Glossary

  • Calendar spread

    A strategy that involves buying and selling options or futures with the same (strike) price but different maturities. Such a strategy is used in futures when one contract month is theoretically cheap and another is expensive. With options, the strategy is often used to play the shape of or expected changes in, the volatility term structure. For example, if one-month volatility is high and one-year volatility low, arbitrageurs might buy one-year straddles and sell short-term straddles, thereby selling short-term volatility and buying long-term volatility. If, all else being equal, short-term volatility declines relative to long-term volatility, the strategy makes money.

  • Call spread

    A strategy that reduces the cost of buying a call option by selling another call at a higher strike price (Bull call spread). This limits potential gain if the underlying goes up, but the premium received from selling the out-of-the-money call partly finances the at-the-money call. A call spread may be advantageous if the purchaser thinks there is only limited upside in the underlying. Alternatively a Bear call spread can be constructed by selling a call option and buying another at a higher strike price.

  • Callable swap

    An interest rate swap in which the fixed-rate payer has the right to terminate the swap after a certain time if rates fall. Often done in conjunction with callable debt issues where an issuer is more concerned with the cost of debt than the maturity. The embedded option is, in effect, a swaption sold by the fixed-rate receiver which enables the fixed-rate payer to receive the same high fixed rate for the remaining years of the swap in the event that interest rates fall. The fixed rate received under the swaption offsets the fixed rate paid under the original swap effectively cancelling the swap. In some definitions of a callable swap, the fixed-rate receiver has the right to terminate the swap. Also known as a cancellable swap.

  • Cap

    A contract whereby the seller agrees to pay to the purchaser, in return for an upfront premium or a series of annuity payments, the difference between a reference rate and an agreed strike rate when the reference exceeds the strike. Commonly, the reference rate is three- or six-month Libor. A cap is therefore a strip of interest rate guarantees that allows the purchaser to take advantage of a reduction in interest rates and to be protected if they rise. They are priced as the sum of the cost of the individual options, known as caplets.

  • Capital-protected

    A structured product that provides capital protection offers an amount that at least matches a given proportion of the investor's original capital input at maturity. Can also be referred to as principal-protected.

  • Capital-protected credit-linked note

    A credit-linked note where the principal is partyly or fully guaranteed to be repaid at maturity. In a 100% principal guaranteed credit-linked not, only the coupons paid under the not bear credit risk. Such a structure can be analyzed as (i) a Treasury strip and (ii) a stream of risky annuities representin the coupon, purchased from the note proceeds minus the cost of the Treasury strip.

  • Capped floater

    A floating-rate note which pays a coupon only up to a specified maximum level of the reference rate. This is done by embedding a cap in a vanilla note where the investor effectively sells the issuer a cap. A capped floater protects the debt issuer from large increases in the interest rate environment.

  • Capped swap

    An interest rate swap with an embedded cap in which the floating payments of the swap are capped at a certain level. A floating-rate payer can thereby limit its exposure to rising interest rates.

  • Caption

    An option on a cap. A type of compound option in which the purchaser has the right, but not the obligation, to buy or sell a cap at a predetermined price on a predetermined date. Captions can be a cheap way of leveraging into the more expensive option.

  • Cash and carry

    When a contango exists, the premium of the forward position over the spot generally reflects costs of buying and holding (eg financing, transaction costs, insurance, custody) for that period.

  • Cash market

    The physical market for buying and selling an underlying (eg equities, bonds), as opposed to a futures market.

  • Cash-and-carry arbitrage

    A strategy used in bond or stock index futures, in which a trader sells a futures contract and buys the underlying to deliver into it, to generate a riskless profit. For the strategy to work, the futures contract must be theoretically expensive relative to cash. Cash-and-carry arbitrage and reverse cash-and-carry arbitrage typically keep the futures and underlying markets closely aligned.

  • Catastrophe bond

    A bond that pays a coupon that decreases only after a catastrophe such as a hurricane or earthquake with a specified magnitude in a specified region and period of time.

  • Catastrophe option

    These options can be American-style or European-style, either paying out if a single specified catastrophe such as a hurricane or earthquake occurs, or alternatively, having a pay-out dependent on an index. For example, the index may represent the number of claims received by property insurance companies.

  • Catastrophe risk swap

    An agreement between two parties to exchange catastrophe risk exposures. For example, in July 2001 Swiss Re and Tokyo Marine arranged a $450 million deal including three risk swaps: Japan earthquake for California earthquake, Japan typhoon for France storm and Japan typhoon for Florida hurricane. Swaps increase diversification and allow each of the parties to lower the amount of capital that they need to hold.

  • Chooser option

    A chooser option offers purchasers the choice, after a predetermined period, between a put and a call option. The pay-outs are similar to those of a straddle but chooser options are cheaper because purchasers must choose before expiry whether they want the put or the call.

  • Cliquet

    Cliquet structures, which can also be called ratchet structures, periodically settle and reset their strike prices, allowing users to lock-in potential profits on the underlying. With a cliquet the payout is worked out from the performance of the underlying asset in a number of set periods during the product's life.

  • Cliquet option

    Also known as a ratchet or reset option. A path-dependent option that allows buyers to lock-in gains on the underlying security during chosen intervals over the life time of the option. The option's strike price is effectively reset on predetermined dates. Gains, if any, are locked in. So if an underlying rises from 100 to 110 in year one, the buyer locks in 10 points and the strike price is reset at 110. If it falls to 97 in the next year the strike price is reset at that lower level, no further profits are locked in, but the accrued profit is kept.

  • Closed-form solution

    Also called an analytical solution. An explicit solution of, for example, an option pricing problem by the use of formulae involving only simple mathematical functions, such as Black-Scholes or Vasicek models. Closed-form models can usually be evaluated much more quickly than numerical models, which are sometimes far more computationally intensive.

  • Collar

    The simultaneous sale of an out-of-the-money call and purchase of an out-of-the-money put (or cap and floor in the case of interest rate options). The premium from selling the call reduces the cost of purchasing the put. The amount saved depends on the strike rate of the two options. If the premium raised by the sale of the call exactly matches the cost of the put, the strategy is known as a zero cost collar. The combination of purchasing the put and selling the call while holding the underlying protects the holder from losses if the underlying falls in price, at the expense of giving away potential upside.

  • Collar swap

    A collar on the floating-rate leg of an interest rate swap. The transaction is zero cost; the purchase of the cap is financed by the sale of the floor. The collar constrains both the upside and the downside of a swap.

  • Collared floater

    A floating-rate note whose coupon payments are subject to an embedded collar. Thus the coupon is capped at a predetermined level, so the buyer forsakes some upside, but also floored, offering protection from a downturn in the reference interest rate. Also known as a mini-max floater.

  • Collateralized bond obligation (CBO)

    A multi-tranche debt structure, similar to a collateralized mortgage obligation. But rather than mortgages, low-rated bonds serve as the collateral.

  • Collateralized debt obligation (CDO)

    Generic name for collateralised bond obligations, collateralized loan obligations, and collateralized mortgage obligations.

  • Collateralized loan obligation (CLO)

    A structured bond backed by the loan repayments from a portfolio of pooled personal or commercial loans, excluding mortgages. The structure allows a bank to remove loans from its balance sheet and so reduce its required capital reserves, while retaining contact with the borrowers and fees from servicing the loans.

  • Collateralized mortgage obligation

    A type of asset-backed security, in this case backed by mortgage payments. Typically, such securities provide a higher return than normal fixed-rate securities but purchasers suffer prepayment risk if mortgage holders redeem their mortgages. Because the right to redeem the mortgage is effectively an embedded call, such securities have negative convexity.

  • Compound option

    A compound option is an option on an option. The tool allows the user to buy or sell an option at a fixed price during a set period. They are often used to hedge against increase in option prices during volatile periods. Examples include captions and floortions.

  • Condor

    The simultaneous purchase (sale) of an out-of-the-money strangle and sale (purchase) of an even further out-of-the-money strangle. The strategy limits the profit or loss of the pay-out and is directionally neutral.

  • Constant maturity swap

    This is an interest rate swap where the floating interest arm is reset periodically with reference to longer duration treasury-based instruments rather than a market index such as LIBOR.

  • Constant maturity treasury derivative

    Over-the-counter swaps and options which use longer-term, Treasury-based instruments for their floating rate reference than money market indexes, such as Libor._and_lsquo;Constant Maturity Treasury_and_rsquo; (CMT) refers to the par yield that would be paid by a treasury bill, note or bond which matures in exactly one, two, three, five, seven, 10, 20 or 30 years. Since there may not be treasury issues in the market with exactly these maturities, the yield is interpolated from the yields on treasuries that are available. In the US, such rates have been calculated and published by the Federal Reserve Bank of New York and the US Treasury department on a daily basis every day for more than 30 years. The H.15 Report from the Federal Reserve Bank is often used as a source for CMT rates. It is then possible for this interpolated yield to form the index rate for instruments such as floating rate notes, which pay interest linked to the CMT yield, options, which pay the difference between a strike price and the CMT yield, and swaps and swaptions, in which one of the cashflows exchanged is the CMT yield. Where necessary, the reference rate is reset at each settlement date. Typical uses of CMT derivatives as hedging tools include the purchase of CMT floors by mortgage servicing companies to protect the value of purchased mortgage servicing portfolios, and the purchase of CMT caps to protect investors with negatively convex mortgage-backed securities portfolios. It is possible to enter into derivatives in other currencies that are based, by analogy, on a _and_lsquo;constant maturity interest rate swap_and_rsquo; interpolated from the swap curve in the relevant currency. Such derivatives are known as constant maturity swap (CMS) derivatives. Unlike CMT derivatives, CMS derivatives incorporate the spread component of swaps.

  • Constant proportion portfolio insurance (CPPI)

    A fund management technique that aims to provide maximum exposure to risky assets while still protecting investors' capital. The technique requires the manager to dynamically rebalance the portfolio between risky assets (such as equities) and safe assets (such as bonds) according to a quantitative model. The level of risky assets is managed such that at all times, in the event of a market crash, the remaining NAV of the fund is still sufficient to meet the stated protection level. Generally the proportion of Risky Assets in the fund is increased when these perform well and decreased when these perform poorly. The capital protection level may be fixed, or rachet up(reset) according to a certain percentage of the fund NAV achieved during the fund term.

  • Contingent swap

    The generic term for a swap activated when rates reach a certain level or a specific event occurs. Swaptions are often considered to be contingent swaps. Other types of swaps, for example, drop-lock swaps, are activated only if rates drop to a certain level or if a specified level over a benchmark is achieved.

  • Contract for difference (CFD)

    A Contract for Difference is typically an agreement made between two parties to exchange (at the closing of the contract) a cashflow equivalent to the difference between the opening and closing prices, multiplied by the number of shares detailed in the contract. CFDs are traded on margin, do not incur stamp duty and can have individual stocks or indexes as the underlying.

  • Convergence trade

    Trading strategy where similar securities are bought and sold simultaneously in the expectation that prices will converge in an orderly fashion.

    1. A way of taking advantage of mispriced options by creating a synthetic short futures position and hedging market risk by buying a futures contract against it. Thus if a put is undervalued, a trader buys it, at the same time selling a fairly valued call and buying a futures contract. The same strategy can be applied if the call is mispriced. If the option is truly undervalued, the trader earns a riskless profit. The whole exercise relies on put-call parity
    2. The act of converting a convertible bond into equity.
  • Convertible bond

    A bond issued by a company that may be exchanged by the holder for a number of that company's shares at a predetermined ratio, or at a discount to the share price at maturity. Because the convertible embeds a call option on the company's equity, convertibles carry much lower rates of interest than traditional debt and are therefore a cheap way for companies to raise debt. The problem for existing shareholders is that conversion dilutes the company's outstanding shares.Typically, bonds are convertible into a company's own stock. There are however third party convertibles that convert into shares of another company.

  • Convexity

    A bond's convexity is the amount that its price sensitivity differs from that implied by the bond's duration. Fixed-rate bonds and swaps have positive convexity: when rates rise the rate of change in their price is slower than suggested by their duration; when rates fall it is faster. Positive convexity is therefore a welcome attribute. The higher the bond's duration, the more its convexity. Bonds or swaps with call options or embedded call options, e.g. collateralised mortgage obligations, have negative convexity: when rates rise their price fall is faster relative to the interest rate move. Convexity effectively describes the same attribute as gamma.

  • Correlation

    Correlation is a measure of the degree to which changes in two variables are related. It is normally expressed as a coefficient between plus one, which means variables are perfectly correlated (in that they move in the same direction to the same degree) and minus one, which means they are perfectly negatively correlated (in that they move in opposite directions to the same degree). In financial markets correlation is important in three areas: 1.The model used for global asset allocation decisions, Sharpe's capital asset pricing model (CAPM), has, as its linchpin, a covariance matrix that measures correlations between markets. 2.Correlation is also central to the pricing of some options, where two-factor or multi-factor models are used. For spread options, yield curve options and cross-currency caps, estimating the correlation between the underlying assets is of primary importance, the degree of correlation between them having a direct influence on the option price. For quantos such as guaranteed exchange rate options, or differential swaps, the correlation effect is the extent to which there is a relationship between movements in the underlying and movements in the ex-change rate, which has a secondary effect on the price of the option. 3.Correlation between markets is also used to offset an option position in one market against another with similar direction and volatility. Such a strategy might be used to reduce cost; to avoid hedging the positions separately, or because implied volatility in the second market is lower; or because hedging is difficult in the first market. Correlation can be estimated historically (like volatility) but tends to be unstable, and historic estimations may be poor predictors of future realised correlations.

  • Correlation swap

    An instrument that allows an investor to take financial exposure on a set of correlations.

  • Corridor option

    The holder of a corridor option receives a coupon at the end of the lifetime of the corridor whose magnitude depends upon the behaviour of a specified spot rate during the lifetime of the corridor. For each day on which the spot rate (typically an official fixing rate observation)remains within the chosen spot range (the accrual corridor) the holder accrues one day's worth of coupon interest. A variation is the knockout corridor option. In this structure, the holder ceases to accrue coupon interest as soon as the spot rate leaves the range. Even if the spot rate subsequently re-enters the range, the holder does not continue to accrue coupon interest. At the end of the option's lifetime, the accrued coupon is calculated according to the following formula: If the accrual corridor is one-sided (the other side of the range bing open-ended), it is known as a wall option. Typically, corridor options are imbedded in a structured note, sometimes called a range note, that pays a higher yield than the corresponding vanilla debt as long as the underlying rate remains sufficiently long within the accrual corridor. A similar option to the corridor option is the range binary, a binary option which pays a fixed coupon amount if the range is not breached but nothing if it is breached.

  • Cost of carry

    The cost of financing an asset. If the cost is lower than the interest received, the asset has a positive cost of carry; if higher, the cost of carry is negative. The cost of carry is determined by the opportunities for lending the asset and the shape of the yield curve. So a bond, for example, would have a positive cost of carry if short-term rates (financing rates) were lower than the asset's yield or (and) if the cost could be mitigated by lending out the securities.

  • Covered call

    To sell a call option while owning the underlying security on which the option is written. The technique is used by fund managers to increase income by receiving option premium. It would be used for securities they are willing to sell, only if the underlying went up sufficiently for the option to be exercised. Generally, covered call writers would undertake the strategy only if they thought volatility was overpriced in the market. The lower the volatility, the less the covered call writer gains in return for giving up upside in the underlying. It provides downside protection only to the extent that the option premium offsets a market downturn.

  • Covered put

    To sell a put option while holding cash. This technique is used to increase income by receiving option premium. If the market goes down and the option is exercised, the cash can be used to buy the underlying to cover. Covered put writing is often used as a way of target buying: if an investor has a target price at which he wants to buy, he can set the strike price of the option at that level and receive option premium to increase the yield of the asset. Investors also sell covered puts if markets have fallen rapidly but seem to have bottomed, because of the high volatility typically received on the option.

  • Cox-Ingersoll-Ross model

    In its simplest form this is a lognormal one-factor model of the term structure of interest rates, which has the short rate of interest as its single source of uncertainty. The model allows for interest rate mean reversion and is also known as the square root model because of the assumptions made about the volatility of the short-term rate. The model provides closed-form solutions for prices of zero-coupon bonds, and put and call options on those bonds.

  • Credit default swap

    A bilateral financial contract in which one counterparty (the protection buyer or buyer) pays a periodic fee, typically expressed in basis points per annum on the notional amount, in return for a contingent payment by the other counterparty (the protection seller or seller) upon the occurrence of a credit event with respect to a specified reference entity. The contingent payment is designed to mirror the loss incurred by creditors of the reference entity in the event of its default. The settlement mechanism may be cash or physical.

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