Partial Matches:
ACCRETING
A description, applicable to a variety of instruments, denoting that the notional principal increases successively over the life of the instrument, e.g., caps, collars, swaps and swaptions. If the increase takes place in increments, the instrument may be known as a step-up.
See also
amortizing
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
ACCRUAL PERIOD
Period over which net payment or receipt pertaining to swaps is accrued. It is inclusive of the start date and runs to the end date without including the end date.
AMORTISING
A description, applicable to a variety of instruments, denoting that the notional principal decreases successively over the life of an instrument, e.g., amortizing swap, index amortizing rate swap, amortizing cap, amortizing collar, amortizing swaption. If the decrease takes place in increments, the instrument may be known as a step-down. Mortgage-style amortization refers to an amortizing swap such that the principal amortization plus interest is the same amount in each interest period.
See also
accreting
ANNUITY SWAP
An interest rate swap in which a series of irregular cashflows are exchanged for a stream of regular cashflows of equivalent present value.
ASSET SWAP
A package of a cash credit instrument and a corresponding swap that transforms the cash flows of the non-par instrument (bond or loan), into a par (floating interest rate) structure. Asset swaps typically transform fixed-rate bonds into par floaters, bearing a net coupon of Libor plus a spread, although cross-currency asset swaps, transforming cashflows from one currency to another are also common.
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).
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.
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.
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.
See also
credit default swap
BASKET SWAP
A swap in which the floating leg is based on the returns on a basket of underlying assets, such as equities, commodities, bonds, or swaps. The fixed leg is usually (but not always) a reference interest rate such as Libor, plus or minus a spread.
BID DATE
In a competitive bid transaction, the date on which swap Providers submit bids and the price/rate/agreement is established with the winning Provider.
BID PACKAGE
Documentation distributed by or on behalf of an Issuer to qualified Providers, detailing the terms, conditions and structure of the swap desired by the Issuer, which the Providers will use to formulate their bid on the scheduled bid date.
BILATERAL NETTING
Agreement between two counterparties whereby the value of all in-the-money contracts is offset by the value of all out-of-the money contracts, resulting in a single net exposure amount owed by one counterparty to the other. Bilateral netting can be multi-product and encompass portfolios of swaps, interest rate options, and forward foreign exchange.
BINARY PAY-OUT
See binary option, credit default swap, exotic option
BLENDED INTEREST RATE SWAP
A technique that involves combining two interest rate swaps to produce a more attractive overall rate. It involves at least two transactions. For example, if a counterparty fixes its floating rate borrowing cost at 10% and rates go down to 8%, it may do another swap with the same counterparty at 8% and combine the two to create a rate closer to the market.
bma index
Formerly the PSA Municipal Swap Index; is the principal benchmark for the floating rate interest payments for tax-exempt Issuers. The BMA Index is a national rate based on a market basket of approximately 250 high-grade, seven-day tax-exempt variable rate demand obligation issues of $10 million or more. In November 2006, the Bond Market Association (BMA) merged with the Securities Industry Association to form the Securities Industry and Financial Markets Association (SIFMA). Officially, the BMA Index is now called the SIFMA Swap Index, but it is still widely referred to by market participants as the BMA Index.
See also
SIFMA Swap Index.
BOND INDEX SWAP
A swap in which one counterparty receives the total rate of return of a bond market or segment of a bond market in exchange for paying a money market rate. Counterparties may also swap the returns of two bond markets. The two most common indexes used to measure bond market returns are the JPMorgan government bond index and the Salomon Brothers world government bond index. Bond index swaps can be an attractive way of gaining exposure to a market if the investor wants to avoid the trouble and expense of buying individual bonds, bearing in mind there are currently no government bond index futures. Bond index swaps can also be used to pass on bond market exposure when an investor does not want to sell core bond holdings, either because of wide price spreads or because they were difficult to obtain.
There can also be tax advantages in using bond swaps. For example, in Japan, banks and securities houses are exempt from withholding tax, but most foreign investors are not. Banks can therefore pass on some of those tax advantages in the swap. Also known as a total rate of return swap.
CANCELLABLE SWAP
See
callable swap
CAPPED SWAP
An interest rate swap with an embedded cap in which the floating payments of the swap are capped at a certain level. A floating-rate payer can thereby limit its exposure to rising interest rates.
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.
COLLAR SWAP
A collar on the floating-rate leg of an interest rate swap. The transaction is zero cost – the purchase of the cap is financed by the sale of the floor. The collar constrains both the upside and the downside of a swap.
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.
COMpetitive bid
Process of entering into a swap agreement where interested swap Providers submit bids to the Issuer on a specified date, and the swap is entered into with the winning Provider offering the interest rate, terms and conditions most favorable to the Issuer.
CONSTANT MATURITY SWAP DERIVATIVE
See
Constant Maturity Treasury (CMT) derivative
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.
CONTINGENT SWAP
The generic term for a swap activated when rates reach a certain level or a specific event occurs. Swaptions are often considered to be contingent swaps. Other types of swaps, for example, drop-lock swaps, are activated only if rates drop to a certain level or if a specified level over a benchmark is achieved.
CONVEXITY
A bond’s convexity is the amount that its price sensitivity differs from that implied by the bond’s duration. Fixed-rate bonds and swaps have positive convexity: when rates rise the rate of change in their price is slower than suggested by their duration; when rates fall it is faster. Positive convexity is therefore a welcome attribute. The higher the bond’s duration, the more its convexity. Bonds or swaps with call options or embedded call options, e.g., collateralized mortgage obligations, have negative convexity: when rates rise their price fall is faster relative to the interest rate move. Convexity effectively describes the same attribute as gamma.
CORRELATION
Correlation is a measure of the degree to which changes in two variables are related. It is normally expressed as a coefficient between plus one, which means variables are perfectly correlated (in that they move in the same direction to the same degree) and minus one, which means they are perfectly negatively correlated (in that they move in opposite directions to the same degree). In financial markets correlation is important in three areas:
1. The model used for global asset allocation decisions, Sharpe’s capital asset pricing model (CAPM), has, as its linchpin, a covariance matrix that measures correlations between markets.
2. Correlation is also central to the pricing of some options, where two-factor or multi-factor models are used. For spread options, yield curve options and cross-currency caps, estimating the correlation between the underlying assets is of primary importance, the degree of correlation between them having a direct influence on the option price. For quantos such as guaranteed exchange rate options, or differential swaps, the correlation effect is the extent to which there is a relationship between movements in the underlying and movements in the ex-change rate, which has a secondary effect on the price of the option.
3. Correlation between markets is also used to offset an option position in one market against another with similar direction and volatility. Such a strategy might be used to reduce cost – to avoid hedging the positions separately, or because implied volatility in the second market is lower – or because hedging is difficult in the first market. Correlation can be estimated historically (like volatility) but tends to be unstable, and historic estimations may be poor predictors of future realized correlations.
CORRELATION SWAP
Often used in currency markets, an instrument that allows an investor to take three volatility swaps and bet on how much one currency will move compared to the two others.
COST OF FUNDS
Refers to an Issuer’s actual interest rate cost on its debt obligations, which may or may not include carrying costs such as remarketing fees, liquidity fees, letter of credit fees, etc., that is sometimes used as the underlying in a swap transaction.
COUNTERPARTY
A party in a swap transaction. From an Issuer’s perspective, this is synonymous with Provider.
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 EVENT
Any one of a specified set of events, which, if occurring with respect to an obligation of the reference entity specified in a credit default swap, will trigger contingent payments. Applicable events, which generally include bankruptcy, repudiation/moratorium, restructuring, failure to pay, and cross-acceleration (as each is defined by ISDA) are determined by negotiation between the parties at the outset of a credit default swap.
CREDIT INTERMEDIATION SWAP
A credit swap with a dynamic notional that for a fixed fee provides the protection buyer with a contingent payment that matches the mark-to-market on any given day of a specified derivative (or other market-sensitive instrument). Also known as a dynamic credit swap
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 PENALTY
The additional requirements (e.g., a higher interest rate, additional insurance, etc.) of a party to a swap imposed due to that party’s lower credit rating.
CREDIT SUpport
Collateral that can be in the form of cash and/or marketable securities posted by one party to a swap agreement to reduce the credit exposure of its counterparty.
See also
swap insurance.
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 CAP
A cap in which the vendor will pay the purchaser the spread between interest rates (usually Libor-based) in different currencies minus a strike spread, where this exceeds zero, in return for a premium. It has the same relationship to a differential swap as a cap has to an interest rate swap.
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.
Cross-default termination
The ability of one party to terminate the swap at its market value if the other party defaults on other obligations of particular types.
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.
DEBT-EQUITY SWAP
This is not a swap in the usual sense. It is a one-off transaction of physical instruments without any exchange of future cashflows. It involves substituting equity for debt, either bonds or loans, usually when the debt becomes unserviceable. They are used by heavily indebted companies and countries.
DEFAULT SWAP
See
credit default swap
DEFERRED SWAP
A swap in which the payments are deferred for a specified period, usually for tax or accounting reasons. Unlike a forward swap, where the entire swap is delayed, in a deferred swap only the payments are deferred. For example, a company wanting to enter a swap, but not wanting cashflows until a future period, might want to defer payment.
DELAYED RESET SWAP
Also known as an in-arrears swap. A swap in which floating payment is based on the future, rather than present, value of the reference rate. For six-month delayed Libor reset swaps, for example, instead of fixing Libor six months and two days before the payment date, the floating-rate borrower delays fixing until two days before payment. Such swaps are popular in a steep yield curve environment, when a fixed-rate receiver may think rates will not rise as fast as the yield curve predicts.
DERIVATIVE
A derivative instrument or product is one whose value changes with changes in one or more underlying market variables, such as equity or commodity prices, interest rates or foreign exchange rates. Basic derivatives include, forwards, futures, swaps, options, warrants and convertible bonds. In mathematical models of financial markets, derivatives are known as contingent claims.
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.
DIGITAL SWAP
A swap in which the fixed leg is only paid on each swap settlement date if the underlying has met certain trigger conditions over the period since the previous payment date. Nothing is paid if this is not the case. The premium for such a swap is amortized over the maturity of the swap and an installment paid at each payment date.
See also
binary option
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.
DOwngrade termination
Provision in some swap agreements allowing one party to terminate the swap at its market value if the other party’s long-term, unsecured debt rating falls below a given level.
DROP-LOCK SWAP
A swap in which, if the rate on the index initially used to set the fixed-rate payments differs from that prevailing at the outset of the swap by a specified amount and for a specified amount of time, the fixed rate is reset.
DUAL CURRENCY SWAP
Dual currency swaps are currency swaps that incorporate the foreign exchange options necessary to hedge the interest payments back into the principal currency for dual currency bonds.
DYNAMIC CREDIT SWAP
A credit swap with a dynamic notional that for a fixed fee provides the protection buyer with a contingent payment that matches the mark-to-market on any given day of a specified derivative (or other market-sensitive instrument). Also known as a credit intermediation swap. Also known as a credit intermediation swap.
Effective date
The first date on which payment obligations begin to accrue, including the date any upfront payment is exchanged. In the case of a forward swap, payment accruals may not begin for months or even years into the future. When a swap is entered into in connection with an issue of bonds, the Effective Date is often set to coincide with the issue date of the bonds.
EMBEDDED OPTION
An option, often an interest rate option, embedded in a debt instrument that affects its redemption. Examples include mortgage-backed securities and callable and putable bonds. Embedded options do not have to be interest rate options; some are linked to the price of an equity index (Nikkei 225 puts embedded in Nikkei-linked bonds) or a commodity (usually gold). Many so-called guaranteed products contain zero-coupon bonds and call options.
EQUITY (INDEX) SWAP
A swap in which the total or price return on an equity index, equity basket or single equity is exchanged for a stream of cashflows based on a short-term interest rate index (or another index).
Equity swaps are a convenient structure for switching into or out of equity markets, particularly for those that prefer to avoid, or are not allowed to use stock index futures. Like futures, the price of the swap is directly related to the cost of carry, although there may also be tax considerations.
EQUITY KNOCKOUT SWAP
An interest rate or cross-currency swap that gets terminated (knocked-out) if a given stock or equity-index reaches a specified trigger level between inception and expiry. The knockout can be un-conditional once the pre-determined equity level is reached, or the client can be given the choice to cancel the swap should the trigger level be reached.
ESCALATING PRINCIPAL SWAP
See
accreting swap
ESCALATING RATE SWAP
Also known as a step-up coupon swap. A swap in which the fixed-rate payments increase over time. For example, a company that expects its income to increase can pay a fixed rate that increases incrementally.
EXTENDIBLE SWAP
A swap in which the fixed-rate payer has an option to extend the swap. A three-year swap extendible for a further two years would simply use a three-year swap in conjunction with a swaption on a two-year swap with a maturity of three years.
See also
callable swap
FIRST-LOSS BASKET SWAP
A basket credit default swap in which the seller of protection agrees to make contingent payments to the buyer of protection upon the occurrence of a credit event with respect to one or more reference entities. The contingent payment amount for each credit event equals the loss incurred with respect to the liquidation value of an obligation of the impaired reference entity, with the aggregate amount of contingent payments due by the seller of protection capped by the swap notional amount. Through this type of structure, the seller of protection obtains levered exposure to a portfolio of credits.
See also
synthetic securitization.
FIRST-TO-DEFAULT BASKET SWAP
A specialized type of basket credit default swap in which the protection seller is exposed to the first reference entity in the basket of reference entities for which a credit event occurs. The applicable notional amount for each reference entity in the basket is typically equal to the notional of the first-to-default swap. Losses are capped at the notional amount and the protection seller does not have exposure to subsequent credit events.
FIXED leg
In a swap transaction, the payments made by one party to another based on a pre-determined fixed interest rate.
FIXED-FLOATING SWAP
See
interest rate swap
FLEXIBLE FREQUENCY DIGITAL SWAP
See
digital swap
FLOATING leG
In a swap transaction, the payments made by one party to another based upon a pre-determined floating (variable) rate index.
FLOATING-FLOATING SWAP
See
basis swap,
interest rate swap
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.
FORWARD SPREAD AGREEMENT
A contract in which counterparties contract into a spread between two variable rates, usually Libors, applied to a nominal amount of one currency. The settlement amount will be the spread between prevailing Libor minus the contracted spread. Differential swaps are therefore a string of forward spread agreements.
FORWARD SWAP
A swap in which rates are fixed before the start date. If a company expects rates to rise soon but only needs funds later, it may enter into a forward swap.
GOLD FORWARD OFFERED RATE
The rates at which dealers will lend gold on swap against US dollars.
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.
HIGH-COUPON SWAP
A swap in which the fixed-rate payments are above market rates. (Also known as a premium swap.)
See also
discount swap
IN the money
Refers to a party’s financial position if it would be owed a payment by the other party if a swap were terminated at the prevailing market price.
IN-ARREARS SWAP
See
delayed reset swap
INDEX AMORTISING SWAP (IAS)
An interest rate swap whose principal amortizes on the back of movements in an index, such as Libor or constant maturity treasuries. The fixed-rate receiver effectively grants an option to the fixed-rate payer to amortize the swap. The option is triggered by interest rate movements after an initial lock-out period. The notional principal amortizes as rates fall or remains constant if rates remain the same. In return for granting the option, the fixed-rate receiver gets a yield above current fixed rates. IAS have been widely used by US regional banks in their asset/liability management activities. By using IAS, banks were able to obtain the negative convexity of a mortgage-backed security and avoid the risk of excessive prepayments due to changes in consumer sentiment.
But the fixed receiver is exposed to both falling and rising rates. If rates fall, there is the possibility at each interest date that some or all of the swap will be terminated, creating a reinvestment risk. If rates rise, the swap may run to maturity, providing meager income while floating rates soar.
An IAS fixed-rate receiver is selling volatility to the payer for an enhanced yield. So the lower the volatility of the index, the lower the option value and yield pick-up. A subsequent fall in volatility benefits the receiver because the likelihood that the swap will amortize decreases. IAS can be structured with negative or positive convexity and the amortization schedules and lock-out periods can be changed in order to increase or decrease yields. Also known as an Indexed Principal Swap.
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.
INTernational swaps and derivatives association
See
ISDA
Isda
International Swaps and Derivatives Association – Represents participants in the privately negotiated derivatives industry; is the largest global financial trade association, by number of member firms. ISDA was chartered in 1985, and today has more than 840 member institutions from 56 countries on six continents. These members include most of the world's major institutions that deal in derivatives, as well as many of the businesses, governmental entities and other end users that rely on over-the-counter derivatives to manage the financial market risks inherent in their core economic activities.
See also
ISDA Master Agreement,
OTC derivatives
Isda master agreement
The standardized master legal agreement for all derivative transactions between an Issuer and a Provider that states standardized definitions, terms, and representations governing the swap transactions.
LEASE RATE SWAP
Similar to an interest rate swap, a lease rate swap is a fixed-for-floating agreement in which gold is borrowed/lent at a “fixed” rate. The floating leg is re-priced at incremental time periods over the maturity of the swap. At the end of each floating period the agreed upon benchmark lease rate is compared to the contract rate and the party in debit pays the differential. The floating component is then rolled out for a further period.
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.
LIBOR
London Inter-Bank Offered Rate is the interest rate banks charge each other for short-term money, up to a 12-month term. LIBOR is commonly used as the underlying for the floating leg of a Swap. The British Bankers’ Association (BBA) sets the rates daily.
LIBOR-IN-ARREARS SWAP
See
delayed reset swap
LINEAR BASKET CREDIT DEFAULT SWAP
A basket credit default swap, where investors are exposed to multiple reference entities as if they had entered into a separate credit default swap contract with respect to each reference entity.
LINEAR FX-LINKED SWAP
An interest rate swap with a quasi-fixed coupon that varies with the movement of a chosen spot foreign exchange rate over the life of the deal. These swaps can be structured to pay a higher (or lower) coupon if a given currency weakens (or strengthens) after the outset of the deal. The observation dates for the FX component coincide with the Libor reset dates for coupon calculation. These swaps can be structured with a leveraged FX exposure.
MARKET MODEL OF INTEREST RATES
A special case of the Heath-Jarrow-Morton model due to Brace, Gatarek and Musiela in which the term structure of interest rates is modeled in terms of simple Libor rates (which are lognormally distributed with respect to forward measure) rather than instantaneous forward rates. This allows the modeler to exclude the possibility of negative interest rates from the model and obtain prices for caps, floors and swaptions consistent with the Black-Scholes framework. The model can be calibrated using readily available market data: forward or swap rates volatilities and correlations, and is particularly suited to path-dependent instruments.
MId-market
The mid-point between the “bid” and “offer” market rate/price, commonly used as a basis for pricing swaps.
MORTGAGE SWAP
An asset swap attached to fixed-rate mortgage payments. Mortgage swaps allow investors to enjoy the flows from a portfolio of mortgages without taking a mortgage asset onto their balance sheet. The principal reduces if and when the outstanding mortgage principal reduces (which can occur if the mortgage holder pays off the mortgage or defaults). Such swaps are complicated because although the fixed-rate receiver receives a higher rate than on a normal swap, the amortization of the principal is not just a function of interest rates. The largest mortgage swap market is in the US; in 1992 and 1993 prepayments accelerated because of historically low interest rates.
See also
index amortizing swap,
prepayment risk,
reverse index amortizing swap
MUNICIPAL SWAP
A swap in which the floating payments are based on an index of tax-exempt US municipal bonds, such as SIFMA.
See also
tax-exempt swap
NAKED SWAP
A swap position without a corresponding asset or liability.
NEGOTIATED bid
Method of entering into a swap agreement where the terms, including the rates, are negotiated between an Issuer and the Provider.
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.
otc derivative
Over-the-counter derivatives are privately negotiated contracts that are traded directly between two parties, rather than on a centralized exchange. Some of the most common derivatives to be traded in the OTC market include swaps, forward rate agreements, and exotic options. The self-regulatory trade organization that oversees the over-the-counter derivatives market is the International Swaps and Derivatives Association (ISDA).
See also
OTC
PARTICIPATING SWAP
A swap in which floating-rate exposure is hedged but in which the hedger still retains some benefit from a fall in rates.
PERIODIC RESETTING SWAP
An interest rate swap in which the floating-rate payments are an average of the floating rates that have prevailed since the last payment, as in a semi-annual swap where the payments are based on a weighted average of monthly rates. (Also known as an average rate swap.)
POWER SWAP
A swap whose floating leg is based on the square (or some higher exponent) of the reference interest rate. Although dismissed by some as little more than a speculative tool for taking highly leveraged positions on the direction of interest rates, power swaps have been shown (by Robert Jarrow and Donald van Deventer) to have their uses in hedging commercial banks’ deposits and credit card loan portfolios.
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.
PROvider
The bank or financial institution that enters into a swap agreement with an Issuer, usually a commercial bank, investment bank, or insurance company.
Psa municipal swap index
PSA stood for the Public Securities Association, a trade organization of dealers and brokers who underwrote municipal bonds. In 1997, PSA was renamed the Bond Market Association to better illustrate the expanded mission of the organization. The PSA Municipal Swap Index was thus renamed the BMA Index. In November 2006, the BMA merged with the Securities Industry Association to form the Securities Industry and Financial Markets Association (SIFMA). The BMA Index was thus renamed the SIFMA swap index, but is still commonly known and referred to as the BMA Index.
PUTTABLE SWAP
An interest rate swap in which the fixed-rate payer has the right to terminate the contract after a specified period. Should interest rates fall, the swap can thus be put back to the fixed receiver. The putable swap is the opposite of a callable swap. The fixed-rate payer is effectively sold a swaption by the floating-rate payer, who receives a higher fixed rate in compensation. Putable swaps are similar to extendible swaps. Also known as a cancellable swap.
QUANTO PRODUCT
An asset or liability denominated in a currency other than that in which it is usually traded, typically equity index futures, equity index options, bond options and interest rate swaps (differential swaps). One example is the Chicago Mercantile Exchange’s Nikkei 225 stock index contract, which uses the nominal price of the yen-denominated index applied to a US dollar notional principal. Quanto products can be hedged with an offsetting position in a local currency product. Variable asset and foreign exchange exposures will arise with changes in the foreign exchange rate and in the underlying, so the structures must be continually dynamically hedged in a similar fashion to option products.
See also
guaranteed exchange rate option
REGULATORY ARBITRAGE
A financial transaction that allows one or both of the counterparties to accomplish an operating or financial objective that would be unavailable to them directly because of regulations: for example, a commercial bank entering into a credit default swap with an OECD bank in order to lower the regulatory capital that it must hold.
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.
RESET-IN-ARREARS SWAP
See
delayed reset swap
REVERSE INDEX AMORTISING SWAP
An interest rate swap in which payments are linked to an index (e.g., Libor or constant maturity Treasuries) and increase if that index declines. The swap therefore exhibits positive convexity. Receiving fixed in a reverse index amortizing swap (reverse IAS) provides a hedge for instruments (such as mortgage swaps) that amortize as interest rates decline, although it is important to ensure that the indexes on which the amortization or accreting schedules are based are highly correlated. Unlike a conventional IAS, the fixed receiver of a reverse IAS is buying volatility (sometimes referred to as “optionality”) which offsets the short option position of a mortgage portfolio.
REVERSIBLE SWAP
An interest rate swap in which one side has an option to alter the payment basis (fixed/floating) after a certain period. This is usually achieved by the use of a swaption, allowing the purchaser the opportunity to enter a swap with payment on the opposite basis. The swaption would be for twice the principal amount, one half nullifying the original swap.
ROLLER-COASTER SWAP
1. An interest rate swap in which one counterparty alternates between paying fixed and paying floating.
2. Another name for a seasonal swap
ROLL-LOCK SWAP
A swap that enables futures traders to lock in their roll-over costs by paying an average difference between near and far contracts measured on the seventh, sixth and fifth days before expiration. The product therefore allows investors to roll over their contracts at a set cost relative to their fair value.
SEASONAL SWAP
An interest rate swap in which the principal alternates between zero and the notional amount (which can change or stay constant). The principal amount of the swap is designed to hedge the seasonal borrowing needs of a company.
SEMI-FIXED SWAP
An interest rate swap with two possible fixed rates which can be tailored to suit bullish or bearish market views. The rate paid by the fixed-rate payer depends on whether current Libor (or another reference rate or asset) is above or below a predetermined level. In a typical structure, if Libor is below the trigger level, the lower of the two rates is paid, if it is above, the higher is paid. These swaps can be used to create asymmetric risk exposures, i.e., cheaper fixed-rate funding for an oil producer when oil prices are low, or an enhanced yield for an insurance company when equity prices are falling.
SEt-off
Swap provision that enables a party that is entitled to a payment under the agreement (e.g., a termination payment) to satisfy that obligation by reducing the amount it owes the other party in another transaction.
sifma swap index
Formerly the BMA Swap Index; produced by Municipal Market Data, is the principal benchmark for the floating rate interest payments for tax-exempt Issuers. The SIFMA Index is a national rate based on a composite of approximately 250 Issuers of high-grade, seven-day tax-exempt variable rate demand obligation issues of $10 million or more.
SPREAD-LOCK SWAP
An interest rate swap in which one payment stream is referenced at a fixed spread over a benchmark rate such as US Treasuries.
STAGED DRAWDOWN SWAP
See
accreting swap
STEP-DOWN SWAP
1. See amortizing swap
2. The opposite of an escalating rate swap; i.e., the fixed rate decreases in increments over the life of the swap
STEP-UP COUPON SWAP
See
escalating rate swap
STEP-UP SWAP
See
accreting,
escalating rate swap
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.
SWAP
See
accreting,
annuity swap,
asset swap,
basis swap,
basket swap,
blended interest rate swap,
bond index swap,
callable swap,
capped swap,
collar swap,
commodity swap,
contingent swap,
credit default swap,
cross-currency swap,
debt-equity swap,
deferred swap,
delayed reset swap,
differential swap,
digital swap,
discount swap,
drop-lock swap,
dual currency swap,
equity (index) swap,
escalating rate swap,
extendible swap,
fixed-floating swap,
floating-floating swap,
forward swap,
high-coupon swap,
index amortizing+swap,
interest rate swap,
mortgage swap,
municipal swap,
naked swap,
participating swap,
periodic resetting swap,
power swap,
putable swap,
reverse index amortizing swap,
reversible swap,
roller-coaster swap,
roll-lock swap,
seasonal swap,
semi-fixed swap,
spread-lock swap,
step-down swap,
tax-exempt swap,
total rate of return swap,
warrant-driven swap,
variable notional swap,
yield curve swap,
zero coupon swap
SWap curve
The name given to the swap’s equivalent of a yield curve. The swap curve identifies the relationship between swap rates at varying maturities.
SWap insurance
Insurance policy purchased to guarantee obligations on a swap, which is underwritten to insure only the regularly scheduled payments under the swap, or also any termination payment that may be required under the swap.
SWAPTION
An option to enter an interest rate swap. A payer swaption gives the purchaser the right to pay fixed, a receiver swaption gives the purchaser the right to receive fixed (pay floating).
Apart from those in the sterling market, many swaptions are capital-market driven. Good-quality borrowers are able to issue putable or callable bonds and use the swaptions market to reduce their financing costs. In the case of callable bonds, the issuer effectively buys an option from the investor in return for a slightly higher coupon, so that it may benefit if rates decline. Because many of these embedded options have traditionally been underpriced, good-quality borrowers have been able to monetize this anomaly by selling an equivalent swaption (a receiver swaption) to a bank at market rates.
The profit from this arbitrage lowers funding costs. If the swaption is exercised against the issuer, it calls the bonds (although the issuer would almost certainly have called the issue given the reduction in rates). In the case of putable bonds, the borrower sells a swaption to the swaption market. The premium gained lowers the funding cost at the expense of leaving the borrower unsure of the maturity of the debt.
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.
TAX-EXEMPT SWAP
An interest rate swap in which the floating-rate index is based upon a tax-exempt rate such as the SIFMA swap index, formerly BMA swap index.
TERM out
Provision of a swap agreement that allows the Issuer to make payments over time for any amount it may be required to pay upon termination of a swap.
TERMination date
The scheduled maturity date of the swap, when the final payment obligation is made (barring an early termination of the swap). When a swap is entered into in connection with an issue of bonds, the termination date is often set to coincide with the maturity date of the bonds.
TERMination event
An event that allows for the termination of a swap, such as a credit downgrade.
TERMination Payment
Payment made from one party to the other if the swap is terminated prior to its scheduled termination date.
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.
TWO-NAME EXPOSURE
Credit exposure that the protection buyer has to the protection seller, which is contingent on the performance of the reference credit. If the protection seller defaults, the buyer must find alternative protection and will be exposed to changes in replacement cost due to changes in credit spreads since the inception of the original swap. More seriously, if the protection seller defaults and the reference entity defaults, the buyer is unlikely to recover the full default payment due, although the final recovery rate on the position will benefit from any positive recovery rate on obligations of both the reference entity and the protection seller.
VARIABLE NOTIONAL OPTION/SWAP
An option or swap where the notional value is linked to the underlying asset price or rate. Usually changes in the notional will be directly proportional to changes in the underlying price; i.e., they both decrease or increase together. Such derivatives have two main uses. In an equity swap, the fixed-rate receiver can opt to receive the return of either a fixed number of stocks, or the number of stocks that could be purchased for a fixed sum. The former case amounts to a variable notional amount for the swap. An example using an option is the case of a firm which sells more exports as exchange rates decline and its products therefore become cheaper abroad. Since it now has greater foreign currency revenue to hedge, it would purchase a variable notional currency option for this purpose.
VARIANCE SWAP
The cash pay-out of a variance swap is equal to notional multiplied by the difference between the realized variance of the underlying index over the life of the swap and the strike variance.
VOLATILITY SWAP
The cash pay-out of a volatility swap is equal to notional multiplied by the difference between the realized volatility of the underlying index over the life of the swap and the strike volatility.
WARRANT-DRIVEN SWAP
A swap with a warrant allowing an issuer of a bond the extension of a swap in the event that he exercises a similar warrant on the bond.
See also
extendible swap
WEATHER DERIVATIVE
Typically swaps and vanilla options such as calls, puts, caps, floors and collars with payoffs linked to temperature, precipitation, humidity or wind speed. Most instruments are linked to heating degree days or cooling degree days. These two indexes measure the deviation of the average of a day’s high and low temperature from a baseline reference temperature.
YIELD ADJUSTMENT
A payment by one counterparty, usually at the outset of a swap or at a reset date, to compensate the other counterparty for entering into a swap on off-market terms.
YIELD CURVE SWAP
A swap in which the two interest streams reflect different points on the swap yield curve. Yield curve swaps can be used to exploit a yield curve steepening or flattening view. For example, one side pays the two-year Constant Maturity Treasury (CMT) rate and the other the 10-year CMT rate.
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.