A range accrual note is a popular derivative product that pays the holder a fixed coupon rate on days when a certain reference rate falls within a specified range. At the beginning of the investing period, the investor does not know the amount of coupon payments he or she will get throughout the life of the note. There are two types of range accrual notes: single-period notes and multi-period notes.
An investor pays a nominal amount of money to enter a single-period range accrual note contract in which the parties involved agree on a fixed interest rate, the range of reference interest rates and the period of investment. During the life of the note, the parties observe the number of days that the reference interest rate falls within the specified range. When the contract expires, the investor gets back the nominal amount of money and the coupon payment. They calculate the coupon rate by multiplying the fixed interest rate by the number of days during the observation period that the reference interest rate falls within the specified range.
For example, an investor pays $100 million US Dollars (USD) to enter a 180-days range accrual note contract in which the Euro-to-U.S.-Dollar (EUR/USD) currency exchange rate serves as the reference rate. The investor gets a 5 percent per annum coupon payment for every day that the EUR/USD exchange rate falls within the $1.22 to $1.30 range. If the reference rate falls within the specified range on 130 days within the observation period of 180 days, the investor gets a coupon rate of = 5 percent x (130/180) = 3.61 percent. At the end of the contract, he or she gets a coupon payment of 100,000,000 x 3.61 percent x 0.5 = $1,805,000 USD. The 0.5 figure adjusts the annual interest rate to the half-year period of the contract, so the investor gets $101,805,000 USD in nominal and coupon payment at the end of the contract period.
A multi-period range accrual note works just like the single-period version, except that it involves more than one successive investment period. At the end of each period, the investor gets the coupon payment for that particular period. At the end of the final period, the investor gets the coupon payment for the final period plus the nominal payment. In such a contract, the coupon rate and the reference rate range could change from period to period.
An investor who expects low volatility — little movement in reference interest rate — could make a profit by getting a range accrual note with a reference rate range that is close to the prevailing reference rate. An investor who expects high volatility could gain from getting a range accrual note with a reference rate range that is above or below the prevailing reference rate. Generally, large institutions use range accrual notes to hedge another position.
