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

Exact Matches:

BASIS RISK

In a futures market, the basis risk is the risk that the value of a futures contract does not move in line with the underlying exposure. Because a futures contract is a forward agreement, many factors can affect the basis. These include shifts in the yield curve, which affect the cost of carry; a change in the cheapest-to-deliver bond; supply and demand; and changing expectations in the futures market about the market’s direction.

Generally, basis risk is the risk of a hedge’s price not moving in line with the price of the hedged position. For example, hedging swap positions with bonds incurs basis risk because changes in the swap spread would result in the hedge being imperfectly correlated. Basis risk increases the more the instrument to be hedged and the underlying are imperfect substitutes.

Partial Matches:

ACCRUAL ACCOUNTING

When swaps are used for asset/liability hedging purposes, that is, to hedge specific on-balance sheet exposures, they are often accounted for on an accrual basis. Under the accrual method, the net payment or receipt each period is accrued and recorded as an adjustment of income or expense.

See also hedge accounting, mark to market

ALTERNATIVE RISK TRANSFER

An approach to risk management combining capital markets, reinsurance and investment banking techniques that allows a party to either free itself from risks not easily transferred via traditional insurance, or alternatively cover such risks in a non-traditional way – by using the capital markets for example.

ARBITRAGE

A guaranteed or riskless profit from simultaneously buying and selling instruments that are perfect equivalents, the first being cheaper than the second.

ASSET ALLOCATION

The distribution of investment funds within a single asset class or across a number of asset classes (such as equities, bonds and commodities) with the aim of diversifying risk or adding value to a portfolio.

ASSET/LIABILITY MANAGEMENT

The practice of matching the term structure and cashflows of an organization’s asset and liability portfolios in order to maximize returns and minimize interest rate risk. An institutional example of this would be a bank converting a fixed-rate loan (asset) by utilizing a fixed-for-floating interest rate swap to match its floating rate funding (deposits).

AUction rate securities

A debt instrument used by tax-exempt and corporate issuers with a long term maturity for which the interest rate is adjusted either daily, or every seven, 28 or 35 days. The interest rate adjustments are determined by an auction, in which the remarketing agent (typically a securities dealer) takes bids from investors in the form of a yield and amount. The remarketing agent then determines the lowest rate to clear the outstanding amount of auction rate securities (ARS).

In early 2008, as the credit crunch continued, Wall Street firms which served as the remarketing agent for the auctions stopped bidding on the auctions themselves, and the auctions failed. A failed auction simply means that there were not enough ‘buy’ orders to fill the number of ‘sell’ orders. In the relatively opaque bidding process, many dealers were supporting auctions by bidding on the ARS to prevent the auction from failing. The result was that many investors who held this paper were not able to sell it, and the investments became illiquid. Because ARS have no bank liquidity facility, there is no put option available for the investor. In the event of a failed auction, the interest rates jump to a pre-determined max rate. The max rates can be absolute, such as 12%, or formulaic, such as 6-month commercial paper + 100 basis points, for example. In the spring of 2008, there were widespread auction failures in the $165 billion municipal ARS market. Many issuers were experiencing borrowing costs that greatly exceeded their budget, and by the summer of 2008, over half of the outstanding municipal ARS had been converted to another debt mode, such as fixed rate, or variable rate bonds.

BARRIER RISK

The value and sensitivities (Greeks) of barrier options can be subject to large swings when the spot rate is at, or near, the trigger level. This is particularly true for reverse barrier options and geared barrier options, where the option has positive intrinsic value at the Barrier. The specific nature of these swings can make the management of such products riskier, hence barrier risk.

BASEL CAPITAL ACCORD

The Basel Capital Accord was first issued in July 1988 by the Basel Committee on Banking Supervision, a panel of banking supervisory authorities established by the central bank Governors of the Group of Ten (G-10) countries in 1975. In April 1993, the Committee announced preliminary details of a package of supervisory proposals for applying capital charges to the market risk of banks. These proposals were centered on the use of a standardized “building-block” methodology, similar to the one eventually used in the European Union’s Capital Adequacy Directive.

  After two years of industry comment, a revised version of the proposed Supplement to the Accord was released in April 1995. The main change was that banks could now calculate capital requirements using their own in-house models as an alternative to the standardized methodology, subject to their regulator’s approval. Following a second period of industry comment, the Committee issued the final version of the Supplement in January 1996, due for implementation by the G-10 supervisory authorities by the end of 1997. This version included the recognition of empirical correlations across broad risk factor categories.

  The supplemented Accord specified both quantitative and qualitative requirements for in-house models. The crucial quantitative requirement is that banks should calculate 99th percentile value-at-risk every day, working with a holding period of 10 days and a historical observation period of a year. Furthermore, it was proposed that there would be additional charges for those banks whose models failed to perform adequately in historical back-testing or were felt to possess specific risk factors.

  In June 1999 the Basel Committee formally released its long-awaited proposal for a new Capital Accord. This first consultative paper signaled a move towards using credit ratings rather than OECD status to set capital allocations. In January 2001 the second consultative paper was released. This new paper – dubbed Basel II – retained the 1999 proposal’s three-pillar approach that included minimal capital requirements, market discipline and supervisory review, but also included substantial additions. Three distinct methods for the calculation of minimum capital requirements were proposed.

  Firstly, a standardized approach geared towards smaller banks was proposed. Exposures to different counterparties will be quantified in terms of risk weights based on assessments by external ratings agencies – with more sensitivity to ratings than in previous risk-bucketing plans.

  For more sophisticated banks, two internal ratings-based (IRB) approaches to credit risk have been devised – the foundation and advanced – that allow greater use of banks’ own internal credit risk models. It is the Basel Committee’s intention to tailor regulations so that banks are encouraged to migrate towards the more sophisticated approaches, and that these new approaches bring regulatory capital more closely in line with the economic capital that banks calculate they should be holding, as determined by their own internal models.

  Implementation of Basel II is due in 2005. Features of Basel II that have caused most discussion include the 20% operational risk charge, a 1.5 multiplication factor in the IRB risk weightings and the w charge for credit derivatives.

BASIS

1. The difference between the prices of a futures contract and the underlying.
2. The convention for calculating interest rates. A bond can be 30/360 or actual/365 in the US, or 360/360 in Europe. Money market instruments can be actual/360 in the US or actual/365 in the UK and Japan.

BASIS SWAP

An interest rate basis swap or a cross-currency basis swap is one in which two streams of floating rate payments are exchanged. Examples of interest rate basis swaps include swapping $Libor payments for floating commercial paper, Prime, Treasury bills, or Constant Maturity Treasury rates; this is also known as a floating-floating swap. A typical cross-currency basis swap exchanges a set of Libor payments in one currency for a set of Libor payments in another currency.

BASIS TRADING

To basis trade is to deal simultaneously in a derivative contract, normally a future, and the underlying asset. The purpose of such a trade is either to cover derivatives sold, or to attempt an arbitrage strategy. This arbitrage can either take advantage of an existing mispricing (in cash-and-carry arbitrage) or be based on speculation that the basis risk will change.

BASKET CREDIT DEFAULT SWAP

A credit default swap which transfers credit risk with respect to multiple reference entities. For each reference entity, an applicable notional amount is specified, with the notional of the basket swap equal to the aggregate of the specified applicable notional amounts. Types of basket credit default swaps include linear basket credit default swaps, first-to-default basket credit default swaps, and first-loss basket credit default swaps.

BETA

1. The beta of an instrument is its standardized covariance with its class of instruments as a whole. Thus the beta of a stock is the extent to which that stock follows movements in the overall market. If a stock has a beta greater than one, it is more volatile than the market; if less than one, it is less volatile.
2. Beta trading is used by currency traders if they take the volatility risk of one currency in another. For example, rather than hedge a sterling/yen option with another sterling/yen option, a trader, either because of liquidity constraints or because of lower volatility, might hedge with euro/yen options. The beta risk indicates the likelihood of the two currencies’ volatilities diverging.

BLACK-SCHOLES MODEL

The original closed-form solution to option pricing developed by Fischer Black and Myron Scholes in 1973. In its simplest form it offers a solution to pricing European-style options on assets with interim cash pay-outs over the life of the option. The model calculates the theoretical, or fair value for the option by constructing an instantaneously riskless hedge: that is, one whose performance is the mirror image of the option pay-out. The portfolio of option and hedge can then be assumed to earn the risk-free rate of return.

Central to the model is the assumption that market returns are normally distributed (i.e., have lognormal prices), that there are no transaction costs, that volatility and interest rates remain constant throughout the life of the option, and that the market follows a diffusion process. The model has five major inputs: the risk-free interest rate, the option’s strike price, the price of the underlying, the option’s maturity, and the volatility assumed. Since the first four are usually determined by the market, options traders tend to trade the implied volatility of the option.

BOND FUTURE

A futures contract on a bond. The underlying can be of two types. The first is a notional (theoretical) bond, for example the 10-year government bond futures contract on Marché à Terme International de France (Matif), which has a notional seven- to 10-year underlying government bond with a 10% coupon. The second type is a futures contract on a specific bond, for example, the futures contract on the Danish government bond 8% 2000, listed on the Guarantee Fund for Danish Options and Futures. The notional type is more common.

The theoretical price of a bond futures contract equals the spot price of the underlying bond plus its net cost of carry. The higher the cost of carry (measured by its implied repo rate) for the cash bond, the more value there is in holding a futures contract instead, which is simply another way of buying a cash bond but at a future date. If the financing costs of holding a bond are lower than the bond’s yield, the bond will have positive carry and the futures contract will trade at a discount. If the financing costs of the bond are higher than the bond’s yield, the futures will trade at a premium. Hence bond futures normally trade at a discount to the cash in an upward-sloping yield curve and at a premium in a downward-sloping one. The degree of premium or discount will decrease the closer the futures contract is to expiry.

When futures are based on a notional bond, the exchange has to specify which bonds are deliverable into the futures contract. These can change periodically as outstanding issues get shorter and reach maturity. Because bonds have differing coupons, the exchange has to specify a conversion factor that allows those bonds to be compared on an equal basis to the notional underlying. A bond’s conversion factor is the value of one unit of that bond were it to trade at a yield to maturity equal to that of the notional bond. Because of demand/supply conditions, some bonds will be cheaper to deliver than others. The cheapest to deliver will be those where the greatest profit can be made from holding the bond and delivering it into the futures contract (called cash-and-carry arbitrage). This is dependent on the supply of bonds in the market, and on a bond’s maturity and coupon.

BOX

To buy/sell mispriced options and hedge the market risk using only options, unlike the conversion or the reversal, which use futures contracts. If a certain strike put is underpriced, the trader buys the put and sells a call at the same strike, creating a synthetic short futures position. To get rid of the market risk, he sells another put and buys another call, but at different strike prices.

BUILDING-BLOCK APPROACH

The building block approach to calculating capital adequacy is the basis for the quantitative requirements of the European Union’s Capital Adequacy Directive (CAD), as well as the standardized approach of the Basel Capital Accord. This approach recognizes to some extent the risk reduction that arises from offsetting positions, but treats individual market risks as additive, and further distinguishes between general market risk and specific risk, the latter reflecting risks specific to individual securities. Capital is charged as a percentage of the net face value of various positions, the percentage being a function of the type and tenor of security, and of the type of risk.

BUTTERFLY SPREAD

The simultaneous sale of an at-the-money straddle and purchase of an out-of-the-money strangle. The structure profits if the underlying remains stable, and has limited risk in the event of a large move in either direction. As a trading strategy to capitalize upon a range trading environment it is usually executed in equal notional amounts.

Alternatively, such trades are often applied to benefit from changes in volatility. In such circumstances the butterfly spread is traded on a “vega-neutral” basis (i.e., the volatility sensitivity of the long position is initially offset by the volatility sensitivity of the short position). As the holder of an initially vega-neutral spread, the trader will benefit from changes in volatility since the strangle position profits more from an increase in volatility than the straddle and loses less than the straddle in a decline in volatility (this is due to the fact that the vomma of the strangle is higher than that of the straddle).

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.

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 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.

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 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.

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.

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.

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.

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.

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.

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.

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 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 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 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 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.

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.

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.

DEBT service fund

Debt service funds are usually required to be deposited with a trustee or in another segregated manner on a monthly basis to meet semi-annual debt service interest payments (1/6 per month) and annual principal payments (1/12 per month). Traditional investment techniques result in these monies being invested short-term and earning short-term rates of interest.

  As an alternative, a debt service fund forward purchase agreement offers an issuer a higher rate of return on invested monies, along with the option of receiving an up-front payment equaling the present value of that future stream of income.

  These agreements can be structured on either a delivery versus payment (DVP) or swap basis. On a DVP basis, the counterparty will deliver to the issuer or issuer’s trustee a U.S. Treasury security maturing prior to the semi-annual debt service payment date with a face value equaling the debt service amount deposited with the counterparty. On a swap basis, the issuer transmits the actual semi-annual earnings on U.S. Treasury Bill investments (variable) in exchange for the guaranteed rate (fixed). On this basis, the counterparty can deliver an upfront payment of a fixed yield over time.

  Collateral on the agreements can range from treasury securities to agency securities to commercial paper to uncollateralized. The collateral requirement corresponds directly with the yield.

  In the event the issue is refunded, a breakage fee may be incurred requiring a payment to the counterparty, thereby reducing the earlier received cash payment. For instance, if an issuer were to enter into an agreement and receive an up-front payment of the cash flow for thirty years, the issuer is contracting to deliver a 20-year stream of monthly cash payments. If the issuer later chooses to call the bonds after seven years, the issuer will be subject to a breakage fee because the issuer will be unable to deliver this stream of cash. To avoid this the issuer can limit the agreement to the first call date rather than out to the final maturity of the issue.

DEFAULT RISK

See credit risk

DIFFERENTIAL SWAP

A quanto product, typically involving the combination of a simple interest rate swap in the denominating currency, and a quantized swap denominated in the same currency but referenced to a different currency. For example, a counterparty receives euro six-month Libor, denominated in euros, and pays US dollar six-month Libor, denominated in euros plus a spread approximately equal to the difference between the fixed rates of the simple swap and the quantized swap as quoted on the same basis, e.g., semi-annual 360.

DISCOUNT SWAP

An off-market swap in which the fixed payments are below the market rate. At the end of the swap the shortfall is made up by one payment. Construct-ion and project finance companies use this type of structure to reduce interest rate payments before start-up and during completion of a project. The more interest rate payments are discounted, the more credit risk is taken by the counterparty.

DYNAMIC REPLICATION

To replicate the pay-out of an option by buying or selling the underlying (or for some markets, because of cheaper transaction costs, futures) in proportion to an option’s delta. If replicating a short call position, the replicator would, as the underlying went up, buy increasing amounts in proportion to the theoretical option’s delta, and likewise decrease the hedge amount as the market falls. Dynamic replicators are at risk from increases in volatility, as this makes it more difficult for the necessary hedge amounts to be transacted at the desired rate.

EQUILIBRIUM MODEL

A model that specifies processes for the underlying economic variables and the extra risk premium investors require for risky assets. The evolution of asset prices and their risk premiums can then be derived from the model thus specified.

EXit price

The revised standard for fair value measurements. The price to sell an asset or transfer a liability; taking into account non-performance risk and excluding transaction costs.

EXPOSURE

A firm’s exposure is its vulnerability to loss from unanticipated events. These events might include movement in financial market variables, such as foreign exchange rates, interest rates, commodity prices or volatilities. Alternatively, a firm could be exposed to credit risk, operational risk, or legal risk. Recognizing and minimizing – or optimizing – exposure is the function of risk management.

FORWARD RATE AGREEMENT

A forward rate agreement (FRA) allows purchasers/sellers to fix the interest rate for a specified period in advance. One party pays fixed, the other an agreed variable rate. Maturities are generally out to two years and are priced off the underlying yield curve. The transaction is done on a nominal amount and only the difference between contracted and actual rates is paid. If rates have risen by the time of the agreement’s maturity, the purchaser receives the difference in rates from the seller and vice versa. A swap is therefore a strip of FRAs. FRAs are off-balance sheet – there are no up-front or margin payments and the credit risk is limited to the mark-to-market value of the transactions. Unlike interest rate swaps, FRAs settle at the beginning of the interest period, two business days after the calculation date.

FUTURE

A future is a contract to buy or sell a standard quantity of a given instrument, at an agreed price, on a given date. A future is similar to a forward contract and differs from an option in that both parties are obliged to abide by the transaction. Futures are traded on a range of underlying instruments including commodities, bonds, currencies, stock indices and even pollution.

  The most important difference between futures and forwards is that futures are almost always traded on an exchange and cleared by a clearing house, whereas forwards are over-the-counter instruments. Furthermore, futures, unlike forwards, have standard delivery dates and trading units. Most futures contracts expire on a quarterly basis. Contracts specify either physical delivery of the underlying instrument or cash settlement at expiry. Cash settlement involves the company paying or being paid the difference between the price struck at the outset and the expiry price of the contract.

  The clearing house is crucial, acting as the counterparty to all transactions; that is, it acts as the buyer to the seller of the future, and as the seller to the buyer. Since for every long futures position there must be a short position, the clearing house has a net position of zero at the end of each day. It also operates a system known as margining. On entering a transaction, a company will be required to lodge a specified sum of money (initial margin) with the clearing house. The amount depends on how much the clearing house considers prudent to set aside to protect against a dramatic move in the underlying market. Each day, the company also gives or receives variation margin, which is the difference between the original contractual price and the daily closing price.

  In pricing futures, an important distinction is between futures on assets held for investment and those held almost exclusively for consumption (such as pork bellies or soya beans). The price of futures on investment assets is determined by the relative interest rates or dividend yields of the asset and cash, such as to eliminate riskless arbitrage through buying the future and selling the asset or vice versa. By contrast, futures on commodities not held for investment cannot readily be priced by an arbitrage approach – perceived supply and demand considerations are much more significant.

  Futures provide a formalized method of transferring risk from those wanting to reduce their market exposure to those wanting to increase it. For example, futures markets allow commodity producers to hedge against falling prices, or fund managers to weight their stock, bond or currency portfolios according to their required risk profiles.

  For fund managers, futures also provide a way of entering and exiting markets with typically much lower transaction costs (friction) than would be the case with cash alternatives. This is especially true in equity markets. Because of their standardized nature, however, futures contracts may not match precise hedging needs. Instead the hedger may incur basis risk, the risk that the return on the futures position may differ from that on the spot.

GAO REPORT

The colloquial name for the May 1994 report “Financial Derivatives: Actions Needed to Protect the Financial System” published by the US General Accounting Office, the investigative arm of Congress. The report made six key points:
    •     Derivatives perform a valuable function by enabling end-users to manage the financial risks associated with their business
    •     The concentration of over-the-counter (OTC) derivatives activity among 15 extensively linked major US dealers opens up the possibility of liquidity problems and systemic risk should any of these dealers fail
    •     There are no comprehensive or federal regulatory requirements to ensure that major OTC players in the US follow good practice in risk management, so newcomers could increase the systemic risk by taking on unnecessary risk
    •     Significant gaps exist in the regulation of many major OTC derivatives, most notably affiliates of securities firms and insurance companies
    •     Insufficient precision in accounting for and financial reporting of derivatives compound the difficulties faced by interested parties when trying to assess their impact
    •     Innovation and creativity are strengths of the US financial services industry which should not be shackled by over-regulation.

GROUP OF THIRTY REPORT

The colloquial name for the July 1993 report “Derivatives: Practices and Principles” of the Global Derivatives Study Group of the Group of Thirty, a private think-tank of dealers, end-users, academics, accountants and lawyers. The report made 20 recommendations on best practices for derivatives management, based on the results of a survey of banks and end-users. (A follow-up survey was conducted in 1994). The report suggested a number of operational improvements for firms using derivatives. These included: involving senior management in policy-making for derivatives, authorizing only skilled professionals to trade derivatives, and establishing autonomous market and credit risk management functions with sophisticated reporting and measurement systems.

On market risk, the report recommended marking derivatives positions to market on a regular basis, quantifying and stress-testing for market risk under extreme market events. On credit risk, it suggested comparing credit exposure with credit limits frequently and establishing legal provisions for default scenarios. It also called for market participants voluntarily to adopt standard accounting and disclosure procedures for international harmonization and greater transparency.

In addition, the report called upon regulators, legislators and supervisors to recognize close-out netting agreements and the provisions of the Basel Capital Accord when setting bank capital requirements, work with market participants to reduce legal uncertainties and improve accounting and disclosure procedures connected with derivatives, and amend tax regulations which disadvantaged the economic use of derivatives.

GUARANTEED EXCHANGE RATE OPTION

An option (also known as a quanto option) on an asset in one currency denominated in a second currency. The exchange rate at which the purchaser converts the currency is fixed at the start. Such options are increasingly popular as investors want exposure to foreign assets without the foreign exchange risk. Most of the demand is for bond and stock index options. The extra cost of the option depends on the correlation between movements in the exchange rate and movements in the underlying. The higher (more positive) the correlation between the underlying and the exchange rate (expressed as the number of units of currency two per unit of currency one) the more expensive a call option will be and the cheaper a put option will be. Quanto options can, however, look cosmetically cheaper (or more expensive) depending on the forward interest rates in the two currencies. For example, buying a call on a US asset could be “cheaper” in euros if there is a wide interest rate differential between the euro and the dollar.

GUARANTEED investment contract (GIC)

A Guaranteed Investment Contract ("GIC") is a contract between a municipal entity or 501(c)(3) organization and a financial institution (the "Provider") in which the Provider guarantees a rate of return on bond proceeds deposited under the investment contract. Guaranteed Investment Contracts have proven to satisfy the unique economic, tax and legal requirements associated with the investment of tax-exempt bond proceeds and have been used with increasing frequency among tax-exempt issuers.

  A GIC offers the preservation of principal, earns a fixed yield, and allows for access to funds with no market risk. A GIC is particularly well suited for construction funds because it allows for full flexibility of draws, thus eliminating any market and/or reinvestment risk if construction draws fluctuate for any reason. GICs can also be used for debt service reserve funds, bond funds, and escrow funds, with draws occurring semi-annually on bond payments dates or as required by the Indenture. The yield on an investment contract will generally exceed the yield on a repurchase agreement by approximately 30 basis points.

  Guaranteed investment contracts can be structured with varying degrees of security. Typically, the security is provided by requiring the Provider of the GIC to maintain a certain level of long-term credit rating by one or more of the recognized Rating Agencies. The rating requirement for the Provider is often determined by the Indenture or other bond documents. In the event the Provider is downgraded below a certain level (e.g. below the "A" category from Moody's or Standard & Poor's) while the GIC is in place, then the Provider is required to provide additional security such as posting collateral with an independent third-party or assigning the contract to a new provider that both meets the rating requirement and is acceptable to the Issuer.

  Documentation for a GIC is usually a straight forward contract between the Provider of the GIC and the Trustee and/or the Issuer.

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

HERSTATT RISK

See settlement risk

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.

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.

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.

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.

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.

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

LEGAL RISK

The risk that a counterparty to a transaction will not be liable to meet its obligations under law. This may be the case for a variety of reasons. Most fundamentally, the transaction may not be sufficiently well documented to be enforceable under law.

  A counterparty may argue that it was not sufficiently well advised of the nature and risks of a transaction prior to entering into it. This may be exacerbated if it can be demonstrated that a dealer was previously acting in a fiduciary (advisory) role, or if the dealer is found guilty of professional misconduct when making the deal. Alternatively, the transaction itself may not comply with the relevant law. For example, it is illegal to trade futures outside a regulated exchange under the terms of the US Commodity Exchange Act.

  A contract may also be may deemed unenforceable if the agent acting on behalf of the counterparty was not authorized to do so. A counterparty may in fact be legally constrained from entering certain types of transaction.

  For example, the London Borough of Hammersmith and Fulham, a British local authority, had extensive involvement in the sterling swaps market between 1986 and 1989. These deals, which far exceeded the council’s debt, were judged in 1989 to be speculative and beyond the council’s powers, leaving those dealers who stood to gain from the council’s losses unable legally to seek redress.

LIQUIDITY RISK

The risk associated with transactions made in illiquid markets. Such markets are characterized by wide bid/offer spreads, lack of transparency and large movements in price after a deal of any size. A firm wishing to unwind a portfolio of illiquid instruments (for example, highly tailored structured notes) may find it has to sell them at prices far below their fair values, exacerbating the problems that prompted the decision to unwind.

MARK to market

To mark-to-market is to calculate the value of a financial instrument (or portfolio of such instruments) based on the current market rates or prices of the underlying. Marking-to-market on a daily (or more frequent) basis is often recommended in risk management guidelines.

See also accrual accounting, hedge accounting

MARKET RISK

Exposure to a change in the value of some market variable, such as interest rates or foreign exchange rates, equity or commodity prices. For holders of a derivatives position, market risk may be passed through from a change in the value of the underlying to the price of the derivative, or may arise from other sources, such as implied volatility or time decay.

MERTON MODEL OF CREDIT RISK

See Credit Risk Models

MId-market

The mid-point between the “bid” and “offer” market rate/price, commonly used as a basis for pricing swaps.

MONTE CARLO SIMULATION

A method of determining the value of a derivative by simulating the evolution of the underlying variable(s) many times over. The discounted average outcome of the simulation gives an approximation of the derivative’s value. This method may be used to value complex derivatives, particularly path-dependent options, for which closed-form solutions have not been or cannot be found. Monte Carlo simulation can also be used to estimate the value-at-risk (VAR) of a portfolio. In this case, a simulation of many correlated market movements is generated for the markets to which the portfolio is exposed, and the positions in the portfolio revalued repeatedly in accordance with the simulated scenarios. The result of this calculation will be a probability distribution of portfolio gains and losses from which the VAR can be determined. The principal difficulty with Monte Carlo VAR analysis is that it can be very computationally intensive.

NATURAL HEDGE

A natural hedge is the reduction in financial risk that can arise from an institution’s normal operating procedures. For instance, a company that has a significant portion of its sales in one country will have a natural hedge to at least part of its currency risk if it also has operations in that country generating expenses in the currency. Firms may act to increase natural hedges by changing sourcing, funding, or operational decisions, but natural hedges are less flexible, and more difficult to reverse, than financial hedges.

NEGATIVE BASIS

Negative basis exists when the cost of buying protection (in the credit derivative market) on a particular reference entity is less than the credit spread (generally expressed as a spread to Libor) on a bond or note of similar maturity issued by that reference entity. When this occurs, investors can lock in riskless profit by buying bonds and buying credit protection. These arbitrage opportunities are generally only available to investors whose cost of funds is Libor flat or better (since funding the bond or note at Libor plus a spread will erode the arbitrage). Technical factors between the bond and credit derivative market account for negative basis.

See credit derivative.

Non-deliverable forward (NDF)

Non-deliverable forward contracts (NDFs) – also called dollar-settled forwards – are synthetic forwards which entail no exchange of currencies at maturity. Instead, settlement is made in US dollars based on the difference between the agreed contract rate at inception and a market reference rate at maturity. NDFs can be used to establish a hedge or take a position in one of a growing group of emerging market currencies where conventional forward markets either do not exist or may be closed to non-residents. As offshore instruments, NDFs offer the advantage of eliminating convertibility risk, since no emerging market currencies are exchanged at maturity.

non-performance risk

FASB’s Statement 157 clarifies that a fair value measurement for a liability should reflect the risk that the obligation will not be fulfilled. A reporting entity’s own credit risk is a component of the nonperformance risk associated with its obligations and, therefore, should be considered in all periods in which a liability is measured at fair value.

notional amount (notional principal)

Similar to bond principal amount; used as the basis to determine the amount of swap interest payments. The Notional Amount will often amortize over time to match the amortization of the bonds to which the swap is related.

OMEGA

The currency risk that arises when the buyer or seller of an option has to account for the transaction in a different currency.

OPERATIONAL RISK

The risk run by a firm that its internal practices, policies and systems are not rigorous or sophisticated enough to cope with untoward market conditions or human or technological errors. Although operational risk is not as easy to identify or quantify as market or credit risk, it has been implicated as a major factor in many of the highly-publicized derivatives losses of recent years.

Sources of operational risk include: failure to correctly measure or report risk; lack of controls to prevent unauthorized or inappropriate transactions being made (the so-called “rogue trader” syndrome); and lack of understanding or awareness among key staff.

OPTION

A contract that gives the purchaser the right, but not the obligation, to buy or sell an underlying at a certain price (the exercise, or strike price) on or before an agreed date (the exercise period).

  For this right, the purchaser pays a premium to the seller. The seller (writer) of an option has a duty to buy or sell at the strike price, should the purchaser exercise his right. With European-style options, purchasers may take delivery of the underlying only at the end of the option’s life. American-style options may be exercised, for immediate delivery, at any time over the life of the option. Holders of semi-American-style or Bermudan options may be exercised on specified dates – typically on a monthly or quarterly basis.

  Options can be bought on commodities, stocks, stock indexes, interest rates, bonds, currencies, etc. The trading terminology, though, may change according to the product. In most cases, the right to buy the underlying is known as a call, and the right to sell, a put.

  Options are traded on formal exchanges and in over-the-counter (OTC) markets. The exchanges, such as the Chicago Board Options Exchange, the London International Financial Futures and Options Exchange and the Philadelphia Stock Exchange, provide primarily standardized options; the OTC markets are able to provide tailored products to fit specific requirements. The choice between OTC and exchange-traded options will depend on the degree of tailoring required, the relative liquidity of both markets (this varies greatly according to the underlying) and credit concerns.

  Such credit concerns increase with the option’s maturity, since the likelihood that a counterparty will default increases with the length of time that passes between the option being bought and being exercised. Several derivatives exchanges have tried to bridge the gap between OTC and exchange-traded options by introducing flexible options that can be customized by the purchaser.

  Pricing models for simple or vanilla options have five major inputs: the option’s exercise or strike price; the time to expiration; the price of the underlying instrument; the risk-free interest rate on the underlying instrument, and the volatility of the underlying instrument (See also historical volatility, implied volatility).

  European-style options are usually priced off a closed-form analytical model first published by Fischer Black and Myron Scholes in 1973, which has subsequently been modified to fit different underlyings (see Black-Scholes model).

  At maturity, an option’s value will depend on the value of the right to buy or sell a product. If an option is purchased giving the right to buy gold at $375 an ounce and at expiration the price is $400, the option is worth $25.

  The extent to which an option is in-the-money (how far the strike price is below/above the current forward market price) is called its intrinsic value. Where the strike price is less favorable than the market price, the option is said to be out-of-the-money, and where the two prices are the same it is at-the-money.

  At any time before maturity, an option’s price will be a combination of its intrinsic value (which is always either greater than, or equal to, zero) and its time value. The latter includes the cost of carry and the probability that the price of the underlying will move into or remain in the money. Options can broadly be used in two ways – for speculation, or for insurance. Their usefulness, both from a buyer’s and a seller’s point of view, derives from their pay-outs.

  In contrast to other types of hedge, options provide insurance against unfavorable moves in a product’s price and the opportunity to take advantage of favorable moves. Forwards and futures, for example, require buyers and sellers to lock into one rate. In return for assuming this risk, sellers of options receive a premium, effectively a risk-taking fee.

  The pay-off of a purchased option means that the price risk of an option is limited to its premium – it is not as exposed to adverse movements as a position in the underlying.

  For speculators selling (writing) options, this often means taking a naked option position and therefore being exposed to adverse movements in the underlying. Hedgers may sell options to garner premium to offset any expected slight downturn in a market. Since option premiums are only a fraction of the cost of the underlying product, it is possible to achieve a much greater exposure to price changes of the underlying compared with a similar investment directly in the product – this is called leverage.

OPTION COMBINATION STRATEGIES

Options may be combined so that their pay-outs produce a desired risk profile. Some combinations are primarily trading strategies, but option combinations can be useful in, for example, allowing investors to construct a strategy to take advantage of a particular view they have of the market. Other strategies allow purchasers to reduce their premiums by giving up some of the benefits they may have received from market movements.

See also bear spread, bull spread, calendar spread, call spread, condor, cylinder, put spread, ratio spread, straddle, strangle

OVERLAY

A strategy to change the exposure of a portfolio using derivatives, while leaving the securities in the underlying portfolio unchanged. This has the advantage of cost and flexibility, as portfolio managers can adjust portfolio risk more quickly and cheaply with derivatives than by liquidating portfolio holdings. Another reason might be tactical – the adjustment may only be desired for a brief period of perceived market threat. A third reason might be to transform a portfolio risk; an international fund manager may wish to segregate the currency aspect of a portfolio and can do so with a currency overlay program.

See also asset allocation, portfolio insurance

PERIODIC CAP

A cap in which the strike rate can vary from period to period. The strike rate in a given period depends upon the strike set in the previous period. Such caps are normally set at a fixed number of basis points above the previous strike, or the index (for example, Libor) plus a spread. Periodic caps can be with or without “memory”. A periodic cap without memory simply looks at the strike in the immediately preceding period to determine a new strike, while one with memory may look at previous settings in determining the new strike. Periodic caps are common features in adjustable rate mortgages (ARMs) in the US where the borrower’s floating interest payments cannot go up by more than a set number of basis points in a given year.

PERIODIC FLOOR

A floor in which the strike rate can vary from period to period. The strike rate in a given period depends upon the strike set in the previous period. Such floors are normally set at a fixed number of basis points above the previous strike or the index (for example Libor) plus a spread.

PIN RISK

The phenomenon where a small move in the underlying can have a significant impact on the value of an at-the-money option shortly before expiration.

PORTFOLIO INSURANCE

A strategy developed in the 1980s as a way of limiting losses on risky asset portfolios. Because put options were not widely available, the strategy synthetically reproduced the pay-out of a put option by a delta-hedging program. As long as markets move continuously, transaction costs are minimal and volatility is relatively stable, option returns can be easily replicated, although one can not predetermine a maximum cost.

The effectiveness of such a strategy was thrown into doubt with the crash of 1987. The unprecedented levels of volatility and the lack of liquidity made the strategy extremely difficult to implement. Its reputation suffered and it was widely blamed for exacerbating the severity of the collapse. Portfolio insurance has not entirely disappeared, though. Some fund managers still synthetically replicate option pay-outs rather than pay option premium, especially if they think volatility will fall. However, most such strategies now involve the covering of a certain amount of volatility risk by buying out-of-the-money options.

POSITIVE BASIS

Positive basis exists when the cost of buying protection (in the credit derivative market) on a particular reference entity exceeds the credit spread (generally expressed as a spread to Libor) on a bond or note of similar maturity issued by that reference entity. When this occurs, investors looking to gain exposure to the reference entity can improve their expected return on an investment by taking exposure to the credit by selling protection in the credit derivative market rather than buying the bond or note. Technical factors between the bond and credit derivative market account for positive basis.

PREPAYMENT RISK

The risk that the value of a mortgage-backed security will change due to a change in the prepayment behavior of the mortgages upon which it is based. If a mortgage is prepaid, the principal of the security declines, as does its average life, although its final maturity remains unchanged. This will in turn affect the duration of the security and its value. Prepayment risk also occurs with callable bonds and cancellable swaps, in which case it refers to the reinvestment risk that an investment repaid early may have to be reinvested at a lower rate of return.

PUT-CALL PARITY

The relationship between a European-style put option and a European-style call option on the same underlying with the same exercise price and maturity. Put-call parity states that the pay-off profile of a portfolio containing an asset plus a put option is identical to that of a portfolio containing a call option of the same strike on that same asset (with the rest of the money earning the risk-free rate of return). In practice, a put option on, say, a stock index, can be constructed by shorting the stock and buying a call option. The relationship means that traders are able to arbitrage mispriced options.

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 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.

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 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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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 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.

TAX risk

The risk that the spread between the taxable and tax-exempt rate will change as a result of changes in income tax laws or other conditions.

TOTAL RATE OF RETURN SWAP

A bilateral financial contract in which one party (the total return payer) makes floating payments to the other party (the total return receiver) equal to the total return on a specified asset or index (including interest or dividend payments and net price appreciation) in exchange for amounts which generally equal the total return payer’s cost of holding the specified asset on its balance sheet. Price appreciation or depreciation may be calculated and exchanged at maturity or on an interim basis. A total (rate of) return swap is a form of credit derivative, but is distinct from a credit default swap in that floating payments are based on the total economic performance of a specified asset and are not contingent upon the occurrence of a credit event.

TRANSLATION RISK

An accounting/financial reporting risk where the earnings of a company can be adversely affected due to its method of accounting for foreign operations.

VALUE-AT-RISK

Formally, the probabilistic bound of market losses over a given period of time (known as the holding period) expressed in terms of a specified degree of certainty (the confidence interval).

Put more simply, the value-at-risk (VAR) is the worst-case loss expected over the holding period within the probability set out by the confidence interval. Larger losses are possible, but with a low probability. For instance, a portfolio whose VAR is $20 million over a one-day holding period, with a 95% confidence interval, would have only a 5% chance of suffering an overnight loss greater than $20 million. Calculation of VAR entails modeling the possible market moves over the holding period, incorporating correlations among market factors, calculating the impact of such potential market moves on portfolio positions, and combining the results to examine risk at different levels of aggregation. The three main approaches to this analysis are historical simulation, the analytical approach using a correlation matrix or empirical (Monte Carlo) simulation. Major trading houses expend considerable energies on their VAR methodologies and have lobbied regulators to recognize their efforts, with some success

VOLATILITY TRADING

A strategy based on a view that future volatility in the underlying will be more or less than the implied volatility in the option price. Option market-makers are volatility traders. The most common way to buy/sell volatility is to buy/sell options, hedging the directional risk with the underlying. Volatility buyers make money if the underlying is more volatile than the implied volatility predicted. Sellers of volatility benefit if the opposite holds. Other methods of buying/ selling volatility are to buy/sell combinations of options, the most usual being to buy/sell straddles or strangles. Other strategies take advantage of the difference between implied volatilities of differing maturity options, not between implied and actual volatility. For example, if implied volatility in short-term options is high and in longer options low, a trader can sell short-term options and buy longer ones.

YIELD CURVE

The yield curve is a graphical representation of the term structure of interest rates. It is usually depicted as the spot yields on bonds with different maturities but the same risk factors (such as creditworthiness of issuer), plotted against maturity. The usual features of a spot yield curve are higher long-term yields than short-term yields and a curve for default-free bonds that is lower at each point than the equivalent curve for riskier debt. It is possible to construct variants of the yield curve from this basic form. The par yield curve is found by calculating the coupons that would be necessary for bonds of each maturity to be priced at par; the forward yield curve is found by extrapolating the spot yield curve point-by-point, based on the implied forward interest rates.

ZERO COUPON SWAP

An off-market swap in which either or both of the counterparties makes one payment at maturity. Usually it is the fixed-rate payments only that are deferred. The party not receiving payment until maturity incurs a greater credit risk than it would with an ordinary swap. The swap is advantageous for a company that will not receive payment for a project until it is completed or to hedge zero coupon liabilities, such as zero coupon bonds.

The majority of the glossary and definitions of terms are provided by Risk Magazine. © Incisive Media Ltd. 2008. Click here to download "Risk Magazine Guide to Risk Management glossary of terms 2001" in its entirety as a PDF.