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.
Showing posts with label Derivatives. Show all posts
Showing posts with label Derivatives. Show all posts
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.
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.).
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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