Exact Matches:
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.
Partial Matches:
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.
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.
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.
FLOORED FLOATER
A floating-rate note that guarantees a minimum coupon even if the reference rate drops below the minimum rate. This is achieved by embedding a floor in a vanilla note. A floored floater protects the buyer from large decreases in the reference interest rate.
FLOORTION
An option on a floor. The purchaser has the right, but not the obligation, to buy or sell a floor at a predetermined price on a predetermined date.
See also
caption;
compound option
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.
KNOCK-IN FLOOR, ONE TOUCH
A floor which will be entered into at any reset date if the reference interest rate rises beyond a trigger level on or before that date. For example, a three-year floor struck at 5% for three-month Libor might have a knock-in level of 4%. If Libor was below 4% on one of the floor’s quarterly reset dates, the floor would be entered into, leaving the seller exposed to the lower rates.
KNOCK-IN FLOOR, PERIODIC
Similar to a one touch, except that only the current period is affected. The remainder of the structure remains intact.
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.
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.
PERIODIC FLOOR
A floor in which the strike rate can vary from period to period. The strike rate in a given period depends upon the strike set in the previous period. Such floors are normally set at a fixed number of basis points above the previous strike or the index (for example Libor) plus a spread.
See also
periodic cap
PREMARKET
Early morning inter-office trading over the telephone or across electronic dealing systems before trading begins on the floor of the London Metal Exchange.
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.