Targeted Accrual Redemption Note (TARN) Explained: 2025 Pricing and How It Works

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What Is a Targeted Accrual Redemption Note (TARN)?

A Targeted Accrual Redemption Note (TARN) is a sophisticated financial derivative designed to end once the total coupon payments reach a pre-set cap. This unique feature allows investors to receive a maximum amount of income before the note terminates early.

TARNs are distinguished by their early redemption clause: if accumulated coupon payments hit the predetermined limit before maturity, the holder obtains the principal repayment, and the contract concludes.

Key Highlights of TARNs

• TARNs are index-linked derivatives with a defined coupon payment cap.
• The cap limits the total accumulated coupon income.
• Upon reaching the cap, the note automatically matures.
• FX-TARNs are a variant tied to currency indexes instead of equity indexes.

How Do Targeted Accrual Redemption Notes Operate?

Essentially, a TARN combines a fixed-income investment with index-linked features, offering attractive initial coupon payments up to a target cap. Upon reaching this cap, investors receive the note’s par value, potentially enabling quicker capital recovery.

TARNs resemble inverse floating-rate notes, often benchmarked to rates like Euribor, and can be viewed as path-dependent options — effectively purchasing call options while simultaneously selling a larger notional amount of put options. Some contracts include knock-out provisions that terminate the note if certain benchmark thresholds are surpassed.

Foreign exchange TARNs (FX-TARNs) are widespread, involving currency exchanges at predetermined rates and dates, with amounts fluctuating based on whether rates exceed or fall below a set forward price.

Valuation Challenges of TARNs in 2024

Valuing TARNs is complex due to their dependency on coupon accruals and early redemption possibilities. The investment ends once the knock-out level is achieved, returning the principal. While an appealing initial coupon and early capital return are ideal for investors, fluctuating indexed rates may extend holding periods, diminishing returns.

The valuation involves calculating the present value of principal and expected coupons but is complicated by uncertainty in coupon receipt. Thus, simulations incorporating interest rate volatility are vital to estimate knock-out probabilities. TARNs linked to volatile benchmarks require more sophisticated models for accurate pricing.

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