Partial Matches:
BASIS
1. The difference between the prices of a futures contract and the underlying.
2. The convention for calculating interest rates. A bond can be 30/360 or actual/365 in the US, or 360/360 in Europe. Money market instruments can be actual/360 in the US or actual/365 in the UK and Japan.
BASIS 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.
BOND FUTURE
A futures contract on a bond. The underlying can be of two types. The first is a notional (theoretical) bond, for example the 10-year government bond futures contract on Marché à Terme International de France (Matif), which has a notional seven- to 10-year underlying government bond with a 10% coupon. The second type is a futures contract on a specific bond, for example, the futures contract on the Danish government bond 8% 2000, listed on the Guarantee Fund for Danish Options and Futures. The notional type is more common.
The theoretical price of a bond futures contract equals the spot price of the underlying bond plus its net cost of carry. The higher the cost of carry (measured by its implied repo rate) for the cash bond, the more value there is in holding a futures contract instead, which is simply another way of buying a cash bond but at a future date. If the financing costs of holding a bond are lower than the bond’s yield, the bond will have positive carry and the futures contract will trade at a discount. If the financing costs of the bond are higher than the bond’s yield, the futures will trade at a premium. Hence bond futures normally trade at a discount to the cash in an upward-sloping yield curve and at a premium in a downward-sloping one. The degree of premium or discount will decrease the closer the futures contract is to expiry.
When futures are based on a notional bond, the exchange has to specify which bonds are deliverable into the futures contract. These can change periodically as outstanding issues get shorter and reach maturity. Because bonds have differing coupons, the exchange has to specify a conversion factor that allows those bonds to be compared on an equal basis to the notional underlying. A bond’s conversion factor is the value of one unit of that bond were it to trade at a yield to maturity equal to that of the notional bond. Because of demand/supply conditions, some bonds will be cheaper to deliver than others. The cheapest to deliver will be those where the greatest profit can be made from holding the bond and delivering it into the futures contract (called cash-and-carry arbitrage). This is dependent on the supply of bonds in the market, and on a bond’s maturity and coupon.
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.
BOX
To buy/sell mispriced options and hedge the market risk using only options, unlike the conversion or the reversal, which use futures contracts. If a certain strike put is underpriced, the trader buys the put and sells a call at the same strike, creating a synthetic short futures position. To get rid of the market risk, he sells another put and buys another call, but at different strike prices.
CALENDAR SPREAD
A strategy that involves buying and selling options or futures with the same (strike) price but different maturities. Such a strategy is used in futures when one contract month is theoretically cheap and another is expensive. With options, the strategy is often used to play expected changes in the shape of the volatility term structure. For example, if one-month volatility is high and one-year volatility low, arbitrageurs might buy one-year straddles and sell short-term straddles, thereby selling short-term volatility and buying long-term volatility. If, all else being equal, short-term volatility declines relative to long-term volatility, the strategy makes money.
CASH MARKET
An underlying, as opposed to a futures market.
CASH-AND-CARRY ARBITRAGE
A strategy used in bond or stock index futures in which a trader sells a futures contract and buys the underlying to deliver into it, to generate a riskless profit. For the strategy to work, the futures contract must be theoretically expensive relative to cash. The value of a futures contract is assessed by looking at the implied repo rate. If the implied repo rate is greater than the market repo rate, then futures are said to be cheap.
Cash-and-carry arbitrage and reverse cash-and-carry arbitrage typically keep the futures and underlying markets closely aligned.
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).
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.
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
CONVERSION
1) A way of taking advantage of mispriced options by creating a synthetic short futures position and hedging market risk by buying a futures contract against it. Thus if a put is undervalued, a trader buys it, at the same time selling a fairly valued call and buying a futures contract. The same strategy can be applied if the call is mispriced. If the option is truly undervalued, the trader earns a riskless profit. The whole exercise relies on put-call+parity. 2) The act of converting a convertible bond into equity.
See also
box,
reversal
CRUSH SPREAD
The simultaneous sale of soybean oil futures and meal, and purchase of soybean futures.
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.
DYNAMIC REPLICATION
To replicate the pay-out of an option by buying or selling the underlying (or for some markets, because of cheaper transaction costs, futures) in proportion to an option’s delta. If replicating a short call position, the replicator would, as the underlying went up, buy increasing amounts in proportion to the theoretical option’s delta, and likewise decrease the hedge amount as the market falls. Dynamic replicators are at risk from increases in volatility, as this makes it more difficult for the necessary hedge amounts to be transacted at the desired rate.
See also
static replication
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.
EXCHANGE FOR PHYSICALS (EFP)
A futures market transaction between two counterparties consisting of a simultaneous exchange of a futures contract and an offsetting OTC quantity. In the case of gold, there is an active EFP market with dealers quoting bid and offer – usually the COMEX active month against loco London spot. Such an exchange allows for counterparties to open/close positions in the futures and OTC market without making outright purchases or sales. The EFP is also used as a trading instrument in its own right as position-takers can establish arbitrage positions.
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.
FUTURES OPTION
An option, either a put or a call, on any futures contract. Also known as an option on a future.
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 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.
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.
LEVERAGE
The ability to control large amounts of an underlying variable for a small initial investment. Futures and options are regarded as leveraged products because the initial premium paid by the purchaser is generally much smaller than the nominal amount of the underlying. Leverage is usually measured as a quantity called lambda. Many structured notes are said to be leveraged because their coupon is governed by a multiple of a reference interest rate (such as Libor). It is also possible to deleverage a note by linking its coupon to a fraction of the reference rate.
LISTED OPTION
See warrant, exchange traded futures, options
MUTUAL OFFSET SYSTEM
A margining system for derivatives exchanges in which positions on different exchanges can offset each other. This means that if a participant has a long position on one exchange but a short position on the other in a fungible (compatible) contract, they can pay reduced margin on one exchange because their total exposure has been reduced by netting over the two exchanges.
For example, the Singapore International Monetary Exchange (Simex) has two mutual offsets, one with the Chicago Mercantile Exchange for Eurodollar futures, and another with the International Petroleum Exchange, for Brent crude oil futures.
OPEN INTEREST
The number of deals left open (deals bought and sold at the same price counting as one) overnight on an exchange-traded futures contract.
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.
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
REPLICATION
To replicate the pay-out of an option by buying or selling other instruments. Creating a synthetic option in this way is always possible in a complete market. In the case of dynamic replication this involves dynamically buying or selling the underlying (or normally, because of cheaper transaction costs, futures) in proportion to an option’s delta. In the case of static replication the option (usually an exotic option) is hedged with a basket of standard options whose composition does not change with time – e.g., an at-expiry digital option can be replicated with a call spread.
REVERSAL
To take advantage of mispriced options by creating a synthetic long futures position and hedging it by selling futures contracts against it. A trader may buy an undervalued call, at the same time selling a fairly valued put and buying a futures contract. The same strategy could be applied if the put was undervalued. The ability to undertake this riskless arbitrage relies on put-call parity.
See also
box,
conversion
REVERSE CASH-AND-CARRY ARBITRAGE
A technique, used mainly in bond futures and stock index futures, that involves buying a futures contract and selling the underlying. It is used when a futures contract is theoretically cheap, such as when the implied repo rate is less than the market repo rate.
See also
cash-and-carry arbitrage
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.
STATIC REPLICATION
Static replication is a method of hedging an options position with a position in standard options whose composition does not change through time. The method attempts to replicate the pay-out of the instrument in a more manageable fashion than dynamic replication, where a position in the underlying or futures contracts must be dynamically adjusted if it is to remain effective.
Because it uses options to hedge options, a static replication portfolio is a better hedge for gamma and volatility, as well as delta, than dynamic replication. Static replication can be used for hedging a position in exotic options with vanilla options, or for replicating a long-term option with short-term options. In practice, however, it is not always possible to hedge using static replication. The number of different options and notional amounts required can quickly become unmanageable.
See also
synthetic asset,
replication,
delta-hedging
STOCK INDEX ARBITRAGE
The technique of selling a futures contract on a stock index and buying the underlying stocks, via program trading, or vice versa when the price of the futures contract is above or below its theoretical value. The ability to conduct such strategies depends on the efficiency of the futures and cash markets.
STOCK INDEX FUTURE
A futures contract on a stock index. Most are cash-settled. The theoretical price of a stock index future equals the cost of carrying the underlying stock for that period: the opportunity cost of the funds invested minus any dividends. If the cost of buying and holding the underlying stocks is less than the futures price, an arbitrageur can sell futures and buy the underlying stocks.
The higher interest rates are (compared with the dividend yield), the greater the opportunity cost of holding the stocks, hence the futures price should be higher than the current index price. If interest rates are less than the dividend yield, the opportunity cost of holding stocks is less and the futures price should fall below the current index price. There is usually a so-called arbitrage band in which, although the futures and underlying prices diverge, it is not worthwhile arbitraging the two. This arises as a result of transaction costs from bid-ask spreads, the market impact of buying and selling stock, and execution risks.
SYNTHETIC ASSET
A synthetic asset is a combination of long and short positions in financial instruments which has the same risk/reward profile as another instrument. For example, it is possible to replicate the pay-out and exposure of a short futures position by going short European-style call options and long European puts with identical strikes and expiries. Synthetic index options can be generated either through positions in the underlying and futures contracts, or with a basket of vanilla options.
See also
replication
UNDERLYING
The variable on which a futures or option contract is based.