PRODUCT SUMMARY

S T R U C T U R E D N O T E S

Prepared by
The Financial Markets Unit
Supervision and Regulation
 PRODUCT SUMMARY

S T R U C T U R E D N O T E S

Karen McCann
Joseph Cilia
Financial Markets Unit
November 1994
 PRODUCT SUMMARIES
Product summaries are produced by the Financial Markets Unit of the
Supervision and Regulation Department of the Federal Reserve Bank of
Chicago. Product summaries are published periodically as events warrant
and are intended to further examiner understanding of the functions and
risks of various financial markets products relevant to the banking indus-
try. While not fully exhaustive of all the issues involved, the summaries
provide examiners background information in a readily accessible form
and serve as a foundation for any further research into a particular prod-
uct or issue. The views expressed are the authors’ and do not necessarily
reflect the views of the management of the Federal Reserve Bank.
Should the reader have any questions, comments, criticisms, or sugges-
tions for future Product Summary topics, please feel free to call any of the
members of the Financial Markets Unit listed below.

FINANCIAL MARKETS UNIT

Joseph Cilia (312) 322-2368

 TABLE OF CONTENTS

Introduction .....................................................................................................................................................1
What are structured notes?................................................................................................................................2
Why have they become popular?.......................................................................................................................2
Background on the Market ...............................................................................................................................2
Regulators find a cause for concern ..................................................................................................................3
Regulators respond ...........................................................................................................................................3
Some Common Structures and Attendant Risks................................................................................................4
Step-Ups/Multi-Steps..........................................................................................................................4
Description..........................................................................................................................................4
Performance ........................................................................................................................................5
Index-Amortizing Notes......................................................................................................................6
Description..........................................................................................................................................6
Performance ........................................................................................................................................6
Dual Index Notes ................................................................................................................................8
Description..........................................................................................................................................8
Performance ........................................................................................................................................8
De-Leveraged and Leveraged Floaters.................................................................................................10
Description ........................................................................................................................................10
Performance.......................................................................................................................................10
Range Notes......................................................................................................................................11
Description ........................................................................................................................................11
Performance.......................................................................................................................................12
Inverse Floaters ..................................................................................................................................13
Description ........................................................................................................................................13
Performance.......................................................................................................................................13
Index Floaters ....................................................................................................................................14
Description ........................................................................................................................................14
Performance.......................................................................................................................................15
Risk Identification .................................................................................................................................16
Market Risk.......................................................................................................................................16
Liquidity Risk....................................................................................................................................16
Interest Rate Risk ..............................................................................................................................16
Examiner Guidance ........................................................................................................................................17
Additional Evaluation Assistance .....................................................................................................................17
Glossary..........................................................................................................................................................19
Bibliography ...................................................................................................................................................20
 INTRODUCTION

Structured notes have become the focus of much attention lately following highly publicized losses sustained by
investors caught off guard by the recent reversal in the trend of interest rates. Since structured notes are still fairly
new, the all-important process of educating investors is underway — but not complete. As is the case with most
financial innovation, structured notes offer issuers and investors a vehicle to isolate and redistribute specific risks.
These same properties, however, also give rise to unique pricing challenges. Pricing straight derivative products (ie,
options, forwards, swaps) requires that assumptions be made about the likelihood of certain future events, and that
those assumptions be subsequently incorporated into sophisticated pricing models. Pricing the derivative compo-
nent of structured notes requires the same level of analysis on the part of investors.
This paper will introduce common structures and explain the type of analysis in which investors should engage both
prior to and subsequent to purchase. It is far from an exhaustive compilation of the numerous types of structures
which have been created. Our intention is to raise awareness about common structures and give examiners a foun-
dation from which they can determine whether the banks that own such securities are conscious of the attendant
risks, and whether they have the capacity to monitor and address fluctuations in value. We have included a brief
glossary at the end which defines some terms used throughout the paper. It may be helpful for the reader to become
familiar with some of the terms before continuing with the paper.

1
 What are structured notes?
Unlike straight derivatives whose entire value is dependent on some underlying security, index or rate, structured
securities are hybrids, having components of straight debt instruments and derivatives intertwined. Rather than
paying a straight fixed or floating coupon, these instruments’ interest payments are tailored to a myriad of possible
indices or rates. The Federal Home Loan Bank (FHLB), one of the United States’ largest issuers of such products,
has more than 175 indices or index combinations against which cash flows are calculated. In addition to the interest
payments, the securities’ redemption value and final maturity can also be affected by the derivatives embedded in
structured notes. Most structures contain embedded options, generally sold by the investor to the issuer. These
options are primarily in the form of caps, floors, or call features. The identification, pricing and analysis of these
options give structured notes their complexity.

Why have structured notes become popular?

Investors in structured notes find the notes attractive for several reasons. In a sustained period of low interest rates
(such as experienced in the U.S. for the five years leading up to February 1994) receiving an “acceptable” return on
an investment becomes increasingly difficult. Structured notes, whose cash flows and market values are linked to
one or more benchmarks, offer the potential for greater returns than prevailing market rates. The desire for higher
yield leads investors to make a risk/return tradeoff which reflects their market view. The fact that most structured
notes are issued by Government Sponsored Enterprises (GSEs) means that credit risk — the risk that the issuer will
default — is minimal. GSEs are not, however, backed by the full faith and credit of the U.S. government, though
most have explicit lines of credit from the Treasury. As a result, investors are attracted by structured notes’ potential
returns, and put at ease by their high credit quality.
Another attractive feature of such securities is that they can serve to hedge unique risks faced by the investor. For
example, a company which is long (owns) Japanese yen is exposed to the risk of yen depreciation. The FHLB issued
a one-year structured range note which accrued interest daily at 7% if the JPY/US$ > 108.50 or at 0% if the
JPY/US$ ≤108.50. If the yen depreciates, the note accrues interest at an above-market rate. Meanwhile, the com-
pany’s yen holdings will decline in value. This note could serve as a perfectly tailored hedge for the company’s busi-
ness risk profile. In fact, the design of many of the most complicated structured notes is driven not by the innova-
tions of note issuers and underwriters, but rather by investors seeking to hedge their own unique risk profiles.
A third reason for purchasing structured notes is to take a market view. Just as purchasers of stock are expressing the
opinion that they expect the stock price to increase, structured notes can be used in the same way. For instance, in
the above example an investor who believed that the dollar would appreciate against the yen would be compensat-
ed handsomely for being correct. However, if the investor’s view proved incorrect, he would be locked into an
investment which paid no interest for a period of up to one year.
The caveat which applies to investments in any derivative instrument must also be extended to structured notes.
This can be summarized in 3 words: UNDERSTAND THE RISKS. It is usually easy to quantify how an invest-
ment will perform under expected (or hoped for) conditions. The challenging, but very necessary, adjunct to such
analysis is to quantify how the investment will perform under adverse, or less than ideal circumstances. Without this
additional scrutiny, institutions which purchase such instruments may find themselves surprised by their invest-
ments’ poor performance.

Background on the market

Structured notes received heightened attention from both regulators and investors in the spring and summer of
1994. As a result of a series of interest rate hikes by the Federal Reserve, structures tied to interest rates experienced
radical shifts in their scheduled payments, causing large, unforeseen losses for many holders of structured notes.
Market values of many of these instruments fell below par as their coupons became vastly inferior to comparable
maturity investments and maturities were extended beyond investors’ original expectations.
Though several investors sustained substantial losses from their investments in structured notes, such securities gen-
erally receive a triple-A rating. The securities are primarily issued by GSEs such as FHLB, FNMA, SLMA and
FHLMC. Thus, though credit risk is minimal, many unsuspecting investors discovered that other risks — interest rate
risk, market (price) risk and liquidity risk — can be material.

2
 Owners of structured notes with call features and/or caps on coupon resets have sold an option (or a series of
options) to the issuer.1 Many money managers lack the systems necessary to adequately value the derivative com-
ponent of the most basic structured note. To help ensure that the risk characteristics and the option component are
priced by sophisticated investors with the means to model cash flows under varying interest rate environments, the
dealers and issuers use large denominations as a screen. For example, most FHLB “plain vanilla” debt instruments
are issued in minimum denominations of $10,000; the minimum denomination on their structured securities is $100,000
and some of the more esoteric notes have a $500,000 minimum. Nevertheless, some complicated securities have found
their way into the portfolios of unsophisticated investors. Purchasers of structured securities tend to be fairly even-
ly allocated among money managers, dealers, state and local governments and commercial banks.

Regulators find a cause for concern

During the spring and summer of 1994, several money market funds sustained major losses tied to their investments
in structured notes. Because the losses were both substantial and widespread, regulators became concerned that
institutions may not have a thorough appreciation of the unique risks associated with many of these products. In sev-
eral instances, structured notes were blamed for losses threatening the $1 net asset value (NAV) of the funds’ shares.
In addition to the money funds, losses were disclosed by banks and other investors whose purchases of certain secu-
rities reflected a view of market interest rates which proved erroneous.

Regulators respond
Beginning with the Securities and Exchange Commission’s (SEC) June 30 warning to money fund managers about
certain types of structured notes and their lack of suitability for investment by money funds, most other financial
regulators issued guidance on investing in such securities. The SEC told money fund managers who had investments
in any of five types of structures to “plan to dispose of the securities in an orderly manner.” The five structures sin-
gled out are:
1) Inverse floaters
2) COFI floaters
3) CMT floaters
4) Dual index floaters, and
5) Range floaters.
The SEC acted in response to losses in money market funds leading to bailouts by the funds’ managers totalling $268
million for PaineWebber, $67.9 million for BankAmerica and substantial amounts for several other prominent mon-
ey managers.2
On July 21, the Office of the Comptroller of the Currency (OCC) issued an Advisory Letter, AL 94-2, which
defined six types of common structures and deemed structured notes “inappropriate investments for most national
banks.” The OCC said that whether an instrument could be found to be appropriate depended on “... the bank’s
ability to understand, measure, monitor, and control that instrument’s risks consistent with [OCC] Banking Circular
2773.” According to Douglas Harris, OCC Senior Deputy Comptroller for Capital Markets, their bank examiners
have uncovered some significant losses tied to holdings of structured notes. He reported that an $80 million bank
lost 25% of its total capital earlier this year as a result of losses on investments in dual index floaters.4
On August 5, the Federal Reserve issued SR letter 94-45, “Supervisory Policies Relating to Structured Notes.” In
this letter, the Fed acknowledged the valuable risk management role which structured notes can serve, while empha-
sizing the importance of bank management’s ability to stress test their portfolios and both understand and manage
the risks associated with structured notes.
The Office of Thrift Supervision (OTS) issued Thrift Bulletin 65 relating to structured notes on August 16. This
bulletin, while recognizing that structured notes can be a beneficial investment vehicle, stressed the importance of

1
In contrast, where coupon floors are present, the investor has purchased an option from the issuer.
2
A discussion of the money fund troubles can be found in the Oct. 1994 issue of The Federal Reserve Bank of Chicago’s Financial Markets News; copies are
available from any FMU member.
3
“Risk Management of Financial Derivatives,” OCC Banking Circular 277, October 27, 1993.
4
“OCC Tells Banks to Beware of Structured Notes,” Derivatives Week, July 18, 1994.
3
 modeling different interest rate scenarios. The OTS advised that stress testing be conducted quarterly, modeling the
changes in the investment’s value for interest rate moves in the range of ± 400 basis points.
The Federal Deposit Insurance Corporation (FDIC) which regulates state-chartered banks that are not members of
the Federal Reserve System, issued guidance to examiners in mid-August on structured notes. The FDIC’s stance
is the most stringent, requiring examiners to classify as “substandard” structured notes that could experience a loss
of principal. William A. Stark, FDIC’s Assistant Director for Capital Markets, was quoted as saying, “We’ve seen
them where you can lose 100% [of principal].”5 In addition, any mark-to-market (unrealized) losses must be classi-
fied as a “loss” by examiners. A common theme underlying each of the regulators’ warnings is that examiners should
confirm that senior management understands the associated risks and regularly evaluates/assesses those risks. Only
the SEC specifically asked for divestment of high risk structured notes, though all other regulators established strin-
gent control guidelines for institutions who chose to make such investments.

SOME COMMON STRUCTURES AND ATTENDANT RISKS

Though the investor and the issuer can mutually agree upon virtually any type of structure, some designs have
become more popular than others. Discussion and simple analysis of the most common types of structures follows.
The purpose of the analysis is to introduce some of the calculations required to evaluate these instruments. Realize,
however, that in many cases very complex probability and pricing models are required to accurately evaluate and
price these instruments. As mentioned earlier, most structures have embedded options, implicitly sold by the
investor to the note’s issuer. The proper valuation of these options poses unique challenges to investors considering
structured notes. Many popular structures include embedded, path-dependent options, for which pricing theory is
still evolving. Additionally, the reader should bear in mind two imperfect assumptions which underlie all our calcu-
lations and analysis:
1) In cases where a yield-to-maturity is referenced, it is an internal rate of return figure. Consequently, the assump-
tion is being made that coupon payments can be reinvested at the derived yield to maturity.
2) Our calculations often reference a comparable maturity Treasury instrument for a judgment on relative perfor-
mance. However, plain vanilla agency securities usually trade at a slightly higher yield than Treasuries due to the
slight difference in credit quality mentioned earlier. For simplicity, our analysis assumes a zero credit spread
between GSE notes and Treasury notes.

Step-Ups/Multi-Steps
Description
Step-up notes/bonds are generally callable by the issuer, pay an initial yield higher than a comparable maturity
Treasury security, and have coupons which rise — or “step up” —at predetermined points in time if the issue is not
called. If the coupon has more than one adjustment period, it is referred to as a multi-step. An example is an FHLB
5-year note issued in May of 1994. The issue is callable in 2 years and the coupons increase according to the
following schedule:
6.25% for year 1 (May 1994)
6.50% for year 2 (May 1995)
7.00% for year 3 (May 1996)
8.20% for year 4 (May 1997)
9.25% for year 5 (May 1998)

5
Rehm, Barbara A., “FDIC Adds Big Stick to Warnings on Dangers of Structured Notes,” American Banker, Sept. 1, 1994.
4
 Since the first call date is May 1996 (and every coupon date thereafter), only the first two coupon levels are
guaranteed.
This note contains embedded call options “sold” to the issuer by the investor. Any time an issue is callable, the pur-
chaser of the security has sold a European call option to the issuer.6 Since this issue has three call dates, it can be
viewed as containing three call options. The issuer has purchased options which allow him to benefit from a declin-
ing rate environment by refunding the debt “early” and refinancing at lower market rates. Unlike callable issues
which pay a flat rate until maturity or call, the step-up feature of these securities increases the value of the call
options to the issuer and likewise increases the prospect of early redemption. Thus, rather than viewing this securi-
ty as a 5-year investment, it makes sense to treat it as a 2-year investment which may extend up to 5 years.
Multi-steps can also be thought of as one-way floaters since the coupon can adjust higher, but never lower. As such,
they can be viewed as securities in which the investor has bought a series of periodic floors and has sold a series of
periodic caps in return for above-market initial yield.7

Performance
Refer to Exhibit 1 in conjunction with the following analysis: How will this security probably perform, however,
at the end of two years (the first call date) under the following scenarios — rates stable, rates up, rates down? If rates
are stable, it is likely that the issue will be called since it is paying above-market returns. In this case, the option which
the investor sold would have proved to be overpriced.

Exhibit 1

May 3, 1994 Step-Up Yield Treasury Spread to

Coupon to Call CMT Treasury
(basis points)
Year 1 6.25
Year 2 6.50% 6.37% 5.85% +52
Year 3 7.00% 6.57% 6.26% +31
Year 4 8.20% 6.93% 6.49% +44
Year 5 9.25% 7.33% 6.72% +61

The investor will realize a yield of 6.3711%.8 This is about 52 bp higher than would have been earned by alterna-
tively buying and holding a 2-year Treasury.
If rates fall in the first two years, the note will also be called. Had the investor been viewing this as a 2-year invest-
ment, the investor will still do well. Alternatively, had the investor viewed this as an investment with a longer matu-
rity, the early return of funds in a lower rate environment will hurt the investment portfolio.
If we assume the last scenario, an increasing rate environment, the note will most likely not be called and will mature
in 5 years. The duration of the security will increase and the likelihood that this instrument will outperform invest-
ments of similar tenor is reduced. Note, however, that rates would need to rise fairly substantially in order to mate-
rially affect the note’s value. The note will yield 7.33% if held to maturity. Since 5-year Treasuries at the time of

6
Unlike American options which can be exercised on any day preceding expiration, European options may only be exercised on their expiration date.
The fact that the issue is only callable on certain dates means that the call options are European. All other things equal, European call options are cheaper
than American call options.
7
Audley, David, Chin, Richard and Ramamurthy, Shrikant, “Callable Multiple Step-Up Bonds” Prudential Securities Financial Strategies Group, May
1994.
8
Cash flows are: 0 = -$10,000
1 = +$312.50 (.0625 ÷ 2 x $10,000)
2 = +$312.50
3 = +$325.00 (.065 ÷ 2 x $10,000)
4 = +$10,325.00
IRR = 3.1855% (Semi-annual; multiply by two to annualized).
5
 issue were yielding about 6.72%, rates would have to rise substantially for an investor to realize greater returns
through alternative Treasury securities.9
This note was issued midway into the Federal Reserve tightening of 1994. As Exhibit 1 demonstrates, this security
will outperform comparable Treasury securities under all scenarios in the prevailing rate environment. It should be
easy to see, however, that a similar lower-coupon note, issued a month or two before rates were increased, could
have quickly underperformed alternative investments. Investors would have been locked into a 5-year investment
which did not fully participate in subsequent market interest rate increases. In cases where they viewed the note as
a 2-year investment, adverse ramifications would be even greater. Had purchasers accurately forecast the timing and
amount of the interest rate increases, they would not have chosen to make such an investment. Thus, an investor’s
market view is incorporated into the purchase of these securities; if the view proves incorrect, the investor will real-
ize below-market returns.
However, it is worth noting that a step-up note will offer an investor more protection in a rising rate environment
than a flat rate callable note. For this reason, prevailing sentiment in the investment community is that among var-
ious types of structured notes, step-ups are the most palatable. Still, investors must analyze step-ups under multiple
scenarios and ensure that any possible redemption horizon is consistent with investment objectives.

Index-Amortizing Notes
Description
An index-amortizing note (IAN) is a form of structured note for which the outstanding principal — or note —
amortizes according to a predetermined schedule. The predetermined amortization schedule is linked to the level
of a designated index (LIBOR, CMT, the prepayment rate of a specified passthrough pool, etc.). Thus, the timing
of future cashflows, and hence the average life and yield to maturity of the note, become uncertain. The IAN does
have a stated maximum maturity date, however, at which time all remaining principal balance is retired.
An embedded option feature is present in this type of security as well. The investor, in return for an above-market
initial yield, effectively sells an option to the issuer. The issuer has the option to alter the principal amortization as
the interest rate environment changes. Caps and floors may also be present if the issue has a floating rate coupon.
A typical IAN is structured so that as the designated index (eg, LIBOR) rises above a trigger level, the average life
extends. Conversely, if the designated index is at or below the trigger level, the IAN’s principal will quickly amor-
tize, leading to a shorter average life. The outstanding principal balance will vary according to the schedule at each
redemption date. One may equate the amortization of the note to the retirement (call) of some portion of the prin-
cipal. As the amortization quickens, more and more of the note is “called.”

Performance
To illustrate, consider an IAN issued by the FHLB on September 15, 1994 and with a maturity date of September
15, 1999. The coupon resets quarterly at [3-month LIBOR + 42 basis points]. However, the coupon can never reset
higher than 50 basis points above the previous coupon, and has a lifetime cap of 9.5%. Additionally, there is an initial “lock
out” period of one year, during which time the entire principal remains outstanding and the amortization sched-
ule is irrelevant. Beginning September 15, 1995, the outstanding principal is redeemed in whole or in part subject
to the schedule, and paydown of principal may continue quarterly thereafter.
Three month LIBOR was quoted at 5.0625% on September 15, 1994; thus the initial coupon level was [5.0625 +
0.42 = 5.4825%]. In an unchanged rate environment (LIBOR below 6%) 100% of the principal will be returned in
one year. Since the prevailing rate on 1-year Treasuries as of September 15, 1994 was 5.69%, a purchaser of this note
would have to expect rising rates in order for this to be an attractive investment. The quarterly amortization sched-
ule is shown below:

9
By using the discounted cash flow analysis illustrated in footnote 8, you can prove that if the three year rate available in two years is greater than 8.5%,
this step-up would underperform an alternative investment consisting of the purchase of a 2-year Treasury in May of 1994 and a 3-year Treasury in May of
1996.
6
 3 MONTH LIBOR REMAINING PRINCIPAL
9.00% or greater 100.00%
8.75% 96.25%
8.50% 92.50%
8.00% 85.00%
7.75% 80.00%
7.50% 75.00%
7.00% 65.00%
6.50% 32.50%
6.25% 16.25%
6.00% or less 0.00%

Assume the investor purchases $1,000,000 of this issue. If, on September 15, 1995, LIBOR is at 7.50%, 25%
($250,000)of the principal is returned, leaving the adjusted principal balance at $750,000 ($1,000,000 x 75%).
According to the formula, we would expect the new coupon on the remaining balance to be 7.92%. However, due
to the periodic “caps” the maximum that the coupon can reset to on this date is 7.4825%.10 So, while the investor
had expectations of rising rates, the degree of the rate change (volatility) is also important. If rates rise sharply, the
investor may be locked in to a 5-year security which underperforms the overall market.
After a partial principal redemption, the adjusted principal balance forms the basis for the next redemption period.
If LIBOR rises to 8.0% by the next quarterly redemption date, $112,500 additional principal is returned to the
investor, leaving the adjusted principal balance at $637,500 ($750,000 x 85%). While we would expect the coupon
to reset to 8.42%, the presence of the caps means that it will only rise to 7.9825%. In this case, the investor would
be earning a rate just below 3-month LIBOR.
Also notice that as LIBOR falls, the note redeems very quickly. Should LIBOR remain steady, the investor will
receive 100% of original principal on September 15, 1994 and will have earned a below-market rate for the year.
The note also has what is known as a 10% “cleanup provision.” Borrowed from the mortgage market, this term
refers to the fact that the issuer has the option to call or redeem the note when the outstanding principal balance
falls to 10% or less of the original principal amount. It acts to “clean up” the issue in the secondary market, and is
advantageous to the investor due to the illiquidity of such a small current principal balance.
One can conclude that the average life of this 5-year note will vary with each redemption date but, as stated earli-
er, will never extend beyond its final maturity. Further quantification as to the exact average life at each period
would require some type of model akin to those used for the analysis of mortgage backed securities (MBS). In sum-
mary, for stable or falling rates, or rapidly rising rates, this investment will be inferior. Only in a period of gradual-
ly rising rates will this particular structure perform relatively well.
Clearly, similarities exist between IANs and collateralized mortgage obligations (CMOs). Both instruments contain
embedded prepayment options; the issuer being the holder in the case of an IAN and the homeowners holding the
option in the case of a CMO. The value of these options depends not only on the general level of interest rates, but
also on the path of future interest rates. An IAN is structured according to a predetermined amortization schedule
which simplifies measurement of the timing and size of future cash flows.
Probably the most significant difference between the two types of securities is their maturity structure. An IAN’s
typical stated final maturity is usually between 5 and 10 years. Most CMOs are backed by either 15 or 30 year mort-
gage collateral. While some CMOs may be “tight” and therefore offer a degree of certainty with respect to cash-
flows and average life, they nonetheless have the capacity to extend (possibly fully) under extreme market scenarios.

10
Assuming that the periodic cap is triggered every quarter, the maximum increase over one year is 200 basis points. Therefore, from the initial coupon
level of 5.4825%, the highest reset level for the coupon one year later would be 7.4825%.
7
 Generally speaking, advantages of IANs with respect to CMOs are:
1) The maximum “extension period” for IANs is generally shorter;
2) Maturity, while not definitively known, cannot exceed a stated maximum tenor;
3) Idiosyncratic prepayment issues (eg, homeowner relocates or dies) which speed prepayment due to
non-interest rate related events, are not present.

Generally speaking, disadvantages of IANs with respect to CMOs are:

1) Many CMOs are issued at a discount, and thus offer the potential of early redemption at par which
creates a capital gain. IANs are generally issued at par, removing this possibility;
2) The secondary market for IANs is less liquid than it is for CMOs.
IANs generally appeal to purchasers who want investments with a CMO-like risk/return profile, but with reduced
uncertainty as to the average life. Depending on the coupon structure (fixed or floating) investors with definite
views on both the direction and volatility of interest rates can improve their returns in situations where their expec-
tations are realized.

Dual Index Notes

Description
A dual index note is a security whose coupon is tied to the spread between two market indices. Typical indices used
to structure payoffs to these notes are: the prime rate, LIBOR, COFI, and CMT yields of different maturities. A
purchaser of this type of security is typically making an assumption about the future shape of the yield curve. These
notes can be structured to reward the investors in either steepening or flattening yield curve environments. This fea-
ture explains an alternative designation for dual index notes: yield curve anticipation notes (YCAN). However,
these notes can also be tied to indices other than interest rates such as foreign exchange rates, stock indices or com-
modity prices.
An example of a note which would appeal to investors with expectations of a flattening yield curve would be one
with a coupon that floats at:
[the 5 year CMT - the 10 year CMT + a designated spread].
Based on this formula, the coupon will increase if the yield curve flattens between the 5 year and the 10 year matu-
rities. Alternatively, a yield curve steepening play would be an issue that floats at:
[the 10 year CMT - the 5 year CMT + a designated spread].
In this case, coupons would increase as the spread between the long and medium term indices widens.

Performance
Let’s take a closer look at a yield curve flattening note issued in the fall of 1993 with a five year maturity. This issue
paid an initial “teaser”coupon of 5.00% for the first year and a coupon of:
[the 5 year CMT - the 10 year CMT + 432 basis points]
for the last four years. At the time of issue, the 5 year CMT yield was 4.70%, and the 10 year CMT yield was
5.34% — a spread of 64 basis points. How would this note perform under the following scenarios — yield curve
unchanged, yield curve flattens, yield curve steepens? Refer to Exhibit 2 in conjunction with the following
analysis.

8
Exhibit 2
Unchanged Flat Steeper Breakeven
Curve Curve Curve

10–Year CMT 5.34% 5.34% 5.34% 5.34%

5–Year CMT 4.70% 5.34% 4.20% 5.68%
Spread 0.64 0.0 1.14 -0.34
YCAN YTM 3.97% 4.47% 3.57% 4.73%
Treasury YTM 4.73% 4.73% 4.73% 4.73%
Performance:
(YCAN–Treasury) -0.76 -0.26 -1.16 0.0

If the yield curve remained unchanged, the note’s coupon for the remaining four years would be 3.68%: [4.70 - 5.34
+ 4.32 = 3.68]. The yield to maturity for this security would be 3.97%. Clearly, in an unchanged yield curve envi-
ronment, this note would underperform comparable investments by 76 basis points [4.73 - 3.97]. However, as stat-
ed earlier, purchasers of this security anticipate a flatter yield curve.
How much must the yield curve flatten in order to make this investment superior to comparable Treasuries? For
simplicity, assume that one year later the curve flattens from a 64 basis point spread to 40 basis points, and remains
there for the remainder of the security’s life. In this case, the coupon for the last four years would be 3.92% and the
yield to maturity would increase to 4.15%. Recall that the alternative investment, the 5-year Treasury note, would
have yielded 4.73%. Taking it one step further, what if the curve completely flattened (ie, the 5-year and 10-year
yields were equivalent)? Even in this scenario, the yield to maturity would only be 4.46%. Consequently, we can
conclude that the curve must invert, that is 10 year securities must yield less than 5 year securities, for this note to
outperform the comparable Treasury!
It is interesting to look at this note one year later. The 5 year CMT (9-30-94) was at 7.28% and the 10-year CMT
was at 7.62%, a spread of 34 basis points. Note the curve is not yet inverted. The note’s coupon per the formula
would now be [7.28% -7.62% + 4.32%] or 3.98%. Should this spread prevail for the remainder of the note’s life, the
yield to maturity would be approximately 4.20%. The 4-year yield (the note has rolled down the curve one year) as
of the same date was roughly 7.1%. Given this information, what would be the market price of this note? In order
to be an investment equivalent to the prevailing 4-year security, this $10,000 note would now be worth only
$8,929.90 — a decline in value of nearly 11%.11 The equivalent five year Treasury we have been discussing would
be worth only $9,187.13 by the same analysis.
The above analysis should convince you that if the yield curve moves in the opposite direction than expected — that
is steepens — the security would perform quite poorly as well. Where does this security break even? That is, what
would the four year coupons need to be in order for this security to match the 5-year Treasury? (The coupons would
reset quarterly, we are assuming that they reset to the same level for simplicity.) The curve would have to invert by
more than 34 basis points (ie, the 5-year must yield 34 basis points more than the 10-year) before the flattening note
would outperform its 5-year Treasury counterpart.
To summarize, this security should be purchased only by investors who expect the yield curve to invert by more
than 34 basis points by the end of the first year and remain that way through the end of the security’s life. In any oth-
er interest rate scenario, this note will underperform an investment in a comparable Treasury security.
Dual index notes can be among the most risky of the various structures depending on the indices chosen and the
spread which drives the coupon resets. For example, if the coupon is dependent only on the difference between two
indices, with no spread or only a very small spread added — the coupon payment can actually become negative! In such
an instance, the original principal is at risk and may be reduced. This potential threat to underlying principal is
unique among most structures and suggests that analysis for dual index securities needs to be extremely compre-
hensive. Some dual index notes do have a stipulation whereby the coupon cannot fall below zero — whether such
a provision exists is obviously very important information.

11
The present value of eight $199 payments discounted at 3.55% semi-annual yield, plus the present value of $10,000 discounted at 3.55% for eight semi-
annual periods = $8,929.90.
9
 These limited computations, while illustrative, are woefully incomplete. Each scenario assumed that at the end of
the first year the coupon reset and remained fixed for the remaining four years, which would not be the case.
Although the structured note provides a superior coupon if the yield curve inverts by more than 34 basis points, what sort
of risk does the investor face if proven wrong? Is the investor being compensated to assume that risk? Clearly, the
answer depends on the investor’s conviction about the term structure of interest rates. But hopefully by quantifying
the scenarios, one can obtain a clearer picture of the risk/reward profile going forward.

De-Leveraged and Leveraged Floaters

Description
De-leveraged and leveraged floating rate notes give investors the opportunity to receive an above-market initial
yield and tie subsequent coupon adjustments to a specific point on the yield curve. A leveraged note’s coupon will
adjust by a multiple of a change in the relevant interest rate, eg, [1.25 x LIBOR + 100 basis points]. Conversely, a
de-leveraged security’s coupon adjusts by a fraction of the change in rates, eg, [.50 x 10-year CMT + 100 basis
points]. The following example illustrates how costly these structures can become if original assumptions prove
incorrect.

Performance
One reported source of BankAmerica’s troubles with their Pacific Horizon Money Funds in 1994 (BankAmerica
injected about $68 million to protect the fund’s net asset value) was their holding of $40 million of a 5-year SLMA
note, issued in March 1993.12 The first year’s coupon was 4.50% after which the coupon reset quarterly according
to the formula: the greater of 4.125% or [50% x 10-year Treasury rate + 125 basis points].13 The exact issue date is
not known, but we will use the security terms for illustration and assume a purchase on March 15, 1993.
To an average investor, this structure wouldn’t (or shouldn’t!) be at all appealing. The 5-year Treasury at the time
was yielding about 5.39% and the 10–year Treasury was yielding about 6.17%. In order for this structure to match
an investment in the 5-year Treasury, 10–year yields would need to rise to, and remain at 8.75% by the end of the
first year!14 Exhibit 3 explores other yield-to-maturity (YTM) scenarios with the assumption that once the coupon
resets, it remains stable for the remaining four years.

Exhibit 3

10–Year CMT 10–Year CMT 10–Year CMT 10–Year CMT 10–Year CMT
=6.17% unchanged +100 basis points +258 basis points –100 basis points

1st Year coupon 4.50% 4.50% 4.50% 4.50%

Yrs. 2-5 coupons 4.335% 4.835% 5.625% 4.125%
Delev. YTM 4.37% 4.76% 5.37% 4.20%
5–Year Treas. YTM 5.39% 5.39% 5.39% 5.39%
Performance:
Delev. – Treas. -1.02 -0.63 -0.02 -1.19

12
Money funds are restricted with respect to the final maturity of instruments in which they can invest subject to certain exclusions. One of these exclu-
sions reads: “An instrument that is issued or guaranteed by the United States government or any agency thereof which has a variable rate of interest readjust-
ed no less frequently than 762 days shall be deemed to have a maturity equal to the period remaining until the next readjustment of the interest rate.”
(Rules and Regulations, Investment Company Act of 1940, §270.2a19-1)
13
Smith, Randall and Lipin, Steven, “Beleaguered Giant,” The Wall Street Journal, August 25, 1994, p. A1.
14
4.5% annual coupon for four periods (one year)
(.50 x 8.75 + 1.25) = 5.625% annual coupon for 16 periods (four years)
IRR = 5.3754% which is still slightly below 5.39%.
10
 What impetus would a money fund have to purchase such an instrument? As described in footnote 12, there are
maturity restrictions placed on securities in which money funds can invest. However, since this coupon reset quar-
terly, it fell under the exceptions for floating rate instruments. Had it been a straight 5-year coupon note with no
regular coupon reset provision, the fund could not have purchased it.
From the fund manager’s standpoint, this security was probably evaluated as a series of 90-day instruments, with an
interest rate floor (a purchased option) of 4.125%. Given that the one-year T-bill available at that time (March 15,
1993) was only yielding about 3.4% this security would look attractive when evaluated in that light. Had the fund
held these securities until final maturity, chances are it would have performed relatively well if measured as a series
of 90 day instruments. The fact remains, however, that this was a five-year security with a five-year interest rate risk
horizon. In the worst case scenario, where the 4.125% floor was activated, the yield on this security would be only
4.2% which should be compared to the 5.39% alternative Treasury investment.
BankAmerica ran into some difficulty when unforeseen redemptions in the fund required it to sell some securities
prematurely to meet liquidity needs. Assume this was a $10,000 note, what could it be sold for in the secondary
market in March of 1994? On March 15, 1994, 5-year yields were 5.91% and 3 year yields were 5.38%. There were
four years remaining to this note’s maturity, so assume the purchaser wants to earn 5.645%.15 The 10-year Treasury
was yielding 6.47%, assume that you expect that rate to prevail for the next four years. Thus, your coupon would
be (50% x 6.47 + 1.25 = 4.485%) in quarterly payments. Discounting these cash flows at an annual rate of 5.645%,
the present value would be $9,587.54. This $10,000 investment would have a market value of only about 96% of its
face value one year later. (This is an approximately accurate scenario; BankAmerica has stated that they lost between
2% and 4% on sales of their structured securities.)16
Note the crucial role that every assumption plays in the analysis. What rate of return does the potential purchaser
want to earn; what are her expectations about the 10-year Treasury rates for the coming 4 years and how much does
she want to be compensated for being locked in to her assumptions? The $9,590 price assumes perfect information
and liquid markets — two assumptions which do not fit the secondary market for structured notes. The absence of
these two factors may dictate that the actual market price differs substantially from a price derived through dis-
counted cash flow analysis.
The inherent risk here is obvious: if rates go up, the note’s coupon would participate in the rise, but only by a frac-
tion. The leverage factor of 50% causes the coupons to lag the actual market. Thus, purchasers of this security would
be anticipating a stable interest rate environment. A leveraged floater, conversely, would be purchased by investors
with an expectation of rising rates — in which they would receive better than 1 to 1 participation. Other alterna-
tives in this category include floaters which do not permit the coupon to decrease, so-called “one-way” de-lever-
aged floaters which can effectively lock in higher coupons in an environment where the index rises then falls.

Range Notes
Description
Range notes (also called accrual notes) accrue interest daily at a set coupon which is tied to an index. Most range
notes have two coupon levels; the higher accrual rate is for the period that the index remains within a designated
range, the lower rate is used during periods that the index falls outside the range. This lower level may be zero. Most
range notes reference the index daily such that interest may accrue at 7% on one day and at 2% on the following day,
if the underlying index crosses in and out of the range. However, they can also reference the index monthly, quar-
terly or only once over the note’s life. If the note only references quarterly, then the index’s relationship to the range
matters only on the quarterly reset date. With the purchase of one of these notes, the investor has sold a series of
digital (or binary) options17; a call struck at the high end of the range and a put struck at the low end of the range.
This means that the accrual rate is strictly defined and the magnitude of movement outside the range is inconse-
quential. The narrower the range, the greater the coupon enhancement over a like instrument. In some cases, the
range varies each year that the security is outstanding.

15
[5.91% + 5.38%] ÷ 2 = 5.645%
16
“BankAmerica Exec Explains What Happened with its $68M Fund Bailout,” American Banker, Monday, Oct. 17, 1994.
17
A digital option has a fixed, predetermined payoff if the underlying instrument or index is at or beyond the strike at expiration. The value of the payoff is
not affected by the magnitude of the difference between the underlying and the strike price.
11
 There also exist, however, range notes which require that the investor sell two barrier options18: a down-and-out
put struck at the low level of the range and an up-and-out call struck at the high level of the range. For these range
notes, the index must remain within the target band for the entire accrual period, and sometimes for the entire life
of the instrument. If it crosses either barrier on even one day, the investor’s coupon will drop to zero for the whole
period.19 This type of range note is quite rare, but investors should pay careful attention to the payment provisions
attached to movements outside the range.

Performance
An example of a range note is depicted in Exhibit 4. For ease of calculation, we will illustrate a note which only ref-
erences the index quarterly, rather than daily. In this case, the coupon remains fixed throughout the entire quarter
based on the level of the index on the reset date. This note was offered on April 28, 1993 and matures on April 28,
1995. The coupon for the first six months was 3.51% and coupons reset semi-annually. Further coupon levels are
tied to 6-month LIBOR and the following range:
If (3.125% ≤ 6 month LIBOR ≤ 3.75%) Coupon = 5%
If (3.125% > 6 month LIBOR > 3.75%) Coupon = 2%

Exhibit 4

Coupon
5%
4%
3%
2%
1%

6-month LIBOR
3.125% 3.75%

The coupons have been:

Date Coupon 6 month LIBOR

4/28/93 3.51% 3.3125%
10/28/93 5.00% 3.50%
4/28/94 2.00% 4.625%
10/28/94 2.00% 6.00%

The 2-year Treasury was yielding 3.875% in April 1993. Exhibit 5 shows calculations of total return for this range
note under a best case, worst case, and actual scenario to illustrate the optimally performing security.

18
Path-dependent options with both their payoff pattern and their survival to the nominal expiration date dependent not only on the final price of the
underlying but on whether the underlying sells at or through a barrier (instrike, outstrike) price during the life of the option.
19
McNeil, Rod, “The Revival of the Structured Note Market,” International Bond Investor (A Euromoney Publication) Summer 1994, pp. 34-37.
12
 Exhibit 5

Date Best Case Worst Case Actual

4/28/93 3.51% 3.51% 3.51%
10/28/93 5.00% 2.00% 5.00%
4/28/94 5.00% 2.00% 2.00%
10/28/94 5.00% 2.00% 2.00%
YTM Range note 4.61% 2.38%% 3.14%
YTM 2–Year 3.875% 3.875% 3.875%
Treasury
Performance:
(Range-Treasury) +0.74 -1.5 -0.74

In the best case scenario, the coupon would reset to 5.00% at each of the three semi-annual periods after the first.
This scenario would result in a yield to maturity of 4.61% for this two year security — 74 basis points higher than
the 2-year Treasury. In the worst case, the coupon would reset to 2.00% each period, netting a yield to maturity of
only 2.38% —150 basis points less than the 2-year Treasury.
The final coupon level reset to 2% on 10-28-94 allowing us to calculate the actual case. Since only the first coupon
reset to the higher 5% level, the actual yield to maturity of this note will be only 3.14%. At maturity, this note will
have underperformed by 74 basis points an alternative investment in a 2-year Treasury note.
Significant conclusions can be drawn from this analysis. This note performs adversely in volatile interest rate envi-
ronments — the direction of interest rate moves is not important. However, since LIBOR was closer to the bottom
of the range than the top at the time of issue, the note offered more protection in an increasing rate environment
than it would have in a decreasing rate environment. To garner the best coupon each reset period, LIBOR could
have moved only 19 basis points lower or 44 basis points higher than its initial 3.3125 level. Consequently, this note
should have been purchased only by investors who forecast stable rates throughout the investment horizon, or by
those needing to hedge a stable rate scenario.
This note would have broken even to a 2-year Treasury only if two of the three coupons had reset to 5%, resulting
in a yield to maturity of 3.84% to 3.98% (depending on the timing of the lower coupon). To outperform the 2-year
Treasury, LIBOR would have had to be within the range on each of the three reset dates.
These notes are most risky when they are of a barrier nature, meaning that even one day outside the range causes
all accrued interest to be lost. As has been illustrated, however, significant opportunity cost is also associated with
binary notes which can accrue interest at a very low level, or even zero, over an extended period.

Inverse Floaters
Description
An inverse floater is a note structured so that its coupon varies inversely with a designated index. Simply stated,
as the index (eg, LIBOR, COFI) falls, the coupon on the note rises, and vice versa. Inverse floaters can be struc-
tured using any index, and are present not only in the agency structured note arena but also in mortgage backed
securities.

Performance
FNMA issued an inverse floater in 1992 which is tied to the level of COFI. The coupon floats at [11.95% - COFI],
resetting monthly and paying semi-annually. It matures 11/16/95. Based on the formula, the note’s coupon will rise
as COFI falls, and fall as COFI rises. The most recent coupon level was 8.09%, set on 9/16/94 when COFI was
3.86%. A secondary market price for this security, provided by a major dealer in early October 1994 was 100.84.

13
 This premium to par reflects the above-market coupon currently being paid by this security and also involves some
assumptions about future movements of COFI.
Based on the prevailing rate environment, it seems likely that COFI will reset higher in the future; recall, however,
that COFI does materially lag other short term rates. Analysis would be required as to how COFI tends to move
vis-a-vis other market rates. After this has been determined, an assumption is required about how much rates are
expected to move through November of 1995. A valuation model will use this information to estimate future
coupons based on the formula, and then derive a market price. We are unable to “back out” the assumptions which
went into the 100.84 market price. However, by making an assumption that COFI will increase 20 basis points every
month between September 1994 and November 1995, we arrived at a present value of 100.85 when discounting
cash flows at 6%. For an inverse floater, COFI may provide some measure of protection because it does tend to lag
other market rates. Had this note been tied to some fixed amount minus LIBOR, it would not have performed
nearly as well since LIBOR reacts very quickly to changing trends in interest rates.

Index Floaters
Description
An index floater usually has a very simple structure, eg, [prime - fixed spread] or [3 month LIBOR + fixed spread].
Investors in such securities make assumptions about expected movements in the index relative to other like-matu-
rity instruments. For example, a coupon of [prime - 263 basis points] with quarterly reset dates would outperform
a 3 month Treasury only for as long as the prime rate remained at least 263 basis points higher than the 3 month
rate. (As of October 1994, the spread was roughly 275 basis points.) For investors who believed that short rates might
begin to trend downward before the prime rate or that rates would remain pretty stable for a while, this structure
would offer a slightly better return than a simple 3 month T-bill.
Floaters tied to COFI and different CMT maturities have received the greatest amount of unfavorable attention.
CMT floaters incorporate a yield curve opinion. For example, compare a security which floats at [5 year CMT -
fixed spread] to another which floats at [3 month LIBOR + a fixed spread]. The CMT floater may have a higher
initial coupon, but its advantage will erode if the yield curve flattens between the 3 month and 5 year maturities. If
short rates rise more sharply than medium-term rates, the CMT-based investor will underperform the LIBOR-
based investor. Floaters tied to COFI, eg, [COFI + fixed spread] will also underperform other floating rate instru-
ments. As mentioned before, increases in COFI materially lag increases in other market rates. This is illustrated in
Exhibit 6. Consequently, investors may feel that they are protected from (and will participate in) rising rates, but
without a complete understanding of the time lags in COFI and the variables which drive its adjustment, they may
be surprised by the extent to which their floating coupon does not perform as expected.

Exhibit 6
5

4.5

3.5

3
COFI
2.5
3-month
2 LIBOR

8-93 12-93 4-94 8-94

14
Performance
Decisions about floating rate instruments are best made in comparison to other floating rate instruments. For exam-
ple, the merits and/or risks of a prime floater will become most pronounced when compared to another floating
rate instrument, such as a LIBOR floater. Comparing the two of these instruments requires some assumption about
the direction of the prime/LIBOR spread.
An example will serve to illustrate this point. Assume that prime is 7.75%, and 3 month LIBOR is 5.5%. Consider
two floater offerings: one floats at [prime - 215 basis points] the other floats at [3 month LIBOR + 15 basis points].
Both notes mature in three years. The decision about which one to purchase is based on assumptions regarding cur-
rent and future spreads between prime and 3 month LIBOR. We want to compare the relative performance of the
prime issue versus the LIBOR issue. This can be interpreted algebraically as:
(prime - 215) - (3 month LIBOR + 15)
or
(prime - 3 month LIBOR) - 230
If the prime to LIBOR spread exceeds 230 basis points, the cash flow on the prime floater exceeds the cash flow on
the LIBOR floater. Based on the above formulas, the LIBOR floater currently has a 5 basis point advantage over
the prime (5.50 + 0.15 = 5.65%) vs. (7.75 - 2.15 = 5.60%) since the prime/LIBOR spread is 225 basis points. An
investor who selects the prime floater at this time implies an expectation that the prime/LIBOR spread will widen
enough beyond 230 basis points in the near future so that the present value of future cash flows will exceed the pre-
sent value of the 5 basis points currently being foregone.
One can perform historical analysis of the prime/LIBOR spread to form expectations about future activity. Results
would indicate that the prime/LIBOR spread is negatively correlated with the overall level of interest rates. This is
because prime is a lagging indicator; that is, changes in prime almost always lag changes in LIBOR. It stands to rea-
son that as interest rates rise, the prime/LIBOR spread will narrow. Given this argument, an investor with an expec-
tation of rising rates going forward should prefer the LIBOR floater.
Similar analytics can and should be performed when comparing other types of indices. When comparing a 2-year
CMT floater to a 3 month LIBOR floater, the shape of the yield curve during the horizon period is critical. While
the CMT floater will have a higher coupon initially, the LIBOR floater will outperform it if the yield curve were
to flatten on the short end. If one’s view of rates going forward incorporates this scenario, then the LIBOR floater
would be the appropriate choice.

15
 RISK IDENTIFICATION
This paper has presented some analysis of the risks specific to each security covered. However, there are broad cat-
egories of risk which apply to all of these products, including the many types of structured notes not discussed here-
in. An understanding of the types of risks that the bank should be evaluating will assist the examiner in determin-
ing whether an institution is properly analyzing the risk profile of its investment in structured notes.

Market Risk
Market risk is defined as the risk to a security’s value (market price) due to adverse moves in the relevant rate or
index. The relevant rate or index may give rise to exposure in fixed income, foreign exchange, agricultural, energy,
precious metals, or equity markets. An institution’s assessment of market risk begins with a determination of current
and potential future market values. The embedded options and other leverage factors inherent in structured notes
result in a great deal of uncertainty with respect to future cash flows. Thus, price volatility is generally high in these
types of securities. An institution should have — or should have ready access to — a model which is able to quan-
tify the risks. The model should be able to forecast the change in market price at various points in time (eg, one year
later, the first call date, etc.) for a given a shift in interest rates. For the many variants of these products which are
tied to the shape of the yield curve, the ability to model price effects from non-parallel interest rate shifts is also cru-
cial. As has been discussed, in most cases full principal will be returned at maturity. However, between issuance and
redemption, changes in fundamental factors can give rise to significant reductions in the “market” price.

Liquidity Risk
Liquidity risk refers to the risk that an institution will not be able to sell or “unwind” a position in a structured note
in a timely fashion at, or very close to, its perceived market value. Due to the complex nature of structured notes,
the number of firms able and willing to competitively price and bid for these securities is quite small; an active sec-
ondary market is only gradually developing. When there are fewer bidders, competition is lessened. Consequently,
an institution hoping to liquidate a structured note holding prior to maturity may find that their only option is to
sell at a significant loss. Often, the issue’s original underwriter is the only source for a bid (and even that is not always
guaranteed).

Interest Rate Risk

As discussed, the vast majority of all structured notes purchased by banks will be tied to future interest rates. Interest
rate risk describes the risk to cash flows posed by an adjustment in market interest rates. Every day, bank asset/lia-
bility managers make investment decisions which incorporate an opinion about future rates, so this should not be
construed as a new risk. The unique feature of these decisions as they relate to structured notes, however, is that the
risk/reward profile is much more pronounced. In addition, these products often require more specific assumptions
tied to very exact points on the yield curve. It is not enough to be correct in assuming that rates will increase or
decrease. Success investing in structured notes can depend on accurately forecasting the timing of a rate change, the
magnitude, and/or the changes to the shape and slope of the yield curve.

Volatility Risk
For each of these structures which have embedded options, assumptions about the volatility of interest rate moves
are also inherent. For any of these options which are purchased by investors, eg, interest rate floors, there exists the
risk that market rate volatility expectations will decrease over time. If this happens, market valuation of these secu-
rities will also decrease and the investor will have “purchased” an over-valued option for which she will not be com-
pensated if she chooses to sell the instrument before maturity.

16
 EXAMINER GUIDANCE
The Board of Governors of the Federal Reserve System issued SR 94-45 on August 5, 1994 on the subject of
Supervisory Policies Relating to Structured Notes. In that pronouncement, the Board offered the following
specific examiner guidance:
The critical factor for examiners to consider is the ability of management to understand the risks
inherent in these instruments and to manage the market risks of their institution in an appropriate
manner. Therefore, examiners should evaluate the appropriateness of these securities bank-by-bank,
with a knowledge of management’s expertise in evaluating such instruments, the quality of the insti-
tutions relevant information systems, and the nature of its overall exposure to market risk. This eval-
uation may include a review of the institution’s ability to conduct stress tests. Failure of management
to understand adequately the dimensions of the risks in these and similar financial products can con-
stitute an unsafe and unsound practice for banks.

The technical descriptions and analysis of each of the structured notes discussed in this Product Summary should
prove beneficial to examiners charged with making a “bank-by-bank” appropriateness judgement. Still, examiners
should incorporate several broad questions into their review of any bank’s use of structured notes. Examples of
questions examiners should consider in making an appropriateness judgement are:
1) How does this structured note investment conform with the bank’s investment guidelines?
2) Movements in what underlying markets contribute to the risk of this security?
a. Fixed Income
b. Foreign Exchange
c. Commodity
d. Equity
e. Other
f. Combination
3) How is the market risk embodied?
a. Volatile, zero, or negative coupon payments
b. Principal Amortization
c. Principal Loss
4) How does this market risk profile relate to the bank’s traditional business risk profile in size and scope?
5) How frequently is the market risk profile of the structured note re-evaluated?
6) Is there leverage in the security structure? If so, how much?
7) Is the security callable? If so, when and under what scenario(s)?
8) What is the best case scenario the bank may hope for vis-a-vis this security?
9) How does this best case scenario affect other aspects of the bank’s business?
10) What is the worst case scenario for this security?
11) How does this worst case scenario affect other aspects of the bank’s business?
12) When purchasing the security, how was a determination made as to whether the bank was adequately com-
pensated for the market risks just identified?
13) If the bank decided to sell the security today, how would the bank derive a fair market value and who might
be potential purchasers?
Although this is not an exhaustive list of the issues purchasers, and hence examiners, should address, it can serve as
a starting point and encourage more detailed discussion.

For Additional Evaluation Assistance:

It is possible to obtain a listing of the various agency structured notes in the secondary market through Bloomberg.
To do this: type in the respective agency ticker symbol <FHLB, FNMA, FHLMC, or SLMA> <space>
<S> <CORP> <GO>. This will bring up a listing of currently outstanding structured notes in maturity order,

17
 including those that have matured in the last few months. By accessing any specific issue, (enter the corresponding
number on the screen) Bloomberg will provide some brief descriptive information about the security. This will
include indices to which it is tied, methodology for coupon calculation, call provisions, final maturity, etc. On some
issues, additional information (such as index amortizing schedules) is also available.
Bloomberg is limited with respect to analytics, however. For many (though not all) step-up notes, they have the
capacity to calculate current yields and total return over a given time horizon. They are continuing to increase cov-
erage of these securities and will be targeting dual index notes/bonds and de-leveraged floaters in the near future.

18
 GLOSSARY

Cap - A provision in a loan or debt contract which sets a maximum rate beyond which an interest rate cannot
increase.
COFI - Cost of Funds Indices. In general, COFI refers to the Cost of Funds Index for the 11th District of the
Federal Home Loan Bank of San Francisco. The COFI reflects the actual interest expenses incurred during a given
month by all savings institutions headquartered in Arizona, California and Nevada. Since the primary sources of
funds for most savings institutions — checking and savings deposits, CDs, money market deposits and loans obtained
through the credit program of the FHLB — are fixed rate deposits of medium and long -term maturities, changing
market rates do not affect them until the deposits mature. Consequently, the COFI for a given month reflects, to a
significant degree, interest rates that were prevalent in previous months or years.

CMT - The Constant Maturity Treasury. An interest rate benchmark index based on the yield of a synthetic secu-
rity of appropriate maturity as interpolated from the Treasury yield curve.20 The CMT can be thought of as a yield
on a bond that doesn’t age — it thus gives investors exposure to a particular point on the Treasury yield curve. CMT
yields are calculated daily by the US Treasury to determine its cost of funds; the rates are published every Monday
by the Fed and are available on most wire services.

FHLB - The Federal Home Loan Bank

FHLMC - (Freddie Mac) The Federal Home Loan Mortgage Corporation

Floor - A provision in a loan or debt contract which sets a minimum rate below which an interest rate
cannot decrease.

FNMA - (Fannie Mae) The Federal National Mortgage Association

LIBOR - The London Interbank Offered Rate. The rate that big banks charge each other for loans of
Eurodollars in the London money market. Most international floating rates are quoted at 3 month LIBOR
± some spread; 6 month LIBOR is also used frequently.

MBS - Mortgage backed security

SLMA - (Sallie Mae) The Student Loan Marketing Association

YCAN - Yield Curve Anticipation Notes

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Gastineau, Gary L., Dictionary of Financial Risk Management, Probus Publishing.
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 BIBLIOGRAPHY

Audley, David, Chin, Richard and Ramamurthy, Shrikant, “Derivative Medium-Term Notes,” (October 1993)
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Betzold, Nicholas and Berg, Richard, “‘Conservative’ structured notes can hurt you,” The ABA Banking Journal,
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Falloon, William, “Fairway to Heaven,” Risk, December 1993, pp. 21-27.

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Gastineau, Gary L., Dictionary of Financial Risk Management, Probus Publishing.

Iwanowski, Raymond, “Floating Rate Securities: Current Markets and Risk/Return Trade-Offs in Rising
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Rehm, Barbara A., “FDIC Adds Big Stick to Warnings on Dangers of Structured Notes,” American Banker,
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Rules and Regulations, Investment Company Act of 1940, §270.2A “Money Market Funds.”

Smith, Randall and Lipin, Steven, “Beleaguered Giant,” The Wall Street Journal, August 25, 1994, p. A1.

“Your Guide to 11th District Cost of Funds Indices,” Federal Home Loan Bank of San Francisco.

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