What is a Targeted Accrual Redemption Note (TARN)?
A Targeted Accrual Redemption Note (TARN) is a sophisticated financial derivative that is designed to terminate when cumulative coupon payments reach a preset limit. This exotic financial product stands out because of its early termination feature, which activates upon hitting the coupon payment target. At this point, the holder receives a final payment equivalent to the note’s par value, and the contract comes to an end.
Key Takeaways
- Index-Linked & Target Cap: TARNs are index-linked derivatives containing a target cap, the maximum limit of accumulated coupon payments.
- Automated Termination: The note automatically terminates once the coupon payment cap is met, leading to the return of the par value to the investor.
- FX-TARNs: These are variations linked to currency indices rather than equity indices.
Understanding Targeted Accrual Redemption Notes (TARNs)
TARNs are essentially financial products that combine fixed-income investments with additional potential returns tied to an index, such as the S&P 500. The distinguishing feature is that once the target cap for coupons is attained, the note terminates and the par value is paid out to the investor.
A typical TARN offers an attractive initial coupon rate, with the potential for a relatively rapid return of the invested capital. Similar to inverse floating-rate notes, where benchmarks like LIBOR or Euribor are used, TARNs sometimes include a knock-out clause. This provision activates if the benchmark reaches a predetermined level, ending the contract.
In terms of structure, TARNs can be compared to path-dependent options: the holder effectively buys a series of call options while selling a corresponding series of put options with a face value that is twice that of the calls. This option structure means the overall investment outcome depends heavily on the path that index rates take over time.
Moreover, for FX-TARNs, parties exchange currencies at pre-determined rates and intervals. The amounts exchanged depend on fluctuations around a set forward rate, offering a way to manage foreign exchange risk.
Valuation of Targeted Accrual Redemption Notes (TARNs)
The valuation of TARNs can be quite complex, primarily due to their early termination feature based on cumulative coupon distributions. Once the targeted coupon cap is reached, the investment ends and the principal is returned to the investor. While the prospect of high initial coupons and early capital return is highly attractive, fluctuating index rates can extend the duration of investment, potentially diminishing its expected return value due to time value erosion.
Typically, a note’s value is assessed by calculating the present values of its par and coupon payments. However, TARNs require more involved modeling because the number of coupon payments that will be received is uncertain. Instead of a simple linear present value calculation, evaluators use simulations to account for interest rate volatility and the probabilities linked to knocking out the note.
Given their dependency on volatile benchmarks, TARNs are inherently challenging to value with high precision, making them more suitable for sophisticated investors capable of managing and analyzing complex financial instruments.
Related Terms: inverse floating-rate notes, path-dependent option, LIBOR, Euribor, foreign exchange.
