A hybrid derivative instrument that allows investors harboring a strong feeling that rates will fall below a specific level to act accordingly by placing bearish bets. The payoff of a snowball will not only accumulate on the basis of the previous coupon, but will also take into account the amount by which rates are below that specific level. For example, an investor holds a 5-year note with quarterly coupons, such that his payoff at the first two coupon dates is set at 4% per annum, resulting, for an accrual period of three months, in coupons of:

Coupon = 0.04 × 0.25 = 1%

The payoff, for subsequent coupon dates, is given by the following formula:

Payoff = Max (previous coupon + accrual period factor × leverage factor × (reference strike – floating rate)

where:

Accrual period factor is the percentage of months within a period to 12 months (e.g., for a 3-month accrual period, the accrual period factor is 3/12=0.25)

Leverage factor is usually determined by the investment bank (e.g., 0.4, 0.5, etc).

Floating rate is usually LIBOR (or any benchmark rate) for the same accrual period.

Reference strike is the lower boundary which if falls below the floating rate, it renders the adjustable rate automatically zero.

In environments with an upward sloping yield curve, it is quite likely that the reference strike will increase with maturity, e.g. the payoff for year 2 may be, assuming leverage factor is 50%,

Payoff= max (previous coupon + 0.25 × 0.5 × (3.5% − LIBOR), 0)

It is noteworthy to say that if 3-month LIBOR is high enough, the coupon will be 0, and the accumulation will automatically start from 0. This why such a product is rather complex (highly leveraged) and investors should be extremely watchful as to the leverage effect of previous coupons. Leverage, if an investor’s view turns out off the mark, may wipe out him of all future coupons.

A snowball will pay off handsomely should interest rates continue to remain low. But that cannot be guaranteed all the time. Therefore, some investors prefer to combine this product with an early termination feature (TARN) as a precaution against unfavorable movement in interest rates. The resulting product is known as the snowblade.

The snowball is also referred to as a ratchet inverse floater.