GLOSSARY OF FINANCIAL DERIVATIVES TERMS

A B C D E F G H I J K L M N O P Q R S T U V W X Y Z

CALENDAR SPREAD

A strategy that involves buying and selling options or futures with the same (strike) price but different maturities. Such a strategy is used in futures when one contract month is theoretically cheap and another is expensive. With options, the strategy is often used to play expected changes in the shape of the volatility term structure. For example, if one-month volatility is high and one-year volatility low, arbitrageurs might buy one-year straddles and sell short-term straddles, thereby selling short-term volatility and buying long-term volatility. If, all else being equal, short-term volatility declines relative to long-term volatility, the strategy makes money.

CALL OPTION

See option

CALL SPREAD

A strategy that reduces the cost of buying a call option by selling another call at a higher level. This limits potential gain if the underlying goes up, but the premium received from selling the out-of-the-money call partly finances the at-the-money call. A call spread may be advantageous if the purchaser thinks there is only limited upside in the underlying.

See also bear spread, bull spread, put spread

CALLABLE SWAP

An interest rate swap in which the fixed-rate payer has the right to terminate the swap after a certain time if rates fall. Often done in conjunction with callable debt issues where an issuer is more concerned with the cost of debt than the maturity. The embedded option is, in effect, a swaption sold by the fixed-rate receiver which enables the fixed-rate payer to receive the same high fixed rate for the remaining years of the swap in the event that interest rates fall. The fixed rate received under the swaption offsets the fixed rate paid under the original swap effectively cancelling the swap. In some definitions of a callable swap, the fixed-rate receiver has the right to terminate the swap. Also known as a cancellable swap.

CANCELLABLE SWAP

See callable swap

CAP

A contract whereby the seller agrees to pay to the purchaser, in return for an upfront premium or a series of annuity payments, the difference between a reference rate and an agreed strike rate when the reference exceeds the strike. Commonly, the reference rate is three- or six-month Libor. A cap is therefore a strip of interest rate guarantees that allows the purchaser to take advantage of a reduction in interest rates and to be protected if they rise. They are priced as the sum of the cost of the individual options, known as caplets.

CAPITAL ADEQUACY DIRECTIVE

First mooted in 1990 and issued in 1993, the European Union’s Capital Adequacy Directive (often shortened to CAD) became law across the European Union on January 1, 1996. The CAD requires banks to separate trading book from more generalized banking book, and to apply the building block approach to interest rate and equity risk in the trading book, as well as foreign exchange risk across both books. In general, the CAD requires banks to apply capital equal to 8% of net positions for general market risk and an additional capital amount to cover specific risk.

  In November 1999, the European Union issued proposals for new capital adequacy rules. In parallel with the Basel Committee’s proposals, the proposals sought to align regulatory capital requirements more closely with underlying risks and to provide institutions with incentives to move to higher standards of risk management.

  In February 2001, the European Union released a second consultation paper for the new capital adequacy framework for banks and investment firms. The Capital Adequacy Directive generally applies to investment firms, including some managers of pension funds. The consultative paper discussed many of the same issues and methodologies as Basel II, including the internal ratings-based and revised standardized approaches, credit risk mitigation, consolidated capital requirements, interest rate and operational risks, the supervisory review process, and disclosure requirements.

  A further consultation period will run in parallel with the further Basel consultation, in the first few months of 2002. Features that have caused most discussion include the impact of the proposed operational risk charge on investment firms and smaller credit institutions and the potential implications of the proposed new regime for lending to small- and medium-sized enterprises.

See also Basel Capital Accord, comprehensive approach

CAPITAL-PROTECTED CREDIT-LINKED NOTE

A credit-linked note where the principal is partly or fully guaranteed to be repaid at maturity. In a 100% principal-guaranteed credit-linked note, only the coupons paid under the note bear credit risk. Such a structure can be analyzed as (i) a Treasury strip and (ii) a stream of risky annuities representing the coupon, purchased from the note proceeds minus the cost of the Treasury strip.

CAPPED FLOATER

A floating-rate note which pays a coupon only up to a specified maximum level of the reference rate. This is done by embedding a cap in a vanilla note where the investor effectively sells the issuer a cap. A capped floater protects the debt issuer from large increases in the interest rate environment.

CAPPED SWAP

An interest rate swap with an embedded cap in which the floating payments of the swap are capped at a certain level. A floating-rate payer can thereby limit its exposure to rising interest rates.

CAPTION

An option on a cap. A type of compound option in which the purchaser has the right, but not the obligation, to buy or sell a cap at a predetermined price on a predetermined date. Captions can be a cheap way of leveraging into the more expensive option.

CARRYING

General term referring to both borrowing and lending on the London Metal Exchange (LME). It is also used to describe a borrowing operation that results in physical metal being held in an LME warehouse by the borrower.

CASH AND CARRY

When a contango exists, the premium of the forward position over the prompt generally reflects costs of storage, insurance and finance for that period. When metal is in surplus, the contango may widen to the point where an effective interest rate that is higher than market rates can be locked-in.

CASH MARKET

An underlying, as opposed to a futures market.

CASH-AND-CARRY ARBITRAGE

A strategy used in bond or stock index futures in which a trader sells a futures contract and buys the underlying to deliver into it, to generate a riskless profit. For the strategy to work, the futures contract must be theoretically expensive relative to cash. The value of a futures contract is assessed by looking at the implied repo rate. If the implied repo rate is greater than the market repo rate, then futures are said to be cheap.

Cash-and-carry arbitrage and reverse cash-and-carry arbitrage typically keep the futures and underlying markets closely aligned.

CASHFLOW-AT-RISK

Cashflow-at-risk (CFAR) is the application of value-at-risk (VAR) methodology to a non-financial firm’s business operations. In this context, the VAR is defined in terms of earnings or cashflow and expressed as the probability that a firm will fail to meet its business targets. Typically, a CFAR model would be used to simulate future financial statements, taking as its input the projected values of the financial prices relevant to the firm. In this way it would be possible to build up a probabilistic picture of the impact of various risks on the company’s cashflow or profitability, in much the same way that financial firms use VAR to find the probability of losses on a portfolio of assets.

CATASTROPHE BOND

A bond that pays a coupon that decreases only after a catastrophe such as a hurricane or earthquake with a specified magnitude in a specified region and period of time.

CATASTROPHE EQUITY PUTS

A put option purchased by an insurance firm, giving it the right to sell a portion of equity to the investor in the event of a catastrophe-related trigger. These instruments are often written to increase liquidity at times when there are lots of claims.

CATASTROPHE OPTION

These options can be American-style or European-style, either paying out if a single specified catastrophe such as a hurricane or earthquake occurs, or alternatively, having a pay-out dependent on an index. For example, the index may represent the number of claims received by property insurance companies.

CATASTROPHE RISK SWAP

An agreement between two parties to exchange catastrophe risk exposures. For example, in July 2001 Swiss Re and Tokio Marine arranged a $450 million deal including three risk swaps: Japan earthquake for California earthquake, Japan typhoon for France storm and Japan typhoon for Florida hurricane. Swaps increase diversification and allow each of the parties to lower the amount of capital that they need to hold.

CHange in tax law risk

The risk that there will be an unanticipated structural change to current tax laws, which would impact the spread between tax-exempt and taxable rates.

CHOOSER OPTION

A chooser option offers purchasers the choice, after a predetermined period, between a put and a call option. The pay-outs are similar to those of a straddle but chooser options are cheaper because purchasers must choose before expiry whether they want the put or the call. Also known as a hermaphrodite, or AC-DC option.

CLIQUET OPTION

Also known as a ratchet or reset option. A path-dependent+option that allows buyers to lock-in gains on the underlying security during chosen intervals over the life time of the option. Cliquet options were developed in France with the CAC 40 stock index as the underlying, although they are used in structured retail products elsewhere in Europe. The option’s strike price is effectively reset on predetermined dates. Gains, if any, are locked in. So if an index rises from 100 to 110 in year one, the buyer locks in 10 points and the strike price is reset at 110. If it falls to 97 in the next year the strike price is reset at that lower level, no further profits are locked in, but the accrued profit is kept.

CLOSED-FORM SOLUTION

Also called an analytical solution. An explicit solution of, for example, an option pricing problem by the use of formulae involving only simple mathematical functions, such as Black-Scholes or Vasicek models. Closed-form models can usually be evaluated much more quickly than numerical models, which are sometimes far more computationally intensive.

COLLAR

The simultaneous purchase of an out-of-the-money call and sale of an out-of-the-money put (or cap and floor in the case of interest rate options). The premium from selling the put reduces the cost of purchasing the call. The amount saved depends on the strike rate of the two options. If the premium raised by the sale of the put exactly matches the cost of the call, the strategy is known as a zero cost collar. When used to hedge an outright position in the underlying, this locks the hedger into a range of values; this hedging strategy is known as a cylinder.

COLLAR SWAP

A collar on the floating-rate leg of an interest rate swap. The transaction is zero cost – the purchase of the cap is financed by the sale of the floor. The collar constrains both the upside and the downside of a swap.

COLLARED FLOATER

A floating-rate note whose coupon payments are subject to an embedded collar. Thus the coupon is capped at a predetermined level, so the buyer forsakes some upside, but also floored, offering protection from a downturn in the reference interest rate. Also known as a mini-max floater.

COLLATERALISED BOND OBLIGATION (CBO)

A multi-tranche debt structure, similar to a collateralized mortgage obligation. But rather than mortgages, low-rated bonds serve as the collateral.

COLLATERALISED DEBT OBLIGATION (CDO)

Generic name for collateralized bond obligations, collateralized loan obligations, and collateralized mortgage obligations.

See also synthetic collateralized debt obligation

COLLATERALISED LOAN OBLIGATION (CLO)

A structured bond backed by the loan repayments from a portfolio of pooled personal or commercial loans, excluding mortgages. The structure allows a bank to remove loans from its balance sheet and so reduce its required capital reserves, while retaining contact with the borrowers and fees from servicing the loans.

COLLATERALISED MORTGAGE OBLIGATION

A type of asset-backed security, in this case backed by mortgage payments. Typically, such securities provide a higher return than normal fixed-rate securities but purchasers suffer prepayment risk if mortgage holders redeem their mortgages. Because the right to redeem the mortgage is effectively an embedded call, such securities have negative convexity.

See also collateralized bond obligation, collateralized debt obligation, collateralized loan obligation.

COllateralization risk

Risk that the circumstances under which an Issuer would have to post collateral pursuant to certain swap agreement provisions will arise in the future.

COMMODITY FUTURE

A futures contract on a commodity. The first futures (as opposed to forward) contract was for grain and was established in about 1865 on the Chicago Board of Trade. Unlike forwards, futures are generally exchange-traded instruments. Futures can either be in contango (where futures prices are higher than spot prices) or backwardation (where they are lower).

COMMODITY SWAP

A swap in which one of the payment streams for a commodity is fixed and the other is floating. Usually only the payment streams, not the principal, are exchanged, although physical delivery is becoming increasingly common. Commodity swaps have been in existence since the mid-1980s and enable producers and consumers to hedge commodity prices. The consumer is usually a fixed payer and the producer a floating payer (receiving fixed), thereby hedging against falls in the price of the commodity. If the floating-rate price of the commodity is higher than the fixed price, the difference is paid by the floating payer, and vice versa.

Swaps are done in oil, natural gas, metals and some agricultural products, although futures are more common in agricultural markets. Swaps allow users to hedge risks which cannot be offset by the use of futures contracts. This could be a geographical or quality basis risk, or it could arise from the maturity of a transaction. Liquidity in commodity swap markets varies greatly – from the very liquid, equivalent to an active futures market (e.g., European jet fuel) to the relatively illiquid, where the swaps provider is assuming an unusual or unique risk.

COMpetitive bid

Process of entering into a swap agreement where interested swap Providers submit bids to the Issuer on a specified date, and the swap is entered into with the winning Provider offering the interest rate, terms and conditions most favorable to the Issuer.

COMPLETE MARKETS

If markets are complete, then any contingent claim can be hedged exactly using tradable assets.

COMPOUND OPTION

An option on an option, permitting the purchaser to buy (or sell) an option on an underlying at a fixed price over a predetermined period. Usually sold on interest rate instruments (e.g., captions or floortions), or currencies. They are also used as components of more complex trades. Compound options are often bought to protect against increases in standard option prices during periods of high volatility. The upfront premium for a compound option is less than for a normal European-style option but if the option is exercised, the overall cost will be greater. Due to their greater flexibility the cost, if both options are exercised, is greater than a conventional option.

Compound options can also be constructed on options other than European style options (e.g., barrier options) or portfolios of options (e.g., compound on a cylinder). Indeed compound options on compound options, otherwise known as installment options are common (often as part of more complex structures). An installment option requires the holder to pay fixed amounts of premium (installment) at certain installment dates to benefit from the right of exercise of the underlying option. At any point that holder can elect to let the installment payments lapse and loses any right of exercise.

COMPREHENSIVE APPROACH

The comprehensive approach to capital adequacy applies a constant capital charge to all positions in a trading book, irrespective of whether they are long or short.

CONDOR

The simultaneous purchase (sale) of an out-of-the-money strangle and sale (purchase) of an even further out-of-the-money strangle. The strategy limits the profit or loss of the pay-out and is directionally neutral.

CONFIDENCE INTERVAL

A statistical term that is often applied in value-at-risk measurement. In this context it refers to the degree of certainty one has that estimated value-at-risk will not be exceeded by actual losses. For example, if a 95% confidence interval is used for a VAR estimate, actual losses should exceed estimates on only one day out of every twenty on average. The greater the confidence interval, the higher the value-at-risk.

CONFirmation

Document governed by the ISDA Master Agreement that is executed for an individual transaction, itemizing the specific terms and conditions for the particular transaction.

CONSTANT MATURITY SWAP DERIVATIVE

See Constant Maturity Treasury (CMT) derivative

CONSTANT MATURITY TREASURY DERIVATIVE

Over-the-counter swaps and options which use longer-term, Treasury-based instruments for their floating rate reference than money market indexes, such as Libor. “Constant Maturity Treasury” (CMT) refers to the par yield that would be paid by a treasury bill, note or bond which matures in exactly one, two, three, five, seven, 10, 20 or 30 years. Since there may not be treasury issues in the market with exactly these maturities, the yield is interpolated from the yields on treasuries that are available. In the US, such rates have been calculated and published by the Federal Reserve Bank of New York and the US Treasury department on a daily basis every day for more than 30 years. The H.15 Report from the Federal Reserve Bank is often used as a source for CMT rates.

It is then possible for this interpolated yield to form the index rate for instruments such as floating rate notes, which pay interest linked to the CMT yield, options, which pay the difference between a strike price and the CMT yield, and swaps and swaptions, in which one of the cashflows exchanged is the CMT yield. Where necessary, the reference rate is reset at each settlement date. Typical uses of CMT derivatives as hedging tools include the purchase of CMT floors by mortgage servicing companies to protect the value of purchased mortgage servicing portfolios, and the purchase of CMT caps to protect investors with negatively convex mortgage-backed securities portfolios. It is possible to enter into derivatives in other currencies that are based, by analogy, on a “constant maturity interest rate swap” interpolated from the swap curve in the relevant currency. Such derivatives are known as constant maturity swap (CMS) derivatives. Unlike CMT derivatives, CMS derivatives incorporate the spread component of swaps.

CONTANGO

Situation when a commodity’s future price is higher than its spot price. Whereas financial futures and forwards are invariably priced off the cost of carry of the underlying, the forward or spot prices of commodities are heavily influenced by supply and demand. Contango arises where there is sufficient supply in the spot market or where future supply is thought to be tight.

See also advance premium forward, backwardation

CONTINGENT CLAIM

The term used to mean a derivative instrument in mathematical models.

CONTINGENT PREMIUM OPTION

An option for which the purchaser pays no premium unless the option is exercised. As a rule of thumb, the premium eventually paid is equal to the premium payable on a normal option divided by the option delta, hence the price increases dramatically for out-of-the-money options. Contingent options can usually be broken down into one or more binary options plus a conventional option. For example, a purchaser could synthesize a contingent call by buying a European-style call and selling enough European binary options with the same strike to pay for the premium on the call. If the options are not in-the-money at expiry, both the total premium paid and the total pay-out are zero. If they are in-the-money, the pay-out on the binary options is simply subtracted from the pay-out on the call. Further flexibility can be obtained by setting the strike for the digitals further out-of-the-money than the call.

CONTINGENT SWAP

The generic term for a swap activated when rates reach a certain level or a specific event occurs. Swaptions are often considered to be contingent swaps. Other types of swaps, for example, drop-lock swaps, are activated only if rates drop to a certain level or if a specified level over a benchmark is achieved.

CONTRACT FOR DIFFERENCE (CFD)

A Contract for Difference is typically an agreement made between two parties to exchange (at the closing of the contract) a cashflow equivalent to the difference between the opening and closing prices, multiplied by the number of shares detailed in the contract. CFDs are traded on margin, do not incur stamp duty and can have individual stocks or indexes as the underlying.

Alternatively, in the currency markets, the term CFD can refer to an OTC currency forward contract that settles for a cash amount (maybe in a third currency) without requiring the exchange of the two underlying currencies. It is often used instead of a traditional forward because it mitigates settlement risk.

CONVENIENCE YIELD

Describes the yield that accrues to the owner of a physical inventory but not to the owner of a contract for future delivery in commodity markets. The convenience yield helps to explain the backwardation often observed in commodity markets.

CONVERGENCE TRADE

Trading strategy where similar securities are bought and sold simultaneously in the expectation that prices will converge in an orderly fashion.

CONVERSION

1) A way of taking advantage of mispriced options by creating a synthetic short futures position and hedging market risk by buying a futures contract against it. Thus if a put is undervalued, a trader buys it, at the same time selling a fairly valued call and buying a futures contract. The same strategy can be applied if the call is mispriced. If the option is truly undervalued, the trader earns a riskless profit. The whole exercise relies on put-call+parity. 2) The act of converting a convertible bond into equity.

CONVERTIBLE BOND

A bond issued by a company that may be exchanged by the holder for a set number of that company’s shares at a predetermined price. Because the bond embeds a call option on the company’s equity, convertibles carry much lower rates of interest than traditional debt and are therefore a cheap way for companies to raise debt. The problem for existing shareholders is that conversion dilutes the company’s outstanding shares. Typically, bonds are convertible into a company’s own stock. There are however “third party convertibles”, which convert into shares of another company.

CONVEXITY

A bond’s convexity is the amount that its price sensitivity differs from that implied by the bond’s duration. Fixed-rate bonds and swaps have positive convexity: when rates rise the rate of change in their price is slower than suggested by their duration; when rates fall it is faster. Positive convexity is therefore a welcome attribute. The higher the bond’s duration, the more its convexity. Bonds or swaps with call options or embedded call options, e.g., collateralized mortgage obligations, have negative convexity: when rates rise their price fall is faster relative to the interest rate move. Convexity effectively describes the same attribute as gamma.

COPULA

In many areas of risk management, the concept of correlation can be used as a measure of dependence between financial instruments. However, when certain technical assumptions about the form of the joint distribution of risks is untenable (as can happen when considering credit risk, for example) copulas provide a more robust measure of dependence.

CORRELATION

Correlation is a measure of the degree to which changes in two variables are related. It is normally expressed as a coefficient between plus one, which means variables are perfectly correlated (in that they move in the same direction to the same degree) and minus one, which means they are perfectly negatively correlated (in that they move in opposite directions to the same degree). In financial markets correlation is important in three areas:
1. The model used for global asset allocation decisions, Sharpe’s capital asset pricing model (CAPM), has, as its linchpin, a covariance matrix that measures correlations between markets.
2. Correlation is also central to the pricing of some options, where two-factor or multi-factor models are used. For spread options, yield curve options and cross-currency caps, estimating the correlation between the underlying assets is of primary importance, the degree of correlation between them having a direct influence on the option price. For quantos such as guaranteed exchange rate options, or differential swaps, the correlation effect is the extent to which there is a relationship between movements in the underlying and movements in the ex-change rate, which has a secondary effect on the price of the option.
3. Correlation between markets is also used to offset an option position in one market against another with similar direction and volatility. Such a strategy might be used to reduce cost – to avoid hedging the positions separately, or because implied volatility in the second market is lower – or because hedging is difficult in the first market. Correlation can be estimated historically (like volatility) but tends to be unstable, and historic estimations may be poor predictors of future realized correlations.

CORRELATION SWAP

Often used in currency markets, an instrument that allows an investor to take three volatility swaps and bet on how much one currency will move compared to the two others.

CORRIDOR

See interest rate corridor

CORRIDOR FLOATER

See range note

CORRIDOR OPTION

The holder of a corridor option receives a coupon at the end of the lifetime of the corridor whose magnitude depends upon the behavior of a specified spot rate during the lifetime of the corridor. For each day on which the spot rate (typically an official fixing rate observation) remains within the chosen spot range (the accrual corridor) the holder accrues one day’s worth of coupon interest. At the end of the lifetime the accrued coupon is paid out. Its value is calculated according to the following formula:

A variation is the knockout corridor option. In this structure, the holder ceases to accrue coupon interest as soon as the spot rate leaves the range. Even if the spot rate subsequently re-enters the range, the holder does not continue to accrue coupon interest. At the end of the option’s lifetime, the accrued coupon is calculated according to the following formula:

If the accrual corridor is one-sided (the other side of the range being open-ended), it is known as a wall option. Typically, corridor options are imbedded in a structured note, sometimes called a range note, that pays a higher yield than the corresponding vanilla debt as long as the underlying rate remains sufficiently long within the accrual corridor. A similar option to the corridor option is the range binary, a binary option which pays a fixed coupon amount if the range is not breached but nothing if it is breached.

COST OF CARRY

The cost of financing an asset. If the cost is lower than the interest received, the asset has a positive cost of carry; if higher, the cost of carry is negative. The cost of carry is determined by the opportunities for lending the asset and the shape of the yield curve. So a bond, for example, would have a positive cost of carry if short-term rates (financing rates) were lower than the bond’s yield or (and) if the cost could be mitigated by lending out the securities.

COST OF FUNDS

Refers to an Issuer’s actual interest rate cost on its debt obligations, which may or may not include carrying costs such as remarketing fees, liquidity fees, letter of credit fees, etc., that is sometimes used as the underlying in a swap transaction.

COUNTERPARTY

A party in a swap transaction. From an Issuer’s perspective, this is synonymous with Provider.

COUNTERPARTY CREDIT RISK

The risk of financial loss arising out of holding a particular contract or portfolio of contracts as a result of one or more parties to the relevant contract(s) failing to fulfill its financial obligations under the contract. Counterparty credit risk is assessed as a function of three variables:
    •     the value of the position exposed to default (the credit or credit risk exposure);
    •     the value of the position exposed to default (the credit or credit risk exposure);
    •     the proportion of the value that would be recovered in the event of a default;
    •     the likelihood of a default occurring.
Counterparty credit risk can be managed through the use of an ISDA Master Agreement, which allows netting of all exposures related to all derivative contracts between two counterparties, and an ISDA Credit Support Annex, which provides for posting of collateral based on net exposure.

COVERED CALL

To sell a call option while owning the underlying security on which the option is written. The technique is used by fund managers to increase income by receiving option premium. It would be used for securities they are willing to sell, only if the underlying went up sufficiently for the option to be exercised. Generally, covered call writers would undertake the strategy only if they thought volatility was overpriced in the market. The lower the volatility, the less the covered call writer gains in return for giving up upside in the underlying. It provides downside protection only to the extent that the option premium offsets a market downturn.

COVERED PUT

To sell a put option while holding cash. This technique is used to increase income by receiving option premium. If the market goes down and the option is exercised, the cash can be used to buy the underlying to cover. Covered put writing is often used as a way of target buying: if an investor has a target price at which he wants to buy, he can set the strike price of the option at that level and receive option premium to increase the yield of the asset. Investors also sell covered puts if markets have fallen rapidly but seem to have bottomed, because of the high volatility typically received on the option.

COVERED WARRANT

A warrant issued by a third party, often a bank or securities house, which entitles the holder to buy existing shares in a company at a fixed price for a given period. The term is also more generically applied to any covered warrant issued by a third party on any underlying.

COX-INGERSOLL-ROSS MODEL

In its simplest form this is a lognormal one-factor model of the term structure of interest rates, which has the short rate of interest as its single source of uncertainty. The model allows for interest rate mean reversion and is also known as the square root model because of the assumptions made about the volatility of the short-term rate. The model provides closed-form solutions for prices of zero-coupon bonds, and put and call options on those bonds.

CRACK SPREAD

The simultaneous purchase or sale of crude oil against the sale or purchase of a refined petroleum product such as heating oil.

CREDIT DEFAULT SWAP

A bilateral financial contract in which one counterparty (the protection buyer or buyer) pays a periodic fee, typically expressed in basis points per annum on the notional amount, in return for a contingent payment by the other counterparty (the protection seller or seller) upon the occurrence of a credit event with respect to a specified reference entity. The contingent payment is designed to mirror the loss incurred by creditors of the reference entity in the event of its default. The settlement mechanism may be cash or physical.

CREDIT DERIVATIVE

A bilateral financial contract which isolates credit risk from an underlying instrument and transfers that credit risk from one party to the contract (the Protection Buyer) to the other (the Protection Seller). There are two main categories of credit derivatives: the first consists of instruments such as credit default swaps in which contingent payments occur as a result of a credit event; the second, which includes credit spread options, seeks to isolate the credit spread component of an instrument’s market yield.

CREDIT EVENT

Any one of a specified set of events, which, if occurring with respect to an obligation of the reference entity specified in a credit default swap, will trigger contingent payments. Applicable events, which generally include bankruptcy, repudiation/moratorium, restructuring, failure to pay, and cross-acceleration (as each is defined by ISDA) are determined by negotiation between the parties at the outset of a credit default swap.

CREDIT INTERMEDIATION SWAP

A credit swap with a dynamic notional that for a fixed fee provides the protection buyer with a contingent payment that matches the mark-to-market on any given day of a specified derivative (or other market-sensitive instrument). Also known as a dynamic credit swap

CREDIT OPTION

Put or call options on the price of either (a) a floating rate note, bond, or loan, or (b) an asset swap package, consisting of a credit-risky instrument with any payment characteristics and a corresponding derivative contract that exchanges the cashflows of that instrument for a floating rate cashflow stream, typically three- or six-month Libor plus a spread.

CREDIT PENALTY

The additional requirements (e.g., a higher interest rate, additional insurance, etc.) of a party to a swap imposed due to that party’s lower credit rating.

CREDIT RISK

Also known as default risk. In broad terms, the risk that a loss will be incurred if a counterparty to a (derivatives) transaction does not fulfill its financial obligations in a timely manner. The term is sometimes loosely used as shorthand for the likelihood or probability of default, irrespective of the value of any position exposed to this risk. More precisely, credit risk is the risk of financial loss arising out of holding a particular contract or portfolio. In this sense, it is a function of three variables:
    •     the value of the position exposed to default (the credit or credit risk exposure);
    •     the proportion of the value that would be recovered in the event of a default;
    •     the likelihood of a default occurring.

CREDIT RISK ASSESSMENT

The process of determining the extent of the credit risk inherent in a financial instrument or portfolio of financial instruments. Such extent is usually measured in terms of exposure, which can be analyzed in several ways:
    •     The current exposure associated with a derivative instrument, its replacement cost, is the present value of the expected future net cash flows of that instrument.
    •     The potential exposure is an estimate of the future replacement cost of a derivative transaction, calculated using probability analysis (e.g., Monte Carlo or historical simulation, option valuation models) over the remaining term of the transaction.
    •     The potential exposure is an estimate of the future replacement cost of a derivative transaction, calculated using probability analysis (e.g., Monte Carlo or historical simulation, option valuation models) over the remaining term of the transaction.
    •     The most likely potential exposure is known as the expected exposure, which is found by taking the mean of all possible replacement costs (weighted by probability), where the replacement cost in any outcome is taken as being equal to the mark-to-market present value if positive, and zero if negative.
    •     It is also possible to calculate a worst case exposure, an estimate of the exposure that might be expected if the market were to move through an amount dictated by a specified confidence interval. This calculation allows capital to be held to protect against possible, but relatively unlikely market moves.

  If the expected or worst case exposures of an instrument are calculated over time, the resulting graph reveals a credit risk exposure profile. The highest point on the profile is the “peak expected (or worst case) exposure” generated by the instrument. This would be the largest possible loss that could occur, to the probability dictated by the confidence interval.

CREDIT RISK MODELS

The success of VAR-based models of market risk and the ongoing development of the Basel Committee's regulatory framework has sparked a wave of interest in credit risk modeling since the 1990s. But default probabilities cannot be observed, and correlations between defaults are difficult to measure – so it's difficult to aggregate credit risk. For these kinds of reasons, the robust modeling of credit risk is a more difficult task than for market risk.

Despite such difficulties, a number of commercial models of portfolio credit risk are available, but they are all broadly based on one of two fundamental models: equity-based and ratings-based. Merton-type models treat the value of a credit exposure as a derivative written on the firm's underlying assets. Volatility and correlation structures are then deduced from changes in the equity's value. Ratings-based models assume that credit risk exposures are defined by credit ratings. Transitions between different ratings and correlations between ratings transitions for pairs of exposures are then modeled.

Despite such difficulties, a number of commercial models of portfolio credit risk are available, but they are all broadly based on one of two fundamental models: equity-based and ratings-based. Merton-type models treat the value of a credit exposure as a derivative written on the firm's underlying assets. Volatility and correlation structures are then deduced from changes in the equity's value. Ratings-based models assume that credit risk exposures are defined by credit ratings. Transitions between different ratings and correlations between ratings transitions for pairs of exposures are then modeled.

CREDIT SPREAD

A credit spread is the difference in yield between two debt issues of similar maturity and duration. The credit spread is often quoted as a spread to a benchmark floating-rate index such as Libor, or alternatively as a spread to a highly rated reference security such as a government security. The credit spread is often used as a measure of relative creditworthiness, with reduction in the credit spread reflecting an improvement in the borrower’s perceived creditworthiness.

CREDIT SPREAD FORWARD

A cash-settled forward contract with settlement amounts based on the credit spread between two predetermined debt issues on the maturity date.

CREDIT SPREAD OPTION

An option on the credit spread between two debt issues. The option will pay out the difference between the credit spread at maturity and a strike spread determined at the outset.

CREDIT SUpport

Collateral that can be in the form of cash and/or marketable securities posted by one party to a swap agreement to reduce the credit exposure of its counterparty.

CREDIT SUpport ANNEX

Document governed by the ISDA Master Agreement which states the provisions and circumstances under which posting of collateral is required.

CREDIT VALUE AT RISK MODEL OF CREDIT RISK

See Credit Risk Models

CREDIT-LINKED NOTE

A security with redemption and/or coupon payments linked to the occurrence of a credit event with respect to a specified reference entity. In effect, a credit-linked note embeds a credit default swap into a funded asset to create a synthetic investment that replicates the credit risk associated with a bond or loan of the reference entity. Credit-linked notes are typically issued on an unsecured basis directly by a corporation or financial institution (e.g., an MTN or Certificates of Deposit issued by JPMorgan Chase Bank). Credit-linked notes may also be issued from a collateralized Special Purpose Vehicle (SPV).

CROSS-CURRENCY CAP

A cap in which the vendor will pay the purchaser the spread between interest rates (usually Libor-based) in different currencies minus a strike spread, where this exceeds zero, in return for a premium. It has the same relationship to a differential swap as a cap has to an interest rate swap.

CROSS-CURRENCY SWAP

A cross-currency swap involves the exchange of cashflows in one currency for those in another. Unlike single-currency swaps, cross-currency swaps often require an exchange of principal. Typically the notional principal is exchanged at inception at the prevailing spot rate. Interest rate payments are then passed back on a fixed, floating or zero basis. The principal is then re-exchanged at maturity at the initial spot rate.

Cross-default termination

The ability of one party to terminate the swap at its market value if the other party defaults on other obligations of particular types.

CRUSH SPREAD

The simultaneous sale of soybean oil futures and meal, and purchase of soybean futures.

CUMULATIVE CAP

A cumulative interest rate cap protects against increases in total interest expense over a specified period of time. This period of time will incorporate several rate settings in determining the final interest expense (for example, four three-month Libor settings for an annual interest expense amount). This differs from a standard cap, which caps an absolute rate of interest in each calculation period. Because a cumulative cap does not provide the period-to-period protection of a standard cap, it is generally cheaper than the corresponding standard cap.

CURRENCY FORWARD

An agreement to exchange a specified amount of one currency for another at a future date at a certain rate. The exchange of currencies is priced so as to allow no risk-free arbitrage. In other words, pricing is not a market estimate of the spot rate at that date, but is made according to the two currencies’ respective interest rates. For example, assuming that Eurosterling interest rates are 10% and Eurodollar 5%, and the US dollar/sterling spot rate is 1.75, the forward rate should reflect the 5% interest rate advantage of depositing money in sterling. Thus the 12-month forward rate should be 1.6695.

Forwards are more appropriate than options if a company has a strong directional view of expected movements in exchange rates. But certainty is rare and hedging entirely with forwards may leave a company locked into unfavorable exchange rates. Unlike options, forwards do not enable companies to take advantage of favorable currency movements. The purchaser of a forward, unlike the purchaser of a future, carries the credit risk of the firm from which it makes the purchase. Since the contracts are not easily reassignable, it is difficult to reduce this risk.

CURRENCY OVERLAY

See overlay

CURRENCY PROTECTED OPTION

The same as guaranteed exchange rate option.

CURRENCY STRUCK OPTION

This is same as joint option

CURRENT EXPOSURE

Another name for replacement cost.

CYLINDER

Also known as range forward or risk-reversal. The simultaneous purchase of an out-of-the-money currency put option and sale of an out-of-the-money currency call option (or vice versa). The choice of strike prices is usually made to result in a zero cost strategy. This strategy enables purchasers to hedge their downside at reduced (or no) cost. This is at the expense of forgoing upside beyond a certain level since the purchase of the put is financed by the sale of the call.