The ABC of Structured Products

Asia Risk guide disclaimer.
qxd 24/10/2005 10:26 Page 1
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The information contained in this document is provided for general educational and informational purposes only. It should not be treated
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do not represent or warrant the reliability, accuracy, completeness, timeliness or fitness for any purpose of any of the information.
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2 The ABC of Structured Products

Asia Risk guide editor’s letter.qxd 24/10/2005 10:27 Page 3
www.asiarisk.com.hk
Foreword
Welcome to the Asia Risk/Société Générale glossary for structured
products, an invaluable guide for structurers, traders, marketers,
distributors, analysts, journalists and investors in this fast-growing market.
However complicated they may seem to the investor, today’s
structured products are based around a combination of some very basic
financial concepts.This book brings these concepts together and offers
standardised definitions and explanations, which can be understood by
the layman and PhD quant alike. It also explains some of the more
common combinations of these essential financial building blocks, while
allowing the imaginations of structurers to roam freely through the terms
dreaming up new and profitable structures.
Terms were selected by the team at Société Générale, with additional
research by Asia Risk journalists.We searched all available literature, spoke
to hundreds of traders and used SG trading and structuring expertise to
select the most common, yet often most misunderstood, words and
phrases.Terms were selected for their fundamental importance and
common use – alas, we had to reject the hamster option, which despite
the clever pun on the German for “range accrual”, has never been heard on
an Asian trading floor nor structurers’office. But we have nearly 500 terms,
representing the most complete guide to structured products
terminology in the market today.
Asia & Pacific Office Incisive Head Office US & Canada Office Incisive
Media Plc, Unit 2708, Incisive Media plc, Haymarket Media Plc,
27th Floor, The Center, 99 House, 270 Lafayette Street, Suite 700,
Queen's Road, Central, 28-29 Haymarket, London, New York, NY 10012, USA
Hong Kong, SAR China SW1Y 4RX, UK Tel (212) 925 6990;
Tel (852) 2545 2710; Tel +44 (0)20 7484 9700; fax (212) 925 7585
fax (852) 2545 7317 fax +44 (0)20 7930 2238
The ABC of Structured Products 3

Asia Risk guide feature.qxd 24/10/2005 10:30 Page 4
Introduction
History of structured
products in Asia
he Asian structured products market has redemption notes (Tarns), equity-linked notes,
T boomed over the past few years.

Starting in 1999, when the first capital-
guaranteed funds were launched in Hong
range accruals and accumulator notes.
Investors have also become more
demanding. The first Tarns typically had a 10-
Kong, these products have become a hit with year maturity, and most of the structures aimed
investors due to their higher potential returns at retail investors were 100% principal
than bank deposits. In early 2002, there were protected. But non-principal-protected
73 guaranteed funds authorised for sale by the products quickly became a sell-out as investors
Securities and Futures Commission in Hong started to demand shorter tenors, higher
Kong with a net asset value (NAV) of US$11.7 payouts and more innovative features.
billion. The number has surged to more than The massive amounts of volatility products
300 guaranteed funds worth more than US$18 that have been sold across Asia to private
billion in NAV at the time of writing. banking and retail investors contributed to a
But these figures are only the tip of the fall in implied volatility levels. Product
iceberg, as they only include funds authorised providers started to incorporate views on
for sale to the public. They do not include the correlation into equity-linked notes to increase
huge volumes of structured notes and product payouts. Basket equity-linked notes that pay
of ferings in the private banking and high coupons and additional amounts based on
institutional markets, where growth has been either the best or worst performer in a basket of
even more tremendous. The Asian market now stocks are now a staple of the market.
rivals (some would argue leads) the European Structured products with Asian underlyings
and US markets in terms of sophistication, with have also been hugely successful. Lyxor Asset
a huge variety of exotic structures available to Management, a 100% subsidiary of the Société
private banking clients. Générale Group (SG), recently offered a
Over the past two years, retail investors have product called Alpha Equity Fund – Hang Seng
also become much more knowledgeable about Index, which incorporates payouts based on a
structured products, and an improved equity formula that tracks the index over an
outlook means investors are no longer satisfied investment cycle of eight years and locks in the
with simple guaranteed funds. The low interest highest positive performance of the index. At
rate environment led investors to take huge maturity, if the index is above its initial level,
interest in products that enabled them to sell investors will get a return based on the highest
volatility for yields. Since 2003, the market has positive performance observed. If the index
seen a proliferation of structures, such as target falls below its initial level, investors will get a

Asia Risk guide feature.qxd 24/10/2005 10:30 Page 5
www.asiarisk.com.hk Introduction
return based on the performance of the index territory is also the major centre for SG’s equity
plus the highest performance observed. derivatives business with market-leading
warrants and structured products. SG also
SG’s expertise provides worldwide expertise ranging from
SG CIB, the corporate and investment equity advisory and mergers and acquisition to
banking arm of SG, is a multi-award-winning private banking, asset management and futures.
leader in structured products, both in Asia and
globally. This position is backed by its Need for education
extensive network in more than 45 countries In the structured products world, words such
across Europe, the Americas and the Asia- as ‘Everest’ and ‘Parisian’ have very different
Pacific region, and its leading expertise in meanings from their common daily usage. The
derivatives across equities, interest rate, credit, growing complexity of products means that
foreign exchange and commodities. many new options and structures are constantly
In the Asia-Pacific, SG CIB has built prime being created and new terminology devised
investment banking operations to become a and added to the universe of product jargon.
leading r egional player in derivatives, Keeping up with the latest trends in structured
structured finance and debt capital markets. products means learning the language and
We combine global and local strengths to understanding how the options work.
provide corporate clients, financial institutions Understanding a product also means
and private investors with value-added understanding the risks behind it. While most
integrated financial solutions. investors have fairly good product knowledge,
SG and its 100% subsidiary Lyxor Asset there are still certain misperceptions about
Management – which won the Asset Manager product risks. For example, many perceive a
of the Year 2004 award from Asia Risk – are ‘guaranteed’ product to be risk-free. In reality,
also leading innovators in alternative a guarantee on principal repayment is subject to
investments. With a platform of 150 managed credit risk of the guarantor and usually holds
accounts and more than €20 billion of assets only when the product is held to maturity.
under management, Lyxor Asset Management This glossary is an A to Z guide to help
is a recognised expert in hedge fund manager readers navigate the maze of str uctured
selection. In January 2004, SG launched the product terms. The focus here is on equity
first capital-guaranteed hedge fund product to derivatives, but many of the options and
target Hong Kong retail investors, a structure features have been adapted to products of other
referenced to the MSCI Hedge Invest Index, asset classes. With this guide in hand, investors
which comprises managed accounts on the will find that the structured products language
Lyxor platform. More recently, Lyxor Asset is not as daunting as it may first have seemed. ●
Management launched Hong Kong’s first
retail-guaranteed product linked to real estate Contact
investment trusts. SG
Hong Kong is SG’s structured finance Nicolas Reille, Managing Director
regional hub, providing leading capabilities in Structured Products Asia EX Japan
Tel: +852 2166 4918
project finance, export finance, syndication, Email: nicolas.reille@sgcib.com
debt capital markets and credit derivatives. The

Asia Risk Glossary .qxd 25/10/05 10:37 am Page 6
Glossary of terms
A Accreting and investment banking techniques that

A description, applicable to a variety of allows a party to either free itself from
instruments, denoting that the notional risks not easily transferred via traditional
principal increases successively over the insurance, or alternatively cover such risks
life of the instrument, eg, caps, collars, in a non-traditional way – by using the
swaps and swaptions. If the increase takes capital markets for example.
place in increments, the instrument may
be known as a step-up. See also amortising Altiplano
An Altiplano is a type of mountain range
Accrual corridor structure, which offers investors a fixed
The range within which an underlying payout at the end of the product’s
reference rate must trade for coupon life on the condition that none of the
payments to accrue in a range note or assets that make up the underlying
corridor option. basket have decreased below a given
level. If the level is breached, the product
Accrual note pays a capital guarantee plus
See range note participation in the growth of the total
underlying basket.
Accrual period
Period over which net payment or receipt American-style option
pertaining to swaps is accrued. It is The holder of an American-style option
inclusive of the start date and runs to the has the right to exercise the option at any
end date without including the end date. time during the life of the option, up to
and including the expiry date. See also
All-or-nothing option option styles
See binary option
Amortising
Alpha A description, applicable to a variety of
Alpha is used to measure the instruments, denoting that the
performance of a fund in relation to its notional principal decreases successively
benchmark. An alpha that measures 2.0 over the life of an instrument, eg,
indicates a fund has achieved a return 2% amortising swap, index amortising rate
better than could have been expected swap, amortising cap, amortising collar,
from its benchmark. amortising swaption. If the decrease
takes place in increments, the instrument
Alternative risk transfer may be known as a step-down.
An approach to risk management Mortgage-style amortisation refers to an
combining capital markets, reinsurance amortising swap such that the principal

Glossary of terms
amortisation plus interest is the AutoRegressive conditional

A
same amount in each interest period. heteroscedasticity (Arch)
See also accreting A discrete time model for a random
variable. It assumes that variance is
Annapurna stochastic and is a function of the
An Annapurna is a kind of mountain variance of previous time steps and the
range product, which offers a return level of the underlying.
equal to the greater of a capital
guarantee plus a fixed coupon and a Asian option
participation in the performance of the See average option
underlying basket.The level of the fixed
coupon and of the participation rate in Asset allocation
the performance depend on if and when The distribution of investment funds
the worst-performing stock breaches a within a single asset class or across a
downside barrier.The later the breach, the number of asset classes (such as equities,
higher the fixed coupon and equity bonds and commodities) with the aim of
participation rate. diversifying risk or adding value to a
portfolio. See also overlay
Annuity swap
An interest rate swap in which a series of Asset backed security
irregular cashflows are exchanged for a An asset backed security is a security
stream of regular cashflows of equivalent collateralised by assets such as bonds,
present value. credit card repayments, loan repayments
or real estate.
Arbitrage
A guaranteed or riskless profit from Asset swap
simultaneously buying and selling A package of a cash credit instrument
instruments that are perfect and a corresponding swap that
equivalents, the first being cheaper transforms the cash flows of the non-par
than the second. instrument (bond or loan), into a par
(floating interest rate) structure.
Arbitrage-free model Asset swaps typically transform
Any model that does not allow arbitrage fixed-rate bonds into par floaters,
on the underlying variable. Some simple bearing a net coupon of Libor plus a
early models assumed parallel shifts in spread, although cross-currency
the yield curve, but the varying yields of asset swaps, transforming cashflows
different duration bonds could be from one currency to another are
arbitraged using butterfly strategies. also common.

Glossary of terms
AAsset/liability management difference between its predetermined

The practice of matching the term strike price and the spot rate (or price) of
structure and cashflows of an the underlying at the time of expiry.The
organisation’s asset and liability portfolios purchaser of an average option (average
in order to maximise returns and price, average strike, average hybrid,
minimise risk. An institutional example of average ratio), on the other hand, will
this would be a bank converting a fixed- receive a pay-out which depends on the
rate loan (asset) by utilising a fixed-for- average value of the underlying.The
floating interest rate swap to match its average can be calculated in a number of
floating rate funding (deposits). ways (arithmetic or geometric, weighted
or simple) from the spot rate on a
At-the-money predetermined series of dates. An average
1 . At-the-money forward: An option rate (or average price) option is a cash-
whose strike is set at the same level as the settled option with a predetermined (ie
prevailing market price of the underlying fixed) strike which is exercised at expiry
forward contract. With a Black-Scholes against the average value of the
model, the delta of a European-style, at- underlying over the specified dates. In
the-money forward option will be close general, hedging with an average option
to 50%. is cheaper than using a portfolio of vanilla
2 . At-the-money spot: An option whose options, since the averaging process
strike is set the same as the prevailing offsets high values with low ones and
market price of the underlying. Because therefore lowers volatility and premium.
forwards commonly trade at a premium Average options, also known as Asian
or discount to the spot, the delta may not options, are particularly popular in the
be close to 50%. See also in-the-money, equity, currency and commodity markets.
out-of-the-money In contrast, the strike for an average strike
option is not fixed until the end of the
Autocap averaging period which is typically much
A standard cap consists of a series of before the expiry.When the strike is set,
caplets hedging future floating rate the option is exercised against the
payments. However, autocaps only prevailing spot rate. Unlike average price
provide a hedge for the first pre-specified options, average strike options may be
number of in-the-money caplets after either cash or physically settled. In the case
which the option expires, and so are a of an average hybrid option (also known
cheaper alternative to caps. as an average-in/average-out option), both
the strike and settlement price of the
Average option option are determined using the average,
A plain vanilla option pays out the where the strike averaging period typically

Glossary of terms
precedes the settlement price averaging

A/B
termination knock-out options behave
period. For the average ratio option, both identically to standard European-style
the strike and settlement price of the options, but carry lower initial premiums
option are determined using the average because they may be extinguished before
as in the hybrid case.The final payout is reaching maturity. In contrast, knock-in
determined by comparing the ratio of options behave identically to European-
settlement price to strike and a fixed style options only if they are activated/
percent strike. knocked-in and so also command a
lower premium.
Average price option The standard barrier options have
See average option barrier levels that are monitored
continually during the lifetime of the
Average rate option option. Single barrier options that have a
See average option barrier level above current spot are
classified as up-and-out or up-and-in
Average strike option options. For single barriers below spot the
See average option usual terminology is down-and-out for
the knock-out barrier option, and down-
and-in for the knock-in barrier option.
B
Back-testing
Many variations on the barrier theme
are available. Barrier levels can be
monitored continually, at discrete fixing
times (discrete barrier options) or only at
The validation of a model by feeding it the final expiry date of the option (at-
historical data and comparing the expiry barrier options). Barriers may be
model’s results with the historical reality. active only during distinct time intervals
The reliability of this technique generally (window barrier options) or may change
increases with the amount of historical value at fixed points during the lifetime of
data used. the option (stepped barrier options).
Barriers may need to be breached for a
Barrier option certain time before they are considered
Barrier options, also known as knock-out, triggered (Parisian Barrier Options) or may
knock-in or trigger options, are path- allow for partial triggering depending
dependent options which are either upon how far beyond the trigger level the
activated (knocked-in) or terminated underlying asset is observed (Soft Barrier
(knocked-out) if a specified spot rate options). Barriers may reference a different
reaches a specified trigger level (or levels) underlying to that of the option itself –
between inception and expiry. Before such barriers are known as outside

Glossary of terms
Bbarriers. See also discrete barrier option, currency basis swap is one in which two
double barrier option, Parisian barrier streams of floating rate payments are
option, path-dependent option, trigger, exchanged. Examples of interest rate
trigger condition basis swaps include swapping $Libor
payments for floating commercial paper,
Basis Prime, Treasury bills, or Constant Maturity
1 . The difference between the price of a Treasury rates; this is also known as a
futures contract and its theoretical value. floating-floating swap. A typical cross-
2 . The convention for calculating interest currency basis swap exchanges a set of
rates. A bond can be 30/360 or actual/365 Libor payments in one currency for a set
in the US, or 360/360 in Europe. Money of Libor payments in another currency.
market instruments can be actual/360 in
the US or actual/365 in the UK and Japan. Basis trading
To basis trade is to deal simultaneously
Basis risk in a derivative contract, normally
In a futures market, the basis risk is the risk a future, and the underlying asset.The
that the value of a futures contract does purpose of such a trade is either to cover
not move in line with the underlying derivatives sold, or to attempt an
exposure. Because a futures contract is a arbitrage strategy.This arbitrage can
forward agreement, many factors can either take advantage of an existing
affect the basis.These include shifts in the mispricing (in cash-and-carry
yield curve, which affect the cost of carry; arbitrage) or be based on speculation
a change in the cheapest-to-deliver bond; that the basis will change. See also cash-
supply and demand; and changing and-carry arbitrage
expectations in the futures market about
the market’s direction. Generally, basis risk Basket credit default swap
is the risk of a hedge’s price not moving in A credit default swap which transfers
line with the price of the hedged position. credit risk with respect to multiple
For example, hedging swap positions with reference entities. For each reference
bonds incurs basis risk because changes entity, an applicable notional amount is
in the swap spread would result in the specified, with the notional of the basket
hedge being imperfectly correlated. Basis swap equal to the aggregate of the
risk increases the more the instrument to specified applicable notional amounts.
be hedged and the underlying are Types of basket credit default swaps
imperfect substitutes. include linear basket credit default swaps,
first-to-default basket credit default
Basis swap swaps, and first-loss basket credit default
An interest rate basis swap or a cross- swaps. See also credit default swap

Glossary of terms
Basket option
B
payout would be based on the increase in
An option that enables a purchaser to value of Stock B.
buy or sell a basket of currencies,
equities or bonds. Beta
1 . The beta of an instrument is its
Basket swap standardised covariance with its class of
A swap in which a floating leg is based on instruments as a whole.Thus the beta of a
the returns on a basket of underlying stock is the extent to which that stock
assets, such as equities, commodities, follows movements in the overall market.
bonds, or swaps.The other leg is usually 2 . Beta trading is used by currency
(but not always) a reference interest rate traders if they take the volatility risk of
such as Libor, plus or minus a spread. one currency in another. For example,
rather than hedge a sterling/yen option
Basket trading with another sterling/yen option, a trader,
See program trading either because of liquidity constraints or
because of lower volatility, might hedge
Bear spread with euro/yen options.The beta risk
An option spread trade that reflects a indicates the likelihood of the two
bearish view on the market. It is usually currencies’ volatilities diverging.
understood as the purchase of a put
spread. See also bull spread, Better-of-two-assets option
call spread See best-of option
Bermudan option Bilateral netting

The holder of a Bermudan option, also Agreement between two counterparties
known as a mid-Atlantic option, has the whereby the value of all in-the-money
right to exercise it on one or more contracts is offset by the value of all
possible dates prior to its expiry. out-of-the money contracts, resulting
See also option styles in a single net exposure amount
owed by one counterparty to the other.
Best-of option Bilateral netting can be multi-product
A best-of option pays out on the best and encompass portfolios of swaps,
performing of a number of underlying interest rate options, and forward
assets over an agreed period of time. foreign exchange.
For instance, if a basket contains
stock A, stock B and stock C and stock B Binary option
gains in value by the larger amount Unlike simple options, which have
during the products term, then the continuous pay-out profiles, that of a

Glossary of terms
Bbinary option is discontinuous and pays process will continue.The process is

out a fixed amount if the underlying usually specified so that an upward
satisfies a predetermined trigger movement followed by a downward
condition but nothing otherwise. Binary movement results in the same price, so
options are also known as digital or all-or- that the branches recombine. If the
nothing options. branches do not recombine it is known as
There are two major forms: at maturity a bushy, or exploded, tree.The size of the
and one-touch. At maturity binaries, also movements and the probabilities are
known as European binaries or at expiry chosen so that the discrete binomial
binaries, pay out only if the spot trades model tends to the normal distribution
above (or below) the trigger level at assumed in option models as the number
expiry. One-touch binary options, also of discrete steps is increased. Options can
known as American binaries, pay out if be evaluated by discounting the terminal
the spot rate trades through the trigger pay-off back through the tree using the
level at any time up to and including determined probabilities. Interest in
expiry.The pay-out of a one-touch binary binomial trees arises from their ability to
may be due as soon as the trigger deal with American-style features and to
condition is satisfied or alternatively at price interest rate options. For example,
expiry (one-touch immediate or one- American-style options can readily be
touch deferred binaries). As with barrier priced because the early exercise
options, variations on the theme include condition can be tested at each point in
discrete binaries, stepped binaries, etc. the tree.
Binary options are frequently combined
with other instruments to create Black-Derman-Toy model
structured products, such as contingent A one-factor log-normal interest rate
premium options. model where the single source of
uncertainty is the short-term rate.
Binomial model The inputs into the model are the
Any model that incorporates a observed term structure of spot
binomial tree. interest rates and their volatility term
structure.The Black-Derman-Toy model,
Binomial tree such as the Ho-Lee model, describes the
Also called a binomial lattice. A discrete evolution of the entire term structure
time model for describing the evolution in a discrete-time binomial tree
of a random variable that is permitted to framework.The model can be used to
rise or fall with given probabilities. After price bonds and interest rate-sensitive
the initial rise, two branches will each securities, though the solutions are not
have two possible outcomes and so the closed-form.

Glossary of terms
Black-Scholes model Bond index swap

B
The original closed-form solution to A swap in which one counterparty
option pricing developed by Fischer Black receives the total rate of return of a bond
and Myron Scholes in 1973. In its simplest market or segment of a bond market in
form it offers a solution to pricing exchange for paying a money market
European-style options on assets with rate. Counterparties may also swap the
interim cash pay-outs over the life of the returns of two bond markets.
option.The model calculates the
theoretical, or fair value for the option by Box
constructing an instantaneously riskless To buy/sell mispriced options and
hedge: that is, one whose performance is hedge the market risk using only options,
the mirror image of the option pay-out. unlike the conversion or the reversal,
The portfolio of option and hedge can which use futures contracts. If a certain
then be assumed to earn the risk-free rate strike put is underpriced, the trader buys
of return. the put and sells a call at the same strike,
Central to the model is the assumption creating a synthetic short futures
that market returns are normally position.To get rid of the market risk, he
distributed (ie have lognormal prices), sells another put and buys another call,
that there are no transaction costs, that but at different strike prices. See also
volatility and interest rates remain convergence trade
constant throughout the life of the
option, and that the market follows a Brace-Gatarek-Musiela (Bgm) model
diffusion process.The model has five See market model of interest rates.
major inputs: the risk-free interest rate,
the option’s strike price, the price of the Bull spread
underlying, the option’s maturity, and the An option spread trade that reflects a
volatility assumed. Since the first four are bullish view on the market. It is usually
usually determined by the market, understood as the purchase of a call
options traders tend to trade the implied spread. See also bear spread, call spread
volatility of the option.
Butterfly spread
Bond The simultaneous sale of a straddle and
Companies or governments issue purchase of a money strangle.The
bonds as a means of raising capital. The structure profits if the underlying remains
bond purchaser is in effect making a stable, and has limited risk in the event of
loan to the issuer, and unlike with shares a large move in either direction. As a
investors at no point hold a stake in trading strategy to capitalise upon a
the company. range trading environment it is usually

Glossary of terms
B/C
executed in equal notional amounts. relative to long-term volatility, the
Alternatively, such trades are often strategy makes money.
applied to benefit from changes in
volatility. In such circumstances the Call option
butterfly spread is traded on a ‘vega- See option
neutral’ basis (ie the volatility sensitivity
of the long position is initially offset by Call spread
the volatility sensitivity of the short A strategy that reduces the cost of buying
position). As the holder of an initially a call option by selling another call at a
vega-neutral spread, the trader will higher strike price (Bull call spread).This
benefit from changes in volatility since limits potential gain if the underlying
the strangle position profits more from an goes up, but the premium received
increase in volatility than the straddle and from selling the out-of-the-money
loses less than the straddle in a decline in call partly finances the at-the-money
volatility (this is due to the fact that the call. A call spread may be advantageous
vomma of the strangle is higher than that if the purchaser thinks there is only
of the straddle). limited upside in the underlying.
Alternatively a Bear call spread can be
constructed by selling a call option
C
Calendar spread
and buying another at a higher strike
price. See also bear spread, bull spread,
put spread
A strategy that involves buying and Callable swap

selling options or futures with the same An interest rate swap in which the
(strike) price but different maturities. Such fixed-rate payer has the right to
a strategy is used in futures when one terminate the swap after a certain
contract month is theoretically cheap and time if rates fall. Often done in
another is expensive. With options, the conjunction with callable debt issues
strategy is often used to play the shape where an issuer is more concerned with
of or expected changes in, the volatility the cost of debt than the maturity. The
term structure. For example, if one-month embedded option is, in effect, a swaption
volatility is high and one-year volatility sold by the fixed-rate receiver which
low, arbitrageurs might buy one-year enables the fixed-rate payer to receive
straddles and sell short-term straddles, the same high fixed rate for the
thereby selling short-term volatility and remaining years of the swap in the event
buying long-term volatility. If, all else that interest rates fall. The fixed rate
being equal, short-term volatility declines received under the swaption offsets the

Glossary of terms
fixed rate paid under the original swap

C
credit-linked note, only the coupons paid
effectively cancelling the swap. In some under the note bear credit risk. Such a
definitions of a callable swap, the structure can be analysed as (i) a Treasury
fixed-rate receiver has the right to strip and (ii) a stream of risky annuities
terminate the swap. Also known as a representing the coupon, purchased from
cancellable swap. the note proceeds minus the cost of the
Treasury strip. See also credit-linked note
Cancellable swap
See callable swap Capped floater
A floating-rate note which pays a coupon
Cap only up to a specified maximum level of
A contract whereby the seller agrees to the reference rate.This is done by
pay to the purchaser, in return for an embedding a cap in a vanilla note where
upfront premium or a series of annuity the investor effectively sells the issuer a
payments, the difference between a cap. A capped floater protects the debt
reference rate and an agreed strike rate issuer from large increases in the interest
when the reference exceeds the strike. rate environment.
Commonly, the reference rate is three- or
six-month Libor. A cap is therefore a strip Capped swap
of interest rate guarantees that allows the An interest rate swap with an embedded
purchaser to take advantage of a cap in which the floating payments of the
reduction in interest rates and to be swap are capped at a certain level. A
protected if they rise.They are priced as floating-rate payer can thereby limit its
the sum of the cost of the individual exposure to rising interest rates.
options, known as caplets. See also collar
Caption
Capital-protected An option on a cap. A type of
A structured product that provides capital compound option in which the
protection offers an amount that at least purchaser has the right, but not the
matches a given proportion of the obligation, to buy or sell a cap at a
investor’s original capital input at predetermined price on a predetermined
maturity. Can also be referred to as date. Captions can be a cheap way of
principal-protected. leveraging into the more expensive
option. See also floortion
Capital-protected credit-linked note
A credit-linked note where the principal is Cash and carry
partly or fully guaranteed to be repaid at When a contango exists, the
maturity. In a 100% principal-guaranteed premium of the forward position over

Glossary of terms
Cthe spot generally reflects costs of buying the index may represent the number of
and holding (eg financing, transaction claims received by property insurance
costs, insurance, custody) for that period. companies.
See also cash and carry arbitrage
Catastrophe risk swap
Cash market An agreement between two parties to
The physical market for buying and exchange catastrophe risk exposures. For
selling an underlying (eg equities, bonds), example, in July 2001 Swiss Re and Tokyo
as opposed to a futures market. Marine arranged a $450 million deal
including three risk swaps: Japan
Cash-and-carry arbitrage earthquake for California earthquake,
A strategy, used in bond or stock index Japan typhoon for France storm and
futures, in which a trader sells a futures Japan typhoon for Florida hurricane.
contract and buys the underlying to Swaps increase diversification
deliver into it, to generate a riskless profit. and allow each of the parties to
For the strategy to work, the futures lower the amount of capital that they
contract must be theoretically expensive need to hold.
relative to cash.
Cash-and-carry arbitrage and reverse Chooser option
cash-and-carry arbitrage typically keep A chooser option offers purchasers the
the futures and underlying markets choice, after a predetermined period,
closely aligned. See also basis trading, between a put and a call option.The
reverse cash-and-carry arbitrage pay-outs are similar to those of a
straddle but chooser options are
Catastrophe bond cheaper because purchasers must
A bond that pays a coupon that decreases choose before expiry whether they want
only after a catastrophe such as a the put or the call.
hurricane or earthquake with a specified
magnitude in a specified region and Cliquet
period of time. Cliquet structures, which can also be
called ratchet structures, periodically
Catastrophe option settle and reset their strike prices,
These options can be American-style or allowing users to lock-in potential
European-style, either paying out if a profits on the underlying. With a cliquet
single specified catastrophe such as a the payout is worked out from the
hurricane or earthquake occurs, or performance of the underlying asset in a
alternatively, having a pay-out number of set periods during the
dependent on an index. For example, product’s life. See also ladder options

Glossary of terms
Cliquet option
C
put, the strategy is known as a zero cost
Also known as a ratchet or reset option. A collar. The combination of purchasing the
path-dependent option that allows buyers put and selling the call while holding the
to lock-in gains on the underlying security underlying protects the holder from
during chosen intervals over the life time losses if the underlying falls in price, at the
of the option.The option’s strike price is expense of giving away potential upside.
effectively reset on predetermined dates. See also cap, equity collar, impact forward,
Gains, if any, are locked in. So if an risk reversal, zero cost option
underlying rises from 100 to 110 in year
one, the buyer locks in 10 points and the Collar swap
strike price is reset at 110. If it falls to 97 in A collar on the floating-rate leg of an
the next year the strike price is reset at interest rate swap.The transaction is zero
that lower level, no further profits are cost – the purchase of the cap is financed
locked in, but the accrued profit is kept. See by the sale of the floor.The collar
also ladder option, lookback option, moving constrains both the upside and the
strike option, path dependent option downside of a swap.
Closed-form solution Collared floater

Also called an analytical solution. An A floating-rate note whose coupon
explicit solution of, for example, an option payments are subject to an embedded
pricing problem by the use of formulae collar.Thus the coupon is capped at a
involving only simple mathematical predetermined level, so the buyer
functions, such as Black-Scholes or Vasicek forsakes some upside, but also floored,
models. Closed-form models can usually offering protection from a downturn in
be evaluated much more quickly than the reference interest rate. Also known as
numerical models, which are sometimes a mini-max floater.
far more computationally intensive.
Collateralised bond obligation (Cbo)
Collar A multi-tranche debt structure, similar to
The simultaneous sale of an out-of-the- a collateralised mortgage obligation. But
money call and purchase of an out-of-the- rather than mortgages, low-rated bonds
money put (or cap and floor in the case of serve as the collateral. See also
interest rate options).The premium from collateralised mortgage obligation
selling the call reduces the cost of
purchasing the put.The amount saved Collateralised debt obligation (Cdo)
depends on the strike rate of the two Generic name for collateralised bond
options. If the premium raised by the sale obligations, collateralised loan
of the call exactly matches the cost of the obligations, and collateralised mortgage

Glossary of terms
Cobligations. See also collateralised period.They are often used to hedge

mortgage obligation, synthetic collateralised against increase in option prices during
debt obligation volatile periods. Examples include
captions and floortions.
Collateralised loan obligation (Clo)
A structured bond backed by the loan Condor
repayments from a portfolio of pooled The simultaneous purchase (sale) of an
personal or commercial loans, out-of-the-money strangle and sale
excluding mortgages.The structure (purchase) of an even further out-of-the-
allows a bank to remove loans from its money strangle.The strategy limits the
balance sheet and so reduce its required profit or loss of the pay-out and is
capital reserves, while retaining contact directionally neutral.
with the borrowers and fees from
servicing the loans. See also collateralised Constant maturity swap
mortgage obligation This is an interest rate swap where the
floating interest arm is reset periodically
Collateralised mortgage obligation with reference to longer duration
A type of asset-backed security, in this treasury-based instruments rather than a
case backed by mortgage payments. market index such as LIBOR.
Typically, such securities provide a
higher return than normal fixed-rate Constant maturity treasury derivative
securities but purchasers suffer Over-the-counter swaps and options
prepayment risk if mortgage holders which use longer-term, Treasury-based
redeem their mortgages. Because the instruments for their floating rate
right to redeem the mortgage is reference than money market indexes,
effectively an embedded call, such such as Libor.‘Constant Maturity Treasury’
securities have negative convexity. (CMT) refers to the par yield that would
See also collateralised bond obligation, be paid by a treasury bill, note or bond
collateralised debt obligation, collateralised which matures in exactly one, two, three,
loan obligation five, seven, 10, 20 or 30 years. Since there
may not be treasury issues in the market
Combo with exactly these maturities, the yield is
See risk reversal interpolated from the yields on treasuries
that are available. In the US, such rates
Compound option have been calculated and published by
A compound option is an option on an the Federal Reserve Bank of New York and
option.The tool allows the user to buy or the US Treasury department on a daily
sell an option at a fixed price during a set basis every day for more than 30 years.

Glossary of terms
The H.15 Report from the Federal

C
portfolio between risky assets (such as
Reserve Bank is often used as a source for equities) and safe assets (such as bonds)
CMT rates. according to a quantitative model. The
It is then possible for this interpolated level of risky assets is managed such that
yield to form the index rate for at all times, in the event of a market crash,
instruments such as floating rate notes, the remaining NAV of the fund is still
which pay interest linked to the CMT sufficient to meet the stated protection
yield, options, which pay the difference level. Generally the proportion of Risky
between a strike price and the CMT yield, Assets in the fund is increased when
and swaps and swaptions, in which one of these perform well and decreased when
the cashflows exchanged is the CMT these perform poorly.
yield. Where necessary, the reference rate The capital protection level may be
is reset at each settlement date.Typical fixed, or rachet up (reset) according to a
uses of CMT derivatives as hedging tools certain percentage of the fund NAV
include the purchase of CMT floors by achieved during the fund term.
mortgage servicing companies to protect
the value of purchased mortgage Contingent swap
servicing portfolios, and the purchase of The generic term for a swap activated
CMT caps to protect investors with when rates reach a certain level or a
negatively convex mortgage-backed specific event occurs. Swaptions are
securities portfolios. It is possible to enter often considered to be contingent
into derivatives in other currencies that swaps. Other types of swaps, for
are based, by analogy, on a ‘constant example, drop-lock swaps, are activated
maturity interest rate swap’ interpolated only if rates drop to a certain level or
from the swap curve in the relevant if a specified level over a benchmark
currency. Such derivatives are known as is achieved.
constant maturity swap (CMS) derivatives.
Unlike CMT derivatives, CMS derivatives Contract for difference (Cfd)
incorporate the spread component A Contract for Difference is typically an
of swaps. agreement made between two parties to
exchange (at the closing of the contract)
Constant proportion portfolio a cashflow equivalent to the difference
insurance (CPPI) between the opening and closing prices,
A fund management technique that aims multiplied by the number of shares
to provide maximum exposure to risky detailed in the contract. CFDs are traded
assets while still protecting investors’ on margin, do not incur stamp duty and
capital.The technique requires the can have individual stocks or indexes as
manager to dynamically rebalance the the underlying.

Glossary of terms
CConvergence trade Convexity

Trading strategy where similar securities A bond’s convexity is the amount that its
are bought and sold simultaneously in price sensitivity differs from that implied
the expectation that prices will converge by the bond’s duration. Fixed-rate bonds
in an orderly fashion. and swaps have positive convexity: when
1 . A way of taking advantage of rates rise the rate of change in their price is
mispriced options by creating a synthetic slower than suggested by their duration;
short futures position and hedging when rates fall it is faster. Positive convexity
market risk by buying a futures contract is therefore a welcome attribute.The
against it.Thus if a put is undervalued, a higher the bond’s duration, the more its
trader buys it, at the same time selling a convexity. Bonds or swaps with call options
fairly valued call and buying a futures or embedded call options, eg collateralised
contract.The same strategy can be mortgage obligations, have negative
applied if the call is mispriced. If the convexity: when rates rise their price fall is
option is truly undervalued, the trader faster relative to the interest rate move.
earns a riskless profit.The whole exercise Convexity effectively describes the same
relies on put-call parity attribute as gamma.
2 . The act of converting a convertible
bond into equity. See also box, reversal Correlation
Correlation is a measure of the degree to
Convertible bond which changes in two variables are related.
A bond issued by a company that may be It is normally expressed as a coefficient
exchanged by the holder for a number of between plus one, which means variables
that company’s shares at a predetermined are perfectly correlated (in that they move
ratio, or at a discount to the share price at in the same direction to the same degree)
maturity. Because the convertible embeds and minus one, which means they are
a call option on the company’s equity, perfectly negatively correlated (in that
convertibles carry much lower rates of they move in opposite directions to the
interest than traditional debt and are same degree). In financial markets
therefore a cheap way for companies to correlation is important in three areas:
raise debt.The problem for existing 1 . The model used for global asset
shareholders is that conversion dilutes the allocation decisions, Sharpe’s capital asset
company’s outstanding shares.Typically, pricing model (CAPM), has, as its linchpin,
bonds are convertible into a company’s a covariance matrix that measures
own stock.There are however ‘third party correlations between markets.
convertibles’, which convert into 2 . Correlation is also central to the pricing
shares of another company. See also of some options, where two-factor or
equity warrant, resettable convertible bond multi-factor models are used. For spread

Glossary of terms
options, yield curve options and cross-

C
coupon at the end of the lifetime of the
currency caps, estimating the correlation corridor whose magnitude depends upon
between the underlying assets is of the behaviour of a specified spot rate
primary importance, the degree of during the lifetime of the corridor. For
correlation between them having a direct each day on which the spot rate (typically
influence on the option price. For quantos an official fixing rate observation) remains
such as guaranteed exchange rate options, within the chosen spot range (the accrual
or differential swaps, the correlation effect corridor) the holder accrues one day’s
is the extent to which there is a worth of coupon interest.
relationship between movements in the A variation is the knockout corridor
underlying and movements in the ex- option. In this structure, the holder ceases
change rate, which has a secondary effect to accrue coupon interest as soon as the
on the price of the option. spot rate leaves the range. Even if the spot
3 . Correlation between markets is also rate subsequently re-enters the range, the
used to offset an option position in one holder does not continue to accrue
market against another with similar coupon interest. At the end of the option’s
direction and volatility. Such a strategy lifetime, the accrued coupon is calculated
might be used to reduce cost – to avoid according to the following formula:
hedging the positions separately, or If the accrual corridor is one-sided (the
because implied volatility in the second other side of the range being open-
market is lower – or because hedging is ended), it is known as a wall option.
difficult in the first market. Correlation can Typically, corridor options are imbedded
be estimated historically (like volatility) in a structured note, sometimes called a
but tends to be unstable, and historic range note, that pays a higher yield than
estimations may be poor predictors of the corresponding vanilla debt as long as
future realised correlations. See also the underlying rate remains sufficiently
joint option long within the accrual corridor. A similar
option to the corridor option is the range
Correlation swap binary, a binary option which pays a fixed
An instrument that allows an investor to coupon amount if the range is not
take financial exposure on a set of breached but nothing if it is breached.
correlations.
Cost of carry
Corridor floater The cost of financing an asset. If the cost
See range note is lower than the interest received, the
asset has a positive cost of carry; if higher,
Corridor option the cost of carry is negative.The cost of
The holder of a corridor option receives a carry is determined by the opportunities

Glossary of terms
Cfor lending the asset and the shape of the writing is often used as a way of target
yield curve. So a bond, for example, would buying: if an investor has a target price at
have a positive cost of carry if short-term which he wants to buy, he can set the
rates (financing rates) were lower than strike price of the option at that level and
the assets’s yield or (and) if the cost could receive option premium to increase the
be mitigated by lending out the yield of the asset. Investors also sell
securities. See also future covered puts if markets have fallen
rapidly but seem to have bottomed,
Counterparty credit risk because of the high volatility typically
See credit risk received on the option.
See also covered call
Covered call
To sell a call option while owning the Covered warrant
underlying security on which the option See warrant
is written. The technique is used by fund
managers to increase income by Cox-Ingersoll-Ross model
receiving option premium. It would be In its simplest form this is a lognormal
used for securities they are willing to sell, one-factor model of the term structure of
only if the underlying went up interest rates, which has the short rate of
sufficiently for the option to be interest as its single source of uncertainty.
exercised. Generally, covered call writers The model allows for interest rate mean
would undertake the strategy only if reversion and is also known as the square
they thought volatility was overpriced in root model because of the assumptions
the market. The lower the volatility, the made about the volatility of the short-
less the covered call writer gains in term rate.The model provides closed-
return for giving up upside in the form solutions for prices of zero-
underlying. It provides downside coupon bonds, and put and call options
protection only to the extent that the on those bonds.
option premium offsets a market
downturn. See also covered put Credit default swap
A bilateral financial contract in which one
Covered put counterparty (the protection buyer or
To sell a put option while holding cash. buyer) pays a periodic fee, typically
This technique is used to increase expressed in basis points per annum on
income by receiving option premium. If the notional amount, in return for a
the market goes down and the option is contingent payment by the other
exercised, the cash can be used to buy counterparty (the protection seller or
the underlying to cover. Covered put seller) upon the occurrence of a credit

Glossary of terms
event with respect to a specified Credit option

C
reference entity.The contingent Put or call options on the price of either
payment is designed to mirror the loss (a) a floating rate note, bond, or loan, or
incurred by creditors of the reference (b) an asset swap package, consisting of a
entity in the event of its default. credit-risky instrument with any payment
The settlement mechanism may be cash characteristics and a corresponding
or physical. See also basket credit derivative contract that exchanges the
default swap cashflows of that instrument for a floating
rate cashflow stream, typically three- or
Credit derivative six-month Libor plus a spread.
A bilateral financial contract, which
isolates credit risk from an underlying Credit risk
instrument and transfers that credit risk Also known as default risk. In broad terms,
from one party to the contract (the the risk that a loss will be incurred if a
protection buyer) to the other (the counterparty to a (derivatives) transaction
protection seller).There are two main does not fulfil its financial obligations in a
categories of credit derivatives: the first timely manner.The term is sometimes
consists of instruments such as credit loosely used as shorthand for the
default swaps in which contingent likelihood or probability of default,
payments occur as a result of a credit irrespective of the value of any position
event; the second, which includes credit exposed to this risk. More precisely, credit
spread options, seeks to isolate the credit risk is the risk of financial loss arising out of
spread component of an instrument’s holding a particular contract or portfolio.
market yield.
Credit spread
Credit event A credit spread is the difference in yield
Any one of a specified set of events, between two debt issues of similar
which, if occurring with respect to an maturity and duration.The credit spread
obligation of the reference entity is often quoted as a spread to a
specified in a credit default swap, will benchmark floating-rate index such as
trigger contingent payments. Libor, or alternatively as a spread to a
Applicable events, which generally highly rated reference security such as a
include bankruptcy, government security.The credit spread is
repudiation/moratorium, restructuring, often used as a measure of relative
failure to pay, and cross-acceleration creditworthiness, with reduction in the
are determined by negotiation between credit spread reflecting an improvement
the parties at the outset of a credit in the borrower’s perceived
default swap. creditworthiness.

Glossary of terms
CCredit spread forward this exceeds zero, in return for a

A cash-settled forward contract with premium. It has the same relationship to
settlement amounts based on the credit a differential swap as a cap has to an
spread between two predetermined debt interest rate swap. See also cross-
issues on the maturity date. See also credit currency floor
spread option
Cross-currency floor
Credit spread option This is an option setting a cap on the
An option on the credit spread between spread between two index interest rates
two debt issues.The option will pay out in different currencies. See also cross-
the difference between the credit spread currency cap
at maturity and a strike spread
determined at the outset. See also credit Cross-currency swap
spread forward A cross-currency swap involves the
exchange of cashflows in one currency for
Credit-linked note those in another. Unlike single-currency
A security with redemption and/or swaps, cross-currency swaps often require
coupon payments linked to the an exchange of principal.Typically the
occurrence of a credit event with respect notional principal is exchanged at
to a specified reference entity. In effect, a inception at the prevailing spot rate.
credit-linked note embeds a credit Interest rate payments are then passed
default swap into a funded asset to create back on a fixed, floating or zero basis.The
a synthetic investment that replicates the principal is then re-exchanged at maturity
credit risk associated with a bond or loan at the initial spot rate.
of the reference entity. Credit-linked
notes are typically issued on an Cumulative cap
unsecured basis directly by a A cumulative interest rate cap protects
corporation or financial institution. Credit- against increases in total interest expense
linked notes may also be issued from a over a specified period of time.This
collateralised Special Purpose Vehicle period of time will incorporate several
(SPV). See also capital-protected rate settings in determining the final
credit-linked note interest expense (for example, four three-
month Libor settings for an annual
Cross-currency cap interest expense amount).This differs
A cap in which the vendor will pay the from a standard cap, which caps an
purchaser the spread between interest absolute rate of interest in each
rates (usually Libor-based) in different calculation period. Because a cumulative
currencies minus a strike spread, where cap does not provide the period-to-

Glossary of terms
period protection of a standard cap, it is

C/D
Currency protected option
generally cheaper than the The same as guaranteed exchange rate or
corresponding standard cap. quanto option.
Currency forward Currency risk

An agreement to exchange a specified Currency risk arises from changes in the
amount of one currency for another at a value of currencies. For example, if a
future date at a certain rate.The exchange company receives a portion of its income
of currencies is priced so as to allow no in a foreign currency, it is exposed to
risk-free arbitrage. In other words, pricing changes in the value of that currency. Risk
is not a market estimate of the spot rate management and derivatives can be used
at that date, but is made according to the to minimise this risk.
two currencies’ respective interest rates.
For example, assuming that Eurosterling Currency struck option
interest rates are 10% and Eurodollar 5%, This is the same as joint option.
and the US dollar/sterling spot rate is
1.75, the forward rate should reflect the Current exposure
5% interest rate advantage of depositing Another name for replacement cost.
money in sterling.Thus the 12-month
forward rate should be 1.6695. Cylinder
Forwards are more appropriate than See risk reversal
options if a company has a strong
directional view of expected movements
in exchange rates. But certainty is rare and
hedging entirely with forwards may leave
a company locked into unfavourable
exchange rates. Unlike options, forwards
D
Deferred payout option
do not enable companies to take A deferred payout option is a variation
advantage of favourable currency on American-style options similar to a
movements.The purchaser of a forward, shout option. The holder of the option
unlike the purchaser of a future, carries may exercise it at any time, for the value
the credit risk of the firm from which it taken by the underlying at that time,
makes the purchase. Since the contracts but the payout is delayed until the
are not easily reassignable, it is difficult to expiry date. This term is also applied to
reduce this risk. certain digital options whose payout is
not paid when triggered, but deferred
Currency overlay until the final maturity. See also
See overlay option styles

Glossary of terms
DDeferred start option position has been taken in the underlying

See forward start option in proportion to its delta. For example, if
one is short a call option on an underlying
Delayed reset swap with a face value of $1 million and a delta
Also known as an in-arrears swap. A swap of 25%, a long position of $250,000 in the
in which floating payment is based on the underlying will leave one delta-neutral
future, rather than present, value of the with no exposure to small changes in the
reference rate. For six-month delayed price of the underlying. Such a hedge is
Libor reset swaps, for example, instead of only effective instantaneously, however.
fixing Libor six months and two days Since the delta of an option is itself altered
before the payment date, the floating-rate by changes in the price of the underlying,
borrower delays fixing until two days interest rates, the option’s volatility and its
before payment. Such swaps are time to expiry, changes in any of these
popular in a steep yield curve factors will shift the net position away
environment, when a fixed-rate receiver from delta-neutrality. In practice,
may think rates will not rise as fast as the therefore, a delta-hedge must be
yield curve predicts. rebalanced continuously if it is to be
effective. See also static replication
Delta
The delta of an option describes its Derivative
premium’s sensitivity to changes in the A derivative instrument or product is one
price of the underlying. In other words, an whose value changes with changes in
option’s delta will be the amount of the one or more underlying market variables,
underlying necessary to hedge changes such as equity or commodity prices,
in the option price for small movements interest rates or foreign exchange rates.
in the underlying.The delta of an option Basic derivatives include: forwards,
changes with changes in the price of the futures, swaps, options, warrants and
underlying. An at-the-money option will convertible bonds. In mathematical
have a delta of close to 50%. It falls for models of financial markets, derivatives
out-of-the-money options and increases are known as contingent claims.
for in-the-money options, but the change
is non-linear: it changes much faster Difference option
when the option is close-to-the-money. See spread option
The rate of change of delta is an
option’s gamma. Diffusion process
A continuous-time model of the behaviour
Delta hedging of a random variable. An example of such a
An option is said to be delta-hedged if a model is Generalised Brownian Motion

Glossary of terms
(GBM), which is often used to model the

D
distribution determines how likely it is
behaviour of spot rates. that the option will be exercised. Many
models assume the logarithm of the
Digital option relative return has a normal distribution,
Digital options pay a set amount if the which can be described by two
underlying asset is above, or sometimes parameters. The first is the distribution’s
below, a certain level on a specific date. mean; the second its standard deviation
These options have only two possible (equivalent, if annualised, to volatility). In
outcomes: a set payout, or nothing at all. practice, most empirically observed asset
Thus, they are also known as binary or all- distributions depart from normality.This
or-nothing options. departure can be described in terms of
the skew (how much it tilts to one side or
Digital swap the other) and kurtosis, which describes
A swap in which the fixed leg is only paid how fat or thin are the tails at either side.
on each swap settlement date if the Most markets tend to have fat tails (to be
underlying has met certain trigger leptokurtic) rather than thin tails
conditions over the period since the (platykurtic).This pushes up the price of
previous payment date. Nothing is paid if out-of-the-money options.
this is not the case.The premium for such
a swap is amortised over the maturity of Double barrier option
the swap and an instalment paid at each This is an option with two barriers; one
payment date. setting the upper limit of the price of the
underlying and one setting the lower
Discrete barrier option limit. If the underlying crosses either of
Barrier options where the trigger level is these barriers the option is either
only active for part of the option’s activated (knock-in) or deactivated
lifetime.This includes barrier options (knock-out). See also barrier option.
where the trigger is only valid on certain
fixing dates, as well as cases where the Double no-touch
trigger is valid for sub-intervals of the A double no-touch option pays a set
option’s lifetime. See also barrier option amount as long as one of two specified
barrier levels are not broken during the
Distribution life of the option.This tool is popular for
The probability distribution of a variable usage in relatively stable markets.
describes the probability of the variable
attaining a certain value. Assumptions Downside risk
about the distribution of the underlying The risk the investor is exposed to if there
are crucial to option models because the is a fall in the value of the underlying.

Glossary of terms
D/E
Dual currency swap on an equity index, equity basket or
Dual currency swaps are currency swaps single equity is exchanged for a stream of
that incorporate the foreign exchange cashflows based on a short-term interest
options necessary to hedge the interest rate index (or another index).
payments back into the principal Equity swaps are a convenient
currency for dual currency bonds. structure for switching into or out of
equity markets, particularly for those that
Dynamic hedging prefer to avoid, or are not allowed to use,
See delta hedging stock index futures. Like futures, the price
of the swap is directly related to the cost
of carry, although there may also be
E
Embedded option
tax considerations.
Equity collar
Equity collars are used by investors keen to
An option, often an interest rate option, reduce their downside risk. An equity collar
embedded in a debt instrument that is formed by buying an equity put option
affects its redemption. Examples include with a strike price below the current value
mortgage-backed securities and callable of the equity, at the same time as selling an
and puttable bonds. Embedded options equity call option with a strike above the
do not have to be interest rate options; current equity price.Thus a collar is
some are linked to the price of an equity imposed around the investor’s equity
index (Nikkei 225 puts embedded in position. If the value of the underlying
Nikkei-linked bonds) or a commodity equity falls through the strike of the
(usually gold). Many so-called guaranteed bought put, it can be exercised to limit
products contain zero-coupon bonds and losses. However, if the underlying stock
call options. rises through the strike of the sold call, the
investor may have to deliver the equity at
Equilibrium model the strike, thus foregoing potential
A model that specifies processes for the additional upside. See also collar
underlying economic variables and the
extra risk premium investors require for Equity knock-out swap
risky assets.The evolution of asset prices An interest rate or cross-currency swap
and their risk premiums can then be that gets terminated (knocked-out) if a
derived from the model thus specified. given stock or equity-index reaches a
specified trigger level between inception
Equity (index) swap and expiry.The knock-out can be
A swap in which the total or price return unconditional once the pre-determined

Glossary of terms
equity level is reached, or the client can

E
offering the investor the sum invested at
be given the choice to cancel the swap maturity and potential upside linked to
should the trigger level be reached. the performance of the least-performing
asset in a predefined basket.The Everest
Equity linked note structure may also pay coupons over
An equity linked note is a tool that is its life.
linked to a single equity, equity index or
basket of equities.They may or may not Exchangeable bond
be principal protected. These are just like convertible bonds.The
main difference is that these are typically
Equity warrant issued on stock, which is not the stock of
A warrant is a financial instrument issued the issuing firm.
by a bank or other financial institutions,
which is traded on a stock exchange’s Exchange-traded option
equity market.Warrants may be issued See option
over securities such as shares in a company,
a currency, an index or a commodity. Exercise
A call warrant gives the holder the See option
right (but not the obligation) to buy a
given security at a given price known as Exotic option
the exercise price, on a given date, known Any option with a more complicated
as the expiry date. Conversely a put payout structure than a plain vanilla put
warrant gives the holder the right to sell or call option.The payout of a plain vanilla
the security at the exercise price on the option is simply the difference between
expiry date.These instruments are the strike price of the option and the spot
sometimes known as covered warrants or price of the underlying at the time of
derivative warrants. See also convertible exercise. For a European-style option, the
bond, warrant exercise time is always the expiry date;
other option styles offer greater flexibility.
European-style option There are a number of ways in which an
European-style options can only be option payout can differ from that of a
exercised on their expiry date.They stand plain vanilla.The payout could also be a
in contrast to American-style options, function of:
which can be exercised at any time ■ the difference between a strike and an
until maturity. average rate for the underlying
(average options)
Everest structure ■ the difference between prices for two
A capital guaranteed structure generally different underlyings (difference

Glossary of terms
E/F options, exchange options), the same on modelling the extreme values of
underlying at different times (high- return distributions.This is important in
low options) finance because many models (for
■ the correlation between two or more example the Black-Scholes Model)
underlyings (outperformance options, assume that the distribution of returns is
outside barrier options) log-normal. However, real-world
■ the difference between a strike and the distributions are found to have fat-tails –
spot rate at some time other than implying that rare events such as crashes
expiry (deferred payout options, shout are more likely than the traditional
options, lookback options, cliquet theories suggest.
options, ladder options)
■ a fixed amount (binary options)
Alternatively, or additionally, a payout
may be conditional on certain trigger
conditions being met. For example, barrier
options are activated or nullified if a spot
F
Fat tails
rate falls or rises through a predetermined See kurtosis
trigger level. Multiple trigger conditions
are possible (as in the case of corridor or Financial engineering
mini-premium options). The design and construction of
investment products to achieve
Exploded tree specified goals.
A tree (binomial or trinomial) in which an
up step followed by a down step gives a Flexible option
different outcome to a down step A flexible option (also known as a flexible
followed by an up step. Consequently, the exchange or flex option) is a customisable
number of nodes increases exponentially, exchange-traded option, which allows the
compared with a recombining tree, in buyer to customise contract terms such
which the number increases as expiry date and contract size in
quadratically.This makes their evaluation addition to the strike price. Flexible
exceptionally computer-intensive.The options with single stock, index, or even
advantage is that they can be used to currency underlyings are traded on
price path-dependent options and they several major exchanges.
are important for modelling interest
rate options. Floor fund
Also known as a ratchet fund. A particular
Extreme value theory type of structured product that aims to
An area of statistical research that focuses deliver minimum returns, which usually

Glossary of terms
are at least equal to the sum invested, FRAs settle at the beginning of the
F
plus some additional upside based on the interest period, two business days after
performance of the stock market. the calculation date.
However, unlike guaranteed funds, very
few floor funds come with a contractual Forward start option
guarantee. Many floor funds are managed An option that gives the purchaser the
using the technique of constant right to receive, after a specified time, a
proportion portfolio insurance (CPPI). standard put or call option.The option’s
strike price is set at the time the option is
Floortion activated, rather than when it is
An option on a floor.The purchaser has purchased.The strike level is usually set at
the right, but not the obligation, to buy or a certain fixed percentage in or out-of-
sell a floor at a predetermined price on a the-money relative to the prevailing spot
predetermined date. See also caption rate at the time the strike is activated.
Forward Forward swap

See future A swap in which rates are fixed before the
start date. If a company expects rates to
Forward rate agreement rise soon but only needs funds later, it
A forward rate agreement (FRA) allows may enter into a forward swap.
purchasers/sellers to fix the interest rate
for a specified period in advance. One Fration
party pays fixed, the other an agreed See interest rate guarantee
variable rate. Maturities are generally out
to two years and are priced off the Future
underlying yield curve.The transaction is A future is a contract to buy or sell a
done on a nominal amount and only standard quantity of a given instrument,
the difference between contracted at an agreed price, on a given date. A
and actual rates is paid. If rates have future is similar to a forward contract and
risen by the time of the agreement’s differs from an option in that both parties
maturity, the purchaser receives the are obliged to abide by the transaction.
difference in rates from the seller Futures are traded on a range of
and vice versa. A swap is therefore a underlying instruments including
strip of FRAs. FRAs are off-balance commodities, bonds, currencies and
sheet – there are no up-front or margin stock indexes.
payments and the credit risk is limited to The most important difference
the mark-to-market value of the between futures and forwards is that
transactions. Unlike interest rate swaps, futures are almost always traded on an

Glossary of terms
F/G
exchange and cleared by a clearing be hedged by mirroring the options
house, whereas forwards are over-the- position. Alternatively, a trader may
counter instruments. Furthermore, choose to adjust the position in the
futures, unlike forwards, have standard underlying continually in order to
delivery dates and trading units. Most maintain delta neutrality. See also vega
futures contracts expire on a quarterly
basis. Contracts specify either physical Garman-Kohlhagen Model
delivery of the underlying instrument or A model developed to price European-
cash settlement at expiry. Cash style options on spot foreign exchange
settlement involves the company paying rates.The model is based upon the
or being paid the difference between the Black-Scholes model with the addition
price struck at the outset and the expiry of an extra interest rate factor for the
price of the contract. See also cost of carry, foreign currency.
implied repo rate
Geared barrier option
Future rate agreement A type of in-the-money barrier option
See forward rate agreement where the barrier is in-the-money and lies
between the strike and the underlying
Futures option spot rate.
An option, either a put or a call, on any
futures contract. Also known as an option Gearing
on a future. Gearing refers to the degree of exposure
of a product to movements in the
underlying index. A product with 100%
G
Gamma
gearing would have returns exactly equal
to any rise in the index. A product’s
gearing is also called participation.
The rate of change in the delta of an Geometric Brownian motion

option for a small change in the Geometric Brownian motion is a model
underlying.The rate of change is greatest frequently used for the diffusion process
when an option is at-the-money and followed by asset prices. Standard
decreases as the price of the underlying Brownian motion is a random walk process
moves further away from the strike price with Gaussian increments; that is, changes
in either direction. A long gamma in the asset price are normally distributed.
position is one in which a trader is long The term geometric means it is the
options. For a position that is short proportional change in the asset price (as
gamma, the opposite holds. Gamma can opposed to the absolute level) that is

Glossary of terms
normally distributed.This gives the model option) on an asset in one currency

G
useful properties, in that the asset price denominated in a second currency. The
cannot be negative, and that the logarithm exchange rate at which the purchaser
of the asset price will be normally converts the currency is fixed at the start.
distributed, making the model analytically Such options are popular as investors
tractable. See also stochastic process want exposure to foreign assets without
the foreign exchange risk. The extra cost
Global floor of the option depends on the
A term usually associated with cliquet correlation between movements
products. A cliquet product with global in the exchange rate and movements in
floor will provide a minimum return that the underlying. The higher (more
is at least equal to the principal invested. positive) the correlation between the
Some cliquet products can have underlying and the exchange rate
guaranteed principal redemption of more (expressed as the number of units of
than 100%. currency two per unit of currency one)
the more expensive a call option will be
Growth product and the cheaper a put option will be.
A term used to describe a type of Quanto options can, however, look
structured product whose payouts are cosmetically cheaper (or more expensive)
only made at maturity with no income depending on the forward interest rates
stream during the product life. A growth in the two currencies. For example,
product can be either principal buying a call on a US asset could be more
guaranteed or non-guaranteed, although expensive in euros if there is a wide
the former is common. interest rate differential between the
euro and the dollar. See also joint option,
Guarantee level quanto product
The amount of principal that is
guaranteed to be repaid at the maturity Guaranteed fund
of the product. A guaranteed fund comes with a
promise by the guarantor to repay a
Guaranteed coupon portion, usually 100% of the principal at
Coupon payments that are guaranteed by maturity. Guaranteed funds can also
the guarantor, and are paid during the life incorporate guaranteed coupons
of the product irrespective of payable regardless of the underlying
performance of the underlying. performance and/or non-guaranteed
coupons linked to the performance of
Guaranteed exchange rate option underlying assets, often a stock
An option (also known as a quanto index or basket of stocks.‘Guaranteed’

Glossary of terms
G/H
H
does not mean the investment is risk-
free. The guarantee on principal
repayment usually holds only when the
product is held to maturity, and is subject
to credit risk of the guarantor. Investors Haircut
who redeem early are usually repaid at The excess of an asset’s market value over
net asset value and thus subject to either the loan for which it can serve as
market risk. A guaranteed fund is adequate capital, or the regulatory capital
constructed by investing part of the value. It can also refer to the dealer’s
proceeds in a zero-coupon bond or other commission on a transaction.
fixed income instrument – which
underwrites the guaranteed payment at Hard protection
maturity – and the rest of the money in A term sometimes used to refer to
an embedded call or put option on the the level of capital protection provided in
underlying for additional returns. Hence, a high-income type of structured
investors also run counterparty risk in product. A hard protection level of 90%
relation to the option strategy. A means that so long as the index or
guaranteed structure can also take the basket of shares is above 90% of the
form of a guaranteed note or starting level, the investor’s capital will
guaranteed bond. Generally, any not be at risk.
structured product with a promise to
return 100% of the principal invested Heath-Jarrow-Morton model
at maturity can be considered a A multi-factor interest rate model, which
guaranteed product. describes the dynamic of forward rate
evolution. An extension of the Ho-Lee
Guaranteed return model, the underlying is the entire term
on investment structure of interest rates.The approach is
Any instrument (usually a structured very similar to the original Black-Scholes
note) which guarantees investors a model: it does not model qualities such as
minimum return on their investment.This the ‘price for risk’.
can be achieved by combining a debt The model requires two inputs: the
issue with a structure, such as a collar or initial yield curve and a volatility structure
cylinder, which locks gains into a range. for the forward.The volatility is only
This means that the investor gains specified in a very general form. By
protection from an adverse market choosing an appropriate volatility
move by limiting participation in any function, it is possible to reduce HJM to
favourable move. simpler models such as Ho-Lee, Vasicek,
See also principal-guaranteed product and Cox-Ingersoll-Ross.

Glossary of terms
The practical importance of the HJM High-low option

H
model is that it provides a single A combination of two lookback options. A
coherent framework for pricing and high-low option pays the difference
hedging an entire book of between the high and low of an
instruments (including instruments underlying, such as a stock index. A
such as caps and swaptions) and is not speculative purchaser would be
excessively computationally taking the view that the market would
intensive. Research building on HJM be more volatile than the implied
(such as the market model) has volatilities of both lookback options
concentrated on widening its scope to incorporated in the structure. See also
remove the possibility of negative path-dependent option
interest rates, include more than one
interest rate curve and incorporate Hindsight option
default risk. See lookback option
Hedge Historic rate rollover

To hedge is to reduce risk by making A historic rate rollover allows an
transactions that reduce exposure to existing currency forward or spot
market fluctuations; for example, an position to be rolled forward without
investor with a long equity position generating any intermediate cash flows.
might compensate by buying Effectively the position is reinstated for a
put options to protect against a fall in new settlement date using a new off-
equity prices. A hedge is also the term market forward rate based on the
for the transactions made to effect historic rate.
this reduction.
Historical volatility
High-coupon swap Historical volatility is a measure of the
A swap in which the fixed-rate payments volatility of an underlying instrument
are above market rates. (Also known over a past period. Historical volatility can
as a premium swap.) be used as a guide to pricing options but
isn’t necessarily a good indicator of future
High-income product volatility. Volatility is normally expressed
A type of structured product that pays an as the annualised standard deviation of
income that is well above the rate of the log relative return.
interest on conventional fixed-rate
deposits. Generally, the higher the rate of Ho-Lee model
return offered on a product, the higher The first model that set out to model
the degree of risk. movements in the entire term structure

Glossary of terms
H/I
I
of interest rates, not just the short
rate, in a way that was consistent
with the initially observed term
structure. However, since the model
only has a single random factor, it makes Impact forward
the simplifying assumption that the A collared forward, such as one in which
volatility structure remains constant the purchaser buys a put and sells a call,
along the yield curve. Heath-Jarrow- both being out-of-the-money.The
Morton later generalised this model, premiums on the two options balance
using a more general form of volatility out, so the strategy is zero cost. See
and introducing continuous trading. also collar
In addition, Ho-Lee allows for the
possibility of negative interest rates. Implied distribution
The model was developed using a The probability distribution of returns for
binomial tree, although closed-form an asset, which is implied by options
solutions have now been found for traded on that asset. The distribution is
discount bonds and discount inferred by combining the variation of
bond options. volatility with strike price (see
volatility smile) and the assumptions
Hull-White model made about the distribution in the
An extension of the Vasicek model option pricing model.
for interest rates, the main difference
being that mean reversion is Implied forward curve
time-dependent. Both are one-factor The forward curve implied by forward
models.The Hull-White model was rate agreements (derived from the par
developed using a trinomial lattice, curve) of various maturities. It is usually
although closed-form solutions for steeper than the spot yield curve.
European-style options and bond
prices are possible. Implied repo rate
The return earned by buying a cheapest-
Hybrid products to-deliver bond for a bond futures
Hybrid products are constructed from contract and selling it forward via the
a combination of interest rate, futures contract. See also future
commodity, equity, credit and currency
derivatives. Implied volatility
The value of volatility embedded in an
Hypothecation option price. All things being equal,
The posting of collateral. higher implied volatility will lead to

Glossary of terms
higher vanilla option prices and vice remain the same. In return for granting
I
versa.The effect of changes in volatility the option, the fixed-rate receiver gets a
on an option’s price is known as vega. If yield above current fixed rates. IAS have
an option’s premium is known, its implied been widely used by US regional banks in
volatility can be derived by inputting all their asset/liability management
the known factors into an option pricing activities. By using IAS, banks were able to
model (the current price of the obtain the negative convexity of a
underlying, interest rates, the time to mortgage-backed security and avoid the
maturity and the strike price).The model risk of excessive prepayments due to
will then calculate the volatility assumed changes in consumer sentiment. But the
in the option price, which will be the fixed receiver is exposed to both falling
market’s best estimate of the future and rising rates. If rates fall, there is the
volatility of the underlying. See also option, possibility at each interest date that some
volatility skew, volatility term structure or all of the swap will be terminated,
creating a reinvestment risk. If rates rise,
In-arrears swap the swap may run to maturity, providing
See delayed reset swap meagre income while floating rates soar.
An IAS fixed-rate receiver is selling
Income product volatility to the payer for an enhanced
A term used for any type of structured yield. So the lower the volatility of the
product that provides a periodic payment index, the lower the option value and
of income.The rate of income is often yield pick-up. A subsequent fall in
higher than the general rate of interest volatility benefits the receiver because
available on fixed-rate deposits and the likelihood that the swap will amortise
therefore there may be a risk the initial decreases. IAS can be structured with
capital invested will not be returned in full. negative or positive convexity and the
amortisation schedules and lock-out
Index amortising swap (Ias) periods can be changed in order to
An interest rate swap whose principal increase or decrease yields. Also known as
amortises on the back of movements in an Indexed principal swap. See also
an index, such as Libor or constant mortgage swap
maturity treasuries.The fixed-rate receiver
effectively grants an option to the fixed- Index arbitrage
rate payer to amortise the swap.The See stock index arbitrage
option is triggered by interest rate
movements after an initial lock-out Indexed strike cap
period.The notional principal amortises A cap for which the payout level is
as rates fall or remains constant if rates indexed to the level of the reference rate.

Glossary of terms
IFor example, such a cap might be struck of the structure as a whole. The buyer of
at 7.5% as long as the reference rate the corridor is protected from rates
remained below 9%, but rise to 8.5% if rising above the first cap’s strike, but
the reference rate exceeded 9%. An exposed if they rise past the second
indexed strike cap is cheaper than a cap’s strike. It is possible to limit this
conventional cap. liability by selling a knock-out cap
rather than a conventional cap. The
Initial index level structure is then known as a knock-out
Most structured products incorporate interest rate corridor.
payouts that are linked to the movement
of an underlying index or share.This Interest rate guarantee
performance is measured relative to the An option on a forward rate agreement
level of the underlying recorded at the (FRA), also known as a FRAtion.
start of the investment term, or the initial Purchasers have the right, but not the
index level. obligation, to purchase an FRA at a
predetermined strike. Caps and floors are
Integrated hedge strips of IRGs.
A hedge that combines more than one
distinct price risk. For example, crude oil is Interest rate swap
usually priced in US dollars.Therefore a An agreement to exchange net future
producer of crude oil whose home cashflows. Interest rate swaps most
currency is not the dollar (say, the euro) is commonly change the basis on which
exposed to both currency risk and the liabilities are paid on a specified principal.
price risk for crude oil. One possible They are also used to transform the
integrated hedge would be a single interest basis of assets. In its commonest
quanto option, which would hedge the form, the fixed-floating swap, one
price of crude oil in euro. As such, it would counterparty pays a fixed rate and the
depend heavily on the correlation (if any) other pays a floating rate based on a
between the two markets. reference rate, such as Libor.There is no
exchange of principal – the interest rate
Interest rate corridor payments are made on a notional
An interest rate corridor is composed of a amount. In floating-floating swaps the
long interest rate cap position and a two counterparties pay a floating rate on
short interest rate cap position. The buyer a different index, such as three-month
of the corridor purchases a cap with a Libor versus six-month Libor.
lower strike while selling a second cap Swaps usually extend out as far as 10
with a higher strike. The premium earned years, although 12–40 year maturities are
on the second cap then reduces the cost available in some liquid currencies.

Glossary of terms
However, the longer the maturity of the Intrinsic value

I/J
swap, the less liquid it becomes and credit The amount by which an option is in-the-
risk increases. Credit enhancements such money, that is, its value relative to the
as mutual put options and collateral are current forward market price. Option
used to ameliorate the credit risk of premiums comprise intrinsic value and
longer term swaps. Interest rate swaps time value.
provide users with a way of hedging the
effects of changing interest rates. For Inverse floater
example, a company can convert floating- The payments made on an inverse
rate interest payments to fixed-rate floating rate note (‘floater’) decrease
payments if it thinks interest rates will rise as the reference interest rate
(which would make its liabilities more increases, the reverse of the typical case
expensive). Companies can also use where the payments rise with the
interest rate swaps in conjunction with reference rate.
new debt issuance, raising money on, say, The purchaser of an inverse floating
a fixed basis and swapping it into rate note is in effect selling interest rate
floating-rate debt. In an interest rate swap caps – this will increase the coupon
there is a fixed-rate payer (floating-rate payments in a stable or lower interest rate
receiver) and a fixed-rate receiver environment, but reduce them should
(floating-rate payer). interest rates rise. Typically, the payment
is found by a fixed rate minus two times
Interest-rate cap the reference rate.The floater can be
See cap further leveraged by using a multiplier
higher than two.
In-the-money
Describes an option whose strike price is
advantageous compared with the
current forward market price of the
underlying. The more an option is
in-the-money, the higher its intrinsic
J
Joint option
value and the more expensive it An option on an underlying, often a stock
becomes. As an option becomes more in- index, denominated in a second
the-money, its delta increases and it currency. Unlike a guaranteed exchange
behaves more like the underlying in rate option, in which exchange rates are
profit and loss terms; hence deep in-the- fixed, the purchaser of a joint call option
money options will have a delta of close benefits from upside in the currency in
to one. See also at-the-money, which the asset is originally
out-of-the-money denominated, for example, S&P 500 call

Glossary of terms
J/K
option struck in euro. In this case, at level. Knock-in options are a kind of
the inception, strike is specified in barrier option.
euro. At the maturity, S&P 500 level is
observed and is multiplied by then Knock-out
current euro/US dollar rate. This Products which knock-out terminate
converted value of S&P 500 is when spot passes through a
compared with the strike to determine predetermined barrier level.
the payout in euro. See also correlation, Knock-out options are a kind of
guaranteed exchange rate option, barrier option.
quanto product
Knock-out interest rate corridor
Jump diffusion A corridor in which a client purchases a
One of the key assumptions of the standard cap with a lower strike and sells
Black-Scholes model is that the asset a knock-out cap with a higher strike
price follows geometric Brownian (rather than selling a conventional cap).
motion with constant volatility and This means that the client is protected
interest rates. In a jump diffusion from an increase in interest rates up to the
model, it is assumed that, in strike level for the knock-out cap, but
addition to this regular diffusion, exposed if rates rise beyond that level.
there are jumps in the market. This However, the client is protected once
type of model is sometimes used for again if the rates rise above the knock-out
modelling equities and emerging level, as the short knock-out cap will then
market currencies. be extinguished.
K
Kurtosis
A measure of how fast the tails or wings
of a probability distribution approach
zero, evaluated relative to a normal
Kicker distribution. The tails are either fat-tailed
A kicker is a bonus payment that is (leptokurtic) or thin-tailed (platykurtic).
sometimes made when a structured Markets are generally leptokurtic. The
product matures if the value of the fatter the tails, the greater the chance a
underlying asset has risen enough. variable will reach an extreme value,
implying that models such as Black-
Knock-in Scholes – which assume perfect
Products which knock-in begin working normal distribution – produce pricing
when the underlying passes through a biases for deep in- or out-of-the-
predetermined spot rate or barrier money options.

Glossary of terms
L
L
Legal risk
Legal risk arises from the risk of not
legally being able to enforce contracts. It
can be a particular issue in emerging
Ladder option markets where derivatives regulations are
A path-dependent option, most often still being developed.
based on an equity index or a foreign
exchange rate.The payout of a ladder Leptokurtosis
option increases stepwise as the See kurtosis
underlying trades upwards (or
downwards) through specified barrier Leverage
levels (the ‘rungs’ of the ladder). Each time The ability to control large amounts of an
the underlying trades through a new underlying variable for a small initial
barrier level, the option payout is locked- investment. Futures and options are
in at the higher level. See also cliquet, regarded as leveraged products
cliquet option, lookback option because the initial premium paid
by the purchaser is generally much
Lambda smaller than the nominal amount of
A measure of the effective leverage of an the underlying. Leverage is usually
instrument. It is defined as the measured as a quantity called lambda.
percentage change in the market value of See also lambda
a derivative for a one-percent move in the
underlying. Unlike gearing, the lambda Leveraged inverse floater
value captures the instrument’s delta. See also inverse floater
See also leverage
Libor
Lease rate swap The London inter-bank offered rate
Similar to an interest rate swap, a lease (LIBOR) is the interest rate charged on
rate swap is a fixed-for-floating short-term interbank loans by banks
agreement in which gold is borrowed/ operating in London.The rate is set on a
lent at a "fixed" rate.The floating leg is daily basis and is commonly used as a
re-priced at incremental time periods guide for the future level of interest rates.
over the maturity of the swap. At the end
of each floating period the agreed upon Libor-in-arrears swap
benchmark lease rate is compared to the See delayed reset swap
contract rate and the party in debit pays
the differential.The floating component Limit binary
is then rolled out for a further period. See range binary

Glossary of terms
LLinear basket credit default swap Lite option

A basket credit default swap, where A European-style basket option with a
investors are exposed to multiple payout determined by the underlying
reference entities as if they had entered assets that remain in the basket, after a
into a separate credit default swap certain number of the best and worst
contract with respect to each performing assets in the basket were
reference entity. removed at a specified date prior to
expiry. Also known as an atlas option.
Linear ex-linked swap
An interest rate swap with a quasi-fixed Local cap
coupon that varies with the movement of A local cap is the maximum return in each
a chosen spot foreign exchange rate over period of a cliquet option, which is used
the life of the deal.These swaps can be to work out the overall payout.
structured to pay a higher (or lower)
coupon if a given currency weakens (or Local floor
strengthens) after the outset of the deal. A local floor is the minimum return in
The observation dates for the forex each period of a cliquet option, which is
component coincide with the Libor used to help work out the overall payout.
reset dates for coupon calculation.These
swaps can be structured with a leveraged Longstaff-Schwartz model
forex exposure. A two-factor model of the term structure
of interest rates. It produces a closed-form
Liquidity risk solution for the price of zero coupon
The risk associated with transactions bonds and a quasi-closed-form solution
made in illiquid markets. Such markets for options on zero coupon bonds.The
are characterised by wide bid/offer model is developed in a Cox-Ingersoll-
spreads, lack of transparency and Ross framework with short interest rates
large movements in price after a deal of and their volatility as the two sources of
any size. A firm wishing to unwind a uncertainty in the equation.
portfolio of illiquid instruments (for
example, highly tailored structured notes) Lookback option
may find it has to sell them at prices far Lookback options give the holder the
below their fair values, exacerbating right at expiry to exercise the option at
the problems that prompted the decision the most favourable rate or price reached
to unwind. by the underlying over the life of the
option. As with average options, the strike
Listed option may be either fixed or floating.With an
See warrant, option optimal rate (or price) lookback option,

Glossary of terms
L/M
M
the strike is fixed at the outset and the
option will pay out against the highest (for
a call) or lowest spot (for a put) reached
over the life of the option, irrespective of
the spot at expiry.The option will usually Mandarin collar
be settled in cash. Since the option is likely The Mandarin collar combines a range
to have a larger payout than the forward with the purchase of a range
corresponding plain vanilla option, it binary structure, such that should the
commands a larger premium.The strike spot stay within the prescribed range, the
for an optimal strike lookback option, on proceeds of the range forward are
the other hand, is not fixed until expiry, enhanced by the payout amount of the
when it is set to be the highest (for a put) range binary. If either of the limits trades
or lowest spot (for a call) over the option’s at any time, the range binary is
life and exercised for cash or physical terminated, but the underlying exposure
against the spot prevailing at expiry. See remains hedged by the range forward.
also cliquet option, ladder option, path-
dependent option, shout option Margrabe option
See outperformance option
Low exercise price option (Lepo)
A low exercise price option (Lepo) is a call Market model of interest rates
option with an exercise price set deep in- A special case of the Heath-Jarrow-
the-money.The limiting case, a zero Morton model due to Brace, Gatarek and
exercise price option, is when the strike Musiela in which the term structure of
price is zero. It is virtually certain to be interest rates is modelled in terms of
exercised and the value and performance simple Libor rates (which are
of its intrinsic value is effectively identical lognormally distributed with respect
to that of the underlying equity. to forward measure) rather than
These features are designed to allow instantaneous forward rates.This allows
participation in the performance of an the modeller to exclude the possibility
equity price where there are legal or of negative interest rates from the
financial obstacles to purchasing the model and obtain prices for caps,
underlying directly. If the Lepo is cash- floors and swaptions consistent with
settled, the buyer profits to the same the Black-Scholes framework.The
extent as with a direct holding in the model can be calibrated using readily
underlying, but without having to available market data: forward or swap
transact in it. However, a Lepo holder does rates volatilities and correlations, and
not earn dividends or have voting rights is particularly suited to path-
over the equity. dependent instruments.

Glossary of terms
MMarket risk Medium-term note (MTN)

Exposure to a change in the value of A medium-term note is a debt instrument
some market variable, such as interest with a maturity of between three and
rates or foreign exchange rates, equity or seven years, which may pay fixed or
commodity prices. For holders of a variable coupons.These notes can be
derivatives position, market risk may be used to construct structured notes by
passed through from a change in the embedding derivatives to create
value of the underlying to the price of the structured coupons which appeal
derivatives, or may arise from other to investors.
sources, such as implied volatility or
time decay. Mid-Atlantic option
See Bermudan option
Market value
See replacement cost Monte Carlo Simulation
A method of determining the value of a
Mark-to-market derivative by simulating the evolution of
This is the value of a financial instrument the underlying variable(s) many times
according to current market rates. over.The discounted average outcome of
the simulation gives an approximation of
Martingale the derivative’s value.This method may
A probabilistic interpretation of the be used to value complex derivatives,
payout of a ‘fair game.’The expected particularly path-dependent options, for
gain at any point in the future is which closed-form solutions have not
equal to the actual gain now. See also been or cannot be found. Monte Carlo
stochastic process simulation can also be used to estimate
the value-at-risk (VaR) of a portfolio. In
Mean reversion this case, a simulation of many correlated
The phenomenon by which interest market movements is generated for the
rates and volatility appear to move markets to which the portfolio is exposed,
back to a long-run average level. and the positions in the portfolio
Interest rates’ mean-reverting revalued repeatedly in accordance with
tendency is one explanation for the the simulated scenarios.The result of this
behaviour of the term structure of calculation will be a probability
volatility. Some interest rate models distribution of portfolio gains and losses
incorporate mean reversion, such as from which the VaR can be determined.
Vasicek and Cox-Ingersoll-Ross, in The principal difficulty with Monte Carlo
which high interest rates tend to go VaR analysis is that it can be very
down and low ones up. computationally intensive.

Glossary of terms
Mortgage swap
M/N
two main reasons. Firstly, they permit
An asset swap attached to fixed-rate more realistic modelling, particularly of
mortgage payments. Mortgage swaps interest rates, although they are very
allow investors to enjoy the flows from a difficult to compute. Secondly, multi-
portfolio of mortgages without taking a factor options (for example, spread
mortgage asset on to their balance sheet. options) have several parameters, each
The principal reduces if and when the with independent volatilities, and also the
outstanding mortgage principal reduces correlation between the underlyings
(which can occur if the mortgage holder must be dealt with separately.
pays off the mortgage or defaults). Such
swaps are complicated because although Multiple strike option
the fixed-rate receiver receives a higher See outperformance option
rate than on a normal swap, the
amortisation of the principal is not just a Municipal swap
function of interest rates.The largest A swap in which the floating payments
mortgage swap market is in the US; in are based on an index of tax-exempt US
1992 and 1993 prepayments accelerated municipal bonds, such as J.J. Kenny.
because of historically low interest rates.
See also index amortising swap, reverse
index amortising swap
Mortgage-backed security
See asset backed security
N
Naked option
An option that is sold (bought)
Moving strike option without holding the underlying or
An option in which the strike is reset otherwise hedging.
over time, such as an interest rate
cap in which the strike is reset for the Natural hedge
next period at the current interest rate A natural hedge is the reduction in
plus a pre-agreed spread. See also financial risk that can arise from an
cliquet option institution’s normal operating procedures.
For instance, a company that has a
Multi-factor model significant portion of its sales in one
Any model in which there are two or country will have a natural hedge to at
more uncertain parameters in the option least part of its currency risk if it also has
price (one-factor models incorporate only operations in that country generating
one cause of uncertainty: the future expenses in the currency. Firms may act
price). Multi-factor models are useful for to increase natural hedges by changing

Glossary of terms
N/O
sourcing, funding, or operational US dollars based on the difference
decisions, but natural hedges are less between the agreed contract rate at
flexible, and more difficult to reverse, than inception and a market reference rate at
financial hedges. maturity. NDFs can be used to establish a
hedge or take a position in one of a
Negative basis growing group of emerging market
Negative basis exists when the cost of currencies where conventional forward
buying protection (in the credit markets either do not exist or may be
derivatives market) on a particular closed to non-residents. As offshore
reference entity is less than the credit instruments, NDFs offer the advantage of
spread (generally expressed as a spread eliminating convertibility risk, since no
to Libor) on a bond or note of similar emerging market currencies are
maturity issued by that reference entity. exchanged at maturity.
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
O
One-factor model
funding the bond or note at Libor plus a A model or description of a system where
spread will erode the arbitrage). the model incorporates only one variable
Technical factors between the bond and or uncertainty: the future price.These are
credit derivatives market account for simple models, usually leading to closed-
negative basis. form solutions, such as the Black-Scholes
model or the Vasicek model.
Net present value
A technique for assessing the Open-ended product
worth of future payments by looking at Structured products that can be used for
the present value of those future investment for an unlimited period are
cashflows discounted at today’s cost sometimes called open-ended products.
of capital. They stand in contrast to tranche or close-
ended products.
Non-deliverable forward
Non-deliverable forward contracts Operational risk
(NDFs) – also called dollar-settled The risk run by a firm that its internal
forwards – are synthetic forwards, which practices, policies and systems are not
entail no exchange of currencies at rigorous or sophisticated enough to cope
maturity. Instead, settlement is made in with untoward market conditions or

Glossary of terms
human or technological errors. Although

O
according to the product. In most cases,
operational risk is not as easy to identify the right to buy the underlying is known
or quantify as market or credit risk, it has as a call, and the right to sell, a put.
been implicated as a major factor in many Options are traded on formal
of the highly-publicised derivatives losses exchanges and in over-the-counter (OTC)
of recent years. markets.The exchanges, such as the Hong
Sources of operational risk include: Kong Stock Exchange, the SIMEX, or the
failure to correctly measure or report risk; ASX provide primarily standardised
lack of controls to prevent unauthorised options; the OTC markets are able to
or inappropriate transactions being made provide tailored products to fit specific
(the so-called ‘rogue trader’ syndrome); requirements.The choice between OTC
and lack of understanding or awareness and exchange-traded options will
among key staff. depend on the degree of tailoring
required, the relative liquidity of both
Option markets (this varies greatly according to
A contract that gives the purchaser the the underlying) and credit concerns.
right, but not the obligation, to buy or sell Pricing models for simple or vanilla
an underlying at a certain price (the options have five major inputs: the
exercise, or strike price) on or before an option’s exercise or strike price; the time
agreed date (the exercise period). to expiration; the price of the underlying
For this right, the purchaser pays a instrument; the risk-free interest rate on
premium to the seller.The seller (writer) of the underlying instrument, and the
an option has a duty to buy or sell at the volatility of the underlying instrument.
strike price, should the purchaser exercise European-style options are usually
his right. With European-style options, priced off a closed-form analytical model
purchasers may take delivery of the first published by Fischer Black and
underlying only at the end of the option’s Myron Scholes in 1973, which has
life. American-style options may be subsequently been modified to fit
exercised, for immediate delivery, at any different underlying.
time over the life of the option. Holders of At maturity, an option’s value will
semi-American-style or Bermudan depend on the value of the right to buy
options may be exercised on specified or sell a product. If an option is purchased
dates – typically on a monthly or giving the right to buy gold at $375 an
quarterly basis. ounce and at expiration the price is $400,
Options can be bought on the option is worth $25.
commodities, stocks, stock indexes, The extent to which an option is in-
interest rates, bonds, currencies, etc.The the-money (how far the strike price is
trading terminology, though, may change below/above the current forward market

Glossary of terms
Oprice) is called its intrinsic value. Where of the underlying product, it is possible to
the strike price is less favourable than the achieve a much greater exposure to price
market price, the option is said to be out- changes of the underlying compared
of-the-money, and where the two prices with a similar investment directly in the
are the same it is at-the-money. product – this is called leverage. See also
At any time before maturity, an option’s implied volatility
price will be a combination of its intrinsic
value (which is always either greater than, Option combination strategies
or equal to, zero) and its time value.The Options may be combined so that their
latter includes the cost of carry and the payouts produce a desired risk profile.
probability that the price of the underlying Some combinations are primarily trading
will move into or remain in the money. strategies, but option combinations can
Options can broadly be used in two ways – be useful in, for example, allowing
for speculation, or for insurance.Their investors to construct a strategy to take
usefulness, both from a buyer’s and a advantage of a particular view they have
seller’s point of view, derives from their of the market. Other strategies allow
payouts. In contrast to other types of purchasers to reduce their premiums by
hedge, options provide insurance against giving up some of the benefits they may
unfavourable moves in a product’s price have received from market movements.
and the opportunity to take advantage of See also put spread, straddle, strangle
favourable moves. Forwards and futures,
for example, require buyers and sellers to Option on future
lock into one rate. In return for assuming See futures option
this risk, sellers of options receive a
premium, effectively a risk-taking fee. Option replication
The payout of a purchased option means See replication
that the price risk of an option is limited
to its premium – it is not as exposed to Option styles
adverse movements as a position in The purchaser of a European-style option
the underlying. has the right to exercise it on a
For speculators selling (writing) predetermined expiry date. In contrast, the
options, this often means taking a naked holder of an American-style option has the
option position and therefore being right to exercise it at any time during its
exposed to adverse movements in the lifetime, up to and including its expiry date.
underlying. Hedgers may sell options to This flexibility means there is a greater
garner premium to offset any expected probability of an American-style option
slight downturn in a market. Since option being exercised than the corresponding
premiums are only a fraction of the cost European-style option with the same

Glossary of terms
strike. Hence the early exercise feature of Outperformance option

O
an American option adds value and makes Also known as a Margrabe option. A two-
it the more expensive of the two. Most factor option giving the purchaser the
exchange-traded options are American- right to receive the outperformance of
style. Further variations on these styles also one asset over another asset. For
exist. A Bermudan option, so called example, a purchaser with a view that
because it falls between American- and the Hang Seng Index (HSI) will
European-style options, has more than one outperform the Dow Jones Euro Stoxx 50
possible exercise date. For example, the (Euro Stoxx) index should buy the
holder of a Bermudan option with a two- outperformance option, which pays
year maturity might have the right to notional multiplied by the
exercise it every quarter or half year during outperformance of the HSI index over
the life of the contract. Bermudans are also the Euro Stoxx index. In this case, the
known as limited exercise or semi- payout is zero if HSI underperforms
American-style options. Another twist is Euro Stoxx. The value of an
the deferred payout option, a variation on outperformance option will largely be
American-style options in which the dictated by the historical correlation
option can be exercised at any time during between the underlyings.
the option’s life, but the payout is delayed
until the expiry date.With the similar shout Overlay
option, the purchaser can lock in a profit at A strategy to change the exposure of a
any time, but retains the right to profit portfolio using derivatives, while leaving
from further favourable moves. See also the securities in the underlying portfolio
American-style option, Bermudan option, unchanged. This has the advantage of
deferred payout option cost and flexibility, as portfolio
managers can adjust portfolio risk
Out-of-the-money more quickly and cheaply with
Describes an option for which the derivatives than by liquidating portfolio
forward market price of the underlying is holdings. Another reason might be
below the strike price in the case of a call, tactical – the adjustment may only be
or above it in the case of a put. The more desired for a brief period of perceived
the option is out-of-the-money, the market threat. A third reason might be
cheaper it is (since the chances of it to transform a portfolio risk; an
being exercised get slimmer). Its delta international fund manager may wish to
also declines and it becomes less segregate the currency aspect of a
sensitive to movements in the portfolio and can do so with a
underlying. See also at-the-money, currency overlay programme. See also
in-the-money asset allocation

Glossary of terms
O/P
Over-the-counter (OTC) returns at maturity that are calculated by
Financial products that are not traded on multiplying the performance of the
formal exchanges are said to be traded underlying (which can be an index, stock
over-the-counter. basket or fund) by a fixed percentage.This
percentage is called the participation rate.
For example, a 70% participation in the
P
Parisian barrier option
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
A barrier option with a barrier that is guarantee, the participation rate will only
triggered only if the underlying has been apply to the upside, not to index losses.
beyond the barrier level for longer than a
specified period of time. See also Path-dependent option
barrier option, trigger, trigger condition A path-dependent option has a payout
directly related to movements in the price
Participating forward of the underlying during the option’s life.
The simultaneous purchase of a call By contrast, the payout of a standard
option (put option) and sale of a put (call) European-style option is determined
at the same strike price, usually for zero solely by the price at expiry. See also
cost.The option purchased must be out- barrier option, cliquet option, high-low
of-the-money and the option sold (to option, lookback option, shout option
finance the option purchase) is for a
smaller amount and will be in-the-money. Pay-as-you-go cap
See also zero cost option A pay-as-you-go cap allows the buyer to
pay for protection from upward moves in
Participating option an interest rate for only as long as
An option whereby the buyer pays a necessary. Usually, the holder will pay an
reduced premium but has to forgo a initial premium (which will be small
portion of his potential gains. compared with the premium for a normal
cap) and a further payment at each reset
Participating swap date.The holder can cancel the cap when
A swap in which floating-rate exposure is he or she feels that the protection is no
hedged but in which the hedger still longer needed. A pay-as-you-go cap is
retains some benefit from a fall in rates. useful for those who feel that caps are too
expensive, that interest rates will
Participation rate eventually stabilise below the capped
Many structured products incorporate level, or that rates are in a short-lived

Glossary of terms
‘spike’ move. Also known as an

P
determine a new strike, while one with
installment cap. memory may look at previous settings in
determining the new strike. Periodic caps
Payout/payoff are common features in adjustable rate
A general term used to describe the mortgages (ARMs) in the US where the
return provided by a structured product borrower’s floating interest payments
or an option. A lot of products pay a fixed cannot go up by more than a set number
coupon plus additional returns linked to of basis points in a given year. See also
performance of the underlying. If the periodic floor
embedded option is path-dependent, the
returns will be a function of both the Periodic floor
performance of the index and the payout A floor in which the strike rate can vary
formula. For example, the payout from a from period to period.The strike rate in a
five-year quarterly Asian option with a given period depends upon the strike set
70% participation of the Dow Jones Euro in the previous period. Such floors are
Stoxx 50 Index is equal to 70% of the normally set at a fixed number of basis
average of 20 different prices over five points above the previous strike or the
years, and not the level of the index index (for example Libor) plus a spread.
at maturity. See also periodic cap
Period resetting swap Pin risk

An interest rate swap in which the The phenomenon where a small move in
floating-rate payments are an average of the underlying can have a significant
the floating rates observed since the impact on the value of an at-the-money
last payment. option shortly before expiration.
Periodic cap Podium

A cap in which the strike rate can vary A type of correlation product that is fully
from period to period.The strike rate in a capital-guaranteed, but with the annual
given period depends upon the strike set coupons dependent upon the number of
in the previous period. Such caps are underlyings within the basket that meet
normally set at a fixed number of basis certain performance criteria.
points above the previous strike, or the
index (for example, Libor) plus a spread. Portfolio option
Periodic caps can be with or without A portfolio option is a multi-factor option
"memory". A periodic cap without that pays out the difference between the
memory simply looks at the strike in the return from a portfolio of assets and a
immediately preceding period to specified strike price.

Glossary of terms
PPositive basis Premium-reduction device

Positive basis exists when the cost of A strategy that aims to reduce the cost of
buying protection (in the credit an option or other derivative.There are
derivatives market) on a particular many ways to achieve this; three common
reference entity exceeds the credit spread techniques follow.
(generally expressed as a spread to Libor) The first is to sell a second derivative;
on a bond or note of similar maturity the premium received can then be used
issued by that reference entity. When this to lower the funding requirement for the
occurs, investors looking to gain exposure purchased derivative.This is the
to the reference entity can improve their technique employed for reducing the
expected return on an investment by cost of a collar.
taking exposure to the credit by selling The second is to limit participation in
protection in the credit derivatives moves in the underlying by imposing
market rather than buying the bond or limitations on the payout profile of the
note.Technical factors between the bond instrument (as in a barrier option or a
and credit derivatives market account for capped floater).
positive basis. The final way is to accept payments
below market rates, with the possibility of
Power option making up the shortfall at the end of the
An option with a payout dependent on instrument’s life (see yield adjustment).
the price of the underlying at expiry,
raised to some power. See also power swap Principal-guaranteed product
Any investment vehicle that allows
Power swap investors to gain exposure to an asset
A swap whose floating leg is based on the while guaranteeing the return of their
square (or some higher exponent) of the principal, often at maturity only. Such
reference interest rate. Although products are normally constructed by
dismissed by some as little more than a buying a deep discount bond (often a
speculative tool for taking highly zero-coupon bond) and using the rest of
leveraged positions on the direction of the money to buy embedded call or put
interest rates, power swaps have been options to gain exposure to a second
shown (by Robert Jarrow and Donald van asset, often a stock index. See also
Deventer) to have their uses in hedging guaranteed return on investment
commercial banks’ deposits and credit
card loan portfolios. See also power option Program trading
A strategy to trade a basket of shares
Premium simultaneously, normally by means of
See option computer-generated instructions. Where

Glossary of terms
the asset class is considered more

P/Q
style put option and a European-style call
important than the selection within that option on the same underlying with the
class, program trading (also known as same exercise price and maturity. Put-call
basket trading) is used to lower trading parity states that the payout profile of a
costs since trading a basket of shares is portfolio containing an asset plus a put
cheaper than buying or selling those option is identical to that of a portfolio
shares individually. Program trading is containing a call option of the same strike
different from stock index arbitrage, on that same asset (with the rest of the
although it is used in such a strategy. money earning the risk-free rate of
return). In practice, a put option on, say, a
Prompt stock index, can be constructed by
For immediate (ie, two days) delivery. shorting the stock and buying a call
option.The relationship means that
Protection level traders are able to arbitrage mispriced
This refers to the safety level of the options. See also reversal
underlying at which the investor can still
keep their capital intact. Once this level is Puttable swap
breached, the original investment An interest rate swap in which the fixed-
amount is at risk. rate payer has the right to terminate the
contract after a specified period. Should
Put option interest rates fall, the swap can thus be
See option put back to the fixed receiver.The
puttable swap is the opposite of a
Put spread callable swap.The fixed-rate payer is
A put spread reduces the cost of buying a effectively sold a swaption by the
put option by selling another put at a floating-rate payer, who receives a higher
lower level.This limits the amount the fixed rate in compensation. Puttable
purchaser can gain if the underlying goes swaps are similar to extendible swaps.
down, but the premium received from Also known as a cancellable swap.
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. See also call spread, option
combination strategies
Q
Quanto product
Put-call parity An asset or liability denominated in a
The relationship between a European- currency other than that in which it is

Glossary of terms
Q/R
usually traded, typically equity index swap to enhance yield with higher interest
futures, equity index options, bond rates in a discount currency.
options and interest rate swaps
(differential swaps). Quanto products can
be hedged with an offsetting position in a
local currency product. Variable asset and
foreign exchange exposures will arise
with changes in the foreign exchange
R
Rainbow option
rate and in the underlying, so the Similar to a multi-factor option. It is an
structures must be continually option with the payout linked to two or
dynamically hedged in a similar fashion more underlying instruments or indexes.
to option products. See also guaranteed Some common types of rainbow options
exchange rate option, joint option are the maximum option, minimum
option, best-of option and worst-of
Quanto swap option.The underlyings are of the same
Also called a differential swap. A quanto asset class and can have different expiry
swap is a fixed-floating or floating-floating dates and strike prices, but for the
interest rate swap. One of the floating rates option to payout, all the underlyings
is a foreign interest rate, but is applied to a must move in the direction that is
notional amount denominated in the favourable to the option holder. However,
domestic currency. For example, a US if the option combines two or more
investor may enter into a five-year swap in types of asset classes, such as a stock
which he makes payments in US dollars at index and an exchange rate, it is called
the six-month USD Libor plus a spread a hybrid option.
semi-annually, and receives payments in
US dollar at JPY Libor.The payments are Random walk
calculated by applying the respective The series of values taken by a random
interest rates to a notional amount of variable with the progress of some
US$100 million. However, the notional parameter such as time. Each new value
principal can also be denominated in the (each new step in the walk) is selected
Japanese yen, or in a third currency such as randomly and describes the path taken
the British pound. A quanto swap enables by the underlying variable.
the investor to avoid exchange rate risk See also stochastic process
while taking advantage of interest rate
differentials. A corporate borrower with Range accrual option
debt in a discount currency can use a An option that pays out a fixed amount at
quanto swap to lower his borrowing costs, expiration for each day that the index rate
while portfolio managers can use a quanto remains within the specified range.

Glossary of terms
Range binary reference interest rate, a foreign

R
The range binary structure has been exchange rate, an equity price or the
developed primarily for trading purposes spread between two interest rates.The
and is essentially a bet on a spot staying range is determined at the outset to suit
within a given range.The strategy is often the investor’s risk/return requirements,
linked with a deposit for yield but might also be reset by the investor or
enhancement purposes. be automatically centred on the
A range is specified by the customer prevailing rate at each reset date.This
over a fixed period. A premium is paid up higher yield is achieved by the investor
front and provided that the spot stays selling an embedded corridor option,
within the range (as monitored on a 24- particularly in times of high volatility.The
hour basis), then a multiple of the holder of the note will therefore benefit
premium invested will be payable. in stable market periods when volatility
A rebate range binary is one in which the is low.
premium invested is rebated if a
designated boundary of the range is Range resettable forward
breached first. A similar structure, the limit A type of forward contract that offers a
binary, is also essentially for trading.This is more favourable forward rate compared
fundamentally a bet on a spot not staying with an ordinary forward, as long as
within a predetermined range.The the spot rate remains within a pre-
customer specifies two spot rates, one defined range.
above and one below the current spot
rate. A premium is paid up front, and Ratchet floater
providing that both levels trade (as Also called a one-way floating rate note. A
monitored on a 24-hour basis), a fixed ratchet floater is a structured note that
multiple of the premium invested will be pays a floating interest rate indexed on a
payable. See also trigger condition reference rate such as Libor. Each floating
interest rate will depend on the previous
Range note interest rate paid.
A range note (also known as a fairway
note, an accrual note, or a corridor floater) Ratchet option
is a structured note, which pays a coupon See cliquet option
for each day that the underlying spot
stays within a specified range (sometimes Ratio calendar spread
called the accrual corridor). If the A strategy that involves the purchase of a
underlying trades outside the specified long-term option (either call or put) and
range, the investor receives no interest for the selling of a greater amount of near-
that day.The underlying can be a term option at the same strike price.

Glossary of terms
RRebate performance of the benchmark against

Barrier options often have a rebate which the fund is measured, prompting
associated with the trigger level(s). A fund redemptions. A similar risk is run by
rebate is an amount paid to the holder of corporate treasury risk managers who are
the derivative if the instrument is measured against benchmark hedge
knocked-out or is never activated during levels. One way to address this type of risk
its lifetime as partial recompense for their is with outperformance options. Relative
initial investment. One example is the performance risk is also used to refer to
rebate range binary. the risk that an individual asset will
underperform relative to its asset class.
Regulatory arbitrage For equities, this may be measured by a
A financial transaction that allows one or stock’s beta, its standardised covariance
both of the counterparties to accomplish with respect to the relevant equity index.
an operating or financial objective that See also specific risk
would be unavailable to them directly
because of regulations: for example, a Replacement cost
commercial bank entering into a credit Often used in terms of credit exposure,
default swap with an OECD bank in order the replacement cost of a financial
to lower the regulatory capital that it instrument is its current value in the
must hold. market – in other words, what it would
cost to replace a given contract if the
Regulatory capital counterparty to the contract defaulted.
The amount of capital that an organisation Aside from bid-ask conventions, it is
is required to hold by its regulator. synonymous with market value.
Reinvestment risk Replication

The risk that an asset manager will be To replicate the payout of an option by
unable to match the yield from an buying or selling other instruments.
interest-rate instrument (such as a swap Creating a synthetic option in this way is
or bond) when reinvesting its coupon always possible in a complete market. In
payments and principal repayments. the case of dynamic replication this
involves dynamically buying or selling
Relative performance option the underlying (or normally, because of
See outperformance option cheaper transaction costs, futures) in
proportion to an option’s delta. In the
Relative performance risk case of static replication the option
The risk that a fund manager’s choice of (usually an exotic option) is
investments will fail to match the hedged with a basket of standard

Glossary of terms
options whose composition does not depending on the average price of the
R
change with time – eg, an at-expiry underlying stock on pre-specified dates.
digital option can be replicated with a See also convertible bond
call spread. See also static replication,
synthetic asset Reversal
To take advantage of mispriced options
Repo agreement by creating a synthetic long futures
To buy (sell) a security while at the same position and hedging it by selling futures
time agreeing to sell (buy) the same contracts against it. A trader may buy an
security at a predetermined future date. undervalued call, at the same time selling
The price at which the reverse transaction a fairly valued put and buying a futures
takes place sets the interest rate over the contract.The same strategy could be
period (the repo rate).The most active applied if the put was undervalued.
repo market is in the US, where the The ability to undertake this riskless
Federal Reserve sets short-term interest arbitrage relies on put-call parity. See also
rates by lending securities. In a reverse convergence trade, put-call parity
repo the buyer sells cash in exchange for a
security. Repos can benefit both parties. Reverse barrier option
Buyers of repos often receive a better See barrier option
return than that available on equivalent
money-market instruments; and financial Reverse cash-and-carry arbitrage
institutions, particularly dealers, are able A technique, used mainly in bond futures
to get sub-Libor funding. A slight variation and stock index futures, that involves
on the repo is the buy/sell back.The buying a futures contract and selling the
buy/sell back’s coupon becomes the underlying. It is used when a futures
property of the purchaser for the duration contract is theoretically cheap, such as
of the agreement. It is preferred by credit- when the implied repo rate is less than
sensitive investors such as central banks. the market repo rate. See also cash-and-
carry arbitrage
Repo rate
See repo agreement Reverse convertible
These are just like convertible bonds.The
Reset-in-arrears swap main difference is that rather than buying
See delayed reset swap a call option on a stock, the investor sells
a put on the stock or index.The investor
Resettable convertible bond receives higher than normal coupons but
It is a convertible bond where the may lose some principal if the put ends
conversion ratio can reset to a new value up in the money.

Glossary of terms
RReverse index amortising swap Risk neutral valuation

An interest rate swap in which payments An argument that underpins most
are linked to an index (eg, Libor or derivatives pricing, including the Black-
constant maturity Treasuries) and Scholes model.The differential equation
increase if that index declines.The swap describing the price of a derivative does
therefore exhibits positive convexity. not involve parameters that depend on
Receiving fixed in a reverse index risk preferences. Derivatives prices in a
amortising swap (reverse IAS) provides a market where all investors are risk neutral
hedge for instruments (such as mortgage must therefore be the same as prices in the
swaps) that amortise as interest rates real world and this corollary considerably
decline, although it is important to ensure simplifies model construction.
that the indexes on which the
amortisation or accreting schedules are Risk reversal
based are highly correlated. Unlike a The term ‘risk reversal’ is also used, by
conventional IAS, the fixed receiver of a currency option traders, to denote the
reverse IAS is buying volatility (sometimes difference in implied volatility between
referred to as ‘optionality’) which offsets out-of-the-money call and put options,
the short option position of a mortgage which both have a delta of 25%.The level
portfolio. See also mortgage swap of the risk reversal is often used as a
sentiment indicator in currency
Reversible swap markets as it indicates the relative
An interest rate swap in which one side demand for calls versus puts. See also
has an option to alter the payment basis collar, volatility skew
(fixed/floating) after a certain period.This
is usually achieved by the use of a Roller-coaster swap
swaption, allowing the purchaser the An interest rate swap in which one
opportunity to enter a swap with payment counterparty alternates between paying
on the opposite basis.The swaption fixed and paying floating. Another name
would be for twice the principal amount, for a seasonal swap.
one half nullifying the original swap.
Roll-over risk
Rho The risk that a derivatives hedge position
Measures an option’s sensitivity to a will be at a loss at expiry, necessitating a
change in interest rates.This will have an cash payment when the expiring hedge is
impact on both the future price of the replaced with a new one. Normally, such a
option and the time value of the roll-over loss simply represents an
premium. Its impact increases with the opportunity loss, but sometimes the cash
maturity of the option. cost is consequential.

Glossary of terms
S
S
low, or an enhanced yield for an insurance
company when equity prices are falling.
Settlement risk
Seasonal swap Settlement risk (delivery risk), as a
An interest rate swap in which the particular form of counterparty credit risk,
principal alternates between zero arises from a non-simultaneous exchange
and the notional amount (which can of payments. For example, a bank that
change or stay constant).The principal makes a payment to a counterparty, but
amount of the swap is designed to will not be recompensed until a later
hedge the seasonal borrowing needs date, is exposed to the risk that the
of a company. counterparty may default before making
the counter-payment. Settlement risk is
Securitisation distinct from market risk because it
The conversion of assets (usually forms of relates to exposure to a counterparty
debt) into securities, which can be traded rather than exposure to the underlying
more freely and cheaply than the risk related to the reference entity of the
underlying assets and generate better derivatives contract.
returns than if the assets were used as
collateral for a loan. One example is the Shout option
mortgage-backed security, which pools A type of path-dependent option that
illiquid individual mortgages into a single allows the investor to lock in profits if he
tradable asset. thinks the market has reached a high (for
a call) or low (for a put).The investor
Semi-fixed swap benefits further if the market finishes
An interest rate swap with two possible higher or lower than the shout level.The
fixed rates, which can be tailored to suit shout option is designed for investors
bullish or bearish market views.The rate who have a directional view on the
paid by the fixed-rate payer depends on market and want to take positions, but
whether current Libor (or another are worried about the volatility of the
reference rate or asset) is above or below asset and want to lock in a minimum
a predetermined level. In a typical return. See also lookback option, path-
structure, if Libor is below the trigger dependent option
level, the lower of the two rates is paid, if
it is above, the higher is paid.These swaps Skew
can be used to create asymmetric risk A skewed distribution is one that is
exposures, ie, cheaper fixed-rate funding asymmetric. Skew is a measure of this
for an oil producer when oil prices are asymmetry. A perfectly symmetrical

Glossary of terms
Sdistribution has zero skew, whereas a spread between interest rates in two
distribution with positive (negative) skew different currencies. A calendar spread, a
is one where outliers above (below) the pair of options with the same strike price
mean are more probable. An example of but different maturities, pays out the
an asymmetric distribution in the price difference for a single asset on two
financial markets is the distribution different dates. Spread options, including
implied by the presence of a volatility calendar spreads, are particularly popular
skew between out-of-the-money call and in the commodity markets.
put options.
Spread-lock swap
Specific risk An interest rate swap in which one
Specific risk, also known as non- payment stream is referenced at a fixed
systematic risk, represents the price spread over a benchmark rate such as
variability of a security that is due to US Treasuries.
factors unique to that security, as
opposed to that portion that is due to Squeeze
systematic risk, the generalised price Pressure on a particular delivery date
variability of the related interest rate or resulting in making the price of that date
equity market. As an example, a US higher relative to other delivery dates.
Treasury note would have no specific risk,
as it is deemed to have no risk other than Static replication
movement in interest rates, while a Static replication is a method of hedging
corporate bond would have a degree of an options position with a position in
default risk as well as more generalised standard options whose composition
yield curve risk. See also relative does not change through time.The
performance risk method attempts to replicate the payout
of the instrument in a more manageable
Spread option fashion than dynamic replication, where a
The underlying for a spread option is the position in the underlying or futures
price differential between two assets (a contracts must be dynamically adjusted if
difference option) or the same asset at it is to remain effective. Because it uses
different times or places. An example of a options to hedge options, a static
financial difference option is the credit replication portfolio is a better hedge for
spread option, the underlying for which is gamma and volatility, as well as delta,
the spread between two debt issues, than dynamic replication. Static
which derives from the relative credit replication can be used for hedging a
rating of the issuers. Another is the cross- position in exotic options with vanilla
currency cap, where the underlying is the options, or for replicating a long-term

Glossary of terms
option with short-term options. In

S
random variables. For example, the value
practice, however, it is not always possible of an American-style option is such that
to hedge using static replication.The the best choice of exercise is always made.
number of different options and notional
amounts required can quickly become Stochastic process
unmanageable. See also delta-hedging, Formally, a process that can be described
replication, synthetic asset by the evolution of some random variable
over some parameter, which may be
Statistical arbitrage either discrete or continuous. Geometric
In the mid-1980s it was discovered that Brownian motion is an example of a
certain stock prices did to an extent stochastic process parameterised by time.
exhibit autocorrelations – implying that Stochastic processes are used in finance
earlier price changes could be used to to develop models of the future price of
forecast future changes. Statistical an instrument in terms of the spot price
arbitrageurs seek to exploit these and some random variable; or
patterns in their trading strategies. analogously, the future value of an
interest or foreign exchange rate. See also
Step-down swap Geometric Brownian motion, martingale,
The opposite of an escalating rate swap; random walk
ie, the fixed rate decreases in increments
over the life of the swap Stochastic volatility
One of the key assumptions of the
Step-up swap Black-Scholes model is that the stock
See accreting price follows geometric Brownian
motion with constant volatility and
Step-up/down range forward interest rates. However, in real
A self-adjusting range forward structure, markets, volatility is far from constant.
which is particularly suitable for hedging If volatility is assumed to be driven by
purposes. If the strike level of the long some stochastic process, however,
put option is breached, the strike the Black-Scholes model no longer
automatically adjusts up or down describes a complete market, since
(according to exposure) to a new, more there is now another source of
favourable, level. uncertainty in the option pricing
model. A variety of approaches
Stochastic optimisation model have been attempted to resolve this
A model or description of a system in difficulty since the mid-1980s, most
which the choice of action that can be notably the Heath-Jarrow-Morton
taken is dependent on the values of some framework.

Glossary of terms
SStock index arbitrage Stock index option

The technique of selling a futures contract An option, either exchange-traded or
on a stock index and buying the over-the-counter, on a stock index.
underlying stocks, via programme trading,
or vice versa when the price of the futures Stock option
contract is above or below its theoretical An option, either exchange-traded or
value.The ability to conduct such over-the-counter, on an individual equity.
strategies depends on the efficiency of
the futures and cash markets. Straddle
The sale or purchase of a put option and a
Stock index future call option, with the same strike price, on
A futures contract on a stock index. Most the same underlying and with the same
are cash-settled.The theoretical price of a expiry.The strike is normally set at-the-
stock index future equals the cost of money.The purchaser benefits, in return
carrying the underlying stock for that for paying two premiums, if the
period: the opportunity cost of the funds underlying moves enough either way. It is
invested minus any dividends. If the cost a way of taking advantage of an expected
of buying and holding the underlying upturn in volatility. Sellers of straddles
stocks is less than the futures price, an assume unlimited risk but benefit if the
arbitrageur can sell futures and buy the underlying does not move. Straddles are
underlying stocks. primarily trading instruments. See also
The higher interest rates are option combination strategies
(compared with the dividend yield), the
greater the opportunity cost of holding Strangle
the stocks, hence the futures price should 1 . As with a straddle, the sale or purchase
be higher than the current index price. If of a put option and a call option on the
interest rates are less than the dividend same instrument, with the same expiry,
yield, the opportunity cost of holding but at strike prices that are out-of-the-
stocks is less and the futures price should money.The strangle costs less than the
fall below the current index price.There is straddle because both options are out-of-
usually a so-called arbitrage band in the-money, but profits are only generated
which, although the futures and if the underlying moves dramatically, and
underlying prices diverge, it is not the break-even is worse than for a
worthwhile arbitraging the two.This straddle. Sellers of strangles make money
arises as a result of transaction costs from in the range between the two strike
bid-ask spreads, the market impact of prices, but lose if the price moves outside
buying and selling stock, and the break-even range (the strike prices
execution risks. plus the premium received).

Glossary of terms
2 . The term strangle is also used, by

S
that bundles up a portfolio of securities
currency option traders, to denote the and other derivatives to create a
average difference in implied volatility single product. For example, a
between out-of-the-money call and put structured note can be a five-year bond
options with a 25% delta and the implied that has an embedded equity or
volatility of at-the-money forward options. currency option in order to enhance its
See also option combination strategies return. A structured product appeals to
the investor who has a view on the
Strap market and a good idea of what his
A strategy that involves purchasing one risk/reward appetite is.
put option and two call options, all with
the exact same strike price, underlyings Structured yield investments
and maturity date. Any security (normally a structured note)
whose yield is conditional on certain
Strategic asset allocation trigger conditions being met. Such a
The distribution of investment funds in security is normally constructed by
response to long-term, fundamental embedding path-dependent options
expectations for markets. (such as binary options) in a vanilla debt
issue.The investor’s return on the note
Stress-testing will then vary according to the payout of
To perform a stress test on a derivatives the options.
position is to stimulate an extreme
market event and examine its behaviour Substitution option
under the ‘stress’ of that event. A bilateral financial contract in which
one party buys the right to substitute a
Strip specified asset or one of a specified
A strategy that involves the purchase of group of assets for another asset at a
one call option and two put options, all point in time or contingent upon a
with the same strike price on the same credit event.
underlying and the same expiry date.The
strikes are set at-the-money. Alternatively, a Swap
strip can refer to the process of removing See accreting, credit default swap,
coupons from a bond and selling the delayed reset swap, digital swap, dual
stripped bond (or zero coupon bond) and currency swap, equity (index) swap,
interest-paying coupons separately. forward swap, high-coupon swap, index
amortising swap, interest rate swap,
Structured product mortgage swap, municipal swap,
A structured product is an investment participating swap, periodic resetting

Glossary of terms
Sswap, power swap, puttable swap, reverse expense of leaving the borrower unsure
index amortising swap, reversible swap, of the maturity of the debt.
roller-coaster swap, seasonal swap,
semi-fixed swap, spread-lock swap, Synthetic asset
step-down swap, variable notional swap, A synthetic asset is a combination of long
yield curve swap, zero coupon swap and short positions in financial
instruments, which has the same
Swaption risk/reward profile as another instrument.
An option to enter an interest rate swap. For example, it is possible to replicate the
A payer swaption gives the purchaser the payout and exposure of a short futures
right to pay fixed, a receiver swaption position by going short European-style
gives the purchaser the right to receive call options and long European puts with
fixed (pay floating). identical strikes and expiries. Synthetic
Apart from those in the sterling index options can be generated either
market, many swaptions are capital- through positions in the underlying and
market driven. Good-quality borrowers futures contracts, or with a basket of
are able to issue puttable or callable vanilla options. See also replication,
bonds and use the swaptions market to static replication
reduce their financing costs. In the case of
callable bonds, the issuer effectively buys Synthetic collateralised debt obligation
an option from the investor in return for a A synthetic collateralised debt obligation
slightly higher coupon, so that it may (CDO) uses credit derivatives to transfer
benefit if rates decline. Because many of credit risk in a portfolio.This is in contrast
these embedded options have to a traditional CDO, which is typically
traditionally been underpriced, good- structured as a securitisation with
quality borrowers have been able to ownership of the assets transferred to a
monetise this anomaly by selling an separate special purpose vehicle (SPV).
equivalent swaption (a receiver swaption) The assets are funded with the proceeds
to a bank at market rates. of debt and equity issued by the vehicle.
The profit from this arbitrage lowers In a synthetic CDO, an institution transfers
funding costs. If the swaption is exercised the total return or default risk of a
against the issuer, it calls the bonds reference portfolio via a credit default
(although the issuer would almost swap, a total return swap, or a credit-
certainly have called the issue given the linked note.The SPV then issues securities
reduction in rates). In the case of puttable with repayment contingent upon the loss
bonds, the borrower sells a swaption to on the portfolio. Proceeds are either held
the swaption market.The premium by the vehicle and invested in highly
gained lowers the funding cost at the rated, liquid collateral, or passed-on to the

Glossary of terms
institution as an investment in a credit-

S/T
a relatively small number of market
linked note. Balance sheet synthetic CDOs participants, with the concomitant risk
are typically used by banks to manage that the failure of a major dealer could
risk capital and are easier to execute than have serious knock-on effects for many
traditional CDOs. Arbitrage synthetic other market participants.
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. See also collateralised
T
Table top
debt obligation Similar to a ratio spread, except that the
purchase of an option is financed by
Synthetic forward sales of the same option at two different
See synthetic asset strike prices.
Synthetic option Tactical asset allocation

See synthetic asset, replication The distribution of investment funds in
response to short-term expectations of
Synthetic securitisation market opportunity or threat.
A first-loss basket swap structure that
references a portfolio of bonds, loans or Theta
other financial instruments held on a This measures the effect on an option’s
firm’s balance sheet.The technique price of a one-day decrease in the time to
replicates the credit risk transfer benefits expiration.The more the market and
of a traditional cash securitisation while strike prices diverge, the less effect theta
retaining the assets on balance sheet. has on a vanilla option’s price.Theta is
Advantages over cash securitisation also non-linear for vanilla options,
include reduced cost, ease of execution meaning that its value decreases faster as
and retention of on-balance sheet the option is closer to maturity. Positive
funding advantage. gamma is generally associated with
negative theta and vice versa.
Systemic risk
The risk that the financial system as a Time decay
whole may not withstand the effects of a See theta
market crisis. Concern on the part of
banking regulators has been caused by Time value
the concentration of derivative risk among The value of an option, other than its

Glossary of terms
Tintrinsic value.The time value therefore broad-based index with which they are
includes cost of carry and the probability being compared.
that the option will be exercised (which in
turn depends on its volatility). Tranche product
A tranche product is one that is
Total return swap open for subscription for only
A bilateral financial contract in which a limited period, as opposed to open-
one party (the total return payer) makes ended products, which accept
floating payments to the other party investments for an unlimited period.
(the total return receiver) equal to the Most structured products are
total return on a specified asset or index tranche products, and the offer period is
(including interest or dividend payments usually four to eight weeks.
and net price appreciation) in exchange
for amounts that generally equal the Translation risk
total return payer’s cost of holding the An accounting/financial reporting
specified asset on its balance sheet. risk where the earnings of a
Price appreciation or depreciation company can be adversely affected
may be calculated and exchanged at due to its method of accounting for
maturity or on an interim basis. A total foreign operations.
(rate of ) return swap is a form of credit
derivative, but is distinct from a credit Treasury lock
default swap in that floating payments A rate agreement based on the yield or
are based on the total economic equivalent market price of a reference US
performance of a specified asset and are Treasury security.These can be
not contingent upon the occurrence of a settled based on yield differential for
credit event. a full tenor, or can be price-settled
based on the exact characteristics of a
Total return option specific security.
A total return option is a put option on
debt. An investor that has a risky Trigger
corporate bond and is worried about Many path-dependent options have
default can buy a total return option that payouts that depend on the underlying
allows him to sell the bond at par if the asset or index or coupons paid/payable
corporation defaults. reaching a specified level before the
expiry date. This level is the trigger. Some
Tracking error options have more than one trigger
Refers to the difference between the level, in which case the payouts are
performance of a portfolio of stocks and a conditional or increase with the number

Glossary of terms
of triggers activated or the order in ■ some combination of these.

T
which they are activated. See barrier See also barrier option, Parisian
option, Parisian barrier option barrier option, range binary
Trigger condition Trigger forward

Path-dependent derivatives such as The trigger forward is primarily
barrier options and binary options have designed for trading purposes,
payouts which depend in some way on a although it can also be used as an
market variable satisfying a specific alternative hedge. It is usually a zero-cost
condition during the derivative’s life. If structure, whereby the purchaser enters
this ‘trigger condition’ is met, the into an outright forward transaction at a
derivative may pay out immediately (early rate significantly more attractive than the
exercise) or at some other specified time prevailing market rate, but where the
(such as expiry). Alternatively, the option whole structure will be knocked out if a
may only become effective (be knocked- predetermined trigger level is reached at
in) or be de-activated (knocked out) when any time before the expiry date.
the trigger condition is met.
The most common condition is that Trinomial tree
the spot rate or price of the underlying Similar to a binomial tree, a trinomial
must breach a specified level, meaning tree is a discrete-time model describing
that it must trade through the barrier, the distribution of assets. After each
either from above or below. Many other time step in the trinomial tree there
trigger conditions are possible, however. are three possible outcomes; an up
Some examples include: move, a down move or no move in the
■ the spot must breach the trigger, asset value. This gives additional
and remain above/below it for a degrees of freedom, which enhance
specified time; the computational power of the
■ the spot trades at the trigger level at a lattice model.
specified time (eg, expiry) or at any
time during the option’s life; Turbo
■ the spot trades within or breaks out of A type of path-dependent option,
a range (for example, range binaries); usually embedded in warrants. A barrier is
■ there is more than one trigger level, set at the same level as the strike price,
with the payout conditional upon or and if the underlying ever touches the
increasing with the number of triggers barrier at any point during the life of the
activated and possibly the order in turbo option, this will immediately cause
which they are activated (for example, the warrant to expire worthless. If the
a mini-premium option); underlying never reaches the strike

Glossary of terms
T/U/V
during the option’s life, the payout will be product or option can be any asset class
similar to a vanilla warrant. (equity index, stock basket, debt
instrument, interest rate, commodity or a
Two-factor model combination of these) that is used to
Any model or description of a system that construct the product and whose
assumes two sources of uncertainty or performance is a key determinant of the
variables; for example, an asset price and payout. In some products, the underlying
its volatility (a stochastic volatility model), may be a basket of 20 stocks, but the
or interest rate levels and curve steepness redemption basket that is used to
(a stochastic interest rate model).Two- calculate the maturity payout may
factor models model interest rate curve comprise only 10 of those stocks.
movements more realistically than one-
factor models. Underwater
Has the same meaning as out-of-
Two-name exposure the-money.
Credit exposure that the protection
buyer has to the protection seller, Up-and-in
which is contingent on the performance of A type of barrier option that pays off
the reference credit. If the protection seller only when the underlying index
defaults, the buyer must find alternative reaches the upper barrier during the life
protection and will be exposed to changes of the option.
in replacement cost due to changes in
credit spreads since the inception of the Up-and-out
original swap. More seriously, if the A type of barrier option that
protection seller defaults and the reference knocks out when the underlying reaches
entity defaults, the buyer is unlikely to the strike.
recover the full default payment due,
although the final recovery rate on the
position will benefit from any positive
recovery rate on obligations of both the
reference entity and the protection seller.
V
Value-at-risk
Formally, the probabilistic bound of
U
Underlying
market losses over a given period of time
(known as the holding period) expressed
in terms of a specified degree of certainty
(the confidence interval). Put more simply,
The underlying of a structured the value-at-risk (VaR) is the worst-case

Glossary of terms
loss expected over the holding period

V
for a vanilla option the vega is lower. If
within the probability set out by the spot and volatility movements are
confidence interval. Larger losses are positively correlated the holder of an
possible, but with a low probability. For option with positive vanna will be
instance, a portfolio whose VaR is $20 expected to profit from this correlation.
million over a one-day holding period, with See also vega
a 95% confidence interval, would have
only a 5% chance of suffering an overnight Variable notional option/swap
loss greater than $20 million. Calculation of An option or swap where the notional
VaR entails modelling the possible market value is linked to the underlying asset
moves over the holding period, price or rate. Usually changes in the
incorporating correlations among market notional will be directly proportional to
factors, calculating the impact of such changes in the underlying price; ie, they
potential market moves on portfolio both decrease or increase together. Such
positions, and combining the results to derivatives have two main uses. In an
examine risk at different levels of equity swap, the fixed-rate receiver can
aggregation.The three main approaches opt to receive the return of either a
to this analysis are historical simulation, fixed number of stocks, or the number
the analytical approach using a correlation of stocks that could be purchased
matrix or empirical (Monte Carlo) for a fixed sum.The former case
simulation. Major trading houses expend amounts to a variable notional amount
considerable energies on their VaR for the swap. An example using an
methodologies and have lobbied option is the case of a firm that
regulators to recognise their efforts, with sells more exports as exchange rates
some success. decline and its products therefore
become cheaper abroad. Since it
Vanilla option now has greater foreign currency revenue
Also known as a plain vanilla option. A to hedge, it would purchase a variable
vanilla option is a standard call or put notional currency option for this purpose.
option in its most basic form.
Variance gamma model
Vanna A jump model that better captures the
The vega of an option is not constant. characteristics of the volatility smile for
Vega changes as spot changes and as shorter-dated options than stochastic
volatility changes. The vanna of an volatility models.
option measures the change in vega for
a change in the underlying spot. Variance swap
As spot moves deeper out-of-the-money The cash payout of a variance swap is

Glossary of terms
Vequal to notional multiplied by the Vertical spread

difference between the realised variance Any option strategy that relies on the
of the underlying index over the life of difference in premium between two
the swap and the strike variance. options on the same underlying with the
same maturity, but different strike prices.
Vasicek model Thus put spreads and call spreads would
An interest rate model that incorporates both be vertical spreads.
mean reversion and a constant
volatility for the short interest rate. It Volatility
is a one-factor model from which A measure of the variability (but not the
discount bond prices and options on direction) of the price of the underlying
those bonds can be deduced. All have instrument. It is defined as the annualised
closed-form solutions. standard deviation of the natural log of
the ratio of two successive prices.
Vega Historical volatility is a measure of the
Measures the change in an option’s price standard deviation of the underlying
caused by changes in volatility. Vega is at instrument over a past period. Implied
its highest when an option is at-the- volatility is the volatility implied in the
money. It decreases the more the market price of an option. All things being equal,
and strike prices diverge. Options closer higher volatility will lead to higher vanilla
to expiration have a lower vega than option prices. In traditional Black-Scholes
those with more time to run. Positions models, volatility is assumed to be
with positive vega will generally have constant over the life of an option. Since
positive gamma.To be long vega (to have traders mainly trade volatility, this is
a positive vega) is achieved by purchasing clearly unrealistic. New techniques have
either put or call options. Positions that been developed to cope with volatility’s
are long vega benefit from increases in variability.The best known are stochastic
implied volatility but also from actual volatility, Arch and Garch.
volatility if the option is being delta
hedged.They will also lose from Volatility skew
reductions in volatility. Spread options The difference in implied volatility
can be an exception: a reduction in the between out-of-the-money puts and
volatility of one of the assets may calls. In most equity option markets
actually increase the price of the option out-of-the money calls have lower
because the correlation between the two implied volatility than out-of-
assets decreases. Vega is sometimes the-money puts.This is mostly
known as kappa or tau. See also gamma, ascribed to the greater supply of volatility
vanna, vomma above, rather than below, the money

Glossary of terms
since fund managers are happy to write effect of changes in volatility on the
V
calls and not so happy to write puts. option price is less the shorter the
Volatility skews can be very pronounced option. Most market-makers take
in the currency markets although advantage of differing volatilities to
whether puts or calls are favoured hedge their books or to trade perceived
depends on market sentiment and anomalies in volatility. Such strategies
demand and supply. See also implied have to be weighted because of the
volatility, risk reversal differing vega effects. See also
implied volatility
Volatility smile
A graph of the implied volatility of an Volatility trading
option versus its strike (for a A strategy based on a view that future
given tenor) typically describes a volatility in the underlying will be more
smile-shaped curve – hence the term or less than the implied volatility in the
‘volatility smile’. This can be attributed to option price. Option market-makers are
the belief that the underlying volatility traders. The most common way
distribution is leptokurtic, since this to buy/sell volatility is to buy/sell options,
tends to increase the value of out-of-the- hedging the directional risk with the
money options. underlying. Volatility buyers make money
if the underlying is more volatile than the
Volatility swap implied volatility predicted. Sellers of
The cash payout of a volatility volatility benefit if the opposite holds.
swap is equal to notional Other methods of buying/selling
multiplied by the difference between the volatility are to buy/sell combinations of
realised volatility of the underlying options, the most usual being to buy/sell
index over the life of the swap and straddles or strangles. Other strategies
the strike volatility. take advantage of the difference
between implied volatilities of differing
Volatility term structure maturity options, not between implied
The term structure of volatility is the and actual volatility. For example, if
curve depicting the differing implied implied volatility in short-term options is
volatilities of options with differing high and in longer options low, a trader
maturities. Such a curve arises partly can sell short-term options and buy
because implied volatility in short longer ones.
options changes much faster than for
longer options. However, the volatility Vomma
term structure also arises because of The vega of an option is not constant.
assumed mean reversion of volatility. The Vega changes as spot changes and as

Glossary of terms
V/W
volatility changes.The vomma of an degree days or cooling degree days.
option is defined as the change in vega These two indexes measure the deviation
for a change in volatility. Vomma of the average of a day’s high and low
measures the convexity of an option price temperature from a baseline reference
with respect to volatility. Vega is to temperature.
vomma (volatility gamma) as delta is to
gamma for spot movements. Holders of Wedding cake deposit
options with a high vomma benefit from A type of range deposit where there is an
volatility of volatility. See also vega inner range and one or more outer
ranges.The payout from the product is at
W
its maximum when the underlying
remains in the inner range, and this is
reduced successively when the spot
reaches each outer range.This
Warrant product is suitable for investors who
An instrument giving the purchaser the have a range-bound view, and want to
right, but not the obligation, to purchase take less risk.
or sell a specified amount of an asset at a
certain price over a specified period of Weekly reset forward
time. Warrants differ from options only in A weekly reset forward is a synthetic
that they are usually listed. Underlying forward where a portion of the contract is
assets include equity, debt, currencies and locked in each week, provided that the
commodities. See also equity warrant spot rate that week meets a
predetermined fixing criterion.
Wasting asset Hence the purchaser can deal at a rate
A wasting asset is a derivative security better than the forward outright, but
that loses value due to time decay and only in an amount corresponding
which may expire worthless at to the frequency with which the criterion
maturity. Derivatives such as options, has been met. If the criterion is met in
rights and warrants are considered to none of the weeks during the life of the
be wasting assets. contract, then the contract is not
activated at all; if it is met every week,
Weather derivative the overall rate is favourable
Typically swaps and vanilla options such compared with the initial prevailing
as calls, puts, caps, floors and collars with market rate.The weekly reset forward
payouts linked to temperature, is used for those with cash-flows
precipitation, humidity or windspeed. spread over time or to hedge
Most instruments are linked to heating balance sheets.

Glossary of terms
Window barrier
W/Y
at the outset of a swap or at a reset date,
A window barrier is a type of barrier to compensate the other counterparty for
option for which the barrier strike only entering into a swap on off-market terms.
applies for a specified period during the
option’s life. If the spot breaches this level Yield curve
during the window period, then the The yield curve is a graphical
option either knocks in or knocks out. If representation of the term structure of
the option is not activated during the interest rates. It is usually depicted as the
window period, the option will retain the spot yields on bonds with different
features of a vanilla option and expire maturities but the same risk factors
at maturity. (such as creditworthiness of issuer),
plotted against maturity. The usual
Worst-of option features of a spot yield curve are higher
An option whose payout is referenced to long-term yields than short-term yields
one or more of the worst performers in a and a curve for default-free bonds that is
basket of shares or indexes. lower at each point than the equivalent
curve for riskier debt. It is possible to
construct variants of the yield curve
Y
Yield
from this basic form. The par yield
curve is found by calculating the
coupons that would be necessary for
bonds of each maturity to be priced at
The interest rate that will make the par; the forward yield curve is found by
present value of the cashflows from an extrapolating the spot yield curve point-
investment equal to the price (or cost) of by-point, based on the implied forward
the investment. Also called the internal interest rates.
rate of return.The current yield relates the
annual coupon yield to the market price Yield curve agreement
by dividing the coupon by the price See yield curve swap
divided by 100 and ignores the time value
of money or potential capital gains or Yield curve option
losses. Simple yield to maturity takes into An option that allows investors to take a
account the effect of the capital gain or view on the shape of a yield curve
loss on maturity of a bond in addition to without taking a view on a bond market’s
the current yield. direction. It is normally structured as the
yield of a longer maturity bond minus the
Yield adjustment yield of a shorter one. A call would
A payment by one counterparty, usually therefore appreciate in value as a curve

Glossary of terms
Y/Z
flattened. A put would decrease in value. offset one another. See also collar,
Such options were developed in the US in participating forward
1991 in response to a steepening
yield curve. Zero coupon bond
A debt instrument issued at below
Yield curve swap par value.The bond pays no coupons;
A swap in which the two interest streams instead, it is redeemed at face value
reflect different points on the swap yield at maturity.
curve.Yield curve swaps can be used to
exploit a yield curve steepening or Zero coupon swap
flattening view. For example, one side An off-market swap in which either or
pays the two-year Constant Maturity both of the counterparties makes one
Treasury (CMT) rate and the other the 10- payment at maturity. Usually it is the
year CMT rate. fixed-rate payments only that are
deferred.The party not receiving
payment until maturity incurs a
Z
Zero cost collar
greater credit risk than it would
with an ordinary swap.The swap is
advantageous for a company that
will not receive payment for a project
See zero cost option until it is completed or to hedge zero
coupon liabilities, such as zero
Zero cost option coupon bonds.
Any option strategy that involves
financing an option purchase by the Zero exercise price option (ZEPO)
simultaneous sale of another option so A low exercise price option whose strike
that paid and received premiums exactly price is exactly zero.

Glossary of terms
notes

Glossary of terms
notes

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Asia Risk guide disclaimer.

qxd 24/10/2005 10:26 Page 1

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2 The ABC of Structured Products

The ABC of Structured Products 3

T boomed over the past few years.

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The ABC of Structured Products 5

A Accreting and investment banking techniques that

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amortisation plus interest is the AutoRegressive conditional

The ABC of Structured Products 7

AAsset/liability management difference between its predetermined

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precedes the settlement price averaging

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Bermudan option Bilateral netting

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Bbinary option is discontinuous and pays process will continue.The process is

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Black-Scholes model Bond index swap

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A strategy that involves buying and Callable swap

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fixed rate paid under the original swap

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Closed-form solution Collared floater

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Cobligations. See also collateralised period.They are often used to hedge

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The H.15 Report from the Federal

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CConvergence trade Convexity

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options, yield curve options and cross-

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event with respect to a specified Credit option

The ABC of Structured Products 23

CCredit spread forward this exceeds zero, in return for a

24 The ABC of Structured Products

period protection of a standard cap, it is

Currency forward Currency risk

The ABC of Structured Products 25

DDeferred start option position has been taken in the underlying

26 The ABC of Structured Products

(GBM), which is often used to model the

The ABC of Structured Products 27

28 The ABC of Structured Products

equity level is reached, or the client can

The ABC of Structured Products 29

30 The ABC of Structured Products

Forward Forward swap

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The rate of change in the delta of an Geometric Brownian motion

32 The ABC of Structured Products

normally distributed.This gives the model option) on an asset in one currency

The ABC of Structured Products 33

34 The ABC of Structured Products