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

ÖDerivatives Dictionary^TM (K-T)  Last revised: 08/03/01

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 #

- K -

Kitchen Sink Bond or MBS

A bond or CMO into which issuers have dumped "everything but the kitchen sink," including "garbage" such as miscellaneous MBSs, CMO tranches, and derivatives. Some people call the contents of the KSB the "toxic waste" of derivatives transactions.

Issuers include agencies such as Fannie Mae or Freddie Mac and securities firms such as Bear Stearns and CS First Boston.

One selling point has been that their components are so diverse that some will increase in value while others decrease, thus reducing overall risk. However, in fact, in the middle of 1994 enough of the components went south to seriously hurt investors in some kitchen sink bonds.

 

Knockin Option

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

 

Knockout Option

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

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- L -

Ladder Option

An option somewhere between a Lookback (q.v.) and a European Option. A Ladder Call Option has one or more "Rungs" (price levels) above the initial spot level. The Call's payoff equals the greater of a European Call's payoff or the excess over Strike (q.v.) of the highest Rung that the underlying price reaches.

For example, suppose that the Underlying Price is 100 and a Ladder Call has a Strike at 105 and Rungs at 115 and the Underlying Price reaches 120 before Expiration, then falls back to 98, the Ladder Call pays 15 = 120 - 105. If the Underlying price never gets above 109, then falls back to 98, the Ladder Call expires worthless.125. If

 

Ladder Periodic Cap

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

LASER

Paribas Capital Markets' Liquid Asset Swap with Enhanced Return. A kind of SPV (q.v.) that Moody's rated A1. The initial US dollar one-year issue contained a repackaged Swiss franc private placement priced at six-month Libor plus 25bp. In the event of a failure of the Laser security, holders receive the underlying coupon and principal payments. (Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html)

 

LEAPS

Long-term Equity AnticiPation Securities. Listed Call and Put Options on shares and indexes, with expirations out as much as two years. Ordinary listed Calls and Puts expire within nine months. LEAPS permit investors to express longer-term views, without buying the underlying instruments.

 

LEPO

In a normal market the bid is less than the ask, and the difference – the bid-ask spread – would be the market maker's profit on a round trip in the stock. In a crossed market, the bid price exceeds the ask (offer) price. In an OTC market one market maker may show the best bid and another the best offer, and these may cross. A crossed market cannot last, in equilibrium.

A Low Exercise Price Option (q.v.) traded on the Australian Stock Exchange (q.v.) or SOFFEX (Switzerland). (Source: Australian Stock Exchange.)

 

LIPS and TRIPs

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

life assurance [insurance] bonds

Bonds backed by life insurance policies. The idea is that life insurance companies are good at underwriting insurance risks, collecting premiums, and servicing the policies, but needn’t tie up their money for the duration.

Examples: USAA, Swiss Winterthur, Swiss Re, and Tokio Marine & Fire have issued such bonds. CSFB, Goldman Sachs, Lehman Brothers, and Merrill Lynch have brought the issues to investors. Good news: This is a logical next step in disintermediation. The cash flows are relatively predictable, in contrast to cash flows on "catastrophe bonds" (q.v.).

Bad news: Investors will be dealing against experts in adverse selection (q.v.) and moral hazard (q.v.).

Source: "An earthquake in insurance," The Economist, 2/28/98.

loan participation fund

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

 

local

A trader in a futures trading pit, either a floor trader (q.v.) or a floor broker (q.v.)

 

locked market

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

Lombard rate

The rate of interest charged on a Lombard loan.

 

Lombard loan

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

Lookback Option

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

 

Lookback Periodic Cap

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

 

Low Exercise Price Option

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

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- M -

Macaulay Duration

1. A measure of the sensitivity of a financial instrument's value to a change in its yield. Macaulay Duration is an overestimate, and Modified Duration (q.v.) is a more precise measure.

2. The weighted average of time until a financial instrument pays its cash flows. Each weight is proportional to the present value of the associated cash flow.

3. Modified Duration (q.v.), times 1 + y/n , where y is the yield and n is the number of coupon payments per year.

 

market

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

market maker

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

 

Market Risk

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

 

Margrabe Option

The option to exchange one asset for another. Margrabe (1978) showed several applications for this sort of option (margin account, corporate exchange offer, and standby commitment) and derived a model for pricing this option. Other people discovered numerous additional examples of this option. The Cross Currency Option (q.v.) is a prime example. The option goes also by the names Exchange Option (q.v.) and Outperformance Option (q.v.).
Source: Gary L. Gastineau and Mark P. Kritzman, Dictionary of Financial Risk Management, Frank Fabozzi, 1996.

 

Market Index Target-Term Securities

Merrill Lynch's registered derivative product, with a payoff that is the greater of (a) some minimum and (b) issue price times the sum of unity and the rate of increase in value of the underlying price. MITTS don't allow the owners to redeem, nor the issuers to call early. The MITTS is equivalent to a position in the underlying index, plus a protective put.

 

For example, Merrill Lynch has listed on the American Stock Exchange an issue of MITTS with an underlying index proportional to an average of the prices of the ten highest-yielding Dow-Jones Industrials, and maturity on 8/15/06. The minimum payoff of this issue is 124% of the issue price.

 

Marché à Terme Internationale de France (MATIF)

The French derivatives exchange, which dominates trading in contracts based on instruments denominated in the French Franc.

7/28/00 martingale

1. A device that keeps a horse's head in position with its rows of teeth more or less horizontal. 
2. A gambling strategy that involves betting one unit, then doubling the bet, until the gambler wins. The strategy appears to assure the gambler a profit of one unit at the end of each string of bets. The problem is that the gambler's -- and house's -- resources are finite. Consequently, the strategy isn't operational.
3. A stochastic process for which the expected change equals zero, e.g., equivalent martingale measure (q.v.). 
Application:  During the 1960s the martingale stochastic process was a standard model for a fair game, hence for stock price movements in an efficient market. 

7/28/00 martingale measure

Any probability measure (q.v.) under which a stochastic variable is a martingale (q.v.), i.e., its expected change equals zero. 
Example: Consider the probability measure that assigns a probability of 1/2 to a head or a tail, and for which successive coin tosses are independent. Then let X(n) be the random variable that starts at zero and increases by one with each "heads" outcome and decreases by one with each "tails" outcome. Then E[X(n)-X(n-1)|X(n-1)] = 1/2 (1) + 1/2 (-1) = 0, and X(n) is a martingale. 

7/28/00 measure

A function that maps a set into the positive portion of the real line. 
Examples: 
1. Length is a measure for subsets of the real line. Add the lengths of subsets of contiguous points in a set to get a positive real number. 
2. Area is a measure for sets in the Cartesian plane. Take any rectangular set of points and compute its area by multiplying length by width to get a non negative real number. 
3. Probability measure (q.v.). 

Matador market

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

Maus-Optionen

Markt Aufstehen Und Sicherheit Optionen. Range Options that pay off like Call Options when the market rises securely within a narrow, upward sloping corridor, but otherwise expire worthless.

 

MBS

Mortgage Backed Security (q.v.).

 

Mid-Curve Option

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

 

Millenium Bond

Definition: A Bond that matures in 1000 years.

Example: Lehman Brothers underwrote a 1000-year issue for Safra Republic Holdings SA.

Application: A Millenium Bond reduces the need for refinancing and reinvesting.

Pricing: The Safra issue yielded 98 basis points over the 30-year U.S. Treasury bond. Price and yield should be nearly reciprocals.

Risk Management: One might hedge them by shorting Safra’s previous 100-year maturity bonds. However, as a practical matter their duration should be close to that of the U.S. Treasury’s Long Bond.

Comment: If the British government could issue perpetuities ("consols") to consolidate its debt, then why can’t a corporation issue bonds maturing in 1000 years?

Source: "Ratings & Briefs," Financial Trader 4 (11), p. 8.

MIPS

Monthly Income Preferred Shares (q.v.).

 

MITTS

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

 

Model Risk

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

 

Modified Duration

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

money market rates

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

Monte Carlo Simulation

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

 

Monthly Income Preferred Shares.

Monthly Income Preferred Shares (or Stock) - which most people call MIPS or Mips, for short - are Preferred Shares (q.v.) that pay monthly dividends. MIPS are callable after some period of call protection, and convertible into common shares. Some observers see MIPS as tax-deductible equity, in effect. Some in the Treasury department see this as abusive, and want a crackdown. Goldman, Sachs & Co. pioneered them circa October 1993. Cf. Step-Down Preferred Stock.

 

The parent corporation (Parent) creates a subsidiary (Sub) or limited partnership to issue the MIPS. Sub sells MIPS for cash and lends the cash to Parent or buys Parent's notes. Parent pays interest to Sub, which pays monthly preferred dividends to its security holders. In at least one case Parent had the option to defer interest for up to five years. That would mean that MIPS holders might receive no dividends for five years.

 

One variation on the MIPS structure involves an offshore Sub, which pays dividends to investors without withholding tax.

 

Part of the motivation for MIPS seems to be reduction of taxes paid by the issuer and its direct or indirect security holders. Parent issues debt and pays interest, so Parent may deduct interest expense. Subsidiary issues preferred shares and pays dividends, so corporations that buy MIPS get a dividend exclusion. This shifts the tax burden to parties besides security holders of Parent and Sub.

 

Texaco, Inc., USX Corp., ConAgra Inc., and others issued more than $2.5 billion in the first year MIPS existed. Merrill Lynch and Smith Barney have issued similar securities.

 

The masochistic or meticulous among you may like to view legal documents from Edgar, pertaining to a proposed offering of MIPS, by Capital Holding Corp., with help from Goldman, Sachs. See also U.K. Mips.

 

Monster ABS

An enormous Asset-Backed Security (q.v.). (For example, see "Natwest Prepares Monster Loan-Backed ABS," BondWeek, 3/10/97. This one was worth about $1.65 billion.)

 

Morgan Stanley - Capital International

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

 

Mortgage Backed Security

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

 

Mortgage Bond, Loan, or Note

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

 

MSCI

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

M-squared

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

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- N -

Naked Dog Basket

The "Basket" is a portfolio of Brady Bonds that someone issued in exchange for rescheduled debt of certain developing countries. One might suppose that some people consider such a bond to be a "Dog". The "Dog Basket" is "Naked", because the terms of the contract call for stripping the yield on U.S. long bond from the gross return on the portfolio. So the coupon on the "dogs" depends on the "stripped spread" between the long bond rate the the Brady Bond yield. (Described in the Financial Times, 11/16/94, p. V.)

 

Nondeliverable Forward

A cash-settled, forward contract, typically on a nonconvertible or thinly traded foreign currency (probably from an emerging or submerging (q.v.) market) or two such currencies, that settles into a convertible currency (typically the USD). The cash value is a function of the contract's reference rate(s) on the fixing date, typically, two business days before the value date. Its main atraction is avoiding currency controls. (Source: William Rhode, "Learning Curve: Nondeliverable Swaps, Derivatives Week, 5/5/97.)

 

Nondeliverable Swaps

A Swap (q.v.) that would be equivalent ideally to a Cross-Currency Swap (q.v.), except that it settles instead in USD. Typically, the NDS omits delivery of the underlying currency at maturity. In simpler cases, the parties offset this omission with the appropriate Nondeliverable Forward (q.v.). In more complicated cases, the parties don't offset it, and pricing is more difficult. "One player at a U.S. bank uses a combination of risk tolerance, onshore interest rate levels and her own currency forecast to price NSDs." The NDS's appeal stems largely from its ability to circumvent prohibitions against converting currencies at market prices. (Source: William Rhode, "Learning Curve: Nondeliverable Swaps, Derivatives Week, 5/5/97.)

 

Notional Amount

A stated amount in a Derivatives Contract, on which the Derivative's payments depend. The Notional Amount is most analogous to the principal amount of a bond.

 

[le] Notionnel

"Notional bonds", the long-term, French bond futures contract on the MATIF (q.v.).

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- O -

OATS

1. Order Audit Trail System. The NASD’s new (as of 1998), SEC-approved system for keeping detailed, *time-stamped records of every trade. (http://investor.nasd.com/notices/9833ntm.txt)
2. Obligations assimilables du trésor. French government bonds, with either fixed and floating coupons, available in book-entry form. Not traded overseas, but available as ADRs in the U.S. (http://www.rcmfinancial.com/o.htm)

Obligations Assimilables du Trésor (OATs)

French government bonds with original maturities of 5-30 years, the underlying assets for French bond futures and option contracts. (http://www.cean.caisse-epargne.fr:5281/html/obligassi.html)

 

Off-the-Run Treasury

A former On-the-Run Issues (q.v.), after the Treasury issues the new On-the-Run.

 

OIS

Overnight Indexed Swaps (q.v.).

 

One-Touch Option

An Option that pays off as soon as the trigger price touches the barrier. Often, it is a Binary Option (q.v.).

 

One Way Collared Note

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

 

One Way Floater

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

 

One Way Floating Rate Note

Definition: A Floating Rate Note whose rates can only ratchet up (usually) or down. Also known as One Way Collared Note, One Way Floater, Ratchet Floater, and Sticky Floater. (Source: Peng, Scott, and Dattatreya, Ravi, The Structured Note Market.)

Example: A Floating Rate Note that pays a quarterly coupon that is at least the previous period’s LIBOR, at most 50 bips (q.v.) above the previous LIBOR, and equals LIBOR if LIBOR falls between these bounds.

Application: This is mainly a vehicle for speculation, because it is difficult to name something that it hedges.

Pricing: The payoff is path dependent, and the most obvious way to price it is with Monte Carlo simulation. (See Peter Fink’s discussion at http://www.sbcm.com/hot/current.htm)

 

On-the-run Treasury

Definition: The most recently issued U.S. Treasury note or bond of a given initial Maturity. Also known as the Current Coupon issue.

Example: For example, when the Treasury auctions a new two-year note it becomes the new On-the-Run two-year note.

Risk Management: The On-the-Run issues tend to be the most liquid – i.e., they have the smallest bid-ask spreads. That makes them most attractive as hedging instruments.

Comment: After the Treasury announces that it will auction a specific security (defined by maturity and coupon), but before the auction, the bond may trade in the When Issued Market (). After the auction, this security becomes the new On-the-Run Issue for its maturity. The previous On-the-Run becomes an Off-the-Run issue.

 

OTM

Out-of-the-Money. Having an Intrinsic Value of zero.

 

Outperformance Option

An option on the performance of one asset in excess of the performance of another. Typically, one measures the outperformance by the excess of the one return or rate of retun over the other. One might also measure the outperformance as the excess of the ratio of the two final price over a benchmark ratio.

 

overnight (o/n)

From today to "tomorrow" (i.e., the next business day).

Overnight Indexed Swaps

Swaps with a floating rate based on Sonia (q.v.).

overnight rate

The interest rate from today to tomorrow (i.e., the next business day). 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 ).

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- P -

Pack

A Forward (q.v.) Strip (q.v.,#2), each corresponding to a particular year, of four consecutive, quarterly Eurodollar or Euroyen futures contracts. Markets, such as Simex offer a Pack as a convenient package of futures contracts, without the execution risk inherent in building up the Strip, contract by contract. A trader can use Packs and Bundles (q.v.) to implement bets on the change in shape of the Forward Curve.

 

paper

Customer buy and sell orders coming to a trading pit.

 

PCS Options

The CBOT's option contracts with the underlying Property Claims Service (PCS) index. Apparently, they operate more or less as a call option on the underlying index, which could be any one of nine indexes. (Source: Robert Clow, "Coping with catastrophe," Institutional Investor, December 1996, pp. 138.)

 

PEEQS

Protected Exchangeable EQuity-linked Securities (q.v.).

 

PERCS

Preference Equity Redemption Cumulative Stock. Preferred stock in Corporation A that behaves on the downside like common stock in Corporation A, but contains an embedded short Call Option on that stock. The PERCS is a descendant of the Prime of the early 1980s, which was itself a descendant of the hoary Buy-Write (q.v.) strategy. (See Pratt, Tom. "You can't keep a lid on public derivatives." IDD, Oct. 24, 1994, pp. 12-18.) The PERCS is like a ELKS (q.v.), except that the company that the company that issues the stock issues the PERCS, and another company issues the ELKS. Morgan Stanley issued the first PERCS in 1991.3.375

 

Periodic Cap

An Interest Rate Cap (q.v.) for which the strike for each Caplet (q.v.) can differ from strikes on other Caplets. Typically, the strike depends on LIBOR, as in a Ladder Periodic Cap (q.v.) or Lookback Periodic Cap (q.v.).

 

PERQS

Performance Equity-Linked Redemption Quarterly-Pay Securities (sm). Morgan Stanley's proprietary Equity Linked Debt Security (q.v.).

Pfandbriefe

German asset backed bonds, backed by private mortgages or public sector loans. The Association of German Mortgage Banks claims that for at least 100 years, through 1998, no investor who has held a Pfandbriefe issue to maturity has ever failed to receive full principal and interest. This claim suggests that some of the payments may not have been timely. Better late than never!

Pfandbriefe, Jumbo

Straight bonds with face value of at least DEM 1 billion, which at least three market makers have pledged to quote continuous, two-way markets during normal market hours, for size up to DEM 25 million. Cf. Pfandbriefe.

Pfandbriefe, Public

Bonds backed by loans to the public sector. Cf. Pfandbriefe.

Pibor

Paris Interbank Offered Rate. The French counterpart of LIBOR.

 

Planned Amortization Class

An indexed amortizing structure with an amortizing rate that is nearly flat over a large range of values for the underlying rate of interest.

 

pooling of interests

Accounting for a merger by simply adding up the financial statements for the merging firms. To a first approximation, the financial statements of the merged firm show the same numbers as the sum of the financial statements of the merging firms. 

 

purchase method

Accounting for a merger by designating one firm the acquirer, computing "goodwill" as the excess of the acquired firm's purchase price over its book value, and amortizing the goodwill over a period, which depresses income. 

 

price

• Clean Price = Quoted Price. What the broker or dealer tells you is the price of a bond = Dirty Price - Accrued Interest.
• Dirty Price = Invoice Price = Full Price. The size of the check you write to buy a bond = Clean Price + Accrued Interest

Principal-Only (PO) Tranche

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

 

Preferred Share

A share that pays a fixed dividend and has preferences over Common Stock (q.v.) with regard to dividends and in case of bankruptcy.

 

7/28/00 probability measure

A measure (q.v.) that maps a set of points in a probability space into a point in the interval [0,1]. Example: If the probability space corresponding to two flips of a fair coin is W = {HH, HT, TH, TT}, and we have the set of all outcomes with tails once out of two flips, A = {HT, TH}, then the probability of that outcome is P(A) = 1/2 and P(.) is the probability measure that assigns a probability of 1/4 to each of the points in the probability space. 

project finance 

Raising money via a loan or bond issue to build a specific project (such as a power plant, hydroelectric dam, or airport) and having only that project as security for the loan or bond. Thus, a project loan is typically "without recourse" or "non recourse" and a project bond is typically a revenue bond. 

 

Protected Exchangeable EQuity-linked Securities

The Morgan Stanley Group, Inc.'s proprietary, listed (American Stock Exchange) equity index derivative product, which pays off at maturity (4/20/01) the greater of issue price ($69.55) or 10% of the S&P 500 Index value on that date. The owner may from 11/17/97 to seven trading days before 4/20/01) exchange 100 PEEQS for ten times the S&P 500 Index level. Thus, at each dividend date, the owner has the option to forgo the dividend in return for a compound option that ultimately pays off as mentioned. (Cf. SPINs.)

 

Putable Bond

Definition: A Bullet Bond (q.v.) that the bondholder can force the issuer to buy back at a scheduled price. The Put Price as a function of calendar time is the Put Schedule. A Bullet Bond plus a Put Option (q.v.) on the Bond. AKA Retractable Bond.

Example: A corporation might issue a ten-year Note (q.v.) with a five-year Put Option.

Application: A Putable Bond is a bet on the cost of refinancing at the Put Date. The issuer is betting that the Put Option will expire worthless – i.e., that interest rates will be low at the Put Date. The bondholder is betting that interest rates will rise, the bond price will fall, he will be able to sell the bond back to the issuer at a profit, and he will be able to reinvest the proceeds of that sale in a bond with a higher coupon.

Pricing: You can price it as a bond, plus a put option on the bond. For it to sell near par requires a low coupon.

Risk Management: For example, suppose that a corporation issues a ten-year bond with an embedded five-year European Put Option. It is exposed to the danger of rising interest rates, in which case the bondholder will put the bond back to the issuer. However, if the issuer also buys a Payer Swaption, struck at the same coupon as the bond, then it will be able to issue floating rate debt to repay the principal on the bond and exercise the Swaption to continue paying the same fixed rate. The floating rate receipts from the Swaption will roughly cover the new floating rate debt interest.

Comment: Cf. Callable Bond, Extendible Bond.

 

 Put Option

The right, but not not the obligation, to sell the underlying asset at the strike price. Cf. Call Option.

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- 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.).

 

7/28/00 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 -

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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