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I was searching on the products issued by the banks to retail investors, and saw some of the Dual Range Accruals having underlying as USD CMS 30Y - 2Y, and USD CMS 10Y, each having low barrier and high barrier respectively.

I understand it is quite obvious that we could think about the correlation and volatility since these two are the two most intuitive things that comes to mind when we think about the payoff condition of the Dual RA.

However it came to my mind that forward rates of USD CMS should also be the one that plays a significant factor. The spot rates of USD CMS 30y & 2y makes it feasible and reasonable for that spread to be an underlying having a lower barrier. However, when we think of the forward rate, it seems it has a very high possibility of reversal, which would be affected by the macro factors especially inflation rate and interest rate.

Is it just a simple rationale( for example, that's why long tenor would have higher coupon since it is exposed to more risk)? Or is there some other logics, especially in perspective of the traders, that would make these underlying seems feasible to be issued to investors?

Hope my question sounded clear. I really hope to share some personal opinions about this.

Thanks in advance.

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    $\begingroup$ There seem to be a lot of investors, I think high net worth is a more accurate label than retail, who just love any notes paying min(cap,max(floor,gearing*(index1-index2))). Perhaps their love for this particular payoff formula may not seem rational. Still your question is not quite clear to me. Can you please clarify what you are asking? $\endgroup$ Aug 18, 2021 at 13:48
  • $\begingroup$ Thank you for your comment. So I was wondering if we want to pitch this dual range accrual with those underlying to with, say 10 years tenors as I explained at the post, but the high net worth investors might come up with the question that the forward rate at 10 years for that underlying makes this barriers highly risky. (ex; I set the low barrier of USD CMS 30 - 2 > 30bps, and spot spread is about 130 bps which makes the investment sound quite safe? but forward rate spread seems to be close to 0 bps, or even negative.) In that case, what rationale you could think of? $\endgroup$
    – cycla
    Aug 18, 2021 at 14:25
  • $\begingroup$ I know it could just be explained by saying: that's why we pay such a high coupon for that case duh... but was curious about what other logic can make this issuance possible. $\endgroup$
    – cycla
    Aug 18, 2021 at 14:26
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    $\begingroup$ So you are asking how to explain a risk averse and worried investor why something is not risky as they think so that you can use that in your pitch to sell it? Same logic as all Tarf variations (pivot Tarf, range Tarf, dual range Tarf, knock in Tarf), Autocallables (reverse convertibles, Phoenix,..) and anything else that is yield enhancing in my opinion. As Buffett puts it: "Reaching for yield is really stupid. Don't listen to sales men telling you I got something giving you 5%. The answer is you learn to live on 1%. Eventually you turn to midnight and everything turns to pumpkin and mice. " $\endgroup$
    – AKdemy
    Aug 18, 2021 at 14:47

2 Answers 2

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There is actually a reasonable rationale for the trade: As OP mentions, the forward value of CMS30 - CMS2 is close to zero for expirations beyond 5yrs, so the market assigns a significant probability that this spread will be negative. In other words, the risk-neutral probability of this quantity being negative is quite high (say 30pct). But, looking at historical time series, you see that this quantity is very rarely negative. In other words, the real world probability of this quantity being negative is quite low (say 5pct). Thus, on average it pays to sell these options. One might ask why the market does this ? In my opinion it is a variation of the common term structure ‘arbitrage’ whereby forward rates are too high , so in general it pays to receive fixed on interest rate swaps and ‘roll down the curve’.

These particular notes are being sold mostly to retail and institutional investors in the Far East (Korea, Taiwan). In most cases they cannot execute the trade in pure derivatives form and they are willing to pay a packaging fee to have a bank construct a note. Having said that , the worst that can happen to these notes is that they turn into zero coupon bonds, so the principal is protected assuming the bank issuer does not actually default.

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  • $\begingroup$ I knew the retail structured product market is turbo charged in South Korea and Taiwan, but wasn't aware retails are actually investing in CMS spread options! $\endgroup$ Oct 6, 2021 at 16:01
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Here is an example term sheet: https://www.sec.gov/Archives/edgar/data/70858/000119312512021960/d288901d424b2.htm .

Here's what I belive to be a typical scenario:

A high net worth individual, Alice, not very well informed about her investment choices, pays advisor Bob to invest her money in something more sophisticated than a passive index fund.

Bob buys for Alice notes like the above from Chris at a bank. Chris issues the notes and statically hedges them with swap having the same payoff with David at the swaps or rates exotics desk of same bank as Chris or a larger bank.

Everybody makes good money off of Alice. Alice pays much more to get this exposure than she would if she could trade the swap directly with David. Alice would have been better off with a passive index fund.

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    $\begingroup$ Interesting to see how the note description somehow assumes the investor does not know what a CMS is, so they need to compare it to the treasury rate! $\endgroup$ Oct 6, 2021 at 16:04

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