Risk Latte - Quanto Capped Range Accrual Swap

Quanto Capped Range Accrual Swap

Third Party Contribution
May 11, 2005

Since many of the liability managers are comfortable taking a view that LIBOR may not rise as fast as the market expects, the following trade idea was suggested by a Regional bank in Asia to a corporate in Taiwan.

The product is a 5 year quanto structure and the main idea behind it is the Cost Reduction Carry trade. We have seen this theme in circulation for quite a while now and it seems that these structures are really passé and peddled by almost every bank in town. The quanto idea is a bit new though for a range accrual structure like this in North Asia.

Maturity 5 years
Client Pays 3m TWD CP subject to the following cap
Year 1: 2.25%
Year 2: 2.75%
Year 3: 3.25%
Year 4: 3.75%
Year 5: 4.25%
Client Receives Accrual Rate as below, subject to the following accrual range
Year 1: 2.15% X n/N subject to 3m USD LIBOR staying within [0 - 3.50%]
Year 2: 2.65% X n/N subject to 3m USD LIBOR staying within [0 - 4.00%]
Year 3: 3.15% X n/N subject to 3m USD LIBOR staying within [0 - 4.50%]
Year 4: 3.15% X n/N subject to 3m USD LIBOR staying within [0 - 5.15%]
Year 5: 3.15% X n/N subject to 3m USD LIBOR staying within [0 - 5.50%]

Swap is callable quarterly after the first 3 months.

The advantage to the client is the carry - e.g in year 1 he receives 2.15% fixed rate (subject to LIBOR staying in the stated range) while he pays only 3m CP which is currently only 1.25%. Further, if there are any spike up in TWD rates, the client is protected by the cap.

The pricing and the risk analysis of the above vanilla structure is really very straightforward and can be done using a BDT tree. But the quanto makes the pricing in the tree framework quite tedious and therefore we will have to ultimately resort to Monte Carlo simulation.

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