Glossary

  • Parisian barrier option

    A barrier option with a barrier that is triggered only if the underlying has been beyond the barrier level for longer than a specified period of time.

  • Participating forward

    The simultaneous purchase of a call option (put option) and sale of a put (call) at the same strike price, usually for zero cost. The option purchased must be out-of-the-money and the option sold (to finance the option purchase) is for a smaller amount and will be in-the-money.

  • Participating option

    An option whereby the buyer pays a reduced premium but has to forgo a portion of his potential gains.

  • Participating swap

    A swap in which floating-rate exposure is hedged but in which the hedger still retains some benefit from a fall in rates.

  • Participation rate

    Many structured products incorporate returns at maturity that are calculated by multiplying the performance of the underlying (which can be an index, stock basket or fund) by a fixed percentage. This percentage is called the participation rate. For example, a 70% participation in the index means that 70% of the performance of the underlying index will be used to calculate the maturity payout. If the product comes with a 100% capital guarantee, the participation rate will only apply to the upside, not to index losses.

  • Path-dependent option

    A path-dependent option has a payout directly related to movements in the price of the underlying during the option's life. By contrast, the payout of a standard European-style option is determined solely by the price at expiry.

  • Pay-as-you-go cap

    A pay-as-you-go cap allows the buyer to pay for protection from upward moves in an interest rate for only as long as necessary. Usually, the holder will pay an initial premium (which will be small compared with the premium for a normal cap) and a further payment at each reset date. The holder can cancel the cap when he or she feels that the protection is no longer needed. A pay-as-you-go cap is useful for those who feel that caps are too expensive, that interest rates will eventually stabilise below the capped level, or that rates are in a short-lived "spike" move. Also known as an installment cap.

  • Payout/Payoff

    A general term used to describe the return provided by a structured product or an option. A lot of products pay a fixed coupon plus additional returns linked to performance of the nderlying. If the embedded option is path-dependent, the returns will be a function of both the performance of the index and the payout formula. For example, the payout from a five-year quarterly Asian option with a 70% participation of the Dow Jones Euro Stoxx 50 Index is equal to 70% of the average of 20 different prices over five years, and not the level of the index at maturity.

  • Period resetting swap

    An interest rate swap in which the floating-rate payments are an average of the floating rates observed since the last payment.

  • Periodic cap

    A cap in which the strike rate can vary from period to period. The strike rate in a given period depends upon the strike set in the previous period. Such caps are normally set at a fixed number of basis points above the previous strike, or the index (for example, Libor) plus a spread. Periodic caps can be with or without "memory." A periodic cap without memory simply looks at the strike in the immediately preceding period to determine a new strike, while one with memory may look at previous settings in determining the new strike. Periodic caps are common features in adjustable rate mortgages (ARMs) in the US where the borrower's floating interest payments cannot go up by more than a set number of basis points in a given year.

  • Periodic floor

    A floor in which the strike rate can vary from period to period. The strike rate in a given period depends upon the strike set in the previous period. Such floors are normally set at a fixed number of basis points above the previous strike or the index (for example Libor) plus a spread.

  • Pin risk

    The phenomenon where a small move in the underlying can have a significant impact on the value of an at-the-money option shortly before expiration.

  • Podium

    A type of correlation product that is fully capital-guaranteed, but with the annual coupons dependent upon the number of underlyings within the basket that meet certain performance criteria.

  • Portfolio option

    A portfolio option is a multi-factor option that pays out the difference between the return from a portfolio of assets and a specified strike price.

  • Positive basis

    Positive basis exists when the cost of buying protection (in the credit derivatives market) on a particular reference entity exceeds 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 looking to gain exposure to the reference entity can improve their expected return on an investment by taking exposure to the credit by selling protection in the credit derivatives market rather than buying the bond or note. Technical factors between the bond and credit derivatives market account for positive basis.

  • Power option

    An option with a payout dependent on the price of the underlying at expiration, raised to some power.

  • Power swap

    A swap whose floating leg is based on the square (or some higher exponent) of the reference interest rate. Although dismissed by some as little more than a speculative tool for taking highly leveraged positions on the direction of interest rates, power swaps have been shown (by Robert Jarrow and Donald van Deventer) to have their uses in hedging commercial banks, deposits and credit card loan portfolios.

  • Premium-reduction device

    A strategy that aims to reduce the cost of an option or other derivative. There are many ways to achieve this; three common techniques are detailed below:

    1. The first is to sell a second derivative; the premium received can then be used to lower the funding requirement for the purchased derivative. This is the technique employed for reducing the cost of a collar.
    2. The second is to limit participation in moves in the underlying by imposing limitations on the payout profile of the instrument (as in a barrier option or a capped floater).
    3. The final way is to accept payments below market rates, with the possibility of making up the shortfall at the end of the instrument's life (see yield adjustment).
  • Principal-guaranteed product

    Any investment vehicle that allows investors to gain exposure to an asset while guaranteeing the return of their principal, often at maturity only. Such products are normally constructed by buying a deep discount bond (often a zero-coupon bond) and using the rest of the money to buy embedded call or put options to gain exposure to a second asset, often a stock index.

  • Program trading

    A strategy to trade a basket of shares simultaneously, normally by means of computer-generated instructions. Where the asset class is considered more important than the selection within that class, program trading (also known as basket trading) is used to lower trading costs since trading a basket of shares is cheaper than buying or selling those shares individually. Program trading is different from stock index arbitrage, although it is used in such a strategy.

  • Prompt

    For immediate (ie, two days) delivery.

  • Protection level

    This refers to the safety level of the underlying at which the investor can still keep their capital intact. Once this level is breached, the original investment amount is at risk.

  • Put Down and In

    A Put Down and In has the same payoff profile as a basic put option, however, for the option to be 'activated', the price of the underlying asset has to fall below a preset downside barrier. The downside barrier will be lower than the price of the underlying asset at the time the option is entered into. If the downside barrier is not reached, the Put Down and In option will expire worthless. If the downside barrier is reached, the option is said to have "Knocked in" and from that point on will behave like a regular put option.

  • Put spread

    A put spread reduces the cost of buying a put option by selling another put at a lower level. This limits the amount the purchaser can gain if the underlying goes down, but the premium received from selling an out-of-the money put partly finances the at-the-money put. A put spread may also be useful if the purchaser thinks there is only limited downside in the market.

  • Put-call parity

    The relationship between a European-style put option and a European-style call option on the same underlying with the same exercise price and maturity. Put-call parity states that the payout profile of a portfolio containing an asset plus a put option is identical to that of a portfolio containing a call option of the same strike on that same asset (with the rest of the money earning the risk-free rate of return). In practice, a put option on, say, a stock index, can be constructed by shorting the stock and buying a call option. The relationship means that traders are able to arbitrage mispriced options.

  • Puttable swap

    An interest rate swap in which the fixed-rate receiver has the right to terminate the contract after a specified period. The puttable swap is the opposite of a callable swap. The fixed-rate payer is effectively sold a swaption, who receives a lower fixed rate in compensation. Puttable swaps are similar to extendible swaps. Also known as a cancellable swap.

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