THE WILLIAM MARGRABE GROUP, INC., CONSULTING, PRESENTS
THE DERIVATIVES 'ZINE^TM     November 2001

Derivatives Dictionary^TM (Q-T)  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 #

- Q -

Quanto

Goldman Sachs's copyrighted (but not enforced) term for a "quantity-adjusting" option or forward. In 1986 Lee Thomas, then of Goldman Sachs, introduced the term. See also Quanto Forward (q.v.), Option (q.v.), and Swap (q.v.). ("Quanto swap challenge: the results," Euromoney, October 1994, p. 30.)  

 

Quanto Forward

A forward contract in which the buyer receives a random number of units of the underlying , and that number depends on another price. For example, consider a Quanto Forward contract on the Nikkei. The forward price might be a fixed number of dollars, while the number of units of the Nikkei would depend proportional to the yen/dollar exchange rate. This is equivalent to a cash-settled forward contract with a nominal dollar value of the Nikkei proportional to the ratio of its true dollar value to the dollar value of one yen.

 

Quanto Option

An option in which the payoff is the greater of zero or the value of a Quanto Forward (q.v.) contract.

 

Quanto Swap

A swap in which the underlying price is quantity adjusted, as with the Quanto Forward and Quanto Option.

 

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Rainbow Option

Definition: An option that has several risk factors of the same type, e.g., two stock prices or three exchange rates.

Examples: The earliest Rainbow Option in the derivatives literature was probably Margrabe’s Option to Exchange One Asset for Another, an Outperformance Option (q.v.), with a payoff that depends on the difference between two prices. An Equity Index Option (q.v.) has a payoff that depends on the average of underlying share prices.

Pricing: Margrabe (1976) published the first pricing model for a Rainbow Option, namely the "Margrabe Option." In some cases one can price a Rainbow Option with a Black-Scholes-Merton model by computing the appropriate adjusted volatility and dividend yield. The most common way to price a general Rainbow Option is with Monte Carlo pricing. Next most common is with a multinomial model (a generalization of the binomial model). Explicit finite difference pricing is easily feasible, but rarely seen.

Risk Management: Rainbow options with n sources of risk have n Deltas, n Kappas, n(n+1)/2 Gammas, and sensitivity to n dividend yields and n(n-1)/2 correlations. With large n this can get complicated.

Comment: If the several risk factors are of two or more types, e.g., a stock price and an exchange rate, then the option is a Hybrid Option (q.v.).

 

random variable

A variable that takes on different numerical values for different points in an underlying probability space (q.v.). 
Example: The number of "heads" outcomes in five coin flips. 

Range Accrual Option

An Option that accrues value for each day that the index rate remains within the specified range. See Range Note, Hamster Option.

 

Range Binary Option

An Option that pays off a fixed amount at expiration if and only if the underlying price remains in the range the option's entire life. .

 

Range Note

An Accrual Note (q.v.).

 

Ratchet Floater

A One Way Floating Rate Note (q.v.).

real option

Definition: An option that involves tangible objects – such as bricks and mortar, pipelines and equipment – rather than financial instruments and cash flows, and physical actions – such as excavation, construction, demolition, physical movement, and hard work – rather than simply tendering notice of the exercise of an option.

Examples: Examples include the following decisions to:

- build a plant today, rather than wait until next year
- choose a more flexible and more expensive production process, rather than a cheaper one with fewer applications
- decline a marriage proposal and play the field, looking for a better proposal
- go for an MBA, rather than a law degree

Applications: The main business application for real options seems to be capital budgeting, i.e., business investment. The idea is that one investment may open doors to other opportunities that may grow or not, and that traditional net present value methods are not up to the task of evaluating such investments.
Comment: Although the real option approach is theoretically sound, the challenge of applying it correctly to get out a useful value is daunting. I have waited 30 years to see widespread use of the capital asset pricing model for capital budgeting. We may have to wait as long to see widespread use of real option theory.

Real Estate Mortgage Investment Conduit (REMIC)

A relatively new vehicle for passing the cash flows from a portfolio of mortgages and MBS's through to holders of REMIC certificates. The REMIC legislation took effect on 1/1/87. Since REMICs appear, new issues of CMOs have nearly disappeared.

 

Red Chip Stocks

Shares listed on the Hong Kong Stock Exchange of companies with headquarters and operations in the People’s Republic of China.

Rediscount credit

Bundesbank (Buba) credit to institutions "against the purchase of bills of exchange". This is typically the lowest rate at which the Buba lends, and the Buba’s Central Bank Council limits the total amount of such credit.

Rembrandt market

Holland’s foreign market (q.v.). Example: Some Exxon debt trades in the Rembrandt market.

 

REMIC

Real Estate Mortgage Investment Conduit (q.v.). A "pot" of real estate mortgage assets, sometimes homogeneous, sometimes a mischmasch, usually sliced an diced to sell for maximum value. 

 

Replicating Portfolio

A portfolio of securities (ordinarily more "basic" and from a more liquid market) that either (1) mimics the returns on a derivative security (static replication) or (2) is part of a trading strategy that mimics those returns (dynamic replication).

 

Residual Tranche

The "equity" portion of a CMO (q.v.). The Tranche (q.v.) that receives what's left over after satisfying all other claims against the underlying cash flow.

 

REX^â

A price index for all fixed-income bonds, debt obligations, and Treasury bills of the German federal government, Treuhandanstalt, and the German Unity Fund. The REXâ bond index is a weighted price average based on 30 synthetic, notional bonds with a constant integer life to maturity periods of one to 10 years and three different coupon types of 6, 7.5, and 9 percent. (Source: http://www.exchange.de/fwb/indices.html#rex).

 

REXP^â

A performance index corresponding to the REX^â (q.v.). (Source: http://www.exchange.de/fwb/indices.html#rex).

 

Right

A Call Warrant (q.v.) – ordinarily in the money – that a corporation grants to current shareholders to buy additional shares.

 

Roller Coaster Swap

A Swap (q.v.) that is a hybrid of an Accreting Swap (q.v.)and an Amortizing Swap (q.v.). The Notional amount both increases and decreases during the Swap's life. (Source: http://www.snowgold.demon.co.uk/webrisk/)

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- S -

8/28/01 Samurai bonds

Definition: Yen-denominated bonds that foreign companies or governments issue in the Japanese market.
Example: In July 2001 Brazil sold in Japan ¥200 billion of two-year Samurai bonds, yielding 3.75%. 
Application: Samurai bonds appeal more to Japanese investors than ordinary foreign bonds, denominated in the foreign currency, because the they avoid the possibility of loss due to devaluation or depreciation of the foreign currency relative to the yen. 
Comment: In July 2001 the two-year swap rate in Japan was about 0.17%. Consequently, the 3.75% coupon on Brazil's issue of` Samurai bonds appears to reflect a credit risk premium.  

 

Samurai market

Japan’s foreign market (q.v.). The market in Japan for securities that non Japanese companies and governments issue. Example: Some shares of General Motors trade in the Samurai market.

 

scalper, scalp-beggar

A exchange floor trader who is a market maker (q.v.). (Source: Charles di Francesca, as quoted by William D. Falloon in "God Doesn't Trade Bonds," Derivatives Quarterly, Fall 1999.)

 

scalping

Disseminating (e.g., via a newsletter, press release, web page, or “spam”) false, favorable information about a stock to boost its price, while unloading your position in it. Also known as "pumping and dumping"

 

SCHATZ

German Federal Treasury Bills (BundesSCHATZanweisungen). (Source: http://www.exchange.de/dtb/SCHATZ-future.html)

 

SCHATZ Futures

The DTB Futures contract on a notional short term (1 3/4 - 2 1/4 years) debt security of the German Federal Government or the Treuhandanstalt, with a notional interest rate of 6%. The SCHATZ (q.v.) and other instruments qualify. (Source: http://www.exchange.de/dtb/SCHATZ-future.html)

Section 215

"Section 215 of the U.S. penal code says those found to have given or received improper financial incentives of more than $1,000 ‘in connection with any business or transaction’ of an institution ‘shall be fined not more than $1 million or three times the value of the thing given, offered, promised, solicited, demanded, accepted or agreed to be accepted, whichever is greater, or imprisoned not more than 30 years, or both."
(Michael Siconolfi, " ‘Spinning’ Of Hot IPOs Is Probed", WSJ, 4/16/98. )

Securitization Conduit

A Special Purpose Vehicle (SPV) (q.v.), with a remote chance of bankruptcy, that a bank forms. The Conduit purchases or originates loans and finances them with various sorts of Asset Backed Securities (q.v.). The underlying loans provide the collateral for the ABS's. Typically, the sponsoring bank guarantees the payments of the ABS's, which the security holders demand. The guarantee may come from a standby letter of credit or from the bank's purchase of the Conduit's junior securities. In return for its guarantees, the bank receives the residual coupon spread of the underlying securities over that of the conduit's securities.

 

settlement date

The date on which the buyer pays (the seller receives) cash and the seller delivers (the buyer receives) property. In the Eurobond market, this is the "value date" (q.v.). (J.P. Morgan Glossary of terms for global sovereign bond markets.)

Sharpe ratio

A measure of investment performance, namely, the investment's average excess rate of return (investment's rate of return minus riskless rate of return), divided by its standard deviation of rate of return. Thus, the Sharpe ratio measures how many standard deviations the average rate of return is from the riskless rate of return. If the distribution of rate of return were normal and we knew its mean and variance exactly, the Sharpe ratio would provide an idea of the probability that the risky investment would beat a riskless investment. William Sharpe, creator of the Sharpe model of capital market equilibrium (1964) and subsequently Nobel Prize Winner in Economics, devised the Sharpe ratio. 

 

short-short rule

A part of the U.S. federal tax code (from 1936 to 1997) that imposed corporate income tax (hence double taxation of income) on a mutual fund that received more than 30 percent of its gross income (i.e., before deducting losses) from gains on positions held less than three months. A mutual fund that violated the short-short rule would owe corporate income tax on all its income for that year. Also known as the 30% Rule.

Its advocates argued that the rule would discourage funds from short-term trading that might destabilize the markets. Its opponents pointed out that it discouraged short selling and trading in derivatives.

SIRES

Merrill Lynch's Secured Individually Repackaged Exchangeable SecuritieS), denominated in several currencies, for international investors. A kind of SPV (q.v.). Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html)

 

SLOB

Secured Lease Obligation Bond. A bond, backed by a portfolio of leases. (Source: Gastineau and Kritzman, Dictionary of Financial Risk Management, Frank J. Fabozzi Associates, 1996.)

 

SOES

Small Order Execution System. NASDAQ’s computerized way for a customer to enter a small order to buy or sell shares of a NASDAQ stock. Under old NASDAQ "order handling rules", market makers had to fill orders for up to 1000 shares. The new (as of 1/24/97) rules – which tend to protect market makers from so-called "SOES Bandits" (q.v.) – reduce this size to only 100 shares. A trader can use SOES for a given stock once every five minutes. Source: Cory Johnson, "Easy Money: Is the NASD's SOES Attack a Ticking Time Bomb?" TheStreet.com (3/3/97).

 

Sonia

Sterling Overnight Interbank Average (q.v.). An average of the rates that London's largest money brokers pay for overnight deposits on a given day.

 

Special Purpose Vehicle (SPV)

A merger of a bond and a derivatives trade into a single contract. For example, one SPV might consist of a fixed rate bond plus a Swap in which the owner of the bond pays fixed and receives floating. Thus, the SPV is equivalent to a floating rate bond. Examples include the ARGO, EX, LASER, SIRES, and STEERS – all of which (q.v.). (Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html)

 

Spiders

Essentially, shares in a trust that owns shares of stock in the same proportion as the S&P 500 stock index portfolio. Spiders are a.k.a. Standard & Poor's Depositary Receipts (SPDRS), and have ticker symbol SPY. The Spider portfolio contains one-tenth of the S&P 500 index portfolio, so it sells for about a dollar amount equal to about one-tenth of the S&P 500 index level. Spiders trade on the American Stock Exchange like ordinary shares, which gives then continuous liquidity while the market is open, the ability to sell short, and ordinary stock transaction costs. Spider's distribute dividends of their underlying stocks quarterly, and do not reinvest them in the meantime, which costs shareholders in rising markets and profits them when the market tumbles.

 

Spiders compete directly with S&P 500 index funds. Investors are stuck in these funds until after each day's market closes. However, transaction costs may be zero. No-load mutual funds often reinvest dividends promptly and without transaction costs.

 

(Source: Vanessa O'Connell, "'Spiders' Offer Another Way to Scale S&P 500's Heights", Wall Street Journal, 3/11/95.)

 

SPINs

Standard & Poor's 500 Index Notes (q.v.).

 

Split Fee Option

An option on an option, in which the buyer makes from one to three payments. The buyer may pay a premium up front, may make a second payment (the second premium, hence the name Split Fee, also known as the first strike price) to keep the option alive, and may make a third payment (the second strike price) to exercise the final option. Also known as a Compound Option (q.v.). A special case of an Installment Option (q.v.).

SPOOs or SPUs

S&P 500 index futures – from its ticker symbol: SPU.

spot date

The date from which interest starts accruing in a fixed income transaction. In the USD swap market (1999), typically, two business days after the transaction date.

spot/next

From the spot date to the following business day.

spot rate

The interest rate from today to the spot date. When the spot date is two business days hence, rates for overnight (q.v.), tom/next (q.v.), and spot date (q.v.) satisfy the following equation:
(1 + r_o/n × t_o/n ) (1 + r_t/n × t_t/n ) = (1 + r_spot × t_spot ).

spread trade

Definition: A trade that profits from a positive move in one risk factor and a negative move in another.

Examples: Long September gold futures and short December gold futures is a calendar spread trade that highlights the difference between gold delivered at the two dates. Other spread trades include: stereo trade (q.v.) , tailed calendar spread (q.v.) , tandem spread (q.v.) , and turtle trade (q.v.).

Pricing: A calendar spread trade can be the basis for cash-and-carry arbitrage, which establishes a relationship between two forward prices.

Risk Management: A simple calendar spread trade cannot establish the relationship between two futures prices, despite the popular belief that it can.

Comment:

Reference: Geoffrey Poitras, "Turtles, Tails and Stereos: Arbitrage and the Design of Futures Spread Trade Strategies," Journal of Derivatives 5, Winter 1997, pp. 71-87.

Standard & Poor's Index Notes (SPINs)

One of Salomon Inc's proprietary, listed (American Stock Exchange) debt securities. SPINs pay no interest and settle in cash. At maturity they pay the maximum of par and an amount equal to K times the current value of the S&P 500 Index level. Throughout most of a SPINs' life the owner can exchange it for cash equal to K times the value of the current S&P 500 Index level. (C.f. PEEQS.)

 

State and Local Government Series (SLGS or Slugs)

Definition: Special U.S. Treasury bonds with low yields and high prices that the Treasury issues for municipalities to use in advanced refundings of their municipal securities.

Application: The idea is to provide securities that will allow the municipalities to benefit from a drop in market interest rates, without giving them an excuse to engage in "tax arbitrage" by issuing tax-exempt debt, investing the proceeds in taxable debt, and keeping the spread without paying tax on it.

Source: Charles Gasparino, "Cities Have a Headache Thanks to Wall Street: It’s ‘Yield Burning’," WSJ, 8/26/97.

 

STEERS

Merrill Lynch's STructured Enhanced Return TrustS, originated in 1990. A kind of SPV (q.v.). (Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html)

 

Step-Down Preferred Stock

Corporate Preferred Stock that a REIT issues, as part of a tax avoidance plan that the IRS declared abusive in 2/97. The parent corporation would set up a REIT that issued preferred shares and lent the proceeds to the parent. The parent then paid tax-deductible interest on the loan to the REIT, which paid tax-deductible preferred dividends (unique to REITs) to its shareholders, who were ordinarily tax exempt. The tax treatment is similar to that of interest on debt that a taxable corporation pays a tax exempt investor. The preferred dividend was typically large, initially and for up to about ten years, then much smaller. Cf. MIPS.

 

The arrangement exploded in popularity during February 1997, with Freddie Mac the most prolific issuer. Morgan Stanley and Bear, Stearns were major underwriters of such issues. The IRS responded to this growth by shutting down this type of security, claiming that it abused the federal tax system.

 

(Robert D. Hershey, Jr., "Newly Popular Corporate Investment Banned as Tax Dodge," New York Times, pp. D1 et seq.)

 

Step-Payment Option

A "free" ordinary European Option, minus a portfolio of Binary Options with successively higher or lower Strikes. For example, for no premium paid up front, party A receives a European Call Option struck at 100 in return for making one payment if the underlying price goes to 98, another if the price goes to 96, etc.

 

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.

Comment: Step Up Bonds are available with different credit qualities. Issuers include federal agencies, blue chip corporations, and lesser corporations. Credit risk can be a significant issue.

Source: For a thorough, nontechnical description and analysis, see Marilyn Cohen, "Step up to the plate," Forbes, 1/26/98, p. 112.

 

Sterling Overnight Average

An index of overnight GBP interest rates that weights its components by volume. (Source: IFR's online version of "Derivatives: Action in Japan," IFR, 5/3/97, http://www.ifrpub.com/ifrstart.htm)

 

stereo trade

A tailed tandem trade (q.v.), with tails designed to produce calendar spread payoffs that depend on the implied repo rates.

 

Sticky Floater

A One Way Floating Rate Note (q.v.).

 

Stock Market CD

A CD (q.v.) that pays a rate of interest that depends on the rate of return on an underlying equity instrument.

 

Stock Upside Note Securtiies

Lehman Brothers' listed, senior debt securities that offer upside participation in the value of a basket of shares, with limited downside risk. The SUNS is equivalent to a position in the underlying basket, plus a protective put.

 

For example, Lehman offered SUNS with an underlying basket of 20 regional bank stocks, and offers SUNS with an underlying basket of 24 international telecommunication stocks.

 

Straddle

An option portfolio consisting of one Call Option and one Put Option, both with the same underlying, direction (long or short), strike, and expiration date.

 

Strap

A Straddle (q.v.) plus another one of the Call Options.

stress test

Definition: A test of a model for pricing or risk management, using an extreme scenario or family of scenarios.
Example: For example, you might price your portfolio, using market conditions at the time of the crash of 1987, or assuming a three-standard-deviation move in prices, or a 100-year move in the forward curve.
Application: You can use a stress test to find out a model’s breaking point.
Pricing: As you move a European barrier call option’s barrier away from the spot price, the option’s value approaches that of an ordinary European call.
Risk Management: Stress-testing of VaR systems is commonplace.
Comment:

strip

1. A Straddle (q.v.) plus another one of the Put Options.
2. A portfolio of similar options, but with different expiration dates and each with an underlying that depends on the expiration date. E.g., an Interest Rate Cap is a Strip of Call Options on LIBOR for consecutive, nonoverlapping accrual periods.
3. A cash flow at a single date, stripped from a note or bond. The Strip could be all or part of either a coupon payment or a principal payment.

structured product

Essentially a portfolio of securities and other (often, Vanilla) Derivative Products, although the dealer that creates it hopes the customer doesn't realize this. A Financial Engineer assembles a Structured Product from readily available Swaps, Options, etc., much the way a designer might assemble a prototype PC from components imported from all over the world.

 

STRYPES (sm)

Structured Yield Product Exchangeable for Stock (sm) (q.v.). A debt product that

• Merrill Lynch and DLJ underwrote,
• is listed on the American Stock Exchange,
• pays a quarterly interest payment, and
• converts at maturity into a number of shares (between 0.8403 and one) that a mathematical formula defines.

For example, let the initial price be X(0)=$14.00 and the "Threshold Appreciation Price" equal $16.66. Then the number of shares upon conversion is

Terminal Price X(T)	# of Shares upon Conversion
X(T)<$14.00	1.0000
$14.00<X(T)<$16.66	14.00/X(T)
$16.66<X(T)	0.8403

 (Source: American Stock Exchange Press release.)

stub Risk

"[T]he risk that interest rate outlooks based on the performance of the front contract in any given futures strip will prove premature." (Source: IFR's online version of "Derivatives: Action in Japan," IFR, 5/3/97, http://www.ifrpub.com/ifrstart.htm)

 

SUNS

Stock Upside Note Securities (q.v.).

 

4/28/00 super replication

Producing returns from a portfolio of financial instruments that precisely match or exceed the returns from another instrument.

 

swap

The exchange of a sequence of cash flows that derive from two difference financial instruments. For example, the party receiving fixed in an ordinary Interest Rate Swap receives the excess of the fixed coupon payment over the floating rate payment. Of course, each payment depends on the rate, the relevant day count convention, the length of the accrual period, and the notional amount.

 

synthetic IO-ette

A REMIC (q.v.) bond with a small principal amount and a huge coupon rate. It absorbs some of the interest payment when market conditions demand that most REMIC bonds have a lower coupon than the collateral. (Its coupon must be less than 1200% for an Agency IO-ette, because of limitations of the Fed's Book Entry system).

 

(Source: "Derivative Mortgage Securities Glossary," Dean Witter, Mortgage Backed Securities Department, Derivative Products Group, January 1995.)

 

swaplet

A Swap (q.v.) that has a single payment.

 

swaption

An option on a Swap (q.v.).

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tailed calendar spread

A calendar spread trade (q.v.) involving one long position and one short position of different sizes (in contracts).

 

tandem spread

A spread (q.v.) consisting of calendar spreads in two commodities.

 

Tanker Freight Swap

A Swap (q.v.) with payoffs that depend on an average of tanker shipping rates. Citibank and Mallory Jones introduced the OTC product ca. 1996 November. (Source: Hampton, Michael. "The shipping forecast." FOW (November 1996): 12-13.)

TED Spread

Definition: The U.S. T-Bill futures price minus the Eurodollar futures price, the premium that lenders require hold Eurodollar deposits, rather than Treasury bills.

Example: For example, if the T-bill futures price is 93.60 (corresponding to a T-bill yield of 6.40%) and the Eurodollar futures price is 92.80 (corresponding to a Eurodollar deposit rate of 7.20%), then the TED Spread is 93.60 - 92.80 = 0.80. One would say that the TED Spread is 80.

Application: If you think the Eurodollar credit quality will improve, hence the TED Spread will narrow, then you would sell the spread, going short T-Bill futures and long ED futures.

termination structure

A design for a DPC (q.v.) that liquidates when the related name defaults. Cf. continuation structure.

tom/next (t/n)

From tomorrow to the following business day.

tom/next rate

The interest rate from tomorrow to the following business day. When the spot date is two business days hence, rates for overnight (q.v.), tom/next (q.v.), and spot date (q.v.) satisfy the following equation:
(1 + r_o/n × t_o/n ) (1 + r_t/n × t_t/n ) = (1 + r_spot × t_spot ).

Total Return Swap

Definition: The synthetic purchase of risky debt with 100% leverage. One of the counterparties receives (and the other pays) the excess of the risky debt’s total rate of return (interest plus capital gain) over LIBOR. A swap that has a floating payment that depends on the value of the remaining payments, hence depends on how likely it appears that the payer will make good its promise to pay. 
Examples:

• A counterparty in a junk bond swap receives the total rate of return on a portfolio of junk bonds and pay LIBOR.
• A bank loan swap might pay the total rate of return on a risky bank loan and receive LIBOR. In particular, Bankers Trust has offered swaps that pay the return on loans that fund the merger of Ralph’s Supermarkets and Yucaipa Companies’ Food 4 Less (Derivatives Week, 11/7/94).
• A counterparty might receive the total return on some risky corporate bond and pay LIBOR minus a fixed spread.

Application: See Credit Derivatives.

Pricing and Risk Management: The replicating portfolio for Total Return Swap is the levered purchase or sale. Consequently, its value is the value of the replicating portfolio, and its hedge is the sale of the replicating portfolio. Thus, the dealer providing this swap could hedge his position by buying the risky corporate bond and financing the purchase with a floating-rate loan. 
Comment: Why doesn’t the customer just do this, directly? The customer may not be able to deal with counterparties with low credit ratings. The dealer might have a higher credit rating. Of course, this looks like a way around regulations.

 

Total Return Option

Definition: A Put Option (q.v.) on debt with credit risk.

Example: A customer fearing a default on his debt could pay a premium for a put option that allows him to sell a risky corporate bond at par if the corporation defaults on any of its debt.

Application: See Credit Derivatives.

Pricing: A standard model for pricing equity options would be a good starting place for pricing a Total Return Option.

Risk Management: One might try to hedge this dynamically with the underlying risky debt.

Comment: Pricing and hedging might be difficult, and market manipulation may be an issue for a thinly traded underlying instrument.

trading post

A location on the floor of a stock exchange where market makers (such as "specialists") and traders come together to determine value for shares in a number of corporations. 

 

tranche

One of the classes of claims making up a CMO (q.v.).

TruPS Units

Trust Preferred Stock Units (q.v.).

Trust Preferred Stock Units

Each unit of Salomon's TruPS issue of 7/3/96 consists of a 9.25%, mandatorily redeemable preferred security of the SI Financing Trust I ("the Trust") and a contract requiring the holder to purchase in 2021 (or earlier, at Salomon's option) 1/20 of a share of Salomon's 9.5% Series F Preferred Stock.

Salomon set up the Trust to issues the TruPS and common shares and invest the proceeds in Salomon's 9.25% secured debt. Also, Salomon contributes 0.25% each year under the terms of the purchase contract. This structure allows Salomon to deduct interest coupon payments to the trust, which pays preferred dividends to investors who would prefer dividends to coupons.

turtle trade

A tailed spread (q.v.) in a commodity, plus a position in interest rate futures.

T+1

Next day, the business day after trade date. The SEC wants firms involved directly in securities trades – shares, bonds, and futures – to settle by T+1. This is supposed to happen by 2002. The current system (since 1995) calls for settlement by T+3, three business days after trade date. T+5 was the old method of settling trades in five business days, typically a calendar week. T+0 means same-day settlement.

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