Derivatives Dictionary^TM (K-M) Last revised: August 03, 2001

A B C D E F G H I J K L M N O P Q R S T U V W X Y Z #

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Kitchen Sink Bond or MBS: A bond or CMO into which issuers have dumped "everything but the kitchen sink," including "garbage" such as miscellaneous MBSs, CMO tranches, and derivatives. Some people call the contents of the KSB the "toxic waste" of derivatives transactions.; Issuers include agencies such as Fannie Mae or Freddie Mac and securities firms such as Bear Stearns and CS First Boston.; One selling point has been that their components are so diverse that some will increase in value while others decrease, thus reducing overall risk. However, in fact, in the middle of 1994 enough of the components went south to seriously hurt investors in some kitchen sink bonds.

Knockin Option: An option that "comes to life" when a trigger event occurs. Typically when a price crosses a particular barrier it pulls the trigger. (Cf. Knockout Option.)
Knockout Option: An option that "dies" when a trigger event occurs. Typically when a price crosses a particular barrier it pulls the trigger. (Cf. Knockin Option.)

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Ladder Option: An option somewhere between a Lookback (q.v.) and a European Option. A Ladder Call Option has one or more "Rungs" (price levels) above the initial spot level. The Call's payoff equals the greater of a European Call's payoff or the excess over Strike (q.v.) of the highest Rung that the underlying price reaches.; For example, suppose that the Underlying Price is 100 and a Ladder Call has a Strike at 105 and Rungs at 115 and the Underlying Price reaches 120 before Expiration, then falls back to 98, the Ladder Call pays 15 = 120 - 105. If the Underlying price never gets above 109, then falls back to 98, the Ladder Call expires worthless.125. If

Ladder Periodic Cap: A Periodic Cap (q.v.) that depends not on LIBOR at the end of the previous period, but on the highest or lowest rung of the Ladder that LIBOR reached during that period. The Ladder is a predetermined set of LIBOR levels, such as 4.00%, 3.50%, 3.00%, etc. The Ladder can change from period to period. The Ladder Periodic Cap is a special case of the Lookback Periodic Cap (q.v.). (Source: Dehnad, Kosrow. "Learning Curve; Lookback and Ladder Periodic Caps." DW, October 25, 1993.)

LASER: Paribas Capital Markets' Liquid Asset Swap with Enhanced Return. A kind of SPV (q.v.) that Moody's rated A1. The initial US dollar one-year issue contained a repackaged Swiss franc private placement priced at six-month Libor plus 25bp. In the event of a failure of the Laser security, holders receive the underlying coupon and principal payments. (Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html)
LEAPS: Long-term Equity AnticiPation Securities. Listed Call and Put Options on shares and indexes, with expirations out as much as two years. Ordinary listed Calls and Puts expire within nine months. LEAPS permit investors to express longer-term views, without buying the underlying instruments.

LEPO: In a normal market the bid is less than the ask, and the difference – the bid-ask spread – would be the market maker's profit on a round trip in the stock. In a crossed market, the bid price exceeds the ask (offer) price. In an OTC market one market maker may show the best bid and another the best offer, and these may cross. A crossed market cannot last, in equilibrium.; A Low Exercise Price Option (q.v.) traded on the Australian Stock Exchange (q.v.) or SOFFEX (Switzerland). (Source: Australian Stock Exchange.)

LIPS and TRIPs: Indexed Principal Swaps, i.e., Amortizing Swaps, where amortization depends on the change in LIBOR (LIPS) or some Treasury yield (TRIPS).

life assurance [insurance] bonds: Bonds backed by life insurance policies. The idea is that life insurance companies are good at underwriting insurance risks, collecting premiums, and servicing the policies, but needn’t tie up their money for the duration.; Examples: USAA, Swiss Winterthur, Swiss Re, and Tokio Marine & Fire have issued such bonds. CSFB, Goldman Sachs, Lehman Brothers, and Merrill Lynch have brought the issues to investors. Good news: This is a logical next step in disintermediation. The cash flows are relatively predictable, in contrast to cash flows on "catastrophe bonds" (q.v.).; Bad news: Investors will be dealing against experts in adverse selection (q.v.) and moral hazard (q.v.).; Source: "An earthquake in insurance," The Economist, 2/28/98.

loan participation fund: A mutual fund that buys unrated or "junk" bonds that are thinly traded. If it doesn't use an independent pricing service to put a value on the fund, then it can basically set the price, itself. This makes the daily at 4 p.m. net asset value (NAV) of questionable validity.

local
locked market: A market where the bid (q.v.) equals the ask (q.v., also known as asked, offer, offered). In a normal market the bid is less than the ask, and the difference – the bid-ask spread – would be the market maker's profit on a round trip in the stock. We would not expect to see a locked market with a single market maker. In a market with more than one market maker, one market maker may show the best bid and another the best offer, and these may lock. However, savvy customers would not let the market makers cover their costs, and a locked market could not last, in equilibrium.

Lombard rate: The rate of interest charged on a Lombard loan.

Lombard loan: A secured loan the Bundesbank makes, based on the pledge of high grade securities, intended for emergencies, with limited availability.

Lookback Option: An option with a payoff based on the path of some risk factor from the option's inception until its expiration. Examples of lookback options include a Call (Put) with (a) underlying price equal to the maximum (minimum) of the reference price during the option's life, and a given strike, or (b) underlying price equal to the reference price at the option's expiration, and strike equal to the minimum (maximum) of the reference price during the option's life.

Lookback Periodic Cap: A Periodic Cap (q.v.) that depends not on LIBOR at the end of the previous period, but on the highest or lowest level that LIBOR reached during that period. (Source: Dehnad, Kosrow. "Learning Curve; Lookback and Ladder Periodic Caps." DW, October 25, 1993.)

Low Exercise Price Option: An extremely deep in-the-money European Call Option traded on the ASX (q.v.) options market, with strike price between one and ten cents. Since the strike price is so low, the LEPO's owner is extremely likely to exercise it, and it is roughly equivalent to a Forward Contract (q.v.) with a low price. The LEPO owner receives no dividends, but has nearly the same exposure to a move in the underlying stock price as if he owned a share. I.e., the LEPO's delta is nearly unity. (Source: Australian Stock Exchange.)

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Macaulay Duration: 1. A measure of the sensitivity of a financial instrument's value to a change in its yield. Macaulay Duration is an overestimate, and Modified Duration (q.v.) is a more precise measure.; 2. The weighted average of time until a financial instrument pays its cash flows. Each weight is proportional to the present value of the associated cash flow.; 3. Modified Duration (q.v.), times 1 + y/n , where y is the yield and n is the number of coupon payments per year.

market: A real or virtual place where people trade things. For example, people trade securities in the securities market, bonds in the bond market, commodities in the commodities market, currency in the foreign exchange market, futures contracts in the futures market, options in the options market, and shares in the stock market.Cf. domestic market and foreign market, internal market and external market.

market maker: A trader who will at that moment is willing and able to either buy or sell at stated bid and ask prices. Also known as scalper (q.v.) or scalp-beggar (q.v.).

Market Risk: The risk of loss from being on the wrong side of a bet about a market move.

Margrabe Option: The option to exchange one asset for another. Margrabe (1978) showed several applications for this sort of option (margin account, corporate exchange offer, and standby commitment) and derived a model for pricing this option. Other people discovered numerous additional examples of this option. The Cross Currency Option (q.v.) is a prime example. The option goes also by the names Exchange Option (q.v.) and Outperformance Option (q.v.).
Source: Gary L. Gastineau and Mark P. Kritzman, Dictionary of Financial Risk Management, Frank Fabozzi, 1996.
Market Index Target-Term Securities: Merrill Lynch's registered derivative product, with a payoff that is the greater of (a) some minimum and (b) issue price times the sum of unity and the rate of increase in value of the underlying price. MITTS don't allow the owners to redeem, nor the issuers to call early. The MITTS is equivalent to a position in the underlying index, plus a protective put.
: For example, Merrill Lynch has listed on the American Stock Exchange an issue of MITTS with an underlying index proportional to an average of the prices of the ten highest-yielding Dow-Jones Industrials, and maturity on 8/15/06. The minimum payoff of this issue is 124% of the issue price.

Marché à Terme Internationale de France (MATIF): The French derivatives exchange, which dominates trading in contracts based on instruments denominated in the French Franc.
martingale: 1. A device that keeps a horse's head in position with its rows of teeth more or less horizontal.
2. A gambling strategy that involves betting one unit, then doubling the bet, until the gambler wins. The strategy appears to assure the gambler a profit of one unit at the end of each string of bets. The problem is that the gambler's -- and house's -- resources are finite. Consequently, the strategy isn't operational.
3. A stochastic process for which the expected change equals zero, e.g., equivalent martingale measure (q.v.).
Application: During the 1960s the martingale stochastic process was a standard model for a fair game, hence for stock price movements in an efficient market.
martingale measure: Any probability measure (q.v.) under which a stochastic variable is a martingale (q.v.), i.e., its expected change equals zero.
Example: Consider the probability measure that assigns a probability of 1/2 to a head or a tail, and for which successive coin tosses are independent. Then let X(n) be the random variable that starts at zero and increases by one with each "heads" outcome and decreases by one with each "tails" outcome. Then E[X(n)-X(n-1)|X(n-1)] = 1/2 (1) + 1/2 (-1) = 0, and X(n) is a martingale.
measure: A function that maps a set into the positive portion of the real line.
Examples:
1. Length is a measure for subsets of the real line. Add the lengths of subsets of contiguous points in a set to get a positive real number.
2. Area is a measure for sets in the Cartesian plane. Take any rectangular set of points and compute its area by multiplying length by width to get a non negative real number.
3. Probability measure (q.v.).
Matador market: Spain’s foreign market (q.v.). Example: Some Exxon debt trades in the Matador market.

Maus-Optionen: Markt Aufstehen Und Sicherheit Optionen. Range Options that pay off like Call Options when the market rises securely within a narrow, upward sloping corridor, but otherwise expire worthless.
MBS: Mortgage Backed Security (q.v.).

Mid-Curve Option: A short-term American option on a CME-listed Eurodollar Futures Contract with delivery in one or two years. The crucial innovation here is that an ordinary CME Futures Option on the ED contract with delivery in one year (two years) expires in one year (two years), while the Mid-Curve Option initially expires in six months. Thus, the Mid-Curve provides a more focused (and less expensive) way to express a view on the news that develops in the next six months about the level of short-term interest rates that we will observe one or two years into the future. (Sources: Aaron Lucchetti, "Exotic Option Wins Followers on Wall Street," Wall Street Journal, 5/6/97. http://www.cme.com/market/interest/serialmc.html)

Millenium Bond: Definition: A Bond that matures in 1000 years.; Example: Lehman Brothers underwrote a 1000-year issue for Safra Republic Holdings SA.; Application: A Millenium Bond reduces the need for refinancing and reinvesting.; Pricing: The Safra issue yielded 98 basis points over the 30-year U.S. Treasury bond. Price and yield should be nearly reciprocals.; Risk Management: One might hedge them by shorting Safra’s previous 100-year maturity bonds. However, as a practical matter their duration should be close to that of the U.S. Treasury’s Long Bond.; Comment: If the British government could issue perpetuities ("consols") to consolidate its debt, then why can’t a corporation issue bonds maturing in 1000 years?; Source: "Ratings & Briefs," Financial Trader 4 (11), p. 8.

MIPS: Monthly Income Preferred Shares (q.v.).

MITTS: Market Index Target-Term Securities (q.v.).

Model Risk: The risk of loss due to weakness of the financial model(s) that a business uses for pricing inventory and managing risk.

Modified Duration

A measure of the sensitivity of a financial instrument's value to a change in its yield.
The first derivative of a financial instrument's value with respect to a change in its yield.
Macaulay Duration (q.v.), divided by 1 + y/n , where y is the bond yield and n is the number of coupon payments per year.

money market rates: Interest rates on short-term instruments, including bankers’ acceptances, commercial paper, LIBOR, and U.S. Treasury bills. The accrual rate to maturity equals the quoted rate times a day count fraction that has 360 in the denominator. The days in the numerator might be actual days or days according to a 30/360 calendar.

Monte Carlo Simulation: A technique for approximating a probability distribution by generating uniformly distributed pseudo random numbers and transforming them into the required sort of random numbers. In option pricing one ordinarily works with lognormal random interest rates, prices, and indexes. If one constructs the probability distributions correctly, then a Derivative Product's value equals the expected discounted value of its payoff (in the limit as the number of random paths approaches infinity). (See http://www.sbcm.com/hot/current.htm for more information)

Monthly Income Preferred Shares.: Monthly Income Preferred Shares (or Stock) - which most people call MIPS or Mips, for short - are Preferred Shares (q.v.) that pay monthly dividends. MIPS are callable after some period of call protection, and convertible into common shares. Some observers see MIPS as tax-deductible equity, in effect. Some in the Treasury department see this as abusive, and want a crackdown. Goldman, Sachs & Co. pioneered them circa October 1993. Cf. Step-Down Preferred Stock.; The parent corporation (Parent) creates a subsidiary (Sub) or limited partnership to issue the MIPS. Sub sells MIPS for cash and lends the cash to Parent or buys Parent's notes. Parent pays interest to Sub, which pays monthly preferred dividends to its security holders. In at least one case Parent had the option to defer interest for up to five years. That would mean that MIPS holders might receive no dividends for five years.; One variation on the MIPS structure involves an offshore Sub, which pays dividends to investors without withholding tax.; Part of the motivation for MIPS seems to be reduction of taxes paid by the issuer and its direct or indirect security holders. Parent issues debt and pays interest, so Parent may deduct interest expense. Subsidiary issues preferred shares and pays dividends, so corporations that buy MIPS get a dividend exclusion. This shifts the tax burden to parties besides security holders of Parent and Sub.; Texaco, Inc., USX Corp., ConAgra Inc., and others issued more than $2.5 billion in the first year MIPS existed. Merrill Lynch and Smith Barney have issued similar securities.
: The masochistic or meticulous among you may like to view legal documents from Edgar, pertaining to a proposed offering of MIPS, by Capital Holding Corp., with help from Goldman, Sachs. See also U.K. Mips.
Monster ABS: An enormous Asset-Backed Security (q.v.). (For example, see "Natwest Prepares Monster Loan-Backed ABS," BondWeek, 3/10/97. This one was worth about $1.65 billion.)

Morgan Stanley - Capital International: The Morgan Stanley unit that maintains a wide range of global stock market indexes for approximately 20 countries and a variety of regions.

Mortgage Backed Security: A security, such as a bond, pass-through, CMO, or REMIC that derives its cash flows and market value from underlying Mortgage Backed Securities and/or Mortgage Bonds, Loans, and/or Notes.

Mortgage Bond, Loan, or Note: A Bond, Loan, or Note plus a security interest in a piece of property, commonly real property (land and/or buildings). A residential mortgage loan typically contains a prepayment option, which is the borrower's call option on the loan and which becomes valuable when interest rates decline. Also, in practice, the lender sells the homeowner a put option on the pledged home, struck at the loan's balance.

MSCI: Morgan Stanley - Capital International (q.v.).

M-squared: A way of measuring the performance of an investment portfolio, namely the average rate of return on a portfolio that (a) consists of investment in T-bills and the investment portfolio and (b) has the same standard deviation as the relevant benchmark portfolio. Thus, if an investment portfolio’s M-squared is greater (less) than the return on the benchmark portfolio, then the investment portfolio’s risk-adjusted return is better (worse) than that of the benchmark. (Noelle Knox, "Slice, Dice and Scrutinize: Risk Measurements Draw a Crowd," NYT, 4/5/98, p. 45.)

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Derivatives DictionaryTM (K-M) Last revised: August 03, 2001

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Derivatives Dictionary^TM (K-M) Last revised: August 03, 2001