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
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.
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
AUTOCAP
A standard cap consists of a series of caplets hedging future floating rate payments. However, autocaps only provide a hedge for the first pre-specified number of in-the-money caplets after which the option expires, and so are a cheaper alternative to caps.
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.
BREAK FORWARD/CAPPED FORWARD
A strategy that involves buying a synthetic off-market currency forward (buying and selling a put and a call at the same strike price) and the simultaneous purchase of another option, allowing a purchaser to benefit from favorable exchange rate movements. The transaction is usually constructed for zero cost because the premium from the off-market forward pays for the option.
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.
See also
comprehensive approach
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.
See also
credit-linked note.
CAPPED FLOATER
A floating-rate note which pays a coupon only up to a specified maximum level of the reference rate. This is done by embedding a cap in a vanilla note where the investor effectively sells the issuer a cap. A capped floater protects the debt issuer from large increases in the interest rate environment.
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.
CAPTION
An option on a cap. A type of compound option in which the purchaser has the right, but not the obligation, to buy or sell a cap at a predetermined price on a predetermined date. Captions can be a cheap way of leveraging into the more expensive option.
See also
floortion
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
The simultaneous purchase of an out-of-the-money call and sale of an out-of-the-money put (or cap and floor in the case of interest rate options). The premium from selling the put reduces the cost of purchasing the call. The amount saved depends on the strike rate of the two options. If the premium raised by the sale of the put exactly matches the cost of the call, the strategy is known as a zero cost collar. When used to hedge an outright position in the underlying, this locks the hedger into a range of values; this hedging strategy is known as a cylinder.
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.
COLLARED FLOATER
A floating-rate note whose coupon payments are subject to an embedded collar. Thus the coupon is capped at a predetermined level, so the buyer forsakes some upside, but also floored, offering protection from a downturn in the reference interest rate. Also known as a mini-max floater.
COLLATERALISED LOAN OBLIGATION (CLO)
A structured bond backed by the loan repayments from a portfolio of pooled personal or commercial loans, excluding mortgages. The structure allows a bank to remove loans from its balance sheet and so reduce its required capital reserves, while retaining contact with the borrowers and fees from servicing the loans.
COMPOUND OPTION
An option on an option, permitting the purchaser to buy (or sell) an option on an underlying at a fixed price over a predetermined period. Usually sold on interest rate instruments (e.g., captions or floortions), or currencies. They are also used as components of more complex trades. Compound options are often bought to protect against increases in standard option prices during periods of high volatility. The upfront premium for a compound option is less than for a normal European-style option but if the option is exercised, the overall cost will be greater. Due to their greater flexibility the cost, if both options are exercised, is greater than a conventional option.
Compound options can also be constructed on options other than European style options (e.g., barrier options) or portfolios of options (e.g., compound on a cylinder). Indeed compound options on compound options, otherwise known as installment options are common (often as part of more complex structures). An installment option requires the holder to pay fixed amounts of premium (installment) at certain installment dates to benefit from the right of exercise of the underlying option. At any point that holder can elect to let the installment payments lapse and loses any right of exercise.
COMPREHENSIVE APPROACH
The comprehensive approach to capital adequacy applies a constant capital charge to all positions in a trading book, irrespective of whether they are long or short.
See also
building-block approach
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.
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.
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.
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.
CUMULATIVE CAP
A cumulative interest rate cap protects against increases in total interest expense over a specified period of time. This period of time will incorporate several rate settings in determining the final interest expense (for example, four three-month Libor settings for an annual interest expense amount). This differs from a standard cap, which caps an absolute rate of interest in each calculation period. Because a cumulative cap does not provide the period-to-period protection of a standard cap, it is generally cheaper than the corresponding standard cap.
ECONOMIC CAPITAL
The amount of capital held by an organization in order to help protect it from unexpected losses.
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.
FLOOR
A contract whereby the seller agrees to pay to the purchaser, in return for upfront premium, the difference between a reference rate and an agreed strike rate should the strike rate exceed the reference rate. Interest rate floors, such as caps, are effectively a string of interest rate guarantees.
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.
HAIRCUT
The excess of an asset’s market value over either the loan for which it can serve as adequate capital, or the regulatory capital value. It can also refer to the dealer’s commission on a transaction.
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.
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.
INDEXED STRIKE CAP
A cap for which the pay-out level is indexed to the level of the reference rate. For example, such a cap might be struck at 7.5% as long as the reference rate remained below 9%, but rise to 8.5% if the reference rate exceeded 9%. An indexed strike cap is cheaper than a conventional cap.
INTEREST RATE CORRIDOR
An interest rate corridor is composed of a long interest rate cap position and a short interest rate cap position. The buyer of the corridor purchases a cap with a lower strike while selling a second cap with a higher strike. The premium earned on the second cap then reduces the cost of the structure as a whole. The buyer of the corridor is then protected from rates rising above the first cap’s strike, but exposed again if they rise past the second cap’s strike. It is possible to limit this liability by selling a knock-out cap rather than a conventional cap. The structure is then known as a knock-out interest rate corridor.
INTEREST RATE GUARANTEE
An option on a forward rate agreement (FRA), also known as a FRAtion. Purchasers have the right, but not the obligation, to purchase an FRA at a predetermined strike. Caps and floors are strips of IRGs.
INTEREST-RATE CAP
See
cap
INVERSE FLOATER
The payments made on an inverse floating rate note (“floater”) decrease as the reference interest rate increases, the reverse of the typical case where the payments rise with the reference rate.
The purchaser of an inverse floating rate note is in effect selling interest rate caps – this will increase the coupon payments in a stable or lower interest rate environment, but reduce them should interest rates rise. Typically, the payment rate is found by multiplying the market rate at the outset by two and subtracting the reference rate from this figure. The floater can be leveraged by using a larger multiplier than two.
KNOCK-OUT CAP, ONE TOUCH
A cap which can be cancelled at any reset date if the reference interest rate rises beyond a trigger level on or before that date. For example, a three-year cap struck at 5% for three-month Libor might have a knock-out level of 7%. If Libor was above 7% on one of the cap’s quarterly reset dates, the cap would be cancelled, leaving the holder exposed to the higher rates. This extinguishing feature of knock-out caps means they can be considerably cheaper than conventional caps. This makes them more useful in creating structures offering cheap protection than their vanilla analogues (for example, knock-out interest rate corridor).
KNOCK-OUT CAP, PERIODIC
Similar to a one touch, except that only the current period is affected. The remainder of the structure remains intact.
KNOCK-OUT INTEREST RATE CORRIDOR
A corridor in which a client purchases a standard cap with a lower strike and sells a knock-out cap with a higher strike (rather than selling a conventional cap). This means that the client is protected from an increase in interest rates up to the strike level for the knock-out cap, but exposed if rates rise beyond that level. However, the client is protected once again if the rates rise above the knock-out level, as the short knock-out cap will then be extinguished.
LAMBDA
A measure of the effective leverage of an instrument. It is defined as the percentage change in the market value of a derivative for a one-percent move in the underlying. Unlike gearing, the lambda value captures the instrument’s delta.
See also
leverage
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.
MOVING STRIKE OPTION
An option in which the strike is reset over time, such as an interest rate cap in which the strike is reset for the next period at the current interest rate plus a pre-agreed spread.
NET PRESENT VALUE
A technique for assessing the worth of future payments by looking at the present value of those future cashflows discounted at today’s cost of capital.
PARTICIPATING CAP
The simultaneous purchase of an out-of-the-money cap and the sale of a lesser amount of an in-the-money floor. Because the in-the-money floor is worth more, the purchaser of a participating cap sells fewer floors for a zero cost combination and can therefore derive some benefit if rates fall. Although the purchaser will not derive as much benefit if rates fall as would have been the case with a straightforward cap, a premium does not have to be paid.
PAY-AS-YOU-GO CAP
A pay-as-you-go cap allows the buyer to pay for protection from upward moves in an interest rate for only as long as necessary. Usually, the holder will pay an initial premium (which will be small compared with the premium for a normal cap) and a further payment at each reset date. The holder can cancel the cap when he or she feels that the protection is no longer needed. A pay-as-you-go cap is useful for those who feel that caps are too expensive, that interest rates will eventually stabilize below the capped level, or that rates are in a short-lived “spike” move. Also known as an installment cap.
See also
compound option,
installment option
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.
See also
periodic floor
PREMIUM-REDUCTION DEVICE
A strategy which aims to reduce the cost of an option or other derivative. There are many ways to achieve this; three common techniques follow.
The first is to sell a second derivative; the premium received can then be used to lower the funding requirement for the purchased derivative. This is the technique employed for reducing the cost of a collar.
The second is to limit participation in moves in the underlying by imposing limitations on the pay-out profile of the instrument (as in a barrier option or a capped floater).
The final way is to accept payments below market rates, with the possibility of making up the shortfall at the end of the instrument’s life (see yield adjustment).
REGULATORY ARBITRAGE
A financial transaction that allows one or both of the counterparties to accomplish an operating or financial objective that would be unavailable to them directly because of regulations: for example, a commercial bank entering into a credit default swap with an OECD bank in order to lower the regulatory capital that it must hold.
REGULATORY CAPITAL
The amount of capital that an organization is required to hold by its regulator.
SPECIFIC RISK
Specific risk, also known as non-systematic risk, represents the price variability of a security that is due to factors unique to that security, as opposed to that portion that is due to systematic risk, the generalized price variability of the related interest rate or equity market. As an example, a US Treasury note would have no specific risk, as it deemed to have no risk other than movement in interest rates, while a corporate bond would have a degree of default risk as well as more generalized yield curve risk.
Specific risk is also the term used by both the European Union’s Capital Adequacy Directive and the Basel Capital Accord to refer to the risks unique to individual holdings that are not covered by capital dedicated to generalized market risk. Specific risks are considered to be only partially diversifiable, and capital dedicated to them is added to generalized market risk capital.
See also
relative performance risk
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.
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 AGREEMENT FOR FORWARD EXCHANGE (SAFE)
The generic term for exchange rate agreements (ERAs) and forward exchange agreements (FXAs). ERAs and FXAs were developed by Bar-clays Bank and Midland Montagu, respectively, to overcome the capital adequacy problems of foreign exchange forwards highlighted by Bank for Inter-national Settlements regulations. Safes are treated as interest rate, rather than foreign exchange, instruments in BIS regulations, so banks have to provide less capital to support outstandings. FXAs are settled with reference to both the spot rate and the forward premium/discounts; ERAs with reference only to the forward premium/discount.
SYNTHETIC 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.
VARIANCE GAMMA MODEL
A jump model that better captures the characteristics of the volatility smile for shorter-dated options than stochastic volatility models.
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
The interest rate that will make the present value of the cashflows from an investment equal to the price (or cost) of the investment. Also called the internal rate of return. The current yield relates the annual coupon yield to the market price by dividing the coupon by the price divided by 100 and ignores the time value of money or potential capital gains or losses. Simple yield to maturity takes into account the effect of the capital gain or loss on maturity of a bond in addition to the current yield.