Glossary

  • Naked option

    An option that is sold (bought) without holding the underlying or otherwise hedging.

  • Natural hedge

    A natural hedge is the reduction in financial risk that can arise from an institution's normal operating procedures. For instance, a company that has a significant portion of its sales in one country will have a natural hedge to at least part of its currency risk if it also has operations in that country generating expenses in the currency. Firms may act to increase natural hedges by changing sourcing, funding, or operational decisions, but natural hedges are less flexible, and more difficult to reverse, than financial hedges.

  • Negative basis

    Negative basis exists when the cost of buying protection (in the credit derivatives market) on a particular reference entity is less than the credit spread (generally expressed as a spread to Libor) on a bond or note of similar maturity issued by that reference entity. When this occurs, investors can lock in riskless profit by buying bonds and buying credit protection. These arbitrage opportunities are generally only available to investors whose cost of funds is Libor flat or better (since funding the bond or note at Libor plus a spread will erode the arbitrage). Technical factors between the bond and credit derivatives market account for negative basis.

  • Net present value (NPV)

    A technique for assessing the worth of future payments by looking at the present value of those future cashflows discounted at today's cost of capital.

  • Non-deliverable forward (NDF)

    Non-deliverable forward contracts (NDFs) - also called dollar-settled forwards - are synthetic forwards, which entail no exchange of currencies at maturity. Instead, settlement is made in US dollars based on the difference between the agreed contract rate at inception and a market reference rate at maturity. NDFs can be used to establish a hedge or take a position in one of a growing group of emerging market currencies where conventional forward markets either do not exist or may be closed to non-residents. As offshore instruments, NDFs offer the advantage of eliminating convertibility risk, since no emerging market currencies are exchanged at maturity.

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