RAINBOW OPTION
The term “rainbow option” is synonymous with “multi-factor option”. The underlying factors are referred to as colors in the context of rainbow options. Hence a two-factor option (such as a spread option) would be a two-color rainbow option.
RANDOM WALK
The series of values taken by a random variable with the progress of some parameter such as time. Each new value (each new step in the walk) is selected randomly and describes the path taken by the underlying variable.
See also
geometric Brownian motion,
stochastic process
RANGE BINARY
The Range Binary structure has been developed primarily for trading purposes and is essentially a bet on a spot rate staying within a range. The strategy is often linked with a deposit for yield enhancement purposes.
A currency range is specified by the customer over a fixed period. A premium is paid up front and provided that the spot stays within the range (as monitored on a 24-hour basis), then a multiple of the premium invested will be payable.
A rebate range binary is one in which the premium invested is rebated if a designated boundary of the range is breached first. A similar structure, the limit binary, is also essentially for trading. This is fundamentally a bet on a spot not staying within a predetermined range. The customer specifies two spot rates, one above and one below the current spot rate. A premium is paid up front, and providing that both levels trade (as monitored on a 24-hour basis), a fixed multiple of the premium invested will be payable. A James-Bond range binary is a range binary with two lives (“You only live twice”). If the initial range is broken a new range is determined (usually centered around the breached barrier). If this second range is breached the holder receives no pay-out.
See also
corridor option,
trigger condition
RANGE FORWARD
See
cylinder
RANGE NOTE
A range note (also known as a fairway note, an accrual note, or a corridor floater) is a structured note, which pays an above-market interest rate for each day that the underlying spot rate stays within a specified range (sometimes called the accrual corridor). If the underlying trades outside the specified range, the investor receives no interest for that day. The underlying is usually a reference interest rate, such as Libor or a Constant Maturity Treasury, but it could also be a foreign exchange rate, an equity price or the spread between two interest rates. The range is determined at the outset to suit the investor’s risk/return requirements, but might also be reset by the investor or be automatically centered on the prevailing rate at each reset date. This higher yield is achieved by the investor selling an embedded corridor option, particularly in times of high volatility. The holder of the note will therefore benefit in stable market periods when volatility is low. It is also possible for the barriers on a range note to act as knock-out levels by embedding a knock-out corridor option or a range binary. In this case the note is extinguished altogether or becomes a zero coupon note if the reference rate trades through a barrier. This is known as a barrier floater or a knock-out range note.
See also
corridor option
RATCHET OPTION
See
cliquet option
RATIO SPREAD
A ratio spread involves buying different amounts of similar options with differing strike prices. The purchase of an in-the-money option is financed by the selling of more out-of-the-money options. Conversely, the out-of-the-money options are financed by selling less of an in-the-money option.
RBDA
The Regional Bond Dealers Association is a trade organization representing 14 US regional, fixed-income securities dealers. Formed in March of 2008, the RBDA’s 14 founding members include Crews & Associates, Inc., Cronin & Co., Inc., Duncan-Williams, Inc., Fifth Third Securities, FTN Financial, G.X. Clarke & Co., Incapital LLC, ML Stern & Co., Seattle-Northwest Securities Corp., Southwest Securities, Inc., Stone & Youngberg LLC, Tejas Securities, Vining-Sparks IBG, and Wells Fargo Brokerage Services LLC.
REAL OPTION
An alternative method (to cashflow models) for valuing a non-traded asset or liability whose profit and loss sensitivity to some market variable mimics that of an option. For example, consider the right to extract oil from an oilfield. Low oil prices mean that the field can be left untapped at no additional cost. However, higher oil prices may mean that the cost of extraction could be more than covered by selling oil into the bullish market. So the right to extract oil resembles an option on the oil price.
REBATE
Barrier options often have a rebate associated with the trigger level(s). A rebate is an amount paid to the holder of the derivative if the instrument is knocked out or is never activated during its lifetime as partial recompense for their initial investment. One example is the rebate range binary.
REBATE RANGE BINARY
See
range binary
RECOMBINING TREE
See
binomial tree
REGULATORY ARBITRAGE
A financial transaction that allows one or both of the counterparties to accomplish an operating or financial objective that would be unavailable to them directly because of regulations: for example, a commercial bank entering into a credit default swap with an OECD bank in order to lower the regulatory capital that it must hold.
REGULATORY CAPITAL
The amount of capital that an organization is required to hold by its regulator.
REINVESTMENT RISK
The risk that an asset manager will be unable to match the yield from an interest-rate instrument (such as a swap or bond) when reinvesting its coupon payments and principal repayments.
RELATIVE PERFORMANCE OPTION
See
outperformance option
RELATIVE PERFORMANCE RISK
The risk that a fund manager’s choice of investments will fail to match the performance of the benchmark against which the fund is measured, prompting fund redemptions. A similar risk is run by corporate treasury risk managers who are measured against benchmark hedge levels. One way to address this type of risk is with outperformance options. Relative performance risk is also used to refer to the risk that an individual asset will underperform relative to its asset class. For equities, this may be measured by a stock’s beta, its standardized covariance with respect to the relevant equity index.
See also
specific risk
REPLACEMENT COST
Often used in terms of credit exposure, the re-placement cost of a financial instrument is its current value in the market – in other words, what it would cost to replace a given contract if the counterparty to the contract defaulted. Aside from bid-ask conventions, it is synonymous with market value.
REPLICATION
To replicate the pay-out of an option by buying or selling other instruments. Creating a synthetic option in this way is always possible in a complete market. In the case of dynamic replication this involves dynamically buying or selling the underlying (or normally, because of cheaper transaction costs, futures) in proportion to an option’s delta. In the case of static replication the option (usually an exotic option) is hedged with a basket of standard options whose composition does not change with time – e.g., an at-expiry digital option can be replicated with a call spread.
REPO AGREEMENT
To buy (sell) a security while at the same time agreeing to sell (buy) the same security at a predetermined future date. The price at which the reverse transaction takes place sets the interest rate over the period (the repo rate). The most active repo market is in the US, where the Federal Reserve sets short-term interest rates by lending securities. In a reverse repo the buyer sells cash in exchange for a security. Repos can benefit both parties. Buyers of repos often receive a better return than that available on equivalent money-market instruments; and financial institutions, particularly dealers, are able to get sub-Libor funding. A slight variation on the repo is the buy/sell back. The buy/sell back’s coupon becomes the property of the purchaser for the duration of the agreement. It is preferred by credit-sensitive investors such as central banks.
REPO RATE
See
repo agreement
REPurchase agreement
See
repo agreement
RESET-IN-ARREARS SWAP
See
delayed reset swap
RESETTABLE CONVERTIBLE BOND
It is a convertible bond where the conversion ratio can reset to a new value depending on the average price of the underlying stock on pre-specified dates.
See also
convertible bond
REVERSAL
To take advantage of mispriced options by creating a synthetic long futures position and hedging it by selling futures contracts against it. A trader may buy an undervalued call, at the same time selling a fairly valued put and buying a futures contract. The same strategy could be applied if the put was undervalued. The ability to undertake this riskless arbitrage relies on put-call parity.
See also
box,
conversion
REVERSE BARRIER OPTION
See
barrier option
REVERSE CASH-AND-CARRY ARBITRAGE
A technique, used mainly in bond futures and stock index futures, that involves buying a futures contract and selling the underlying. It is used when a futures contract is theoretically cheap, such as when the implied repo rate is less than the market repo rate.
See also
cash-and-carry arbitrage
REVERSE CONVERTIBLE
These are just like convertible bonds. The main difference is that rather than buying a call option on a stock, the investor sells a put on the stock or index. The investor receives higher than normal coupons but may lose some principal if the put ends up in the money.
REVERSE FLOATER
See
inverse floater
REVERSE INDEX AMORTISING SWAP
An interest rate swap in which payments are linked to an index (e.g., Libor or constant maturity Treasuries) and increase if that index declines. The swap therefore exhibits positive convexity. Receiving fixed in a reverse index amortizing swap (reverse IAS) provides a hedge for instruments (such as mortgage swaps) that amortize as interest rates decline, although it is important to ensure that the indexes on which the amortization or accreting schedules are based are highly correlated. Unlike a conventional IAS, the fixed receiver of a reverse IAS is buying volatility (sometimes referred to as “optionality”) which offsets the short option position of a mortgage portfolio.
REVERSIBLE SWAP
An interest rate swap in which one side has an option to alter the payment basis (fixed/floating) after a certain period. This is usually achieved by the use of a swaption, allowing the purchaser the opportunity to enter a swap with payment on the opposite basis. The swaption would be for twice the principal amount, one half nullifying the original swap.
RHO
Measures an option’s sensitivity to a change in interest rates. This will have an impact on both the future price of the option and the time value of the premium. Its impact increases with the maturity of the option.
RING
A five-minute trading period in a single metal on the London Metal Exchange. It can also refer to the circle of seats where such trading takes place.
RISK MANAGEMENT
Control and limitation of the risks faced by an organization due to its exposure to changes in financial market variables, such as foreign exchange and interest rates, equity and commodity prices or counterparty creditworthiness. This may be because of the financial impact of an adverse move in the market variable (market risk), because the organization is ill-prepared to respond to such a move (operational risk), because a counterparty defaults (credit risk), or because a specific contract is not enforceable (legal risk).
Market risks are usually managed by hedging with financial instruments, although a firm may also reduce risk by adjusting its business practices (see natural hedge). While financial derivatives lend themselves to this purpose, risk can also be reduced through judicious use of the underlying assets (for example, by diversifying portfolios).
RISK MEASUREMENT
Assessment of a firm’s exposure to risk.
See also
credit risk assessment,
value-at-risk
RISK NEUTRAL VALUATION
An argument that underpins most derivatives pricing, including the Black-Scholes+model. The differential equation describing the price of a derivative does not involve parameters that depend on risk preferences. Derivative prices in a market where all investors are risk neutral must therefore be the same as prices in the real world and this corollary considerably simplifies model construction.
RISK REVERSAL
1) See cylinder
2) The term “risk reversal” is also used, by currency option traders, to denote the difference in implied volatility between out-of-the-money call and put options which both have a delta of 25%. The level of the risk reversal is often used as a sentiment indicator in currency markets as it indicates the relative demand for calls versus puts.
ROLLER-COASTER SWAP
1. An interest rate swap in which one counterparty alternates between paying fixed and paying floating.
2. Another name for a seasonal swap
ROLL-LOCK SWAP
A swap that enables futures traders to lock in their roll-over costs by paying an average difference between near and far contracts measured on the seventh, sixth and fifth days before expiration. The product therefore allows investors to roll over their contracts at a set cost relative to their fair value.
ROLL-OVER RISK
The risk that a derivative hedge position will be at a loss at expiry, necessitating a cash payment when the expiring hedge is replaced with a new one. Normally, such a roll-over loss simply represents an opportunity loss, but sometimes the cash cost is consequential, as was the case with the losses made by the New York arm of German industrial conglomerate Metallgesellschaft in 1993. Metallgesellschaft’s hedging policy relied on repeatedly rolling over short-term crude oil contracts. However, roll-over losses grew so large that the company suffered a severe liquidity crisis, precipitating a near-collapse.