Partial Matches:
ACCRETING
A description, applicable to a variety of instruments, denoting that the notional principal increases successively over the life of the instrument, e.g., caps, collars, swaps and swaptions. If the increase takes place in increments, the instrument may be known as a step-up.
See also
amortizing
CONSTANT MATURITY TREASURY DERIVATIVE
Over-the-counter swaps and options which use longer-term, Treasury-based instruments for their floating rate reference than money market indexes, such as Libor. “Constant Maturity Treasury” (CMT) refers to the par yield that would be paid by a treasury bill, note or bond which matures in exactly one, two, three, five, seven, 10, 20 or 30 years. Since there may not be treasury issues in the market with exactly these maturities, the yield is interpolated from the yields on treasuries that are available. In the US, such rates have been calculated and published by the Federal Reserve Bank of New York and the US Treasury department on a daily basis every day for more than 30 years. The H.15 Report from the Federal Reserve Bank is often used as a source for CMT rates.
It is then possible for this interpolated yield to form the index rate for instruments such as floating rate notes, which pay interest linked to the CMT yield, options, which pay the difference between a strike price and the CMT yield, and swaps and swaptions, in which one of the cashflows exchanged is the CMT yield. Where necessary, the reference rate is reset at each settlement date. Typical uses of CMT derivatives as hedging tools include the purchase of CMT floors by mortgage servicing companies to protect the value of purchased mortgage servicing portfolios, and the purchase of CMT caps to protect investors with negatively convex mortgage-backed securities portfolios. It is possible to enter into derivatives in other currencies that are based, by analogy, on a “constant maturity interest rate swap” interpolated from the swap curve in the relevant currency. Such derivatives are known as constant maturity swap (CMS) derivatives. Unlike CMT derivatives, CMS derivatives incorporate the spread component of swaps.
CONTINGENT SWAP
The generic term for a swap activated when rates reach a certain level or a specific event occurs. Swaptions are often considered to be contingent swaps. Other types of swaps, for example, drop-lock swaps, are activated only if rates drop to a certain level or if a specified level over a benchmark is achieved.
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.
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.
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.