Partial Matches:
ADVANCE PREMIUM FORWARD
A forward contract in which the contango is partly payable in advance. This transaction is also known as a flat rate forward or stabilized contango. An advanced premium forward is particularly useful during the early years of a project when the greater contango can provide greater cash flow. The conversion of a standard forward into an advanced premium forward allows for the early realization of hedging values. In this case, the early payment of the contango is at the expense of yield in the later years in a strip of forwards.
AT MATURITY TRIGGER FORWARD
See trigger forward
AT-THE-MONEY
1. At-the-money forward: An option whose strike is set at the same level as the prevailing market price of the underlying forward contract. With a Black-Scholes model , the delta of a European-style, at-the-money forward option will be close to 50%.
2. At-the-money spot: An option whose strike is set the same as the prevailing market price of the underlying. Because forwards commonly trade at a premium or discount to the spot, the delta may not be close to 50%.
BACKWARDATION
The situation when the cash or spot price of a commodity is greater than its forward price. A backwardation occurs when there exists insufficient supply to satisfy nearby demand in a commodity market. The size of the backwardation is determined by differences between supply/ demand factors in the nearby positions compared with the same factors on the forward position. There is no inherent limit to the backwardation, also referred to as a “back”.
See also
contango
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.
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.
BORROWING
Derived from “borrowing metal from the market,” which is achieved by buying a nearby date and simultaneously selling a date further forward.
See also
cash and carry
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.
CASH AND CARRY
When a contango exists, the premium of the forward position over the prompt generally reflects costs of storage, insurance and finance for that period. When metal is in surplus, the contango may widen to the point where an effective interest rate that is higher than market rates can be locked-in.
COMMODITY FUTURE
A futures contract on a commodity. The first futures (as opposed to forward) contract was for grain and was established in about 1865 on the Chicago Board of Trade. Unlike forwards, futures are generally exchange-traded instruments. Futures can either be in contango (where futures prices are higher than spot prices) or backwardation (where they are lower).
CONTANGO
Situation when a commodity’s future price is higher than its spot price. Whereas financial futures and forwards are invariably priced off the cost of carry of the underlying, the forward or spot prices of commodities are heavily influenced by supply and demand. Contango arises where there is sufficient supply in the spot market or where future supply is thought to be tight.
See also
advance premium forward,
backwardation
CONTRACT FOR DIFFERENCE (CFD)
A Contract for Difference is typically an agreement made between two parties to exchange (at the closing of the contract) a cashflow equivalent to the difference between the opening and closing prices, multiplied by the number of shares detailed in the contract. CFDs are traded on margin, do not incur stamp duty and can have individual stocks or indexes as the underlying.
Alternatively, in the currency markets, the term CFD can refer to an OTC currency forward contract that settles for a cash amount (maybe in a third currency) without requiring the exchange of the two underlying currencies. It is often used instead of a traditional forward because it mitigates settlement risk.
CREDIT SPREAD FORWARD
A cash-settled forward contract with settlement amounts based on the credit spread between two predetermined debt issues on the maturity date.
See also
credit spread option.
CURRENCY FORWARD
An agreement to exchange a specified amount of one currency for another at a future date at a certain rate. The exchange of currencies is priced so as to allow no risk-free arbitrage. In other words, pricing is not a market estimate of the spot rate at that date, but is made according to the two currencies’ respective interest rates. For example, assuming that Eurosterling interest rates are 10% and Eurodollar 5%, and the US dollar/sterling spot rate is 1.75, the forward rate should reflect the 5% interest rate advantage of depositing money in sterling. Thus the 12-month forward rate should be 1.6695.
Forwards are more appropriate than options if a company has a strong directional view of expected movements in exchange rates. But certainty is rare and hedging entirely with forwards may leave a company locked into unfavorable exchange rates. Unlike options, forwards do not enable companies to take advantage of favorable currency movements. The purchaser of a forward, unlike the purchaser of a future, carries the credit risk of the firm from which it makes the purchase. Since the contracts are not easily reassignable, it is difficult to reduce this risk.
CYLINDER
Also known as range forward or risk-reversal. The simultaneous purchase of an out-of-the-money currency put option and sale of an out-of-the-money currency call option (or vice versa). The choice of strike prices is usually made to result in a zero cost strategy. This strategy enables purchasers to hedge their downside at reduced (or no) cost. This is at the expense of forgoing upside beyond a certain level since the purchase of the put is financed by the sale of the call.
See also
collar
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 service reserve fund
The Debt Service Reserve Fund (“DSRF”) has traditionally been invested in a long term treasury security combined with a simultaneous purchase of a par put option to insure liquidity and par value of the treasury. The problem with purchasing the treasury put is that it can be expensive (up to 100 bps), reducing the overall yield of the DSRF. Furthermore, once purchased, a treasury put is relatively illiquid with little resale value. Sometimes, the long term treasury is bought “naked,” that is, without the put option, which eminently sets up the issuer for a probable underfunded DSRF sometime in the future.
The DSRF Forward Purchase Agreement (“FPA”) provides essentially the same long term rate as long term treasuries, while eliminating the need for a treasury put option. The DSRF FPA works as follows: A FPA provider would initially deliver a 90 day T-Bill to the trustee. When that T-bill matured the FPA provider would deliver a new 90 day T-Bill in exchange for the cash resulting from the previous maturing T-Bill. This cycle would continue for the term of the agreement. The yield for this type of instrument is fixed for the term of the agreement. The agreement is extremely safe, as the issuer always has either cash or a T-Bill in the trustee possession, and will be approved by most bond counsel.
If allowed by the indenture, the interest to be earned for the term of the FPA can be taken over time or taken up front as a lump sum payment. An issuer can partially fund the DSRF by taking earnings up-front which reduces the overall bond issuance amount. The up-front payment can represent 25-50% of the total DSRF requirement. Similarly, if an issuer had bought a long term treasury in a lower interest rate environment to fund a DSRF which is now underfunded, a partial up-front payment from an FPA can bring the DSRF back to par, eliminating the need to look to other sources of monies to fill the requirement. The remaining interest can then be taken over time or be taken up-front to release locked DSRF funds for other uses.
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.
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.
DOUBLE TRIGGER FORWARD
See
trigger forward
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.
EXCHANGE RATE AGREEMENT (ERA)
A synthetic agreement for forward exchange (SAFE) that changes in value as the spread between two forward currency exchange rates (for example, the three-month and six-month forward) changes. Unlike a forward exchange rate agreement, the ERA is settled with reference to two forward rates rather than a forward and the spot rate on settlement.
FORWARD EXCHANGE RATE AGREEMENT (FXA)
A synthetic agreement for forward exchange (SAFE) developed by Midland Montague. Essentially a cash-settled forward. The counterparties agree on a forward exchange rate for a chosen delivery date, and at the maturity of the contract the two counterparties make mark-to-market payments based on the prevailing spot rates.
See also
synthetic agreement for exchange
FORWARD EXTRA
The Forward Extra structure has been developed primarily for hedging purposes, and is essentially a European option that becomes a synthetic forward contract at the strike level of the option if a trigger level is reached. For zero cost, the purchaser of the structure acquires protection against an adverse exchange rate move and can benefit from a favorable limited move on the underlying (provided that the trigger level is not hit). The Forward Extra Plus offers the protection of the Forward Extra. However, if a pre-determined trigger level is reached, the Forward Extra becomes a synthetic forward contract struck at the initial forward outright rate.
See also
trigger forward,
weekly reset forward
FORWARD EXTRA PLUS
See
forward extra
FORWARD purchase AGREEMENT
Forward Purchase Agreements/Float Contracts can be structured to offer a municipal debt issuer a yield over time in exchange for a commitment by an issuer to direct the monthly debt service principal and interest payments to a counterparty for their use prior to semi-annual debt service payments. This contract provides long term yields on short term cash flows. The contract is also very effective in reducing negative arbitrage in escrow portfolios.
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 rate curve
The yield curve, as of a future (or forward) date, constructed using currently prevailing rates on instruments settling in the future; commonly used to price many interest rate derivative instruments.
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 START OPTION
An option that gives the purchaser the right to receive, after a specified time, a standard put or call option. The option’s strike price is set at the time the option is activated, rather than when it is purchased. The strike level is usually set at a certain fixed percentage in or out-of-the-money relative to the prevailing spot rate at the time the strike is activated.
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.
FUTURE
A future is a contract to buy or sell a standard quantity of a given instrument, at an agreed price, on a given date. A future is similar to a forward contract and differs from an option in that both parties are obliged to abide by the transaction. Futures are traded on a range of underlying instruments including commodities, bonds, currencies, stock indices and even pollution.
The most important difference between futures and forwards is that futures are almost always traded on an exchange and cleared by a clearing house, whereas forwards are over-the-counter instruments. Furthermore, futures, unlike forwards, have standard delivery dates and trading units. Most futures contracts expire on a quarterly basis. Contracts specify either physical delivery of the underlying instrument or cash settlement at expiry. Cash settlement involves the company paying or being paid the difference between the price struck at the outset and the expiry price of the contract.
The clearing house is crucial, acting as the counterparty to all transactions; that is, it acts as the buyer to the seller of the future, and as the seller to the buyer. Since for every long futures position there must be a short position, the clearing house has a net position of zero at the end of each day. It also operates a system known as margining. On entering a transaction, a company will be required to lodge a specified sum of money (initial margin) with the clearing house. The amount depends on how much the clearing house considers prudent to set aside to protect against a dramatic move in the underlying market. Each day, the company also gives or receives variation margin, which is the difference between the original contractual price and the daily closing price.
In pricing futures, an important distinction is between futures on assets held for investment and those held almost exclusively for consumption (such as pork bellies or soya beans). The price of futures on investment assets is determined by the relative interest rates or dividend yields of the asset and cash, such as to eliminate riskless arbitrage through buying the future and selling the asset or vice versa. By contrast, futures on commodities not held for investment cannot readily be priced by an arbitrage approach – perceived supply and demand considerations are much more significant.
Futures provide a formalized method of transferring risk from those wanting to reduce their market exposure to those wanting to increase it. For example, futures markets allow commodity producers to hedge against falling prices, or fund managers to weight their stock, bond or currency portfolios according to their required risk profiles.
For fund managers, futures also provide a way of entering and exiting markets with typically much lower transaction costs (friction) than would be the case with cash alternatives. This is especially true in equity markets. Because of their standardized nature, however, futures contracts may not match precise hedging needs. Instead the hedger may incur basis risk, the risk that the return on the futures position may differ from that on the spot.
GOLD FORWARD OFFERED RATE
The rates at which dealers will lend gold on swap against US dollars.
GOLD LEASE RATE
The gold lease rate is the cost to borrow gold. Similar to other commodities it is a function of supply and demand. The rate (non-credit adjusted) is determined by the difference between Libor and the gold forward rate for the specified period. Credit adjustments are subsequent to the calculation.
GUARANTEED EXCHANGE RATE OPTION
An option (also known as a quanto option) on an asset in one currency denominated in a second currency. The exchange rate at which the purchaser converts the currency is fixed at the start. Such options are increasingly popular as investors want exposure to foreign assets without the foreign exchange risk. Most of the demand is for bond and stock index options. The extra cost of the option depends on the correlation between movements in the exchange rate and movements in the underlying. The higher (more positive) the correlation between the underlying and the exchange rate (expressed as the number of units of currency two per unit of currency one) the more expensive a call option will be and the cheaper a put option will be. Quanto options can, however, look cosmetically cheaper (or more expensive) depending on the forward interest rates in the two currencies. For example, buying a call on a US asset could be “cheaper” in euros if there is a wide interest rate differential between the euro and the dollar.
See also
joint option
GUARANTEED investment contract (GIC)
A Guaranteed Investment Contract ("GIC") is a contract between a municipal entity or 501(c)(3) organization and a financial institution (the "Provider") in which the Provider guarantees a rate of return on bond proceeds deposited under the investment contract. Guaranteed Investment Contracts have proven to satisfy the unique economic, tax and legal requirements associated with the investment of tax-exempt bond proceeds and have been used with increasing frequency among tax-exempt issuers.
A GIC offers the preservation of principal, earns a fixed yield, and allows for access to funds with no market risk. A GIC is particularly well suited for construction funds because it allows for full flexibility of draws, thus eliminating any market and/or reinvestment risk if construction draws fluctuate for any reason. GICs can also be used for debt service reserve funds, bond funds, and escrow funds, with draws occurring semi-annually on bond payments dates or as required by the Indenture. The yield on an investment contract will generally exceed the yield on a repurchase agreement by approximately 30 basis points.
Guaranteed investment contracts can be structured with varying degrees of security. Typically, the security is provided by requiring the Provider of the GIC to maintain a certain level of long-term credit rating by one or more of the recognized Rating Agencies. The rating requirement for the Provider is often determined by the Indenture or other bond documents. In the event the Provider is downgraded below a certain level (e.g. below the "A" category from Moody's or Standard & Poor's) while the GIC is in place, then the Provider is required to provide additional security such as posting collateral with an independent third-party or assigning the contract to a new provider that both meets the rating requirement and is acceptable to the Issuer.
Documentation for a GIC is usually a straight forward contract between the Provider of the GIC and the Trustee and/or the Issuer.
HEATH-JARROW-MORTON MODEL
A multi-factor interest rate model which describes the dynamic of forward rate evolution. An extension of the Ho-Lee model, the underlying is the entire term structure of interest rates. The approach is very similar to the original Black-Scholes Model: it does not model qualities such as the “price for risk.”
The model requires two inputs: the initial yield curve and a volatility structure for the forward. The volatility is only specified in a very general form. By choosing an appropriate volatility function, it is possible to reduce HJM to simpler models such as Ho-Lee, Vasicek, and Cox-Ingersoll-Ross.
The practical importance of the HJM model is that it provides a single coherent framework for pricing and hedging an entire book of instruments (including instruments like caps and swaptions) and is not excessively computationally intensive. Research building on HJM (such as the market model) has concentrated on widening its scope to remove the possibility of negative interest rates, include more than one interest rate curve and incorporate default risk.
HISTORIC RATE ROLLOVER
A historic rate rollover allows an existing currency forward or spot position to be rolled forward without generating any intermediate cash flows. Effectively the position is reinstated for a new settlement date using a new off-market forward rate based on the historic rate.
IMPACT FORWARD
A collared forward, such as one in which the purchaser buys a put and sells a call, both being out-of-the-money. The premiums on the two options balance out, so the strategy is zero cost. Upside and downside is limited to the gap between the strike prices.
See also
collar
IMPLIED FORWARD CURVE
The forward curve implied by forward rate agreements (derived from the par curve) of various maturities. It is usually steeper than the normal yield curve.
IMPLIED REPO RATE
The return earned by buying a cheapest-to-deliver bond for a bond futures contract and selling it forward via the futures contract.
See also
future
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.
IN-THE-MONEY
Describes an option whose strike price is advantageous compared to the current forward market price of the underlying. The more an option is in-the-money, the higher its intrinsic value and the more expensive it becomes. As an option becomes more in-the-money, its delta increases and it behaves more like the underlying in profit and loss terms; hence deep in-the-money options will have a delta of close to one.
See also
at-the-money,
out-of-the-money
INTRINSIC VALUE
The amount by which an option is in-the-money, that is, its value relative to the current forward market price. Option premiums comprise intrinsic value and time value.
LENDING
Derived from lending metal to the market. Selling metal on a nearby date and simultaneously buying it back on a forward date
LONG-DATED FORWARD
A forward contract for a value date in excess of 12 months. Cost of carry becomes more significant for the pricing of forward contracts with longer maturities.
MANDARIN COLLAR
The Mandarin Collar combines a range forward with the purchase of a range binary structure, such that should the spot stay within the prescribed range, the proceeds of the range forward are enhanced by the pay-out amount of the range binary. If either of the limits trades at any time, the range binary is terminated, but the underlying exposure remains hedged by the range forward. The graph displays the payoff of a long exposure hedged using a Mandarin Collar; the choice of name should be apparent from this picture.
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.
Non-deliverable forward (NDF)
Non-deliverable forward contracts (NDFs) – also called dollar-settled forwards – are synthetic forwards which entail no exchange of currencies at maturity. Instead, settlement is made in US dollars based on the difference between the agreed contract rate at inception and a market reference rate at maturity. NDFs can be used to establish a hedge or take a position in one of a growing group of emerging market currencies where conventional forward markets either do not exist or may be closed to non-residents. As offshore instruments, NDFs offer the advantage of eliminating convertibility risk, since no emerging market currencies are exchanged at maturity.
OPTION
A contract that gives the purchaser the right, but not the obligation, to buy or sell an underlying at a certain price (the exercise, or strike price) on or before an agreed date (the exercise period).
For this right, the purchaser pays a premium to the seller. The seller (writer) of an option has a duty to buy or sell at the strike price, should the purchaser exercise his right. With European-style options, purchasers may take delivery of the underlying only at the end of the option’s life. American-style options may be exercised, for immediate delivery, at any time over the life of the option. Holders of semi-American-style or Bermudan options may be exercised on specified dates – typically on a monthly or quarterly basis.
Options can be bought on commodities, stocks, stock indexes, interest rates, bonds, currencies, etc. The trading terminology, though, may change according to the product. In most cases, the right to buy the underlying is known as a call, and the right to sell, a put.
Options are traded on formal exchanges and in over-the-counter (OTC) markets. The exchanges, such as the Chicago Board Options Exchange, the London International Financial Futures and Options Exchange and the Philadelphia Stock Exchange, provide primarily standardized options; the OTC markets are able to provide tailored products to fit specific requirements. The choice between OTC and exchange-traded options will depend on the degree of tailoring required, the relative liquidity of both markets (this varies greatly according to the underlying) and credit concerns.
Such credit concerns increase with the option’s maturity, since the likelihood that a counterparty will default increases with the length of time that passes between the option being bought and being exercised. Several derivatives exchanges have tried to bridge the gap between OTC and exchange-traded options by introducing flexible options that can be customized by the purchaser.
Pricing models for simple or vanilla options have five major inputs: the option’s exercise or strike price; the time to expiration; the price of the underlying instrument; the risk-free interest rate on the underlying instrument, and the volatility of the underlying instrument (See also historical volatility, implied volatility).
European-style options are usually priced off a closed-form analytical model first published by Fischer Black and Myron Scholes in 1973, which has subsequently been modified to fit different underlyings (see Black-Scholes model).
At maturity, an option’s value will depend on the value of the right to buy or sell a product. If an option is purchased giving the right to buy gold at $375 an ounce and at expiration the price is $400, the option is worth $25.
The extent to which an option is in-the-money (how far the strike price is below/above the current forward market price) is called its intrinsic value. Where the strike price is less favorable than the market price, the option is said to be out-of-the-money, and where the two prices are the same it is at-the-money.
At any time before maturity, an option’s price will be a combination of its intrinsic value (which is always either greater than, or equal to, zero) and its time value. The latter includes the cost of carry and the probability that the price of the underlying will move into or remain in the money. Options can broadly be used in two ways – for speculation, or for insurance. Their usefulness, both from a buyer’s and a seller’s point of view, derives from their pay-outs.
In contrast to other types of hedge, options provide insurance against unfavorable moves in a product’s price and the opportunity to take advantage of favorable moves. Forwards and futures, for example, require buyers and sellers to lock into one rate. In return for assuming this risk, sellers of options receive a premium, effectively a risk-taking fee.
The pay-off of a purchased option means that the price risk of an option is limited to its premium – it is not as exposed to adverse movements as a position in the underlying.
For speculators selling (writing) options, this often means taking a naked option position and therefore being exposed to adverse movements in the underlying. Hedgers may sell options to garner premium to offset any expected slight downturn in a market. Since option premiums are only a fraction of the cost of the underlying product, it is possible to achieve a much greater exposure to price changes of the underlying compared with a similar investment directly in the product – this is called leverage.
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
OUT-OF-THE-MONEY
Describes an option for which the currency forward market price of the underlying is below the strike price in the case of a call, or above it in the case of a put. The more the option is out-of-the-money, the cheaper it is (since the chances of it being exercised get slimmer). Its delta also declines and it becomes less sensitive to movements in the underlying.
PARTICIPATING FORWARD
The simultaneous purchase of a call option (put option) and sale of a put (call) at the same strike price, usually for zero cost. The option purchased must be out-of-the-money and the option sold (to finance the option purchase) is for a smaller amount and will be in-the-money.
PLATFORM TRIGGER FORWARD
See
trigger forward
RANGE FORWARD
See
cylinder
STEP-UP/DOWN RANGE FORWARD
A self-adjusting range forward structure which is particularly suitable for hedging purposes. If the strike level of the long put option is breached, the strike automatically adjusts up or down (according to exposure) to a new, more favorable, level.
STRANGLE
1) As with a straddle, the sale or purchase of a put option and a call option on the same instrument, with the same expiry, but at strike prices that are out-of-the-money. The strangle costs less than the straddle because both options are out-of-the-money, but profits are only generated if the underlying moves dramatically, and the break-even is worse than for a straddle. Sellers of strangles make money in the range between the two strike prices, but lose if the price moves outside the break-even range (the strike prices plus the premium received).
2) The term strangle is also used, by currency option traders, to denote the average difference in implied volatility between out-of-the-money call and put options with a 25% delta and the implied volatility of at-the-money forward options.
STRUCTURED NOTE
Structured notes are over-the-counter products, which bundle several disparate elements to create a single product, generally by embedding options in a debt instrument such as a medium-term note. They are often view-oriented and are generally tailored to be attractive to investors with highly focused risk/reward appetites and opinions on the market. For example, a structured note might embed equity or currency options or forwards in a debt issue in an effort to enhance the yield of a normal debt holding. Heavily promoted in the early 1990s, structured notes fell out of favor somewhat in 1993–94 as a sequence of surprise market moves and widely publicized losses pointed to the difficulty of pricing and trading such instruments, as well as the cost of taking the incorrect market view. During this time, the comparatively undeveloped secondary market for structured notes allowed sophisticated relative value players to buy “broken” structured notes on an asset swapped basis much more cheaply than vanilla assets from the same issuers.
SYNTHETIC 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 FORWARD
See
synthetic asset
TRIGGER FORWARD
The trigger forward is primarily designed for trading purposes, although it can also be used as an alternative hedge. It is usually a zero-cost structure, whereby the purchaser enters into an outright forward transaction at a rate significantly more attractive than the prevailing market rate, but where the whole structure will be knocked out if a predetermined trigger level is reached at any time before the expiry date.
Other variations on this structure are the at-maturity trigger forward, double trigger forward and the platform trigger forward.
• The at-maturity trigger forward is an outright forward structure which is knocked out if a pre-determined trigger level is breached on the expiry date.
• The double trigger forward is a standard trigger forward with two trigger levels (one above and one below the current market level).
• The platform trigger forward combines a regular trigger forward with the purchase of a vanilla option struck at the trigger level with the trigger forward. This provides extra protection should the trigger level be breached.
See also
forward extra
WEEKLY RESET FORWARD
A weekly reset forward is a synthetic forward where a portion of the contract is locked in each week, provided that the spot rate that week meets a predetermined fixing criterion. Hence the purchaser can deal at a rate better than the forward outright, but only in an amount corresponding to the frequency with which the criterion has been met. If the criterion is met in none of the weeks during the life of the contract, then the contract is not activated at all; if it is met every week, the overall rate is favorable compared to the initial prevailing market rate. The weekly reset forward is used for those with cash-flows spread over time or to hedge balance sheets.
See also
forward extra,
wall option
YIELD CURVE
The yield curve is a graphical representation of the term structure of interest rates. It is usually depicted as the spot yields on bonds with different maturities but the same risk factors (such as creditworthiness of issuer), plotted against maturity. The usual features of a spot yield curve are higher long-term yields than short-term yields and a curve for default-free bonds that is lower at each point than the equivalent curve for riskier debt. It is possible to construct variants of the yield curve from this basic form. The par yield curve is found by calculating the coupons that would be necessary for bonds of each maturity to be priced at par; the forward yield curve is found by extrapolating the spot yield curve point-by-point, based on the implied forward interest rates.