HAIRCUT
The excess of an asset’s market value over either the loan for which it can serve as adequate capital, or the regulatory capital value. It can also refer to the dealer’s commission on a transaction.
HARMLESS WARRANT
A warrant exercisable into debt of issuer, which does not result in the creation of more debt.
HEATH-JARROW-MORTON MODEL
A multi-factor interest rate model which describes the dynamic of forward rate evolution. An extension of the Ho-Lee model, the underlying is the entire term structure of interest rates. The approach is very similar to the original Black-Scholes Model: it does not model qualities such as the “price for risk.”
The model requires two inputs: the initial yield curve and a volatility structure for the forward. The volatility is only specified in a very general form. By choosing an appropriate volatility function, it is possible to reduce HJM to simpler models such as Ho-Lee, Vasicek, and Cox-Ingersoll-Ross.
The practical importance of the HJM model is that it provides a single coherent framework for pricing and hedging an entire book of instruments (including instruments like caps and swaptions) and is not excessively computationally intensive. Research building on HJM (such as the market model) has concentrated on widening its scope to remove the possibility of negative interest rates, include more than one interest rate curve and incorporate default risk.
HEDGE
To hedge is to reduce risk by making transactions that reduce exposure to market fluctuations; for example, an investor with a long equity position might compensate by buying put options to protect against a fall in equity prices. A hedge is also the term for the transactions made to effect this reduction.
HEDGE ACCOUNTING
The practice of deferring accounting recognition of gains and losses on financial market hedges until the corresponding gain or loss of the underlying exposure is recognized. Companies favor hedge accounting because it enables them to incorporate costs of hedges into the cost basis of the exposure. This matches gains against offsetting losses, reducing earnings volatility in a manner consistent with the purpose of the hedge. At this writing, the US Federal Accounting Standards Board was in the midst of a long-term project to codify accounting for derivatives transactions which will address the circumstances under which hedge accounting is permitted.
See also
FAS 133 and
IAS 39;
accrual accounting,
mark to market
HEloc
A Home Equity Line of Credit is a loan to a homeowner in which the lender agrees to lend a maximum amount of money within an agreed period, or term, using the borrower’s equity in his/her house as collateral. A HELOC is different from a traditional home equity loan in that the borrower does not receive a total sum of money up-front. Rather, he/she uses a line of credit to borrow sums of money that total no more than the amount of the HELOC, similar to a credit card.
HERSTATT RISK
See
settlement risk
HETEROSCEDASTICITY
Describes a random variable whose variance is not constant.
See also
ARCH,
homoscedasticity.
HIGH-COUPON SWAP
A swap in which the fixed-rate payments are above market rates. (Also known as a premium swap.)
See also
discount swap
HIGH-LOW OPTION
A combination of two lookback options. A high-low option pays the difference between the high and low of an underlying, such as a stock index. A speculative purchaser would be taking the view that the market would be more volatile than the implied volatilities of both lookback options incorporated in the structure.
HISTORIC RATE ROLLOVER
A historic rate rollover allows an existing currency forward or spot position to be rolled forward without generating any intermediate cash flows. Effectively the position is reinstated for a new settlement date using a new off-market forward rate based on the historic rate.
HISTORICAL SIMULATION
A method of calculating value-at-risk which uses historical data to assess the impact of market moves on a portfolio. The first step is to record the changes in the relevant market factors over a given historical period, where each change occurs over a constant holding period. The next step is to revalue the portfolio for each change in market factors, as if such change were to occur in the future. The result is a distribution of possible profits and losses on the portfolio over the holding period, from which it is possible to calculate the maximum loss at a given confidence level. An advantage of historical simulation is that because it uses real data, it captures outlying events and correlations which would not necessarily be predicted by a theoretical model.
HISTORICAL VOLATILITY
Historical volatility is a measure of the volatility of an underlying instrument over a past period. Historical volatility can be used as a guide to pricing options but isn’t necessarily a good indicator of future volatility. Volatility is normally expressed as the annualized standard deviation of the log relative return.
HOLDING PERIOD
The time that it is assumed would be needed to liquidate or hedge a portfolio for the purpose of calculating value-at-risk. The longer the holding period, the higher the value-at-risk.
HO-LEE MODEL
The first model that set out to model movements in the entire term structure of interest rates, not just the short rate, in a way that was consistent with the initially observed term structure. However, since the model only has a single random factor, it makes the simplifying assumption that the volatility structure remains constant along the yield curve. Heath-Jarrow-Morton later generalized this model, using a more general form of volatility and introducing continuous trading. In addition, Ho-Lee allows for the possibility of negative interest rates. The model was developed using a binomial tree, although closed-form solutions have now been found for discount bonds and discount bond options.
HOMOSCEDASTICITY
Describes a random variable whose variance is constant. Models that assume this are simple models with closed-form solutions, such as Black-Scholes and Vasicek. They benefit from being closed-form solutions but are not as consistent with reality as two- or multi-factor models.
HULL-WHITE MODEL
An extension of the Vasicek model for interest rates, the main difference being that mean reversion is time-dependent. Both are one-factor models. The Hull-White model was developed using a trinomial lattice, although closed-form solutions for European-style options and bond prices are possible.
HYPOTHECATION
The posting of collateral.