Structured Products: Accumulator and Target Redemption
image: Google
Product Features:
Target Redemption (TR) options are conceptually similar to Accrual options:
Both have Fixing schedules
And in some sense target redemption knock out on time while accruals knock out on Spot. The similarity extends to the pricing: Both products have minimal model risk. This can be confirmed by pricing the TARF using various smile pricing models; different models will often give similar valuations.
The main feature of a TR option is that payoff depends on a quantity that counts up to a target over time, the client’s gains count up and the whole structure expires once a target is reached. The client’s losses do not count toward the target.
The most common structure is known as Target Redemption Forwards (TARF). As always, there’re are many TR and TARF variations, often based around differences in behaviors shown when the target is reached or exceeded, or variations on the payoff
TARF EKI: a European Knock-in payoff;
TARF Box: a digital range payoff
Another variation is a Count TARF, in which the target is not based on the accumulated gain, but on the number of times that the client receives a positive gain
For risk management purpose, the one to look out is the behavior at Fixings, particularly when the target is around to be exceed.
Trade Example:
Within a typical TARF product, the client enters into a strip of forwards (or similar, e.g., leveraged forwards) with rates better than the forward outrights. From the structuring point of view, TARF is more similar to a vanilla Accumulator. Recall the two most important features of an Accumulator:
Client enters the trade at a discounted rate
Buy once if up, buy twice if down
EUR/USD 1yr TARF with monthly fixings. Spot is at 1.2770 and the 1yr forward is 1.2800. At each fixing, the client buys EUR against USD at the Strike 1.2290 (well below the forward) provided the USD30,000 target profit has not been reached. Once the USD30,000 target profit is reached, the structure terminates. At each fixing, the client buys either:
EUR300k against USD at 1.2290 if EUR/USD spot Fixing > Strike (buy once if up)
EUR600k against USD at 1.2290 if EUR/USD spot Fixing < Strike (buy twice if down)
The accumulated positive gain is calculated by summing up the client’s gains at each fixing. Within this trade, client gains occur above the strike and client losses occur below the strike, plus note that the trade has leverage: 2× notional is transacted below the strike.
Note here this is very similar to what we’ve studies as Accumulator: the Client buys 1 when Spot > Shrike and buys 2 when Spot < Strike. Regarding the termination condition, Accumulator usually has a fixed amount of time period during which the losses will be enhanced if the market goes against the condition. While TARF in some aspect mitigated the market risk by pre-setting a payout target