What is a Targeted Cumulative Refund Ticket?
A Targeted Repayment Repayment Note (TARN) is an exotic derivative that terminates when a limit for paying coupons to the holder is reached.
Target Accural Repayment Notes (TARN) have the particularity of being subject to early termination. If the coupon accumulation reaches a predetermined amount before the settlement date, the note holder receives a final payment of the face value and the contract is terminated.
Key points to remember
- A Targeted Accurment Repayment Note (TARN) is an indexed derivative containing a target ceiling.
- The cap refers to the maximum amount of cumulative coupon payments received.
- Once the cap is reached, the note ends automatically.
- FX-TARNS are linked to a currency index rather than stocks.
Understanding Targeted Accumulation Redemption Ratings (TARNs)
A targeted accrual redemption note is essentially an indexed note that has a fixed amount of coupons that represent the target cap. Once the target cap is reached, the note will be terminated and the par value of the note will be paid. So there is usually an attractive initial coupon combined with the possibility of recovering face value relatively quickly. An indexed note is an investment product that combines a fixed income investment with potential additional returns linked to the performance of a stock index such as the S&P 500 Index.
Besides these indexed features, TARNs are similar to inverse floating rate notes where the benchmark can be LIBOR, Euribor or a similar rate. TARNs can also be conceptualized as path-dependent options: the end user actually buys a band of call options while selling a band of put options with a notional value that is twice the options of purchase. The contract may include an opt-out clause that terminates it if the benchmark reaches a certain level.
Foreign Exchange TARNs or FX-TARNs are a common form of TARNs in which counterparties exchange currencies at a predetermined rate on predetermined dates. The amount of currency traded varies depending on whether the rate is above or below a defined forward price.
Valuation of Targeted Accrual Redemption Notes (TARNs)
Valuation of Targeted Maturity Redemption Notes can be difficult as redemption times depend on coupons received to date. Once the deactivation threshold is reached, the investment is terminated and the principal is repaid. From an investor’s point of view, an excellent initial coupon rate for a period of time and a rapid return of capital is an ideal result. However, depending on the performance of indexed rates, an investor may become locked into investing and see the time value of money erode what was once an attractive short-term investment.
Generally speaking, the value of a note is the present value of the par payments and coupons. However, there is uncertainty with target-maturity redemption notes, as not all coupon payments will necessarily be received. Thus, instead of a linear calculation on present value, a TARN requires a simulation of interest rate volatility to assess the probability of triggering the knockout level given the terms of the note. TARNs linked to volatile benchmarks will necessarily be more difficult to assess accurately.
