Partial Matches:
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%.
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.
BARRIER OPTION
Barrier options, also known as knock-out, knock-in or trigger options, are path-dependent options which are either activated (knocked-in) or terminated (knocked-out) if a specified spot rate reaches a specified trigger level (or levels) between inception and expiry. Before termination knock-out options behave identically to standard European-style options, but carry lower initial premiums because they may be extinguished before reaching maturity. In contrast, knock-in options behave identically to European-style options only if they are activated/knocked-in and so also command a lower premium.
The standard barrier options have barrier levels that are monitored continually during the lifetime of the option. Single barrier options that have a barrier level above current spot are classified as up-and-out or up-and-in options. For single barriers below spot the usual terminology is down-and-out for the knock-out barrier option, and down-and-in for the knock-in barrier option.
An alternative terminology for single barrier options classifies barrier options where the barrier is out-of-the money with respect to the strike price as regular barrier options. In-the-money barrier options are further differentiated into reverse barrier options (for cases where the barrier may be breached as the underlying asset’s spot rate moves deeper in-the-money) and geared barrier options (examples where the barrier is in-the-money and lies between the strike and the underlying spot rate) A double barrier option has both an upper and lower barrier.
Many variations on the barrier theme are available. Barrier levels can be monitored continually, at discrete fixing times (discrete barrier options) or only at the final expiry date of the option (at-expiry barrier options). Barriers may be active only during distinct time intervals (window barrier options) or may change value at fixed points during the lifetime of the option (stepped barrier options). Barriers may need to be breached for a certain time before they are considered triggered (Parisian Barrier Options) or may allow for partial triggering depending upon how far beyond the trigger level the underlying asset is observed (Soft Barrier options). Barriers may reference a different underlying to that of the option itself – such barriers are known as outside barriers.
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.
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.
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.
BUTTERFLY SPREAD
The simultaneous sale of an at-the-money straddle and purchase of an out-of-the-money strangle. The structure profits if the underlying remains stable, and has limited risk in the event of a large move in either direction. As a trading strategy to capitalize upon a range trading environment it is usually executed in equal notional amounts.
Alternatively, such trades are often applied to benefit from changes in volatility. In such circumstances the butterfly spread is traded on a “vega-neutral” basis (i.e., the volatility sensitivity of the long position is initially offset by the volatility sensitivity of the short position). As the holder of an initially vega-neutral spread, the trader will benefit from changes in volatility since the strangle position profits more from an increase in volatility than the straddle and loses less than the straddle in a decline in volatility (this is due to the fact that the vomma of the strangle is higher than that of the straddle).
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.
CALL SPREAD
A strategy that reduces the cost of buying a call option by selling another call at a higher level. This limits potential gain if the underlying goes up, but the premium received from selling the out-of-the-money call partly finances the at-the-money call. A call spread may be advantageous if the purchaser thinks there is only limited upside in the underlying.
See also
bear spread,
bull spread,
put spread
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.
CONDOR
The simultaneous purchase (sale) of an out-of-the-money strangle and sale (purchase) of an even further out-of-the-money strangle. The strategy limits the profit or loss of the pay-out and is directionally neutral.
CONSTANT MATURITY TREASURY DERIVATIVE
Over-the-counter swaps and options which use longer-term, Treasury-based instruments for their floating rate reference than money market indexes, such as Libor. “Constant Maturity Treasury” (CMT) refers to the par yield that would be paid by a treasury bill, note or bond which matures in exactly one, two, three, five, seven, 10, 20 or 30 years. Since there may not be treasury issues in the market with exactly these maturities, the yield is interpolated from the yields on treasuries that are available. In the US, such rates have been calculated and published by the Federal Reserve Bank of New York and the US Treasury department on a daily basis every day for more than 30 years. The H.15 Report from the Federal Reserve Bank is often used as a source for CMT rates.
It is then possible for this interpolated yield to form the index rate for instruments such as floating rate notes, which pay interest linked to the CMT yield, options, which pay the difference between a strike price and the CMT yield, and swaps and swaptions, in which one of the cashflows exchanged is the CMT yield. Where necessary, the reference rate is reset at each settlement date. Typical uses of CMT derivatives as hedging tools include the purchase of CMT floors by mortgage servicing companies to protect the value of purchased mortgage servicing portfolios, and the purchase of CMT caps to protect investors with negatively convex mortgage-backed securities portfolios. It is possible to enter into derivatives in other currencies that are based, by analogy, on a “constant maturity interest rate swap” interpolated from the swap curve in the relevant currency. Such derivatives are known as constant maturity swap (CMS) derivatives. Unlike CMT derivatives, CMS derivatives incorporate the spread component of swaps.
CONTINGENT PREMIUM OPTION
An option for which the purchaser pays no premium unless the option is exercised. As a rule of thumb, the premium eventually paid is equal to the premium payable on a normal option divided by the option delta, hence the price increases dramatically for out-of-the-money options. Contingent options can usually be broken down into one or more binary options plus a conventional option. For example, a purchaser could synthesize a contingent call by buying a European-style call and selling enough European binary options with the same strike to pay for the premium on the call. If the options are not in-the-money at expiry, both the total premium paid and the total pay-out are zero. If they are in-the-money, the pay-out on the binary options is simply subtracted from the pay-out on the call. Further flexibility can be obtained by setting the strike for the digitals further out-of-the-money than the call.
See also
rebate,
mini-premium 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
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.
DISTRIBUTION
The probability distribution of a variable describes the probability of the variable attaining a certain value. Assumptions about the distribution of the underlying are crucial to option models because the distribution determines how likely it is that the option will be exercised. Many models assume the logarithm of the relative return has a normal distribution, which can be described by two parameters.
The first is the distribution’s mean; the second its standard deviation (equivalent, if annualized, to volatility). In practice, most empirically observed asset distributions depart from normality. This departure can be described in terms of the skew (how much it tilts to one side or the other) and kurtosis, which describes how fat or thin are the tails at either side. Most markets tend to have fat tails (to be leptokurtic) rather than thin tails (platykurtic). This pushes up the price of out-of-the-money options.
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.
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.
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
HEloc
A Home Equity Line of Credit is a loan to a homeowner in which the lender agrees to lend a maximum amount of money within an agreed period, or term, using the borrower’s equity in his/her house as collateral. A HELOC is different from a traditional home equity loan in that the borrower does not receive a total sum of money up-front. Rather, he/she uses a line of credit to borrow sums of money that total no more than the amount of the HELOC, similar to a credit card.
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
IN the money
Refers to a party’s financial position if it would be owed a payment by the other party if a swap were terminated at the prevailing market price.
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.
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.
KURTOSIS
A measure of how fast the tails or wings of a probability distribution approach zero, evaluated relative to a normal distribution. The tails are either fat-tailed (leptokurtic) or thin-tailed (platykurtic). Markets are generally leptokurtic. The fatter the tails, the greater the chance a variable will reach an extreme value, implying that models such as Black-Scholes – which assume perfect normal distribution – produce pricing biases for deep in- or out-of-the-money options.
LIBOR
London Inter-Bank Offered Rate is the interest rate banks charge each other for short-term money, up to a 12-month term. LIBOR is commonly used as the underlying for the floating leg of a Swap. The British Bankers’ Association (BBA) sets the rates daily.
LOW EXERCISE PRICE OPTION (LEPO)
A low exercise price option (Lepo) is a call option with an exercise price set deep in-the-money. The limiting case, a zero exercise price option, is when the strike price is zero. It is virtually certain to be exercised and the value and performance of its intrinsic value is effectively identical to that of the underlying equity.
These features are designed to allow participation in the performance of an equity price where there are legal or financial obstacles to purchasing the underlying directly. If the Lepo is cash-settled, the buyer profits to the same extent as with a direct holding in the underlying, but without having to transact in it. However, a Lepo holder does not earn dividends or have voting rights over the equity.
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.
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 CAP
The simultaneous purchase of an out-of-the-money cap and the sale of a lesser amount of an in-the-money floor. Because the in-the-money floor is worth more, the purchaser of a participating cap sells fewer floors for a zero cost combination and can therefore derive some benefit if rates fall. Although the purchaser will not derive as much benefit if rates fall as would have been the case with a straightforward cap, a premium does not have to be paid.
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.
PIN RISK
The phenomenon where a small move in the underlying can have a significant impact on the value of an at-the-money option shortly before expiration.
PORTFOLIO INSURANCE
A strategy developed in the 1980s as a way of limiting losses on risky asset portfolios. Because put options were not widely available, the strategy synthetically reproduced the pay-out of a put option by a delta-hedging program. As long as markets move continuously, transaction costs are minimal and volatility is relatively stable, option returns can be easily replicated, although one can not predetermine a maximum cost.
The effectiveness of such a strategy was thrown into doubt with the crash of 1987. The unprecedented levels of volatility and the lack of liquidity made the strategy extremely difficult to implement. Its reputation suffered and it was widely blamed for exacerbating the severity of the collapse. Portfolio insurance has not entirely disappeared, though. Some fund managers still synthetically replicate option pay-outs rather than pay option premium, especially if they think volatility will fall. However, most such strategies now involve the covering of a certain amount of volatility risk by buying out-of-the-money options.
See also
asset allocation
PRINCIPAL-GUARANTEED PRODUCT
Any investment vehicle that allows investors to gain exposure to an asset while guaranteeing the return of their principal. Such products are normally constructed by buying a deep discount bond (often a zero-coupon bond) and using the rest of the money to buy embedded call or put options to gain exposure to a second asset, often a stock index.
See also
guaranteed return on investment
PUT SPREAD
A put spread reduces the cost of buying a put option by selling another put at a lower level. This limits the amount the purchaser can gain if the underlying goes down, but the premium received from selling an out-of-the money put partly finances the at-the-money put. A put spread may also be useful if the purchaser thinks there is only limited downside in the market.
See also
call spread
PUT-CALL PARITY
The relationship between a European-style put option and a European-style call option on the same underlying with the same exercise price and maturity. Put-call parity states that the pay-off profile of a portfolio containing an asset plus a put option is identical to that of a portfolio containing a call option of the same strike on that same asset (with the rest of the money earning the risk-free rate of return). In practice, a put option on, say, a stock index, can be constructed by shorting the stock and buying a call option. The relationship means that traders are able to arbitrage mispriced options.
See also
box,
conversion,
reversal
RATIO SPREAD
A ratio spread involves buying different amounts of similar options with differing strike prices. The purchase of an in-the-money option is financed by the selling of more out-of-the-money options. Conversely, the out-of-the-money options are financed by selling less of an in-the-money option.
REPO AGREEMENT
To buy (sell) a security while at the same time agreeing to sell (buy) the same security at a predetermined future date. The price at which the reverse transaction takes place sets the interest rate over the period (the repo rate). The most active repo market is in the US, where the Federal Reserve sets short-term interest rates by lending securities. In a reverse repo the buyer sells cash in exchange for a security. Repos can benefit both parties. Buyers of repos often receive a better return than that available on equivalent money-market instruments; and financial institutions, particularly dealers, are able to get sub-Libor funding. A slight variation on the repo is the buy/sell back. The buy/sell back’s coupon becomes the property of the purchaser for the duration of the agreement. It is preferred by credit-sensitive investors such as central banks.
REVERSE CONVERTIBLE
These are just like convertible bonds. The main difference is that rather than buying a call option on a stock, the investor sells a put on the stock or index. The investor receives higher than normal coupons but may lose some principal if the put ends up in the money.
RISK REVERSAL
1) See cylinder
2) The term “risk reversal” is also used, by currency option traders, to denote the difference in implied volatility between out-of-the-money call and put options which both have a delta of 25%. The level of the risk reversal is often used as a sentiment indicator in currency markets as it indicates the relative demand for calls versus puts.
SKEW
A skewed distribution is one which is asymmetric. Skew is a measure of this asymmetry. A perfectly symmetrical distribution has zero skew, whereas a distribution with positive (negative) skew is one where outliers above (below) the mean are more probable. An example of an asymmetric distribution in the financial markets is the distribution implied by the presence of a volatility skew between out-of-the-money call and put options.
STRADDLE
The sale or purchase of a put option and a call option, with the same strike price, on the same underlying and with the same expiry. The strike is normally set at-the-money. The purchaser benefits, in return for paying two premiums, if the underlying moves enough either way. It is a way of taking advantage of an expected upturn in volatility. Sellers of straddles assume unlimited risk but benefit if the underlying does not move. Straddles are primarily trading instruments.
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.
VANNA
The vega of an option is not constant. Vega changes as spot changes and as volatility changes. The vanna of an option measures the change in vega for a change in the underlying spot rate. As spot moves deeper out-of-the-money for a vanilla option the vega is lower. If spot and volatility movements are positively correlated the holder of an option with positive vanna will be expected to profit from this correlation.
See also
vega
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 SKEW
The difference in implied volatility between out-of-the-money puts and calls. In most equity option markets out-of-the money calls have lower implied volatility than out-of-the-money puts. This is mostly ascribed to the greater supply of volatility above, rather than below, the money since fund managers are happy to write calls and not so happy to write puts. Volatility skews can be very pronounced in the currency markets although whether puts or calls are favored depends on market sentiment and demand and supply.
See also
risk reversal
VOLATILITY SMILE
A graph of the implied volatility of an option versus its strike (for a given tenor) typically describes a smile-shaped curve – hence the term “volatility smile”. This can be attributed to the belief that the underlying distribution is leptokurtic, since this tends to increase the value of out-of-the-money options.
VOLATILITY TRADING
A strategy based on a view that future volatility in the underlying will be more or less than the implied volatility in the option price. Option market-makers are volatility traders. The most common way to buy/sell volatility is to buy/sell options, hedging the directional risk with the underlying. Volatility buyers make money if the underlying is more volatile than the implied volatility predicted. Sellers of volatility benefit if the opposite holds. Other methods of buying/ selling volatility are to buy/sell combinations of options, the most usual being to buy/sell straddles or strangles. Other strategies take advantage of the difference between implied volatilities of differing maturity options, not between implied and actual volatility. For example, if implied volatility in short-term options is high and in longer options low, a trader can sell short-term options and buy longer ones.
YIELD
The interest rate that will make the present value of the cashflows from an investment equal to the price (or cost) of the investment. Also called the internal rate of return. The current yield relates the annual coupon yield to the market price by dividing the coupon by the price divided by 100 and ignores the time value of money or potential capital gains or losses. Simple yield to maturity takes into account the effect of the capital gain or loss on maturity of a bond in addition to the current yield.