This document provides an overview of Target Accrual Redemption Forwards (TARFs), including their characteristics, analytics, valuation, and risks. It discusses TARFs as complex financial products with customized payoff structures involving multiple currency options. The document also examines a 2008 case study where Citic Pacific incurred large losses on its TARF portfolio, resulting in regulatory actions.

1. Copyright 2015 CapitaLogic Limited
Target Accrual
Redemption Forwards
Date Tuesday 7 July 2015
Time 6:30 pm to 7:15 pm
By Dr. LAM Yat-fai, Doctor of Business Administration (Finance)
CFA, CAIA, FRM, PRM
E-mail address: faiylam@caplogic.com

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Characteristics of the TARFs
Analytics of the TARFs
Case study: Citic Pacific 2008
Outline

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Simple financial products
Spot
Linear derivatives
Forwards and futures
Vanilla options
European and American, call and put
Trading strategies
Bull spread, bear spread, butterfly, straddle

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Complex financial products
First generation exotic options
Binary, one-touch, no-touch, barrier options
Second generation exotic options
Corridors, faders, step-up, step-down options
Fixed income with embedded options
Currency linked deposits
Principal protected notes
Multiple fixings
Accumulator, decumulator, TARF

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An ideal financal product
Investor
Large upside potential
Small downside loss
No initial cash outflow
Issuer
Large commission income
Low hedging cost

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Functional purposes
Investor
To hedge a currency exposure at a lower initial
cost
To speculate in the direction of a currency rate
with a lower upfront cash outflow
Issuer
To earn a high profit at origination
To exit the position in a sure loss situation

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Structuring
A series of call options with payoff function
Max[Current rate - Strike rate, 0]
× Call notional principal
A series of put options with payoff function
Max[Strike rate - Current rate, 0]
× Put notional principal
An early termination feature

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Bull TARF

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Multiple fixing

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Bonus target
Bonus target
Cash inflows from
call options

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TARF specification
Full paymentTreatment to termination bonus10.
USD 136,000Bonus target9.
MonthlyFixing frequency8.
19 December 2014Maturity date7.
USD 1.3500 per EURStrike rate6.
Domestic currencySettlement approach5.
EUR 2,000,000Put notional principal4.
EUR 1,000,000Call notional principal3.
EURForeign currency2.
USDDomestic currency1.
ValueParameter

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Zero value TARF
A TARF with zero value at origination is
most welcome
No cash outflow from acquirer
No cash outflow from issuer
Long in-the-money (ITM) option
Moderate cost x 1
Short out-of-the-money (OTM) option
Small revenue x N

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Zero-value TARF
Loss probability
Lossamount

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Revenue model
Investment bank
Synthesize a TARF with vanilla call and put
options
Mark up a profit
Sell to a commercial bank
Commercial bank
Acquire a TARF from investment bank
Mark up a profit
Sell to an investor

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Sales and marketing
The attractive product features of a TARF
The professional sales team which performs
the marketing
The price of a TARF
The post sales customer services

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Bull and bear TARFs

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Dual-strike and survival gap TARFs

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Pivot TARFs

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Characteristics of the TARFs
Analytics of the TARFs
Case study: Citic Pacific 2008
Outline

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Valuation
TARFs are custom-made instruments
have no liquid secondary market
have no market price
Price of a TARF ≠ Value of a TARF
Value of a TARF
The raw material cost for synthesizing a TARF in the
currency market with the underlying currency, forwards
and/or options
Price of a TARF
Value of a TARF + Mark up profit

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Major valuation factors
-
(for the common construction where the
put notional principal is substantially
larger than the call notional principal)
Volatility
+Spot currency rate
-Aggregated bonus
+Bonus target
-Strike rate
-Put notional principal
+Call notional principal
Bull TARF

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Valuation with
Monte Carlo simulation

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Theoretical value
The raw material cost of synthesize a TARF
with vanilla call and put options under certain
model assumptions
TV = Average(Simulated TARF values)

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Market risk of investor
Capped upside potential
Unbound downside loss
Present value-at-risk (PVaR)
PVaR = Average(Simulated TARF values)
- Percentile(Simulated TARF values, 1%)

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Credit risk of issuer
The risk that an investor fails to pay the issuer
on a payment day when the investor is subject
to a loss
Margin as a credit risk control
What is the margin amount on portfolio basis?
Too small, insufficient protection
Too large, losing customer
A very difficult topic

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Standardized portfolio analysis of risk
Standardized portfolio analysis of risk (SPAN)
Used by many derivatives exchanges
All TARFs with the same foreign currency grouped into one sub-
portfolio
A worst scenario approach
A = The maximum potential change of the rate of the
underlying currency between two margin calculation days
B = The maximum potential change of the volatility of the
underlying currency between two margin calculation days

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Scenario values (1)
Currency volatility - BSpot rate + 2A/38.
Currency volatility + BSpot rate + 2A/37.
Currency volatility - BSpot rate - A/36.
Currency volatility + BSpot rate - A/35.
Currency volatility - BSpot rate + A/34.
Currency volatility + BSpot rate + A/33.
Currency volatility - BSpot rate2.
Currency volatility + BSpot rate1.
VolatilityCurrency rate

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Scenario values (2)
Currency volatilitySpot rate - 3A16.
Currency volatilitySpot rate + 3A15.
Currency volatility - BSpot rate - A14.
Currency volatility + BSpot rate + A13.
Currency volatility - BSpot rate + A12.
Currency volatility + BSpot rate + A11.
Currency volatility - BSpot rate - 2A/310.
Currency volatility + BSpot rate - 2A/39.
VolatilityCurrency rate

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Maximum scenario loss
Scenario loss
= Scenario value – origination value
Margin
= Maximum of
Scenario losses for scenario 1 to 14; and
32% of scenario losses for scenarios 15 and 16

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Other risks and analytics
Operational risk
Liquidity risk
Legal risk
Derivative accounting

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Characteristics of the TARFs
Analytics of the TARFs
Case study: Citic Pacific 2008
Outline

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2008 AUD losses controversy
Prospective expenditure AUD 1.6 bn
TARFs AUD 9 bn
Loss USD 2 bn

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2008 AUD losses controversy
Share price dropped 55% to HKD 6.52 from
HKD14.52
SFC sought compensation up to 4,500
investors
Chairman Mr. Larry YUNG stepped down
General manager Mr. Henry FAN stepped
down

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Suitability assessment
Suitability
assessment
Investor profiling Product assessment
Product risk level
Product features
Risk tolerance level
Know your client