home

about

industries

services

news and links

Definitions

podcasts

contact

Exact Matches:

MARK to market

To mark-to-market is to calculate the value of a financial instrument (or portfolio of such instruments) based on the current market rates or prices of the underlying. Marking-to-market on a daily (or more frequent) basis is often recommended in risk management guidelines.

See also accrual accounting, hedge accounting

---

Partial Matches:

ACCELERATED SUPPLY

Gold that reaches the market through leasing, lending, or the derivative market before it is physically produced. Commonly used to describe the effect of a gold producer hedging on the short-term market. This term is sometimes used in other commodity markets as well.

ALTERNATIVE RISK TRANSFER

An approach to risk management combining capital markets, reinsurance and investment banking techniques that allows a party to either free itself from risks not easily transferred via traditional insurance, or alternatively cover such risks in a non-traditional way – by using the capital markets for example.

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%.

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.

AVERAGE OPTION

A plain vanilla option pays out the difference between its predetermined strike price and the spot rate (or price) of the underlying at the time of expiry. The purchaser of an average option (average price, average strike, average hybrid, average ratio), on the other hand, will receive a pay-out which depends on the average value of the underlying. The average can be calculated in a number of ways (arithmetic or geometric, weighted or simple) from the spot rate on a predetermined series of dates (usually official fixing rates). An average rate (also known as average price) option is a cash-settled option with a predetermined (i.e., fixed) strike which is exercised at expiry against the average value of the underlying over the option’s life. In general, hedging with an average option is cheaper than using a portfolio of vanilla options, since the averaging process offsets high values with low ones and therefore lowers volatility and premium. Average rate options, also known as Asian options, are particularly popular in the currency and commodity markets.
 

  In contrast, the strike for an average strike option is not fixed until the end of the averaging period which is typically much before the expiry. When the strike is set, the option is exercised against the prevailing spot rate. Unlike average price options, average strike options may be either cash or physically settled. In the case of an average hybrid option (also known as an average-in/average-out option), both the strike and settlement price of the option are determined using the average, where the strike averaging period typically precedes the settlement price averaging period. For the average ratio option, both the strike and settlement price of the option are determined using the average as in the hybrid case. The final payoff is determined by comparing the ratio of settlement price to strike and a fixed percent strike.

BACKWARDATION

The situation when the cash or spot price of a commodity is greater than its forward price. A backwardation occurs when there exists insufficient supply to satisfy nearby demand in a commodity market. The size of the backwardation is determined by differences between supply/ demand factors in the nearby positions compared with the same factors on the forward position. There is no inherent limit to the backwardation, also referred to as a “back”.

See also contango

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

1. The difference between the prices of a futures contract and the underlying.
2. The convention for calculating interest rates. A bond can be 30/360 or actual/365 in the US, or 360/360 in Europe. Money market instruments can be actual/360 in the US or actual/365 in the UK and Japan.

BASIS RISK

In a futures market, the basis risk is the risk that the value of a futures contract does not move in line with the underlying exposure. Because a futures contract is a forward agreement, many factors can affect the basis. These include shifts in the yield curve, which affect the cost of carry; a change in the cheapest-to-deliver bond; supply and demand; and changing expectations in the futures market about the market’s direction.

  Generally, basis risk is the risk of a hedge’s price not moving in line with the price of the hedged position. For example, hedging swap positions with bonds incurs basis risk because changes in the swap spread would result in the hedge being imperfectly correlated. Basis risk increases the more the instrument to be hedged and the underlying are imperfect substitutes.

BEAR SPREAD

An option spread trade that reflects a bearish view on the market. It is usually understood as the purchase of a put spread.

See also bull spread

BETA

1. The beta of an instrument is its standardized covariance with its class of instruments as a whole. Thus the beta of a stock is the extent to which that stock follows movements in the overall market. If a stock has a beta greater than one, it is more volatile than the market; if less than one, it is less volatile.
2. Beta trading is used by currency traders if they take the volatility risk of one currency in another. For example, rather than hedge a sterling/yen option with another sterling/yen option, a trader, either because of liquidity constraints or because of lower volatility, might hedge with euro/yen options. The beta risk indicates the likelihood of the two currencies’ volatilities diverging.

BINARY OPTION

Unlike simple options, which have continuous pay-out profiles, that of a binary option is discontinuous and pays out a fixed amount if the underlying satisfies a predetermined trigger condition but nothing otherwise. Binary options are also known as digital or all-or-nothing options.

  There are two major forms: at maturity and one-touch. At maturity binaries, also known as European binaries or at expiry binaries, pay out only if the spot trades above (or below) the trigger level at expiry. One-touch binary options, also known as American binaries, pay out if the spot rate trades through the trigger level at any time up to and including expiry. The pay-out of a one-touch binary may be due as soon as the trigger condition is satisfied or alternatively at expiry (one-touch immediate or one-touch deferred binaries). As with barrier options, variations on the theme include discrete binaries, stepped binaries, etc. Binary options are frequently combined with other instruments to create structured products, such as contingent premium options.

BLACK-DERMAN-TOY MODEL

A one-factor log-normal interest rate model where the single source of uncertainty is the short-term rate. The inputs into the model are the observed term structure of spot interest rates and their volatility term structure. The Black-Derman-Toy model, such as the Ho-Lee model, describes the evolution of the entire term structure in a discrete-time binomial tree framework. The model can be used to price bonds and interest rate-sensitive securities, though the solutions are not closed-form.

BLACK-SCHOLES MODEL

The original closed-form solution to option pricing developed by Fischer Black and Myron Scholes in 1973. In its simplest form it offers a solution to pricing European-style options on assets with interim cash pay-outs over the life of the option. The model calculates the theoretical, or fair value for the option by constructing an instantaneously riskless hedge: that is, one whose performance is the mirror image of the option pay-out. The portfolio of option and hedge can then be assumed to earn the risk-free rate of return.

  Central to the model is the assumption that market returns are normally distributed (i.e., have lognormal prices), that there are no transaction costs, that volatility and interest rates remain constant throughout the life of the option, and that the market follows a diffusion process. The model has five major inputs: the risk-free interest rate, the option’s strike price, the price of the underlying, the option’s maturity, and the volatility assumed. Since the first four are usually determined by the market, options traders tend to trade the implied volatility of the option.

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 FUTURE

A futures contract on a bond. The underlying can be of two types. The first is a notional (theoretical) bond, for example the 10-year government bond futures contract on Marché à Terme International de France (Matif), which has a notional seven- to 10-year underlying government bond with a 10% coupon. The second type is a futures contract on a specific bond, for example, the futures contract on the Danish government bond 8% 2000, listed on the Guarantee Fund for Danish Options and Futures. The notional type is more common.

  The theoretical price of a bond futures contract equals the spot price of the underlying bond plus its net cost of carry. The higher the cost of carry (measured by its implied repo rate) for the cash bond, the more value there is in holding a futures contract instead, which is simply another way of buying a cash bond but at a future date. If the financing costs of holding a bond are lower than the bond’s yield, the bond will have positive carry and the futures contract will trade at a discount. If the financing costs of the bond are higher than the bond’s yield, the futures will trade at a premium. Hence bond futures normally trade at a discount to the cash in an upward-sloping yield curve and at a premium in a downward-sloping one. The degree of premium or discount will decrease the closer the futures contract is to expiry.

  When futures are based on a notional bond, the exchange has to specify which bonds are deliverable into the futures contract. These can change periodically as outstanding issues get shorter and reach maturity. Because bonds have differing coupons, the exchange has to specify a conversion factor that allows those bonds to be compared on an equal basis to the notional underlying. A bond’s conversion factor is the value of one unit of that bond were it to trade at a yield to maturity equal to that of the notional bond. Because of demand/supply conditions, some bonds will be cheaper to deliver than others. The cheapest to deliver will be those where the greatest profit can be made from holding the bond and delivering it into the futures contract (called cash-and-carry arbitrage). This is dependent on the supply of bonds in the market, and on a bond’s maturity and coupon.

BOND INDEX SWAP

A swap in which one counterparty receives the total rate of return of a bond market or segment of a bond market in exchange for paying a money market rate. Counterparties may also swap the returns of two bond markets. The two most common indexes used to measure bond market returns are the JPMorgan government bond index and the Salomon Brothers world government bond index. Bond index swaps can be an attractive way of gaining exposure to a market if the investor wants to avoid the trouble and expense of buying individual bonds, bearing in mind there are currently no government bond index futures. Bond index swaps can also be used to pass on bond market exposure when an investor does not want to sell core bond holdings, either because of wide price spreads or because they were difficult to obtain.

  There can also be tax advantages in using bond swaps. For example, in Japan, banks and securities houses are exempt from withholding tax, but most foreign investors are not. Banks can therefore pass on some of those tax advantages in the swap. Also known as a total rate of return swap.

BOND OPTION

An option offered on debt, usually government securities, although OTC options are available on corporate debt. The options can either be ex-change-traded, listed or OTC. Bond options have traditionally been standard European-style or American-style puts and calls. There is more interest in exotic structures such as yield curve options, inter-market spread options, and quanto options.

BORROWING

Derived from “borrowing metal from the market,” which is achieved by buying a nearby date and simultaneously selling a date further forward.

See also cash and carry

BOX

To buy/sell mispriced options and hedge the market risk using only options, unlike the conversion or the reversal, which use futures contracts. If a certain strike put is underpriced, the trader buys the put and sells a call at the same strike, creating a synthetic short futures position. To get rid of the market risk, he sells another put and buys another call, but at different strike prices.

BREAK FORWARD/CAPPED FORWARD

A strategy that involves buying a synthetic off-market currency forward (buying and selling a put and a call at the same strike price) and the simultaneous purchase of another option, allowing a purchaser to benefit from favorable exchange rate movements. The transaction is usually constructed for zero cost because the premium from the off-market forward pays for the option.

BUILDING-BLOCK APPROACH

The building block approach to calculating capital adequacy is the basis for the quantitative requirements of the European Union’s Capital Adequacy Directive (CAD), as well as the standardized approach of the Basel Capital Accord. This approach recognizes to some extent the risk reduction that arises from offsetting positions, but treats individual market risks as additive, and further distinguishes between general market risk and specific risk, the latter reflecting risks specific to individual securities. Capital is charged as a percentage of the net face value of various positions, the percentage being a function of the type and tenor of security, and of the type of risk.

See also comprehensive approach

BULL SPREAD

An option spread trade that reflects a bullish view on the market. It is usually understood as the purchase of a call spread.

See also bear spread

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

CASH AND CARRY

When a contango exists, the premium of the forward position over the prompt generally reflects costs of storage, insurance and finance for that period. When metal is in surplus, the contango may widen to the point where an effective interest rate that is higher than market rates can be locked-in.

CASH MARKET

An underlying, as opposed to a futures market.

CASH-AND-CARRY ARBITRAGE

A strategy used in bond or stock index futures in which a trader sells a futures contract and buys the underlying to deliver into it, to generate a riskless profit. For the strategy to work, the futures contract must be theoretically expensive relative to cash. The value of a futures contract is assessed by looking at the implied repo rate. If the implied repo rate is greater than the market repo rate, then futures are said to be cheap.

  Cash-and-carry arbitrage and reverse cash-and-carry arbitrage typically keep the futures and underlying markets closely aligned.

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.

COMPLETE MARKETS

If markets are complete, then any contingent claim can be hedged exactly using tradable assets.

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.

CONTANGO

Situation when a commodity’s future price is higher than its spot price. Whereas financial futures and forwards are invariably priced off the cost of carry of the underlying, the forward or spot prices of commodities are heavily influenced by supply and demand. Contango arises where there is sufficient supply in the spot market or where future supply is thought to be tight.

See also advance premium forward, backwardation

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

CONTRACT FOR DIFFERENCE (CFD)

A Contract for Difference is typically an agreement made between two parties to exchange (at the closing of the contract) a cashflow equivalent to the difference between the opening and closing prices, multiplied by the number of shares detailed in the contract. CFDs are traded on margin, do not incur stamp duty and can have individual stocks or indexes as the underlying.

  Alternatively, in the currency markets, the term CFD can refer to an OTC currency forward contract that settles for a cash amount (maybe in a third currency) without requiring the exchange of the two underlying currencies. It is often used instead of a traditional forward because it mitigates settlement risk.

CONVENIENCE YIELD

Describes the yield that accrues to the owner of a physical inventory but not to the owner of a contract for future delivery in commodity markets. The convenience yield helps to explain the backwardation often observed in commodity markets.

CONVERSION

1) A way of taking advantage of mispriced options by creating a synthetic short futures position and hedging market risk by buying a futures contract against it. Thus if a put is undervalued, a trader buys it, at the same time selling a fairly valued call and buying a futures contract. The same strategy can be applied if the call is mispriced. If the option is truly undervalued, the trader earns a riskless profit. The whole exercise relies on put-call+parity. 2) The act of converting a convertible bond into equity.

See also box, reversal

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.

COVERED CALL

To sell a call option while owning the underlying security on which the option is written. The technique is used by fund managers to increase income by receiving option premium. It would be used for securities they are willing to sell, only if the underlying went up sufficiently for the option to be exercised. Generally, covered call writers would undertake the strategy only if they thought volatility was overpriced in the market. The lower the volatility, the less the covered call writer gains in return for giving up upside in the underlying. It provides downside protection only to the extent that the option premium offsets a market downturn.

See also covered put

COVERED PUT

To sell a put option while holding cash. This technique is used to increase income by receiving option premium. If the market goes down and the option is exercised, the cash can be used to buy the underlying to cover. Covered put writing is often used as a way of target buying: if an investor has a target price at which he wants to buy, he can set the strike price of the option at that level and receive option premium to increase the yield of the asset. Investors also sell covered puts if markets have fallen rapidly but seem to have bottomed, because of the high volatility typically received on the option.

See also covered call

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 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 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 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.

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.

CUMULATIVE CAP

A cumulative interest rate cap protects against increases in total interest expense over a specified period of time. This period of time will incorporate several rate settings in determining the final interest expense (for example, four three-month Libor settings for an annual interest expense amount). This differs from a standard cap, which caps an absolute rate of interest in each calculation period. Because a cumulative cap does not provide the period-to-period protection of a standard cap, it is generally cheaper than the corresponding standard cap.

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.

DAILY CALL OPTION

Common in the natural gas markets, this option allows the buyer to take additional volumes of gas with a single day’s notice.

DEBT service reserve fund

The Debt Service Reserve Fund (“DSRF”) has traditionally been invested in a long term treasury security combined with a simultaneous purchase of a par put option to insure liquidity and par value of the treasury. The problem with purchasing the treasury put is that it can be expensive (up to 100 bps), reducing the overall yield of the DSRF. Furthermore, once purchased, a treasury put is relatively illiquid with little resale value. Sometimes, the long term treasury is bought “naked,” that is, without the put option, which eminently sets up the issuer for a probable underfunded DSRF sometime in the future.

  The DSRF Forward Purchase Agreement (“FPA”) provides essentially the same long term rate as long term treasuries, while eliminating the need for a treasury put option. The DSRF FPA works as follows: A FPA provider would initially deliver a 90 day T-Bill to the trustee. When that T-bill matured the FPA provider would deliver a new 90 day T-Bill in exchange for the cash resulting from the previous maturing T-Bill. This cycle would continue for the term of the agreement. The yield for this type of instrument is fixed for the term of the agreement. The agreement is extremely safe, as the issuer always has either cash or a T-Bill in the trustee possession, and will be approved by most bond counsel.

  If allowed by the indenture, the interest to be earned for the term of the FPA can be taken over time or taken up front as a lump sum payment. An issuer can partially fund the DSRF by taking earnings up-front which reduces the overall bond issuance amount. The up-front payment can represent 25-50% of the total DSRF requirement. Similarly, if an issuer had bought a long term treasury in a lower interest rate environment to fund a DSRF which is now underfunded, a partial up-front payment from an FPA can bring the DSRF back to par, eliminating the need to look to other sources of monies to fill the requirement. The remaining interest can then be taken over time or be taken up-front to release locked DSRF funds for other uses.

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.

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.

DOUBLE TOPS/ DOUBLE BOTTOMS

A double top formation is a chart pattern of commodity or financial asset price movements that reflects a rising market which hits resistance at a certain level. The market rises, retreats, rises again, but still cannot breach the previous resistance point, and falls back again. These price patterns are used by technical analysts to recognize the reversal of a price trend. The inverse of this would be a double bottom, which reflects a support level that has been established and serves as support under a falling market.

DOwngrade termination

Provision in some swap agreements allowing one party to terminate the swap at its market value if the other party’s long-term, unsecured debt rating falls below a given level.

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.

DYNAMIC REPLICATION

To replicate the pay-out of an option by buying or selling the underlying (or for some markets, because of cheaper transaction costs, futures) in proportion to an option’s delta. If replicating a short call position, the replicator would, as the underlying went up, buy increasing amounts in proportion to the theoretical option’s delta, and likewise decrease the hedge amount as the market falls. Dynamic replicators are at risk from increases in volatility, as this makes it more difficult for the necessary hedge amounts to be transacted at the desired rate.

See also static replication

EQUITY (INDEX) SWAP

A swap in which the total or price return on an equity index, equity basket or single equity is exchanged for a stream of cashflows based on a short-term interest rate index (or another index).

  Equity swaps are a convenient structure for switching into or out of equity markets, particularly for those that prefer to avoid, or are not allowed to use stock index futures. Like futures, the price of the swap is directly related to the cost of carry, although there may also be tax considerations.

EXCHANGE FOR PHYSICALS (EFP)

A futures market transaction between two counterparties consisting of a simultaneous exchange of a futures contract and an offsetting OTC quantity. In the case of gold, there is an active EFP market with dealers quoting bid and offer – usually the COMEX active month against loco London spot. Such an exchange allows for counterparties to open/close positions in the futures and OTC market without making outright purchases or sales. The EFP is also used as a trading instrument in its own right as position-takers can establish arbitrage positions.

EXCHANGE OPTION

Depending on the context, this can either refer to an outperformance option, or, alternatively an option giving the purchaser the right to exchange one asset for another. The latter type of options are useful if there isn’t a cross-market, as with a barrel of oil priced in Euros. The purchaser of a Euro-oil exchange option would have the right to exchange a certain amount of Euros for a certain number of barrels of oil.

See also integrated hedge

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.

FAir value

As defined by FAS 157, fair value is “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

See also FAS 157

FAS 133

The Financial Accounting Standards Board’s derivatives accounting rule that came into force in June 2000. The rule requires all SEC-registered companies to include the fair (i.e., mark to market) value of their derivatives positions in their balance sheet. Hedge accounting is only permitted where hedge effectiveness – i.e., that the change in the value of the derivatives is offset by the corresponding change in the value of the financial item being hedged – can be demonstrated. FAS 133 is also abbreviated as FAS133, SFAS 133, and Statement No. 133.

See also IAS 39, fair value

FAS 157

The Financial Accounting Standards Board’s fair value measurements rule that came into force in November 2007. FAS 157 applies to for-profit and not-for profit entities that prepare their financial statements in accordance with GAAP.

At its heart, FAS 157 redefines fair value as, “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” The Statement redefines “fair value” as an exit price, rather than an entry price, regardless of whether the entity plans to hold or sell the asset.

FAS 157 is also abbreviated as FAS157, SFAS 157, or Statement No. 157.

FINra

The Financial Industry Regulatory Authority is the largest non-governmental regulator for all securities firms doing business in the United States. FINRA oversees nearly 5,000 brokerage firms, about 173,000 branch offices and more than 676,000 registered securities representatives. FINRA was created in July 2007 through the consolidation of NASD and the member regulation, enforcement and arbitration functions of the New York Stock Exchange.

  FINRA is involved with many aspects of the securities business, including registering and educating industry participants; examining securities firms; writing rules; enforcing those rules and the federal securities laws; informing and educating the investing public; providing trade reporting and other industry utilities; and administering a dispute resolution forum for investors and registered firms. FINRA also performs market regulation under contract for The NASDAQ Stock Market, the American Stock Exchange, the International Securities Exchange and the Chicago Climate Exchange.

FORWARD EXCHANGE RATE AGREEMENT (FXA)

A synthetic agreement for forward exchange (SAFE) developed by Midland Montague. Essentially a cash-settled forward. The counterparties agree on a forward exchange rate for a chosen delivery date, and at the maturity of the contract the two counterparties make mark-to-market payments based on the prevailing spot rates.

See also synthetic agreement for exchange

FORWARD 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.

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.

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.

GUARANTEED RETURN ON INVESTMENT

Any instrument (usually a structured note) which guarantees investors a minimum return on their investment. This can be achieved by combining a debt issue with a structure, such as a collar or cylinder, which locks gains into a range. This means that the investor gains protection from an adverse market move by limiting participation in any favorable move.

See also principal-guaranteed note

HAIRCUT

The excess of an asset’s market value over either the loan for which it can serve as adequate capital, or the regulatory capital value. It can also refer to the dealer’s commission on a transaction.

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.

HEDGE

To hedge is to reduce risk by making transactions that reduce exposure to market fluctuations; for example, an investor with a long equity position might compensate by buying put options to protect against a fall in equity prices. A hedge is also the term for the transactions made to effect this reduction.

HEDGE ACCOUNTING

The practice of deferring accounting recognition of gains and losses on financial market hedges until the corresponding gain or loss of the underlying exposure is recognized. Companies favor hedge accounting because it enables them to incorporate costs of hedges into the cost basis of the exposure. This matches gains against offsetting losses, reducing earnings volatility in a manner consistent with the purpose of the hedge. At this writing, the US Federal Accounting Standards Board was in the midst of a long-term project to codify accounting for derivatives transactions which will address the circumstances under which hedge accounting is permitted.

See also FAS 133 and IAS 39; accrual accounting, mark to market

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.

HIGH-COUPON SWAP

A swap in which the fixed-rate payments are above market rates. (Also known as a premium swap.)

See also discount swap

HIGH-LOW OPTION

A combination of two lookback options. A high-low option pays the difference between the high and low of an underlying, such as a stock index. A speculative purchaser would be taking the view that the market would be more volatile than the implied volatilities of both lookback options incorporated in the structure.

HISTORIC RATE ROLLOVER

A historic rate rollover allows an existing currency forward or spot position to be rolled forward without generating any intermediate cash flows. Effectively the position is reinstated for a new settlement date using a new off-market forward rate based on the historic rate.

HISTORICAL SIMULATION

A method of calculating value-at-risk which uses historical data to assess the impact of market moves on a portfolio. The first step is to record the changes in the relevant market factors over a given historical period, where each change occurs over a constant holding period. The next step is to revalue the portfolio for each change in market factors, as if such change were to occur in the future. The result is a distribution of possible profits and losses on the portfolio over the holding period, from which it is possible to calculate the maximum loss at a given confidence level. An advantage of historical simulation is that because it uses real data, it captures outlying events and correlations which would not necessarily be predicted by a theoretical model.

IMPLIED VOLATILITY

The value of volatility embedded in an option price. All things being equal, higher implied volatility will lead to higher vanilla option prices and vice versa. The effect of changes in volatility on an option’s price is known as vega. If an option’s premium is known, its implied volatility can be derived by inputting all the known factors into an option pricing model (the current price of the underlying, interest rates, the time to maturity and the strike price). The model will then calculate the volatility assumed in the option price, which will be the market’s best estimate of the future volatility of the underlying.

See also volatility skew, volatility term structure

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.

INDEX PARTICIPATION UNITS

The generic term for investment vehicles that provide the return of a specific index (usually a stock market index) while guaranteeing the investor the return of the principal.

INTEGRATED HEDGE

A hedge which combines more than one distinct price risk. For example, crude oil is usually priced in US dollars. Therefore a producer of crude oil whose home currency is not the dollar (say, the euro) is exposed to both currency risk and the price risk for crude oil. One possible integrated hedge would be a single quanto option, which would hedge the price of crude oil in euro. As such, it would depend heavily on the correlation (if any) between the two markets.

See also exchange option

INTEREST RATE risk

The risks associated with changes in interest rates (i.e., the risk that changes in interest rates will adversely affect an Issuer’s position with respect to borrowing costs, re-investment opportunities, at-market investment termination, etc.)

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.

IN-THE-MONEY

Describes an option whose strike price is advantageous compared to the current forward market price of the underlying. The more an option is in-the-money, the higher its intrinsic value and the more expensive it becomes. As an option becomes more in-the-money, its delta increases and it behaves more like the underlying in profit and loss terms; hence deep in-the-money options will have a delta of close to one.

See also at-the-money, out-of-the-money

INTRINSIC VALUE

The amount by which an option is in-the-money, that is, its value relative to the current forward market price. Option premiums comprise intrinsic value and time value.

INVERSE FLOATER

The payments made on an inverse floating rate note (“floater”) decrease as the reference interest rate increases, the reverse of the typical case where the payments rise with the reference rate.

  The purchaser of an inverse floating rate note is in effect selling interest rate caps – this will increase the coupon payments in a stable or lower interest rate environment, but reduce them should interest rates rise. Typically, the payment rate is found by multiplying the market rate at the outset by two and subtracting the reference rate from this figure. The floater can be leveraged by using a larger multiplier than two.

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

Jj kenny index

JJ Kenny Index is now called the S&P Weekly High Grade Index, established in 1982 at the inception of the variable rate demand bond market, the JJ Kenny index represents the current rate that 7 day variable rate demand bonds will clear the market at par. The index is comprised of over 250 high grade short term variable rate municipal bonds.

JUMP DIFFUSION

One of the key assumptions of the Black-Scholes model is that the asset price follows geometric Brownian motion with constant volatility and interest rates. In a jump diffusion model, it is assumed that in addition to this regular diffusion, there are jumps in the market. This type of model is sometimes used for modeling equities and emerging market currencies.

KERB

In the base metals market, specifically on the London Metal Exchange, the kerb refers to the brief trading period after the market settlement prices have been posted. This kerb period, during which all seven base metals can be simultaneously traded across the Ring, only lasts a few minutes. It derives its name from the early century practice of dealing members meeting along the roadside after the morning session to continue to trade.

KNOCK-IN FLOOR, ONE TOUCH

A floor which will be entered into at any reset date if the reference interest rate rises beyond a trigger level on or before that date. For example, a three-year floor struck at 5% for three-month Libor might have a knock-in level of 4%. If Libor was below 4% on one of the floor’s quarterly reset dates, the floor would be entered into, leaving the seller exposed to the lower rates.

KNOCK-IN FLOOR, PERIODIC

Similar to a one touch, except that only the current period is affected. The remainder of the structure remains intact.

KNOCK-OUT CAP, ONE TOUCH

A cap which can be cancelled at any reset date if the reference interest rate rises beyond a trigger level on or before that date. For example, a three-year cap struck at 5% for three-month Libor might have a knock-out level of 7%. If Libor was above 7% on one of the cap’s quarterly reset dates, the cap would be cancelled, leaving the holder exposed to the higher rates. This extinguishing feature of knock-out caps means they can be considerably cheaper than conventional caps. This makes them more useful in creating structures offering cheap protection than their vanilla analogues (for example, knock-out interest rate corridor).

KNOCK-OUT CAP, PERIODIC

Similar to a one touch, except that only the current period is affected. The remainder of the structure remains intact.

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.

LAMBDA

A measure of the effective leverage of an instrument. It is defined as the percentage change in the market value of a derivative for a one-percent move in the underlying. Unlike gearing, the lambda value captures the instrument’s delta.

See also leverage

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.

LENDING

Derived from lending metal to the market. Selling metal on a nearby date and simultaneously buying it back on a forward date

LIQUIDITY RISK

The risk associated with transactions made in illiquid markets. Such markets are characterized by wide bid/offer spreads, lack of transparency and large movements in price after a deal of any size. A firm wishing to unwind a portfolio of illiquid instruments (for example, highly tailored structured notes) may find it has to sell them at prices far below their fair values, exacerbating the problems that prompted the decision to unwind.

MARKET MODEL OF INTEREST RATES

A special case of the Heath-Jarrow-Morton model due to Brace, Gatarek and Musiela in which the term structure of interest rates is modeled in terms of simple Libor rates (which are lognormally distributed with respect to forward measure) rather than instantaneous forward rates. This allows the modeler to exclude the possibility of negative interest rates from the model and obtain prices for caps, floors and swaptions consistent with the Black-Scholes framework. The model can be calibrated using readily available market data: forward or swap rates volatilities and correlations, and is particularly suited to path-dependent instruments.

MARKET RISK

Exposure to a change in the value of some market variable, such as interest rates or foreign exchange rates, equity or commodity prices. For holders of a derivatives position, market risk may be passed through from a change in the value of the underlying to the price of the derivative, or may arise from other sources, such as implied volatility or time decay.

MARKET VALUE

See replacement cost

MARKING-TO-MARKET

See mark to market

MId-market

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

MINI-PREMIUM OPTION

The purchaser of a mini-premium option (also known as a step-payment or installment option) pays no initial premium. Instead, a fixed premium becomes payable if the market spot rate subsequently trades through each of a number of predetermined trigger levels for the spot rate. While this offers hedgers protection at zero cost, the total premium paid if all the triggers are activated will be greater than the premium for the equivalent plain vanilla option. However, in this case, the spot rate would have moved in favor of the hedger’s underlying position.

See also binary option, contingent premium option

MONTE CARLO SIMULATION

A method of determining the value of a derivative by simulating the evolution of the underlying variable(s) many times over. The discounted average outcome of the simulation gives an approximation of the derivative’s value. This method may be used to value complex derivatives, particularly path-dependent options, for which closed-form solutions have not been or cannot be found. Monte Carlo simulation can also be used to estimate the value-at-risk (VAR) of a portfolio. In this case, a simulation of many correlated market movements is generated for the markets to which the portfolio is exposed, and the positions in the portfolio revalued repeatedly in accordance with the simulated scenarios. The result of this calculation will be a probability distribution of portfolio gains and losses from which the VAR can be determined. The principal difficulty with Monte Carlo VAR analysis is that it can be very computationally intensive.

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

MUTUAL OFFSET SYSTEM

A margining system for derivatives exchanges in which positions on different exchanges can offset each other. This means that if a participant has a long position on one exchange but a short position on the other in a fungible (compatible) contract, they can pay reduced margin on one exchange because their total exposure has been reduced by netting over the two exchanges.

  For example, the Singapore International Monetary Exchange (Simex) has two mutual offsets, one with the Chicago Mercantile Exchange for Eurodollar futures, and another with the International Petroleum Exchange, for Brent crude oil futures.

NAsd

The National Association of Securities Dealers was a self-regulatory organization of US financial securities dealers responsible for the enforcement of rules and trading for the over-the-counter securities market. In July of 2007, the NASD merged with the New York Stock Exchange’s regulation committee to form the Financial Industry Regulatory Authority, or FINRA.

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.

NET PRESENT VALUE

A technique for assessing the worth of future payments by looking at the present value of those future cashflows discounted at today’s cost of capital.

Non-deliverable forward (NDF)

Non-deliverable forward contracts (NDFs) – also called dollar-settled forwards – are synthetic forwards which entail no exchange of currencies at maturity. Instead, settlement is made in US dollars based on the difference between the agreed contract rate at inception and a market reference rate at maturity. NDFs can be used to establish a hedge or take a position in one of a growing group of emerging market currencies where conventional forward markets either do not exist or may be closed to non-residents. As offshore instruments, NDFs offer the advantage of eliminating convertibility risk, since no emerging market currencies are exchanged at maturity.

ONE-TOUCH OPTION

See binary option

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.

OPTION COMBINATION STRATEGIES

Options may be combined so that their pay-outs produce a desired risk profile. Some combinations are primarily trading strategies, but option combinations can be useful in, for example, allowing investors to construct a strategy to take advantage of a particular view they have of the market. Other strategies allow purchasers to reduce their premiums by giving up some of the benefits they may have received from market movements.

See also bear spread, bull spread, calendar spread, call spread, condor, cylinder, put spread, ratio spread, straddle, strangle

otc

Over-the-counter, referring to the trade or transaction of a security or derivative negotiated directly between two parties, rather than on a centralized exchange. Also refered to as the OTC Market.

See also OTC Derivative

otc derivative

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

See also OTC

OUT-OF-THE-MONEY

Describes an option for which the currency forward market price of the underlying is below the strike price in the case of a call, or above it in the case of a put. The more the option is out-of-the-money, the cheaper it is (since the chances of it being exercised get slimmer). Its delta also declines and it becomes less sensitive to movements in the underlying.

OVERLAY

A strategy to change the exposure of a portfolio using derivatives, while leaving the securities in the underlying portfolio unchanged. This has the advantage of cost and flexibility, as portfolio managers can adjust portfolio risk more quickly and cheaply with derivatives than by liquidating portfolio holdings. Another reason might be tactical – the adjustment may only be desired for a brief period of perceived market threat. A third reason might be to transform a portfolio risk; an international fund manager may wish to segregate the currency aspect of a portfolio and can do so with a currency overlay program.

See also asset allocation, portfolio insurance

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

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.

PREMIUM-REDUCTION DEVICE

A strategy which aims to reduce the cost of an option or other derivative. There are many ways to achieve this; three common techniques follow.

  The first is to sell a second derivative; the premium received can then be used to lower the funding requirement for the purchased derivative. This is the technique employed for reducing the cost of a collar.

  The second is to limit participation in moves in the underlying by imposing limitations on the pay-out profile of the instrument (as in a barrier option or a capped floater).

  The final way is to accept payments below market rates, with the possibility of making up the shortfall at the end of the instrument’s life (see yield adjustment).

Psa municipal swap index

PSA stood for the Public Securities Association, a trade organization of dealers and brokers who underwrote municipal bonds. In 1997, PSA was renamed the Bond Market Association to better illustrate the expanded mission of the organization. The PSA Municipal Swap Index was thus renamed the BMA Index. In November 2006, the BMA merged with the Securities Industry Association to form the Securities Industry and Financial Markets Association (SIFMA). The BMA Index was thus renamed the SIFMA swap index, but is still commonly known and referred to as the BMA Index.

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

RANGE NOTE

A range note (also known as a fairway note, an accrual note, or a corridor floater) is a structured note, which pays an above-market interest rate for each day that the underlying spot rate stays within a specified range (sometimes called the accrual corridor). If the underlying trades outside the specified range, the investor receives no interest for that day. The underlying is usually a reference interest rate, such as Libor or a Constant Maturity Treasury, but it could also be a foreign exchange rate, an equity price or the spread between two interest rates. The range is determined at the outset to suit the investor’s risk/return requirements, but might also be reset by the investor or be automatically centered on the prevailing rate at each reset date. This higher yield is achieved by the investor selling an embedded corridor option, particularly in times of high volatility. The holder of the note will therefore benefit in stable market periods when volatility is low. It is also possible for the barriers on a range note to act as knock-out levels by embedding a knock-out corridor option or a range binary. In this case the note is extinguished altogether or becomes a zero coupon note if the reference rate trades through a barrier. This is known as a barrier floater or a knock-out range note.

See also corridor option

REAL OPTION

An alternative method (to cashflow models) for valuing a non-traded asset or liability whose profit and loss sensitivity to some market variable mimics that of an option. For example, consider the right to extract oil from an oilfield. Low oil prices mean that the field can be left untapped at no additional cost. However, higher oil prices may mean that the cost of extraction could be more than covered by selling oil into the bullish market. So the right to extract oil resembles an option on the oil price.

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 CASH-AND-CARRY ARBITRAGE

A technique, used mainly in bond futures and stock index futures, that involves buying a futures contract and selling the underlying. It is used when a futures contract is theoretically cheap, such as when the implied repo rate is less than the market repo rate.

See also cash-and-carry arbitrage

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).

RISK NEUTRAL VALUATION

An argument that underpins most derivatives pricing, including the Black-Scholes+model. The differential equation describing the price of a derivative does not involve parameters that depend on risk preferences. Derivative prices in a market where all investors are risk neutral must therefore be the same as prices in the real world and this corollary considerably simplifies model construction.

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.

SEC

The Securities and Exchange Commission is a US government agency with the primary responsibility of regulating the securities markets and enforcing federal securities laws. Created by the Securities Exchange Act of 1934, the SEC is also comcerned with protecting the investing public against fraudulent and manipulative abuses in the securities market.

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

SHOUT OPTION

An option that allows a purchaser to lock in a minimum return if he thinks the market is at its high (low).

  If, for example, he buys a shout call option at 100 and the market moves up to 110, he can, if he thinks it is the high, “shout” and lock in 10 points. If the market declines, he still receives 10 points. If the market finishes higher than 110, the holder receives the additional gain above 110.

  With a lookback option, the holder is guaranteed to sell at the highest price the market reaches, even if it goes down again. The holder of the shout option is able to sell only at the level shouted, even if the market subsequently rises further before going down.

sifma swap index

Formerly the BMA Swap Index; produced by Municipal Market Data, is the principal benchmark for the floating rate interest payments for tax-exempt Issuers. The SIFMA Index is a national rate based on a composite of approximately 250 Issuers of high-grade, seven-day tax-exempt variable rate demand obligation issues of $10 million or more.

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.

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

SPOT TRADER OPTION

A spot trader option (perfect trader option, passport option) provides the holder with the ability to trade the underlying market with limited downside in return for a fixed premium. The holder of a spot trader option enters into a number of simulated “paper” trades with the writer of the option. The holder may enter into a long, short or flat position in underlying up to a fixed notional amount. The position can be changed a fixed number of times during the lifetime of the option. At maturity, the return from these simulated trades is calculated. If this results in a profit, the holder receives this amount as a pay-out. If a loss results, the holder does not suffer this loss. The maximum loss faced by the holder is the premium paid for the option.

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.

STOCHASTIC VOLATILITY

One of the key assumptions of the Black-Scholes model is that the stock price follows geometric Brownian motion with constant volatility and interest rates. However, in real markets, volatility is far from constant (see trading volatility). If volatility is assumed to be driven by some stochastic process, however, the Black-Scholes model no longer describes a complete market, since there is now another source of uncertainty in the option pricing model. A variety of approaches have been attempted to resolve this difficulty since the mid-1980s, most notably the Heath-Jarrow-Morton framework.

STOCK INDEX ARBITRAGE

The technique of selling a futures contract on a stock index and buying the underlying stocks, via program trading, or vice versa when the price of the futures contract is above or below its theoretical value. The ability to conduct such strategies depends on the efficiency of the futures and cash markets.

STOCK INDEX FUTURE

A futures contract on a stock index. Most are cash-settled. The theoretical price of a stock index future equals the cost of carrying the underlying stock for that period: the opportunity cost of the funds invested minus any dividends. If the cost of buying and holding the underlying stocks is less than the futures price, an arbitrageur can sell futures and buy the underlying stocks.

  The higher interest rates are (compared with the dividend yield), the greater the opportunity cost of holding the stocks, hence the futures price should be higher than the current index price. If interest rates are less than the dividend yield, the opportunity cost of holding stocks is less and the futures price should fall below the current index price. There is usually a so-called arbitrage band in which, although the futures and underlying prices diverge, it is not worthwhile arbitraging the two. This arises as a result of transaction costs from bid-ask spreads, the market impact of buying and selling stock, and execution risks.

STRATEGIC ASSET ALLOCATION

The distribution of investment funds in response to long-term, fundamental expectations for markets.

See also asset allocation

STRESS-TESTING

To perform a stress test on a derivatives position is to stimulate an extreme market event and examine its behavior under the “stress” of that event.

STRUCTURED NOTE

Structured notes are over-the-counter products, which bundle several disparate elements to create a single product, generally by embedding options in a debt instrument such as a medium-term note. They are often view-oriented and are generally tailored to be attractive to investors with highly focused risk/reward appetites and opinions on the market. For example, a structured note might embed equity or currency options or forwards in a debt issue in an effort to enhance the yield of a normal debt holding. Heavily promoted in the early 1990s, structured notes fell out of favor somewhat in 1993–94 as a sequence of surprise market moves and widely publicized losses pointed to the difficulty of pricing and trading such instruments, as well as the cost of taking the incorrect market view. During this time, the comparatively undeveloped secondary market for structured notes allowed sophisticated relative value players to buy “broken” structured notes on an asset swapped basis much more cheaply than vanilla assets from the same issuers.

SWAPTION

An option to enter an interest rate swap. A payer swaption gives the purchaser the right to pay fixed, a receiver swaption gives the purchaser the right to receive fixed (pay floating).

  Apart from those in the sterling market, many swaptions are capital-market driven. Good-quality borrowers are able to issue putable or callable bonds and use the swaptions market to reduce their financing costs. In the case of callable bonds, the issuer effectively buys an option from the investor in return for a slightly higher coupon, so that it may benefit if rates decline. Because many of these embedded options have traditionally been underpriced, good-quality borrowers have been able to monetize this anomaly by selling an equivalent swaption (a receiver swaption) to a bank at market rates.

  The profit from this arbitrage lowers funding costs. If the swaption is exercised against the issuer, it calls the bonds (although the issuer would almost certainly have called the issue given the reduction in rates). In the case of putable bonds, the borrower sells a swaption to the swaption market. The premium gained lowers the funding cost at the expense of leaving the borrower unsure of the maturity of the debt.

SWING OPTION

A derivative found in energy markets allowing the purchaser to vary energy delivery in terms of quantity and timing within specified limits.

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.

SYSTEMIC RISK

The risk that the financial system as a whole may not withstand the effects of a market crisis. Concern on the part of banking regulators has been caused by the concentration of derivative risk among a relatively small number of market participants, with the concomitant risk that the failure of a major dealer could have serious knock-on effects for many other market participants.

TABLE TOP

Similar to a ratio spread, except that the purchase of an option is financed by sales of the same option at two different strike prices.

TACTICAL ASSET ALLOCATION

The distribution of investment funds in response to short-term expectations of market opportunity or threat.

See also asset allocation

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.

TREASURY LOCK

A rate agreement based on the yield or equivalent market price of a reference US Treasury security. These can be settled based on yield differential for a full tenor, or can be price-settled based on the exact characteristics of a specific security.

TRIGGER CONDITION

Path-dependent derivatives such as barrier options and binary options have pay-outs which depend in some way on a market variable satisfying a specific condition during the derivative’s life. If this “trigger condition” is met, the derivative may pay out immediately (early exercise) or at some other specified time (such as expiry). Alternatively, the option may only become effective (be knocked-in) or be de-activated (knocked out) when the trigger condition is met (see barrier options).

  The most common condition is that the spot rate or price of the underlying must breach a specified level, meaning that it must trade through the barrier, either from above or below. Many other trigger conditions are possible, however. Some examples include:
    •     the spot rate must breach the trigger, and remain above/below it for a specified time (see Parisian options);
    •     the spot trades at the trigger level at a specified time (e.g., expiry) or at any time during the option’s life;
    •     the spot trades within or breaks out of a range (for example, range binaries);
    •     there is more than one trigger level, with the pay-out conditional upon or increasing with the number of triggers activated and possibly the order in which they are activated (for example, a mini-premium option);
    •     some combination of these.

TRIGGER FORWARD

The trigger forward is primarily designed for trading purposes, although it can also be used as an alternative hedge. It is usually a zero-cost structure, whereby the purchaser enters into an outright forward transaction at a rate significantly more attractive than the prevailing market rate, but where the whole structure will be knocked out if a predetermined trigger level is reached at any time before the expiry date.

  Other variations on this structure are the at-maturity trigger forward, double trigger forward and the platform trigger forward.
    •     The at-maturity trigger forward is an outright forward structure which is knocked out if a pre-determined trigger level is breached on the expiry date.
    •     The double trigger forward is a standard trigger forward with two trigger levels (one above and one below the current market level).
    •     The platform trigger forward combines a regular trigger forward with the purchase of a vanilla option struck at the trigger level with the trigger forward. This provides extra protection should the trigger level be breached.

See also forward extra

VALUE-AT-RISK

Formally, the probabilistic bound of market losses over a given period of time (known as the holding period) expressed in terms of a specified degree of certainty (the confidence interval).

  Put more simply, the value-at-risk (VAR) is the worst-case loss expected over the holding period within the probability set out by the confidence interval. Larger losses are possible, but with a low probability. For instance, a portfolio whose VAR is $20 million over a one-day holding period, with a 95% confidence interval, would have only a 5% chance of suffering an overnight loss greater than $20 million. Calculation of VAR entails modeling the possible market moves over the holding period, incorporating correlations among market factors, calculating the impact of such potential market moves on portfolio positions, and combining the results to examine risk at different levels of aggregation. The three main approaches to this analysis are historical simulation, the analytical approach using a correlation matrix or empirical (Monte Carlo) simulation. Major trading houses expend considerable energies on their VAR methodologies and have lobbied regulators to recognize their efforts, with some success

See also Basel Capital Accord

VARIABLE NOTIONAL OPTION/SWAP

An option or swap where the notional value is linked to the underlying asset price or rate. Usually changes in the notional will be directly proportional to changes in the underlying price; i.e., they both decrease or increase together. Such derivatives have two main uses. In an equity swap, the fixed-rate receiver can opt to receive the return of either a fixed number of stocks, or the number of stocks that could be purchased for a fixed sum. The former case amounts to a variable notional amount for the swap. An example using an option is the case of a firm which sells more exports as exchange rates decline and its products therefore become cheaper abroad. Since it now has greater foreign currency revenue to hedge, it would purchase a variable notional currency option for this purpose.

VEGA

Measures the change in an option’s price caused by changes in volatility. Vega is at its highest when an option is at-the-money. It decreases the more the market and strike prices diverge. Options closer to expiration have a lower vega than those with more time to run. Positions with positive vega will generally have positive gamma. To be long vega (to have a positive vega) is achieved by purchasing either put or call options. Positions that are long vega benefit from increases in implied volatility but also from actual volatility if the option is being delta hedged. They will also lose from reductions in volatility. Spread options can be an exception: a reduction in the volatility of one of the assets may actually increase the price of the option because the correlation between the two assets decreases. Vega is sometimes known as kappa or tau.

See also gamma

VOLATILITY 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 TERM STRUCTURE

The term structure of volatility is the curve depicting the differing implied volatilities of options with differing maturities. Such a curve arises partly because implied volatility in short options changes much faster than for longer options. However, the volatility term structure also arises because of assumed mean reversion of volatility. The effect of changes in volatility on the option price is less the shorter the option. Most market-makers take advantage of differing volatilities to hedge their books or to trade perceived anomalies in volatility. Such strategies have to be weighted because of the differing vega effects.

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.

WEEKLY RESET FORWARD

A weekly reset forward is a synthetic forward where a portion of the contract is locked in each week, provided that the spot rate that week meets a predetermined fixing criterion. Hence the purchaser can deal at a rate better than the forward outright, but only in an amount corresponding to the frequency with which the criterion has been met. If the criterion is met in none of the weeks during the life of the contract, then the contract is not activated at all; if it is met every week, the overall rate is favorable compared to the initial prevailing market rate. The weekly reset forward is used for those with cash-flows spread over time or to hedge balance sheets.

See also forward extra, wall option

YIELD

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.

YIELD ADJUSTMENT

A payment by one counterparty, usually at the outset of a swap or at a reset date, to compensate the other counterparty for entering into a swap on off-market terms.

YIELD CURVE OPTION

An option that allows investors to take a view on the shape of a yield curve without taking a view on a bond market’s direction. It is normally structured as the yield of a longer maturity bond minus the yield of a shorter one. A call would therefore appreciate in value as a curve flattened. A put would decrease in value. Such options were developed in the US in 1991 in response to a steepening yield curve.

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.