Glossary

  • Rainbow option

    Similar to a multi-factor option. It is an option with the payout linked to two or more underlying instruments or indexes. Some common types of rainbow options are the maximum option, minimum option, best-of option and worst-of option. The underlyings are of the same asset class and can have different expiry dates and strike prices, but for the option to payout, all the underlyings must move in the direction that is favourable to the option holder. However, if the option combines two or more types of asset classes, such as a stock index and an exchange rate, it is called a hybrid option.

  • Random walk

    The series of values taken by a random variable with the progress of some parameter such as time. Each new value (each new step in the walk) is selected randomly and describes the path taken by the underlying variable.

  • Range accrual option

    An option that pays out a fixed amount at expiration for each day that the index rate remains within the specified range.

  • Range binary

    The range binary structure has been developed primarily for trading purposes and is essentially a bet on a spot staying within a given range. The strategy is often linked with a deposit for yield enhancement purposes. A range is specified by the customer over a fixed period. A premium is paid up front and provided that the spot stays within the range (as monitored on a 24-hour basis), then a multiple of the premium invested will be payable. A rebate range binary is one in which the premium invested is rebated if a designated boundary of the range is breached first. A similar structure, the limit binary, is also essentially for trading. This is fundamentally a bet on a spot not staying within a predetermined range. The customer specifies two spot rates, one above and one below the current spot rate. A premium is paid up front, and providing that both levels trade (as monitored on a 24-hour basis), a fixed multiple of the premium invested will be payable.

  • Range note

    A range note (also known as a fairway note, an accrual note, or a corridor floater) is a structured note that pays a coupon for each day that the underlying spot stays within a specified range (sometimes called the accrual corridor). If the underlying trades outside the specified range, the investor receives no interest for that day. The underlying can be a reference interest rate, a foreign exchange rate, an equity price or the spread between two interest rates. The range is determined at the outset to suit the investor's risk/return requirements, but might also be reset by the investor or be automatically centred on the prevailing rate at each reset date. This higher yield is achieved by the investor selling an embedded corridor option, particularly in times of high volatility. The holder of the note will therefore benefit in stable market periods when volatility is low.

  • Range resettable forward

    A type of forward contract that offers a more favourable forward rate compared with an ordinary forward, as long as the spot rate remains within a pre-defined range.

  • Ratchet floater

    Also called a one-way floating rate note. A ratchet floater is a structured note that pays a floating interest rate indexed on a reference rate such as Libor. Each floating interest rate will depend on the previous interest rate paid.

  • Ratio calendar spread

    A strategy that involves the purchase of a long-term option (either call or put) and the selling of a greater amount of near-term option at the same strike price.

  • Regulatory capital

    The amount of capital that an organisation is required to hold by its regulator.

  • Reinvestment risk

    The risk that an asset manager will be unable to match the yield from an interest-rate instrument (such as a swap or bond) when reinvesting its coupon payments and principal repayments.

  • Relative performance risk

    The risk that a fund manager's choice of investments will fail to match the performance of the benchmark against which the fund is measured, prompting fund redemptions. A similar risk is run by corporate treasury risk managers who are measured against benchmark hedge levels. One way to address this type of risk is with outperformance options. Relative performance risk is also used to refer to the risk that an individual asset will underperform relative to its asset class. For equities, this may be measured by a stock's beta, its standardised covariance with respect to the relevant equity index.

  • Replacement cost

    Often used in terms of credit exposure, the replacement cost of a financial instrument is its current value in the market; in other words, what it would cost to replace a given contract if the counterparty to the contract defaulted. Aside from bid-ask conventions, it is synonymous with market value.

  • Replication

    To replicate the payout of an option by buying or selling other instruments. Creating a synthetic option in this way is always possible in a complete market. In the case of dynamic replication this involves dynamically buying or selling the underlying (or normally, because of cheaper transaction costs, futures) in proportion to an option's delta. In the case of static replication the option (usually an exotic option) is hedged with a basket of standard options whose composition does not change with time (e.g. an at-expiry digital option can be replicated with a call spread).

  • Repo agreement

    To buy (sell) a security while at the same time agreeing to sell (buy) the same security at a predetermined future date. The price at which the reverse transaction takes place sets the interest rate over the period (the repo rate). The most active repo market is in the US, where the Federal Reserve sets short-term interest rates by lending securities. In a reverse repo the buyer sells cash in exchange for a security. Repos can benefit both parties. Buyers of repos often receive a better return than that available on equivalent money-market instruments; and financial institutions, particularly dealers, are able to get sub-Libor funding. A slight variation on the repo is the buy/sell back. The buy/sell back's coupon becomes the property of the purchaser for the duration of the agreement. It is preferred by credit-sensitive investors such as central banks.

  • Resettable convertible bond

    It is a convertible bond where the conversion ratio can reset to a new value depending on the average price of the underlying stock on pre-specified dates.

  • Reversal

    To take advantage of mispriced options by creating a synthetic long futures position and edging it by selling futures contracts against it. A trader may buy an undervalued call, at the same time selling a fairly valued put and buying a futures contract. The same strategy could be applied if the put was undervalued. The ability to undertake this riskless arbitrage relies on put-call parity.

  • Reverse cash-and-carry arbitrage

    A technique, used mainly in bond futures and stock index futures, that involves buying a futures contract and selling the underlying. It is used when a futures contract is theoretically cheap, such as when the implied repo rate is less than the market repo rate.

  • Reverse convertible

    These are just like convertible bonds. The main difference is that rather than buying a call option on a stock, the investor sells a put on the stock or index. The investor receives higher than normal coupons but may lose some principal if the put ends up in the money.

  • Reverse index amortizing swap

    An interest rate swap in which payments are linked to an index (eg, Libor or constant maturity Treasuries) and increase if that index declines. The swap therefore exhibits positive convexity. Receiving fixed in a reverse index amortising swap (reverse IAS) provides a hedge for instruments (such as mortgage swaps) that amortize as interest rates decline, although it is important to ensure that the indexes on which the amortisation or accreting schedules are based are highly correlated. Unlike a conventional IAS, the fixed receiver of a reverse IAS is buying volatility (sometimes referred to as "optionality" which offsets the short option position of a mortgage portfolio.

  • Reversible swap

    An interest rate swap in which one side has an option to alter the payment basis (fixed/floating) after a certain period. This is usually achieved by the use of a swaption, allowing the purchaser the opportunity to enter a swap with payment on the opposite basis. The swaption would be for twice the principal amount, one half nullifying the original swap.

  • Rho

    Measures an option's sensitivity to a change in interest rates. This will have an impact on both the future price of the option and the time value of the premium. Its impact increases with the maturity of the option.

  • Risk neutral valuation

    An argument that underpins most derivatives pricing, including the Black-Scholes model. The differential equation describing the price of a derivative does not involve parameters that depend on risk preferences. Derivatives prices in a market where all investors are risk neutral must therefore be the same as prices in the real world and this corollary considerably simplifies model construction.

  • Risk reversal

    The term "risk reversal" is also used, by currency option traders, to denote the difference in implied volatility between out-of-the-money call and put options, which both have a delta of 25%. The level of the risk reversal is often used as a sentiment indicator in currency markets as it indicates the relative demand for calls versus puts.

  • Roll-over risk

    The risk that a derivatives hedge position will be at a loss at expiry, necessitating a cash payment when the expiring hedge is replaced with a new one. Normally, such a roll-over loss simply represents an opportunity loss, but sometimes the cash cost is consequential.

  • Roller-coaster swap

    An interest rate swap in which one counterparty alternates between paying fixed and paying floating. Another name for a seasonal swap.

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