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561 Cards in this Set

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An accreting principal is one which increases during the life of the deal. See amortising, bullet.
Accreting swap
Swap whose notional amount increases during the life of the swap (opposite of amortising swap).
Accrued interest
The proportion of interest or coupon earned on a bond from the previous coupon payment date until the value date.
Accumulated value
The same as future value.
A day/year count convention taking the number of calendar days in a period and a "year" of 360 days.
A day/year convention taking the number of calendar days in a period and a "year" of 365 days. Under the ISDA definitions used for interest rate swap documentation, act/365 means the same as act/act.
A day/year count convention taking the number of calendar days in a period and a "year" equal to the number of days in the current coupon period multiplied by the coupon frequency. For an interest rate swap, that part of the interest period falling in a leap year is divided by 366 and the remainder is divided by 365.
Agency securities
In the United States, securities issued by government-sponsored entities, such as the Government National Mortgage Association (GNMA) and the Federal Home Loan Mortgage Corporation (FHLMC).
All or nothing
Digital option. This option’s put (call) pays out a pre-determined amount ("the all") if the index is below (above) the strike price at the option’s expiration. The amount by which the index is below (above) the strike is irrelevant; the payout will be all or nothing.
All-in price
See dirty price.
An American option is one which may be exercised at any time during its life.
An amortising principal is one which decreases during the life of a deal, or is repaid in stages during a loan. Amortising an amount over a period of time also means accruing for it pro rata over the period. See accreting, bullet.
An investment providing a series of (generally equal) future cash flows.
An increase in the market value of a currency in terms of other currencies. See depreciation, revaluation.
The process of buying securities in one country, currency or market, and selling identical securities in another to take advantage of price differences. When this is carried out simultaneously, it is in theory a risk-free transaction. There are many forms of arbitrage transactions. For instance in the cash market a bank might issue a money market instrument in one money centre and invest the same amount in another centre at a higher rate, such as an issue of three-month US dollar CDs in the United States at 5.5% and a purchase of three-month Eurodollar CDs at 5.6%. In the futures market arbitrage might involve buying three-month contracts and selling forward six-month contracts.
Someone who undertakes arbitrage trading.
(autoreggressive conditional heteroscedasticity) A discrete-time model for a random variable. It assumes that variance is stochastic and is a function of the variance of previous time steps and the level of the underlying.
An Asian option depends on the average value of the underlying over the option’s life.
See offer.
Probable future economic benefit obtained or controlled as a result of past events or transactions. Generally classified as either current or long-term.
Asset & Liability Management (ALM)
The practice of matching the term structure and cash flows of an organisation’s asset and liability portfolios to maximise returns and minimise risk. Also includes the deliberate mis-matching of cash flows to take account of views on the short-term yield curve.
Asset allocation
Distribution of investment funds within an asset class or across a range of asset classes for the purpose of diversifying risk or adding value to a portfolio.
Asset securitisation
The process whereby loans, receivables and other illiquid assets in the balance sheet are packaged into interest-bearing securities that offer attractive investment opportunities.
Asset swap
An interest rate swap or currency swap used in conjunction with an underlying asset such as a bond investment. See liability swap.
Asset-backed security
A security which is collaterised by specific assets – such as mortgages – rather than by the intangible creditworthiness of the issuer.
Asset-risk benchmark
Benchmark against which the riskiness of a corporation’s assets may be measured. In sophisticated corporate risk management strategies the dollar risk of the liability portfolio may be managed against an asset-risk benchmark.
At-the-money (ATM)
An option is at-the-money if the current value of the underlying is the same as the strike price. See in-the-money, out-of-the-money.
A method of issuing bonds where institutions submit bids to the issuer on a price or yield basis. Auction rules vary considerably across markets.
Average cap
Also known as an average rate cap, a cap on an average interest rate over a given period rather than on the rate prevailing at the end of the period. See also average price (rate) option.
Average price (rate) option
Option on a currency's average exchange rate or commodity's average spot price in which four variables have to be agreed between buyer and seller: the premium, the strike price, the source of the exchange rate or commodity price data and the sampling interval (each day, for example). At the end of the life of the option the average spot exchange rate is calculated and compared with the strike price. A cash payment is then made to the buyer of the option that is equal to the face amount of the option times the difference between the two rates (assuming the option is in-the-money; otherwise it expires worthless).
The validation of a model by feeding it historical data and comparing the results with historical reality.
The situation when a forward of futures price for something is lower than the spot price (the same as forward discount in foreign exchange). See contango.
Balance sheet
Statement of the financial position of an enterprise at a specific point in time, giving assets, liabilities and stockholders’ equity.
The Exchange Rate Mechanism (ERM II) of the European Union links the currencies of Denmark and Greece in a system which limits the degree of fluctuation of each currency against the euro within a band (of 15 per cent for the drachma and 21/4 per cent for the krone) either side of an agreed par value.
Banker’s acceptance
See bill of exchange.
In its simplest form, a position consisting of long positions in short- and long-dated bonds, and no holding of a medium-dated bond. A barbell portfolio would consist of a portfolio of very short-dated and very long-dated bonds.
A transaction undertaken on the London Stock Exchange.
Barrier option
A barrier option is one which ceases to exist, or starts to exist, if the underlying reaches a certain barrier level. See knock out/in.
Base currency
Exchange rates are quoted in terms of the number of units of one currency (the variable or counter currency) which corresponds to one unit of the other currency (the base currency).
The underlying cash market price minus the futures price. In the case of a bond futures contract, the futures price must be multiplied by the conversion factor for the cash bond in question.
Basis point
In interest rate quotations, 0.01 per cent.
Basis rate
The rate applicable in a basis swap.
Basis risk
A form of market risk that arises whenever one kind of risk exposure is hedged with an instrument that behaves in a similar, but not necessarily identical way. For instance a bank trading desk may use three-month interest rate futures to hedge its commercial paper or euronote programme. Although eurocurrency rates, to which futures prices respond, are well correlated with commercial paper rates they do not always move in lock step. If, therefore, commercial paper rates move by 10 basis points but futures prices dropped by only 7 basis points, the 3 bp gap would be the basis risk.
Basis swap
An interest rate swap where both legs are based on floating rate payments.
Basis trade
Buying the basis means selling a futures contract and buying the commodity or instrument underlying the futures contract. Selling the basis is the opposite.
Basket option
Option based on an underlying basket of bonds, currencies, equities or commodities.
Bear spread
A spread position taken with the expectation of a fall in value in the underlying.
Bearer bond
A bond for which physical possession of the certificate is proof of ownership. The issuer does not know the identity of the bondholder. Traditionally the bond carries detachable coupon, one for each interest payment date, which are posted to the issuer when payment is due. At maturity the bond is redeemed by sending in the certificate for repayment. These days bearer bonds are usually settled electronically, and while no register of ownership is kept by the issuer, coupon payments may be made electronically.
A bond whose terms set a standard for the market. The benchmark usually has the greatest liquidity, the highest turnover and is usually the most frequently quoted. It also usually trades expensive to the yield curve, due to higher demand for it amongst institutional investors.
The sensitivity of a stock relative to swings in the overall market. The market has a beta of one, so a stock or portfolio with a beta greater than one will rise of fall more than the overall market, whereas a beta of less than one means that the stock is less volatile.
The price at which a market maker will buy bonds. A tight bid-offer spread is indicative of a liquid and competitive market. The bid rate in a repo is the interest rate at which the dealer will borrow the collateral and lend the cash. See offer.
The two-way price at which a market maker will buy and sell stock.
Big figure
In a bond price quotation, the price omitting the decimal portion. For example, if the 10-year benchmark is quoted as 109.15-21, the big figure is 109. See points.
Bilateral netting
The ability to offset amounts owed to a counterparty under one contract against amounts owed to the same counterparty under another contract – for example, where both transactions are governed by one master agreement. Also known as cherry-picking.
A bill of exchange is a payment order written by one person (the drawer) to another, directing the latter (drawee) to pay a certain amount of money at a future date to a third party. A bill of exchange is a bank draft when drawn on a bank. By accepting the draft, a bank agrees to pay the face value of the obligation if the drawer fails to pay, hence the term banker’s acceptance. A Treasury bill is short-term government paper of up to one year’s maturity, sold at a discount to principal value and redeemed at par.
Bill of exchange
A short-term, zero-coupon debt issued by a company to finance commercial trading. If it is guaranteed by a bank, it becomes a banker’s acceptance.
Binomial tree
A mathematical model to value options, based on the assumption that the value of the underlying can move either up or down a given extent over a given short time. This process is repeated many times to give a large number of possible paths (the "tree") which the value could follow during the option’s life.
BIS (Bank for International Settlements)
Known as the central bank for central banks, an international organisation situated in Basel, Switzerland, which acts as the central bank for sovereign entities. It produced the "Basel accord" in 1988, implemented in 1992, which established capital requirements for banking institutions based on the risk-weighting of their assets; it also produced rules on the capital treatment of derivative instruments.
A widely used option pricing formula devised by Fischer Black and Myron Scholes.
Blended interest rate swap
Result of adding forward swap to an existing swap and blending the rates over the total life of the transaction.
The trading, analytics and news service produced by Bloomberg LP; also used to refer to the terminal itself. Introduced by ex-Salomon Brothers trader Mike Bloomberg.
Bond basis
An interest rate is quoted on a bond basis if it is on an act/365, act/act or 30/360 basis. In the short term (for accrued interest, for example), these three are different. Over a whole (non-leap) year, however, they all equate to 1. In general, the expression "bond basis" does not distinguish between them and is calculated as act/365. See money-market basis.
Bond-equivalent yield
The yield which would be quoted on a US treasury bond which is trading at par and which has the same economic return and maturity as a given treasury bill.
A method of deriving the term structure of interest rates from market bond prices and yields, using successive bonds to calculate the spot rate along the maturity term structure. In mathematics, a method of solving simultaneous equations in which the first equation contains one unknown, the next equation contains two unknowns and so on. The result obtained by solving the first equation is used to solve the second equation, and so on.
Basis point value. The price movement resulting from a one basis point change in yield.
Break forward
A product equivalent to a straightforward option, but structured as a forward deal at an off-market rate which can be reversed at a penalty rate.
Broken date
A maturity date other than the standard ones (such as 1 week, 1, 2, 3, 6 and 12 months) normally quoted.
Members of the London Stock Exchange who may intermediate between customers and market makers; may also act as principals, transacting business with customers from their own holdings of stock.
Bull spread
A spread position taken with the expectation of a rise in value in the underlying.
Sterling domestic bonds issued by non-UK domiciled borrowers. These bonds trade under a similar arrangement to Gilts and are settled via the Central Gilts Office (now CREST).
A loan/deposit has a bullet maturity if the principal is all repaid at maturity. See amortising.
Opposite of sell/buy-back.
The exchange rate for sterling against the US dollar.
The European Union’s Capital Adequacy Directive.
Calendar spread
The simultaneous purchase/sale of a futures contract for one date and the sale/purchase of a similar futures contract for a different date. See spread.
Call option
An option to purchase the commodity or instrument underlying the option. See put.
Call price
The price at which the issuer can call in a bond.
Callable bond
A bond which provides the borrower with an option to redeem the issue before the original maturity date. In most cases certain terms are set before the issue, such as the date after which the bond is callable and the price at which the issuer may redeem the bond.
Cancellable swap
Swap in which the payer of the fixed rate has the option, usually exercisable on a specified date, to cancel the deal (see also swaption).
A series of borrower’s IRGs, designed to protect a borrower against rising interest rates on each of a series of dates.
Capital market
Long term market (generally longer than one year) for financial instruments. See money market.
Capital structure arbitrage
A trade strategy pursued by hedge funds and banks. It involves a play of a company's debt against its equity. Generally this is done using derivatives rather than cash instruments, so it involves putting a on a long/short Credit Default Swap position in a specific reference entity name against a short/long equity option position in the same name. Both are usually OTC although one could trade the latter as an exchange-traded option. The idea is to make money because of either perceived mispricing of the debt against the equity or one expects the relative value of one against the other to change in a particular direction.
Option on a cap.
See cash market.
Cash market
The market in instruments that represent actual cash, which is an on-balance sheet asset. For example, an interbank deposit of £10 million represents £10 million by value of funds placed in the deposit institution. Bonds are cash instruments.
The US market term for basis trading, an arbitrage-type trade in which a simultaneous position in cash bond and associated bond futures contract is put on, with a view to exploiting price differentials between the spot price of the bond and the future price implied by the current price of the bond future. A cash-and-carry trade is a long bond/short futures position, while the opposite of short the bond and long the future is known as a reverse cash-and-carry.
The Chicago Board of Trade, one of the two futures exchanges in Chicago, USA and one of the largest in the world.
See certificate of deposit.
Centrale de Livraison de Valeurs Mobilieres; a clearing system for Euro-currency and international bonds. Cedel is located in Luxembourg and is jointly owned by a number of European banks. Subsequently renamed Clearstream on merger with Deutsche Bourse.
The same as cap.
Central Gilts Office
The office of the Bank of England which runs the computer-based settlement system for gilt-edged securities and certain other securities (mostly bulldogs) for which the Bank acts as Registrar. Subsequently merged with CREST.
Central limit theorem
The assertion that as sample size, n, increases, the distribution of the mean of a random sample taken from almost any population approaches a normal distribution.
Certificate of Deposit (CD)
A money market instrument of up to one year’s maturity (although CDs of up to five years have been issued) that pays a bullet interest payment on maturity. After issue, CDs can trade freely in the secondary market, the ease of which is a function of the credit quality of the issuer.
Central Government Net Cash Requirement.
Central Government Borrowing Requirement.
CGO reference prices
Daily prices of gilt-edged and other securities held in CGO which are used by CGO in various processes, including revaluing stock loan transactions, calculating total consideration in a repo transaction, and DBV assembly. Also known as CREST prices or DMO prices.
Cheapest to deliver (CTD)
In a bond futures contract, the one underlying bond among all those that are deliverable, which is the most price-efficient for the seller to deliver.
See bilateral netting.
Classic repo
Repo is short for "sale and repurchase agreement" – a simultaneous spot sale and forward purchase of a security, equivalent to borrowing money against a loan of collateral. A reverse repo is the opposite. The terminology is usually applied from the perspective of the repo dealer. For example, when a central bank undertakes repos, it is lending cash (the repo dealer is borrowing cash from the central bank).
Clean deposit
The same as time deposit.
Clean price
The price of a bond excluding accrued coupon. The price quoted in the market for a bond is generally a clean price rather than a dirty price.
Clearing house
The body that settles trades on a futures exchange, and which acts as the counterparty to every transaction. The clearing house is able to guarantee settlement by charging margin to all exchange participants, which is used to establish a default fund.
The international bond market clearing system, resulting from a merger between CEDEL and Deutsche Bank.
Close-out netting
The ability to net a portfolio of contracts with a given counterparty in the event of default. See also bilateral netting.
Closing leg
In a repo transaction, the termination of the trade when the bonds (or other assets) are returned against receipt of borrowed funds and repo interest.
Central Moneymarkets Office which settles transactions in Treasury bills and other money markets instruments, and provides a depository (in the UK). Now merged with CREST.
Current mark-to-market value. See current exposure and replacement cost.
The simultaneous sale of a put (or call) option and purchase of a call (or put) at different strikes – typically both out-of-the-money.
Something of value, often of good creditworthiness such as a government bond, given temporarily to a counterparty to enhance a party’s creditworthiness. In a repo, the collateral is actually sold temporarily by one party to the other rather than merely lodged with it.
Commercial paper
A short-term security issued by a company or bank, generally with a zero coupon.
Commodity swap
Swap where one of the cash flows is based on a fixed value for the underlying commodity and the other is based on a floating index value. The commodity is often oil or natural gas, although copper, gold, other metals and agricultural commodities are also commonly used. The end-users are consumers, who pay a fixed-rate, and producers.
Competitive bid
A bid for the stock at a price stated by a bidder in an auction. Non-competitive bid is a bid where no price is specified; such bids are allotted at the weighted average price of successful competitive bid prices.
Compound interest
When some interest on an investment is paid before maturity and the investor can reinvest it to earn interest on interest, the interest is said to be compounded. Compounding generally assumes that the reinvestment rate is the same as the original rate. See simple interest.
Compound option
Option on an option, the first giving the buyer the right, but not the obligation, to buy the second on a specific date at a pre-determined price. There are two kinds. One, on currencies, is useful for companies tendering for overseas contracts in a foreign currency. The interest rate version comprises captions and floortions.
The total price paid in a transaction, including taxes, commissions and (for bonds) accrued interest.
The situation when a forward or futures price for something is higher than the spot price (the same as forward premium in foreign exchange). See backwardation.
Contingent option
Option where the premium is higher than usual but is only payable if the value of the underlying reaches a specified level. Also known as a contingent premium option.
Continuous compounding
A mathematical, rather than practical, concept of compound interest where the period of compounding is infinitesimally small.
Contract date
The date on which a transaction is negotiated. See value date.
Contract for differences
A deal such as an FRA and some futures contracts, where the instrument or commodity effectively bought or sold cannot be delivered; instead, a cash gain or loss is taken by comparing the price dealt with the market price, or an index, at maturity.
Conventional gilts (included double-dated)
Gilts on which interest payments and principal repayments are fixed.
Conversion factor
In a bond futures contract, a factor to make each deliverable bond comparable with the contract’s notional bond specification. Defined as the price of one unit of the deliverable bond required to make its yield equal the notional coupon. The price paid for a bond on delivery is the futures settlement price times the conversion factor.
Convertible currency
A currency that may be freely exchanged for other currencies.
A measure of the curvature of a bond’s price/yield curve (mathematically).
Corporate bond
A cash debt instrument that has been issued by a corporate, and is therefore an IOU issued by the company and which it is obliged to redeem in accordance with its contractual terms.
Correlation matrices
Statistical constructs used in the value-at-risk methodology to measure the degree of relatedness of various market forces.
The same as collar.
Cost of carry
The net running cost of holding a position (which may be negative) – for example, the cost of borrowing cash to buy a bond less the coupon earned on the bond while holding it.
Counterparty risk weighting
See risk weighting.
Country risk
The risks, when business is conducted in a particular country, of adverse economic or political conditions arising in that country. More specifically, the credit risk of a financial transaction or instrument arising from such conditions.
The interest payment(s) made by the issuer of security to the holders, based on the coupon rate and the face value.
Coupon swap
An interest rate swap in which one leg is fixed-rate and the other floating-rate. See basis rate.
A statistical measure of how much two ransom variables are related to each other.
To cover an exposure is to deal in such a way as to remove the risk – either reversing the position, or hedging it by dealing in an instrument with a similar but opposite risk profile. Also the amount by how much a bond auction is subscribed.
Covered call/put
The sale of a covered call option is when the option writer also owns the underlying. If the underlying rises in value so that the option is exercised, the writer is protected by his position in the underlying. Covered puts are defined analogously. See naked.
Covered interest arbitrage
Creating a loan/deposit in one currency by combining a loan/deposit in another with a forward foreign exchange swap.
See commercial paper.
Credit (or default) risk
The risk that a loss will be incurred if a counterparty to a derivatives transaction does not fulfil its financial obligations in a timely manner.
Credit derivatives
Financial contracts that involve a potential exchange of payments in which at least one of the cash flows is linked to the performance of a specified underlying credit-sensitive asset or liability. Payment is made by the seller of credit protection, to the buyer, in the event of a specified credit event.
Credit risk (or default risk) exposure
The value of the contract exposed to default. If all transactions are marked to market each day, such positive market value is the amount of previously recorded profit that might have to be reversed and recorded as a loss in the event of counterparty default.
Credit spread
The interest rate spread between two debt issues of similar duration and maturity, reflecting the relative creditworthiness of the issuers.
Credit value-at-risk (CVAR)
See value-at-risk (VAR).
Credit-equivalent amount
As part of the calculation of the risk-weighted amount of capital the Bank for International Settlements (BIS) advises each bank to set aside against derivative credit risk; banks must compute a credit-equivalent amount for each derivative transaction. The amount is calculated by summing the current replacement cost, or market value, of the instrument and an add-on factor.
The paperless share settlement system through which trades conducted on the London Stock Exchange can be settled. The system is operated by CRESTCo and was introduced in 1996.
Commissioners for the Reduction of the National Debt, formally responsible for investment of funds held within the public sector e.g., National Insurance Fund.
See cross-rate.
Generally an exchange rate between two currencies, neither of which is the US dollar. In the American market, spot cross is the exchange rate for US dollars against Canadian dollars in its direct form.
See cheapest to deliver.
literally "with dividend", stock that is traded with interest or dividend accrued included in the price.
Cumulative default rate
See probability of default.
Currency option
The option to buy or sell a specified amount of a given currency at a specified rate at or during a specified time in the future.
Currency swap
An agreement to exchange a series of cash flows determined in one currency, possibly with reference to a particular fixed or floating interest payment schedule, for a series of cash flows based in a different currency. See interest rate swap.
Current assets
Assets which are expected to be used or converted to cash within one year or one operating cycle.
Current exposure
The risk exposure, whether this is market, credit or operational risk, to liabilities that are ongoing.
Current liabilities
Obligations which the firm is expected to settle within one year or one operating cycle.
Current yield
Bond coupon as a proportion of clean price per 100; does not take principal gain/loss or time value of money into account. See yield to maturity, simple yield to maturity.
The same as collar.
Delivery against collateral – receipt against payment. Same as DVP.
Daily range
The difference between the high and low points of a single trading day.
Day count
The convention used to calculate accrued interest on bonds and interest on cash. For UK gilts the convention changed to actual/actual from actual/365 on 1 November 1998. For cash the convention in sterling markets is actual/365.
DBV (delivery by value)
A mechanism whereby a CREST/CGO member may borrow from or lend money to another CREST/CGO member against overnight gilt collateral. The CREST/CGO system automatically selects and delivers securities to a specified aggregate value on the basis of the previous night’s CREST/CGO reference prices; equivalent securities are returned the following day. The DBV functionality allows the giver and taker of collateral to specify the classes of security to included within the DBV. The options are: all classes of security held within CREST/CGO, including strips and bulldogs; coupon bearing gilts and bulldogs; coupon bearing gilts and strips; only coupon bearing gilts.
Daily earnings at risk.
In the US market, an unsecured domestic bond, backed by the general credit quality of the issuer. Debentures are issued under a trust deed or indenture. In the UK market, a bond that is secured against the general assets of the issuer.
Debt capital
Capital raised by governments and corporate institutions that is raised through issuance of bonds.
Debt Management Office (DMO)
An executive arm of the UK Treasury, responsible for cash management of the government’s borrowing requirement. This includes responsibility for issuing government bonds (gilts), a function previously carried out by the Bank of England. The DMO began operations in April 1998.
Default correlation
The degree of covariance between the probabilities of default of a given set of counterparties. For example, in a set of counterparties with positive default correlation, a default by one counterparty suggests an increased probability of a default by another counterparty.
Default probability
See probability of default.
Default risk
See credit risk.
Default risk exposure
See credit risk exposure.
Default start options
Options purchased before their "lives" actually commence. A corporation might, for example, decide to pay for a deferred start option to lock into what it perceives as current advantageous pricing for an option that it knows it will need in the future.
Deferred strike option
Option where the strike price is established at a future date on the basis of the spot foreign exchange price prevailing at that future date.
Deliverable bond
One of the bonds which is eligible to be delivered by the seller of a bond futures contract at the contract’s maturity, according to the specifications of that particular contract.
Transfer of bonds (in settlements) from seller to buyer.
Delivery versus payment (DVP)
The simultaneous exchange of securities and cash. The assured payment mechanism of the CGO achieves the same protection.
The change in an option’s value relative to a change in the underlying’s value.
A decrease in the market value of a currency in terms of other currencies. See appreciation, devaluation.
Strictly, any financial instrument whose value is derived from another, such as a forward foreign exchange rate, a futures contract, an option, an interest rate swap, and so on. Forward deals to be settled in full are not always called derivatives, however.
An official one-off decrease in the value of a currency in terms of other currencies. See depreciation, revaluation.
Digital option
Unlike simple European and American options, a digital option has fixed payouts and, rather like binary digital circuits, which are either on or off, pays out either this amount or nothing. Digital options can be added together to create assets that exactly mirror index price movements anticipated by investors. See one touch all-or-nothing.
An exchange rate quotation against the US dollar in which the dollar is the variable currency and the other currency is the base currency.
Dirty price
The price of a bond including accrued interest. Also known as the "all-in" price.
The amount by which a bond is trading below par. In FX markets, amount by which a currency is cheaper, in terms of another currency, for future delivery than for spot.
Discount house
In the UK money market, originally securities houses that dealt directly with the Bank of England in T-bills and bank bills, or discount instruments, hence the name. Most discount houses were taken over by banking groups and the term is not now generally used, as the BoE now also deals directly with clearing banks and securities houses. Following closure of Gerard & King in 2000, the only remaining discount house is Cater Allen (part of Abbey National group).
Discount rate
The method of market quotation for certain securities (US and UK treasury bills, for example), expressing the return on the security as a proportion of the face value of the security received at maturity – as opposed to a yield which expresses the yield as a proportion of the original investment.
Discount swap
Swap in which the fixed-rate payments are less than the internal rate of return on the swap, the difference being made up at maturity by a balloon payment.
Dividend discount model
Theoretical estimate of market value that computes the economic or the net present value of future cash flows due to an equity investor.
The UK Debt Management Office.
The Debt Management Report, published annually by HM Treasury.
Down-and-in option
Barrier option where the holder’s ability to exercise is activated if the value of the underlying drops below a specified level. See also up-and-in option.
Down-and-out option
Barrier option where the holder’s ability to exercise expires if the value of the underlying drops below a specified level.
Dual currency option
Option allowing the holder to buy either of two currencies.
Dual currency swap
Currency swap where both the interest rates are fixed rates.
Dual strike option
Interest rate option, usually a cap or a floor, with one floor or ceiling rate for part of the option’s life and another for the rest.
A measure of the weighted average life of a bond or other series of cash flows, using the present values of the cash flows as the weights. See modified duration.
Duration gap
Measurement of the interest rate exposure of an institution.
Duration weighting
The process of using the modified duration value for bonds to calculate the exact nominal holdings in a spread position. This is necessary because £1 million nominal of a two-year bond is not equivalent to £1 million of say, a five-year bond. The modified duration value of the five-year bond will be higher, indicating that its "basis point value" (bpv) will be greater, and that therefore £1 million worth of this bond represents greater sensitivity to a move in interest rates (risk). As another example consider a fund manager holding £10 million of five-year bonds. The fund manager wishes to switch into a holding of two-year bonds with the same overall risk position. The basis point values of the bonds are 0.041583 and 0.022898 respectively. The ratio of the bpvs are 0.041583/0.022898 = 1.816. The fund manager therefore needs to switch into £10m * 1.816 = £18.160 million of the two-year bond.
Delivery versus payment, in which the settlement mechanics of a sale or loan of securities against cash is such that the securities and cash are exchanged against each other simultaneously through the same clearing mechanism and neither can be transferred unless the other is.
Early exercise
The exercise or assignment of an option prior to expiration.
The European Currency Unit, a basket composed of European Union currencies, now defunct following introduction of euro currency.
Effective rate
An effective interest rate is the rate which, earned as simple interest over one year, gives the same return as interest paid more frequently than once per year and then compounded. See nominal rate.
Efficient frontier method
Technique used by fund managers to allocate assets.
Efficient market
Attributed to Eugene Fama (1970), a market in which asset prices reflect all price-relevant information.
Embedded option
Interest-rate sensitive option within a debt instrument that affects its redemption. Such instruments include mortgage-backed securities and callable bonds.
A money market deal commencing on the last working day of a month and lasting for a whole number of months, maturing on the last working day of the correlation.
The same as vega.
The residual interest in the net assets of an entity that remains after deducting the liabilities.
Equity options
Options on shares of an individual common stock.
Equity warrant
Warrant, usually attached to a bond, entitling the holder purchase share(s).
Equity-linked swap
Swap where one of the cash flows is based on an equity instrument or index, when it is known as an equity index swap.
Equivalent life
The weighted average life of the principal of a bond where there are partial redemptions, using the present values of the partial redemptions as the weights.
See exchange rate agreement.
The same as vega.
The reference rate for the euro currency, fixed in Brussels.
The name for the domestic currency of the European Monetary Union. Not to be confused with Eurocurrency.
An international clearing system for Euro-currency and international securities. Euroclear is based in Brussels and managed by Morgan Guaranty Trust Company.
A Eurocurrency is a currency owned by a non-resident of the country in which the currency is legal tender. Not to be confused with euro.
The issue of gilts (or other securities) denominated in euro.
The international market in which Eurocurrencies are traded.
A European option is one that may be exercised only at expiry. See American.
Exchange controls
Regulations restricting the free convertibility of a currency into other currencies.
Exchange rate agreement
A contract for differences based on the movement in a forward-forward foreign exchange swap price. Does not take account of the effect of spot rate changes as an FXA does. See SAFE.
Futures contracts are traded on a futures exchange, as opposed to forward deals which are OTC. Option contracts are similarly exchange traded rather than OTC.
Ex-dividend (xd) date
A bond’s record date for the payment of coupons. The coupon payment will be made to the person who is the registered holder of the stock on the xd date. For UK gilts this is seven working days before the coupon date.
To exercise an option (by the holder) is to require the other party (the writer) to fulfil the underlying transaction. Exercise price is the same as strike price.
Exotic option
Usually referred to simply as an "exotic", a non-standard or non-vanilla option that differs from conventional options, in one or more ways. Examples included path-dependent options such as Asian or lookback options.
Expected (credit) loss
Estimate of the amount a derivatives counterparty is likely to lose as a result of default from a derivatives contract, with a given level of probability. The expected loss of any derivative position can be derived by combining the distributions of credit exposures, rate of recovery and probabilities of default.
Expected default rate
Estimate of the most likely rate of default of a counterparty expressed as a level of probability.
Expected rate of recovery
See rate of recovery.
An option’s expiry is the time after which it can no longer be exercised.
Risk to market movements.
Exposure profile
The path of worst-case or expected exposures over time. Different instruments reveal quite differently shaped exposures profiles due to the interaction of the diffusion and amortisation effects.
Extinguishable option
Option in which the holder’s right to exercise disappears if the value of the underlying passes a specified level. See also barrier option.
The process of estimating a price or rate for a particular value date, from other known prices, when the value date required lies outside the period covered by the known prices. See interpolation.
Face value
The principal amount of a security generally repaid ("redeemed") at maturity, but sometimes repaid in stages, on which the coupon amounts are calculated. Also known as nominal amount.
See Libor fixing.
Floating rate
An interest rate set with reference to an external index. Also an instrument paying a floating rate is one where the rate of interest is refixed in line with market conditions at regular intervals such as every three or six months. In the current market, an exchange rate determined by market forces with no government intervention.
Floating rate CD
CD on which the rate of interest payable is refixed in line with market conditions at regular intervals (usually six months).
Floating rate gilt
Gilt issued with an interest rate adjusted periodically in line with market interbank rates.
Floating rate note
Capital market instrument on which the rate of interest payable is refixed in line with market conditions at regular intervals (usually six months).
A series of lender’s IRGs, designed to protect an investor against falling interest rates on each of a series of dates.
Option on a floor.
In general, a deal for value later that the normal value date for that particular commodity or instrument. In the foreign exchange market, a forward price is the price quoted for the purchase or sale of one currency against another where the value date is at least one month after the spot date. See short date.
Forward band
Zero-cost collar, that is one in which the premium payable as a result of buying the cap is offset exactly by that obtained from selling the floor.
Forward break
See break forward.
Forward exchange agreement
A contract for differences designed to create exactly the same economic result as a foreign exchange cash forward–forward deal. See ERA, SAFE.
Forward price
The price agreed today for an asset that will be delivered to the buyer at a date in the future.
Forward rate agreement
Short-term interest rate hedge. Specifically, a contract between buyer and seller for an agreed interest rate on a notional deposit of a specified maturity on a predetermined future date. No principal is exchanged. At maturity the seller pays the buyer the difference if rates have risen above the agreed level, and vice versa.
Forward swap
Swap arranged at the current rate but entered into at some time in the future.
Another term for an interest rate effective from a forward short date. Also a short-term exchange of currency deposits.
See forward rate agreement.
Option on a forward rate agreement. Also known as an interest rate guarantee.
See floating rate CD.
The Financial Services Authority, the body responsible for the regulation of investment business, and the supervision of banks and money market institutions in the UK. The FSA took over these duties from nine "self-regulatory organisations" that had previously carried out this function, including the Securities and Futures Authority (SFA), which had been responsible for regulation of professional investment business in the City of London. The FSA commenced its duties in 1998.
Index comprising 100 major UK shares listed on The International Stock Exchange in London. Futures and options on the index are traded at the London International Financial Futures and Options Exchange (LIFFE).
The USD/CAD exchange rate for value on the next business day (standard practice for USD/CAD in preference to spot).
A financial instrument that is equivalent in value to another, and easily exchanged or substituted. The best example is cash money, as a £10 note has the same value and is directly exchangeable with another £10 note. A bearer bond also has this quality.
A futures contract is a contract to buy or sell securities or other goods at a future date at a pre-determined price. Futures contracts are standardised and traded on an exchange.
Future exposure
See potential exposure.
Future value
The amount of money achieved in the future, including interest, by investing a given amount of money now. See time value of money, present value.
Futures contract
A deal to buy or sell some financial instrument or commodity for value on a future date. Unlike a forward deal, futures contracts are traded only on an exchange (rather than OTC), have standardised contract sizes and value dates, and are often only contract for differences rather than deliverable.
The "Group of Seven" countries, the USA, Canada, UK, Germany, France, Italy and Japan.
The change in an option’s delta relative to a change in the underlying’s value.
Gap ratio
Ratio of interest-rate sensitive assets to interest-rate sensitive liabilities; used to determine changes in the risk profile of an institution with changes in interest rate levels.
Gross domestic product, the value of total output produced within a country’s borders.
A gilt-edged market maker, a bank or securities house registered with the Bank of England as a market maker in gilts. A GEMM is required to meet certain obligations as part of its function as a registered market maker, including making two-way price quotes at all times in all gilts and taking part in gilt auctions. The Debt Management Office now make a distinction between conventional gilt GEMMs and index-linked GEMMs, known as IG GEMMs.
General collateral (GC)
Securities, which are not "special", used as collateral against cash borrowing. A repo buyer will accept GC at any time that a specific stock is not quoted as required in the transaction. In the gilts market GC includes DBVs.
Guaranteed investment contract.
A UK Government sterling denominated, listed security issued by HM Treasury with initial maturity of over 365 days when issued. The term "gilt" (or gilt-edged) is a reference to the primary characteristic of gilts as an investment: their security and risk-free status.
Gilt-edged market maker
Gross national product, the total monetary value of a country’s output, as produced by citizens of that country.
Gross redemption yield
The same as yield to maturity; "gross" because it does not take tax effects into account.
See gross redemption yield.
Hedge ratio
The ratio of the size of the position it is necessary to take in a particular instrument as a hedge against another, to the size of the position being hedged.
Protecting against the risks arising from potential market movements in exchange rates, interest rates or other variables. See arbitrage, cover, speculation.
Herstatt risk
See settlement risk.
High coupon swap
Off-market coupon swap where the coupon is higher than the market rate. The floating-rate payer pays a front-end fee as compensation. Opposite of low coupon swap.
Historic rate rollover
A forward rate swap in FX where the settlement exchange rate for the near date is based on a historic off-market rate rather than the current market rate. This is prohibited by many central banks.
Historic volatility
The actual volatility recorded in market prices over a particular period.
Historical simulation methodology
Method of calculating value-at-risk (VAR) using historical data to assess the likely effect of market moves on a portfolio.
The holder of an option is the party that has purchased it.
Inter-Dealer Broker, in this context a broker that provides facilities for dealing in bonds between market makers.
Index-linked gilt whose coupons and final redemption payment are related to the movements in the Retail Price Index (RPI).
This is the process by which a bond portfolio is created that has an assured return for a specific time horizon irrespective of changes in interest rates. The mechanism underlying immunisation is a portfolio structure that balances the change in the value of a portfolio at the end of the investment horizon (time period) with the return gained from the reinvestment of cash flows from the portfolio. As such, immunisation requires the portfolio manager to offset interest-rate risk and reinvestment risk.
Implied repo rate
The break-even interest rate at which it is possible to sell a bond futures contract, buy a deliverable bond, and repo the bond out. See cash and carry.
Implied volatility
The volatility used by a dealer to calculate an option price; conversely, the volatility implied by the price actually quoted.
Index option
An option whose underlying security is an index. Index options enable a trader to bet on the direction of the index.
Index swap
Sometimes the same as a basis swap. Otherwise a swap like an interest rate swap where payments on one or both of the legs are based on the value of an index – such as an equity index, for example.
Indexed notes
Contract whereby the issuer usually assumes the risk of unfavourable price movements in the instrument, commodity or index to which the contract is linked, in exchange for which the issuer can reduce the cost of borrowing (compared with traditional instruments without the risk exposure).
An exchange rate quotation against the US dollar in which the dollar is the base currency and the other currency is the variable currency.
Initial margin
The excess either of cash over the value of securities, or of the value of securities over cash in a repo transaction at the time it is executed and subsequently, after margin calls.
The market in unsecured lending and trading between banks of roughly similar credit quality.
Interest rate cap
See cap.
Interest rate floor
See floor.
Interest rate guarantee
An option on a specified interest rate, usually referenced to Libor.
Interest rate option
Option to pay or receive a specified rate of interest on or from a predetermined future date.
Interest rate swap
An agreement to exchange a series of cash flows determined in one currency, based on fixed or floating interest payments on an agreed notional principal, for a series of cash flows based in the same currency but on a different interest rate. May be combined with a currency swap.
Intermarket spread
A spread involving futures contracts in one market spread against futures contracts in another market.
Internal rate of return
The yield necessary to discount a series of cash flows to an NPV of zero.
The process of estimating a price or rate for value on a particular date by comparing the prices actually quoted for value dates either side. See extrapolation.
Purchases or sales of currencies in the market by central banks in an attempt to reduce exchange rate fluctuations or to maintain the value of a currency within a particular band, or at a particular level. Similarly, central bank operations in the money markets to maintain interest rates at a certain level.
A call (put) option is in-the-money if the underlying is currently more (less) valuable than the strike price. See at-the-money, out-of-the-money.
Intrinsic value
The amount by which an option is in-the-money.
Inverse floater
A floating-rate note structured so that it’s coupon falls as interest rates rise, and vice-versa.
Invoice price
For exchange-traded bond futures contracts, the price received by the short future; calculated as (conversion factor * futures price) + accrued interest.
See interest rate guarantee.
See internal rate of return.
The International Securities Market Association. This association compiled with the PSA (now renamed the Bond Market Association) the PSA/ISMA Global Master repurchase Agreement.
Issuer risk
Risk to an institution when it holds debt securities issued by another institution. (See also credit risk).
The repetitive mathematical process of estimating the answer to a problem, by trying how well this estimate fits the data, adjusting the estimate appropriately and trying against it, until the fit is acceptably close. Used, for example, in calculating a bond’s yield from its price.
Junk bonds
The common term for high-yield bonds; higher risk, low rated debt.
An alternative term to refer to volatility; see vega.
Knock out/in
A knock out (in) option ceases to exist (starts to exist) if the underlying reaches a certain trigger level. See barrier option.
The same as vega.
Lender option
Floor on a single-period forward rate agreement.
The non-normal distribution of asset-price returns. Refers to a probability distribution that has a fatter tail and a sharper hump than the normal distribution.
Level payment swap
Evens out those fixed-rate payments that would otherwise vary, for example, because of the amortisation of the principal.
The ability to control large amounts of an underlying variable for a small initial investment.
Probable future sacrifice of economic benefit due to present obligations to transfer assets or provide services to other entities as a result of past events or transactions. Generally classed as either current or long-term.
Liability swap
An interest rate swap or currency swap used in conjunction with an underlying liability such as a borrowing. See asset swap.
The London Interbank Bid Rate, the rate at which banks will pay for funds in the interbank market.
The London Interbank Offered Rate, the lending rate for all major currencies up to one-year set at 11am each day by the British Bankers Association.
Libor fixing
The Libor rate "fixed" by the British Bankers Association (BBA) at 11am each day, for maturities up to one year.
The London International Financial Futures and Options Exchange, the largest futures exchange in Europe.
The arithmetic average of Libor and Libid rates.
Limit up/down
Futures prices are generally not allowed to change by more than a specified total amount in a specified time, in order to control risk in very volatile conditions. The maximum movements permitted are referred to as limit up and limit down.
Any transaction that closes out or offsets a futures or options position.
A word describing the ease with which one can undertake transactions in a particular market or instrument. A market where there are always ready buyers and sellers willing to transact at competitive prices is regarded as liquid. In banking, the term is also used to describe the requirement that a portion of a bank’s assets be held in short-term risk-free instruments, such as government bonds, T-Bills and high quality Certificates of Deposit. This is the responsibility of the liquidity desk, part of Treasury.
Loan-equivalent amount
Description of derivative exposure which is used to compare the credit risk of derivatives with that of traditional bonds or bank loans.
A variable’s probability distribution is lognormal if the logarithm of the variable has a normal distribution.
Lognormal distribution
The assumption that the natural logarithm of today’s interest rate, for example, minus the natural logarithm of yesterday’s rate is normally distributed.
A long position is a surplus of purchases over sales of a given currency or asset, or a situation which naturally gives rise to an organisation benefiting from a strengthening of that currency or asset. To a money market dealer, however, a long position is a surplus of borrowings taken in over money lent out (which gives rise to a benefit if that currency weakens rather than strengthens). See short.
Long-dated forward
Forward foreign exchange contract with a maturity of greater than one year. Some long-dated forwards have maturities as great as 10 years.
Long-term assets
Assets which are expected to provide benefits and services over a period longer than one year.
Long-term liabilities
Obligations to be repaid by the firm more than one year later.
Lookback option
Option that allows the purchaser, at the end of a given period of time, to choose as the rate for exercise any rate that has existed during the option’s life.
Low coupon swap
Tax-driven swap in which the fixed-rate payments are significantly lower than current market interest rates. The floating-rate payer is compensated by a front-end fee.
London Stock Exchange.
Macaulay duration
See duration.
The process whereby a bank’s trading positions are related to a set of risk "buckets", of fixed maturities.
Initial margin is collateral, placed by one party with a counterparty at the time of the deal, against the possibility that the market price will move against the first party, thereby leaving the counterparty with a credit risk. Variation margin is a payment or extra collateral transferred subsequently from one party to the other because the market price has moved. Variation margin payment is either in effect a settlement of profit/loss (for example, in the case of a futures contract) or the reduction of credit exposure (for example, in the case of a repo). In repos, variation margin refers to the fluctuation band or threshold within which the existing collateral’s value may vary before further cash or collateral needs to be transferred. In a loan, margin is the extra interest above a benchmark (e.g., a margin of 0.5 per cent over Libor) required by a lender to compensate for the credit risk of that particular borrower.
Margin call
A request following marking-to-market of a repo transaction for the initial margin to be reinstated or, where no initial margin has been taken, to restore the cash/securities ratio to parity. In the context of a futures exchange, call to make good trading losses and maintain initial margin levels.
Margin default rate
See probability of default.
Margin transfer
The payment of a margin call.
Market comparables
Technique for estimating the fair value of an instrument for which no price is quoted by comparing it with the quoted prices of similar instruments.
Market risk
Risks related to changes in prices of tradeable macroeconomics variables, such as exchange rate risks.
Market participant who is committed, explicitly or otherwise, to quoting two-way bid and offer prices at all times in a particular market.
The act of revaluing securities to current market values. Such revaluations should include both coupon accrued on the securities outstanding and interest accrued on the cash.
Matched book
Repo market making, or only trading to cover one’s own requirements. It carries no implications that the trader’s position is "matched" in terms of exposure, for example to short-term interest rates.
Maturity date
Date on which stock is redeemed. Also known as the expiry date.
Minmax option
One of the strategies for reducing the cost of options by forgoing some of the potential for gain. The buyer of a currency option, for example, simultaneously sells an option on the same amount of currency but at a different strike price.
Modified duration
A measure of the proportional change in the price of a bond or other series of cash flows, relative to a change in yield (mathematically). See duration.
Modified following business day (MFBD)
The convention that if a value date in the future falls on a non-business day, the value date will be moved to the next following business day, unless this moves the value date to the next month, in which case the value date is moved back to the last previous business day.
The strength behind an upward or downward movement in price.
Money market
Short-term market (generally up to one year) for financial instruments. See capital market.
Money-market basis
An interest rate quoted on an act/360 basis is said to be on a money-market basis. See bond basis.
Monte Carlo simulation
Technique used to determine the likely value of a derivative or other contract by simulating the evolution of the underlying variables many times. The discounted average outcome of the simulation gives an approximation of the derivative’s value. Monte Carlo simulation can be used to estimate the value-at-risk (VAR) of a portfolio. Here, it generates a simulation of many correlated market movements for the markets to which the portfolio is exposed, and the positions in the portfolio are revalued repeatedly in accordance with the simulated scenarios. This gives a probability distribution of portfolio gains and losses from which the VAR can be determined.
A method for calculating the yield of a bond.
Mortgage-backed security (MBS)
Security guaranteed by a pool of mortgages.
Moving average convergence/divergence
The crossing of two exponentially smoothed moving averages that oscillate above and below an equilibrium line (MACD).
Multi-index option
Option which gives the holder the right to buy the asset that performs best out of a number of assets (usually two). The investor would typically buy a call allowing him or her to buy the equity.
A naked option position is one not protected by an offsetting position in the underlying. See covered call/put.
National Audit Office.
Negative divergence
When at least two indicators, indices or averages show conflicting or contradictory trends.
A security which can be bought and sold in a secondary market is negotiable.
Net present value
The net present value of a series of cash flows is the sum of the present values of each cash flow (some or all of which may be negative).
National Loans Fund, the account which brings together all UK Government lending and borrowing.
Fluctuations in the market which can confuse or impede interpretation of market direction.
Nominal amount
Another term for the face value of a security.
Nominal rate
A rate of interest as quoted, rather than the effective rate to which it is equivalent.
A normal probability distribution is a particular distribution assumed to prevail in a wide variety of circumstances, including the financial markets. Mathematically, it corresponds to the probability density function.
In a bond futures contract, the bond bought or sold is a standardised non-existent notional bond, as opposed to the actual bonds which are deliverable at maturity. Contracts for differences also require a notional principal amount on which settlement can be calculated.
Replacement of a contract or, more usually, a series of contracts with one new contract.
See net present value.
See overnight.
Odd date
See broken date.
The price at which a market maker will sell bonds. Also called "ask".
A rate which is not the current market rate.
Off-market coupon swap
Tax-driven swap strategy, in which the fixed-rate payments differ significantly from current market rates. There are high and low coupon swaps.
One touch all-or-nothing
Digital option. The option’s put pays out a predetermined amount (the "all") if the index goes below (above) the strike price at any time during the option’s life. How far below (above) the strike price the index moves is irrelevant; the payout will be the "all" or nothing.
Open interest
The quantity of futures contracts (of a particular specification) which have not yet been closed out by reversing. Either all long positions or all short positions are counted, but not both.
Opening leg
The first half of a repo transaction (see closing leg).
Operational Market Notice
Sets out the DMO’s (previously the Bank’s) operations and procedures in the gilt market.
Operational risk
Risk of loss occurring due to inadequate systems and control, human error, or management failure.
Opportunity cost
Value of an action that could have been taken if the current action had not been chosen.
The right (but not the obligation) to buy or sell securities at a fixed price within a specified period.
Option forward
See time option.
Option-adjusted spread (OAS)
For a bond with an embedded option or a mortgage-backed security, the additional spread earned over the term structure of returns that is implied from benchmark government yields in order for the value of the bond to be equal to its observed market price. The higher yield spread reflects the interest-rate option embedded in the callable bond or MBS security.
Ornstein–Uhlenbeck equation
A standard equation that describes mean reversion. It can be used to characterise and measure commodity price behaviour.
Over the counter. Strictly speaking, any transaction not conducted on a registered stock exchange. Trades conducted via the telephone between banks, and contracts such as FRAs and (non-exchange traded) options, are said to be "over-the-counter" instruments. OTC also refers to non-standard instruments or contracts traded between two parties; for example, a client with a requirement for a specific risk to be hedged with a tailor-made instrument may enter into an OTC structured option trade with a bank that makes markets in such products.
A call (put) option is out-of-the-money if the underlying is currently less (more) valuable than the strike price. See at-the-money, in-the-money.
An outright (or forward outright) is the sale or purchase of one foreign currency against another value on any date other than spot. See forward, short date, spot, swap.
A position in which a dealer’s liabilities (borrowings taken in) are of longer maturity than the assets (loans out).
A position in which a dealer’s assets (loans out) are of longer maturity than the liabilities (borrowings taken in).
A deal from today until the next working day ("tomorrow").
P(t, T)
The price at time t of a risk-free zero-coupon bond that matures at time T (with T > t).
Another term for a bond or debt issue.
When the price of a security is equal to the face value, usually expressed as 100, it is said to be trading at par. A par swap rate is the current market rate for a fixed interest rate swap against Libor. In foreign exchange, when the outright and spot exchange rates are equal, the forward swap is zero or par.
Par yield curve
A curve plotting maturity against yield for bonds priced at par.
The official rate of exchange for one currency in terms of another which a government is obliged to maintain by means of intervention.
Participation forward
A product equivalent to a straightforward option plus a forward deal, but structured as a forward deal at an off-market rate plus the opportunity to benefit partially if the market rate improves.
A path-dependent option is one which depends on what happens to the underlying throughout the option’s life (such as the American or barrier option) rather than only at expiry (a European option).
Peak exposure
If the worst case or the expected credit risk exposures of an instrument is calculated over time, the resulting graph reveals a credit risk exposure profile. The highest exposure marked out by the profile is the peak exposure generated by the instrument.
Perfect market
A theoretical market in which transactions may be undertaken without the need to pay a bid-offer spread or other transaction costs such as commission, taxes and so on. It also assumes that buy and sell trades can be undertaken in any size without affecting the market.
Periodic resetting swap
Swap where the floating-rate payment is an average of floating rates that have prevailed since the last payment, rather than the interest rate prevailing at the end of the period. For example, the average of six one-month Libor rates rather than one six-month Libor rate.
See points.
Plain vanilla
See vanilla.
In bond markets, one whole unit of price. In FX markets, the last two decimal places in an exchange rate. For example, when EUR/USD is 1.0520/1.0530, the points are 20/30. See bid figure.
Portfolio variance
The square of the standard deviation of a portfolio’s return from the mean.
Positive cash flow collar
Collar other than a zero-cost collar.
Potential exposure
Estimate of the future replacement cost, or positive market value, of a derivative transaction. Potential exposure should be calculated using probability analysis based on broad confidence intervals (e.g., two standard deviations) over the remaining term of the transaction.
Preference shares
These are a form of corporate financing. They are normally fixed interest shares whose holders have the right to receive dividends ahead of ordinary shareholders. If a company were to go into liquidation, preference shareholders would rank above ordinary shareholders for the repayment of their investment in the company. Preference shares ("prefs") are normally traded within the fixed interest division of a bank or securities house.
The amount above par at which a bond is trading. In the FX market, the amount by which a currency is more expensive, relative to another currency, for future delivery compared to spot delivery. This is the forward premium, and reflects the interest-rate differential between the two currencies.
Present value
The amount of money which needs to be invested now to achieve a given amount in the future when interest is added. See future value, time value of money.
Pre-settlement risk
As distinct from credit risk arising from intra-day settlement risk, this term describes the risk of loss that might be suffered during the life of the contract if a counterparty to a trade defaulted and if, at the time default, the instrument had a positive economic value.
Price factor
See conversion factor.
Price–earnings ratio
A ratio giving the price of a stock relative to the earnings per share.
Primary market
The market for new debt, into which new bonds are issued. The primary market is made up of borrowers, investors and the investment banks which place new debt into the market, usually with their clients. Bonds that trade after they have been issued are said to be part of the secondary market.
Probability distribution
The mathematical description of how probable it is that the value of something is less than or equal to a particular level.
Probability of default
The statistical measure of how likely it is that an institution will default on its debt obligations over the next 12 months. As calculated by the ratings agencies, this is based on historical measures of institutions in the same credit rating category.
A put option is an option to sell the commodity or instrument underlying the option. See call option.
An option that has its final payoff linked to two or more underlying assets or reference rates.
Quanto swap
A swap where the payments of one or both legs are based on a measurement (such as the interest rate) in one currency but payable in another currency.
Quasi-coupon date
The regular date for which a coupon payment would be scheduled if there were one. Used for price/yield calculations for zero-coupon instruments.
Range forward
A zero-cost collar where the customer is obliged to deal with the same bank at spot if neither limit of the collar is breached at expiry.
Rate of recovery
Estimate of the percentage of the amount exposed to default – that is, the credit risk exposure – which is likely to be recovered if a counterparty defaults.
Record date
A coupon or other payment due on a security is paid by the issuer to whoever is registered on the record date as being the owner. See cum-dividend, ex-dividend date.
A security is said to be redeemed when the principal is repaid.
Redemption yield
The rate of interest at which all future payments (coupons and redemption) on a bond are discounted so that their total equals the current price of the bond (inversely related to price). The redemption yield is also known as the yield to maturity (YTM) or gross redemption yield and is the most frequently used measure of return from holding a bond.
Read a fuller definition here.
A change in the currency unit in which the nominal value of a security is expressed (in context, from sterling to euro). Also the gross redemption yield.
Reduced-cost option
Generic term for options for which there is a reduced premium, either because the buyer undertakes to forgo a percentage of any gain, or because the buyer offsets the cost by writing other See also zero-premium option.
The practice whereby a trader instructs a broker to put "under reference" any prices or rates he has quoted to him, meaning that they are no longer "firm" and the broker must refer to the trader before he can trade on the price initially quoted.
Record of ownership of securities. For gilts, excluding bearer bonds, entry in an official register confers title.
Registered bond
A bond for which the issuer keeps a record (register) of its owners. Transfer of ownership must be notified and recorded in the register. Interest payments are posted (more usually electronically transferred) to the bondholder.
Registrar’s Department
Department of the Bank of England which maintains the register of holdings of gilts.
Reinvestment rate
The rate at which interest paid during the life of an investment is reinvested to earn interest-on-interest, which in practice will generally not be the same as the original yield quoted on the investment.
Relative performance option
Option whose value varies in line with the relative value of two assets.
Replacement cost
The present value of the expected future net cash flows of a derivative instrument. Aside from various conventions dealing with the bid/ask spread, synonymous with the "market value" or "current exposure" of an instrument.
A collateralised loan. Usually refers in particular to classic repo. Also used as a term to include classic repos, buy/sell-backs and securities lending.
Repo rate
The return earned on a repo transaction expressed as an interest rate on the cash side of the transaction.
Repurchase agreement
See repo.
The return on an investment, put simply, the ratio of the asset price at the start of the investment (P0) and the asset price at the maturity of the investment (PT), that is P0/PT. The market convention is to quote annualised returns.
Return on assets
The net earnings of a company divided by its assets.
Return on equity
The net earning of a company divided by its equity.
Return on value-at-risk
An analysis conducted to determine the relative rates of return on different risks, allowing corporations to compare different risk capital allocations and capital structure decisions effectively.
An official one-off increase in the value of a currency in terms of other currencies. See devaluation.
See reverse repo.
Reverse repo
The other side of a repo.
The change in an option’s value relative to a change in interest rates.
Risk reversal
Changing a long (or short) position in a call option to the same position in a put option by selling (or buying) forward, and vice versa.
Risk weighting
Assigning risk exposure according to specified levels, according to the type of institution that is the counterparty. For example, bank risk capital, as applied under the Basle rules, assigned varying degrees of risk weighting depending on whether the counterparty is an OECD sovereign, banking institution or corporate.
Risk-free arbitrage
An arbitrage opportunity arising whenever it is possible to create two portfolios that have identical payoff profiles but different prices.
Risk-free return
Also known as riskless return, the return available to the holder of a risk-free asset, such as a gilt or US Treasury security. The interest rate on these instruments is the risk-free interest rate. The risk-free interest rate used in market analysis is the rate observed on a Treasury bill, this being the shortest-dated risk-free instrument available in any market.
See tom/next. Also refers to the renewal of a loan.
A gilt issue so designated because it is illiquid, generally because there is a very small nominal amount left in existence.
Running yield
Same as current yield.
See spot/next
See synthetic agreement for forward exchange.
Secondary market
The market in instruments after they have been issued. Bonds are bought and sold after their initial issue by the borrower, and the marketplace for this buying and selling is referred to as the secondary market. The new issues market is the primary market.
Securities and Exchange Commission (SEC)
The central regulatory authority in the United States, responsible for policing the financial markets including the bond markets.
Securities lending
When a specific security is lent against some form of collateral. Also known as stock lending.
The process of raising finance, via a framework in which liquid or illiquid assets of an institution are transformed into a package of debt securities backed by these assets. Assets can include mortgages, corporate loans, credit card receivables, lease receivables and so on. To remove the assets from the originating company’s balance sheet, securities are often issued by a special purpose vehicle (SPV), an incorporated entity created specially for the process. The SPV is bankruptcy-remote, so that any financial difficulties of the originating institution will not affect the pool of financial assets held by the SPV.
A financial asset sold initially for cash by a borrowing organisation (the "issuer"). The security is often negotiable and usually has a maturity date when it is redeemed.
Simultaneous spot sale and forward purchase of a security, with the forward price calculated to achieve an effect equivalent to a classic repo.
The process of transferring stock from seller to buyer and arranging the corresponding movement of funds between the two parties.
Settlement bank
Bank which agrees to receive and make assured payments for gilts bought and sold by a CGO member.
Settlement date
Date on which transfer of bonds and payment occur, usually one, two or three days after the trade is conducted.
Settlement risk
The risk that occurs when there is a non-simultaneous exchange of value. Also known as "delivery risk" and "Herstatt risk".
Sharpe ratio
A measure of the attractiveness of the return on an asset by comparing how much risk premium the investor can expect it to receive in return for the incremental risk (volatility) the investment carries. It is the ratio of the risk premium to the volatility of the asset.
A short position is a surplus of sales over purchases of a given currency or asset, or a situation which naturally gives rise to an organisation benefiting from a weakening of that currency or asset. To a money market dealer, however, a short position is a surplus of money lent out over borrowings taken in (which give rise to a benefit if that currency strengthens rather than weakens). See long.
Short date
The interest rate for short-term deposits, up to one month in maturity. Also a deal for value on a date other than spot but less than one month after spot.
Simple interest
When interest on an investment is paid all at maturity or not reinvested to earn interest on interest, the interest is said to be simple. See compound interest.
Simple yield to maturity
Bond coupon plus principal gain/loss amortised over the time to maturity, as a proportion of the clean price per 100. Does not take time value of money into account. See current yield, yield to maturity.
A security which for any reason is sought-after in the repo market, thereby enabling any holder of the security to earn incremental income (in excess of the General Collateral (GC) rate) through lending them via a repo transaction. The repo rate for a special will be below the GC rate, as this is the rate the borrower of the cash is paying in return for supplying the special bond as collateral. An individual security can be in high demand for a variety of reasons; for instance, if there is sudden heavy investor demand for it, or (if it is a benchmark issue) it is required as a hedge against a new issue of similar maturity paper.
A deal undertaken because the dealer expects prices to move in his favour, as opposed to hedging or arbitrage.
In the money market, a deal to be settled on the day after the customary value date for that particular instrument. In the foreign exchange market, standard settlement for value in two working days’ time.
Spot price
The price of an asset for delivery today, or at the earliest possible delivery date. Compare to the forward price, which is the price agreed today for delivery of the asset at a specified date in the future.
A transaction from spot until the next working day.
The difference between the bid and offer prices in a quotation. Also a strategy involving the purchase of an instrument and the simultaneous sale of a similar related instrument, such as the purchase of a call option at one strike and the sale of a call option at a different strike.
A position in which sales exactly match purchases, or in which assets exactly match liabilities. See long, short.
Standard deviation
A measure of how much the values of something fluctuate around its mean value. Defined as the square root of the variance.
Step-down swap
Swap in which the fixed-rate payment decreases over the life of the swap.
Step-up swap
Swap in which the fixed-rate payment increases over the life of the swap.
Stock index future
Future on a stock index, allowing a hedge against, or bet on, a broad equity market movement.
Stock index option
Option on a stock index future.
Stock lending
See securities lending.
Stock option
Option on an individual stock.
A position combining the purchase of both a call and put at the same strike for the same date. See strangle.
A position combining the purchase of both a call and a put at different strikes for the same date. See straddle.
The "street" is a term for the market, originating as "Wall Street". A US term for market convention, so in the US market it is the convention for quoting the price or yield for a particular instrument.
Stress testing
Analysis that gives the value of a portfolio under a range of worst-case scenarios.
The strike price or strike rate of an option is the price or rate at which the holder can insist on the underlying transaction being fulfilled.
A zero-coupon bond which is produced by separating a standard coupon-bearing bond into its constituent principal and interest components. To strip a bond is to separate its principal amount and its coupons and trade each individual cash flow as a separate instrument ("separately traded and registered for interest and principal"). Also, a strip of futures is a series of short-term futures contracts with consecutive delivery dates, which together create the effect of a longer term instrument (for example, four consecutive 3-month futures contracts as a hedge against a one-year swap). A strip of FRAs is similar.
A foreign exchange swap is the purchase of one currency against another for delivery on one date, with a simultaneous sale to reverse the transaction on another value date. See also currency swap, interest rate swap.
An option on an interest rate swap or currency swap.
In the gilt market, exchanges of one gilt holding for another, sometimes entered into between the DMO and a GEMM as part of the DMO’s secondary market operations.
A package of transactions which is economically equivalent to a different transaction (for example, the purchase of a call option and simultaneous sale of a put option at the same strike is a synthetic forward purchase).
Synthetic agreement for forward exchange
A generic term for ERAs and FXAs.
See tom/next.
The exposure to interest rates over a forward–forward period arising from a mismatched position (such as a two-month borrowing against a three-month loan). In the FX market, a forward foreign exchange dealer’s exposure to spot movements.
The issue of a gilt for exceptional market management reasons and not on a pre-announced schedule.
The term to maturity of a financial instrument.
The time between the beginning and end of a deal or investment.
Term structure of interest rates
a plot of spot interest rates over time.
The change in an option’s value relative to a change in the time left to expiry.
The minimum change allowed in a futures price. Also, in some bond markets, 1/32nd of a point, or 0.03125.
Time deposit
A non-negotiable deposit for a specific term.
Time option
A forward currency deal in which the value date is set to be within a period rather than on a particular day. The customer sets the exact date two working days before settlement.
Time value of money
The concept that a future cash flow can be valued as the amount of money which it is necessary to invest now in order to achieve that cash flow in the future. See future value, present value.
See overnight.
Tomorrow to the next. A transaction from the next working day ("tomorrow") until the day after ("next day" – i.e., spot in the foreign exchange market).
Total return swap
Swap agreement in which the total return of bank loans or credit-sensitive securities is exchanged for some other cash flow usually tied to Libor, or other loans, or credit-sensitive securities. It allows participants effectively to go long or short the credit risk of the underlying asset.
Traded option
Option that is listed on and cleared by an exchange, with standard terms and delivery months.
One of a series of two or more issues with the same coupon rate and maturity date. The tranches become fungible at a future date, usually just after the first coupon date. In a structured product, different bonds in the same securitisation, usually with different credit ratings and coupon rates.
Transaction risk
Extent to which the value of transactions that have already been agreed is affected by market risk.
A term used to refer to how clear asset prices are in a market. A transparent market is one in which a majority of market participants are aware of what level a particular bond or instrument is trading.
Treasury bill
A short-term security issued by a government, generally with a zero coupon.
Trigger option
See barrier option.
The same as collar.
Tunnel options
Set of collars, typically zero-cost, covering a series of maturities from the current date. They might, for example, be for dates 3, 6, 9 or 12 months ahead. The special feature of a tunnel option is that the strike price on both sets of options is constant.
Uncovered option
When the writer of the option does not own the underlying security. Also known as a naked option.
Undated gilts
Gilts for which there is no final date by which the gilt must be redeemed.
The underlying of a futures or option contract is the commodity or financial instrument on which the contract depends. The underlying for a bond option is the bond; the underlying for a short-term interest rate futures contract is typically a three-month deposit.
An arrangement by which a company is guaranteed that an issue of debt (bonds) will raise a given amount of cash. Underwriting is carried out by investment banks, who undertake to purchase any part of the debt issue not taken up by the public. A commission is charged for this service.
Unexpected default rate
The distribution of future default rates is often characterised in terms of an expected default rate (e.g., 0.05%) and a worst-case default rate (e.g., 1.05%). The difference between the worst-case default rate and the expected default rate is often termed the "unexpected default" (that is 1% = (1.05 - 0.05%)).
Unexpected loss
The distribution of credit losses associated with a derivative instrument is often characterised in terms of an expected loss or a worst-case loss. The unexpected loss associated with an instrument is the difference between these two measures.
Up-and-away option
See up-and-out option.
Up-and-in option
Type of barrier option which is activated if the value of the underlying goes above a predetermined level. (See also down-and-in option).
Up-and-out option
Type of barrier option that is extinguished if the value of the underlying goes above a predetermined level. See also down-and-out option.
Value date
The date on which a deal is to be consummated. In some bond markets, the value date for coupon accruals can sometimes differ from the settlement date, as the latter can only be a working day.
Value-at-risk (VAR)
Formally, the probabilistic bound of market losses over a given period of time (known as the holding period) expressed in terms of a specified degree of certainty (known as the confidence interval). Put more simply, the VAR is the worst-case loss that would be expected over the holding period within the probability set out by the confidence interval. Larger losses are possible but with a low probability. For instance, a portfolio whose VAR is $20 million over a one-day holding period, with a 95% confidence interval, would have only a 5% chance of suffering an overnight loss greater than $20 million.
A vanilla transaction is a straightforward one.
See value-at-risk.
Variable currency
Exchange rates are quoted in terms of the number of units of one currency (the variable or counter currency) which corresponds to one unit of the other currency (the base currency).
A measure of how much the values of something fluctuate around its mean value. Defined as the average of See standard deviation.
Variance-covariance methodology
Methodology for calculating the value-at-risk of a portfolio as a function of the volatility of each asset or liability position in the portfolio and the correlation between the positions.
Variation margin
The band agreed between the parties to a repo transaction at the outset within which the value of the collateral may fluctuate before triggering a right to call for cash or securities to reinstate the initial margin on the repo transaction.
The change in an option’s value relative to a change in the underlying’s volatility.
The standard deviation of the continuously compounded return on the underlying. Volatility is generally annualised.See historic volatility, implied volatility
A security giving the holder a right to subscribe to a share or bond at a given price and from a certain date. If this right is not exercised before the maturity date, the warrant will expire worthless.
Warrant-driven swap
Swap with a warrant attached allowing the issuer of the fixed-rate bond to go on paying a floating rate in the event that he or she exercises another warrant allowing him or her to prolong the life of the bond.
When-issued trading
Trading a bond before the issue date; no interest is accrued during this period. Also known as the "grey market".
Worst-case (credit risk) exposure
Estimate of the highest positive market value a derivative contract or portfolio is likely to attain at a given moment or period in the future, with a given level of confidence.
Worst-case (credit risk) loss
Estimate of the largest amount a derivative counterparty is likely to lose, with a given level of probability, as a result of default from a derivatives contract or portfolio.
Worst-case default rate
The highest rates of default that are likely to occur at a given moment or period in the future, with a given level of confidence.
To sell an option is to write it. The person selling an option is known as the writer.
The same as "seller" of an option.
Used to denote the strike price of an option; sometimes this is denoted using the term K or S.
The interest rate which can be earned on an investment, currently quoted by the market or implied by the current market price for the investment – as opposed to the coupon paid by an issuer on a security, which is based on the coupon rate and the face value. For a bond, generally the same as yield to maturity unless otherwise specified.
Yield curve
Graphical representation of the maturity structure of interest rates, plotting yields of bonds that are all of the same class or credit quality against the maturity of the bonds.
Yield to equivalent life
The same as yield to maturity for a bond with partial redemptions.
Yield to maturity
The internal rate of return of a bond – the yield necessary to discount all the bond’s cash flows to an NPV equal to its current price. See current yield, gross redemption yield, simple yield to maturity.
Yield-curve option
Option that allows purchasers to take a view on a yield curve without having to take a view about a market’s direction.
Yield-curve swap
Swap in which the index rates of the two interest streams are at different points on the yield curve. Both payments are refixed with the same frequency whatever the index rate.
See yield to maturity.
Zero-cost collar
A collar where the premiums paid and received are equal, giving a net zero cost.
A zero-coupon security is one that does not pay a coupon. Its price is correspondingly less to compensate for this. A zero-coupon yield is the yield which a zero-coupon investment for that term would have if it were consistent with the par yield curve.
Zero-coupon bond
Bond on which no coupon is paid. It is either issued at a discount or redeemed at a premium to face value.
Zero-coupon swap
Swap converting the payment pattern of a zero-coupon bond, either to that of a normal, coupon-paying fixed-rate bond or to a floating rate.
Zero-premium option
Generic term for options for which there is no premium, either because the buyer undertakes to forgo a percentage of any gain or because the buyer offsets the cost by writing other options.