Shift Curve Flattening
that the long term rates will not rise as quickly as the 5YNonCall6M, 5YNC2Y) A parallel shift

Yield

Yield
downwards or
forwards suggest or expects rates to be stable. Investors > The coupon structure can step up (for example in an a flattening of
the yield curve
achieve a pick-up over the equivalent reference rate by environment where the curve is very steep: as the step will normally be
positive for the
selling ABN AMRO the option to call the structure (redeem up is in line with the forward rates it increases the option structure.
early) at a pre-determined level (usually 100%) on pre- value). This is a Step-Up Callable Note
determined dates through the life of the note. Maturity Maturity

Example: Bermudan Callable Note Upward Shift Curve Steepening

Market View A parallel shift

Yield

Yield
upwards or
a steepening of
A Bermudan Callable Structure is most attractive if the Currency EUR the yield curve
will normally be
investor believes that the market will be relatively stable Maturity 10 years negative for the
or that rates will rise less than implied by the forwards. If Coupon 3.55%, s.a 30/360 (10Y ref rate 3.23%) structure.

the investor expects rates to go down, he will buy a fixed ABN receives
rate security. If he expects rates to go up, he will prefer a Callable
floating rate instrument. The embedded Bermudan option
allows the investor to achieve a coupon pick-up in return Delta Profile of a 10Y Callable Note
for the risk of early redemption. The investor sacrifices a
0
known duration of a normal bond for a higher yield and
uncertain duration of a Bermudan Callable Note.
-1
Description of Product
Delta
6M EURIBOR – 11bps or Notional Maturity Maturity
NC12M, thereafter semi-annual
If interest rates move up, the probability that the note
will be called decreases (assuming constant volatility).
If interest rates move down, the likelihood of the note
being called increases. As the investor has sold an
option, an increase in implied volatility will decrease
the mark-to-market value of the structure; a decrease in

In a Callable Note, the investor sells a call option with a -2

implied volatility will increase the value of the structure
strike at 100% to the issuer, meaning that he sold the right (and also increase the probability of being called).
(but not the obligation) to redeem the notes at 100% on
any given call date. For this the investor is compensated -3 Risks
1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y
by an option premium, which will be paid in the form of a An increase in rates can result in a mark-to-market loss
higher coupon. The option sold is a Bermudan Swaption, (the note will trade below par), as with any fixed rate
giving the buyer the right to exchange a stream of floating In the graph above the delta profile is shown. As instrument (an opportunity loss).
interest rate payments for a stream of fixed interest rate expected, the main sensitivity is to 10 year interest
payments, beginning at a future date for a pre-agreed amount rates. A decrease in the 10 year rate will increase the The structure is sensitive to changes in volatility.
and based upon pre-agreed conventions. This embedded mark-to-market value of the structure.
option in the note shortens the duration of the note and leads If interest rates fall and the structure is called, the
to negative convexity: when yields fall, the duration falls too investor is exposed to reinvestment risk.
as it becomes more likely that the call will be exercised. The
yield pick-up of a Callable Note over the fixed rate depends Also Consider
on several factors. Higher maturity, volatility and steepness > Callable Zero Coupon Note
of the forward curve generally increase the yield pick-up. > Callable Range Accrual with a “wide” range
Investors are essentially selling swaption volatility and
prefer high volatility at inception of the trade as this will
enhance their coupon. The reason behind the Bermudan
Callable Note’s popularity is the fact that most investors
prefer uncertainty in maturity over uncertainty in yield.

32 33
 Attitude to Risk: Medium Conservative Attitude to Risk: Medium Conservative

Callable Zero Coupon Note

Summary Description of Product Example: Callable Zero Coupon Note Sensitivity to Rate Moves
A Callable Zero Coupon Note suits an investor who In a Callable Zero Coupon Note, the investor sells a call Downward Shift Curve Flattening
A parallel shift

Yield

Yield
expects rates to be stable, or has the view that the long option to the issuer, meaning that the investor has sold Currency EUR downwards or
a flattening of
term rate will not rise as quickly as implied by the forwards. the right (but not the obligation) to redeem the note at a Maturity 10 years the yield curve
will normally be
A yield pick-up over the equivalent reference rate is achieved predetermined level and call date. For this the investor is IRR 3.75% (10Y rate 3.26%) positive for the
by selling ABN AMRO the option to call the structure compensated by an option premium, which will be paid Call NC1Y, annual afterwards structure.

(redeem early) at a pre-determined level on pre-determined in the form of an enhanced fixed internal rate of return ABN receives 6M EURIBOR -11bps or Notional Maturity Maturity
dates throughout the life of the note. As the name suggests (IRR). The option sold is actually a Receiver Bermudan
Upward Shift Curve Steepening
coupons are not paid during the life of the note, but are Swaption. The IRR will be higher when the Swaption Delta profile of a 10Y Callable Zero Coupon Note A parallel shift

Yield

Yield
upwards or
automatically reinvested at a fixed annual rate of return, volatility at inception is higher. The embedded option a steepening of
0 the yield curve
and paid at maturity. A popular variant is the Zero Accreting in the note shortens its duration and leads to negative will normally be
Swap, in which an annual coupon is paid, but over an convexity: when yields fall, the duration falls too as it negative for the
structure.
-1
accreting notional. It replicates the normal zero coupon becomes more likely that the call will be exercised. The
structure, but lowers the credit risk for the investor on IRR of a Callable Zero Coupon Note therefore depends Maturity Maturity

Delta
-2
the counterparty. on the shape of the curve and volatility.
-3 If rates increase, the relative mark-to-market of a Zero
Market View Variations will suffer as the fixed IRR will be lower than the prevailing
A Callable Zero structure is most attractive for an investor > Zero Coupon Notes can be callable or non-callable (with -4 market rate. If rates are stable or increase less than implied
who does not need a regular cash flow, and believes that no reinvestment risk). The yield of a Callable Zero Coupon 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y by the forwards the Zero will outperform the benchmark.
the market will be relatively stable or that the forwards will look more attractive relative to a non Callable Zero If rates decrease, the likelihood of the note being called
imply that rates will not rise by too much. If the investor Coupon if the curve is relative flat after the first call date In the graph above the delta profile is shown. As increases and the investor will have had an above market
believes rates will decrease a Normal (Non Callable) Zero > Zero Accreting Swaps where the notional over which an expected, the main sensitivity is to 10 year interest IRR but has to reinvest in a lower yield environment.
Coupon is a well suited product as it has a duration equal annual coupon is paid increases rates. A decrease in the 10 year rate will increase the
to its maturity (i.e. high interest rate sensitivity) and the > To enhance the yield, the non-callable Zero Coupon can mark-to-market value of the structure. Risks
investor is not exposed to reinvestment risk. The advantage be linked to a preferred credit (for example GE, Philips or Zero Coupon Notes have a duration equal to its maturity
is that a Zero Coupon Note will generally have a higher BMW). In this case the investor sells default protection and therefore have mark-to-market high interest rate
yield than a coupon bearing note in an upward sloping on the selected entity for which he receives a premium. sensitivity.
yield curve environment. Another reason for buying a If the underlying entity defaults, the investor loses its
Zero Coupon Note could be the desire to defer tax on principal and will receive the unknown recovery value. When the Zero Coupon Note is made callable, the
interest until a later date. In a Callable Zero Coupon the This is a Credit Linked Zero Coupon Note investor is still exposed to reinvestment risk.
investor sacrifices a known duration of a straight zero
coupon bond for a higher yield and uncertain duration. Also Consider
Bermudan Callable Note

34 35
 Attitude to Risk: Medium Aggressive Attitude to Risk: Medium Aggressive

(Callable) Inverse Floater

Summary Example: Callable Inverse Floater Sensitivity to Rate Moves

An Inverse Floater suits an investor with the view that Downward Shift Curve Flattening
A parallel shift

Yield

Yield
a certain index will stay low while the forward for that Currency EUR downwards or
a flattening of
index is upward sloping. The coupon structure of an Maturity 10 years the yield curve
Inverse Floater is a fixed rate minus a particular index, Coupon 11.35% - (2 x 6M EURIBOR). will normally be
positive for the
which therefore floats inversely with the chosen index. (At time of pricing 10Y Euro = 3.49%) structure.

ABN receives 6M EURIBOR - 11bps or Notional

Maturity Maturity
Market View Callable Semi annual
The Inverse Floater suits an investor with the view that a Upward Shift Curve Steepening
A parallel shift

Yield

Yield
upwards or
certain index will decrease or stay low while the forward Delta Profile of a Callable Inverse Floater a steepening of
for that index is upward sloping. To support the view that the yield curve
will normally be
0
the market is overestimating the future fixings, leverage negative for the
structure.
is possible by subtracting a multiple of the index from a -1
higher fixed rate. Higher leverage provides greater potential Maturity Maturity

upside, but also increases the probability of reaching the

Delta

-2
worst case scenario: a 0.00% coupon. By choosing the extent Risks
of leverage the investor can express his risk appetite. -3 An unanticipated upward move of the chosen reference
index can result in a low coupon or zero coupon structure
Description of Product -4 (worst case scenario: 0.00% coupons and a value of the
6M 9M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y
An Inverse Floater is the opposite of a normal Floating structure close to the value of a Zero Coupon Note).
Rate Note: rather than receiving the index, (a multiple of)
the index is subtracted from a fixed amount. The lower In the graph above the delta profile of the Callable The structure is sensitive to absolute changes in rates
the index resets, the higher the coupon. The most Inverse Floater is shown. As expected, the investor and implied volatility.
commonly used indices are short-term interest rates like prefers rates to decrease over all maturities.
6-month EURIBOR or 3-month USD LIBOR. Investors If the structure is callable the investor is exposed to
generally floor the coupons at zero by buying a series of Payoff Profile of a Callable Inverse Floater reinvestment risk.
caps with a strike equal to the fixed amount divided by
6
the leverage. If the structure is Bermudan Callable, the When transacted in note form, the note may trade below
investor has sold a Bermudan Swaption to the issuer 5
par during the life of the transaction.
meaning that he sold the right (but not the obligation) to
Interest Rate

redeem the notes at 100% on any given call date. As the 4 Also Consider
investor sells the option, he prefers swaption volatility to > Target Redemption Note (since most Target Redemption
be high at inception (the investor is selling volatility). 3 Notes are Inverse Floaters)
> Snowball
Variations 2
Oct 05 Oct 07 Oct 09 Oct 11 Oct 13 Oct 15
> The index can be LIBOR, CMS, FX or the spread
between 2 indices Coupon 6M Forward

> 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, whereby in arrears
fixing will take extra advantage of a steep yield curve

36 37
 Attitude to Risk: Aggressive Attitude to Risk: Aggressive

Target Redemption Note (TARN)

Summary Example: Inverse Floater TARN Sensitivity to Rate Moves

A TARN suits an investor with the view that interest rates structure has a minimum IRR). As such the product has Downward Shift Curve Flattening
A parallel shift

Yield

Yield
will remain within a pre-defined band, or, as in the most an unknown duration. If interest rates and volatility fail to Type Guaranteed Inverse Floater TARN downwards or
a flattening of
popular structures, decrease over time (or increase less rise or fall as much as implied by the forward curve then Currency USD the yield curve
will normally be
than implied by the forwards). The TARN automatically the duration of the trade can change significantly. In other Maturity 5 years positive for the
redeems when the total sum of the paid out coupons words, the uncertainty of this product lies in the timing Coupon Y1: 6.00%, s.a. 30/360 structure.

equals a designated target level (the Lifetime Cap) and of the final payment and maturity. Y2 - Y5: [13.50% - (2 x 6M USD LIBOR Maturity Maturity
therefore has by definition an unknown duration. Although in arrears)]
Upward Shift Curve Steepening
the TARN can be seen as a feature (and implemented in Variations ABN receives 3M USD LIBOR – 11bps or Notional A parallel shift

Yield

Yield
upwards or
many products), due to its popularity we will describe > The TARN is available in those currencies where ABN Lifetime Cap 10% a steepening of
the yield curve
TARNs as a separate product. AMRO operates underlying vanilla cap/floor and swaption will normally be
portfolios (in most currencies up to 10-years, in USD and Delta Profile of a GIF TARN negative for the
structure.
Market View Yen up to 12-years and in Euro up to 15-years)
2
The TARN coupon structure can take several forms, but in > The TARN payout may be a coupon bearing instrument or Maturity Maturity

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. The most almost any coupon type that exists for a traded market 0 Possible outcomes for a few volatility scenarios given
popular structures are the Guaranteed Inverse Floater index (a short term index such as LIBOR, a swap rate the GIF version

and the Guaranteed Ladder Inverse Floater. It is of course
possible to structure the TARN such that it profits from an
increase in rates. With the Guaranteed Fixed Range Accrual
variant the barriers can be defined in such a way that the
investor profits from increasing rates (by having a lower
boundary only). Obviously, the investor wants the duration
of the product to be as short as possible (which will be
the case if his view proves to be correct) as the rate of
return is known per possible redemption date and decreases
with time.
Description of Product
The product derives its name from its embedded life time
cap (sometimes referred to as the aggregate cap or min-
max cap) and sets an absolute limit on the aggregate
amount of coupon that will be paid over the lifetime of
the structure. The sum of all coupons paid over the life
of the transaction will be equal to the Lifetime Cap, and
once this target is reached, the structure automatically
or an FX rate coupon). Currently, ABN AMRO offers the
following coupon types within the TARN structure:
> Guaranteed Inverse Floater (GIF): The coupon pays
Max [Fixed Rate – (gearing x floating index), 0] up to
the lifetime cap level, e.g. Max [X.XX% - (2 x 6M USD
LIBOR in arrears), 0] subject to aggregate cap level of
Y.YY%
> Guaranteed Ladder Inverse Floater (GLIF): The coupon
pays Max [Previous coupon + X.XX% - (gearing x
floating index), 0] up to the lifetime cap level
> Guaranteed Capped Floater (GCF): The coupon pays
(Floating Index + spread) capped at X.XX% and subject
to the lifetime cap
> Guaranteed Fixed Range Accrual (GFRA): Fixed Rate x
N/M (see Range Accruals)
> The Guaranteed SnowRange (GSR) combines the GFRA
and a variant of the GLIF
> Hybrid Coupon: combines any of the coupon types
Delta
An increase in volatility increases the probability of higher
-2
interest rates and thus a decrease in expected coupon
payout which would result in a lengthening of the duration.
-4 The converse holds true for decreases in volatility. Although
6M 9M 1Y 2Y 3Y 4Y 5Y 6Y
an increase in volatility also increases the probability of
lower rates, in an upward sloping curve environment more
In the graph above the delta profile of the Guaranteed “risk” is on the “higher rates” side.
Inverse Floater TARN is shown. As the structure has
possible automatic redemption in years 2 and 3, the Risks
investor prefers these rates to go down as the in-arrears The coupon payoff from target redemption structures is
fixing is like a digital: a fixing at a level which will result sensitive to changes in the shape of the yield curve and
in auto redemption or a fixing which will result in a volatility curve.
continuation of the structure.
The TARN has an unknown duration by nature, with in the
GIF TARN Payoff Profile worst case the final coupon (if the structure has a lifetime
floor, otherwise no coupon at all) on the maturity date of
6
the note.
5 When transacted in note form, the note may trade below
Interest Rate

redeems. As most of the LIBOR based target redemption described par during the life of the transaction.
structures can potentially result in a negative coupon for 4
a particular coupon period as well, most structures are Also Consider
floored at zero. Also, in most structures the lifetime cap > SnowRange Note
is the lifetime floor: at maturity the final coupon pays any 3 > CMS Spread Note (Flattener)
Oct 05 Oct 06 Oct 07 Oct 08 Oct 09 Oct 10
remaining unpaid portion of the lifetime cap/floor (so the
Coupon 6M Forward

38 39
 Attitude to Risk: Aggressive Attitude to Risk: Aggressive

Multi Index Note

Summary Variations Delta Profile of a Double Digital Range Risks

A Multi Index Note suits an investor with a specific view
on multiple markets or indices. 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.
> Different underlying indices are possible such as Accrual A bet on multiple indices will result in a higher probability of
(quantoed) money market rates, swap rates and FX rates receiving a zero coupon. The worst case is a consecutive
5.0
> Double Digital Option: the digital pay-off depends on 2 breach of one of the barriers resulting in 0.00% coupons
boundaries and 2 indices. For example the client receives 2.5 and a value of the note close to the value of a Zero
9.00% if 3M USD LIBOR fixes below X.XX% AND 10Y Coupon Note.
0.0
USD CMS fixes above Y.YY%

Delta
Market View > Linear Trigger Option. For example the client receives -2.5 The investor is exposed to more complex (and less
Multi Index Notes are designed for investors looking for USD 10Y CMS + 35bps if (10Y CMS - 2Y CMS) > 0. observable) sensitivities.
-5.0
additional yield pick-up and/or have a very specific view > Dual Range Option: the investor will receive a fixed or
on multiple indices and want to leverage this. An example floating payoff if 2 conditions are met. For example the -7.5 When transacted in note form, the note may trade below
is the Double Digital Option Note in which the digital client receives a coupon of X.XX% x N/M for all days 3M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 20Y par during the life of the transaction.
payoff depends on two boundaries and two indices. USD LIBOR is within (2.50% - 6.00%) AND USD/JPY is
within 90.00 - 120.00). In the graph above the delta profile of the Double Digital Also Consider
Description of Product Range Accrual is shown. As expected, the structure > Hybrid Coupon TARN
Multi Index Products have payoffs which depend on Example: Double Digital Range Accrual profits from increasing rates and a steepening of the > Dynamic Cap
multiple interest rates, multiple underlying indices or curve. The negative delta in year 5 is partly due to the
a combination of the two. Consequently, correlation Currency USD notional effect, since it is a 5-year note.
is a consideration. In general, the investor prefers the Maturity 5 years
correlation to be low at inception and increase over time Coupon 9.50% x N/M Sensitivity to Rate Moves
as most investors prefer selling out-of-the-money options. N number of days CMS 2Y > 4.50%
Upward Shift Curve Steepening
Low correlation increases the likelihood that the two AND CMS 10Y - CMS 2Y > 0.00% A parallel shift

Yield

Yield
upwards or
indices will breach a certain constraint, and therefore the M Total number of days a steepening of
the yield curve
upfront pick-up for the investor is higher. After trading, ABN receives 3M USD LIBOR or Notional will normally be
positive for the
if correlation increases, the likelihood of the two indices structure.
breaching a certain rule falls, since they move more in
line. Therefore the note becomes less risky for the investor, Maturity Maturity

which will have a positive effect on the mark-to-market of Downward Shift Curve Flattening
A parallel shift

Yield

Yield
the structure (the investor is said to be “long” correlation). downwards or
a flattening of
Since the investor usually sells out-of-the-money options, the yield curve
will normally be
he prefers volatility to be high at inception but to decrease negative for the
over time, as an out-of-the-money option with decreasing structure.

volatility has a smaller likelihood of becoming in-the-money. Maturity Maturity

40 41
 Attitude to Risk: Medium Conservative Attitude to Risk: Medium Conservative

Dynamic Cap Note

Summary Delta Profile of a Dynamic Cap

A dynamic cap suits investors with a view on the slope spread between the 2 rates in 2 different currencies is
5 Upward Shift Curve Steepening
of the yield curve or on the difference between 2 rates low) the dynamic cap investor is long volatility on the A steepening of

Yield

Yield
the yield curve
in different currencies, and is a variant of the well known spread at inception. He prefers low volatility at inception will be positive
for the structure.
spread option. This variable strike cap can be added to a to reduce the cost of the floor, but prefers high volatility 0 The parallel shift
exposure is limited
structure in order to finance the extra leverage sometimes after trading, as it raises the likelihood that the spread but correlates with

Delta
the steepness of
sought. So instead of having a cap fixed at 7.00%, the cap will widen. the curve.
-5 Maturity Maturity
is at 3M USD LIBOR + 100bps; hence, it is “dynamic”.
The coupon therefore depends on the minimum of 2 Variations A flattening of
Downward Shift Curve Flattening

Yield

Yield
payoffs: the leveraged difference between 2 indices and > A guaranteed minimum coupon can be achieved, although -10 the yield curve
will be negative
EDH7 EDU7 EDH8 4Y 6Y 8Y 10Y 12Y 14Y
an index plus a margin. this decreases the upside for the structure.
The parallel shift
> The absolute coupon can be capped, increasing the exposure is limited
Market View leverage over the spread or margin over the single index This graph shows the delta profile of the Dynamic Cap. but correlates with
the steepness of
the curve.
Selling a dynamic cap gives the investor both a relative > A flattening view can be accommodated. However, in As expected, the investor profits from a steepening of Maturity Maturity
rate view (i.e. an intra-curve or inter-curve) and a view on current market conditions the floor will be expensive to the curve. The structure overall has a slightly negative
the absolute level of interest rates. For example, if a curve finance delta due to the notional effect, the floor at 0.00% and
shifts upwards and also steepens, the dynamic cap strike > A fixed rate can be added to the leveraged Spread (for the fixed element in the cap. A structure with a fixed cap Risks
increases and avoids a negative impact on the payout of example Min (3M + 1.00%, 2.00% + 5 x (10Y – 2Y)) would have a higher negative delta. The high negative The main risk will be with the underlying payoff which is
the steepening as opposed to a fixed cap. Selling the > A Dynamic Floor can be structured (for example Max (3M delta in year 5 is partly due to the notional effect: it is capped by the dynamic cap (worst case scenario: 0.00%
variable cap enables the investor to finance the leverage – 1.00%, 6 x (10Y – 2Y)), floored at 0.00% a 5 year trade. coupons and a value of the structure close to the value
on the Spread. An example payout is a note which pays of a zero coupon bond).
the minimum of a weighting times an index, plus a spread Example: Dynamic Cap Sensitivity to Rate Moves
(for example: 3M USD LIBOR + 100bps), or a leveraged Overall, the structure benefits from a steepening of the A Flattening of the curve will have a negative impact on
difference between 2 indices (for example: 10 x (10Y CMS Currency USD curve. Although the structure has limited parallel shift the mark-to-market of the structure.
– 2Y CMS)). Without the dynamic cap the leverage would Maturity 5 years exposure, a parallel upward shift will be slightly negative
have been lower, for example 8 x (10Y – 2Y). The structure Coupon Y1 - Y2: 8.00% for the structure due to the notional effect, but slightly When transacted in note form, the note may trade below
is often floored at 0.00% (always in note format), and the Thereafter : Min [3M USD LIBOR + positive for the structure if it is combined with a steepening par during the life of the transaction.
investor generally profits if the curve steepens or a spread 1.00%, 10 x (10Y CMS – 2Y CMS)] of the curve. A steepening of the curve implies higher
widens (in the case of a spread on 2 rates in 2 different floored at 0.00% forward rates and thus a higher forward cap. The advantage Also Consider
currencies) and the 3rd reference rate shifts upward. ABN receives 3M USD LIBOR or Notional of a dynamic cap over a fixed cap in a parallel upward > CMS Spread Note
shift is therefore obvious: a parallel upward shift won’t > Multi Index Note
Description of Product impact the absolute coupon level. The structure is more
The dynamic cap product is an enhancement of the attractive when at inception the forward curve is flat.
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). The variable cap depends
on one of the 2 indices in the spread or a third index.
Typically, the investor buys a spread option to floor the
structure. Furthermore, when the curve is flat (or the

42 43
 Attitude to Risk: Medium

Volatility Note

Summary Delta profile of a 10Y Volatility Note

The Volatility Note suits an investor with the view that the
5
volatility of a particular index will go up. A Volatility Note
pays a coupon which is linked to the absolute variation of
an index over a set period of time. The more variation, the 0

higher the payout will be.

Delta
-5
Market View
A Volatility Note suits an investor with the view that the
volatility of an index will go up. The investor takes advantage -10
1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y 20Y
of any movements of the index, without having to take a
view on the direction of the index. The note can also be In the graph above the delta profile of the 10 year digital
used as a hedge for long term bond investors whose Volatility Note is shown. The negative delta in year 10 is the
portfolios have natural negative volatility. notional effect: it’s a 10-year note. The longer maturity
buckets indicate a preference for increasing rates which is
Description of Product logical as the 11 year rate can be seen as the 10 year rate
A Volatility Note paying an annual coupon of (gearing x 1 year forward, which the investor obviously likes to increase.
the absolute change of an index) is similar to being long a Overall the investor prefers a steepening of the curve.
string of cash-settled one-year swaption straddles, reset
at-the-money every year. The investor is therefore said to Sensitivity to Rate Moves
be “long Vega”: he profits from an increase in volatility. A
A parallel shift Downward Shift Curve Steepening
major advantage of the Volatility Note is the fact that the downwards will

Yield

Yield
normally be
investor can play the absolute variation of an index, without positive for the
investor as the
the complexity of managing a rolling option position. relative value of
the fixed coupon
increases. A
Variations steepening will
normally be positive
Maturity Maturity
> The Volatility Note can be made digital: if Index X in as it signals rising
(thus changing) yields.
arrears – Index X fixes at or above Y.YY%, the investor Upward Shift Curve Flattening

Yield

Yield
A flattening
receives a fixed coupon. Otherwise no coupon is paid of the yield
> The note can be constructed as an inverse floater, curve or an
upward shift
profiting from a decrease in volatility will normally
be negative for
> Instead of one index, two indices can be used the structure.

Maturity Maturity
Example: 10Y Digital Volatility Note
Risks
Currency EUR A decrease in volatility will result in a below-market or
Maturity 10 years zero coupon (worst case are consecutive 0.00% coupons
Coupon 5.25% if |10Y CMS in arrears - 10Y with the value of the structure close to the value of a Zero
CMS| > 0.40%, annual 30/360 Coupon Note). When transacted in note form, the note
Fixing Annual, 2 bd before coupon payment may trade below par during the life of the transaction.
ABN Receives 6M EURIBOR + 8bps or Notional
Also Consider
(One Look or Multi Look) Digital Note

44 45
 Attitude to Risk: Medium Attitude to Risk: Medium

Bond Discount Note

Summary Variations Delta Profile of a Bond Discount Note Risks

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). The
investor receives his money back if the fixing is at or above
> 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,
A fall in the price of the underlying bond can result in
2
delivery of the bond at a higher price than the present
market price (not a capital guaranteed structure).
0

the strike (the preferred scenario: cash settlement) or or the coupon can be based on the investor’s strike Also Consider

Delta
receives the underlying bonds at a higher price than the preference One Look Digital Note
-2
spot price of that bond (bond delivery, resulting from a > Instead of government bonds the investor can select a
fixing below the strike). A BDN is mostly a short term play. corporate bond. By selecting a corporate bond the maturity
has a maximum of 6-months -4

Market View > It is possible to structure a BDN in which bond delivery 6M 9M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y

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), because with a large
fall in rates he would prefer to buy the underlying bond.
Description of Product
With a BDN, the investor sells a put option on a bond
with a certain strike to the issuer, 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, paid as an above-market coupon. In
order to maximise the coupon it is important for the BDN
that the reference bond’s coupon is not too high, and the
bond does not have too many accrued days of interest.
This would reduce the Participation Level. If at maturity
is the preferred scenario and cash settlement the non
preferred one (for example cash settlement at a lower The delta profile shows that the sensitivity is obviously
level than 100%) to the long rate. If rates decrease the price of a fixed
> This structure is also very popular on FX (called DCD’s: income instrument will increase so the probability of
Dual Currency Deposits) or Equity (Reverse Convertibles) delivery of the underlying bond will decrease (as the
spot price will move away from the strike price).
Example: Bond Discount Note
If rates increase the probability of the strike being
Currency EUR triggered at the maturity date increases.
Maturity 3 months
Coupon 4.75% (3M EURIBOR at 2.17%) As the structure involves selling a put option, there is
Underlying Nether 3.25% 2015 some mark-to-market sensitivity to volatility.
Strike 100.50% (at time of pricing 100.71%)
Sensitivity to Rate Moves
If fixing is at or above 100.50%, the investor receives the
Downward Shift Curve Flattening
coupon and the note will be settled in cash (the investor A parallel shift

Yield

Yield
downwards or
the option is in-the-money, the underlying bonds are receives his money back). If fixing is below 100.50%, the a flattening of
the yield curve
delivered “dirty” (with accrued interest). A relatively high investor will receive his coupon, but settlement will be in will normally be
positive for the
coupon and accrued interest leads to a relatively higher bonds: the investor receives a number of the reference structure.
dirty price, therefore reducing the number of deliverable bonds instead of his money back.
bonds per denomination. Hence the upfront premium will Maturity Maturity

be lower. High volatility at inception is positive for the Upward Shift Curve Steepening
A parallel shift

Yield

Yield
investor as the option sold has more value and therefore upwards or
a steepening of
increases the coupon. A Bond Discount Note is also the yield curve
will normally be
known as a Bond Reverse Convertible. The structure is negative for the
not capital guaranteed. structure.

Maturity Maturity

46 47
 Appendix Most Popular Products

Most Popular Products Summary 2006 1st Semester CMS Breakdown

Interest Rate linked MTNs still hold the major share of
Standard CMS Linked 54%
the structured MTN market, with a wide and growing CMS Spread Range Accrual 25%
Structured Note Market variety of structures.
CMS Spread
CMS Volatility Linked
10%
4%
CMS Linked Range Accrual 4%
CMS Linked Quanto 2%
CMS Linked Target Redemption 1%
Turbo Certificates Despite the difficult market conditions, CMS structures
still have a large market share (11% of YTD MTN issuance).
However, the progression made within interest-rate linked
Interest Rate Models MTNs has been significant. The numerous innovative Source: mtn-i.com.

structures developed within the sector have diversified

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

48 49
 Range Accrual Notes Innovation Interest Rate Linked Product Innovation
The standard Range Accrual structure accrues interest for The main conclusion to be drawn from the graph below With H1 06 interest rate-linked MTN sales down by USD
200 104%
every day that the reference rate fixes within a predefined is that relatively vanilla structures, such as the fixed rate 51bn on H1 05 and the Euro and US dollar yield curves

Contribution of Top 10 Structures

range. The standard version remains a popular structure, and zero coupon callables, have gained market share in uninspiring, rate structure buyers seemed to have moved 150
accounting for 10% of overall MTN issuance YTD in 2006. away from some of the heavily structured IR-linked

Product Variations
2006 so far. The Zero Coupon Callable Note is finding its 90%

The range accrual feature is increasingly used in more place in the market due to the higher IRR on offer, made instruments that were popular in 2005. Hybrid products 100
exotic varieties: for example cumulative coupon, flippable possible through the higher yield curve environment. on the other hand have seen a significant increase in
75%
and target redemption. Similarly, fixed rate issues now look more attractive after volume, notably those that combine interest rate plays 50

a period of rate hikes in Europe and the US. with inflation exposure.
USD Range Accrual issues have fallen. USD issuance 0 60%
2001 2002 2003 2004 2005 Q1 2006
accounted for 80% of all Range Accruals in 2004, 67% in Similarly, there has been a fall in activity of cumulative In just the first eight weeks of 2006 hybrid issuance had
Source: mtn-i.com.
2005 and now down to 33% YTD 2006. Investor demand structures, whereby the payout of each coupon is “path already overtaken 2005’s volume. This underlines the
for USD denominated issues has fallen amidst the prolonged dependent” – reliant on the level of the previous coupon. emergence of an important new product tailored to a
Fed Funds tightening cycle, leading to concern about rates In 2005, 4.5% of all issuance had a cumulative element, specific set of risk preferences. Many of these structures
breaking out of the predefined range. The demand was falling to 1.9% in the first half of 2006 (by value). tend to exploit the behaviour of the forward EURIBOR
further lowered by continuing USD weakness. curve versus the forwards for Eurozone Harmonised
In summary, the overall change in activity in the MTN Index of Consumer Prices (excluding tobacco; HICPx).
Callable & Cumulative market can be attributed to market conditions that affect The majority pay a floating rate plus a spread capped
Callable MTNs are notes where the issuer has the option the risk appetite of investors, as well as issuers delaying at a multiple of the HICPx and floored at 0%.
of early redemption. In 2004, 31% of all Interest Rate issuance until there is more confidence in the market.
Linked MTNs were callable, compared to 19% in 2005 The interest rate-linked MTN market has responded by
and back up to 24% in 2006 YTD (by USD eqv. value). delivering bespoke solutions to investor demands and
has adapted its offering to the changing rate markets.
Main Callable Structures - 2005 vs. 2006 (1st semester)
Innovation is clearly the driving factor behind the market.
10
Within Interest-Rate linked MTNs alone, the number of
% of Intrest-Rate Linked MTNs

8 product variations issued per year has risen from 42 in

2001 to 163 in 2005. 130 different structures have been
6
issued during the first quarter of 2006 and the fast-paced
4 and bespoke nature of the market means this figure is
sure to reach 200 by year end.
2

0 Furthermore, the contribution of the ten most popular

Floating Rate European Bermudan Fixed Rate Zero Coupon
structures to total IR-linked issuance has shown a steady
2005 H1 2006 decline since 2002. Added to the speed of product take-
Source: mtn-i.com. up, it makes flexibility and responsiveness crucial for
market participants. See graph.

50 51
 Structured Note Market
Summary
Although lower than last year’s record figures, 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, followed by
a slight downturn thereafter. Strong issuance at the start
of the year is a trend that is often observed, amid strong
investor appetite and fresh issuer funding targets. This
was also the case at the start of 2006, with a strong pick-
up in issuance over Q4 2005. As could be expected in an
environment of booming equity markets, equity linked
structures have gained in market share. Having said this,
despite difficult bond market conditions, interest rate
linkers still dominate the issuance with a market share of
48%. 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%).
Structured MTN Market Size
80%
60%
Issuance
40%
20%
0%
Q2 Q2 Q2
01 02 03
Interest Rate Linked
Equity and Equity Index Linked
Currency Linked
Other (Credit, Commodity, Hybrid, Fund, B o nd Linked)
Total Issuance
Source: mtn-i.com.
Market Sectors
Interest Rate Linked issues continue to dominate the
structured market at 48% of YTD new issuance (USD
45bn), 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. CMS-linked structures
have so far been less popular than in 2005, brought on
primarily by the severe flattening of the yield curve.
52
The high returns observed in stock markets have led to
increasing equity linkage (22% of YTD deal volume), showing
a significant increase from 14% in 2005. Issuance doubled
from H2 05 to almost USD 21bn in H1 06.
Investors are once again looking for real returns through
inflation linked products. 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. In particular, the inflation capped
FRN accounted for most of these. It is a simple yield
enhancing structure that exploits the correlation between
the forward EURIBOR curve versus the forward HICPx curve.
Pure inflation sales were dominated by HICPx (Eurozone)
and UK RPI. Spanish and, for the first time, Polish inflation
also featured. Q2 06 has begun with leveraged cross-market
differential notes referencing local and pan-European
inflation.
90
USD Equivalent in USD bn
60
30
0 strong with continuing inflation fears in both Europe and
Q2 Q2 Q2
04 05 06
FX-linked MTNs showed a significant sales surge with
almost a four-fold increase from USD 1.4bn in Q4 05
to close to USD 5bn in Q1 06. This supply was driven
by investor appetite for exposure to emerging market
currencies. The largest ever FX-linked MTN was an Asian
currency basket, whilst the most dominant currencies
were the Chinese renminbi, Indian rupee, Indonesian
rupiah and Korean won.
The Credit-linked MTN market has shown one of the
strongest recoveries at the start of the year, but, perhaps
surprisingly, commodity linked MTNs have not taken off
(only USD 1.1bn of new issuance in the first semester).
Outlook
Interest rate linkers look set to remain the dominant
asset class, although the difficult environment for CMS
based structures has also shifted the focus to different
asset classes. Amid investor uncertainty about market
direction, a revival in simple callable structures has
emerged. Ratchet Notes, Capped FRNs and zero accreting
notes have also been gaining in popularity. This trend
towards relatively straightforward structures is expected
to continue in the near future. The inflation capped FRN
has been the year’s major development; appetite for these
and other inflation-linked structures should continue to be
the US. Another factor that might drive the market is the
continued development of hybrid structures linked to
multiple assets and markets. This has greatly enhanced
investment possibilities. Lastly, Japan’s departure from
the zero interest rate policy offers new opportunities,
particularly for Asian investors.
53
 Turbo Certificates
Summary
Turbo Certificates (“Turbos”) are delta-one investment
instruments which give investors leveraged exposure to
an underlying bond future. Depending on whether the
investor has a bullish or bearish view on interest rates in
certain maturities and geographic regions, he can choose
to buy a Turbo Long or Turbo Short. Turbos on bond futures
are defined by their underlying future, the financing level
and stop-loss level.
Market View
An investor can use Turbos to take an aggressive view on
a certain bond market. If he expects sharply rising long
term interest rates in Japan for instance, he can buy a
Turbo Short on the JGB future. Equally, an investor who
anticipates declining long term rates in Europe can
choose to buy a Turbo Long on the Bund future.
Equally, Turbos can be used to hedge interest rate risk in
a bond portfolio. Because Turbos always reference the
first maturing futures contract, their interest rate sensitivity
is relatively constant. This allows an investor to match the
duration of his bond portfolio with a required amount of
Turbos. The hedge achieved in this way will never be perfect,
as it will for example not necessarily protect against changes
in slope of the yield curve, but it is easy to implement and
requires little capital outlay.
Description of Product
A Turbo is designed to offer one-for-one exposure to the
price changes of the underlying future. 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).
54
Example
The price of a Turbo is equal to the difference between
the market price of the underlying future and the financing Type Turbo Long
level of the Turbo. The financing level can be seen as the Current Underlying Future Euro-Bund Future Sep. 2006
amount of money that ABN AMRO has to contribute to Price of Underlying 116.80 EUR
buy the underlying above the premium paid by the investor. Financing Level 104.14 EUR
Because the underlying is a future (not a physical asset) Stop-Loss Level 106.27 EUR
in this case, ABN AMRO does not physically have to Fair Value Turbo 12.66 EUR
“lend” money to the structure. This means that no Leverage 9.2 (Price of Underlying/Price
interest is charged over the financing level; however, of Turbo)
the management fee does accrue over this amount. Management Fee 1.5% p.a., accrued daily over
the Financing Level
The stop-loss level is slightly above the financing level in
the case of a Turbo Long, and slightly below the financing Underlyings
level in the case of a Turbo Short. If the underlying future Turbos Long and Short are currently offered on the
hits the stop-loss level, the Turbo ceases to exist and following Bond Futures:
ABN AMRO unwinds the position. Depending on market
circumstances, the investor will then receive the residual > Europe: BOBL, Schatz, Bund, BUXL
value of the Turbo, which can never be smaller than zero. > United States: T-Note, T-Bond
The stop-loss level is determined by ABN AMRO, and is > Japan: JGB
largely dependent on the volatility of the underlying market.
Risks
As Turbos will always reference the first maturing futures > Turbos are highly leveraged investments, which means
contract, ABN AMRO periodically rolls the underlying that buyers risk losing their entire invested capital.
contract. On a roll date, the price of the next maturing
future will not be the same as the price of the current > A stop-loss event will result in the position being
future. To keep the price of the Turbo constant during the unwound and the investor receiving the residual value,
rolling process, the financing level is adjusted to account which is dependent on market circumstances and could
for the price difference between the two futures contracts be zero.
and any costs incurred during rolling.
> An interest rate hedge using Turbos may not be perfect.
55
 Interest Rate Models
Background
In the last twenty years interest rate sensitive products
have become increasingly popular. The values of these
securities are closely related to the shape and the apparently
random movements of the term structure. Therefore,
numerous models have been developed to simulate the
fluctuations of the yield curve.
Unlike other asset classes as equities and foreign exchange,
where the Black-Scholes framework is universally accepted
to determine the price of derivative products, no such
agreement exists with regard to interest rate modelling.
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.
The first generation proposed to model the interest rate
directly starting with the nearest maturities (short end):
the short rate models. The second generation models
comprise the Heath-Jarrow-Morton (HJM) models which
attempted to model the forward curve directly. The latest
generation are market models. The LIBOR specification
of these models is also known as the Brace-Gatarek-
Musiela (BGM), who were amongst the first to publish it.
BGM attempts to model the forward rate curve starting
with market observable forward rates.
Common Themes
Underlying all three generations of models, a stochastic
differential equation describes the yield curve. 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, volatility
and correlation.
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. The value
of a derivative is simply the replica costs and therefore
independent of the risk appetite of the investor.
56
To use any model for pricing, it must be calibrated to
the market. Besides matching the initial yield curve, the
prices of caps/floors and swaptions are required (very
liquid securities). Ideally the model is capable of providing
an analytical formula for these vanilla instruments, but
otherwise a very efficient numerical algorithm is necessary.
Spot and forward models must derive the appropriate
calibrating quantities from market observable rates. By
construction, market models are based on observable
rates in the market and hence readily price-standard
instruments.
The first generation of models developed were generally
spot rate based, in which the entire yield curve is specified
by a single variable. This choice was due to a combination
of mathematical convenience and numerical ease of
implementation.
Short Rate Models
By short rate here, it is the rate that is observed for the
shortest-term loans starting at a certain point, borrowing
now and repayment after a small time interval (i.e. a
second, minute or even a day). The model is characterised
by the exact specification of the spot rate dynamics
through time. 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 basic
model implies that all rates move in the same direction
over a short time interval, but not all by the same amount.
Parallel shifts are possible and steepening or flattening as
well only when the relative shift along the curve varies in
the same direction.
The later model engineered by Vasicek is more common
in this category as it incorporates the concept of mean
reversion. Mean reversion is the tendency to revert back
to some long-run average level over time. That is if rates
are observed much higher than the long-run average, it is
pulled back to that average and vice versa for lower rates.
An extension of Vasicek is the Hull-White model that
correctly reproduces the initial entire yield curve and
incorporates time dependant mean reversion. This
model still leads to explicit formulas and can be used to
analytically price caps and floors, however valuing these
vanilla instruments is useful primarily for calibration. The
real use of the model is to value more exotic options
such as Bermudan Swaptions.
Forward Rate Models
The Heath, Jarrow & Morton (HJM) model, in contrast to
the spot rate approach, models the entire yield curve by,
in small time stages, changes to the forward curve. By
taking the initial forward rate curve as given, the HJM
methodology directly models the entire term structure
of forward rates. The HJM model permits more than one
factor to influence the forward rates: it can have more
than one source of volatility.
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. Moreover, it gives the model characteristics
similar to the Black-Scholes model, used to price options
for other asset classes. It takes the price of the underlying
asset, the term structure, as given, and requires knowledge
of the volatility of the underlying. Heath, Jarrow and Morton
suggest several functional forms for the volatility of the
term structure, such as letting volatility exponentially dampen,
meaning that it decreases proportionally with time.
Due to the time dependency and flexibility, the model
is computationally intensive although it allows for more
sophisticated and consistent pricing. HJM models require
the use of a Monte Carlo Simulation, a procedure that
randomly samples changes in market variables by running
the model repeatedly (10,000 or more) and taking the
average result.
Market Models
The motivation for the development of market models
arose from the fact that, although the HJM framework is
theoretically appealing, its standard formulation is based
on unobservable instantaneous rates. These rates are
therefore fundamentally different from actual forward
LIBOR and swap rates, as traded in the market.
Market models can be used to price any instrument
whose pay-off can be decomposed into a set of forward
rates, and is commonly used for exotic interest rate
derivatives such as a Bermudan Swaption and a Callable
Range Accrual. Each forward rate has a time dependent
volatility and time dependent correlation with the other
forward rates being evolved. After specifying these
volatilities and correlations, an instrument can be priced
using Monte Carlo simulation to evolve the forward rates.
The match to the market Black pricing formula (1976) for
option prices makes calibration of market models very
simple. The quoted implied Black volatilities can directly
be inserted in the model, avoiding the numerical fitting
procedures that are needed for the spot rate or forward
rate models. They have the advantage when calibrating
to their associated vanilla product (i.e. a LIBOR model for
cap products) in allowing a separate fitting to volatility
and correlation, since the formulation of this category
of model allows a decoupling between the two.
Conclusion
The three generations of interest rate term structure
models, by virtue of being arbitrage-free, are equivalent
mathematically and are all within the general HJM
framework. Each is distinguished by different methods
of constructing the effective volatility function which
determines its use in practice.
57
 Modelling Processes
Background
The pricing of any derivative product is dependent on
the (expected) future price of the underlying asset. When
modelling asset price movements over a period, a number
of models have been associated with the process driving
the numbers. Asset prices, like molecules, are often
assumed to follow Brownian motion, which is an extension
of the ideas discussed on where a “drunkard” might end
up after some time on their walk home.
The value of a derivative is the value today (present
value) of all expected discounted cash flows. The expected
discounted cash flow is basically the probability of receiving
the cash flow times the expected payout, conditional on
receiving the cash flow (i.e. in option terms, receiving the
expected payout conditional upon the option being in the
money). For this reason numerous models have attempted
to model price movements to value derivative instruments.
The Processes
To understand how asset prices can be modelled, an
understanding of the variable (price) is first required. 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. 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, however, intuitively it is quite unlikely. This
means that after a large number of sequential throws
(with a “fair” dice), we expect to see each number an
equal number of times, though might see a “6” rolled
four times in a row.
An extension to this idea introduces a Markov process,
which is a particular kind of stochastic process. Its property
is that only the current value of the dependent variable
(i.e. the asset price) is relevant for predicting its next value.
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.
58
More technically speaking, a Markov process is consistent
with the “weak” form of the efficient market hypothesis.
Historical asset prices are not of any use in predicting
future prices; therefore it is impossible to produce
consistently superior returns through technical analysis.
Stochastic processes can be classified as discrete or
continuous time. A discrete-time process is one where
the value of the variable can only change at certain fixed
points in time, whereas a continuous-time process allows
for a change at any time. The same breakdown can be
applied to the variable that the process is modelling, in
this case, the asset price. In a continuous-variable process,
the underlying variable can take any value within a certain
range; whereas in a discrete-variable process, only certain
discrete values are possible. In practice, asset prices are
restricted to discrete values (e.g. multiples of a cent) and
changes can be observed only when the exchange is open.
The Random-Walk Process
The foundation for asset price modelling is the “Random
Walk”. It is the intuitive idea of taking successive steps in
a random direction for modelling stochastic processes. 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, 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.
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, and no direction is more probable
than another (the drunkard is just as likely to slump to
the left as to the right)
Suppose we draw a line some distance from the origin of
the walk to the intended end point. For any random walk,
every point in the domain will be crossed a number of times
almost surely. The graph below shows eight random walks
of 100 time steps, each aiming to go straight across.
An important result that follows is the deviation from the
intended straight line (variance) of a random walk increases
linearly with time. An individual walker strays further away
from the intended straight line with time. If the whole pub
were to attempt the same walk, the average position away
from the line would indeed be on the line at each point.
8 random walks aiming to go straight across
130%
100%
70%
0 20 40 60 80 100
The motion analyzed is called a Simple Random Walk. It is
simple in the sense that the walker makes discrete fixed
movements of constant lengths at specified time intervals.
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. > the price is derived from the previous one but does not
Wiener Process
A Wiener process puts a mathematical probability and range
constraint upon the driving variable. 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). This means that about
two-thirds of the time, the number will be between +1 and -1,
or one standard deviation around the average of zero. About
95 percent of the time, the numbers will be between two
standard deviations of the zero and 99 percent of the time,
they will be between three standard deviations of zero.
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. When
simplified for the Wiener process, the random variable is
the product of the driving variable, described above, and
the square root of the time interval. 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. It has a deterministic element
(the expected return/drift) and a random term (which is
more or less important dependent on the volatility). Due
to the characteristic of the Markov process, the price
chart will vary considerably each occasion the model is
run. A Monte Carlo simulation of the stochastic process
is required to sample the random driving variable and
derive the price chart. The simulation runs the model
repeatedly (often 10,000 times) and takes the average
result. If the model were to be adapted for continuous
time, the model describes geometric Brownian motion
which is the basis of the Black-Scholes model. As discussed,
the return to the holder of the stock in a small period of
time is normally distributed and the returns in two non-
overlapping periods are independent.
Conclusion
When pricing derivative products, to avoid overcomplicating
the process, an understanding of the modelling behind the
underlying asset pricing is essential. The “random walk”
of asset prices includes a number of simple assumptions
combined together:
affect the result (Markov)
> the annual expected return should depend on the risk of
the return on the asset
nature of the price
59
 Yield Curve Considerations

Summary Supply and Demand Demand Side Factors

The Yield Curve, also known as the Term Structure of
Interest Rates, is the relationship between yields and
maturities for a given security. Its shape and absolute
level are of vital importance to investors, and an array of
structured products makes it possible to link returns to
any view on the future movements of the curve. Where
parallel shifts express current rate moves, the slope is
about expectations of future moves.
Main Theories
The main considerations of the yield curve are its level,
slope and curvature. Typical shapes of the curve include:
“Normal” (upward sloping); “Flat” (horizontal); and
“Inverse” (downward sloping). The curve may also be
“humped” (see graph below).
Hypothetical Yield Curves
Normal Inverted
Yield
Pure Expectations Theory: According to this theory, the
forward rates (interest rates between two future dates)
implied by the yield curve are pure expectations of future
interest rates. An upwards sloping yield curve environment
reflects the expectations that interest rates will rise; a flat
curve implies that interest rates will stay broadly constant;
and a downward sloping curve implies falling interest rates.
The main shortfall of this theory is that no consideration
is given to the inherent risk associated with investing for
longer maturities.
Biased Expectations Theory: This theory suggests
that whilst the forward rates do reflect interest rate
expectations, they also contain a risk premium. The
Liquidity Preference Theory proposes that investors
prefer to retain liquidity by holding short term securities,
whereas borrowers prefer to borrow for longer periods,
giving the yield curve an upward bias. The Preferred
Habitat Theory agrees that a risk premium is reflected
90-95% of yield curve movements are accounted for by
parallel shifts in the curve, and the debate over which
theory explains these movements continues. However,
the supply and demand factors influencing the yield
curve environment warrant consideration:
Supply Side Factors
Central Bank monetary policy is arguably the most
important determinant of the yield curve, certainly in
the short term. The direct effect of Central Bank rate
movements is to alter supply conditions at the very short
end of the yield curve. Although the main effect would be
a parallel shift in the yield curve, 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, driving them higher than less sensitive long term
rates. 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
Growth and Inflation Expectations are key drivers at
the long end of the yield curve. Expectations of declining
economic conditions and correspondingly lower future
interest rates can lead to a shift by investors into longer
maturity, “safe haven” securities, pushing yields down,
and leading to an inverted yield curve. Conversely,
expectations of rapid economic expansion may lead to
a steepening of the curve, as a result of the increased
demand for capital, and the willingness to borrow for
longer maturities. A flat yield curve may signal uncertainty.
Expectations of higher inflation, often linked to economic
growth, will lead to an expected rise in nominal interest
rates, and hence a steeper yield curve.
Worth noting is that the effect of demand and inflationary
shocks is not always straight forward. For example, 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. However,

Yield

in forward rates. However, this theory suggests that pressure on long term interest rates, relative to short the yield curve effects of a sharp oil price shock, or a
investors and borrowers have different maturity preferences, term rates. technology driven supply shock are not as clear. This is
and are willing to switch away from their “preferred because these type of shocks move output and inflation
habitat” maturity if sufficiently rewarded. Government Finances can also affect the shape of the expectations in opposite directions, and the yield curve
Maturity Maturity yield curve. Sustained budget deficits require increased effect depends on whether the output or inflation response
Flat "Humped" Market Segmentation Theory: Like the Preferred Habitat government borrowing to fund them. Eventually, this is dominant.
Yield

Yield

Maturity
There are three dominant theories which attempt to
explain the term structure of interest rates:
Theory, this theory suggests that different market
participants have differing maturity preferences. However,
the Market Segmentation Theory does not allow for any
switching between “segments” (areas of the yield curve),
Maturity
and therefore the yield in any segment is independent
of other sections of the curve. Most market participants
agree that this theory offers a rather dubious explanation
of the yield curve.
increased supply in an increasingly global market would
induce investors to demand higher yields, resulting in a
parallel shift of the curve.
Borrowers’ maturity preference changes can alter the
slope of the yield curve. For example, the 2001 halt in US
Treasury 30 year issuance created a shortage at the long
end of the yield curve, pushing prices up, yields down,
and flattening the curve. Similarly, a shift of corporate
borrowing preferences between fixed and floating rate
terms can alter the supply conditions at either end of the
yield curve, changing its slope or curvature.

60 61

Convexity Bias is a factor which influences the long end
of the yield curve. Convexity measures the curvature in
the relationship between bond prices and their yields.
Bonds with high convexity perform better if rates change;
if rates fall their price rises by more, if rates rise their
price falls by less. The benefits of convexity cause more
convex bonds to have higher prices and consequently
lower yields. Convexity increases strongly with maturity
and is of great influence at the long end of the curve. The
convexity bias therefore tends to lower yields at the long
end of the curve.
Central Bank Reputation is also important. If the Central
Bank has strong inflation fighting credentials, and if they
follow a highly transparent monetary policy, then the
yield curve may be flatter than it otherwise would. This is
because concerns about future growth would outweigh
inflationary worries, and investors would require a smaller
liquidity premium, because of the reduced uncertainty
about future rate changes.
Foreign Central Bank purchases of government bonds
have a significant effect on the shape of the yield curve.
Countries with large foreign currency reserves resulting
from current account surpluses are major buyers in the
government bond markets. 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.
Regulatory Changes such as recent moves towards
closer asset/liability matching amongst pension funds,
insurance companies, and other financial institutions
have led to increased demand (and correspondingly
lower yields) at the longer end of the yield curve.
Financial Innovation can also affect the shape of the
yield curve. The emergence of structured notes has given
borrowers the flexibility of raising finance in maturities they
would not have otherwise considered. Through the process
of “reverse inquiry” (whereby an issuance is driven by the
investor’s, not the issuer’s, preference), investors have an
increasingly important influence on the supply and demand
dynamics at a given point on the yield curve.
62
Glossary
Conclusion Accretion – an increase of notional amount throughout
Whilst numerous factors are clearly relevant in shaping the life of a structure.
the term structure of interest rates, the graph below
summarises the main determinants of the different parts American Option – an option that allows for exercise at
of the curve. any time during its life.
Main Determinants of the Yield Curve Amortisation – a decrease of notional amount throughout
the life of a structure in a predetermined way.
Yield
Arrears – observation and fixing of the underlying rate at
the end of the coupon period as opposed to the start of
the coupon period.
Central Expectations Inflations
Bank of Future Expectations
Monetary Monetary and Convexity Barrier Options – options where the payoff depends on whether
Policy Policy Bias
the underlying asset’s price reaches a certain level during a
Maturity
certain observation period.
Bearish – a view that an asset or underlying index will
fall. In “rates” it means a rise in yields (a fall in price).
Bermudan Option – an option that allows for exercise at
certain discrete predetermined times during its life.
Bullet – an obligation that must be paid in a single lump
sum at the end of its term.
Bullish – a view that an asset or underlying index will rise.
In “rates” it means a fall in yields (an increase in price).
Callable – the option but not the obligation for the issuer
to redeem a security prior to its stated maturity, at a
predetermined price.
Cap – an option that provides a payoff when a specified
interest rate is above a certain strike level. The interest rate
cap can be thought of as a series of caplets which exist
for each period the cap agreement is in existence.
Caplet – one component of an interest rate cap.
Clean Price – the price of a bond which does not include
accrued interest.
Collar (or Corridor) – a combination of an interest rate
cap and interest rate floor.
Collateralized Debt Obligation (CDO) – a way of re-
packaging credit risk by dividing a pool of securities
or financial assets into tranches. These tranches have
different risk and return profiles, essentially redistributing
the risk from the underlying portfolio.
Convexity – a measure of the curvature in the relationship
between price and yield. The greater the convexity, the
more sensitive the duration is to changes in yield. Callable
securities will exhibit negative convexity at certain price-
yield combinations. Negative convexity means that as
market yields decrease, duration decreases as well.
Correlation – a statistical measure describing the degree
of dependence between the fluctuations of two variables.
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. The protection seller makes no payments unless a
specified credit event occurs on a predefined reference entity.
Credit Event – an event which triggers payment in a
Credit Default Swap. Common examples are bankruptcy,
restructuring and failure to pay.
Credit Spread – the yield spread between risk free
securities and others that are identical in all respects
except for credit quality.
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.
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.
63
 Delta – a measure of the sensitivity of a derivative to
changes in its underlying asset or index.
Derivative – a financial contract whose price and cash
flows are dependent upon one or more underlying
assets.
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, and zero (or “low
payout”) otherwise.
Dirty Price – the price of a bond which includes the
accrued interest.
(Modified) Duration – the measure of the price
sensitivity of a fixed-income security to an infinitesimal
change in yield. The greater the duration, the greater the
sensitivity to interest rate movements.
European Option – an option that can only be exercised
at the end of its life.
Exotic – structured products which are more complex
than the derivatives usually traded on an exchange. As
opposed to vanilla products, they are generally traded
over the counter.
First-To-Default Basket (FTD) – provides multiple name
exposure in a CLN. 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.
Floor – an option that provides a payoff when a specified
interest rate is below a certain strike level.
Floorlet – one component of a floor. The interest rate
floor can be thought of as a series of floorlets which exist
for each period the floor agreement is in existence.
Forward Curve – a graph of forward rates for different
maturities.
64
Forward Rate – the interest rate for a future period of
time implied by the rates prevailing in the market today.
Hedge Fund – a discretionarily managed portfolio of
investments that uses strategies such as leverage, long,
short and derivative positions with the goal of generating
above market returns at an acceptable level of risk.
Historical Volatility – the volatility of a financial
instrument actually realised over a given period in the past.
Hybrid – a derivative product that depends on the
performance of two or more underlying assets or indices.
Implied Volatility – the future volatility of an instrument’s
price estimated from derivatives currently traded in the
market.
In-the-money – an option is said to be in-the-money
when its intrinsic value is positive, e.g. for a call option
when the spot price is higher than the strike price.
Internal Rate of Return (IRR) – the discount rate that
makes the net present value of future cash flows equal
to zero.
Knock-in Option – a type of barrier option which only
comes into existence if a certain barrier is hit.
Knock-out Option – a type of barrier option which
ceases to exist if a certain barrier is hit.
Leverage – the use of derivatives or borrowed capital to
increase notional exposure to an investment.
Lifetime Cap – the maximum cumulative coupon amount
that an investor in for instance a Target Redemption Note
can earn. When this level is reached, the product is
generally automatically redeemed.
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.
Notional – the cash amount over which the pay-off of a
derivative or structured product is calculated.
Notional Effect – Apart from pure floating rate bonds,
each bond displays the notional effect. This means that
the mark-to-market price of a bond will be negatively
impacted by an increase in interest rates, because an
equivalent investment will pay a higher coupon in this
situation. The biggest notional effect is displayed in case
of fixed rate bonds, but also in case of structures with
some possibility of fixed coupons such as embedded
caps and floors this effect will be displayed.
Out-of-the-money – an option is said to be out-of-the-
money when its intrinsic value is zero, e.g. for a call
option when the spot price is lower than the strike price.
Par Value – the face value of a fixed-income asset.
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.
Path Dependent – a feature for a derivative whereby
the payoff depends on the whole path followed by the
underlying variable, not just its final value.
Quanto – a derivative in which the relevant performance
of the underlying asset or index is paid out in a foreign
currency.
Sensitivity – the magnitude of a financial instrument’s
reaction to changes in underlying factors, such as interest
rates.
Spot Price – the current market price for an asset or
index.
Straddle – an option strategy primarily used to profit
from an increase in volatility. It involves buying a call and
a put with the same strike price and expiration date. A
loss will occur if the spot price is close to the strike price
at expiration of the options.
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.
Structured Note – a debt obligation that contains a
derivative component to achieve a specific risk/reward
profile.
Swap – an agreement between two parties to exchange
defined cash flows over a period of time.
Swaption – the option to enter into a swap. In exchange
for an option premium, the buyer gains the right but not
the obligation to enter into a specified swap agreement
with the counterparty on a specified future date.
Underlying Asset – the asset or index upon which the
value and pay-off of a derivative contract is based.
Vanilla – the most basic version of a derivative contract.
Vega – a measure of an option’s sensitivity to volatility. It
shows the change in the option’s value resulting from a
small change in volatility of the underlying index.
Volatility – the annualised standard deviation of an asset’s
return. It is a measure of the variability of the asset price.
Yield – the annual rate of return for a security.
Yield curve – the relationship between yields and maturities
for a given security (also known as the Term Structure).
65
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