Step Up Bond
Definition: A bond with a coupon that increases over time on schedule – unless the issuers call it. Ordinarily, the coupon begins slightly above the going rate for short-term bonds and the bond is callable at par on each coupon reset date.
Example: FHLBB issued in December 1997 a bond that matures in 1/03. Its first coupon is 6%, and the coupon increases to 6 3/8 % in 1/99, 6.5% in 1/00, 7% in 1/01, then 8% in 1/02 through maturity.
Application: At the start of each coupon accrual period, the investor bets that the next oversize coupon compensates for the possibility that the issuer may call the bond.
Pricing: At the last reset date, the issuer has an option to call the bond. At each previous reset date, the issuer can either call the bond or pay a forward premium (the excess of the next coupon(s) over the going market coupon) for the current installment of a compound option. Thus, the Step Up Bond has a sort of embedded Chooser Option (q.v.).
Risk Management: The Step Up Bond embodies two kinds of market risk (interest rate risk and exposure to the volatility of the rates), and may embody credit risk.
Thursday, August 7, 2008
Put Options
Putable Bond
Definition: A Bullet Bond (q.v.) that the bondholder can force the issuer to buy back at a scheduled price. The Put Price as a function of calendar time is the Put Schedule. A Bullet Bond plus a Put Option (q.v.) on the Bond. AKA Retractable Bond.
Definition: A Bullet Bond (q.v.) that the bondholder can force the issuer to buy back at a scheduled price. The Put Price as a function of calendar time is the Put Schedule. A Bullet Bond plus a Put Option (q.v.) on the Bond. AKA Retractable Bond.
Example: A corporation might issue a ten-year Note (q.v.) with a five-year Put Option.
Application: A Putable Bond is a bet on the cost of refinancing at the Put Date. The issuer is betting that the Put Option will expire worthless – i.e., that interest rates will be low at the Put Date. The bondholder is betting that interest rates will rise, the bond price will fall, he will be able to sell the bond back to the issuer at a profit, and he will be able to reinvest the proceeds of that sale in a bond with a higher coupon.
Application: A Putable Bond is a bet on the cost of refinancing at the Put Date. The issuer is betting that the Put Option will expire worthless – i.e., that interest rates will be low at the Put Date. The bondholder is betting that interest rates will rise, the bond price will fall, he will be able to sell the bond back to the issuer at a profit, and he will be able to reinvest the proceeds of that sale in a bond with a higher coupon.
Pricing: You can price it as a bond, plus a put option on the bond. For it to sell near par requires a low coupon.
Risk Management: For example, suppose that a corporation issues a ten-year bond with an embedded five-year European Put Option. It is exposed to the danger of rising interest rates, in which case the bondholder will put the bond back to the issuer. However, if the issuer also buys a Payer Swaption, struck at the same coupon as the bond, then it will be able to issue floating rate debt to repay the principal on the bond and exercise the Swaption to continue paying the same fixed rate. The floating rate receipts from the Swaption will roughly cover the new floating rate debt interest.
Inflation-Linked Bonds
Inflation-Linked Bonds
Inflation-Linked Bonds have coupons that depend on the rate of inflation or a related index. They have two main structures.
1. Capital Indexed Bonds. The principal accretes according to the CPI or another price index or deflator. The bond's coupon is a fixed percent of the accreted principal.
2. Floating Rate Bonds. The principal is fixed, but its coupon floats. The floating rate depends on inflation or something related, such as the rate of change in the CPI or on the Treasury Inflation Protected Security (TIPS) variable coupon rate.
A flurry of issues have hit the market in 1997. Issuers include Federal Home Loan Banks, JP Morgan & Co. Inc., Sallie Mae, Salomon Brothers, Toyota Motor Credit Corporation, the U.S. Treasury.
The two main unresolved issues of Inflation-Linked Bonds are how large and variable (1) the coupon and (2) the market price should be.The real yields on Inflation-Linked Treasury Bondsbegan large enough to surprise many observers, and has fallen little in a few months. Some observers believe that these high real rates are sustainable and have historical precedent. Others believe that they are the result of investor uncertainty about the market and will fall over time. (Jonathan Clements, "Second Thoughts: Inflation-Tied Bonds Offer an Intriguing Option for Investors," Wall Street Journal, 3/11/97.)
Advocates for the U.S. market envisioned a bond with a variable coupon and a stable price. However, the experience with Australian Capital Indexed Bonds is that the price varies significantly
Inflation-Linked Bonds have coupons that depend on the rate of inflation or a related index. They have two main structures.
1. Capital Indexed Bonds. The principal accretes according to the CPI or another price index or deflator. The bond's coupon is a fixed percent of the accreted principal.
2. Floating Rate Bonds. The principal is fixed, but its coupon floats. The floating rate depends on inflation or something related, such as the rate of change in the CPI or on the Treasury Inflation Protected Security (TIPS) variable coupon rate.
A flurry of issues have hit the market in 1997. Issuers include Federal Home Loan Banks, JP Morgan & Co. Inc., Sallie Mae, Salomon Brothers, Toyota Motor Credit Corporation, the U.S. Treasury.
The two main unresolved issues of Inflation-Linked Bonds are how large and variable (1) the coupon and (2) the market price should be.The real yields on Inflation-Linked Treasury Bondsbegan large enough to surprise many observers, and has fallen little in a few months. Some observers believe that these high real rates are sustainable and have historical precedent. Others believe that they are the result of investor uncertainty about the market and will fall over time. (Jonathan Clements, "Second Thoughts: Inflation-Tied Bonds Offer an Intriguing Option for Investors," Wall Street Journal, 3/11/97.)
Advocates for the U.S. market envisioned a bond with a variable coupon and a stable price. However, the experience with Australian Capital Indexed Bonds is that the price varies significantly
Forwards
Forward Contract
A contract to exchange (buy or sell) an underlying instrument for a fixed forward price at a specific, future delivery date. In certain cases – but not always – the Forward Price exceeds the spot price by the cost of carrying the underlying asset from the spot delivery date to the forward delivery date. The cost of carry is an increasing function of the rate of interest and storage costs, and a decreasing function of the rate of dividends, interest, or other cash flows from the underlying instrument. Cf. Futures Contract.
Forward Forward Curve
The Forward Curve at a specific future date, based on today's Forward Curve.
Forward Rate Agreement
A contract calling for one counterparty to receive the fixed FRA rate and pay the floating rate (e.g., LIBOR) for a particular accrual period in the future, and for the other counterparty to do the reverse. Settlement is at the beginning of the accrual period, when the markets resolve the uncertainty about the floating rate, mainly because that reduces the credit risk associated with the contract. Cf. Swaplet.
A contract to exchange (buy or sell) an underlying instrument for a fixed forward price at a specific, future delivery date. In certain cases – but not always – the Forward Price exceeds the spot price by the cost of carrying the underlying asset from the spot delivery date to the forward delivery date. The cost of carry is an increasing function of the rate of interest and storage costs, and a decreasing function of the rate of dividends, interest, or other cash flows from the underlying instrument. Cf. Futures Contract.
Forward Forward Curve
The Forward Curve at a specific future date, based on today's Forward Curve.
Forward Rate Agreement
A contract calling for one counterparty to receive the fixed FRA rate and pay the floating rate (e.g., LIBOR) for a particular accrual period in the future, and for the other counterparty to do the reverse. Settlement is at the beginning of the accrual period, when the markets resolve the uncertainty about the floating rate, mainly because that reduces the credit risk associated with the contract. Cf. Swaplet.
Derivatives
Derivative
1. Not original, secondary, originating in or transformed from something else.
2. fin. A short form of "derivative product" (q.v.).
3. chem. A substance or compound obtained from or derived from another substance or compound.
4. math. The instantaneous rate of change of a function with respect to a change in an argument: df(x)/dx. For example, acceleration is the first derivative of velocity with respect to time. In a financial context, we call some such derivatives, with respect to time or market risk factors, "sensitivitites" or Greeks. For example, the Greek, delta, is the first derivative of option value with respect to underlying price.
Derivative product
A financial contract whose value depends on a risk factor, such as
· the price of a bond, commodity, currency, share, etc.
· a yield or rate of interest
· an index of prices or yields
· weather data, such as inches of rainful or heating-degree-days,
· insurance data, such as claims paid for a disastrous earthquake or flood,
etc. Also known as "derivative", for short.
Derivative Products Company (DPC)
A subsidiary that exists solely as a secure home for some of its parent’s financial transactions, contracts, and derivative products (q.v.). The DPC’s credit rating typically exceeds the parent’s, because the parent infuses it with a large amount of capital, compared to the credit exposure that that DPC counterparties have to it. In case the parent is insolvent or bankrupt, the DPC might either continue (continuation structure, q.v.) or terminate (termination structure, q.v.).
1. Not original, secondary, originating in or transformed from something else.
2. fin. A short form of "derivative product" (q.v.).
3. chem. A substance or compound obtained from or derived from another substance or compound.
4. math. The instantaneous rate of change of a function with respect to a change in an argument: df(x)/dx. For example, acceleration is the first derivative of velocity with respect to time. In a financial context, we call some such derivatives, with respect to time or market risk factors, "sensitivitites" or Greeks. For example, the Greek, delta, is the first derivative of option value with respect to underlying price.
Derivative product
A financial contract whose value depends on a risk factor, such as
· the price of a bond, commodity, currency, share, etc.
· a yield or rate of interest
· an index of prices or yields
· weather data, such as inches of rainful or heating-degree-days,
· insurance data, such as claims paid for a disastrous earthquake or flood,
etc. Also known as "derivative", for short.
Derivative Products Company (DPC)
A subsidiary that exists solely as a secure home for some of its parent’s financial transactions, contracts, and derivative products (q.v.). The DPC’s credit rating typically exceeds the parent’s, because the parent infuses it with a large amount of capital, compared to the credit exposure that that DPC counterparties have to it. In case the parent is insolvent or bankrupt, the DPC might either continue (continuation structure, q.v.) or terminate (termination structure, q.v.).
CUSIP
CUSIP
The acronym for the Committee on Uniform Securities Identification Procedures. "The CUSIP Service Bureau seeks to assign unique numbers and standardized descriptions [to securities] in a timely and accurate manner, using its best efforts to use primary or reliable sources of information."
Proposed by: Matthew Foss.
Source: http://www.cusip.com/cusip/cusip/index.html.
CUSIP number
A unique identifier for securities, consisting of nine alphanumeric characters. The first six uniquely identify the issuer. The next two (alphabetic or numeric) identify the issue. Two numeric digits indicate an equity issue. Two alphabetical characters or a mix of alphabetical and numerical indicate a debt issue. The ninth digit is the check digit.
Standard & Poor's owns and operates the CUSIP Service Bureau, which maintains the CUSIP system.
Proposed by: Matthew Foss
Source: http://www.cusip.com/cusip/cusip/index.html.
The acronym for the Committee on Uniform Securities Identification Procedures. "The CUSIP Service Bureau seeks to assign unique numbers and standardized descriptions [to securities] in a timely and accurate manner, using its best efforts to use primary or reliable sources of information."
Proposed by: Matthew Foss.
Source: http://www.cusip.com/cusip/cusip/index.html.
CUSIP number
A unique identifier for securities, consisting of nine alphanumeric characters. The first six uniquely identify the issuer. The next two (alphabetic or numeric) identify the issue. Two numeric digits indicate an equity issue. Two alphabetical characters or a mix of alphabetical and numerical indicate a debt issue. The ninth digit is the check digit.
Standard & Poor's owns and operates the CUSIP Service Bureau, which maintains the CUSIP system.
Proposed by: Matthew Foss
Source: http://www.cusip.com/cusip/cusip/index.html.
Credit Option
Definition: An Option with a payoff that depends on credit quality, without bearing ordinary interest-rate risk.
Example: The Option to Exchange private debt for U.S. Treasury debt.
Natural Buyers and Sellers: See Credit Derivatives.
Pricing: Pricing an Option to Exchange () private and Treasury debt would involve a hybrid option model, having characteristics of equity and debt option pricing.
Hedging: One could try to dynamically hedge the delta risks.
Comment: Pricing and hedging might be difficult, and market manipulation may be an issue for a thinly traded underlying instrument.
Example: The Option to Exchange private debt for U.S. Treasury debt.
Natural Buyers and Sellers: See Credit Derivatives.
Pricing: Pricing an Option to Exchange () private and Treasury debt would involve a hybrid option model, having characteristics of equity and debt option pricing.
Hedging: One could try to dynamically hedge the delta risks.
Comment: Pricing and hedging might be difficult, and market manipulation may be an issue for a thinly traded underlying instrument.
Credit Derivatives
Derivative Products with payoffs that depend on risk factors related to credit quality, such as yield spread over Treasuries, price discount from par, or a "credit event." A credit event might be a drop in credit rating or some sort of failure, such as occurrence of default, insolvency or bankruptcy.
One goal of Credit Derivatives is to split credit risk from market risk. The key concept here is that credit risk is an undesirable element, akin to pollution. When you allow a market for pollution, people who don't want it sell it at at market price to the parties who mind it the least or handle it the best.
Credit Derivatives already come in a variety of flavors, and infinitely many types are possible. However, nearly all current structures are variations on Call or Put Options (q.v.) on Credit Spreads (q.v.), Binary Options (q.v.), or Knockout Options (q.v.). In the last two cases the trigger is a "credit event". Typically, the payoff depends on the state of the world some time – as much as months – after the event. Here are some examples of Credit Derivatives:
Notes that Bankers Trust and CSFP issued in 1993, which promised large coupons if the reference asset didn't suffer a "credit event" – namely, default or sufficient deterioration in its credit rating – and small coupons if it did. The spread of the large coupon over ordinary debt depended on the reference asset's credit quality, and was sometimes 80 - 100 b.p. (over LIBOR). This is a sort of Binary Option that is a function of the credit event.
A Binary Option that Bankers Trust offered, with a payoff that depended on the credit performance of a basket of bonds. If any of the bonds defaulted, then a counterparty paid Bankers Trust a fee.
A Call or Put Option on a credit spread over Treasuries.
A One-Touch (q.v.) Knockin Put (q.v.) Option on the value of a corporate bond.
A One-Touch (q.v.) Knockin Put Option (q.v.) on the lowest value of n corporate bonds in a portfolio.
One goal of Credit Derivatives is to split credit risk from market risk. The key concept here is that credit risk is an undesirable element, akin to pollution. When you allow a market for pollution, people who don't want it sell it at at market price to the parties who mind it the least or handle it the best.
Credit Derivatives already come in a variety of flavors, and infinitely many types are possible. However, nearly all current structures are variations on Call or Put Options (q.v.) on Credit Spreads (q.v.), Binary Options (q.v.), or Knockout Options (q.v.). In the last two cases the trigger is a "credit event". Typically, the payoff depends on the state of the world some time – as much as months – after the event. Here are some examples of Credit Derivatives:
Notes that Bankers Trust and CSFP issued in 1993, which promised large coupons if the reference asset didn't suffer a "credit event" – namely, default or sufficient deterioration in its credit rating – and small coupons if it did. The spread of the large coupon over ordinary debt depended on the reference asset's credit quality, and was sometimes 80 - 100 b.p. (over LIBOR). This is a sort of Binary Option that is a function of the credit event.
A Binary Option that Bankers Trust offered, with a payoff that depended on the credit performance of a basket of bonds. If any of the bonds defaulted, then a counterparty paid Bankers Trust a fee.
A Call or Put Option on a credit spread over Treasuries.
A One-Touch (q.v.) Knockin Put (q.v.) Option on the value of a corporate bond.
A One-Touch (q.v.) Knockin Put Option (q.v.) on the lowest value of n corporate bonds in a portfolio.
-C-
Callable Bond
Definition: A (noncallable) Bullet Bond (q.v.), minus (i.e., short) a Call Option (q.v.) on the bond. The Call Price as a function of calendar time is the Call Schedule.
Example: The U.S. Treasury issued a long sequence of Callable Bonds, callable five years before maturity.
Application: A Callable Bond is a way to make a bet about refinancing costs at the Call Date. The issuer is betting that interest rates will drop, the bond price will rise, he will call the bond, and he will refinance at a lower rate. The bondholder takes the other side of that bet.
Pricing: The Callable Bond is equivalent to a portfolio, so its value should equal the value of the portfolio, namely, the value of the Bullet Bond minus the value of the Call Option.
Risk Management: An issuer could offset the short position in the Bond Option (q.v.) by buying a corresponding Receiver Swaption on a Swap with the same coupon as the Bond.
Comment: For a given coupon rate the Callable Bond will be worth less than the noncallable bond. Hence, for a given price (such as par) the Callable Bond will have a higher coupon rate.
Call Option
The right, but not the obligation to buy the underlying asset at the previously agreed-upon price on (European) or anytime through (American) the expiration date.
Catastrophe Bond
Definition: A Bond that promises a coupon (and principal, in some cases) that starts out high, but drops after a suitable catastrophe occurs. A suitable catastrophe might be an earthquake or hurricane of sufficient magnitude and within a particular region.
Catastrophe Bonds may be ABS's (q.v.). The underlying assets may include a pool of Treasury securities. The underlying income stream might be reinsurance premiums. The ABS issue may have two or more classes of securities.
Example: A recently proposed (as of 5/30/97) USAA, Inc. Catastrophe issue has a principal protected class (secured by Treasury Zero Strips) and a principal variable class that would become worthless after a hurricane did $1.5 billion of damage anywhere from Maine to Texas.
Application: The natural issuer of a Catastrophe Bond is an insurance company or a government agency such as the California Earthquake Authority – any organization exposed to claims resulting from the underlying catastrophe. The Catastrophe Bond is in theory and perhaps even in practice a highly efficient way of paying outside investors (i.e., outside the insurance industry, including the reinsurance market) to share the risk of the catastrophe with the vast general capital market. It is a simple extension of the time-honored concept of securitization.
Pricing: Equilibrium of supply and demand.
Risk Management: Traditional hedging is impossible. Diversification is possible.
Comments:
The holder of a Catastrophe Bond is short a Bet, Binary, or Digital Option (all of which q.v.). The Catastrophe Bond is an ideal instrument for an unscrupulous security salesman to present to unsuitably naive retail or even institutional customers, who lack any concept of that game's odds, or perhaps even its basic rules. Thus, it has excellent potential as a successor to the sometimes abusive or fraudulent sales of poorly understood Florida real estate, securitized receivables, mortgage-backed securities and derivatives, limited partnership interests in real estate and oil exploration, etc.
I predict confidently three things:
(1) Competent underwriters of Catastrophe Bonds will not play Russian roulette by holding large positions in them in their investment portfolios for long periods. They will distribute the bonds as soon as possible.
(2) Accordingly, almost all of these Catastrophe Bonds will end up in the portfolios of institutional investors, high-rolling individual investors, and retail customers – many of whom will have no idea what they're getting into.
(3) In at least one exceptional case, some manager of a Catastrophe Bond (or Derivatives) desk will convince his naive boss that "the market has badly underestimated the real value of certain Catastrophe Bonds (Derivatives), and we should take them into inventory, temporarily." At that point the chips are down and the outcome – "heroism" or disaster – is up to fate.
Comment: Scholars are praising cat bonds and other derivatives for attracting low-cost capital into the industry. (Robert Hunter, "Cat Fever," Derivatives Strategy, February 1998, p. 6.) However, it's not clear that society is better off if the newcomers are paying to much for claims based on catastrophic claims.
Catastrophe Futures
The ill-fated futures contract that the CBOT introduced in 1993. The underlying risk factor was the Property Claims Service (PCS) index, which was too broad an index for most natural hedgers to use. (Source: Robert Clow, "Coping with catastrophe," Institutional Investor, December 1996, pp. 138.)
Catastrophe Options
The CBOT's option contracts on several regional indexes of losses. The option on the Eastern Catastrophic contract boomed as Hurricane Fran smashed the Carolinas in the fall of 1996. (Source: Robert Clow, "Coping with catastrophe," Institutional Investor, December 1996, pp. 138.)
Catastrophe options come in two main varieties: (1) Property Claims Services (PCS) options pay out (European style) based on an index of all claims against property insurance companies. (2)Single-Cat options pay out (American or one-touch style) based on a single, large atmospheric or seismic disaster in a single region (northeast, southeast, east, midwest, or west) or in California, Texas, or Florida. ("A New Take on Cat Options," Derivatives Strategy, February 1998, pp. 5-6.)
Catastrophe Swaps
Contracts similar to standard reinsurance contracts and traded on New York's Catastrophe Exchange. (Source: Robert Clow, "Coping with catastrophe," Institutional Investor, December 1996, pp. 138.)
Definition: A (noncallable) Bullet Bond (q.v.), minus (i.e., short) a Call Option (q.v.) on the bond. The Call Price as a function of calendar time is the Call Schedule.
Example: The U.S. Treasury issued a long sequence of Callable Bonds, callable five years before maturity.
Application: A Callable Bond is a way to make a bet about refinancing costs at the Call Date. The issuer is betting that interest rates will drop, the bond price will rise, he will call the bond, and he will refinance at a lower rate. The bondholder takes the other side of that bet.
Pricing: The Callable Bond is equivalent to a portfolio, so its value should equal the value of the portfolio, namely, the value of the Bullet Bond minus the value of the Call Option.
Risk Management: An issuer could offset the short position in the Bond Option (q.v.) by buying a corresponding Receiver Swaption on a Swap with the same coupon as the Bond.
Comment: For a given coupon rate the Callable Bond will be worth less than the noncallable bond. Hence, for a given price (such as par) the Callable Bond will have a higher coupon rate.
Call Option
The right, but not the obligation to buy the underlying asset at the previously agreed-upon price on (European) or anytime through (American) the expiration date.
Catastrophe Bond
Definition: A Bond that promises a coupon (and principal, in some cases) that starts out high, but drops after a suitable catastrophe occurs. A suitable catastrophe might be an earthquake or hurricane of sufficient magnitude and within a particular region.
Catastrophe Bonds may be ABS's (q.v.). The underlying assets may include a pool of Treasury securities. The underlying income stream might be reinsurance premiums. The ABS issue may have two or more classes of securities.
Example: A recently proposed (as of 5/30/97) USAA, Inc. Catastrophe issue has a principal protected class (secured by Treasury Zero Strips) and a principal variable class that would become worthless after a hurricane did $1.5 billion of damage anywhere from Maine to Texas.
Application: The natural issuer of a Catastrophe Bond is an insurance company or a government agency such as the California Earthquake Authority – any organization exposed to claims resulting from the underlying catastrophe. The Catastrophe Bond is in theory and perhaps even in practice a highly efficient way of paying outside investors (i.e., outside the insurance industry, including the reinsurance market) to share the risk of the catastrophe with the vast general capital market. It is a simple extension of the time-honored concept of securitization.
Pricing: Equilibrium of supply and demand.
Risk Management: Traditional hedging is impossible. Diversification is possible.
Comments:
The holder of a Catastrophe Bond is short a Bet, Binary, or Digital Option (all of which q.v.). The Catastrophe Bond is an ideal instrument for an unscrupulous security salesman to present to unsuitably naive retail or even institutional customers, who lack any concept of that game's odds, or perhaps even its basic rules. Thus, it has excellent potential as a successor to the sometimes abusive or fraudulent sales of poorly understood Florida real estate, securitized receivables, mortgage-backed securities and derivatives, limited partnership interests in real estate and oil exploration, etc.
I predict confidently three things:
(1) Competent underwriters of Catastrophe Bonds will not play Russian roulette by holding large positions in them in their investment portfolios for long periods. They will distribute the bonds as soon as possible.
(2) Accordingly, almost all of these Catastrophe Bonds will end up in the portfolios of institutional investors, high-rolling individual investors, and retail customers – many of whom will have no idea what they're getting into.
(3) In at least one exceptional case, some manager of a Catastrophe Bond (or Derivatives) desk will convince his naive boss that "the market has badly underestimated the real value of certain Catastrophe Bonds (Derivatives), and we should take them into inventory, temporarily." At that point the chips are down and the outcome – "heroism" or disaster – is up to fate.
Comment: Scholars are praising cat bonds and other derivatives for attracting low-cost capital into the industry. (Robert Hunter, "Cat Fever," Derivatives Strategy, February 1998, p. 6.) However, it's not clear that society is better off if the newcomers are paying to much for claims based on catastrophic claims.
Catastrophe Futures
The ill-fated futures contract that the CBOT introduced in 1993. The underlying risk factor was the Property Claims Service (PCS) index, which was too broad an index for most natural hedgers to use. (Source: Robert Clow, "Coping with catastrophe," Institutional Investor, December 1996, pp. 138.)
Catastrophe Options
The CBOT's option contracts on several regional indexes of losses. The option on the Eastern Catastrophic contract boomed as Hurricane Fran smashed the Carolinas in the fall of 1996. (Source: Robert Clow, "Coping with catastrophe," Institutional Investor, December 1996, pp. 138.)
Catastrophe options come in two main varieties: (1) Property Claims Services (PCS) options pay out (European style) based on an index of all claims against property insurance companies. (2)Single-Cat options pay out (American or one-touch style) based on a single, large atmospheric or seismic disaster in a single region (northeast, southeast, east, midwest, or west) or in California, Texas, or Florida. ("A New Take on Cat Options," Derivatives Strategy, February 1998, pp. 5-6.)
Catastrophe Swaps
Contracts similar to standard reinsurance contracts and traded on New York's Catastrophe Exchange. (Source: Robert Clow, "Coping with catastrophe," Institutional Investor, December 1996, pp. 138.)
-B-
- B -
back months
Futures contracts with delivery dates in the more distant future.
bankruptcy futures
The futures contract based on the CME Quarterly Bankruptcy Index. The CME computes the index daily, based on personal and business bankruptcy filings, with personal bankruptcies getting 96% of the weight. (Aaron Luchetti, "Commodity Traders May Go for Broke With Novel Contract," WSJ, 4/3/98.)
basis point
One percent of one percent of a principal amount or Notional Value (q.v.). Also, known as "bp" – pronounced "bip". For example, the on-the-run Ten-year Treasury might have a coupon of 6.5%, and the 10-year Swap Spread over that might be 22 basis points.
basis risk
The name attached to the random gains or losses a hedger realizes, when he hedges with something that has an imperfect correlation with his underlying position.
benchmark notes
Agency notes aimed at filling the partial vacuum in the Treasury note market, now that the deficit appears somewhat under control. Fannie Mae began issuing benchmark notes, and Freddie Mac and other agencies have followed. Apparently, the U.S. Treasury is considering halting its auction of two-, three-,or five-year notes. (Guy Dixon and Ross A. Snel, "Bonds Stay Put as Traders Wait for Jobs Report; Fannie Mae to Offer Additional Benchmark Notes," WSJ, 5/5/98.)
Best-of-Two Option
A payoff which equals the maximum of two option payoffs, such as the maximum of a call on asset 1 and a put on asset two. Cf. Worst-of-Two Option.
Bet Option
A Binary Option. (q.v.)
big dogs
Traders who do large volume. As in "You can't pee like a puppy if you want to run with the big dogs."
Binary Call (Put) Option
Typically, a Binary Call (Put) Option (q.v.) that pays off nothing if the underlying risk factor is below (above) the strike, and a constant amount if the risk factor exceeds (is below) the strike.
BOBL
German Federal Debt Obligations (BundesOBLigationen). (Source: http://www.exchange.de/dtb/BOBL-future.html)
BOBL Futures
The DTB Futures contract on a notional medium term (3.5 - 5 years) debt security of the German Federal Government or the Treuhandanstalt, with a notional interest rate of 6%. The BOBL (q.v.) and other instruments qualify. (Source: http://www.exchange.de/dtb/BOBL-future.html)
BOBL Futures Option
An American option that settles into a BOBL Futures (q.v.) contract. Payment of the option premium is "futures-style", which means none of it occurs immediately, and a piece of it occurs with each daily mark-to-market. An implication of this is that the "buyer" (really, the "long") may pay no premium and the "seller" (really, the "short") may pay all the premium! (Source: http://www.exchange.de/dtb/BOBL-future-option.html)
Boolean trades
Definition: Trades based on orders that contain Boolean logic, including the concepts of “if”, “if and only if”, “or”, and “and”.
Example: “I want to sell Microsoft at 75 if and only if I can buy IBM at 110 and buy Intel at 120.”
Source: Hal R. Varian, “Boolean Trades and Hurricane Bonds,” Wall Street Journal, 5/8/00.
Bowie Bond
A specific, $55 million issue of 10-year Asset-Backed Bonds (q.v.) that British rock star David Bowie issued and Prudential Insurance Co. bought. The specific collateral consists of royalties from 25 of Mr. Bowie's albums that he recorded before 1990.
Source: Bloomberg News, 2/20/97
B-Piece
Definition: A security from the riskier tranche of a two-tranche ABS (q.v.) deal. It receives the residual income from the underlying collateral and takes second place in line for the collateral in case of default. In terms of income and collateral, B-pieces are to the ABS’s assets as common shares are to a corporation’s assets. (The analogy breaks down when it comes to taxation and control.)
Example: A bank with large credit card operations issues ABS’s backed by credit card receivables. The A-piece has a AAA rating and little credit risk. If the economy heads south, then the B-piece may not pay off in full.
Application: Dividing an ABS issue into senior and junior pieces permits the issuer to tap two types of investor. The more (less) risk averse investor that wants to avoid (place) a bet on the performance of the underlying assets can buy the A-Piece (B-Piece).
Pricing and Risk Management: This is difficult. The whole point of having a B-piece is to have a place to put the return that is more difficult to price and the risk that is more difficult to manage. Then, people who are more talented at pricing derivatives and managing their risk will buy these pieces. Pricing the A-Pieces is nearly as easy as pricing Treasuries, and their risk is mainly market risk.
Source: Cecile Gutscher, "SEC Is Examining Whether Some Underwriters Are Marketing Bonds at Artificially Low Yields", Wall Street Journal, 5/2/97).
Bullet Bond
Definition: A Bond that Amortizes (q.v.) fully on a single date. Its cash flows consist of regular coupon payments of interest and a final repayment of principal.
Example: An ordinary, 30-year, noncallable Treasury bond with a semiannual coupon.
Application: A Bullet Bond is a commonplace way of raising capital.
Pricing: A Bullet Bond is a portfolio of Zero Coupon Bonds (q.v.), so its value is the value of the portfolio.
Risk Management: A common way to measure a fixed income portfolio’s risk is by its Duration (q.v.) or DV01 (q.v.), and its Convexity (q.v.). Consequently, one might combine a Bullet Bond with other fixed income instruments in a portfolio, in an effort to control the portfolio’s Duration and Convexity.
Comment: When a layman thinks of a bond, this is the bond.
BUND German Federal Government Bonds (BUNDesanleihen) .
BUND Futures
The DTB Futures contract on a notional long term (8.5 - 10 years) debt security of the German Federal Government or the Treuhandanstalt, with a notional interest rate of 6%. The BUND (q.v.) and other instruments qualify. (Source: http://www.exchange.de/dtb/BUND-future.html)
BUND Futures Option
An American option that settles into a BUND Futures (q.v.) contract. Payment of the option premium is "futures-style", which means none of it occurs immediately, and a piece of it occurs with each daily mark-to-market. An implication of this is that the "buyer" (really, the "long") may pay no premium and the "seller" (really, the "short") may pay all the premium! (Source: http://www.exchange.de/dtb/BUND-future-option.html)
Bundle
A Strip (q.v.,#2) of consecutive, quarterly Eurodollar or Euroyen futures contracts. Markets, such as Simex offer a Bundle as a convenient package of futures contracts, without the execution risk inherent in building up the Strip, contract by contract. A trader can use Bundles and Packs (q.v.) to implement bets on the change in shape of the Forward Curve.
Buy-Write
An investment strategy that consists of buying an asset and selling a call on it. Thus, the investor sells upside potential to elevate the rest of his payoff function.
back months
Futures contracts with delivery dates in the more distant future.
bankruptcy futures
The futures contract based on the CME Quarterly Bankruptcy Index. The CME computes the index daily, based on personal and business bankruptcy filings, with personal bankruptcies getting 96% of the weight. (Aaron Luchetti, "Commodity Traders May Go for Broke With Novel Contract," WSJ, 4/3/98.)
basis point
One percent of one percent of a principal amount or Notional Value (q.v.). Also, known as "bp" – pronounced "bip". For example, the on-the-run Ten-year Treasury might have a coupon of 6.5%, and the 10-year Swap Spread over that might be 22 basis points.
basis risk
The name attached to the random gains or losses a hedger realizes, when he hedges with something that has an imperfect correlation with his underlying position.
benchmark notes
Agency notes aimed at filling the partial vacuum in the Treasury note market, now that the deficit appears somewhat under control. Fannie Mae began issuing benchmark notes, and Freddie Mac and other agencies have followed. Apparently, the U.S. Treasury is considering halting its auction of two-, three-,or five-year notes. (Guy Dixon and Ross A. Snel, "Bonds Stay Put as Traders Wait for Jobs Report; Fannie Mae to Offer Additional Benchmark Notes," WSJ, 5/5/98.)
Best-of-Two Option
A payoff which equals the maximum of two option payoffs, such as the maximum of a call on asset 1 and a put on asset two. Cf. Worst-of-Two Option.
Bet Option
A Binary Option. (q.v.)
bid
The price at which a dealer (market maker) stands ready to buy. Ordinarily the bid is less than the ask (q.v.), and the bid-ask spread is what the dealer stands to make by quickly turning around one unit of product.
The price at which a dealer (market maker) stands ready to buy. Ordinarily the bid is less than the ask (q.v.), and the bid-ask spread is what the dealer stands to make by quickly turning around one unit of product.
big dogs
Traders who do large volume. As in "You can't pee like a puppy if you want to run with the big dogs."
Binary Call (Put) Option
Typically, a Binary Call (Put) Option (q.v.) that pays off nothing if the underlying risk factor is below (above) the strike, and a constant amount if the risk factor exceeds (is below) the strike.
Binary Option
An option with a payoff function that has two levels, such as zero dollars or one million dollars.
blank check company
A public, shell company with few or no assets, income, products, services, activities, business plan, management team, employees, or anything else that an ongoing business ordinarily has -- except for registration with the SEC. A private company can use a blank check company to go public via a "reverse merger" without doing an expensive IPO. An unscrupulous stock promoter can also use a blank check company to defraud sleepy investors. (Schellhardt, Timothy D. "As 'Blank-Check' Firms Regain Allure, Businessman Lines Up Numerous Suitors." WSJ, 10/29/99.)
BISTRO
Definition: An acronym for either of the following, depending on who's talking and who might be listening.
1. Broad Index Secured Trust Offering. J.P.Morgan's preferred vehicle for transferring a significant amount of diverse credit risk to an SPV.
2. BIS Total Rip Off. An alternative definition of unknown meaning.
An option with a payoff function that has two levels, such as zero dollars or one million dollars.
blank check company
A public, shell company with few or no assets, income, products, services, activities, business plan, management team, employees, or anything else that an ongoing business ordinarily has -- except for registration with the SEC. A private company can use a blank check company to go public via a "reverse merger" without doing an expensive IPO. An unscrupulous stock promoter can also use a blank check company to defraud sleepy investors. (Schellhardt, Timothy D. "As 'Blank-Check' Firms Regain Allure, Businessman Lines Up Numerous Suitors." WSJ, 10/29/99.)
BISTRO
Definition: An acronym for either of the following, depending on who's talking and who might be listening.
1. Broad Index Secured Trust Offering. J.P.Morgan's preferred vehicle for transferring a significant amount of diverse credit risk to an SPV.
2. BIS Total Rip Off. An alternative definition of unknown meaning.
BOBL
German Federal Debt Obligations (BundesOBLigationen). (Source: http://www.exchange.de/dtb/BOBL-future.html)
BOBL Futures
The DTB Futures contract on a notional medium term (3.5 - 5 years) debt security of the German Federal Government or the Treuhandanstalt, with a notional interest rate of 6%. The BOBL (q.v.) and other instruments qualify. (Source: http://www.exchange.de/dtb/BOBL-future.html)
BOBL Futures Option
An American option that settles into a BOBL Futures (q.v.) contract. Payment of the option premium is "futures-style", which means none of it occurs immediately, and a piece of it occurs with each daily mark-to-market. An implication of this is that the "buyer" (really, the "long") may pay no premium and the "seller" (really, the "short") may pay all the premium! (Source: http://www.exchange.de/dtb/BOBL-future-option.html)
Boolean trades
Definition: Trades based on orders that contain Boolean logic, including the concepts of “if”, “if and only if”, “or”, and “and”.
Example: “I want to sell Microsoft at 75 if and only if I can buy IBM at 110 and buy Intel at 120.”
Source: Hal R. Varian, “Boolean Trades and Hurricane Bonds,” Wall Street Journal, 5/8/00.
Bowie Bond
A specific, $55 million issue of 10-year Asset-Backed Bonds (q.v.) that British rock star David Bowie issued and Prudential Insurance Co. bought. The specific collateral consists of royalties from 25 of Mr. Bowie's albums that he recorded before 1990.
Source: Bloomberg News, 2/20/97
B-Piece
Definition: A security from the riskier tranche of a two-tranche ABS (q.v.) deal. It receives the residual income from the underlying collateral and takes second place in line for the collateral in case of default. In terms of income and collateral, B-pieces are to the ABS’s assets as common shares are to a corporation’s assets. (The analogy breaks down when it comes to taxation and control.)
Example: A bank with large credit card operations issues ABS’s backed by credit card receivables. The A-piece has a AAA rating and little credit risk. If the economy heads south, then the B-piece may not pay off in full.
Application: Dividing an ABS issue into senior and junior pieces permits the issuer to tap two types of investor. The more (less) risk averse investor that wants to avoid (place) a bet on the performance of the underlying assets can buy the A-Piece (B-Piece).
Pricing and Risk Management: This is difficult. The whole point of having a B-piece is to have a place to put the return that is more difficult to price and the risk that is more difficult to manage. Then, people who are more talented at pricing derivatives and managing their risk will buy these pieces. Pricing the A-Pieces is nearly as easy as pricing Treasuries, and their risk is mainly market risk.
Source: Cecile Gutscher, "SEC Is Examining Whether Some Underwriters Are Marketing Bonds at Artificially Low Yields", Wall Street Journal, 5/2/97).
Bulldog bond
Definition: A bond, denominated in British pounds sterling, that a company or government that is foreign to the U.K. issues in the U.K. bond market.
Example: A Brazilian company might issue £100 million of debt in London.
Source: Edna Carew, The Language of Money.
Definition: A bond, denominated in British pounds sterling, that a company or government that is foreign to the U.K. issues in the U.K. bond market.
Example: A Brazilian company might issue £100 million of debt in London.
Source: Edna Carew, The Language of Money.
Bullet Bond
Definition: A Bond that Amortizes (q.v.) fully on a single date. Its cash flows consist of regular coupon payments of interest and a final repayment of principal.
Example: An ordinary, 30-year, noncallable Treasury bond with a semiannual coupon.
Application: A Bullet Bond is a commonplace way of raising capital.
Pricing: A Bullet Bond is a portfolio of Zero Coupon Bonds (q.v.), so its value is the value of the portfolio.
Risk Management: A common way to measure a fixed income portfolio’s risk is by its Duration (q.v.) or DV01 (q.v.), and its Convexity (q.v.). Consequently, one might combine a Bullet Bond with other fixed income instruments in a portfolio, in an effort to control the portfolio’s Duration and Convexity.
Comment: When a layman thinks of a bond, this is the bond.
BUND German Federal Government Bonds (BUNDesanleihen) .
BUND Futures
The DTB Futures contract on a notional long term (8.5 - 10 years) debt security of the German Federal Government or the Treuhandanstalt, with a notional interest rate of 6%. The BUND (q.v.) and other instruments qualify. (Source: http://www.exchange.de/dtb/BUND-future.html)
BUND Futures Option
An American option that settles into a BUND Futures (q.v.) contract. Payment of the option premium is "futures-style", which means none of it occurs immediately, and a piece of it occurs with each daily mark-to-market. An implication of this is that the "buyer" (really, the "long") may pay no premium and the "seller" (really, the "short") may pay all the premium! (Source: http://www.exchange.de/dtb/BUND-future-option.html)
Bundle
A Strip (q.v.,#2) of consecutive, quarterly Eurodollar or Euroyen futures contracts. Markets, such as Simex offer a Bundle as a convenient package of futures contracts, without the execution risk inherent in building up the Strip, contract by contract. A trader can use Bundles and Packs (q.v.) to implement bets on the change in shape of the Forward Curve.
Buy-Write
An investment strategy that consists of buying an asset and selling a call on it. Thus, the investor sells upside potential to elevate the rest of his payoff function.
-A-
- A -
ABS
Asset-Backed Security (q.v.).
Accrual Note
A note that accrues daily interest only when the index rate (e.g., LIBOR) falls within some range (such as under 6.5%). A Fixed (Floating) Rate Accrual Note accrues interest that is a spread over the corresponding ordinary Fixed (Floating) Note. The spread compensates for the probability that the note will accrue no interest over some day.
AC-DC Option
An option that the owner could choose to become at some future date either a Call or a Put. Another name for a Hermaphrodite Option (q.v.).
Accreting Swap
A Swap (q.v.) for which the Notional Amount (q.v.) increases during its life.
Act-of-God Bond
A Catastrophe Bond (q.v.). (Source: Sophie Belcher, "USAA to Try Again with Hurricane Bond, Derivatives Week, 5/5/97.)
ADR
American Depository Receipt (q.v.).
All Ordinaries Index
An index of stock prices on the Australian Stock Exchange.
alpha
The amount that an investment's average rate of return exceeds the riskless rate, adjusted for the inherent systematic risk. One way to compute alpha is to regress an investment's excess rate of return (rate of return minus the riskless rate) against the market portfolio's excess rate of return. The intercept in this regression is an estimate of the risk-adjusted excess rate of return.
American Depository Receipt
A receipt indicating a claim on some number (less than one, one, or more than one) of shares in a foreign corporation that a Depository Bank holds for U.S. investors.
Amortizing Swap
A Swap (q.v.) for which the Notional Amount (q.v.) decreases during its life.
APO
Average Price Option (q.v.).
Arbitrage
Atlantic spread
Long (short) an American option and short (long) the otherwise identical European option – hence, long (short) the value of early exercise. (Stephen R. Gould)
ARGO
A J.P. Morgan SPV (q.v.), originated in 1994. It hedges the swap leg with puts. (Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html)
Asian Option
Definition: An Average Price Option (q.v.).
Example: Some banks offer their retail customers an equity-linked CD that repays principal, plus a form of "average return" on the S&P 500 that amounts to an Average Price Call Option.
Application: Some hedgers use an Asian Option as a one-stop way to hedge the price risk of regular purchase or sale of a constant amount of a currency or commodity.
Pricing: One can ordinarily price an Average Price Option satisfactorily by using an adjusted volatility and dividend yield in the Black-Scholes-Merton pricing model. If the underlying source of risk is an exchange rate, the price of gold or silver, a share price, or an equity index, then the "square root of three" rule for the volatility may apply. For underlying oil price risk that rule may not work so well.
Risk Management: With underlying currency, precious metal, or equity risk, one can ordinarily delta hedge an Asian Option with a single position in the underlying. With underlying oil risk and averaging over a long period, delta hedging an Asian Option may require hedging in oil futures contracts with several different delivery dates.
Comment: Rarely, the expression, Asian Option, may indicate an Average Strike Option (q.v.).
ask (asked)
The price at which a dealer (market maker) stands ready to sell. Ordinarily the ask exceeds the bid (q.v.), and the bid-ask spread is what the dealer stands to make by quickly turning around one unit of product. Also known as offer, offered, or offering price.
Asset-Backed Bond
A bond that is also an Asset-Backed Security (q.v.). An Asset-Backed Bond is to an Asset-Backed Security as a Mortgage-Backed Bond is to a Mortgage-Backed Security.
Asset-Backed Security (ABS)
A "fixed income" security that pays its coupon and principal from a specific revenue stream and has a specific asset as collateral. Collateral has included accounts receivable for aircraft, automobile and r.v. loans, credit card receivables, health club contracts, lottery winnings, mortgages, real property, and taxi medalions. Sources of revenue have included payments on various loans, credit card payments, mortgage payemts, rent, royalities, lotter payments, mortgage debt service, and rent from real estate. An Asset-Backed Bond may or may not have an issuer's or guarantor's full faith and credit behind it. A special case is an Asset-Backed Bond (q.v.).
The revenue stream and collateral may support more than one "class", "piece", or "tranche", just a corporation's assets may support shares and bonds. Thus, the ABS, whose value depends on the underlying revenue stream and collateral, is a Derivative Product in the same sense that financial economists have long recognized that corporate shares and bonds are Derivatives, whose prices depend on the underlying asset value and cash flow.
Asset Swap
A Swap that converts a fixed- (floating-) coupon asset into a floating- (fixed-) coupon asset. This is in contrast to the more familiar (Liability) Swap that converts a fixed- (floating-) coupon liability into a floating- (fixed-) coupon liability.
ATM
At-the-money (q.v.).
At-the-money
Having a strike price that equals the spot price.
At-the-money forward
Having a strike price that equals the forward price.
Average Price [Call or Put] Option
An Option – Call or Put – whose underlying price is an average over time of a risk factor.
ABS
Asset-Backed Security (q.v.).
Accrual Note
A note that accrues daily interest only when the index rate (e.g., LIBOR) falls within some range (such as under 6.5%). A Fixed (Floating) Rate Accrual Note accrues interest that is a spread over the corresponding ordinary Fixed (Floating) Note. The spread compensates for the probability that the note will accrue no interest over some day.
AC-DC Option
An option that the owner could choose to become at some future date either a Call or a Put. Another name for a Hermaphrodite Option (q.v.).
Accreting Swap
A Swap (q.v.) for which the Notional Amount (q.v.) increases during its life.
Act-of-God Bond
A Catastrophe Bond (q.v.). (Source: Sophie Belcher, "USAA to Try Again with Hurricane Bond, Derivatives Week, 5/5/97.)
ADR
American Depository Receipt (q.v.).
All Ordinaries Index
An index of stock prices on the Australian Stock Exchange.
alpha
The amount that an investment's average rate of return exceeds the riskless rate, adjusted for the inherent systematic risk. One way to compute alpha is to regress an investment's excess rate of return (rate of return minus the riskless rate) against the market portfolio's excess rate of return. The intercept in this regression is an estimate of the risk-adjusted excess rate of return.
American Depository Receipt
A receipt indicating a claim on some number (less than one, one, or more than one) of shares in a foreign corporation that a Depository Bank holds for U.S. investors.
Amortizing Swap
A Swap (q.v.) for which the Notional Amount (q.v.) decreases during its life.
APO
Average Price Option (q.v.).
Arbitrage
1. The act of buying something at a low price in one market and simultaneously selling it for a higher price in another.
2. Buying something at the lowest price available in the market, rather than stupidly paying the higher price.
3. Doing a spread trade – i.e., selling one thing and using the proceeds to buy a second thing.
4. (Yield Curve Arbitrage) Doing a spread trade that exploits anomalies in the yield curve.
5. (Statistical Arbitrage) Taking a calculated gamble that the two sides of a spread trade will move in your favor, back to a more normal relationship.
Atlantic spread
Long (short) an American option and short (long) the otherwise identical European option – hence, long (short) the value of early exercise. (Stephen R. Gould)
ARGO
A J.P. Morgan SPV (q.v.), originated in 1994. It hedges the swap leg with puts. (Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html)
Asian Option
Definition: An Average Price Option (q.v.).
Example: Some banks offer their retail customers an equity-linked CD that repays principal, plus a form of "average return" on the S&P 500 that amounts to an Average Price Call Option.
Application: Some hedgers use an Asian Option as a one-stop way to hedge the price risk of regular purchase or sale of a constant amount of a currency or commodity.
Pricing: One can ordinarily price an Average Price Option satisfactorily by using an adjusted volatility and dividend yield in the Black-Scholes-Merton pricing model. If the underlying source of risk is an exchange rate, the price of gold or silver, a share price, or an equity index, then the "square root of three" rule for the volatility may apply. For underlying oil price risk that rule may not work so well.
Risk Management: With underlying currency, precious metal, or equity risk, one can ordinarily delta hedge an Asian Option with a single position in the underlying. With underlying oil risk and averaging over a long period, delta hedging an Asian Option may require hedging in oil futures contracts with several different delivery dates.
Comment: Rarely, the expression, Asian Option, may indicate an Average Strike Option (q.v.).
ask (asked)
The price at which a dealer (market maker) stands ready to sell. Ordinarily the ask exceeds the bid (q.v.), and the bid-ask spread is what the dealer stands to make by quickly turning around one unit of product. Also known as offer, offered, or offering price.
Asset-Backed Bond
A bond that is also an Asset-Backed Security (q.v.). An Asset-Backed Bond is to an Asset-Backed Security as a Mortgage-Backed Bond is to a Mortgage-Backed Security.
Asset-Backed Security (ABS)
A "fixed income" security that pays its coupon and principal from a specific revenue stream and has a specific asset as collateral. Collateral has included accounts receivable for aircraft, automobile and r.v. loans, credit card receivables, health club contracts, lottery winnings, mortgages, real property, and taxi medalions. Sources of revenue have included payments on various loans, credit card payments, mortgage payemts, rent, royalities, lotter payments, mortgage debt service, and rent from real estate. An Asset-Backed Bond may or may not have an issuer's or guarantor's full faith and credit behind it. A special case is an Asset-Backed Bond (q.v.).
The revenue stream and collateral may support more than one "class", "piece", or "tranche", just a corporation's assets may support shares and bonds. Thus, the ABS, whose value depends on the underlying revenue stream and collateral, is a Derivative Product in the same sense that financial economists have long recognized that corporate shares and bonds are Derivatives, whose prices depend on the underlying asset value and cash flow.
Asset Swap
A Swap that converts a fixed- (floating-) coupon asset into a floating- (fixed-) coupon asset. This is in contrast to the more familiar (Liability) Swap that converts a fixed- (floating-) coupon liability into a floating- (fixed-) coupon liability.
ATM
At-the-money (q.v.).
At-the-money
Having a strike price that equals the spot price.
At-the-money forward
Having a strike price that equals the forward price.
Average Price [Call or Put] Option
An Option – Call or Put – whose underlying price is an average over time of a risk factor.
Tuesday, July 29, 2008
Inflation Derivatives
Inflation derivatives (or inflation-indexed derivatives) refer to over-the-counter and exchange-traded derivatives that are used to transfer inflation risk from one counterparty to another. Typically, real rate swaps also come under this bracket, such as asset swaps of inflation-indexed bonds (government-issued inflation-indexed bonds, such as the Treasury Inflation Protected Securities, TIPS, UK Inflation Linked Gilts, ILGs, French OATei's, Italian BTPei's, German Bundei's and Japanese JGBi's are prominent examples). Inflation swaps are the linear form of these derivatives. They can take a similar form to fixed versus floating interest rate swaps (which are the derivative form for fixed rate bonds), but use a real rate coupon versus floating, but also pay a redemption pickup at maturity (i.e., the derivative form of inflation indexed bonds).
Freight Derivatives
Freight derivatives, which includes Forward Freight Agreement (FFA) and options based on these, are financial instruments for trading in future levels of freight rates, for dry bulk carriers and tankers. These instruments are settled against various freight rate indices published by the Baltic Exchange (for Dry and some Wet contract)& Platt's (some Wet contracts.) FFAs are often traded over-the-counter (through brokers such as ICAPHYDE, Clarkson's Securities, SSY- Simpson, Spence and Young, FIS -Freight Investor Services, GFI, BRS & Tradition-Platou), but screen-based trading is becoming more popular, through various screen. Trades can be given up for clearing by the broker to one of the clearing houses that support such trades. There are three clearing houses for freight: NOS Clearing, LCH.Clearnet & SGX (Singapore). Freight derivatives are primarily used by shipowners and operators, oil companies, trading companies and grain houses as tools for managing freight rate risk. Recently with Commodities now standing at the forefront of international economics; the large financial trading house, including banks and hedgefunds have entered the market.
Dry Freight or Dry-Bulk FFAs
The Baltic Exchange, Baltic Dry Index which measures the cost for shipping goods like iron ore and grains, doubled over the past 12 months and has risen more than fourfold since 2006.
The trading volume of dry freight derivatives, a market estimated to be worth about $200 billion in 2007, grew as those needing ships attempted to contain their risks and investment banks and hedge funds looked to make profits from speculating on price movements. At the close of the 2007 financial year, the number of traded lots on dry FFAs doubled the derived physical product.
Dry Freight or Dry-Bulk FFAs
The Baltic Exchange, Baltic Dry Index which measures the cost for shipping goods like iron ore and grains, doubled over the past 12 months and has risen more than fourfold since 2006.
The trading volume of dry freight derivatives, a market estimated to be worth about $200 billion in 2007, grew as those needing ships attempted to contain their risks and investment banks and hedge funds looked to make profits from speculating on price movements. At the close of the 2007 financial year, the number of traded lots on dry FFAs doubled the derived physical product.
Derivatives Definition
Derivatives are financial instruments whose value changes in response to the changes in underlying variables. The main types of derivatives are futures, forwards, options, and swaps.
The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a huge range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the pay-offs.
The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a huge range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the pay-offs.
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