Partial Matches:
ACCRUAL ACCOUNTING
When swaps are used for asset/liability hedging purposes, that is, to hedge specific on-balance sheet exposures, they are often accounted for on an accrual basis. Under the accrual method, the net payment or receipt each period is accrued and recorded as an adjustment of income or expense.
See also
hedge accounting,
mark to market
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.
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.
BETA
1. The beta of an instrument is its standardized covariance with its class of instruments as a whole. Thus the beta of a stock is the extent to which that stock follows movements in the overall market. If a stock has a beta greater than one, it is more volatile than the market; if less than one, it is less volatile.
2. Beta trading is used by currency traders if they take the volatility risk of one currency in another. For example, rather than hedge a sterling/yen option with another sterling/yen option, a trader, either because of liquidity constraints or because of lower volatility, might hedge with euro/yen options. The beta risk indicates the likelihood of the two currencies’ volatilities diverging.
BLACK-SCHOLES MODEL
The original closed-form solution to option pricing developed by Fischer Black and Myron Scholes in 1973. In its simplest form it offers a solution to pricing European-style options on assets with interim cash pay-outs over the life of the option. The model calculates the theoretical, or fair value for the option by constructing an instantaneously riskless hedge: that is, one whose performance is the mirror image of the option pay-out. The portfolio of option and hedge can then be assumed to earn the risk-free rate of return.
Central to the model is the assumption that market returns are normally distributed (i.e., have lognormal prices), that there are no transaction costs, that volatility and interest rates remain constant throughout the life of the option, and that the market follows a diffusion process. The model has five major inputs: the risk-free interest rate, the option’s strike price, the price of the underlying, the option’s maturity, and the volatility assumed. Since the first four are usually determined by the market, options traders tend to trade the implied volatility of the option.
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.
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.
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.
COMPLETE MARKETS
If markets are complete, then any contingent claim can be hedged exactly using tradable assets.
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
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.
DELTA
The delta of an option describes its premium’s sensitivity to changes in the price of the underlying. In other words, an option’s delta will be the amount of the underlying necessary to hedge changes in the option price for small movements in the underlying. The delta of an option changes with changes in the price of the underlying. An at-the-money option will have a delta of close to 50%. It falls for out-of-the-money options and increases for in-the-money options, but the change is non-linear: it changes much faster when the option is close-to-the-money. The rate of change of delta is an option’s gamma.
DELTA-HEDGING
An option is said to be delta-hedged if a position has been taken in the underlying in proportion to its delta. For example, if one is short a call option on an underlying with a face value of $1 million and a delta of 25%, a long position of $250,000 in the underlying will leave one delta-neutral with no exposure to small changes in the price of the underlying. Such a hedge is only effective instantaneously, however. Since the delta of an option is itself altered by changes in the price of the underlying, interest rates, the option’s volatility and its time to expiry, changes in any of these factors will shift the net position away from delta-neutrality. In practice, therefore, a delta-hedge must be rebalanced continuously if it is to be effective.
DUAL CURRENCY SWAP
Dual currency swaps are currency swaps that incorporate the foreign exchange options necessary to hedge the interest payments back into the principal currency for dual currency bonds.
DYNAMIC 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
FAS 133
The Financial Accounting Standards Board’s derivatives accounting rule that came into force in June 2000. The rule requires all SEC-registered companies to include the fair (i.e., mark to market) value of their derivatives positions in their balance sheet. Hedge accounting is only permitted where hedge effectiveness – i.e., that the change in the value of the derivatives is offset by the corresponding change in the value of the financial item being hedged – can be demonstrated. FAS 133 is also abbreviated as FAS133, SFAS 133, and Statement No. 133.
See also
IAS 39,
fair value
FAS 157
The Financial Accounting Standards Board’s fair value measurements rule that came into force in November 2007. FAS 157 applies to for-profit and not-for profit entities that prepare their financial statements in accordance with GAAP.
At its heart, FAS 157 redefines fair value as, “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” The Statement redefines “fair value” as an exit price, rather than an entry price, regardless of whether the entity plans to hold or sell the asset.
FAS 157 is also abbreviated as FAS157, SFAS 157, or Statement No. 157.
FaSB
Financial Accounting Standards Board - The designated private sector organization in the US whose primary purpose is to develop and establish financial accounting and reporting standards for for-profit and not-for-profit entities. FASB’s two most important statements in relation to the accounting of financial derivatives and fair value measurement are FAS 133 and FAS 157.
FINANCIAL accounting standards board
See
FASB
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.
GAap
Generally Accepted Accounting Principles - A widely accepted set of standards, conventions, rules, and procedures that for-profit and not-for-profit entities follow in the recording and reporting of accounting and financial information as established by FASB.
GAMMA
The rate of change in the delta of an option for a small change in the underlying. The rate of change is greatest when an option is at-the-money and decreases as the price of the underlying moves further away from the strike price in either direction – gamma is therefore -shaped. A long gamma position is one in which a trader is long options. For a position that is short gamma, the opposite holds. Gamma can be hedged by mirroring the options position. Alternatively, a trader may choose to adjust the position in the underlying continually in order to maintain delta neutrality.
See also
convexity
GAO REPORT
The colloquial name for the May 1994 report “Financial Derivatives: Actions Needed to Protect the Financial System” published by the US General Accounting Office, the investigative arm of Congress. The report made six key points:
• Derivatives perform a valuable function by enabling end-users to manage the financial risks associated with their business
• The concentration of over-the-counter (OTC) derivatives activity among 15 extensively linked major US dealers opens up the possibility of liquidity problems and systemic risk should any of these dealers fail
• There are no comprehensive or federal regulatory requirements to ensure that major OTC players in the US follow good practice in risk management, so newcomers could increase the systemic risk by taking on unnecessary risk
• Significant gaps exist in the regulation of many major OTC derivatives, most notably affiliates of securities firms and insurance companies
• Insufficient precision in accounting for and financial reporting of derivatives compound the difficulties faced by interested parties when trying to assess their impact
• Innovation and creativity are strengths of the US financial services industry which should not be shackled by over-regulation.
gasb
Governmental Accounting Standards Board – A private, independent, not-for-profit organization that – through an open and thorough due process – establishes and improves standards of financial accounting and reporting for state and local government. Governments and the accounting industry recognize GASB as the official source of generally accepted accounting principles (GAAP) for state and local governments.
GOvernmental accounting standards board (GASB)
See
GASB
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.
HEDGE
To hedge is to reduce risk by making transactions that reduce exposure to market fluctuations; for example, an investor with a long equity position might compensate by buying put options to protect against a fall in equity prices. A hedge is also the term for the transactions made to effect this reduction.
HOLDING PERIOD
The time that it is assumed would be needed to liquidate or hedge a portfolio for the purpose of calculating value-at-risk. The longer the holding period, the higher the value-at-risk.
IAS 39
The London-based International Accounting Standards Committee’s derivatives accounting rule, similar to FAS+133. IAS 39 came into force in 2001 and is applicable to all companies using international accounting standards – i.e., most of the world’s multinationals. The scope of IAS 39 is wider than FAS 133 because the fair value for all financial instruments, not just derivatives, must be included on balance sheet. The rule will become compulsory for all European-quoted companies in 2005.
INTEGRATED HEDGE
A hedge which combines more than one distinct price risk. For example, crude oil is usually priced in US dollars. Therefore a producer of crude oil whose home currency is not the dollar (say, the euro) is exposed to both currency risk and the price risk for crude oil. One possible integrated hedge would be a single quanto option, which would hedge the price of crude oil in euro. As such, it would depend heavily on the correlation (if any) between the two markets.
See also
exchange option
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.
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.
MINI-PREMIUM OPTION
The purchaser of a mini-premium option (also known as a step-payment or installment option) pays no initial premium. Instead, a fixed premium becomes payable if the market spot rate subsequently trades through each of a number of predetermined trigger levels for the spot rate. While this offers hedgers protection at zero cost, the total premium paid if all the triggers are activated will be greater than the premium for the equivalent plain vanilla option. However, in this case, the spot rate would have moved in favor of the hedger’s underlying position.
See also
binary option,
contingent premium option
NATURAL HEDGE
A natural hedge is the reduction in financial risk that can arise from an institution’s normal operating procedures. For instance, a company that has a significant portion of its sales in one country will have a natural hedge to at least part of its currency risk if it also has operations in that country generating expenses in the currency. Firms may act to increase natural hedges by changing sourcing, funding, or operational decisions, but natural hedges are less flexible, and more difficult to reverse, than financial hedges.
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.
PARTICIPATING SWAP
A swap in which floating-rate exposure is hedged but in which the hedger still retains some benefit from a fall in rates.
PERFECT hedge
A hedge that completely eliminates any possible future gain or loss on the hedged asset/liability.
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
RELATIVE PERFORMANCE RISK
The risk that a fund manager’s choice of investments will fail to match the performance of the benchmark against which the fund is measured, prompting fund redemptions. A similar risk is run by corporate treasury risk managers who are measured against benchmark hedge levels. One way to address this type of risk is with outperformance options. Relative performance risk is also used to refer to the risk that an individual asset will underperform relative to its asset class. For equities, this may be measured by a stock’s beta, its standardized covariance with respect to the relevant equity index.
See also
specific risk
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.
REVERSE INDEX AMORTISING SWAP
An interest rate swap in which payments are linked to an index (e.g., Libor or constant maturity Treasuries) and increase if that index declines. The swap therefore exhibits positive convexity. Receiving fixed in a reverse index amortizing swap (reverse IAS) provides a hedge for instruments (such as mortgage swaps) that amortize as interest rates decline, although it is important to ensure that the indexes on which the amortization or accreting schedules are based are highly correlated. Unlike a conventional IAS, the fixed receiver of a reverse IAS is buying volatility (sometimes referred to as “optionality”) which offsets the short option position of a mortgage portfolio.
RISK MANAGEMENT
Control and limitation of the risks faced by an organization due to its exposure to changes in financial market variables, such as foreign exchange and interest rates, equity and commodity prices or counterparty creditworthiness. This may be because of the financial impact of an adverse move in the market variable (market risk), because the organization is ill-prepared to respond to such a move (operational risk), because a counterparty defaults (credit risk), or because a specific contract is not enforceable (legal risk).
Market risks are usually managed by hedging with financial instruments, although a firm may also reduce risk by adjusting its business practices (see natural hedge). While financial derivatives lend themselves to this purpose, risk can also be reduced through judicious use of the underlying assets (for example, by diversifying portfolios).
ROLL-OVER RISK
The risk that a derivative hedge position will be at a loss at expiry, necessitating a cash payment when the expiring hedge is replaced with a new one. Normally, such a roll-over loss simply represents an opportunity loss, but sometimes the cash cost is consequential, as was the case with the losses made by the New York arm of German industrial conglomerate Metallgesellschaft in 1993. Metallgesellschaft’s hedging policy relied on repeatedly rolling over short-term crude oil contracts. However, roll-over losses grew so large that the company suffered a severe liquidity crisis, precipitating a near-collapse.
SEASONAL SWAP
An interest rate swap in which the principal alternates between zero and the notional amount (which can change or stay constant). The principal amount of the swap is designed to hedge the seasonal borrowing needs of a company.
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.
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
TRANSLATION RISK
An accounting/financial reporting risk where the earnings of a company can be adversely affected due to its method of accounting for foreign operations.
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
VARIABLE NOTIONAL OPTION/SWAP
An option or swap where the notional value is linked to the underlying asset price or rate. Usually changes in the notional will be directly proportional to changes in the underlying price; i.e., they both decrease or increase together. Such derivatives have two main uses. In an equity swap, the fixed-rate receiver can opt to receive the return of either a fixed number of stocks, or the number of stocks that could be purchased for a fixed sum. The former case amounts to a variable notional amount for the swap. An example using an option is the case of a firm which sells more exports as exchange rates decline and its products therefore become cheaper abroad. Since it now has greater foreign currency revenue to hedge, it would purchase a variable notional currency option for this purpose.
VEGA
Measures the change in an option’s price caused by changes in volatility. Vega is at its highest when an option is at-the-money. It decreases the more the market and strike prices diverge. Options closer to expiration have a lower vega than those with more time to run. Positions with positive vega will generally have positive gamma. To be long vega (to have a positive vega) is achieved by purchasing either put or call options. Positions that are long vega benefit from increases in implied volatility but also from actual volatility if the option is being delta hedged. They will also lose from reductions in volatility. Spread options can be an exception: a reduction in the volatility of one of the assets may actually increase the price of the option because the correlation between the two assets decreases. Vega is sometimes known as kappa or tau.
See also
gamma
VOLATILITY TERM STRUCTURE
The term structure of volatility is the curve depicting the differing implied volatilities of options with differing maturities. Such a curve arises partly because implied volatility in short options changes much faster than for longer options. However, the volatility term structure also arises because of assumed mean reversion of volatility. The effect of changes in volatility on the option price is less the shorter the option. Most market-makers take advantage of differing volatilities to hedge their books or to trade perceived anomalies in volatility. Such strategies have to be weighted because of the differing vega effects.
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
ZERO COUPON SWAP
An off-market swap in which either or both of the counterparties makes one payment at maturity. Usually it is the fixed-rate payments only that are deferred. The party not receiving payment until maturity incurs a greater credit risk than it would with an ordinary swap. The swap is advantageous for a company that will not receive payment for a project until it is completed or to hedge zero coupon liabilities, such as zero coupon bonds.