SAFE
See
synthetic agreement for forward exchange
Schedule to the master agreement
A schedule amending or supplementing the ISDA Master Agreement which sets out the specific business terms and conditions governing the transactions executed under the agreement.
SEASONAL SWAP
An interest rate swap in which the principal alternates between zero and the notional amount (which can change or stay constant). The principal amount of the swap is designed to hedge the seasonal borrowing needs of a company.
SEC
The Securities and Exchange Commission is a US government agency with the primary responsibility of regulating the securities markets and enforcing federal securities laws. Created by the Securities Exchange Act of 1934, the SEC is also comcerned with protecting the investing public against fraudulent and manipulative abuses in the securities market.
SECtion 501(c)3 organizations
Not-for-profit or public purpose entities as defined under Section 501(c) 3 of the IRS tax code. These organizations are exempt from federal income tax. Examples of 501(c)3 organizations include private education schools, colleges, universities, museums, charitable organizations, and non-profit hospitals.
SECURITISATION
The conversion of assets (usually forms of debt) into securities which can be traded more freely and cheaply than the underlying assets and generate better returns than if the assets were used as collateral for a loan. One example is the mortgage-backed security, which pools illiquid individual mortgages into a single tradable asset.
SEMI-FIXED SWAP
An interest rate swap with two possible fixed rates which can be tailored to suit bullish or bearish market views. The rate paid by the fixed-rate payer depends on whether current Libor (or another reference rate or asset) is above or below a predetermined level. In a typical structure, if Libor is below the trigger level, the lower of the two rates is paid, if it is above, the higher is paid. These swaps can be used to create asymmetric risk exposures, i.e., cheaper fixed-rate funding for an oil producer when oil prices are low, or an enhanced yield for an insurance company when equity prices are falling.
SEt-off
Swap provision that enables a party that is entitled to a payment under the agreement (e.g., a termination payment) to satisfy that obligation by reducing the amount it owes the other party in another transaction.
SETTLEMENT RISK
Settlement risk (delivery risk), as a particular form of counterparty credit risk, arises from a non-simultaneous exchange of payments. For example, a bank that makes a payment to a counterparty, but will not be recompensed until a later date, is exposed to the risk that the counterparty may default before making the counter-payment. Settlement risk is distinct from market risk because it relates to exposure to a counterparty rather than exposure to the underlying risk related to the reference entity of the derivative contract.
Settlement risk is most pronounced in the foreign exchange markets, where payments in different currencies take place during the normal business hours in their respective countries and can therefore be made up to eighteen hours apart, and where the volume of payments makes it impossible to monitor receipts except on a delayed basis. This type of risk afflicted counterparties of Bank Herstatt in 1974, which closed its doors after receipt but before payment on foreign exchange contracts. As a result, settlement risk is sometimes called Herstatt risk. There are now a number of settlement processing organizations for foreign exchange, such as Multinet and Echo, which aim to reduce settlement risk by centralizing the settlement process.
See also credit risk
SHOUT OPTION
An option that allows a purchaser to lock in a minimum return if he thinks the market is at its high (low).
If, for example, he buys a shout call option at 100 and the market moves up to 110, he can, if he thinks it is the high, “shout” and lock in 10 points. If the market declines, he still receives 10 points. If the market finishes higher than 110, the holder receives the additional gain above 110.
With a lookback option, the holder is guaranteed to sell at the highest price the market reaches, even if it goes down again. The holder of the shout option is able to sell only at the level shouted, even if the market subsequently rises further before going down.
sifma swap index
Formerly the BMA Swap Index; produced by Municipal Market Data, is the principal benchmark for the floating rate interest payments for tax-exempt Issuers. The SIFMA Index is a national rate based on a composite of approximately 250 Issuers of high-grade, seven-day tax-exempt variable rate demand obligation issues of $10 million or more.
SKEW
A skewed distribution is one which is asymmetric. Skew is a measure of this asymmetry. A perfectly symmetrical distribution has zero skew, whereas a distribution with positive (negative) skew is one where outliers above (below) the mean are more probable. An example of an asymmetric distribution in the financial markets is the distribution implied by the presence of a volatility skew between out-of-the-money call and put options.
SMILING TREE
See
implied tree
SPECIFIC RISK
Specific risk, also known as non-systematic risk, represents the price variability of a security that is due to factors unique to that security, as opposed to that portion that is due to systematic risk, the generalized price variability of the related interest rate or equity market. As an example, a US Treasury note would have no specific risk, as it deemed to have no risk other than movement in interest rates, while a corporate bond would have a degree of default risk as well as more generalized yield curve risk.
Specific risk is also the term used by both the European Union’s Capital Adequacy Directive and the Basel Capital Accord to refer to the risks unique to individual holdings that are not covered by capital dedicated to generalized market risk. Specific risks are considered to be only partially diversifiable, and capital dedicated to them is added to generalized market risk capital.
See also
relative performance risk
SPOT TRADER OPTION
A spot trader option (perfect trader option, passport option) provides the holder with the ability to trade the underlying market with limited downside in return for a fixed premium. The holder of a spot trader option enters into a number of simulated “paper” trades with the writer of the option. The holder may enter into a long, short or flat position in underlying up to a fixed notional amount. The position can be changed a fixed number of times during the lifetime of the option. At maturity, the return from these simulated trades is calculated. If this results in a profit, the holder receives this amount as a pay-out. If a loss results, the holder does not suffer this loss. The maximum loss faced by the holder is the premium paid for the option.
SPREAD OPTION
The underlying for a spread option is the price differential between two assets (a difference option) or the same asset at different times or places.
An example of a financial difference option is the credit spread option, the underlying for which is the spread between two debt issues which derives from the relative credit rating of the issuers. Another is the cross-currency cap, where the underlying is the spread between interest rates in two different currencies. A calendar spread, a pair of options with the same strike price but different maturities, pays out the price difference for a single asset on two different dates. Spread options, including calendar spreads, are particularly popular in the commodity markets. Variations include:
• Location spreads, based on the price of the same commodity at two different locations. These can be used to hedge the basis risk incurred when taking delivery of a commodity at one location but required at another.
• Processing spreads, known as crack spreads in the crude oil market and frac spreads in the natural gas market. These are based on the price differential between a feedstock (e.g., crude oil or natural gas) and the products that can be obtained by refining or fractionating it (e.g., heating oil or propane).
• Quality spreads, based on the differential between different grades of the same commodity, such as “sweet” and “sour” crudes or heating oils of varying sulfur content.
SPREAD-LOCK SWAP
An interest rate swap in which one payment stream is referenced at a fixed spread over a benchmark rate such as US Treasuries.
SQUEEZE
Pressure on a particular delivery date resulting in making the price of that date higher relative to other delivery dates.
STAGED DRAWDOWN SWAP
See
accreting swap
STATIC REPLICATION
Static replication is a method of hedging an options position with a position in standard options whose composition does not change through time. The method attempts to replicate the pay-out of the instrument in a more manageable fashion than dynamic replication, where a position in the underlying or futures contracts must be dynamically adjusted if it is to remain effective.
Because it uses options to hedge options, a static replication portfolio is a better hedge for gamma and volatility, as well as delta, than dynamic replication. Static replication can be used for hedging a position in exotic options with vanilla options, or for replicating a long-term option with short-term options. In practice, however, it is not always possible to hedge using static replication. The number of different options and notional amounts required can quickly become unmanageable.
See also
synthetic asset,
replication,
delta-hedging
STATISTICAL ARBITRAGE
In the mid-1980s it was discovered that certain stock prices did to an extent exhibit autocorrelations – implying that earlier price changes could be used to forecast future changes. Statistical arbitrageurs seek to exploit these patterns in their trading strategies.
STEALTH
Stealth measures the percentage difference between the strike and the trigger level for a barrier option. Stealth is a particularly important measure for reverse and geared barrier options, where it measures the percentage intrinsic value at the trigger level of the option.
See also
barrier risk
STEP PAYMENT OPTION
See
mini-premium option
STEP-DOWN SWAP
1. See amortizing swap
2. The opposite of an escalating rate swap; i.e., the fixed rate decreases in increments over the life of the swap
STEP-UP COUPON SWAP
See
escalating rate swap
STEP-UP SWAP
See
accreting,
escalating rate swap
STEP-UP/DOWN RANGE FORWARD
A self-adjusting range forward structure which is particularly suitable for hedging purposes. If the strike level of the long put option is breached, the strike automatically adjusts up or down (according to exposure) to a new, more favorable, level.
STOCHASTIC OPTIMISATION MODEL
A model or description of a system in which the choice of action that can be taken is dependent on the values of some random variables. For example, the value of an American-style option is such that the best choice of exercise is always made.
STOCHASTIC PROCESS
Formally, a process that can be described by the evolution of some random variable over some parameter, which may be either discrete or continuous. geometric Brownian motion is an example of a stochastic process parameterized by time. Stochastic processes are used in finance to develop models of the future price of an instrument in terms of the spot price and some random variable; or analogously, the future value of an interest or foreign exchange rate.
See also
martingale
STOCHASTIC VOLATILITY
One of the key assumptions of the Black-Scholes model is that the stock price follows geometric Brownian motion with constant volatility and interest rates. However, in real markets, volatility is far from constant (see trading volatility). If volatility is assumed to be driven by some stochastic process, however, the Black-Scholes model no longer describes a complete market, since there is now another source of uncertainty in the option pricing model. A variety of approaches have been attempted to resolve this difficulty since the mid-1980s, most notably the Heath-Jarrow-Morton framework.
STOCK INDEX ARBITRAGE
The technique of selling a futures contract on a stock index and buying the underlying stocks, via program trading, or vice versa when the price of the futures contract is above or below its theoretical value. The ability to conduct such strategies depends on the efficiency of the futures and cash markets.
STOCK INDEX FUTURE
A futures contract on a stock index. Most are cash-settled. The theoretical price of a stock index future equals the cost of carrying the underlying stock for that period: the opportunity cost of the funds invested minus any dividends. If the cost of buying and holding the underlying stocks is less than the futures price, an arbitrageur can sell futures and buy the underlying stocks.
The higher interest rates are (compared with the dividend yield), the greater the opportunity cost of holding the stocks, hence the futures price should be higher than the current index price. If interest rates are less than the dividend yield, the opportunity cost of holding stocks is less and the futures price should fall below the current index price. There is usually a so-called arbitrage band in which, although the futures and underlying prices diverge, it is not worthwhile arbitraging the two. This arises as a result of transaction costs from bid-ask spreads, the market impact of buying and selling stock, and execution risks.
STOCK INDEX OPTION
An option, either exchange-traded or OTC, on a stock index.
STOCK OPTION
An option, either exchange-traded or OTC, on an individual equity.
STRADDLE
The sale or purchase of a put option and a call option, with the same strike price, on the same underlying and with the same expiry. The strike is normally set at-the-money. The purchaser benefits, in return for paying two premiums, if the underlying moves enough either way. It is a way of taking advantage of an expected upturn in volatility. Sellers of straddles assume unlimited risk but benefit if the underlying does not move. Straddles are primarily trading instruments.
STRANGLE
1) As with a straddle, the sale or purchase of a put option and a call option on the same instrument, with the same expiry, but at strike prices that are out-of-the-money. The strangle costs less than the straddle because both options are out-of-the-money, but profits are only generated if the underlying moves dramatically, and the break-even is worse than for a straddle. Sellers of strangles make money in the range between the two strike prices, but lose if the price moves outside the break-even range (the strike prices plus the premium received).
2) The term strangle is also used, by currency option traders, to denote the average difference in implied volatility between out-of-the-money call and put options with a 25% delta and the implied volatility of at-the-money forward options.
STRATEGIC ASSET ALLOCATION
The distribution of investment funds in response to long-term, fundamental expectations for markets.
See also
asset allocation
STRESS-TESTING
To perform a stress test on a derivatives position is to stimulate an extreme market event and examine its behavior under the “stress” of that event.
STRIKE PRICE (RATE)
See
option
STRUCTURED NOTE
Structured notes are over-the-counter products, which bundle several disparate elements to create a single product, generally by embedding options in a debt instrument such as a medium-term note. They are often view-oriented and are generally tailored to be attractive to investors with highly focused risk/reward appetites and opinions on the market. For example, a structured note might embed equity or currency options or forwards in a debt issue in an effort to enhance the yield of a normal debt holding. Heavily promoted in the early 1990s, structured notes fell out of favor somewhat in 1993–94 as a sequence of surprise market moves and widely publicized losses pointed to the difficulty of pricing and trading such instruments, as well as the cost of taking the incorrect market view. During this time, the comparatively undeveloped secondary market for structured notes allowed sophisticated relative value players to buy “broken” structured notes on an asset swapped basis much more cheaply than vanilla assets from the same issuers.
STRUCTURED YIELD INVESTMENTS
Any security (normally a structured note) whose yield is conditional on certain trigger conditions being met. Such a security is normally constructed by embedding path-dependent options (such as binary options) in a vanilla debt issue. The investor’s return on the note will then vary according to the pay-out of the options.
SUBSTITUTION OPTION
A bilateral financial contract in which one party buys the right to substitute a specified asset or one of a specified group of assets for another asset at a point in time or contingent upon a credit event.
SWAP
See
accreting,
annuity swap,
asset swap,
basis swap,
basket swap,
blended interest rate swap,
bond index swap,
callable swap,
capped swap,
collar swap,
commodity swap,
contingent swap,
credit default swap,
cross-currency swap,
debt-equity swap,
deferred swap,
delayed reset swap,
differential swap,
digital swap,
discount swap,
drop-lock swap,
dual currency swap,
equity (index) swap,
escalating rate swap,
extendible swap,
fixed-floating swap,
floating-floating swap,
forward swap,
high-coupon swap,
index amortizing+swap,
interest rate swap,
mortgage swap,
municipal swap,
naked swap,
participating swap,
periodic resetting swap,
power swap,
putable swap,
reverse index amortizing swap,
reversible swap,
roller-coaster swap,
roll-lock swap,
seasonal swap,
semi-fixed swap,
spread-lock swap,
step-down swap,
tax-exempt swap,
total rate of return swap,
warrant-driven swap,
variable notional swap,
yield curve swap,
zero coupon swap
SWap curve
The name given to the swap’s equivalent of a yield curve. The swap curve identifies the relationship between swap rates at varying maturities.
SWap insurance
Insurance policy purchased to guarantee obligations on a swap, which is underwritten to insure only the regularly scheduled payments under the swap, or also any termination payment that may be required under the swap.
SWAPTION
An option to enter an interest rate swap. A payer swaption gives the purchaser the right to pay fixed, a receiver swaption gives the purchaser the right to receive fixed (pay floating).
Apart from those in the sterling market, many swaptions are capital-market driven. Good-quality borrowers are able to issue putable or callable bonds and use the swaptions market to reduce their financing costs. In the case of callable bonds, the issuer effectively buys an option from the investor in return for a slightly higher coupon, so that it may benefit if rates decline. Because many of these embedded options have traditionally been underpriced, good-quality borrowers have been able to monetize this anomaly by selling an equivalent swaption (a receiver swaption) to a bank at market rates.
The profit from this arbitrage lowers funding costs. If the swaption is exercised against the issuer, it calls the bonds (although the issuer would almost certainly have called the issue given the reduction in rates). In the case of putable bonds, the borrower sells a swaption to the swaption market. The premium gained lowers the funding cost at the expense of leaving the borrower unsure of the maturity of the debt.
SWING OPTION
A derivative found in energy markets allowing the purchaser to vary energy delivery in terms of quantity and timing within specified limits.
SYNTHETIC AGREEMENT FOR FORWARD EXCHANGE (SAFE)
The generic term for exchange rate agreements (ERAs) and forward exchange agreements (FXAs). ERAs and FXAs were developed by Bar-clays Bank and Midland Montagu, respectively, to overcome the capital adequacy problems of foreign exchange forwards highlighted by Bank for Inter-national Settlements regulations. Safes are treated as interest rate, rather than foreign exchange, instruments in BIS regulations, so banks have to provide less capital to support outstandings. FXAs are settled with reference to both the spot rate and the forward premium/discounts; ERAs with reference only to the forward premium/discount.
SYNTHETIC ASSET
A synthetic asset is a combination of long and short positions in financial instruments which has the same risk/reward profile as another instrument. For example, it is possible to replicate the pay-out and exposure of a short futures position by going short European-style call options and long European puts with identical strikes and expiries. Synthetic index options can be generated either through positions in the underlying and futures contracts, or with a basket of vanilla options.
See also
replication
SYNTHETIC COLLATERALISED DEBT OBLIGATION
A synthetic collateralized debt obligation (CDO) uses credit derivatives to transfer credit risk in a portfolio. This is in contrast to a traditional CDO which is typically structured as a securitization with ownership of the assets transferred to a separate special purpose vehicle (SPV). The assets are funded with the proceeds of debt and equity issued by the vehicle. In a synthetic CDO, an institution transfers the total return or default risk of a reference portfolio via a credit default swap, a total return swap, or a credit-linked note. The SPV then issues securities with repayment contingent upon the loss on the portfolio. Proceeds are either held by the vehicle and invested in highly rated, liquid collateral, or passed-on to the institution as an investment in a credit-linked note.
Balance sheet synthetic CDOs are typically used by banks to manage risk capital and are easier to execute than traditional CDOs. Arbitrage synthetic CDOs are often used by insurance companies and asset managers and exploit the spread between the yield on the underlying assets and the reduced expense of servicing a CDO structure.
SYNTHETIC FORWARD
See
synthetic asset
SYNTHETIC OPTION
See
synthetic asset,
replication
SYNTHETIC SECURITISATION
A first-loss basket swap structure that references a portfolio of bonds, loans or other financial instruments held on a firm’s balance sheet. The technique replicates the credit risk transfer benefits of a traditional cash securitization while retaining the assets on balance sheet. Advantages over cash securitization include reduced cost, ease of execution and retention of on-balance sheet funding advantage.
SYSTEMIC RISK
The risk that the financial system as a whole may not withstand the effects of a market crisis. Concern on the part of banking regulators has been caused by the concentration of derivative risk among a relatively small number of market participants, with the concomitant risk that the failure of a major dealer could have serious knock-on effects for many other market participants.