Forex Investment and Currency Trading

Description

A Fixed Rate Range Accrual Swap is a structured swap where the company receives a relatively high return if the reference index fixes within a certain range. Typically, a structured coupon is of the form X% x n/N, where X% is a fixed rate, N is the total number of observation days associated with the structured coupon and n is the total number of observation days for which a reference rate (e.g. 1 month, 3 month, 6 month or 12 month LIBOR) lies within a pre-defined range.

Application

Fixed Range Accrual Swaps are used in structured deposits and notes, where the coupon received by the company is the structured leg of the swap. To illustrate how this works, this example shows the cash flows of a Fixed Rate Range Accrual Swap on a standalone basis.

• For each observation day that 3 month USD LIBOR fixes below the specified upper bounds of the ranges, the coupon received by the company will be 9.00%.
• In exchange, the company pays a LIBOR-based floating rate (in the case of a structured deposit, this will take the form of the market yield on the deposit that is forfeited by the company).
• The structure yields a relatively high return (9.00%) for the company if its view on LIBOR is correct for each observation day; however, the downside is a potential 0% return if the range requirements are not met on any day.
• The breakeven return (the vanilla swap rate) is achieved when 252 x 5.20% / 9.00% = 146 observation days are within the specified range.
• A Fixed Rate Range Accrual Swap is equivalent to a vanilla Swap (receiving 9.00% vs 3 month LIBOR, in our example) combined with a sale of a strip of digital Floors.
• More attractive terms will be possible when (i) cap volatilities are high and (ii) the cap volatility curve is flat around the lower and upper bounds of the accruing range (which increases the value of the sold digital floors).

Variations

• The accruing range may vary from one coupon period to the next (as in the above example) – this is known as a Step Down Range Accrual Swap.
• The accruing range can have an upper bound and/or a lower bound, and the definition of an observation day can vary.
• The reference rate can be a CMS rate, a spread, or a basket of indices, or it can be from a different currency (this would be called a Quanto Fixed Range Accrual Swap).
• The structured coupon can be based off a floating rate (i.e. rather than the fixed 9.00% above). This is known as a Floating Rate Range Accrual Swap.