Glossary

Impact forward
A collared forward, such as one in which the purchaser buys a put and sells a call, both being outofthemoney. The premiums on the two options balance out, so the strategy is zero cost.

Implied distribution
The probability distribution of returns for an asset, which is implied by options traded on that asset. The distribution is inferred by combining the variation of volatility with strike price and the assumptions made about the distribution in the option pricing model.

Implied forward curve
The forward curve implied by forward rate agreements (derived from the par curve) of various maturities. It is usually steeper than the spot yield curve.

Implied repo rate
The return earned by buying a cheapesttodeliver bond for a bond futures contract and selling it forward via the futures contract.

Implied volatility
The value of volatility embedded in an option price. All things being equal, higher implied volatility will lead to higher vanilla option prices and vice versa. The effect of changes in volatility on an option_and_rsquo;s price is known as vega. If an option's premium is known, its implied volatility can be derived by inputting all the known factors into an option pricing model (the current price of the underlying, interest rates, the time to maturity and the strike price). The model will then calculate the volatility assumed in the option price, which will be the market's best estimate of the future volatility of the underlying.

Inthemoney
Describes an option whose strike price is advantageous compared with the current forward market price of the underlying. The more an option is inthemoney, the higher its intrinsic value and the more expensive it becomes. As an option becomes more inthemoney, its delta increases and it behaves more like the underlying in profit and loss terms; hence deep inthemoney options will have a delta of close to one.

Income product
A term used for any type of structured product that provides a periodic payment of income. The rate of income is often higher than the general rate of interest available on fixedrate deposits and therefore there may be a risk the initial capital invested will not be returned in full.

Index amortising swap (Ias)
An interest rate swap whose principal amortises on the back of movements in an index, such as Libor or constant maturity treasuries. The fixedrate receiver effectively grants an option to the fixedrate payer to amortise the swap. The option is triggered by interest rate movements after an initial lockout period. The notional principal amortises as rates fall or remains constant if rates remain the same. In return for granting the option, the fixedrate receiver gets a yield above current fixed rates. IAS have been widely used by US regional banks in their asset/liability management activities. By using IAS, banks were able to obtain the negative convexity of a mortgagebacked security and avoid the risk of excessive prepayments due to changes in consumer sentiment. But the fixed receiver is exposed to both falling and rising rates. If rates fall, there is the possibility at each interest date that some or all of the swap will be terminated, creating a reinvestment risk. If rates rise, the swap may run to maturity, providing meagre income while floating rates soar. An IAS fixedrate receiver is selling volatility to the payer for an enhanced yield. So the lower the volatility of the index, the lower the option value and yield pickup. A subsequent fall in volatility benefits the receiver because the likelihood that the swap will amortise decreases. IAS can be structured with negative or positive convexity and the amortisation schedules and lockout periods can be changed in order to increase or decrease yields. Also known as an Indexed principal swap.

Indexed strike cap
A cap for which the payout level is indexed to the level of the reference rate. For example, such a cap might be struck at 7.5% as long as the reference rate remained below 9%, but rise to 8.5% if the reference rate exceeded 9%. An indexed strike cap is cheaper than a conventional cap.

Initial index level
Most structured products incorporate payouts that are linked to the movement of an underlying index or share. This performance is measured relative to the level of the underlying recorded at the start of the investment term, or the initial index level.

Integrated hedge
A hedge that combines more than one distinct price risk. For example, crude oil is usually priced in US dollars. Therefore a producer of crude oil whose home currency is not the dollar (say, the euro) is exposed to both currency risk and the price risk for crude oil. One possible integrated hedge would be a single quanto option, which would hedge the price of crude oil in euro. As such, it would depend heavily on the correlation (if any) between the two markets.

Interest rate corridor
An interest rate corridor is composed of a long interest rate cap position and a short interest rate cap position. The buyer of the corridor purchases a cap with a lower strike while selling a second cap with a higher strike. The premium earned on the second cap then reduces the cost of the structure as a whole. The buyer of the corridor is protected from rates rising above the first cap's strike, but exposed if they rise past the second cap's strike. It is possible to limit this liability by selling a knockout cap rather than a conventional cap. The structure is then known as a knockout interest rate corridor.

Interest rate guarantee
An option on a forward rate agreement (FRA), also known as a FRAtion. Purchasers have the right, but not the obligation, to purchase an FRA at a predetermined strike. Caps and floors are strips of IRGs.

Interest rate swap
An agreement to exchange net future cashflows. Interest rate swaps most commonly change the basis on which liabilities are paid on a specified principal. They are also used to transform the interest basis of assets. In its commonest form, the fixedfloating swap, one counterparty pays a fixed rate and the other pays a floating rate based on a reference rate, such as Libor. There is no exchange of principal _and_ndash; the interest rate payments are made on a notional amount. In floatingfloating swaps the two counterparties pay a floating rate on a different index, such as threemonth Libor versus sixmonth Libor. Swaps usually extend out as far as 10 years, although 12_and_ndash;40 year maturities are available in some liquid currencies. However, the longer the maturity of the swap, the less liquid it becomes and credit risk increases. Credit enhancements such as mutual put options and collateral are used to ameliorate the credit risk of longer term swaps. Interest rate swaps provide users with a way of hedging the effects of changing interest rates. For example, a company can convert floatingrate interest payments to fixedrate payments if it thinks interest rates will rise (which would make its liabilities more expensive). Companies can also use interest rate swaps in conjunction with new debt issuance, raising money on, say, a fixed basis and swapping it into floatingrate debt. In an interest rate swap there is a fixedrate payer (floatingrate receiver) and a fixedrate receiver (floatingrate payer).

Intrinsic value
The amount by which an option is inthemoney, that is, its value relative to the current forward market price. Option premiums comprise intrinsic value and time value.

Inverse floater
The payments made on an inverse floating rate note ("floater") decrease as the reference interest rate increases, the reverse of the typical case where the payments rise with the reference rate. The purchaser of an inverse floating rate note is in effect selling interest rate caps; this will increase the coupon payments in a stable or lower interest rate environment, but reduce them should interest rates rise. Typically, the payment is found by a fixed rate minus two times the reference rate.The floater can be further leveraged by using a multiplier higher than two.