Rationale and Motivation:

Following couple of scenarios are good candidates for a logical entry into a long side of this exotic structure.

A client is likely to enter into a long position in Range Accrual Note, mostly based on a view that the forward curve is too steep and that he/she forecasts that the actual increase in rates will be slower than what is predicated by the market's assumption of the curve.

The perception of a player entering into the product is "perhaps the Fed is going to be on a hold" longer than what the market participants are anticipating. The current state of economy is likely to last much longer than what the curve predicts. The implied volatility will therefore, show a decline due to the fact that there is not going to be major moves on either side of current trend.

Based on these assumptions, a Range Accrual Note is typically structured to pay an enhanced coupon for each day that the Reference Index (say Libor) sets below a pre-determined range (or within a pre-determined boundary levels).

Funding Leg:

The underlying structure of a range note, is a combination of a structured and a funding leg. The funding leg pays a normal Libor coupon: where c is the call/put flag, fi is the Libor rate setting at the beginning of the period, mif is the margin over Libor on the floating leg, tif is the funding leg tenor.

Structured Leg:

Gearing is an important aspect of this leg, because the risk-profile of this product vehemently rests on the gearing multiple in the equation. The structured leg pays a coupon which is a linear function of the Libor setting at the beginning (as per the funding leg), but proportional to the number of days in the accrual period that the Libor of the same frequency set within the specified range: where gi is the Libor gearing on the structured leg, mis is the margin over Libor on the structured leg, tis is the structured leg tenor, Ni is the notional for that roll, ni is the days-in-range factor.

Relative Merits and Weak-points of the structure:

Positive points - Product suitability:
1. Simple to understand the design of the structure, eventhough valuation aspects are relatively complex.
2. Enhanced return when the Reference rate is within pre-determined boundaries.
3. Some variants of these notes offer principal protection (particularly for trades with retail clients)

Points against the structure:
1. Returns are subject to major fluctuations, particularly when Reference Rates oscillate beyond the rate-boundaries.
2. In the callable RAN version, investors have to face re-investment risk if the note is called by the issuer.
3. Due to the relative complexity of the structure, it is Not likely that the notes will have liquidity similar to the vanilla bond structures.

Trade Conventions:

In simple terms, coupon on a Range Accrual Note in any given coupon period, equals Fixed Rate * n / N where n represents Number of days that the Reference Rate is within the predetermined levels, and N represents the Total number of days within the coupon period. The days in range is defined to be the number of days during the accrual period that the spot Libor rate set below the upper band, and above the lower band, divided by the total number of days in the accrual period. Note that the tenors need not be those used to determine the yield curve.