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Partial Matches:

ACCRETING

A description, applicable to a variety of instruments, denoting that the notional principal increases successively over the life of the instrument, e.g., caps, collars, swaps and swaptions. If the increase takes place in increments, the instrument may be known as a step-up.

See also amortizing

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

ACCRUAL PERIOD

Period over which net payment or receipt pertaining to swaps is accrued. It is inclusive of the start date and runs to the end date without including the end date.

ASSET SWAP

A package of a cash credit instrument and a corresponding swap that transforms the cash flows of the non-par instrument (bond or loan), into a par (floating interest rate) structure. Asset swaps typically transform fixed-rate bonds into par floaters, bearing a net coupon of Libor plus a spread, although cross-currency asset swaps, transforming cashflows from one currency to another are also common.

ASSET-BACKED SECURITY

A financial instrument which is collateralized by bundled assets such as mortgages, real estate, credit card repayments or other receivables. This class of securities includes collateralized mortgage obligations and mortgage-backed securities, which are debt instruments collateralized with pooled real-estate mortgages.

AUction rate securities

A debt instrument used by tax-exempt and corporate issuers with a long term maturity for which the interest rate is adjusted either daily, or every seven, 28 or 35 days. The interest rate adjustments are determined by an auction, in which the remarketing agent (typically a securities dealer) takes bids from investors in the form of a yield and amount. The remarketing agent then determines the lowest rate to clear the outstanding amount of auction rate securities (ARS).

  In early 2008, as the credit crunch continued, Wall Street firms which served as the remarketing agent for the auctions stopped bidding on the auctions themselves, and the auctions failed. A failed auction simply means that there were not enough ‘buy’ orders to fill the number of ‘sell’ orders. In the relatively opaque bidding process, many dealers were supporting auctions by bidding on the ARS to prevent the auction from failing. The result was that many investors who held this paper were not able to sell it, and the investments became illiquid. Because ARS have no bank liquidity facility, there is no put option available for the investor. In the event of a failed auction, the interest rates jump to a pre-determined max rate. The max rates can be absolute, such as 12%, or formulaic, such as 6-month commercial paper + 100 basis points, for example. In the spring of 2008, there were widespread auction failures in the $165 billion municipal ARS market. Many issuers were experiencing borrowing costs that greatly exceeded their budget, and by the summer of 2008, over half of the outstanding municipal ARS had been converted to another debt mode, such as fixed rate, or variable rate bonds.

BASEL CAPITAL ACCORD

The Basel Capital Accord was first issued in July 1988 by the Basel Committee on Banking Supervision, a panel of banking supervisory authorities established by the central bank Governors of the Group of Ten (G-10) countries in 1975. In April 1993, the Committee announced preliminary details of a package of supervisory proposals for applying capital charges to the market risk of banks. These proposals were centered on the use of a standardized “building-block” methodology, similar to the one eventually used in the European Union’s Capital Adequacy Directive.

  After two years of industry comment, a revised version of the proposed Supplement to the Accord was released in April 1995. The main change was that banks could now calculate capital requirements using their own in-house models as an alternative to the standardized methodology, subject to their regulator’s approval. Following a second period of industry comment, the Committee issued the final version of the Supplement in January 1996, due for implementation by the G-10 supervisory authorities by the end of 1997. This version included the recognition of empirical correlations across broad risk factor categories.

  The supplemented Accord specified both quantitative and qualitative requirements for in-house models. The crucial quantitative requirement is that banks should calculate 99th percentile value-at-risk every day, working with a holding period of 10 days and a historical observation period of a year. Furthermore, it was proposed that there would be additional charges for those banks whose models failed to perform adequately in historical back-testing or were felt to possess specific risk factors.

  In June 1999 the Basel Committee formally released its long-awaited proposal for a new Capital Accord. This first consultative paper signaled a move towards using credit ratings rather than OECD status to set capital allocations. In January 2001 the second consultative paper was released. This new paper – dubbed Basel II – retained the 1999 proposal’s three-pillar approach that included minimal capital requirements, market discipline and supervisory review, but also included substantial additions. Three distinct methods for the calculation of minimum capital requirements were proposed.

  Firstly, a standardized approach geared towards smaller banks was proposed. Exposures to different counterparties will be quantified in terms of risk weights based on assessments by external ratings agencies – with more sensitivity to ratings than in previous risk-bucketing plans.

  For more sophisticated banks, two internal ratings-based (IRB) approaches to credit risk have been devised – the foundation and advanced – that allow greater use of banks’ own internal credit risk models. It is the Basel Committee’s intention to tailor regulations so that banks are encouraged to migrate towards the more sophisticated approaches, and that these new approaches bring regulatory capital more closely in line with the economic capital that banks calculate they should be holding, as determined by their own internal models.

  Implementation of Basel II is due in 2005. Features of Basel II that have caused most discussion include the 20% operational risk charge, a 1.5 multiplication factor in the IRB risk weightings and the w charge for credit derivatives.

BASIS SWAP

An interest rate basis swap or a cross-currency basis swap is one in which two streams of floating rate payments are exchanged. Examples of interest rate basis swaps include swapping $Libor payments for floating commercial paper, Prime, Treasury bills, or Constant Maturity Treasury rates; this is also known as a floating-floating swap. A typical cross-currency basis swap exchanges a set of Libor payments in one currency for a set of Libor payments in another currency.

BASKET CREDIT DEFAULT SWAP

A credit default swap which transfers credit risk with respect to multiple reference entities. For each reference entity, an applicable notional amount is specified, with the notional of the basket swap equal to the aggregate of the specified applicable notional amounts. Types of basket credit default swaps include linear basket credit default swaps, first-to-default basket credit default swaps, and first-loss basket credit default swaps.

See also credit default swap

BASKET OPTION

An option that enables a purchaser to buy or sell a basket of currencies, equities or bonds.

BASKET SWAP

A swap in which the floating leg is based on the returns on a basket of underlying assets, such as equities, commodities, bonds, or swaps. The fixed leg is usually (but not always) a reference interest rate such as Libor, plus or minus a spread.

BASKET TRADING

See program trading

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.

BINARY PAY-OUT

See binary option, credit default swap, exotic option

BISTRO

BISTRO (Broad Index Secured Trust Offering), the synthetic securitization program developed by JPMorgan in 1997, is a structure that transfers tranched credit exposure to large, diversified portfolios of commercial or consumer loans from the securitizing bank to investors.

BLENDED INTEREST RATE SWAP

A technique that involves combining two interest rate swaps to produce a more attractive overall rate. It involves at least two transactions. For example, if a counterparty fixes its floating rate borrowing cost at 10% and rates go down to 8%, it may do another swap with the same counterparty at 8% and combine the two to create a rate closer to the market.

bma index

Formerly the PSA Municipal Swap Index; is the principal benchmark for the floating rate interest payments for tax-exempt Issuers. The BMA Index is a national rate based on a market basket of approximately 250 high-grade, seven-day tax-exempt variable rate demand obligation issues of $10 million or more. In November 2006, the Bond Market Association (BMA) merged with the Securities Industry Association to form the Securities Industry and Financial Markets Association (SIFMA). Officially, the BMA Index is now called the SIFMA Swap Index, but it is still widely referred to by market participants as the BMA Index.

See also SIFMA Swap Index.

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.

CAPITAL ADEQUACY DIRECTIVE

First mooted in 1990 and issued in 1993, the European Union’s Capital Adequacy Directive (often shortened to CAD) became law across the European Union on January 1, 1996. The CAD requires banks to separate trading book from more generalized banking book, and to apply the building block approach to interest rate and equity risk in the trading book, as well as foreign exchange risk across both books. In general, the CAD requires banks to apply capital equal to 8% of net positions for general market risk and an additional capital amount to cover specific risk.

  In November 1999, the European Union issued proposals for new capital adequacy rules. In parallel with the Basel Committee’s proposals, the proposals sought to align regulatory capital requirements more closely with underlying risks and to provide institutions with incentives to move to higher standards of risk management.

  In February 2001, the European Union released a second consultation paper for the new capital adequacy framework for banks and investment firms. The Capital Adequacy Directive generally applies to investment firms, including some managers of pension funds. The consultative paper discussed many of the same issues and methodologies as Basel II, including the internal ratings-based and revised standardized approaches, credit risk mitigation, consolidated capital requirements, interest rate and operational risks, the supervisory review process, and disclosure requirements.

  A further consultation period will run in parallel with the further Basel consultation, in the first few months of 2002. Features that have caused most discussion include the impact of the proposed operational risk charge on investment firms and smaller credit institutions and the potential implications of the proposed new regime for lending to small- and medium-sized enterprises.

See also Basel Capital Accord, comprehensive approach

CAPITAL-PROTECTED CREDIT-LINKED NOTE

A credit-linked note where the principal is partly or fully guaranteed to be repaid at maturity. In a 100% principal-guaranteed credit-linked note, only the coupons paid under the note bear credit risk. Such a structure can be analyzed as (i) a Treasury strip and (ii) a stream of risky annuities representing the coupon, purchased from the note proceeds minus the cost of the Treasury strip.

See also credit-linked note.

CATASTROPHE RISK SWAP

An agreement between two parties to exchange catastrophe risk exposures. For example, in July 2001 Swiss Re and Tokio Marine arranged a $450 million deal including three risk swaps: Japan earthquake for California earthquake, Japan typhoon for France storm and Japan typhoon for Florida hurricane. Swaps increase diversification and allow each of the parties to lower the amount of capital that they need to hold.

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.

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 SWAP

The generic term for a swap activated when rates reach a certain level or a specific event occurs. Swaptions are often considered to be contingent swaps. Other types of swaps, for example, drop-lock swaps, are activated only if rates drop to a certain level or if a specified level over a benchmark is achieved.

CONVEXITY

A bond’s convexity is the amount that its price sensitivity differs from that implied by the bond’s duration. Fixed-rate bonds and swaps have positive convexity: when rates rise the rate of change in their price is slower than suggested by their duration; when rates fall it is faster. Positive convexity is therefore a welcome attribute. The higher the bond’s duration, the more its convexity. Bonds or swaps with call options or embedded call options, e.g., collateralized mortgage obligations, have negative convexity: when rates rise their price fall is faster relative to the interest rate move. Convexity effectively describes the same attribute as gamma.

COPULA

In many areas of risk management, the concept of correlation can be used as a measure of dependence between financial instruments. However, when certain technical assumptions about the form of the joint distribution of risks is untenable (as can happen when considering credit risk, for example) copulas provide a more robust measure of dependence.

CORRELATION

Correlation is a measure of the degree to which changes in two variables are related. It is normally expressed as a coefficient between plus one, which means variables are perfectly correlated (in that they move in the same direction to the same degree) and minus one, which means they are perfectly negatively correlated (in that they move in opposite directions to the same degree). In financial markets correlation is important in three areas:
1. The model used for global asset allocation decisions, Sharpe’s capital asset pricing model (CAPM), has, as its linchpin, a covariance matrix that measures correlations between markets.
2. Correlation is also central to the pricing of some options, where two-factor or multi-factor models are used. For spread options, yield curve options and cross-currency caps, estimating the correlation between the underlying assets is of primary importance, the degree of correlation between them having a direct influence on the option price. For quantos such as guaranteed exchange rate options, or differential swaps, the correlation effect is the extent to which there is a relationship between movements in the underlying and movements in the ex-change rate, which has a secondary effect on the price of the option.
3. Correlation between markets is also used to offset an option position in one market against another with similar direction and volatility. Such a strategy might be used to reduce cost – to avoid hedging the positions separately, or because implied volatility in the second market is lower – or because hedging is difficult in the first market. Correlation can be estimated historically (like volatility) but tends to be unstable, and historic estimations may be poor predictors of future realized correlations.

CORRELATION SWAP

Often used in currency markets, an instrument that allows an investor to take three volatility swaps and bet on how much one currency will move compared to the two others.

COST OF FUNDS

Refers to an Issuer’s actual interest rate cost on its debt obligations, which may or may not include carrying costs such as remarketing fees, liquidity fees, letter of credit fees, etc., that is sometimes used as the underlying in a swap transaction.

COUNTERPARTY CREDIT RISK

The risk of financial loss arising out of holding a particular contract or portfolio of contracts as a result of one or more parties to the relevant contract(s) failing to fulfill its financial obligations under the contract. Counterparty credit risk is assessed as a function of three variables:
    •     the value of the position exposed to default (the credit or credit risk exposure);
    •     the value of the position exposed to default (the credit or credit risk exposure);
    •     the proportion of the value that would be recovered in the event of a default;
    •     the likelihood of a default occurring.
Counterparty credit risk can be managed through the use of an ISDA Master Agreement, which allows netting of all exposures related to all derivative contracts between two counterparties, and an ISDA Credit Support Annex, which provides for posting of collateral based on net exposure.

See also settlement risk

CREDIT DEFAULT SWAP

A bilateral financial contract in which one counterparty (the protection buyer or buyer) pays a periodic fee, typically expressed in basis points per annum on the notional amount, in return for a contingent payment by the other counterparty (the protection seller or seller) upon the occurrence of a credit event with respect to a specified reference entity. The contingent payment is designed to mirror the loss incurred by creditors of the reference entity in the event of its default. The settlement mechanism may be cash or physical.

CREDIT DERIVATIVE

A bilateral financial contract which isolates credit risk from an underlying instrument and transfers that credit risk from one party to the contract (the Protection Buyer) to the other (the Protection Seller). There are two main categories of credit derivatives: the first consists of instruments such as credit default swaps in which contingent payments occur as a result of a credit event; the second, which includes credit spread options, seeks to isolate the credit spread component of an instrument’s market yield.

CREDIT EVENT

Any one of a specified set of events, which, if occurring with respect to an obligation of the reference entity specified in a credit default swap, will trigger contingent payments. Applicable events, which generally include bankruptcy, repudiation/moratorium, restructuring, failure to pay, and cross-acceleration (as each is defined by ISDA) are determined by negotiation between the parties at the outset of a credit default swap.

CREDIT INTERMEDIATION SWAP

A credit swap with a dynamic notional that for a fixed fee provides the protection buyer with a contingent payment that matches the mark-to-market on any given day of a specified derivative (or other market-sensitive instrument). Also known as a dynamic credit swap

CREDIT OPTION

Put or call options on the price of either (a) a floating rate note, bond, or loan, or (b) an asset swap package, consisting of a credit-risky instrument with any payment characteristics and a corresponding derivative contract that exchanges the cashflows of that instrument for a floating rate cashflow stream, typically three- or six-month Libor plus a spread.

CREDIT PENALTY

The additional requirements (e.g., a higher interest rate, additional insurance, etc.) of a party to a swap imposed due to that party’s lower credit rating.

CREDIT RISK

Also known as default risk. In broad terms, the risk that a loss will be incurred if a counterparty to a (derivatives) transaction does not fulfill its financial obligations in a timely manner. The term is sometimes loosely used as shorthand for the likelihood or probability of default, irrespective of the value of any position exposed to this risk. More precisely, credit risk is the risk of financial loss arising out of holding a particular contract or portfolio. In this sense, it is a function of three variables:
    •     the value of the position exposed to default (the credit or credit risk exposure);
    •     the proportion of the value that would be recovered in the event of a default;
    •     the likelihood of a default occurring.

See also settlement risk

CREDIT RISK ASSESSMENT

The process of determining the extent of the credit risk inherent in a financial instrument or portfolio of financial instruments. Such extent is usually measured in terms of exposure, which can be analyzed in several ways:
    •     The current exposure associated with a derivative instrument, its replacement cost, is the present value of the expected future net cash flows of that instrument.
    •     The potential exposure is an estimate of the future replacement cost of a derivative transaction, calculated using probability analysis (e.g., Monte Carlo or historical simulation, option valuation models) over the remaining term of the transaction.
    •     The potential exposure is an estimate of the future replacement cost of a derivative transaction, calculated using probability analysis (e.g., Monte Carlo or historical simulation, option valuation models) over the remaining term of the transaction.
    •     The most likely potential exposure is known as the expected exposure, which is found by taking the mean of all possible replacement costs (weighted by probability), where the replacement cost in any outcome is taken as being equal to the mark-to-market present value if positive, and zero if negative.
    •     It is also possible to calculate a worst case exposure, an estimate of the exposure that might be expected if the market were to move through an amount dictated by a specified confidence interval. This calculation allows capital to be held to protect against possible, but relatively unlikely market moves.

  If the expected or worst case exposures of an instrument are calculated over time, the resulting graph reveals a credit risk exposure profile. The highest point on the profile is the “peak expected (or worst case) exposure” generated by the instrument. This would be the largest possible loss that could occur, to the probability dictated by the confidence interval.

CREDIT RISK MODELS

The success of VAR-based models of market risk and the ongoing development of the Basel Committee's regulatory framework has sparked a wave of interest in credit risk modeling since the 1990s. But default probabilities cannot be observed, and correlations between defaults are difficult to measure – so it's difficult to aggregate credit risk. For these kinds of reasons, the robust modeling of credit risk is a more difficult task than for market risk.

  Despite such difficulties, a number of commercial models of portfolio credit risk are available, but they are all broadly based on one of two fundamental models: equity-based and ratings-based. Merton-type models treat the value of a credit exposure as a derivative written on the firm's underlying assets. Volatility and correlation structures are then deduced from changes in the equity's value. Ratings-based models assume that credit risk exposures are defined by credit ratings. Transitions between different ratings and correlations between ratings transitions for pairs of exposures are then modeled.

  Despite such difficulties, a number of commercial models of portfolio credit risk are available, but they are all broadly based on one of two fundamental models: equity-based and ratings-based. Merton-type models treat the value of a credit exposure as a derivative written on the firm's underlying assets. Volatility and correlation structures are then deduced from changes in the equity's value. Ratings-based models assume that credit risk exposures are defined by credit ratings. Transitions between different ratings and correlations between ratings transitions for pairs of exposures are then modeled.

CREDIT SPREAD

A credit spread is the difference in yield between two debt issues of similar maturity and duration. The credit spread is often quoted as a spread to a benchmark floating-rate index such as Libor, or alternatively as a spread to a highly rated reference security such as a government security. The credit spread is often used as a measure of relative creditworthiness, with reduction in the credit spread reflecting an improvement in the borrower’s perceived creditworthiness.

CREDIT SPREAD FORWARD

A cash-settled forward contract with settlement amounts based on the credit spread between two predetermined debt issues on the maturity date.

See also credit spread option.

CREDIT SPREAD OPTION

An option on the credit spread between two debt issues. The option will pay out the difference between the credit spread at maturity and a strike spread determined at the outset.

CREDIT SUpport

Collateral that can be in the form of cash and/or marketable securities posted by one party to a swap agreement to reduce the credit exposure of its counterparty.

See also swap insurance.

CREDIT SUpport ANNEX

Document governed by the ISDA Master Agreement which states the provisions and circumstances under which posting of collateral is required.

CREDIT VALUE AT RISK MODEL OF CREDIT RISK

See Credit Risk Models

CREDIT-LINKED NOTE

A security with redemption and/or coupon payments linked to the occurrence of a credit event with respect to a specified reference entity. In effect, a credit-linked note embeds a credit default swap into a funded asset to create a synthetic investment that replicates the credit risk associated with a bond or loan of the reference entity. Credit-linked notes are typically issued on an unsecured basis directly by a corporation or financial institution (e.g., an MTN or Certificates of Deposit issued by JPMorgan Chase Bank). Credit-linked notes may also be issued from a collateralized Special Purpose Vehicle (SPV).

CROSS-CURRENCY SWAP

A cross-currency swap involves the exchange of cashflows in one currency for those in another. Unlike single-currency swaps, cross-currency swaps often require an exchange of principal. Typically the notional principal is exchanged at inception at the prevailing spot rate. Interest rate payments are then passed back on a fixed, floating or zero basis. The principal is then re-exchanged at maturity at the initial spot rate.

Cross-default termination

The ability of one party to terminate the swap at its market value if the other party defaults on other obligations of particular types.

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.

DEFAULT PUT

See credit default swap

DEFAULT RISK

See credit risk

DEFAULT SWAP

See credit default swap

DELAYED RESET SWAP

Also known as an in-arrears swap. A swap in which floating payment is based on the future, rather than present, value of the reference rate. For six-month delayed Libor reset swaps, for example, instead of fixing Libor six months and two days before the payment date, the floating-rate borrower delays fixing until two days before payment. Such swaps are popular in a steep yield curve environment, when a fixed-rate receiver may think rates will not rise as fast as the yield curve predicts.

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.

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.

DISCOUNT SWAP

An off-market swap in which the fixed payments are below the market rate. At the end of the swap the shortfall is made up by one payment. Construct-ion and project finance companies use this type of structure to reduce interest rate payments before start-up and during completion of a project. The more interest rate payments are discounted, the more credit risk is taken by the counterparty.

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.

DURATION

Duration is the average life of the present values of all future cashflows from a bond. For a given maturity, the higher the coupon, the more it (rather than the redemption payment) contributes to yield. So the higher the coupon, the shorter the duration. Although the duration of a bond increases monotonically as the maturity increases, it is non-linear (except for zero-coupon bonds), because the coupon payments are increasingly important to the yield. Duration usually refers to what technically should be described as modified duration. This measures the effect on a bond’s price of a unit change in yield. So if a bond has a duration of two, a yield change of 1% will produce a price change of 2% in the other direction. The higher the modified duration, the more sensitive the bond is to interest rate changes.

See also convexity

DYNAMIC CREDIT SWAP

A credit swap with a dynamic notional that for a fixed fee provides the protection buyer with a contingent payment that matches the mark-to-market on any given day of a specified derivative (or other market-sensitive instrument). Also known as a credit intermediation swap. Also known as a credit intermediation swap.

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.

EXPOSURE

A firm’s exposure is its vulnerability to loss from unanticipated events. These events might include movement in financial market variables, such as foreign exchange rates, interest rates, commodity prices or volatilities. Alternatively, a firm could be exposed to credit risk, operational risk, or legal risk. Recognizing and minimizing – or optimizing – exposure is the function of risk management.

FIRST-LOSS BASKET SWAP

A basket credit default swap in which the seller of protection agrees to make contingent payments to the buyer of protection upon the occurrence of a credit event with respect to one or more reference entities. The contingent payment amount for each credit event equals the loss incurred with respect to the liquidation value of an obligation of the impaired reference entity, with the aggregate amount of contingent payments due by the seller of protection capped by the swap notional amount. Through this type of structure, the seller of protection obtains levered exposure to a portfolio of credits.

See also synthetic securitization.

FIRST-TO-DEFAULT BASKET SWAP

A specialized type of basket credit default swap in which the protection seller is exposed to the first reference entity in the basket of reference entities for which a credit event occurs. The applicable notional amount for each reference entity in the basket is typically equal to the notional of the first-to-default swap. Losses are capped at the notional amount and the protection seller does not have exposure to subsequent credit events.

FORWARD RATE AGREEMENT

A forward rate agreement (FRA) allows purchasers/sellers to fix the interest rate for a specified period in advance. One party pays fixed, the other an agreed variable rate. Maturities are generally out to two years and are priced off the underlying yield curve. The transaction is done on a nominal amount and only the difference between contracted and actual rates is paid. If rates have risen by the time of the agreement’s maturity, the purchaser receives the difference in rates from the seller and vice versa. A swap is therefore a strip of FRAs. FRAs are off-balance sheet – there are no up-front or margin payments and the credit risk is limited to the mark-to-market value of the transactions. Unlike interest rate swaps, FRAs settle at the beginning of the interest period, two business days after the calculation date.

FORWARD SPREAD AGREEMENT

A contract in which counterparties contract into a spread between two variable rates, usually Libors, applied to a nominal amount of one currency. The settlement amount will be the spread between prevailing Libor minus the contracted spread. Differential swaps are therefore a string of forward spread agreements.

GOLD LEASE RATE

The gold lease rate is the cost to borrow gold. Similar to other commodities it is a function of supply and demand. The rate (non-credit adjusted) is determined by the difference between Libor and the gold forward rate for the specified period. Credit adjustments are subsequent to the calculation.

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.

GUARANTEED investment contract (GIC)

A Guaranteed Investment Contract ("GIC") is a contract between a municipal entity or 501(c)(3) organization and a financial institution (the "Provider") in which the Provider guarantees a rate of return on bond proceeds deposited under the investment contract. Guaranteed Investment Contracts have proven to satisfy the unique economic, tax and legal requirements associated with the investment of tax-exempt bond proceeds and have been used with increasing frequency among tax-exempt issuers.

  A GIC offers the preservation of principal, earns a fixed yield, and allows for access to funds with no market risk. A GIC is particularly well suited for construction funds because it allows for full flexibility of draws, thus eliminating any market and/or reinvestment risk if construction draws fluctuate for any reason. GICs can also be used for debt service reserve funds, bond funds, and escrow funds, with draws occurring semi-annually on bond payments dates or as required by the Indenture. The yield on an investment contract will generally exceed the yield on a repurchase agreement by approximately 30 basis points.

  Guaranteed investment contracts can be structured with varying degrees of security. Typically, the security is provided by requiring the Provider of the GIC to maintain a certain level of long-term credit rating by one or more of the recognized Rating Agencies. The rating requirement for the Provider is often determined by the Indenture or other bond documents. In the event the Provider is downgraded below a certain level (e.g. below the "A" category from Moody's or Standard & Poor's) while the GIC is in place, then the Provider is required to provide additional security such as posting collateral with an independent third-party or assigning the contract to a new provider that both meets the rating requirement and is acceptable to the Issuer.

  Documentation for a GIC is usually a straight forward contract between the Provider of the GIC and the Trustee and/or the Issuer.

HEATH-JARROW-MORTON MODEL

A multi-factor interest rate model which describes the dynamic of forward rate evolution. An extension of the Ho-Lee model, the underlying is the entire term structure of interest rates. The approach is very similar to the original Black-Scholes Model: it does not model qualities such as the “price for risk.”

  The model requires two inputs: the initial yield curve and a volatility structure for the forward. The volatility is only specified in a very general form. By choosing an appropriate volatility function, it is possible to reduce HJM to simpler models such as Ho-Lee, Vasicek, and Cox-Ingersoll-Ross.

  The practical importance of the HJM model is that it provides a single coherent framework for pricing and hedging an entire book of instruments (including instruments like caps and swaptions) and is not excessively computationally intensive. Research building on HJM (such as the market model) has concentrated on widening its scope to remove the possibility of negative interest rates, include more than one interest rate curve and incorporate default risk.

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.

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.

INTernational swaps and derivatives association

See ISDA

Isda

International Swaps and Derivatives Association – Represents participants in the privately negotiated derivatives industry; is the largest global financial trade association, by number of member firms. ISDA was chartered in 1985, and today has more than 840 member institutions from 56 countries on six continents. These members include most of the world's major institutions that deal in derivatives, as well as many of the businesses, governmental entities and other end users that rely on over-the-counter derivatives to manage the financial market risks inherent in their core economic activities.

See also ISDA Master Agreement, OTC derivatives

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.

LINEAR BASKET CREDIT DEFAULT SWAP

A basket credit default swap, where investors are exposed to multiple reference entities as if they had entered into a separate credit default swap contract with respect to each reference entity.

LINEAR FX-LINKED SWAP

An interest rate swap with a quasi-fixed coupon that varies with the movement of a chosen spot foreign exchange rate over the life of the deal. These swaps can be structured to pay a higher (or lower) coupon if a given currency weakens (or strengthens) after the outset of the deal. The observation dates for the FX component coincide with the Libor reset dates for coupon calculation. These swaps can be structured with a leveraged FX exposure.

LITE OPTION

A European-style basket option with a payoff determined by the underlying assets that remain in the basket, after a certain number of the best and worst performing assets in the basket were removed at a specified date prior to expiry.

MERTON MODEL OF CREDIT RISK

See Credit Risk Models

MId-market

The mid-point between the “bid” and “offer” market rate/price, commonly used as a basis for pricing swaps.

MORTGAGE SWAP

An asset swap attached to fixed-rate mortgage payments. Mortgage swaps allow investors to enjoy the flows from a portfolio of mortgages without taking a mortgage asset onto their balance sheet. The principal reduces if and when the outstanding mortgage principal reduces (which can occur if the mortgage holder pays off the mortgage or defaults). Such swaps are complicated because although the fixed-rate receiver receives a higher rate than on a normal swap, the amortization of the principal is not just a function of interest rates. The largest mortgage swap market is in the US; in 1992 and 1993 prepayments accelerated because of historically low interest rates.

See also index amortizing swap, prepayment risk, reverse index amortizing swap

NEGATIVE BASIS

Negative basis exists when the cost of buying protection (in the credit derivative market) on a particular reference entity is less than the credit spread (generally expressed as a spread to Libor) on a bond or note of similar maturity issued by that reference entity. When this occurs, investors can lock in riskless profit by buying bonds and buying credit protection. These arbitrage opportunities are generally only available to investors whose cost of funds is Libor flat or better (since funding the bond or note at Libor plus a spread will erode the arbitrage). Technical factors between the bond and credit derivative market account for negative basis.

See credit derivative.

non-performance risk

FASB’s Statement 157 clarifies that a fair value measurement for a liability should reflect the risk that the obligation will not be fulfilled. A reporting entity’s own credit risk is a component of the nonperformance risk associated with its obligations and, therefore, should be considered in all periods in which a liability is measured at fair value.

OPERATIONAL RISK

The risk run by a firm that its internal practices, policies and systems are not rigorous or sophisticated enough to cope with untoward market conditions or human or technological errors. Although operational risk is not as easy to identify or quantify as market or credit risk, it has been implicated as a major factor in many of the highly-publicized derivatives losses of recent years.

  Sources of operational risk include: failure to correctly measure or report risk; lack of controls to prevent unauthorized or inappropriate transactions being made (the so-called “rogue trader” syndrome); and lack of understanding or awareness among key staff.

OPTION

A contract that gives the purchaser the right, but not the obligation, to buy or sell an underlying at a certain price (the exercise, or strike price) on or before an agreed date (the exercise period).

  For this right, the purchaser pays a premium to the seller. The seller (writer) of an option has a duty to buy or sell at the strike price, should the purchaser exercise his right. With European-style options, purchasers may take delivery of the underlying only at the end of the option’s life. American-style options may be exercised, for immediate delivery, at any time over the life of the option. Holders of semi-American-style or Bermudan options may be exercised on specified dates – typically on a monthly or quarterly basis.

  Options can be bought on commodities, stocks, stock indexes, interest rates, bonds, currencies, etc. The trading terminology, though, may change according to the product. In most cases, the right to buy the underlying is known as a call, and the right to sell, a put.

  Options are traded on formal exchanges and in over-the-counter (OTC) markets. The exchanges, such as the Chicago Board Options Exchange, the London International Financial Futures and Options Exchange and the Philadelphia Stock Exchange, provide primarily standardized options; the OTC markets are able to provide tailored products to fit specific requirements. The choice between OTC and exchange-traded options will depend on the degree of tailoring required, the relative liquidity of both markets (this varies greatly according to the underlying) and credit concerns.

  Such credit concerns increase with the option’s maturity, since the likelihood that a counterparty will default increases with the length of time that passes between the option being bought and being exercised. Several derivatives exchanges have tried to bridge the gap between OTC and exchange-traded options by introducing flexible options that can be customized by the purchaser.

  Pricing models for simple or vanilla options have five major inputs: the option’s exercise or strike price; the time to expiration; the price of the underlying instrument; the risk-free interest rate on the underlying instrument, and the volatility of the underlying instrument (See also historical volatility, implied volatility).

  European-style options are usually priced off a closed-form analytical model first published by Fischer Black and Myron Scholes in 1973, which has subsequently been modified to fit different underlyings (see Black-Scholes model).

  At maturity, an option’s value will depend on the value of the right to buy or sell a product. If an option is purchased giving the right to buy gold at $375 an ounce and at expiration the price is $400, the option is worth $25.

  The extent to which an option is in-the-money (how far the strike price is below/above the current forward market price) is called its intrinsic value. Where the strike price is less favorable than the market price, the option is said to be out-of-the-money, and where the two prices are the same it is at-the-money.

  At any time before maturity, an option’s price will be a combination of its intrinsic value (which is always either greater than, or equal to, zero) and its time value. The latter includes the cost of carry and the probability that the price of the underlying will move into or remain in the money. Options can broadly be used in two ways – for speculation, or for insurance. Their usefulness, both from a buyer’s and a seller’s point of view, derives from their pay-outs.

  In contrast to other types of hedge, options provide insurance against unfavorable moves in a product’s price and the opportunity to take advantage of favorable moves. Forwards and futures, for example, require buyers and sellers to lock into one rate. In return for assuming this risk, sellers of options receive a premium, effectively a risk-taking fee.

  The pay-off of a purchased option means that the price risk of an option is limited to its premium – it is not as exposed to adverse movements as a position in the underlying.

  For speculators selling (writing) options, this often means taking a naked option position and therefore being exposed to adverse movements in the underlying. Hedgers may sell options to garner premium to offset any expected slight downturn in a market. Since option premiums are only a fraction of the cost of the underlying product, it is possible to achieve a much greater exposure to price changes of the underlying compared with a similar investment directly in the product – this is called leverage.

otc derivative

Over-the-counter derivatives are privately negotiated contracts that are traded directly between two parties, rather than on a centralized exchange. Some of the most common derivatives to be traded in the OTC market include swaps, forward rate agreements, and exotic options. The self-regulatory trade organization that oversees the over-the-counter derivatives market is the International Swaps and Derivatives Association (ISDA).

See also OTC

POSITIVE BASIS

Positive basis exists when the cost of buying protection (in the credit derivative market) on a particular reference entity exceeds the credit spread (generally expressed as a spread to Libor) on a bond or note of similar maturity issued by that reference entity. When this occurs, investors looking to gain exposure to the reference entity can improve their expected return on an investment by taking exposure to the credit by selling protection in the credit derivative market rather than buying the bond or note. Technical factors between the bond and credit derivative market account for positive basis.

POWER SWAP

A swap whose floating leg is based on the square (or some higher exponent) of the reference interest rate. Although dismissed by some as little more than a speculative tool for taking highly leveraged positions on the direction of interest rates, power swaps have been shown (by Robert Jarrow and Donald van Deventer) to have their uses in hedging commercial banks’ deposits and credit card loan portfolios.

PREPAYMENT RISK

The risk that the value of a mortgage-backed security will change due to a change in the prepayment behavior of the mortgages upon which it is based. If a mortgage is prepaid, the principal of the security declines, as does its average life, although its final maturity remains unchanged. This will in turn affect the duration of the security and its value. Prepayment risk also occurs with callable bonds and cancellable swaps, in which case it refers to the reinvestment risk that an investment repaid early may have to be reinvested at a lower rate of return.

PROGRAM TRADING

A strategy to trade a basket of shares simultaneously, normally by means of computer-generated instructions. Where the asset class is considered more important than the selection within that class, program trading (also known as basket trading) is used to lower trading costs since trading a basket of shares is cheaper than buying or selling those shares individually. Program trading is different from stock index arbitrage, although it is used in such a strategy.

PUTTABLE SWAP

An interest rate swap in which the fixed-rate payer has the right to terminate the contract after a specified period. Should interest rates fall, the swap can thus be put back to the fixed receiver. The putable swap is the opposite of a callable swap. The fixed-rate payer is effectively sold a swaption by the floating-rate payer, who receives a higher fixed rate in compensation. Putable swaps are similar to extendible swaps. Also known as a cancellable swap.

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

REGULATORY ARBITRAGE

A financial transaction that allows one or both of the counterparties to accomplish an operating or financial objective that would be unavailable to them directly because of regulations: for example, a commercial bank entering into a credit default swap with an OECD bank in order to lower the regulatory capital that it must hold.

REPLACEMENT COST

Often used in terms of credit exposure, the re-placement cost of a financial instrument is its current value in the market – in other words, what it would cost to replace a given contract if the counterparty to the contract defaulted. Aside from bid-ask conventions, it is synonymous with market value.

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.

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 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).

SEMI-FIXED SWAP

An interest rate swap with two possible fixed rates which can be tailored to suit bullish or bearish market views. The rate paid by the fixed-rate payer depends on whether current Libor (or another reference rate or asset) is above or below a predetermined level. In a typical structure, if Libor is below the trigger level, the lower of the two rates is paid, if it is above, the higher is paid. These swaps can be used to create asymmetric risk exposures, i.e., cheaper fixed-rate funding for an oil producer when oil prices are low, or an enhanced yield for an insurance company when equity prices are falling.

SETTLEMENT RISK

Settlement risk (delivery risk), as a particular form of counterparty credit risk, arises from a non-simultaneous exchange of payments. For example, a bank that makes a payment to a counterparty, but will not be recompensed until a later date, is exposed to the risk that the counterparty may default before making the counter-payment. Settlement risk is distinct from market risk because it relates to exposure to a counterparty rather than exposure to the underlying risk related to the reference entity of the derivative contract.

  Settlement risk is most pronounced in the foreign exchange markets, where payments in different currencies take place during the normal business hours in their respective countries and can therefore be made up to eighteen hours apart, and where the volume of payments makes it impossible to monitor receipts except on a delayed basis. This type of risk afflicted counterparties of Bank Herstatt in 1974, which closed its doors after receipt but before payment on foreign exchange contracts. As a result, settlement risk is sometimes called Herstatt risk. There are now a number of settlement processing organizations for foreign exchange, such as Multinet and Echo, which aim to reduce settlement risk by centralizing the settlement process.

See also credit risk

SPECIFIC RISK

Specific risk, also known as non-systematic risk, represents the price variability of a security that is due to factors unique to that security, as opposed to that portion that is due to systematic risk, the generalized price variability of the related interest rate or equity market. As an example, a US Treasury note would have no specific risk, as it deemed to have no risk other than movement in interest rates, while a corporate bond would have a degree of default risk as well as more generalized yield curve risk.

  Specific risk is also the term used by both the European Union’s Capital Adequacy Directive and the Basel Capital Accord to refer to the risks unique to individual holdings that are not covered by capital dedicated to generalized market risk. Specific risks are considered to be only partially diversifiable, and capital dedicated to them is added to generalized market risk capital.

See also relative performance risk

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.

SUBSTITUTION OPTION

A bilateral financial contract in which one party buys the right to substitute a specified asset or one of a specified group of assets for another asset at a point in time or contingent upon a credit event.

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

SYNTHETIC COLLATERALISED DEBT OBLIGATION

A synthetic collateralized debt obligation (CDO) uses credit derivatives to transfer credit risk in a portfolio. This is in contrast to a traditional CDO which is typically structured as a securitization with ownership of the assets transferred to a separate special purpose vehicle (SPV). The assets are funded with the proceeds of debt and equity issued by the vehicle. In a synthetic CDO, an institution transfers the total return or default risk of a reference portfolio via a credit default swap, a total return swap, or a credit-linked note. The SPV then issues securities with repayment contingent upon the loss on the portfolio. Proceeds are either held by the vehicle and invested in highly rated, liquid collateral, or passed-on to the institution as an investment in a credit-linked note.

  Balance sheet synthetic CDOs are typically used by banks to manage risk capital and are easier to execute than traditional CDOs. Arbitrage synthetic CDOs are often used by insurance companies and asset managers and exploit the spread between the yield on the underlying assets and the reduced expense of servicing a CDO structure.

SYNTHETIC SECURITISATION

A first-loss basket swap structure that references a portfolio of bonds, loans or other financial instruments held on a firm’s balance sheet. The technique replicates the credit risk transfer benefits of a traditional cash securitization while retaining the assets on balance sheet. Advantages over cash securitization include reduced cost, ease of execution and retention of on-balance sheet funding advantage.

TERMination event

An event that allows for the termination of a swap, such as a credit downgrade.

the Wppss municipal default (Whoops)

The Washington Public Power Supply System (WPPSS) Municipal Default (commonly referred to as, “whoops”), was the largest municipal bond default in US history. In the late 1970s, WPPSS planned to build 5 nuclear power plants to help with state’s projected need for more electricity. Construction was started on all 5 plants, but through poor project management, delays were experienced and costs exceeded budget by 5 times. The project was financed with a total of $2.25 billion of tax-exempt bonds, but total project costs were projected to be more than $24 billion. The result was the largest municipal default in US history. In the end, one of the power plants was finished, which is now called the Columbia Generating Station. The other four structures were eventually demolished in 1995.

THETA

This measures the effect on an option’s price of a one-day decrease in the time to expiration. The more the market and strike prices diverge, the less effect theta has on a vanilla option’s price. Theta is also non-linear for vanilla options, meaning that its value decreases faster as the option is closer to maturity. Positive gamma is generally associated with negative theta and vice versa.

TOTAL RATE OF RETURN SWAP

A bilateral financial contract in which one party (the total return payer) makes floating payments to the other party (the total return receiver) equal to the total return on a specified asset or index (including interest or dividend payments and net price appreciation) in exchange for amounts which generally equal the total return payer’s cost of holding the specified asset on its balance sheet. Price appreciation or depreciation may be calculated and exchanged at maturity or on an interim basis. A total (rate of) return swap is a form of credit derivative, but is distinct from a credit default swap in that floating payments are based on the total economic performance of a specified asset and are not contingent upon the occurrence of a credit event.

TWO-NAME EXPOSURE

Credit exposure that the protection buyer has to the protection seller, which is contingent on the performance of the reference credit. If the protection seller defaults, the buyer must find alternative protection and will be exposed to changes in replacement cost due to changes in credit spreads since the inception of the original swap. More seriously, if the protection seller defaults and the reference entity defaults, the buyer is unlikely to recover the full default payment due, although the final recovery rate on the position will benefit from any positive recovery rate on obligations of both the reference entity and the protection seller.

UNEXPECTED LOSS

Usually defined as the standard deviation of the amount of credit losses that a lender should anticipate on a portfolio in a single year.

WEATHER DERIVATIVE

Typically swaps and vanilla options such as calls, puts, caps, floors and collars with payoffs linked to temperature, precipitation, humidity or wind speed. Most instruments are linked to heating degree days or cooling degree days. These two indexes measure the deviation of the average of a day’s high and low temperature from a baseline reference temperature.

YIELD CURVE

The yield curve is a graphical representation of the term structure of interest rates. It is usually depicted as the spot yields on bonds with different maturities but the same risk factors (such as creditworthiness of issuer), plotted against maturity. The usual features of a spot yield curve are higher long-term yields than short-term yields and a curve for default-free bonds that is lower at each point than the equivalent curve for riskier debt. It is possible to construct variants of the yield curve from this basic form. The par yield curve is found by calculating the coupons that would be necessary for bonds of each maturity to be priced at par; the forward yield curve is found by extrapolating the spot yield curve point-by-point, based on the implied forward interest rates.

YIELD CURVE SWAP

A swap in which the two interest streams reflect different points on the swap yield curve. Yield curve swaps can be used to exploit a yield curve steepening or flattening view. For example, one side pays the two-year Constant Maturity Treasury (CMT) rate and the other the 10-year CMT rate.

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.