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

Derivatives Dictionary^TM (A-J) 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 #

- 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: 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.

- 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.)
Bernoulli Option: See Introducing: the Bernoulli Option in "Derivative Games".

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.
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.
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.; Comment: Not for the timid or naive.; Source: Cecile Gutscher, "SEC Is Examining Whether Some Underwriters Are Marketing Bonds at Artificially Low Yields", Wall Street Journal, 5/2/97).
8/28/01 Bulldog bond: Definition: A bond, denominated in British pounds sterling, that a non-U.K. company or government 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) . (Source: http://www.exchange.de/dtb/BUND-future.html)
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.

- C -

cabinet trade: A trade that allows options traders to close out deep out-of-the-money options by trading at a price equal to one-half tick. (Elizabeth Lekan, Chicago Mercantile Exchange)
calendar spread: A spread trade (q.v.) involving one long position and one short position.
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.
Cap: A strip of Caplets (q.v.) - that is, a portfolio of Caplets with sequential accrual periods. Also known as a Ceiling.
Caplet: An Interest Rate Option to pay fixed in an FRA (q.v.). Its payoff is proportional to that of a Call Option on a floating rate of interest.
Caption: An option on a Cap (q.v.).
car: The size of one futures contract, based on the idea that some commodity futures contracts historically called for the delivery of one railroad car of the underlying commodity.
carry trade: Definition: A trade that consists of borrowing and paying interest in order to finance the purchase of an investment that pays a greater interest or a dividend stream.
Example: In a single currency, borrowing short-term and buying bonds leads to a carry that is the coupon minus the interest on the borrowing. The yen carry trade consists of borrowing yen in the Tokyo market and paying the currently (1999) low yen rate, buying dollars in the spot market, and buying dollar bonds paying higher coupons.
Application: The idea is to collect the positive carry, interest and dividends received, minus interest paid.
Pricing: The trade is initially worth about zero, except for small transaction costs.
Risk Management: The major risk is the depreciation in price of the long asset and appreciation in price of the short asset. However, if you get rid of that risk, then you essentially take off the trade.
Comment: The yen carry trade has been a popular trade for hedge funds and others, with the yen rate around one percent and the dollar rate around five percent. However, by 6/12/99 Gretchen Morgenson was able to write, "The dollar fell 2.5 percent against the yen in four days of trading." That’s an annualized, continuously compounded rate of about 950%!
Source: Gretchen Morgenson, "Once Again, Wall St. Worries About Hedge Funds," New York Times, 6/12/99.
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.)
CD: Certificate of Deposit (q.v.).
Ceiling: A Cap (q.v.).
Certificate of Deposit: A sort of bank savings account that ties up the depositor's money until the certificate matures, and acts more like a bill, note, or bond than a traditional savings account.
CFD: Contract for Difference (q.v.).
CHIPS: Common-Linked Higher Income Participation Securities (sm). Bear Stearns' proprietary Equity Linked Debt Security (q.v.).
clean price: Definition: The quoted bond price without the accrued interest. (Cf. dirty price.)
Application: In the U.S. bond market, if you ask your broker a bond's price, he quotes the clean price. However, your check for that amount would be insufficient to buy the bond, because you must also pay the amount of the accrued interest since the previous coupon date.
CMO: Collateralized Mortgage Obligation (q.v.).
CMT Derivative: A Derivative Product, such as a Swap or Option, based on the CMT Yield (q.v.). These are tricky to price.
CMT Yield: Constant Maturity Treasury Yield. Every day the Federal Reserve Board publishes the yield for a hypothetical Treasury having each standard maturity, such as two years, even though such an instrument doesn't exist. Every time the Fed issues a new, on-the-run Treasury, the CMT yield equals the observable market yield. Between those issue dates the CMT and closest on-the-run yields can differ.
Collar: A portfolio of two options with the same underlying risk factor and expiration date: a long call with a higher strike and a short put with a lower strike. An investor with long (short) exposure to the underlying factor can go short (long) a collar, retaining exposure to the factor within a range, while limiting downside exposure at the cost of upside potential.
Collateralized Bond Obligation (CBO): Definition: An ABS (q.v.) structure similar to a CMO (q.v.), but with a portfolio of bonds as collateral, instead of a portfolio of Mortgage Backed Securities (q.v.) and/or mortgage loans. A sponsor transfers the collateral into a Special Purpose Vehicle (SPV), such as a trust or corporation, which has no other assets and which issues claims. A typical CBO has more than one "tranche" or "tier", and a more junior tranche has more risk of default.; Example: For example, a CBO might have senior, junior (or mezzanine), and subordinated (or equity) tranches. The senior tranche, like senior debt, has first claim on the collateral’s cash flows to cover its interest and principal payments. The junior tranche has second claim. The equity tranche claims the residual.; Application: Junk bond money managers create CBOs to create highly rated bonds and highly speculative "equity" out of a portfolio of junk bonds.; Pricing: Predicting default rates is the most difficult aspect of pricing these bonds.; Risk Management:; Comment: Agencies, such as Moody’s Investors Service and Standard and Poor’s Corp., assign credit ratings.; Source: (Pimbley, Joseph. "LC: Evaluating Risk in Russian Roulette Notes and CBOs." DW, 7/17/95, p. 7.)
Collateralized Loan Obligation (CLO): Definition: An ABS (q.v.) structure similar to a CMO (q.v.), but with a portfolio of commercial or personal loans as collateral, instead of a portfolio of Mortgage Backed Securities (q.v.) and/or mortgage loans. A sponsor transfers the collateral into a Special Purpose Vehicle (SPV), such as a trust or corporation, which has no other assets and which issues claims. A typical CLO has more than one "tranche" or "tier", and a more junior tranche has more risk of default.; Example: A CLO might have senior, junior (or mezzanine), and subordinated (or equity) tranches. The senior tranche, like senior debt, has first claim on the collateral’s cash flows to cover its interest and principal payments. The junior tranche has second claim. The equity tranche claims the residual. For example, National Westminster transferred $5 billion of loans from its balance sheet to an asset-backed trust October 1996 and created an early and large CLO.; Application: Some commercial banks have created CLOs to create highly rated bonds and highly speculative "equity" out of a portfolio of loans. A CLO allows a bank to remove loans from its balance sheet and reduce its required reserves, yet keep contact with the borrowers and fees from servicing the loans.; Pricing: Predicting default rates is the most difficult aspect of pricing CLOs. In the case of investment grade loans, this is less of a problem than it is with problem loans.; Risk Management:; Comment: Agencies, such as Moody’s Investors Service and Standard and Poor’s Corp., assign credit ratings.; Source: Jodi D'Amico, "COLLATERALIZED LOAN OBLIGATIONS -CHANGING THE WAY BANKS DO BUSINESS," http://www.van-kampen.com/nz/Fixed_Income_Newsletter/23-3.htm.

Collateralized Mortgage Obligation (CMO): A portfolio of claims against a portfolio of mortgages and/or Mortgage-Backed Securities. The claims separate naturally into "tranches" that differ by the rules defining their interest and principal payments. One of the charms of the CMO is the wide range of possible rules. However, the sum over all tranches of the CMO interest (principal) payouts must equal the sum over all mortages and/or MBS's of interest (principal) payments – except for any difference due to servicing or the issuer's residual. The CMO is archaic, and the REMIC (q.v.) is a more current vehicle for derivatives of a portfolio of mortgages.

Commission Bancaire

The French Banking Commission. The Banque de France’s "general secretariat" for enforcing compliance of French credit institutions with applicable laws and regulations, as well as principles of good business practice and standards of sound finances. http://www.banque-france.fr/us/finance/regle/3c.htm

Common Share

A sort of Call Option (q.v.) on the assets of the corporation, because the common shareholder gets those assets if he pays off everyone else with a claim against the assets. The Common Share represents a fractional ownership interest in the corporation, it has voting rights, and may receive a dividend.

Common Stock

A collective term for Common Shares (q.v.).

Compound Option

An option on an option. Also known as a Split Fee Option (q.v.). A special case of an Installment Option (q.v.).

concentration risk

According to "Risk Concentrations Principles," which the BIS released in 12/99, risk concentrations in financial conglomerates come in seven categories of exposures, to: individual counterparties, groups of individual counterparties, counterparties in specified geographical locations, counterparties in industries, counterparties in products, key business services (such as back-office services), and natural disasters. (BIS Examines Concentration Risk, 2/2000, p. 11.)

Confirm

Confirmation (q.v.).

Confirmation

A document that defines a Derivatives contract that a dealer has just entered with a customer. The Confirmation ordinarily incorporates one or more ISDA (q.v.) documents by reference. The Confirmation comes after the oral agreement – ordinarily over the telephone – which the dealer ordinarily records and saves for months.

continuation structure

A design for a DPC (q.v.) that does not liquidate when the related name defaults. Cf. termination structure.

Continuous Accrual Currency Option with a One-Touch Knock-out Range

A Derivative Product that accrues nominal value at a constant rate for every day that the index exchange rate stays within the accrual range, then loses all value when the index strikes either side of the knock-out barrier range. (Source: Victor Kremer and William Rhode, "Dollar Gyrations Lead Investors to Exotics," Derivatives Week, 2/3/97.)

The term, "Option", is a misnomer, because no one has a true option, not even one as trivial as for an ordinary European Call Option.
The product's value is a decreasing function of volatility. Thus, during a period of high anticipated volatility it is possible to buy the product inexpensively. If the index remains within the range, then the percentage payout is relatively large.

Contract for Difference

Definition: An OTC Currency Forward Contract that settles for a cash amount, perhaps in a third currency, without requiring the exchange of the two underlying currencies.

Example: Instead of settling a Forward Contract by having party A deliver 10,000,000 DEM (worth 6,000,000 USD) in Germany and party B deliver 600,000,000 JPY (worth 6,100,000 USD) in Tokyo, party B would deliver the net dollar value of the two payments (100,000 USD) in New York.

Application: The CFD would reduce the problem of Herstatt Risk (q.v.).

Pricing: Prices for the two legs of the transaction should be readily visible in the liquid currency markets.

Risk Management: This tool is for managing market risk, while managing settlement risk.

Comment:

Source: Laure Edwards, "Chase Manhattan Offers an Answer to BIS Concerns," Financial Trader 4 (June 1997), p. 7.

Convertible Bond

A Bond that the owner can convert into Common Shares under specific terms. A Convertible Bond is an ordinary Bond, plus the option to exchange the Bond for the Shares.

Convexity

The sensitivity of a financial instrument's Modified Duration (q.v.) to its yield.
The second derivative of a financial instrument's value with respect to its yield.

Corridor Note

An Accrual Note (q.v.).

"Costless" Collar

Definition: A Collar (q.v.) in which the proceeds of the sale of the short Call option exactly finance the purchase of the long Put option.

Application: This strategy helps a trader get close to "flat". This can be particularly useful for a money manager who is close to having a good measurement period and doesn't want to screw it up in the last moment. Also, it may be a good tax play for an investor who really wants to sell out, but doesn't want to pay capital gains taxes.

Comment: The term may mislead beginners in Derivatives markets, who might take it at face value. However, of course, the dealer or market maker wouldn't do the trade at no cost. In fact, the cost is roughly the bid-ask spread of one of the Collar's component options. Particularly in OTC option markets, the name, "Costly Collar", would be more appropriate, because bid-ask spreads require the buyer to give up much upside participation for little downside protection.

Credit Default Swap

A Swap in which A pays B the periodic fee, and B pays A the floating payment that depends on whether a predefined credit even has occurred, or not. The fee might be quarterly, semiannual, or annual. The floating payment would likely occur only once, and might be proportional to the discount of the reference loan below par. The credit event might be a declaration of bankruptcy or violation of a bond indenture or loan agreement.

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.

Credit Linked Note: Definition: A note that pays interest and repays principal that depends on a credit event, such as bankruptcy and default.; Example: Swiss Bank Corporation issued global floating rate notes, which it would redeem for 51% of par value or 100% of the value of a reference security (a similar bond from the same issuer, less the credit exposure), if a particular credit event occurs.; Application: The usual, speculation and hedging.; Pricing:; Risk Management:; Comment:; Source: "Swiss Bank Ready to Offer Big Note Issue," WSJ, 9/7/97.

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.

Credit Option on Brady Bonds (COBRA): A credit spread option (q.v.) with a payoff that depends on the yield spread between a Brady bond and another bond – usually, a comparable maturity Treasury. (Gary L. Gastineau and Mark P. Kritzman, Dictionary of Financial Risk Management, Frank J. Fabozzi Associates, 1996.)

Credit Risk: The risk of loss from not receiving one's reward for being on the right side of a bet about a market move, due to the losing counterparty's failure to meet his obligations.

Credit Spread: 1. An option spread trade – long one option, short another – that generates cash.
2. The excess of the yield on a note with credit risk over a comparable note without credit risk.

Credit Spread Option: Definition: An Option with a payoff that depends on a Credit Spread (q.v.).; Example: A one-year European Call (q.v.) on Mexican par bond credit that pays
Max[0, 147 bp - (Mexican Brady Bond Yield - Yield on corresponding U.S. Treasury)].; Application: To spread credit risk associated with lending or assume credit risk without lending.; Pricing:; Risk management:; Comment:

Credit Spread Swap: Definition: A Swap with a payoff that depends on a Credit Spread (q.v.).; Examples: A Swap with a Floating Leg () that depends on the Credit Spread.; Application: A lender who might share its credit exposure to a risky counterparty.; Pricing: Requires advanced techniques or SWAG Pricing (q.v.).; Risk management: Dynamic Hedging (q.v.) based on PV01s (q.v.), etc.; Comment: Not for the cautious.
Credit Swap: Definition: A Swap whose value depends on underlying credit quality, preferably without bearing ordinary interest-rate risk.; Examples: A Total Return Swap (q.v.) with underlying risky debt might qualify, although this has a heavy dose of interest rate risk. An Outperformance Swap, with a payoff proportional to the excess of the rate of return on the risky debt over the rate of return on a comparable Treasury bond, would be a clearer example. A Total Return Swap plus an ordinary Interest Rate Swap () that offsets the interest rate risk. The exchange of a constant fee per period versus a binary floating payment of either zero or a Credit Event Payment. A Credit Spread Swap.; Application: See Credit Derivatives for applications.; Pricing and Risk management: See the specific type of Credit Swap.; Comment: Pricing and hedging might be difficult, and market manipulation may be an issue for a thinly traded underlying instrument.

Cross Currency Option: Definition: An option to exchange units of one currency for units of another, as seen from the point of view of a third currency. A Margrabe Option (q.v.) with underlying currency risk.; Example: A New York trader might consider an option to pay 1.5 DEM for 100 JPY as a Cross Currency Option. A trader in Frankfurt might call that a call on yen. A trader in Tokyo might consider it a put on Deutschemarks.

Cross Currency Swap: A Swap (q.v.) that involves payments in two currencies. For example, the fixed payment might be in DEM and the floating payment might be proportional to JPY LIBOR. In addition, the swap involves an exchange at maturity of Notional Amounts (q.v.) in the two currencies at the original exchange rates.

crossed market: A market where the bid (q.v.) exceeds 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 crossed 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 cross. However, a crossed market indicates an arbitrage opportunity and cannot last, in equilibrium.

CUBS: Customized Upside Basket Securities (q.v.). Bear Stearns's proprietary debt securities, with participation in moves in an average over time of the index value of a basket of securities, but with downside protection. The underlying average equals an arithmetic average of the index values on the 24th of each month from issue through maturity. Thus, the underlying price is an average, and any optionality is an option on an arithmetic average. The holder may not redeem CUBS before maturity.

For example, Bear Stearns listed a CUBS issue on 7/25/95 that matures on 7/24/98. The underlying index is a mischmasch of biotech, energy, and other stocks. The CUBS issue price is $3.33. The CUBS gives 90% participation in price moves. The minimum payoff is $3.00.

currency swap: The exchange of specified amounts of currencies on one (nearby) date, exchange of specified amounts of currencies in opposite directions on a future date, and (possibly) exchange of specified coupons in between. A currency swap is like the exchange of bills, notes, or bonds in different currencies.
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.

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DAXâ: A stock performance index (dividends added in) composed of the 30 most actively traded German blue chip stocks on the Frankfurt Stock Exchange. (Source: http://www.exchange.de/fwb/indices.html#dax)

DAXâ Futures: A cash-settled Futures contract based on the DAXâ (q.v.) stock performance index. (Source: http://www.exchange.de/dtb/daxfuture.html)

DAXâ Futures Option: An American option that settles into a DAXâ 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/daxfuture-option.html)

DAXâ Option: A cash-settled, European option on the DAXâ (q.v.) stock performance index. (Source: http://www.exchange.de/dtb/daxoption.html)

DCS: Direct Credit Substitute (q.v.).

deck: A floor broker's (q.v.) stack of customer orders.

Degree-Day: A unit of measure for the deviation of a day's average temperature from the arbitrary standard of 65 degrees Fahrenheit. The U.S. Energy Information Administration publishes indexes of accumulated Degree Days. If the average temperature one day is 75 (55) degrees, then the index increases (decreases) ten Degree-Days on that day. Degree-days come in two varieties – Heating Degree-Days and Cooling Degree-Days. When the average temperature is above (below) 65 degrees, then the number of cooling (heating) Degree-Days increases.; (Source: Victor Kremer, "Utility to Make First Use of Degree-Day Swaps, Derivatives Week, 5/5/97.)

Degree-Day Swaps: A Swap (q.v.) that receives (pays) a floating payment proportional to the change in Degree-Days (q.v.) over the accrual period, and pays (receives) a fixed payment. Dealers of such swaps claim that they are good hedges of heating costs, because (1) a negative number of Degree-Days over the accrual period results in (2) a positive number of Heating Degree-Days, which leads to (3) a negative floating payoff, which is (4) a hedge for the resulting positive heating costs, because (5) a large number of Heating Degree-Days translates into both a large volume of energy and a high price for it. (Source: Victor Kremer, "Utility to Make First Use of Degree-Day Swaps, Derivatives Week, 5/5/97.); However, this argument has some problems. First, energy cost is a U- or V-shaped function of Degree-Days. Heating Degree-Days lead to heating costs, and Cooling Degree-Days lead to cooling costs. Second, nobody knows what that function is. Consequently, Degree-Days Swaps will have some Basis Risk (q.v.).

Delivery Point: In a Futures Contract (q.v.) the location where the short must deliver the underlying "commodity" to the long. This can be crucial in the case of physical products, transportation bottlenecks can make it easier for the longs to squeeze the shorts. In April, 1996, the CBOT tried to eliminate Toledo, Ohio as a delivery point. Farmers and processors who favored delivery there complained to the CFTC, which delayed approval of the change in the contract. (Source: "CBOT Gets Warning Concerning Changes in Certain Contracts, WSJ, 5/6/97.)

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.).

Digital Option: A Binary Option (q.v.).

Direct Credit Substitute: The Federal Reserve Board's term for a credit enhancement, that is, a means of improving the credit quality of a loan or a bond.

dirty price: Definition: The quoted bond price, including the accrued interest. (Cf. clean price.)
Application: In certain non-U.S. bond markets, if you ask your broker a bond's price, he quotes the dirty price. Thus, your check for that amount would be sufficient to buy the bond.

Discount rate: The rate of interest that the Bundesbank (Buba) charges for granting "rediscount credit". Typically, the discount rate is the lowest rate at which the Buba lends.

domestic market: The securities market in a country where securities of that country’s companies and governments trade.; Example: Bank of America securities that trade in the U.S. trade in the domestic market.; Source: http://www.jobs.washingtonpost.com/wp-srv/business/longterm/glossary/a_m/domestic_market.htm

DPC: Derivative Products Company (q.v.).

DTB: Deutsche Terminbörse. The Futures and Options Exchange associated with the Frankfurt Stock Exchange (Frankfurter Wertpapierbörse, FWB) in Frankfurt, Germany.

Duration: 1. A weighted average of the number of years until a financial instrument's cash flows (e.g., a bond's principal and each of its coupons) arrives.; 2. A measure of the sensitivity of the value of a financial instrument (i.e., a sequence of cash flows) to a change in its yield to maturity. The two main variants of Duration are Macaulay Duration (q.v.) and Modified Duration (q.v.).

DV01: The change in the dollar value of a bond (conventionally, one with a Par Value of 100) when its yield falls one basis point. Also known as PV01, PVBP, DVBP.

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ECB: European Central Bank (q.v.).

ECN: An acronym for either electronic communications network or electronic crossing network. An electronic market place. Examples are Island and Archipelago. At least one ECN is able to submit orders directly to NASDAQ and some may be applying to the SEC to qualify as stock markets.

Edge Act Corporation, Edge Corporation: Definition: A bank subsidiary corporation with a federal or state charter, created under the Edge Act (1919) to engage in international banking and investing. FRB Regulation K defines the equivalent "Edge Corporation" as a corporation formed under section 25(a) of the Federal Reserve Act (12 USC 611-631). (Source: Federal Reserve System Regulation K, 12 CFR 211; as amended effective October 8, 1993.)
Application: Unlike its U.S. parent bank, the subsidiary can own a bank outside the U.S. and can invest in foreign commercial and industrial corporations.
Comment: The motivation of the act was to allow U.S. firms more flexibility in competing with foreign firms.

ELKS: Equity Linked Securities (sm). Salomon Brothers Inc's proprietary Equity Linked Debt Security (q.v.). A debt obligation of Corporation A, equivalent to a buy-write on one share of Corporation B. The ELKS is like a PERCS (q.v.), except that the company that issues the stock issues the PERCS, and another company issues the ELKS. Salomon Brothers Inc issued the first ELKS in 1993.

Embeddo: An Embedded Option.

Endowment Warrant: A Call Options on shares, where the strike price grows at the rate of interest, but shrinks by the amount of the dividends that the share pays. In essence, the buyer of an Endowment Call Warrant uses the dividends from the shares to pay off the strike price, but is not obligated to complete the transaction. If at expiration the balance reaches zero, then the buyer may take delivery without further payment. If the balance reaches a positive amount, then the buyer may pay that amount and take delivery. If the balance reaches a negative amount, then the buyer may settle in cash for the value of the shares plus the absolute value of the balance.; (Source: Australian Financial Review Dictionary of Investment Terms.)

Equity-Linked Debt Security: Fixed-income, equity-linked debt securities of corporation A, that participate in the change in price of the "linked" common stock of corporation B.; Four main examples, listed on the American Stock Exchange, include Salomon Brothers' ELKS (sm) (q.v.), Bear Stearns' CHIPS (sm) (q.v.), Lehman Brother's YEELDS (sm) (q.v.), and Morgan Stanley's PERQ's (sm) (q.v.). These four pay quarterly interest at a fixed percentage rate.
(Source: http://www.amex.com)

Equity Swap: A Swap (q.v.) in which one of the payment streams derives from an equity instrument. For example, in one sort of ordinary Equity Swap, each period, Party A receives (and Party B pays) the capital gains on an equity investment of a given notional amount, while Party B receives (and Party A pays) a floating interest payment based on LIBOR and the same notional amount. This swap is practically equivalent to buying the underlying equity with 100% borrowing (zero margin) and realizing the gain or loss each period.; Equity Swaps are useful for obtaining leverage, avoiding withholding taxes, and enjoying the returns from ownership without legally owning anything.
7/28/00 equivalent: A concept in probability theory that means that two probability measures (q.v.) assign a probability of zero to precisely the same sets.
Example: If the probability space corresponding to two flips of a fair coin is W = {HH, HT, TH, TT}, and two probability measures, P(.) and Q(.), both assign a probability of zero to the empty set, P(Æ) = Q(Æ) = 0, and to no other set, then they are equivalent probability measures.
7/28/00 equivalent martingale measure: Any probability measure (q.v.) that is "equivalent" (q.v.) to the true probability measure, and under which a random variable (q.v.) -- such as an asset price or the ratio of two asset prices -- is a martingale (q.v.).
Application: In Arrow-Debreu equilibrium, there exists an equivalent martingale measure, under which the ratio of two asset prices is a martingale.
Euribor: Euro Interbank Offered Rate. The Brussels-based European Banking Federation’s Euro-denominated counterpart to LIBOR. As of January, 1999, Euribor seems to be winning its battle for acceptance over the British Bankers Association’s Euro LIBOR (q.v.), but London still hopes to win the war for the financial business. On 1/7/99 LIFFE announced plans for new contracts, based on five- and ten-year Euribor swaps.

Euroclear: A major system settling securities trades.

Eurojunk: High-yield corporate bonds of European companies. Of course, the high yield is compensation for a high probability of default.
For example, Richard Branson’s Virgin Group financed its new, V2 Music Holdings PLC label with L74 million in high yield bonds, rather than using a venture capitalist.

Euro LIBOR: The British Bankers Association’s Euro-denominated analog to dollar LIBOR. As of January, 1999, the European Banking Federation’s Euribor (q.v.) seems to be winning its battle for acceptance over Euro LIBOR, but London still hopes to win the war for the financial business. On 1/7/99 LIFFE announced plans for new contracts, based on five- and ten-year Euribor swaps.

European Central Bank: The institution that the European Monetary Union has put in charge of maintaining the value of its currency, the euro. (Dagmar Aalund, "What's the Euro?", The Wall Street Journal, 9/28/98.)

EX: One of J.P. Morgan's SPVs (q.v.). Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html)

Exchange Option: An option to exchange one asset for another. A Margrabe Option (q.v.).

Exotic Option: Any Option that is well out of the ordinary, hence not a "Plain Vanilla" Option. The list of Exotic Options changes over time. It grows as dealers innovate new and marvelous options, and shrinks as a jaded market grows accustomed to products that once thrilled it.

external market: The market outside a country’s borders for securities that its companies governments issue. The Eurosecurities market. Example: Bank of America debt that trades in Asia and Europe trades in the external market for securities of U.S. companies. Source: http://www.jobs.washingtonpost.com/wp-srv/business/longterm/glossary/a_m/external_market.htm

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fading a big dog: Buying (selling) when a big dog (q.v.) is selling (buying).

Fairway Bond or Note

Another name for Accrual Note (q.v.), Corridor Note (q.v.), or Range Note (q.v.). It accrues interest if and only if the index rate stays within a range (analogous to a golf ball staying on the fairway).

Fannie Mae: Federal National Mortgage Association. The largest player in the secondary mortgage market.

Fiona: Frankfurt Interbank Overnight Average (q.v.).

Flex Option: An exchange-traded options that does not have the standard terms of listed options. The customer and the market maker can negotiate various terms, such as strike price and expiration date.

Floor: A strip of Floorlets (q.v.). Cf. Cap.

floor broker: A local (q.v.) who trades for customer accounts, on commission.

Floorlet: An Interest Rate Option to receive fixed in an FRA (q.v.). Its payoff is proportional that to that of a Put Option on a floating rate of interest.

Floortion: An option on a Floor (q.v.).

floor trader: A local (q.v.) who trades for his own account, trying to buy low and sell high.

foreign market: The securities market inside a country’s borders for securities of foreign companies and governments. Example: Bank of America securities trade in Tokyo in the Japanese foreign market (the Samurai market). Nomura securities trade in New York in the U.S. foreign market (the Yankee market). Further examples are the Bulldog (q.v.), Matador (q.v.), and Rembrandt (q.v.) markets. Source: http://www.jobs.washingtonpost.com/wp-srv/business/longterm/glossary/a_m/foreign_market.htm
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.

Frankfurt Interbank Overnight Average: An average of overnight DEM interest rates that uses the Frankfurt market's fixing system. (Source: IFR's online version of "Derivatives: Action in Japan," IFR, 5/3/97, http://www.ifrpub.com/ifrstart.htm)

Freddie Mac: Federal Home Loan Mortgage Association. The second largest player in the secondary mortgage market.

front months: Futures contracts with delivery dates in the nearer future.

Futures Contract: An exchange-traded contract that on its last trading day settles into a Forward Contract (q.v.). The Futures Price and the corresponding Forward Price differ systematically in a world where interest rates are stochastic, and the difference depends on the correlation between the underlying spot price and the price of the zero coupon bond that matures on the last trading day.

Futures Option: A listed option that settles into a Futures Contract (q.v.).

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Gilt Strip: A Zero Coupon Bond that is either a coupon or the principal of a UK government bond, trading separately. The UK counterpart of Strips (q.v.) on U.S. Treasury notes and bonds.
Green Shoe option: Definition: An underwriter's right to issue more than the stated number of shares of an issue. Named after the Green Shoe Company, which was the first issuer to grant an underwriter such an option.
Application: For example, if Underwriter offers 1,000,000 of ABC's shares at $10 and investors oversubscribe the issue, Underwriter can require ABC to issue another 100,000 shares at $10.
Comment: It's good for Underwriter. It's good for the investors in the 100,000 shares. Not so great for the other shareholders, but two out of three ain't bad!
Source: IFCI, http://risk.ifci.ch/00011628.htm.

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Haircut: The excess of an asset's market value over either (a) the regulatory capital value or (b) the loan for which it can serve as adequate capital.

Hamster Option: A form of Range Option that SBC created. I can describe it no better than Professor S. Trautmann explained it to me: "The German noun Hamster has the same meaning as the English noun hamster: it is the name of a small rodent. But HAMSTER is also a acronym standing for Hoffnung Auf MarktSTabilitaet in Einer Range (literally: Hope on market stability in a given range). It really is a pun as in German the verb 'hamstern' has the meaning of 'to hoard'. HAMSTER options hoard the fixed amount one gets for every day the underlying stays in the prespecified range. What is earned cannot be lost anymore."

Hamster-Optionen: Hamster Options (q.v.).

Heavy Hitter List: A list of wealthy individuals who qualify as substantial investors for the purpose of investing in hedge funds, commodity pools, etc.

Hermaphrodite Option: An option that the owner could choose to be either a Call or a Put. Another name for a "AC-DC" option (q.v.).

Herstatt risk: Definition: The risk to Counterparty A in the settlement of a foreign currency transaction with Counterparty B, that A would deliver its payment to B, but B might not pay, as agreed. If A and B deliver their payments in different time zones, then Herstatt risk occurs regularly. However, in 1994 a report indicated that Herstatt risk lasts more than one day in a significant portion of transactions. The eponymous Bankhaus Herstatt defaulted on a number of currency transactions when it failed in 1974.
Example: Bank A might agree to deliver DEM in Frankfurt at 3 p.m., in exchange for Bank B’s delivery of USD in New York at 3 p.m. on the same day. Although the times appear the same, the New York delivery comes later, because of the difference in time zones.
Comment: The potential for Herstatt risk has increased enormously, over the past decades, as daily currency transactions increased from about $10 billion in 1973 and about $1.25 billion in 1995. Actual defaults have been few, but when Barings collapsed, it failed to deposit $47.8 million worth of pesetas in a Deutsche Bank branch in Spain. Efforts to avoid the problem include bilateral "netting" arrangements, extended hours for the FedWire system, and clearing houses.
References: "Ghostbusters," The Economist, 3/16/96. .

HH List: Heavy Hitter List.

Hurricane Bond: A form of Catastrophe Bond (q.v.), where the catastrophe is a hurricane. (Source: Sophie Belcher, "USAA to Try Again with Hurricane Bond, Derivatives Week, 5/5/97.)

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Index Amortizing Swap: A swap whose Notional Amount (q.v.) amortizes (declines) each period by an amount that depends on the level of one or more interest rates. This gives the IAS a superficial resemblance to a mortgage loan or mortgage-backed security, which has optional prepayment. This superficial similarity has been the basis for a sales pitch to institutions with a large prepayment risk to hedge. Alas, the basis risk is large enough to discourage intelligent, experienced – or even merely intelligent – professionals from hedging this way. The IAS – like the legendary House of the Rising Sun, in New Orleans – has been the ruin of many a poor boy.

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. (Wesley Phoa, "Inflation-Linked Bonds; are they too safe or too exciting?", Financial Trader 4 (2), p. 30.)

Installment Option: An option on an option on an option ...

Installment Warrant: Aussie for what is simultaneously a Compound Option (q.v.) and a Warrant (q.v.), and which apparently confers some of the benefits of ownership. "They involve two payments: an initial payment followed by a second, which includes fees and interest, paid optionally about 14 months afterwards. In the meantime, depending on the issuer, the instalments confer full dividends, franking credits and voting rights." (Source: Australian Financial Review Dictionary of Investment Terms.)

interest bought/sold date: The "value date" (q.v.). (J.P. Morgan Glossary of terms for global sovereign bond markets.)

Interest-Only (IO) Tranche: A CMO (q.v.) Tranche (q.v.) that receives a portion of only the CMO's underlying principal payments.

internal market: The securities market within the boundaries of a particular country, consisting of the domestic market (q.v.) and the foreign market (q.v.). Example: Most Daimler Chrysler debt trades in the German internal market. Source: http://www.jobs.washingtonpost.com/wp-srv/business/longterm/glossary/a_m/internal_market.htm

International Swaps and Derivatives Association: The principal trade association for Swap and Derivatives dealers, as well as allied organizations.

ISDA: International Swaps and Derivatives Association (q.v.).

Inverse Floater: A Floating Rate Note with a coupon that decreases as the underlying index rate increases (e.g., a simple Inverse Floater's coupon rate might be 11.5% minus LIBOR). The Replicating Portfolio (q.v.) for a simple Inverse Floater is long a pair of Fixed Rate Notes and short a Floating Rate Note. Commonly, an Inverse Floater's coupon has a ceiling and a floor, (e.g., no more than ten percent, never negative). Thus, its replicating portfolio is the same as for a simple Inverse Floater, plus long a Cap and short a Floor.

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Jamming

Definition: Executing a large sell (buy) order in stages by asking for a market on a small size, hitting the bid (offer), then repeating the process with a different market maker, ultimately driving the price considerably lower (higher).
Application: "It is entirely against proper market etiquette in foreign exchange and gold, but somewhat permissible in fixed income trading. You never jam a friend." (Nassim Taleb)

Jelly Roll

A roll that a trader does using synthetic Forward Contracts (q.v.). Each synthetic Forward Contract consists of a long call and a short put, on the same underlying instrument, with the same strike and expiration.

Jump Z

A last-pay "companion" (sort of residual) tranche of a REMIC (q.v.) that "jumps" into first-pay status if interest rates fall or prepayments are rapid. The desired effect of the jump provision is to promote positive convexity (like a bond), rather than negative convexity (like a mortgage) in another tranche.

(Source: "Derivative Mortgage Securities Glossary," Dean Witter, Mortgage Backed

Securities Department, Derivative Products Group, January 1995.)

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Derivatives DictionaryTM (A-J) Last revised: August 03, 2001

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Derivatives Dictionary^TM (A-J) Last revised: August 03, 2001