Risk Latte - Was 1994 a LEAN Year?

Was 1994 a LEAN Year?

Rahul Bhattacharya
Mar 10, 2005

One of the most popular type of range accrual notes that were introduced in 1994 was LEAN - Libor Enhancement Accrual Notes. Coupons of the LEAN have much higher spread to Libor (or some other index) than comparable FRNs, but do not accrue interest when the accrual index is outside an accrual range.

The story of LEAN is one of phenomenal growth followed by spectacular decline. 1994 was a watershed year in the history of bond markets and the U.S. economy as a whole.

LEANs were introduced in January 1994 when investors were mulling over how to take advantage of low volatility in the Libor market coupled with their belief that there would not be any interest rate hikes in the near future (since there were no signs of inflation on the horizon). They instantly liked this structure which was actually designed to suit this investor psychology that was prevailing at that time. Within a short span of two weeks over US$1 billion in new issue of LEANs were created and purchased by the investors.

Unfortunately, the U.S. Federal Reserve did not share investors' view and optimism about inflation and rapidly raised interest rates thereafter in the first quarter of 1994. Not only the interest in LEANs waned but also a large outstanding pool of notes was created with accrual indices outside the accrual range.

(Referenced from Exotic Options by Scott Peng and Ravi Dattatreya).

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