Glossary

  • Embedded option

    An option, often an interest rate option, embedded in a debt instrument that affects its redemption. Examples include mortgage-backed securities and callable and puttable bonds. Embedded options do not have to be interest rate options; some are linked to the price of an equity index (Nikkei 225 puts embedded in Nikkei-linked bonds) or a commodity (usually gold). Many so-called guaranteed products contain zero-coupon bonds and call options.

  • Equilibrium model

    A model that specifies processes for the underlying economic variables and the extra risk premium investors require for risky assets. The evolution of asset prices and their risk is derived from the model thus specified.

  • Equity (index) swap

    A swap in which the total or price return on an equity index, equity basket or single equity is exchanged for a stream of cashflows based on a short-term interest rate index (or another index). Equity swaps are a convenient structure for switching into or out of equity markets, particularly for those that prefer to avoid, or are not allowed to use, stock index futures. Like futures, the price of the swap is directly related to the cost of carry, although there may also be tax considerations.

  • Equity collar

    Equity collars are used by investors keen to reduce their downside risk. An equity collar is formed by buying an equity put option with a strike price below the current value of the equity, at the same time as selling an equity call option with a strike above the current equity price. Thus a collar is imposed around the investorr's equity position. If the value of the underlying equity falls through the strike of the bought put, it can be exercised to limit losses. However, if the underlying stock rises through the strike of the sold call, the investor may have to deliver the equity at the strike, thus foregoing potential additional upside.

  • Equity knock-out swap

    An interest rate or cross-currency swap that gets terminated (knocked-out) if a given stock or equity-index reaches a specified trigger level between inception and expiry. The knock-out can be unconditional once the pre-determined equity level is reached, or the client can be given the choice to cancel the swap should the trigger level be reached.

  • Equity linked note

    An equity linked note is a tool that is linked to a single equity, equity index or basket of equities. They may or may not be principal protected.

  • Equity warrant

    A warrant is a financial instrument issued by a bank or other financial institutions, which is traded on a stock exchange_and_rsquo;s equity market. Warrants may be issued over securities such as shares in a company, a currency, an index or a commodity. A call warrant gives the holder the right (but not the obligation) to buy a given security at a given price known as the exercise price, on a given date, known as the expiry date. Conversely a put warrant gives the holder the right to sell the security at the exercise price on the expiry date. These instruments are sometimes known as covered warrants or derivative warrants.

  • European-style option

    European-style options can only be exercised on their expiry date. They stand in contrast to American-style options, which can be exercised at any time until maturity.

  • Everest structure

    A capital guaranteed structure generally offering the investor the sum invested at maturity and potential upside linked to the performance of the least-performing asset in a predefined basket. The Everest structure may also pay coupons over its life.

  • Exchangeable bond

    These are just like convertible bonds. The main difference is that these are typically issued on stock, which is not the stock of the issuing firm.

  • Exotic option

    Any option with a more complicated payout structure than a plain vanilla put or call option. The payout of a plain vanilla option is simply the difference between the strike price of the option and the spot price of the underlying at the time of exercise. For a European-style option, the exercise time is always the expiry date; other option styles offer greater flexibility. There are a number of ways in which an option payout can differ from that of a plain vanilla. The payout could also be a function of:

    • The difference between a strike and an average rate for the underlying (average options) 
    • The difference between prices for two different underlyings (difference options, exchange options), the same underlying at different times (high-low options) 
    • The correlation between two or more underlyings (outperformance options, outside barrier options) 
    • The difference between a strike and the spot rate at some time other than expiry (deferred payout options, shout options, lookback options, cliquet options, ladder options) 
    • A fixed amount (binary options) 

    Alternatively, or additionally, a payout may be conditional on certain trigger conditions being met. For example, barrier options are activated or nullified if a spot rate falls or rises through a predetermined trigger level. Multiple trigger conditions are possible (as in the case of corridor or mini-premium options).

  • Exploded tree

    A tree (binomial or trinomial) in which an up step followed by a down step gives a different outcome to a down step followed by an up step. Consequently, the number of nodes increases exponentially, compared with a recombining tree, in which the number increases quadratically. This makes their evaluation exceptionally computer-intensive. The advantage is that they can be used to price path-dependent options and they are important for modelling interest rate options.

  • Extreme value theory

    An area of statistical research that focuses on modelling the extreme values of return distributions. This is important in finance because many models (for example the Black-Scholes Model) assume that the distribution of returns is log-normal. However, real-world distributions are found to have fat-tails, implying that rare events such as crashes are more likely than the traditional theories suggest.

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