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.
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