What it means
A structured product is a package that combines a basic investment with a derivative, which is a contract whose value depends on something else, such as an exchange rate. In a TARN, the coupon each period depends on where the market stands.
If the market behaves as the investor hoped, the coupon is high, and if it does not, the coupon may be low or zero. The defining feature is the target.
The coupons paid are added up, and once the total reaches a stated figure, the note is redeemed immediately. This is called a knock-out, and it means the investor does not receive any further coupons.
That feature makes the true life of the note uncertain. The investor may be repaid in a few months if conditions are favourable, or may be locked in for the full term if they are not.
Because the best case ends early, the upside is capped at the target coupon total. The downside is often unlimited in the derivative form of the product.
In some versions, an adverse market move can lead to payments owed by the investor rather than received, and those losses continue until the note ends. Large currency swings have caused serious losses for holders of such products in the past.
For a finance professional, the question to ask is what happens in the worst case. The headline coupon may look generous, but the investor is effectively selling protection and accepting a capped gain against a possibly large loss.
Treasury policies at many companies restrict or ban these instruments for that reason.
In practice
Real-world examples.
Example
A wealthy investor buys a TARN linked to a currency pair because the coupon is much higher than bank deposits. The currency moves as hoped and the target is reached in nine months. She receives the coupons and the original amount, but then has to find a new investment.
Example
A company treasurer, advised by a bank, considers a TARN to hedge currency exposure. The finance director examines the worst-case scenario and discovers that losses would continue if the currency moved against the company. The board rejects the proposal.
Example
A bank's risk team reviews its clients' structured products after a sharp move in an exchange rate. Several TARNs are paying very low coupons and so remain in place for the full term. The team writes to clients to explain the position.
Formula
Calculation
Cumulative coupons = sum of all coupons paid to date
The note ends when cumulative coupons are greater than or equal to the target
An investor holds a TARN with a notional amount of $1,000,000 and a target of 12% of notional. The coupon is 3% in favourable quarters and 0% otherwise. The quarters pay 3%, 3%, 0%, 3% and 3%, so cumulative coupons are 3%, 6%, 6%, 9% and 12%. The target is reached after five quarters, with total coupons of 0.12 x 1,000,000 = $120,000, and the note ends with the $1,000,000 repaid. The return is 12% over 1.25 years, or about 9.6% a year, which is 12 / 1.25.Case study
Seen in the real world.
Bellweather Textiles is an illustrative, fictional exporter that entered a currency TARN with a notional of $5,000,000 and a target of 10% in cumulative coupons. The bank described the structure as a way to improve the exchange rate on the company's sales.
In the first two quarters, the currency moved in the company's favour, and the note paid 2% a quarter, totalling $200,000. Then the currency reversed, and the note began to produce losses for the company of about $150,000 a quarter, with no end in sight because the coupon target had not been reached.
The illustrative finance director learned that the structure offered a small, capped gain and a large, open-ended loss. The company paid $600,000 to exit early, and its treasury policy was changed to ban products that could not be fully valued by the finance team.
Watch out
Common mistakes.
- Focusing on the attractive headline coupon and ignoring what happens when markets move the wrong way.
- Assuming the note will always end early, when an adverse market can keep it running for the full term.
- Buying a product that the finance team cannot value independently of the seller.
Questions
People also ask.
What does TARN stand for?
It stands for Target Accrual Redemption Note, sometimes called a target redemption note.
Why does the note end early?
It ends when the total coupons paid reach the target, which is called a knock-out.
Who should consider a TARN?
Only investors with a clear understanding of the risks and the ability to absorb large losses, and ideally with independent valuation of the product.
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