IAS 39
The London-based International Accounting Standards Committee’s derivatives accounting rule, similar to FAS+133. IAS 39 came into force in 2001 and is applicable to all companies using international accounting standards – i.e., most of the world’s multinationals. The scope of IAS 39 is wider than FAS 133 because the fair value for all financial instruments, not just derivatives, must be included on balance sheet. The rule will become compulsory for all European-quoted companies in 2005.
IMPACT FORWARD
A collared forward, such as one in which the purchaser buys a put and sells a call, both being out-of-the-money. The premiums on the two options balance out, so the strategy is zero cost. Upside and downside is limited to the gap between the strike prices.
See also
collar
IMPLIED DISTRIBUTION
The probability distribution of returns for an asset which is implied by options traded on that asset. The distribution is inferred by combining the variation of volatility with strike price (see volatility smile) and the assumptions made about the distribution in the option pricing model.
IMPLIED FORWARD CURVE
The forward curve implied by forward rate agreements (derived from the par curve) of various maturities. It is usually steeper than the normal yield curve.
IMPLIED REPO RATE
The return earned by buying a cheapest-to-deliver bond for a bond futures contract and selling it forward via the futures contract.
See also
future
IMPLIED TREE
A binomial or trinomial tree, which models the distribution implied by vanilla option prices and their implied volatilities.
See also
implied volatility,
implied distribution,
volatility smile.
IMPLIED VOLATILITY
The value of volatility embedded in an option price. All things being equal, higher implied volatility will lead to higher vanilla option prices and vice versa. The effect of changes in volatility on an option’s price is known as vega. If an option’s premium is known, its implied volatility can be derived by inputting all the known factors into an option pricing model (the current price of the underlying, interest rates, the time to maturity and the strike price). The model will then calculate the volatility assumed in the option price, which will be the market’s best estimate of the future volatility of the underlying.
See also
volatility skew,
volatility term structure
IN the money
Refers to a party’s financial position if it would be owed a payment by the other party if a swap were terminated at the prevailing market price.
IN-ARREARS SWAP
See
delayed reset swap
INDEX AMORTISING SWAP (IAS)
An interest rate swap whose principal amortizes on the back of movements in an index, such as Libor or constant maturity treasuries. The fixed-rate receiver effectively grants an option to the fixed-rate payer to amortize the swap. The option is triggered by interest rate movements after an initial lock-out period. The notional principal amortizes as rates fall or remains constant if rates remain the same. In return for granting the option, the fixed-rate receiver gets a yield above current fixed rates. IAS have been widely used by US regional banks in their asset/liability management activities. By using IAS, banks were able to obtain the negative convexity of a mortgage-backed security and avoid the risk of excessive prepayments due to changes in consumer sentiment.
But the fixed receiver is exposed to both falling and rising rates. If rates fall, there is the possibility at each interest date that some or all of the swap will be terminated, creating a reinvestment risk. If rates rise, the swap may run to maturity, providing meager income while floating rates soar.
An IAS fixed-rate receiver is selling volatility to the payer for an enhanced yield. So the lower the volatility of the index, the lower the option value and yield pick-up. A subsequent fall in volatility benefits the receiver because the likelihood that the swap will amortize decreases. IAS can be structured with negative or positive convexity and the amortization schedules and lock-out periods can be changed in order to increase or decrease yields. Also known as an Indexed Principal Swap.
INDEX ARBITRAGE
See
stock index arbitrage
INDEX PARTICIPATION UNITS
The generic term for investment vehicles that provide the return of a specific index (usually a stock market index) while guaranteeing the investor the return of the principal.
INDEXED STRIKE CAP
A cap for which the pay-out level is indexed to the level of the reference rate. For example, such a cap might be struck at 7.5% as long as the reference rate remained below 9%, but rise to 8.5% if the reference rate exceeded 9%. An indexed strike cap is cheaper than a conventional cap.
INSTALLMENT OPTION
See
compound option
INTEGRATED HEDGE
A hedge which combines more than one distinct price risk. For example, crude oil is usually priced in US dollars. Therefore a producer of crude oil whose home currency is not the dollar (say, the euro) is exposed to both currency risk and the price risk for crude oil. One possible integrated hedge would be a single quanto option, which would hedge the price of crude oil in euro. As such, it would depend heavily on the correlation (if any) between the two markets.
See also
exchange option
INTEREST RATE CORRIDOR
An interest rate corridor is composed of a long interest rate cap position and a short interest rate cap position. The buyer of the corridor purchases a cap with a lower strike while selling a second cap with a higher strike. The premium earned on the second cap then reduces the cost of the structure as a whole. The buyer of the corridor is then protected from rates rising above the first cap’s strike, but exposed again if they rise past the second cap’s strike. It is possible to limit this liability by selling a knock-out cap rather than a conventional cap. The structure is then known as a knock-out interest rate corridor.
INTEREST RATE GUARANTEE
An option on a forward rate agreement (FRA), also known as a FRAtion. Purchasers have the right, but not the obligation, to purchase an FRA at a predetermined strike. Caps and floors are strips of IRGs.
INTEREST RATE risk
The risks associated with changes in interest rates (i.e., the risk that changes in interest rates will adversely affect an Issuer’s position with respect to borrowing costs, re-investment opportunities, at-market investment termination, etc.)
INTEREST RATE SWAP
An agreement to exchange net future cashflows. Interest rate swaps most commonly change the basis on which liabilities are paid on a specified principal. They are also used to transform the interest basis of assets. In its commonest form, the fixed-floating swap, one counterparty pays a fixed rate and the other pays a floating rate based on a reference rate, such as Libor. There is no exchange of principal – the interest rate payments are made on a notional amount. In floating-floating swaps the two counterparties pay a floating rate on a different index, such as three-month Libor versus six-month Libor.
Swaps usually extend out as far as 10 years, although 12–40 year maturities are available in some liquid currencies. However, the longer the maturity of the swap, the less liquid it becomes and credit risk increases. Credit enhancements such as mutual put options and collateral are used to ameliorate the credit risk of longer term swaps.
Interest rate swaps provide users with a way of hedging the effects of changing interest rates. For example, a company can convert floating-rate interest payments to fixed-rate payments if it thinks interest rates will rise (which would make its liabilities more expensive). Companies can also use interest rate swaps in conjunction with new debt issuance, raising money on, say, a fixed basis and swapping it into floating-rate debt. In an interest rate swap there is a fixed-rate payer (floating-rate receiver) and a fixed-rate receiver (floating-rate payer). If there is a preponderance of fixed-rate payers (for example, when companies want to lock into low rates), the swap spread (the yield spread over equivalent maturity government bonds) increases. If there is a preponderance of fixed-rate receivers, the swap spread declines.
Interest rate swaps were initially transacted back-to-back, with a bank acting as an intermediary. In return for putting the differing requirements together and for taking the credit risk on the interest rate payments, the bank took a fee – either fixed or a small proportion of the interest payments. Now banks run swap books and act as principals in transactions. As a result they have to hedge the swaps they put on their books. This can be done with another swap or with securities. Since US dollar and sterling interest rate swaps are priced as a spread over Treasuries, this is not too difficult, although movement in the swap spread does create basis risk.
Most dealers use short-term interest rate futures such as Eurodollar futures or Euroyen futures to hedge swap positions. Disparities between futures and cash bonds and notes can drive swap spreads up and down. Such hedges can be imperfect when swap payments differ from the contract’s maturity.
INTEREST-RATE CAP
See
cap
INTernational swaps and derivatives association
See
ISDA
IN-THE-MONEY
Describes an option whose strike price is advantageous compared to the current forward market price of the underlying. The more an option is in-the-money, the higher its intrinsic value and the more expensive it becomes. As an option becomes more in-the-money, its delta increases and it behaves more like the underlying in profit and loss terms; hence deep in-the-money options will have a delta of close to one.
See also
at-the-money,
out-of-the-money
INTRINSIC VALUE
The amount by which an option is in-the-money, that is, its value relative to the current forward market price. Option premiums comprise intrinsic value and time value.
INVERSE FLOATER
The payments made on an inverse floating rate note (“floater”) decrease as the reference interest rate increases, the reverse of the typical case where the payments rise with the reference rate.
The purchaser of an inverse floating rate note is in effect selling interest rate caps – this will increase the coupon payments in a stable or lower interest rate environment, but reduce them should interest rates rise. Typically, the payment rate is found by multiplying the market rate at the outset by two and subtracting the reference rate from this figure. The floater can be leveraged by using a larger multiplier than two.
Isda
International Swaps and Derivatives Association – Represents participants in the privately negotiated derivatives industry; is the largest global financial trade association, by number of member firms. ISDA was chartered in 1985, and today has more than 840 member institutions from 56 countries on six continents. These members include most of the world's major institutions that deal in derivatives, as well as many of the businesses, governmental entities and other end users that rely on over-the-counter derivatives to manage the financial market risks inherent in their core economic activities.
See also
ISDA Master Agreement,
OTC derivatives
Isda master agreement
The standardized master legal agreement for all derivative transactions between an Issuer and a Provider that states standardized definitions, terms, and representations governing the swap transactions.
ITO’S LEMMA
A mathematical relationship that allows the stochastic process followed by a function of a variable to be deduced. Ito’s Lemma is fundamental to the derivation of a number of options pricing models.