Glossary

  • Seasonal swap

    An interest rate swap in which the principal alternates between zero and the notional amount (which can change or stay constant). The principal amount of the swap is designed to hedge the seasonal borrowing needs of a company.

  • Securitisation

    The conversion of assets (usually forms of debt) into securities, which can be traded more freely and cheaply than the underlying assets and generate better returns than if the assets were used as collateral for a loan. One example is the mortgage-backed security, which pools illiquid individual mortgages into a single tradable asset.

  • Semi-fixed swap

    An interest rate swap with two possible fixed rates, which can be tailored to suit bullish or bearish market views. The rate paid by the fixed-rate payer depends on whether current Libor (or another reference rate or asset) is above or below a predetermined level. In a typical structure, if Libor is below the trigger level, the lower of the two rates is paid, if it is above, the higher is paid. These swaps can be used to create asymmetric risk exposures, ie, cheaper fixed-rate funding for an oil producer when oil prices are low, or an enhanced yield for an insurance company when equity prices are falling.

  • Settlement risk

    Settlement risk (delivery risk), as a particular form of counterparty credit risk, arises from a non-simultaneous exchange of payments. For example, a bank that makes a payment to a counterparty, but will not be recompensed until a later date, is exposed to the risk that the counterparty may default before making the counter-payment. Settlement risk is distinct from market risk because it relates to exposure to a counterparty rather than exposure to the underlying risk related to the reference entity of the derivatives contract.

  • Shout option

    A type of path-dependent option that allows the investor to lock in profits if he thinks the market has reached a high (for a call) or low (for a put). The investor benefits further if the market finishes higher or lower than the shout level. The shout option is designed for investors who have a directional view on the market and want to take positions, but are worried about the volatility of the asset and want to lock in a minimum return.

  • Skew

    A skewed distribution is one that is asymmetric. Skew is a measure of this asymmetry. A perfectly symmetrical distribution has zero skew, whereas a distribution with positive (negative) skew is one where outliers above (below) the mean are more probable. An example of an asymmetric distribution in the financial markets is the distribution implied by the presence of a volatility skew between out-of-the-money call and put options.

  • Specific risk

    Specific risk, also known as non-systematic risk, represents the price variability of a security that is due to factors unique to that security, as opposed to that portion that is due to systematic risk, the generalised price variability of the related interest rate or equity market. As an example, a US Treasury note would have no specific risk, as it is deemed to have no risk other than movement in interest rates, while a corporate bond would have a degree of default risk as well as more generalised yield curve risk.

  • Spread option

    The underlying for a spread option is the price differential between two assets (a difference option) or the same asset at different times or places. An example of a financial difference option is the credit spread option, the underlying for which is the spread between two debt issues, which derives from the relative credit rating of the issuers. Another is the cross-currency cap, where the underlying is the spread between interest rates in two different currencies. A calendar spread, a pair of options with the same strike price but different maturities, pays out the price difference for a single asset on two different dates. Spread options, including calendar spreads, are particularly popular in the commodity markets.

  • Spread-lock swap

    An interest rate swap in which one payment stream is referenced at a fixed spread over a benchmark rate such as US Treasuries.

  • Squeeze

    Pressure on a particular delivery date resulting in making the price of that date higher relative to other delivery dates.

  • Static replication

    Static replication is a method of hedging an options position with a position in standard options whose composition does not change overtime. The method attempts to replicate the payout of the instrument in a more manageable fashion than dynamic replication, where a position in the underlying or futures contracts must be dynamically adjusted if it is to remain effective. Because it uses options to hedge options, a static replication portfolio is a better hedge for gamma and volatility, as well as delta, than dynamic replication. Static replication can be used for hedging a position in exotic options with vanilla options, or for replicating a long-term option with short-term options. In practice, however, it is not always possible to hedge using static replication. The number of different options and notional amounts required can quickly become unmanageable.

  • Statistical arbitrage

    In the mid-1980s it was discovered that certain stock prices did to an extent exhibit autocorrelations, implying that earlier price changes could be used to forecast future changes. Statistical arbitrageurs seek to exploit these patterns in their trading strategies.

  • Step-down swap

    The opposite of an escalating rate swap; ie, the fixed rate decreases in increments over the life of the swap

  • Step-up/down range forward

    A self-adjusting range forward structure, which is particularly suitable for hedging purposes. If the strike level of the long put option is breached, the strike automatically adjusts up or down (according to exposure) to a new, more favorable, level.

  • Stochastic optimisation model

    A model or description of a system in which the choice of action that can be taken is dependent on the values of some random variables. For example, the value of an American-style option is such that the best choice of exercise is always made.

  • Stochastic process

    Formally, a process that can be described by the evolution of some random variable over some parameter, which may be either discrete or continuous. Geometric Brownian motion is an example of a stochastic process parameterised by time. Stochastic processes are used in finance to develop models of the future price of an instrument in terms of the spot price and some random variable; or analogously, the future value of an interest or foreign exchange rate.

  • Stochastic volatility

    One of the key assumptions of the Black-Scholes model is that the stock price follows geometric Brownian motion with constant volatility and interest rates. However, in real markets, volatility is far from constant. If volatility is assumed to be driven by some stochastic process, however, the Black-Scholes model no longer describes a complete market, since there is now another source of uncertainty in the option pricing model. A variety of approaches have been attempted to resolve this difficulty since the mid-1980s, most notably the Heath-Jarrow-Morton framework.

  • Stock index arbitrage

    The technique of selling a futures contract on a stock index and buying the underlying stocks, via programme trading, or vice versa when the price of the futures contract is above or below its theoretical value. The ability to conduct such strategies depends on the efficiency of the futures and cash markets.

  • Stock index future

    A futures contract on a stock index. Most are cash-settled. The theoretical price of a stock index future equals the cost of carrying the underlying stock for that period: the opportunity cost of the funds invested minus any dividends. If the cost of buying and holding the underlying stocks is less than the futures price, an arbitrageur can sell futures and buy the underlying stocks. The higher interest rates are (compared with the dividend yield), the greater the opportunity cost of holding the stocks, hence the futures price should be higher than the current index price. If interest rates are less than the dividend yield, the opportunity cost of holding stocks is less and the futures price should fall below the current index price. There is usually a so-called arbitrage band in which, although the futures and underlying prices diverge, it is not worthwhile arbitraging the two. This arises as a result of transaction costs from bid-ask spreads, the market impact of buying and selling stock, and execution risks.

  • Stock index option

    An option, either exchange-traded or over-the-counter, on a stock index.

  • Stock option

    An option, either exchange-traded or over-the-counter, on an individual equity.

  • Straddle

    The sale or purchase of a put option and a call option, with the same strike price, on the same underlying and with the same expiry. The strike is normally set at-the-money. The purchaser benefits, in return for paying two premiums, if the underlying moves enough either way. It is a way of taking advantage of an expected upturn in volatility. Sellers of straddles assume unlimited risk but benefit if the underlying does not move. Straddles are primarily trading instruments.

  • Strangle

    1. As with a straddle, the sale or purchase of a put option and a call option on the same instrument, with the same expiry, but at strike prices that are out-of-the-money. The strangle costs less than the straddle because both options are out-of-the-money, but profits are only generated if the underlying moves dramatically, and the break-even is worse than for a straddle. Sellers of strangles make money in the range between the two strike prices, but lose if the price moves outside the break-even range (the strike prices plus the premium received).
    2. The term strangle is also used, by currency option traders, to denote the average difference in implied volatility between out-of-the-money call and put options with a 25% delta and the implied volatility of at-the-money forward options.
  • Strap

    A strategy that involves purchasing one put option and two call options, all with the exact same strike price, underlyings and maturity date.

  • Strategic asset allocation

    The distribution of investment funds in response to long-term, fundamental expectations for markets

  • Stress-testing

    To perform a stress test on a derivatives position is to stimulate an extreme market event and examine its behavior under the stress of that event.

  • Strip

    A strategy that involves the purchase of one call option and two put options, all with the same strike price on the same underlying and the same expiry date. The strikes are set at-the-money. Alternatively, a strip can refer to the process of removing coupons from a bond and selling the stripped bond (or zero coupon bond) and interest-paying coupons separately.

  • Structured product

    A structured product is an investment that bundles up a portfolio of securities and other derivatives to create a single product. For example, a structured note can be a five-year bond that has an embedded equity or currency option in order to enhance its return. A structured product appeals to the investor who has a view on the market and a good idea of what his risk/reward appetite is.

  • Structured yield investments

    Any security (normally a structured note) whose yield is conditional on certain trigger conditions being met. Such a security is normally constructed by embedding path-dependent options (such as binary options) in a vanilla debt issue. The investor's return on the note will then vary according to the payout of the options.

  • Substitution option

    A bilateral financial contract in which one party buys the right to substitute a specified asset or one of a specified group of assets for another asset at a point in time or contingent upon a credit event.

  • Swaption

    An option to enter an interest rate swap. A payer swaption gives the purchaser the right to pay fixed, a receiver swaption gives the purchaser the right to receive fixed (pay floating). Apart from those in the sterling market, many swaptions are capital-market driven. Good-quality borrowers are able to issue puttable or callable bonds and use the swaptions market to reduce their financing costs. In the case of callable bonds, the issuer effectively buys an option from the investor in return for a slightly higher coupon, so that it may benefit if rates decline. Because many of these embedded options have traditionally been underpriced, good-quality borrowers have been able to monetise this anomaly by selling an equivalent swaption (a receiver swaption) to a bank at market rates. The profit from this arbitrage lowers funding costs. If the swaption is exercised against the issuer, it calls the bonds (although the issuer would almost certainly have called the issue given the reduction in rates). In the case of puttable bonds, the borrower sells a swaption to the swaption market. The premium gained lowers the funding cost at the expense of leaving the borrower unsure of the maturity of the debt.

  • Synthetic asset

    A synthetic asset is a combination of long and short positions in financial instruments, which has the same risk/reward profile as another instrument. For example, it is possible to replicate the payout and exposure of a short futures position by going short European-style call options and long European puts with identical strikes and expiries. Synthetic index options can be generated either through positions in the underlying and futures contracts, or with a basket of vanilla options.

  • Synthetic collateralized debt obligation

    A synthetic collateralized debt obligation (synthetic CDO) uses credit derivatives to transfer credit risk in a portfolio. This is in contrast to a traditional CDO, which is typically structured as a securitisation with ownership of the assets transferred to a separate special purpose vehicle (SPV). The assets are funded with the proceeds of debt and equity issued by the vehicle. In a synthetic CDO, an institution transfers the total return or default risk of a reference portfolio via a credit default swap, a total return swap, or a credit-linked note. The SPV then issues securities with repayment contingent upon the loss on the portfolio. Proceeds are either held by the vehicle and invested in highly rated, liquid collateral, or passed-on to the institution as an investment in a credit-linked note. Balance sheet synthetic CDOs are typically used by banks to manage risk capital and are easier to execute than traditional CDOs. Arbitrage synthetic CDOs are often used by insurance companies and asset managers and exploit the spread between the yield on the underlying assets and the reduced expense of servicing a CDO structure.

  • Synthetic securitization

    A first-loss basket swap structure that references a portfolio of bonds, loans or other financial instruments held on a firm's balance sheet. The technique replicates the credit risk transfer benefits of a traditional cash securitization while retaining the assets on balance sheet. Advantages over cash securitization include reduced cost, ease of execution and retention of on-balance sheet funding advantage.

  • Systemic risk

    The risk that the financial system as a whole may not withstand the effects of a market crisis. Concern on the part of banking regulators has been caused by the concentration of derivative risk among a relatively small number of market participants, with the concomitant risk that the failure of a major dealer could have serious knock-on effects for many other market participants.

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