The ability of one country to produce more of a given good with its endowed resources. In the context of swaps, the ability of one party to borrow at a lower rate of interest in a given currency than another party.
Any swap in which the notional principal increases over the tenor of the swap. Thus, interest exchanges are made on a progressively larger notional principal.
The management of a portfolio based on the judgment of the portfolio manager. Active management seeks to outperform an index or a benchmark. It involves active trading to take advantage of opportunities based on relative valuations across securities within the investment universe.
Bonds issued by an entity of the U.S. government, such as Ginnie Mae, or by a Government Sponsored Enterprise (GSE), such as Fannie Mae, Freddie Mac, Federal Home Loan Bank System and Sallie Mae.
Also called effective annual percentage cost (the latter term is often applied to component costs individually). An important measure of the total cost of a financing that expresses the cost on an annual percentage basis. This measure is very useful for comparing alternative financing opportunities.
The unsystematic or non-market risk in a portfolio. Alpha is the risk specific to an asset and can be eliminated in a diversified portfolio of assets.
An option that allows the buyer of the option the right to exercise the option at any time during the life of the option.
A loan repayment schedule, which describes the payment process by which the principal on a loan will be amortized. Such schedules usually also depict the interest payments and the total payments (principal and interest combined).
Any form of debt in which the principal balance is repaid gradually over the term of the loan.
A yield that is expressed on an annualized basis regardless of the number of payments per year.
A series of fixed payments made at equal intervals in time.
The simultaneous transacting in two or more markets to exploit a price discrepancy. As generally understood, arbitrage involves little risk and little investment.
Arbitrage Pricing Theory (APT)
A multi-factor model whose theory states that the excess return on any security or portfolio should be proportional to its systematic risk, as measured by beta.
The average return from any investment, calculated by summing up the returns of all the periods and then dividing this sum by the number of periods.
Sometimes referred to as the offered price and part of a two way price quote, known as the bid-ask spread. In regard to the bid-ask spread, it is the right side of the quote and is the price at which the seller of the security is offering to sell.
The process of distributing investment funds among various investment avenues such as stocks, bonds, money market instruments, cash equivalents, precious metals, real estate etc. This distribution enables diversification of funds among various sectors and asset classes. It helps in gaining a balance between an investors return objectives and his risk appetite, as the risks and returns are not the same for all asset categories.
Asset Backed Security (ABS)
A fixed income security that is collateralized or securitized by the cash flows from other assets, usually smaller, illiquid assets that are pooled together. Examples of ABS collateral are credit cards, home equity loans, auto loans and student loans. Other names for ABS are Securitization and Structured Finance.
Any swap written to transform the cash flow characteristics of an asset in order to replicate the cash flows characteristics of another asset. The combination of the original asset together with the swap often constitutes a synthetic instrument.
Asset/liability Management (ALM)
Simply known as ALM. 1) In a portfolio management context, it is the management of assets and/or liabilities in such a way as to match cash flows, durations, or maturities of assets and liabilities. 2) In commercial banking, it is the management of the balance sheet including interest rate, prepayment, credit and liquidity risks. There are some institutions that refer to ALM as risk management. Using this title all risks, including operational risk, would fall under this umbrella.
A situation in which an option’s strike price and the current market price of the underlying asset are the same.
1). A process used to analyze the sources of excess returns from a portfolio against its benchmark into the active decisions of the investment management process. This process helps to separate investment management skills from performance by luck.
2). The process of identifying the source of excess returns from a portfolio over its benchmark wherein a fund manager’s performance is evaluated based on returns due to style allocation, sector allocation, stock selection and activity.
A maturity measurement indicating the average amount of time that principal and interest will be received. It is calculated by weighting the future cash flows by the time period they are received divided by the original principal. Used in the U.S. mortgage markets to approximate the maturity of the security, the yield of the mortgage backed security is compared to the yield of the Treasury security whose maturity most closely matches the average life of the mortgage.
Also known as discount basis. A yield measure used to express the yield on certain non-coupon bearing securities, such as T-bills, that always sell at a discount from face value.
Bank Reserve Requirements
The Federal Reserve requires banks to put “in reserve” a certain portion of their deposits.
A bond portfolio structuring technique where investments are made primarily in securities with only short term and long-term maturities. Such a strategy helps in achieving a targeted average maturity or duration and the price volatility of an intermediate bond. This strategy allows one portion of the portfolio to take advantage of high yields, while the other portion controls risk. When compared to an intermediate bond a barbell has an advantage of higher convexity.
A type of exotic option that provides a payoff if the value of the underlying reaches (or does not reach) a predetermined price or “barrier level”. Barrier options are called “knock in” if the right to exercise the option is met, or “knock out” if the right is not met. It is characterized as “up” if the price of the underlying is above the barrier, and as “down” if the price is below the barrier.
1) Generally refers to the differences in two prices.
2) Also can refer to the day count convention uses in fixed income securities. For example, in the United States, money market instruments pay interest on an actual over 360 days basis or day count convention. The basis is 360 days. (The United Kingdom pays actual over 365).
An interest rate equal to one one-hundredth of 1 percentage point, that is, 0.01 percent. The term “basis points” is often abbreviated in the text as “bps.”
1) The degree to which the difference between two prices fluctuates.
2) The residual risk that remains after a hedge has been placed.
A swap in which both counter-parties pay a floating rate of interest but these are tied to different reference rates. Also called floating-for-floating interest rate swaps.
Securities which are physically held by investors. To receive interest payments, the holder actually clips the coupon and sends it to the obligor.
A standard that works as a reference point for performance measurement. A benchmark is usually an index comprised of securities from various asset classes such as stocks, bonds etc. The Benchmark selected has characteristics similar to that of the investment strategy for which the benchmark is applied.
Arises from using an incorrect or inappropriate benchmark to compare and assess portfolio returns and management.
An option which can be exercised only on certain discreet dates after the premium is paid and up to expiration.
Measures the price/yield sensitivity of a security versus the market as a whole. A beta of 1 means the security has the same degree of price sensitivity or price risk as the general market. A beta < 1 means the security is less sensitive and a beta > 1 means the security is more sensitive than the general market.
The price that a buyer is willing to pay for a security. In regard to the bid-ask spread, it is the left side of the quote and is the price at which the buyer of the security is offering to buy.
Also called bid-asked spread. The difference between the bid price and the asked price for any marketed instrument. In dealer markets, the bid-asked spread is one source of the dealer’s income.
Treasury bills or T-bills as they are known in the market, are short-term, discounted government securities issued for one year or less. T-bills are extremely liquid.
Also known as all-or-nothing options, digital options and Bet options. Options that pay a fixed amount of cash if they expire in the money, no matter how deeply, otherwise nothing.
Board of Governors of the Federal Reserve
The Federal Reserve’s governing body.
A marketable debt obligation of an issuer. Issuers are governments, agencies and corporates.
Bond Anticipation Notes
When a municipality or local government requires short term funding in anticipation of issuing longer dated notes/bonds.
Bond equivalent yield (BEY)
Also known as the coupon equivalent yield. A method of calculating and stating the yield on a coupon bearing instrument. Most often assumes semiannual compounding.
1) Market slang that means that a transaction giving rise to a position is recorded among the institution’s assets and/or liabilities.
2) Market slang that refers to an institution’s portfolio of some specific asset type such as a “swap book,” a “foreign exchange book,” and an “options book.”
As the term is used in swap finance, an iterative numerical procedure to determine the implied spot yield curve from the conventional yield curve.
British Bankers’ Association (BBA)
A London-based trade association that deals with matters of common interest to member banks. The BBA documentation can be used for swaps and forward rate agreements.
A banking term that describes a loan in which the principal is repaid in a single transaction upon maturity of the instrument.
The ups and downs of the economy measured by four phases: peak, recession, trough and recovery and expansion.
Buy and hold strategy
A passive portfolio management strategy in which stocks or bonds are purchased and held for several years or up to maturity regardless of the market’s fluctuations. Such a strategy enables investors to minimize the cost of transactions and tax obligations from capital gains.
The date specified as such for the calculation of the cash settlement amount on an interest-rate or exchange-rate contract. If the calculation and settlement dates differ, the calculation date will precede the settlement date.
1). An option that grants the holder the right to buy the underlying asset from the option writer.
2). The act of redeeming an instrument prior to its scheduled maturity.
A feature on a bond allowing the issuer to buy back or call the bond at a specific price and on a specific date.
A swap that may be terminated prior to its scheduled maturity at the discretion of the fixed-rate payer.
The difference between market value of a bank’s/financial institution’s assets and liabilities. The primary purpose is to protect against large unexpected losses. As seen in the ‘credit crisis’ it is also meant to instill confidence to external investors and protect the firm’s credit rating.
Refers to a desired level of capital maintained by a financial institution to cover losses. It is an indication of the firm’s ability to remain a viable concern.
Capital Adequacy Ratio (CAR)
See capital ratio.
An increase in the value of a portfolio or a particular security due to a rise in the market price from the time of purchase to the time of sale.
Capital Asset Pricing Model (CAPM)
CAPM explains the relationship that should exist between the expected return and the risk, of a security or a portfolio. This theory is concerned with deriving the expected or required rates of return on a risky asset based on the asset’s systematic risk level measured by beta. In this financial model, the cost of capital for any security or portfolio of securities equals a risk-free rate plus a risk premium that is proportionate to the systematic risk of the security or portfolio.
Capital Market Line
A straight line in a risk-return map showing all the combinations of total return and market risk that are possible by allocating capital between an optimal portfolio of risky assets and a risk-free investment.
Markets that bring issuers of debt and equity together with investors.
Also known as capital adequacy ratio (CAR) and risk based capital ratio. It is a measure, specifically a ratio, of a financial institution’s capital position. In general, it is the amount of capital held by the firm divided by the amount of assets adjusted for risk:
Multi- period cash settled options on interest-rates. The cap purchaser receives a cash payment whenever the reference rate exceeds the ceiling rate (also called the cap and sometimes called the contract rate) on a fixing date.
Cash flow stream
The series of cash flows associated with a debt instrument, swap, or other derivative instrument.
The payments made by one party to a contract to another party to the contract.
1) A transaction made for immediate settlement.
2) In futures trading, refers to contracts that do not provide for physical delivery of the underlying asset. Instead, contracts are settled in cash on a final settlement date using a mark-to-market procedure.
A combination involving a fixed-for-floating interest rate swap and a fixed-for-floating currency swap in which both floating rate sides are LIBOR based in the same currency. Allows for the creation of a fixed-for-fixed or floating-for-floating currency swap.
Exchange affiliated organizations that handle the clearing, settling, matching of trades.
Also called an offsetting trade. A trade that closes an existing position by taking an offsetting position equal and opposite to that of the existing position.
1) An interest rate collar or simply collar, is the purchase of a cap and the sale of a floor. A collar is constructed to reduce the cost of the cap.
2) The term collar can also be used to purchase a put and sell a call.
Collateralized Bond Obligation (CBO)
Securitized product that is backed by low quality, or junk bonds. The cash flows are divided, or tranched into different risk exposures. CBOs are issued as investment grade bonds even though they are backed by junk bonds because the credit diversification within the structure increases the credit quality of the bond.
Collateralized Debt Obligations
Known as CDO’s, the pooling of bonds (CBO’s) or loans (CLO’s) that are transferred to a trust and the claims to these assets are subsequently sold to investors in different classes or tranches. Each tranche has different credit and investment characteristics.
Collateralized Loan Obligation (CLO)
Securitized product that is backed by bank loans. The cash flows are divided, or tranched into different risk exposures. The sale of the loans allows the financial institution to reduce regulatory capital requirements.
Collateralized Mortgage Obligation
Known as a CMO or REMIC (Real Estate Mortgage Investment Conduit). A structure which allows issuers to carve the cash flows of the underlying pass-through securities into various classes or tranches having different investment characteristics.
Short-term corporate IOUs often used as part of a rollover strategy to obtain long-term financing at lower cost. Often called paper and sometimes denoted CP. May be placed directly or through commercial paper dealers. May be used as an index for leg of a swap.
Swaps that are structured to convert floating-prices paid (or received) for commodities to fixed prices, or vice versa. These swaps have a similar structure to interest-rate swaps.
A tranche of a CMO, companion classes absorb the excess cash flow generated by faster prepayments so that the other tranches in the structure, such as PACs and TACs have more stable cash flows. Further, when prepayments are slow, the companion classes will extend so that the PACs and TACs in the structure can receive the required cash flows. Companion classes have the most volatile cash flows in a CMO structure, even more so than the underlying collateral.
A situation in which one country (or firm) can produced a good (or engage in a borrowing) at less cost than another country (or firm) in the special sense that it must sacrifice less of an alternative good to achieve production. The term is associated with the Theory of Comparative Advantage used to explain trade between nations.
The rate of return earned on an investment when all of the cash flows received over a given time period are reinvested. The rate takes into account earning interest on interest.
When an initial investment earns interest, the newly earned interest also begins to earn interest. It may be thought of as earning interest on interest. May also be referred to as the effective rate.
Conforming loans meet FNMA and FHLMC eligibility requirements. Among the requirements that are necessary to qualify as a conforming loan, the two most important are: maximum loan size, which changes every year and minimum loan to value ratio, also subject to change. Use of property and payment to income ratio are also analyzed.
Arrangement entered into, before an event occurs which would trigger losses exceeding a certain threshold, giving the company the flexibility to raise capital by issuing securities or borrowing money to cover those losses. Generally a fee is paid by the company to the party who agrees to advance the funds.
The rate of interest (or exchange) to serve as the basis of a cash settlement on a forward contract or an option contract. More precisely, the difference between the contract rate and the reference rate serves as the basis of the cash settlement.
Conventional Mortgages are non-government guaranteed mortgages.
A bond with an added feature where the holder/owner of the bond has the option to exchange the bond for a specific number of shares of the company’s common stock at a future date. The price at which the bond will be converted and the conversion ratio is determined at the time the bond is issued.
A measure of price sensitivity for fixed income securities. Duration measures the linear change in price for a change in yield; convexity is the second derivative of a bond’s price relative to its yield. Convexity explains the price change that is not explained by duration.
Generally speaking, regulators break down capital into tier 1 and tier 2 capital. Tier 1 is considered core capital and generally contains items such as equity and retained earnings and other qualifying items. Tier 2 is referred to as supplemental capital (see supplemental capital).
Debt issued by a corporation. Can be money markets such as commercial paper or note or bonds.
The degree to which the price of one or more securities correspond to each other. Perfect positive correlation, or +1, means that the prices will move 100% in the same direction. Perfect negative correlation, or -1, means that the prices will move 100% in the opposite direction. Zero correlation means that the prices move independently of each other with no distinct relationship.
A principal to a swap or other derivative instrument, as opposed to an agent such as a broker.
Counterparty Credit Risk
A term used in derivatives to define the risk that a counterparty will not meet their obligations under the terms of a derivatives contract. This can be further broken down into pre-settlement and settlement risk. In pre-settlement risk the counterparty defaults prior to maturity. Settlement risk refers to the risk that the counterparty defaults on the day the transaction is to be paid for or settled
(1) The periodic interest payment on a debt instrument.
(2) The periodic interest payment on the fixed-rate side of an interest rate or currency swap.
Bonds that pay periodic interest. The periodic payment is called the coupon.
The dates that the coupons are paid and can be annual, quarterly, semi-annual or monthly.
(1) The fixed rate of interest on a debt instrument.
(2) The fixed rate of interest on the fixed-rate side of a swap.
The process of analyzing financial and non-financial information on companies, individuals, sovereign states, local bodies or any other obligation seeker in order to estimate the ability of the obligation seeker to live up to its future contractual obligations. The inputs to credit analysis are from many sources, some of which include: detailed financial analysis, industry analysis, economic analysis, and views of the experts. The output of a credit analysis process is usually a subjective judgment on the credit quality (rating) of the obligation seeker.
Credit Default Swaps
A financial contract where the protection buyer (PB) pays a premium commonly referred to as a spread, to the protection seller (PS). The amount paid will be based on the percentage (basis points) of a notional principal. The notional is agreed up front between the PB and PS. The premium is broken down into two parts. First a fixed coupon is paid by the protection buyer to the protection seller for the life of the contract. It is generally paid quarterly and in arrears. Second the difference between the fixed coupon and the current market spread will be present valued and settled up front. If the current spread is higher than the fixed coupon, the PB pays the PS. If the current spread is lower than the fixed coupon the PS pays the PB. In return the PS agrees to make a payment to the PB, contingent on a credit event.
Payment trigger in a credit derivative, resulting from bankruptcy, failure to pay or restructuring.
The risk that a counterparty to a contract will be unable to fulfill its obligations due to bankruptcy or other cause.
A reference to the likelihood that a party to a contract will default on its obligations. The greater the likelihood of default the less creditworthy is the party.
Also known as foreign exchange markets, FOREX markets, and FX markets. These are the markets in which the world’s currencies are exchanged.
An agreement between two parties providing for the exchange of a future series of interest and principal payments in which one party pays in one currency and the other party pays in a different currency. The exchange rate is fixed over the life of the swap.
Newly originated mortgages represent the current coupon in mortgage issuance. In the MBS market, practitioners refer to the current coupon as the coupon trading at or near par.
Cash received on a regular basis in the form of interest, dividend etc. from investments such as stocks, fixed income securities, or mutual funds.
A financial institution with the legal responsibility for safekeeping, administering and servicing customers’ assets.
Industries with high betas, specifically, consumer durables, properties, capital equipment.
Various fixed income instruments follow set conventions to calculate interest. In the United States, money market instruments calculate interest using the actual number of days over a 360-day basis (act/360). Many U.K. commonwealth countries use an act/365 and not act/360. (U.S. credit unions also follow this act/365 day convention). U.S. Treasuries calculate accrued interest on an actual number of days over actual number of days (act/act). U.S. corporate bonds calculate accrued interest assuming there is 30 days in every month and a 360-day basis (30/360).
Dedicated Cash Flow Matching
One of the methods of constructing a dedicated portfolio. It involves developing a portfolio of bonds that will provide an income stream by way of coupon payments, and principal payments at maturity, which will exactly offset a specific set of liabilities over a given time period.
A bond portfolio management strategy in which cash flows from specific assets are earmarked to retire a specified set of liabilities over a period of time. Dedicated portfolios are normally immunized against interest rate risk. Dedication can either be “Cash Flow Matched” or with “Reinvestment”.
1) The risk that a party to a contract will fail to make a payment when required to do so. Usually associated with an inability to make the payment due to insolvency or bankruptcy. When used in this way, the term is synonymous with credit risk.
2) In swap markets, the term is used more broadly to describe the risk of an “event of default.”
3) In swap markets the term is sometimes used to describe a swap bank’s exposure from the combination of credit risk and market risk.
Counterparty to a derivative transaction that has committed an event of default.
Non-cyclical stocks having low betas in industries such as food retailers and public utilities.
A contract delivery schedule that involves a period of time longer than that customary for cash transactions, implying immediate delivery. Both futures and forward contracts involve deferred delivery.
Delayed rate setting swap
Also called a deferred rate-setting swap. A fixed-for-floating interest rate swap in which the swap commences immediately but the swap coupon is not set until later.
Deliverable obligation (DO)
Obligation/security that will be delivered if a credit event is triggered.
Also called settlement risk. The risk that differences between market settlement hours may result in exchanges of interest and/or principals at different times or even on different days. The first paying party is exposed to the risk that the later paying party will default after the first paying party has made its required payment but before the later paying party has made its payment.
Delta shows the relationship between the price of an option and the asset underlying the option. It is the ratio of the change in the price of an option to the change in the price of the underlying asset. It shows the amount by which an option’s price will change for every one-unit change in price of the underlying asset.
The buying or selling of the underlying instrument in order to eliminate the exposure of the underlying price movement found in the price of an option.
An instrument that is defined on, and whose value is a function of, some other instrument or asset. Examples include futures, options, and swaps.
Digital FX linked note
A plain vanilla FX linked note combined with a digital option. Coupon payment is determined by the strike rate (pre-determined exchange rate) of the embedded option.
See binary option.
When the price of a security is below par (100.00), the bond is said to be trading at a discount and when it is trading above par it is trading at a premium.
1) The rate that banks can borrow money from the Federal Reserve.
2) The rate used to discount future cash flows to determine the current value of the instrument.
3) The rate used in certain money market instruments e.g. U.S. Treasury Bills, when there is no coupon. The interest is said to be paid up front i.e. the interest amount is calculated first using the discount rate and the appropriate conventions and then subtracted from the principal. Therefore the equivalent yield will always be higher than the discount rate.
The act of taking a future cash flow(s) and present valuing them to determine the current market value.
Risk on an individual security that can be eliminated by owning that security in a well-diversified portfolio of assets. Also known as non-systematic risk, specific risk.
The product of the modified duration and the market value of the bond. Dollar duration expresses the price volatility of an asset or portfolio of assets in absolute dollar amounts as opposed to modified duration which shows the price volatility in terms of percentage changes in price.
Dollar Value of a Basis Point (DVBP, DV01)
The dollar value change that would result from a 1 basis point change in an instrument’s yield. In order to make the definition usable, the DVBP must be stated per some amount of face value.
Dual currency note
A dual currency note (DC) pays coupons in the investors’ domestic currency with the notional in the issuers’ domestic currency.
A measure developed by Frederick Macaulay that allows for accurate measurement of a debt instrument’s price sensitivity to yield changes. Duration is the instrument’s weighted average time to maturity.
A measure of price sensitivity for fixed income securities having embedded options, such as callable bonds and mortgage backed securities. Changes in cash flow due to changes in interest rates are taken into account such that the effective duration estimates the change in the price of the security for a 100 basis point change in yield.
The rate of return earned on an investment when all of the cash flows received over a given time period are reinvested. The rate takes into account earning interest on interest. May also be referred to as the compounded rate.
Market participant that uses the market makers price.
A debt instrument issued in the Euromarkets (excluding money market instruments).
Any Euro market for longer-term debt instruments (specifically excludes the money markets). Examples include Euro sterling and Euro yen.
Dollar-denominated bonds and bond-like instruments sold outside the United States
An option that can only be exercised during a limited exercise period at the very end of the option’s life.
Also called foreign exchange rate. The price of one unit of one currency stated in terms of units of another currency.
The risk that on closing a position, the current exchange rate will be different then the original contract rate.
Also known as strike price. The amount that must be paid (or the price that will be received) by an option owner to buy (or sell) the underlying asset from the option writer.
The final maturity of an option contract.
The redemption value of a bond. Also known as par value.
Federal Housing Administration is responsible for the various mortgage insurance programs for the U.S. Department of Housing and Urban Development.
Federal Home Loan Mortgage Corporation, or Freddie Mac, is a government sponsored enterprise or GSE. FHLMC is a public, shareholder owned company trading on the New York Stock Exchange. FHLMC provides low-cost funds to mortgage lenders, which in turn lend to home buyers throughout the United States. FHLMC supports the secondary mortgage market for conventional mortgages. Put into conservatorship September 2008.
A person who is legally authorized to supervise the investment portfolio of a third party and make investment decisions in accordance with the wishes of the beneficiary. Examples of fiduciaries include executors of wills and estates, trustees, and those who administer the assets of the underage or incompetent beneficiaries.
Fixed Income Security
A marketable debt obligation where an issuer agrees to pay a certain amount of interest over the life of the security.
Fixed-for-floating rate swap
A swap in which one counterparty pays a floating rate of interest while the other counterparty pays a fixed rate of interest. This is the most common type of swap.
Floating rate notes
Notes issued with a floating rate of interest that is tied to a specified index, such as LIBOR.
Also referred to as an interest rate floor. A multi-period interest-rate option that provides a cash payment to the holder of the option whenever the reference rate is below the floor rate (also called the “floor” and sometimes the contract rate”) on a fixing date.
Federal National Mortgage Association, pronounced Fannie Mae, is a government sponsored enterprise or GSE. FNMA is a public, shareholder owned company trading on the New York Stock Exchange. FNMA provides low-cost funds to mortgage lenders, which in turn lend to home buyers throughout the United States. FNMA supports the secondary mortgage market for both government insured and conventional mortgages. Put into conservatorship September 2008.
Also called a forward. A contract for deferred delivery traded in over-the-counter dealer-type markets. Less standardized than a futures contract but more easily tailored to commercial users’ idiosyncratic needs than futures.
Forward exchange rate
Current rate of exchange for a foreign exchange transaction scheduled to take place at a later date. Also called a forward rate, but the latter term can also refer to a forward interest rate.
Forward rate agreement (FRA)
An interest-rate forward contract written on a notional principal and cash settled on the basis of the difference between the contract rate and the prevailing reference rate on the settlement date. The resultant settlement value is discounted to adjust for an up-front settlement.
Also called a deferred swap. A fixed-for-floating interest rate swap in which the swap coupon is set at the outset but the start of the swap is delayed.
Forward yield curve
A yield curve currently expected to prevail at some later date. For example, a three-month forward yield curve graphically shows a series of 3 month forward rates.
The amount that a sum of money invested today, earning a simple or compounded interest, will be worth at a future date
Also known as futures. Standardized contracts for deferred delivery (or cash settlement) of commodities and financial instruments. Always traded on a designated futures exchange and regulated by the Commodity Futures Trading Commission.
An exchange is a central meeting place where buyers and seller come together to exchange goods and services. A futures exchange is where buyers and sellers meet to buy and sell futures and options contracts. Must be designated a futures exchange by the Commodities Futures Trading Commission (CFTC).
All futures contracts having identical terms (including the same delivery month) and trading on the same exchange constitute a series.
A series of futures contracts with successive delivery (settlement) months. Most often used to refer to a series of interest-rate futures such as Eurodollars.
A measure of the compounded rate of return of the market value of the initial portfolio during the evaluation period, assuming that all cash distributions are reinvested in the portfolio. Geometric Return is given by the nth root of the product of the returns for n number of years.
Government National Mortgage Association, pronounced Ginnie Mae, is a wholly owned U.S. government agency guaranteeing government issued or guaranteed mortgages.
A position taken in order to offset the risk associated with some other position. Most often, the initial position is a cash position and the hedge position involves a risk-management instrument such as a swap or a futures contract.
Pooled investor funds that are aggressively managed by professionals with the goal of generating high returns. Hedge funds use leverage and derivative instruments to aid in generating high returns and attract a more sophisticated type of investor, ie, requiring minimum amounts of income and money to invest, to be eligible.
The number of units of a hedging instrument that must be held to minimize the overall portfolio variance (cash position and hedge combined) of a portfolio or individual instrument.
High Yield Bond
Also called junk bonds, these bonds have a credit rating of BB or lower. A high yield bond is considered a speculative grade bond or below investment grade bond and is issued by companies with a higher credit risk. As the name suggests, a high yield bond earns high gross income, to compensate for the high credit risk.
A measure of the actual volatility (a statistical measure of dispersion) observed in the marketplace.
A variant of immunization strategy, in which the cash flows due up to a certain intermediate horizon are matched on a cash flow basis, and the cash flows due after this intermediate horizon are matched on a duration basis.
A hybrid security that the issuer classifies or structures as capital. Generally between debt and equity in regard to subordination.
A security that has features of both equity and fixed income securities.
IMM settlement dates
The settlement dates of IMM Eurodollar futures contracts. These dates are often used as settlement dates on forward rate agreements, and swap contracts
Short-dated swaps that are priced off the IMM’s Eurodollar futures strip.
A bond portfolio strategy of matching the modified duration of the assets in a portfolio to the liability it is intended to pay off through portfolio rebalancing. The term of the liability represents the investment horizon of the investor. This strategy helps to eliminate interest rate risk, as interest rate changes will have equal and offsetting effects on the investor’s portfolio of assets and liabilities.
Inferred from option pricing model (typically Black-Scholes) using the market value of an option and solving for the value of volatility consistent with the observed value of the option. Inputs include price of underlying, strike price of option, interest rates, time to expiration, volatility and type of option.
In the case of a call option, a situation in which the price of the underlying asset exceeds the strike price of the option. In the case of a put option, a situation in which the price of the underlying asset is below the strike price of the option.
A statistical measure of the weighted value of a group of securities used as a performance indicator. Example: S&P 500, Dow Jones, FTSE Indices etc. Indices act as mirrors of any given market (stock market or bond market), industry or economy and as benchmarks against which the performance of individual securities or portfolios is measured.
A passive portfolio management strategy, which aims to replicate the performance of a select index such as, the S&P 500, Dow Jones, and FTSE Indices etc, by investing in companies that make up the index.
The increase of prices within the economy.
Inflation Linked Notes
Corporations and Government Sponsored Enterprises issue inflation-linked structures as part of their overall funding program. The notes are typically issued with a “floating coupon” structure based on the change in the Consumer Price Index for All Urban Consumers (CPI) over the previous year. The inflation component is added to the fixed rate coupon and paid to the investor. At maturity, the initial investment is returned to the investor without any inflation adjustment. Therefore, a portion of each interest payment is meant to offset inflation, and the remainder is the real return.
The rate differential between instruments of the same maturity but denominated in different currencies.
Interest rate anticipation swaps
A portfolio immunization strategy where bonds in a portfolio are exchanged for new bonds in order to achieve the target portfolio duration, given the investor’s expectations about changes in interest rates.
Interest rate option
Generic term used to imply inters rate caps, inters rate floors or inter rate collars. See caps, floors and collars.
A combination of an interest-rate cap and an interest-rate floor such that a cap is purchased and a floor is sold. The effect is to place upper and lower bounds on the cost of funds.
Futures on debt instruments or debt indexes. Known as bond futures or short term interest rate futures (STIRs) depending on the underlying asset.
1) The risk that on closing a position, the current interest rate will be different then the original contract rate.
2) The price risk associated with holding a fixed-rate debt/derivative instrument as a result of fluctuations in the instrument’s yield.
An agreement between two parties to engage in a series of exchange of interest payments on the same notional principal denominated in the same currency.
Internal rate of return (IRR)
The discount rate that equates the sum of the present values of the cash flows associated with an investment with the initial cost of the investment.
International Swap and Derivatives Association (ISDA®)
A New York-based trade association that deals with matters of common interest to member swap dealers.
A major component of an option’s value. It is the greater of the amount by which an option is in-the-money or zero.
Bonds whose coupon rates increase as rates decline and decrease as rates rise. The coupon rate is based on a formula using an index and moves in the opposite direction of changes in that index. Some inverse floaters may be a type of structured note. Other inverse floaters, such as interest-only (I/O) and principal-only (P/O) strips are types of collateralized mortgage obligations (CMOs).
Investment grade bond
Any bond that has been rated as such by a rating agency. In the case of Moody’s, Standard & Poor’s and Fitchratings, these would be ratings of Baa or better and BBB or better, respectively.
The time period over which an investor wishes to keep his money invested. Investment horizon varies from one investor to another depending on their investment objectives in terms of risk, return, market conditions and most importantly their liability profiles.
Investment Policy Statement (IPS)
A formal written plan, which communicates the long-term investment objectives, constraints and guidelines to be followed for achieving investors’ objectives. It lays down the possible courses of action that have to be followed to achieve the investment objectives.
A bond portfolio construction strategy in which equal amounts are invested in every maturity within a given range.
An acronym for London Interbank Offered Rate. This interest rate is the standard rate for quoting interbank lendings of Eurocurrency deposits.
LIBOR quoted without any premium or discount.
Loan Loss Reserves
Reserves which are intended to absorb anticipated, or expected, losses. Provision for loan losses is an expense item in the income statement.
A party is said to be long an instrument when he or she owns the instrument.
A measurement of the price sensitivity of a fixed income security to changes in interest rates. Macaulay duration is measured in years and is the weighted average of the security’s cash flows.
The study of the entire economy in terms of total goods and services produced, total income earned, the level of employment and the general behavior of prices.
The compensation paid to the investment advisor / manager by a mutual fund or Investment Company or investors for the services rendered.
1) In futures trading refers to a required performance bond tendered by a party to a futures contract.
2) Buying on margin refers to borrowing money, generally from a broker, to buy securities.
Also known as a dealer. A party that makes a market in an instrument by offering to both buy and sell the instrument. The market maker profits from the difference between its bid and ask prices.
The risk that current market prices will deviate from the contracted rate. Refers to equity, foreign exchange, interest rate and commodity risk.
1) The practice of periodically adjusting a margin account by adding or subtracting funds based on changes in market value. The practice has long been employed in futures trading and for writers of options.
2) The revaluation of a financial instrument or portfolio based on current market rate(s) and the current make up of the portfolio.
1) The date a fixed income security matures and the issuer repays the principal to the investor.
2) In options, the maturity refers to the expiration date of the contract.
Medium term notes
Fixed income securities that are not traditionally underwritten but offered through a shelf registration that is filed with the SEC. After SEC approval, the company can issue notes of any size and with any coupon or maturity, for up to two years after the filing.
The study of total goods and services produced, total income earned, the level of employment and the general behavior of prices on the level of individuals and firms within the economy.
The risk to a portfolio from failing to precisely match the risks associated with the underlying portfolio. For example, a swap book may mismatch maturities or notional principals and will be exposed to the respective risks.
A modified form of duration obtained by dividing the duration measure developed by Macaulay by 1 plus the yield divided by the frequency of the coupon payments. Measures the percentage price change of a fixed income security given a change in yield.
Refers to the amount of money circulating within the economy. Monetary policy is used by central banks or other monetary authorities to impact economic performance by controlling the money supply.
Money market instruments
Debt instruments having a maturity of less than one year.
Money market yield
Also known as money market basis. A method of calculating the yield on certain money market instruments. The method assumes the payment frequency is annual and uses an actual over 360 day count convention in the yield calculation. Some countries use a 365-day basis for their money market calculations. U.S. credit unions use an actual over 365-day basis.
Monte Carlo Simulation
A simulation that attempts to simulate the future using an uncertain variable. For example, to simulate the future stock price, a simulation may use an algorithm using the current price, mean/average of the stock and volatility/standard deviation. The simulation will randomly generate a term that will change the volatility resulting in a single simulated future price. However, the Monte Carlo method refers to the simulation being run hundreds if not thousands of times with each simulation referred to as a path. In this simplistic example, the future price is determined by taking the average of all of the prices. Customary way to value MBS and other securities with embedded options. Monte Carlo simulations generate numerous random interest rate paths, present valuing the cash flows of the security under each path while taking the option into account, to derive the value of the security.
Known by the acronym MBS. Securities backed by whole mortgages or by mortgage pass-through certificates. Mortgage pass-through certificates are themselves mortgage-backed securities.
Bonds issued by state and local governments, often known as general obligation bonds. The credit worthiness is based on the credit of the municipality. Special Revenue bonds are issued by agencies or authorities of state and local governments for specific public work projects, the cash flows of these projects secure the bond. The coupons paid to investors are tax-exempt from Federal taxes and often tax-exempt from the issuing State’s income taxes.
A type of investment fund which pools investors’ monies together, targeting a specific market and/or sector, which is managed by professional asset managers. Mutual funds offer the individual investor diversification that they generally cannot get on their own. The investor buys shares in the fund and participates in the fund’s gain or loss on a pro-rata basis.
Nationally Recognized Statistically Rating Organization (NRSRO)
Moody’s, Standard and Poor’s, FitchRatings and Egan-Jones are the most well-known of the 10 NRSRO’s.
Convexity is defined as the property of a financial instrument that dictates the amount by which its value changes with changes in market rates. For example, a MBS is said to have negative convexity if its price rises by an amount p1 when yields fall, and its price falls by an amount p2 when yields rise, and if p1<p2. Negative convexity is undesirable for the investor. Graphically, the curve of the instrument’s price against its yield will be a concave curve.
Assets will move in the opposite direction. Benefits of diversification are greater when assets are negatively correlated.
1) The standard practice in swap documentation requiring that only the interest differential on interest-rate swaps be exchanged with the higher paying party making payment of this difference to the lower paying party.
2) The reduction of risk exposures by netting payments under a master swap agreement. This includes other derivative instruments such as caps, floors etc.
The spread, in basis points, that a security is trading over the appropriate maturity Treasury security.
The rate of return over a given time period, e.g., quarterly or semi-annually, without taking compounding into account.
A debt obligation in which the full principal is repaid in a single transaction upon maturity of the debt with no repayments of principal prior to maturity. See also bullet transaction.
A shift in the yield curve where the short end of the curve doesn’t move by the same number of basis points as the long end of the curve. Can result in a widening, flattening and inversion of the yield curve.
The amount of principal on which the interest is calculated on a swap or related instrument including FRAs and interest rate options. In the case of interest rate swaps, FRAs, and interest-rate options, the principal is purely “notional” in that no exchange of principal ever takes place.
1) The outcomes expected of a particular strategy or course of action within a given time frame.
2) Investment objectives refer to the investor’s goals expressed in terms of risk and return profiles, acceptable asset classes, and acceptable trading strategies and are included in the policy investment statement.
Whenever a swap or other instrument must be priced with a coupon or floating rate that deviates from currently prevailing market conditions.
A position with potential financial consequence that does not appear on either the asset side or the liabilities side of a balance sheet. The advent of recent accounting changes such as FAS 133 and IAS 39 require these instruments to be accounted/recognized on the balance sheet. However, the term OBS still tends to be used in the marketplace.
Those U.S. Treasury securities that are not the most recent issues for their respective maturities.
Those U.S. Treasury securities that are the most recent issues for their respective maturities.
Open market Operations
The buying and selling of securities in the “open market” by central banks. Purchasing securities by central banks adds money to the banking system and selling securities by central banks drains money from the banking system.
A portfolio of risky assets that maximizes the Sharpe ratio or the Treynor ratio.
Option adjusted spread (OAS)
Refers to the spread over Treasuries after an adjustment is made for the value of the embedded call option. OAS present values the future cash flows by using some constant spread over the Treasury spot curve such that it takes into account any potential exercise of embedded options. Also known as an effective spread.
A contract giving the owner the right, but not the obligation to purchase or sell the underlying asset. A call option gives the owner the right to buy the underlying asset at the strike price and a put option gives the owner the right to sell the underlying asset at the strike price. Option contracts have set maturities, e.g., 30 days.
The name given to the price paid for an option or an option-like feature. The premium is determined by two types of value called intrinsic value and time value.
In the case of a call option, the price of the underlying asset is below the strike price of the option. In the case of a put option, the price of the underlying asset is above the strike price of the option.
Known more commonly by the acronym OTC. A dealer market in which transactions take place via telephone, Reuters, Bloomberg and other electronic forms of communication as opposed to trading on the floor of an exchange. Such markets allow for great flexibility in product design.
A repurchase agreement that provides for a secured lending for a period of one business day.
The redemption value of a bond. Also known as face value.
With reference to yield curve movements, a parallel shift is an equal shift of the whole curve; either upwards or downwards. A parallel shift in the yield curve occurs when the interest rate on all maturities increases or decreases by the same number of basis points.
A security backed by mortgages where the interest and principal paid on the underlying mortgages is passed through to the holders of the pass-through security on a pro-rata basis, less any servicing and guaranty fees.
An investment strategy which aims to track the performance of an index but not to beat it. Buy and hold strategy and indexing are passive management strategies.
Compares the actual performance of the portfolio with the desired performance, on the parameters of returns and risks. It also includes attributing the reasons for the variances.
The process of quantifying the performance of a security/portfolio by calculating returns generated and the risks faced by the portfolio over the measurement period.
The risk that the performance of a portfolio / manager may not track the appropriate benchmark over the next measurement period. Investors try to minimize this risk by allocating the investments to two or more investment managers.
The simplest form of a financial instrument. Often associated with the first manifestation of an instrument, e.g. a “plain vanilla swap”.
Planned Amortization Class (PAC)
A structure to give the investor more stable cash flow by channeling prepayments from the underlying mortgage pass-throughs to companion or support classes.
A set of investments made by an investor in assets such as stocks, bonds, money market instruments, mutual funds, precious metals, real estate etc. with different risk/return characteristics and maturities. A well structured portfolio offers an investor the benefit of diversification which an individual security, asset class or investment sector may not offer.
The weighted average duration of a bond portfolio. The modified duration of each bond is multiplied by the market value weight of that bond to the entire portfolio; this product is then summed over all the bonds in the portfolio to get the portfolio duration. This is a measure of the interest rate risk of the portfolio.
The risk and return characteristics of all possible combinations of two assets in a portfolio plotted on a risk-return graph to sketch out a curve whose shape depends on the correlation of the assets.
Positioning a swap
Also called booking a swap. The taking of a position in a swap by a swap dealer. This contrasts with a broker in which the swap facilitator acts as an agent in a swap and does not take the swap on its own books.
Convexity is defined as the property of a financial instrument that dictates the amount by which its value changes with changes in market rates. For example, a straight bond is said to have positive convexity if its price rises by an amount p1 when yields fall, and its price falls by an amount p2 when yields rise, and if p1>p2. Graphically, the curve of the instrument’s price against its yield will be a convex curve.
Assets will move in the same direction. Benefits of diversification are limited when assets are positively correlated.
Power Reverse Dual Currency Notes
A power reverse dual currency note (PRDN) or power reverse dual currency bond (PRDB) is an exotic financial structured product where an investor is seeking a better return and a borrower a lower rate by taking advantage of the interest rate differential between two countries. The power component of the name denotes higher initial coupons and the fact that coupons rises as the domestic/foreign exchange rate depreciates. The power feature comes with a higher risk for the investor. Cash flows may have a digital cap feature where the rate gets locked once it reaches a certain threshold. Other add-on features are barriers such as knockouts and cancel provision for the issuer.
When the price of a security is above par (100.00), the bond is said to be trading at a premium and when it is trading below par it is trading at a discount.
Usually referred to in the ABS and MBS markets, this is the risk that borrowers prepay their loan early. In the mortgage market, homeowners will prepay their mortgage when interest rates decline. As rates decline, the MBS investor will receive their principal back sooner than expected and will have to reinvest the proceeds at lower interest rates, thus exposing them their portfolios to lower returns than originally expected.
The current value of a sum of money that is to be received at some later date.
The market for raising capital by issuing securities, debt or equity, either to the general investing public or to a special class of investors.
The market for raising capital by issuing securities, debt or equity, either to the general investing public or to a special class of investors.
Principal Only (PO)
The principal only cash flows of a mortgage pass-through.
Bonds that are directly placed with investors rather than underwritten and sold to the general public. The issuer doesn’t have to register with the SEC and investors are able to write stronger covenants into the deal. Private placements are less liquid but offer higher yield versus comparable credit/maturity public issues.
The purchase of a put option to hedge an asset or a portfolio from a decrease in price of the underlying asset or assets.
Public Securities Association (now known as the SIFMA) developed a prepayment benchmark based on CPR (conditional prepayment rate). PSA is used as a measure of relative prepayment speeds.
The change in an option’s premium for a given increase in the yield of the underlying instrument. Has the opposite effect of Rho.
An option that grants its holder the right to sell the underlying asset to the option writer at the option’s strike price within a given time frame.
A bond that allows the owner to terminate or redeem the bond prior to its scheduled maturity date.
A fixed-for-floating interest rate swap in which the floating ratepayer has the right to terminate the swap prior to its scheduled maturity date.
Refers to predetermined increase in interest rates over a set period of time. For example, increase the yield curve by 100 bps every six months. Generally used in Asset Liability Management to determine “what if” scenarios on the institutions’ income.
A fixed-for-floating interest-rate swap in which the floating rate side is capped. Can be created as a unit or by combining an interest-rate swap with a separate interest-rate cap.
Real Estate Mortgage Investment Conduit (REMIC)
A structure which allows issuers to carve the cash flows of the underlying pass-through securities into various classes or tranches having different investment characteristics. REMIC is the legal term but market practitioners simply refer to them as CMO’s or Collateralized Mortgage Obligations.
The repayment of a debt obligation.
An index (such as LIBOR, EurIbor or three-month T-bill) designated to determine the interest rate payable on floating rate cash/derivative instruments.
The amount of capital a bank is required to maintain as dictated by regulators.
1) Risk that arises when the cash flows from assets precedes the cash requirements for meeting the liabilities of a portfolio. These early cash inflows need to be reinvested at the future dates, at rates largely unknown today.
2) The risk of reinvesting the incomes or other cash flows at rates other than those envisaged today.
Relative Return Strategy
The measurement of the comparative attractiveness of a security with respect to the associated risks, the liquidity and the return on the security relative to another security.
The measurement of the comparative attractiveness of a security with respect to the associated risks, the liquidity and the return on the security relative to another security.
A swap that is entered to replace a swap that is terminated prematurely. This most often becomes necessary when a one of a pair of matched swaps is terminated early.
Also known as a repo and an RP. A method of borrowing that involves the sale of a security with the simultaneous agreement to buy it back at a specific later date and at a specific price. These agreements are widely used in the securities industry as a means of obtaining relatively inexpensive short term financing.
Required rate of return
Return required by investors to invest in a security that has a specific amount of risk. Also refers to the return required to meet a specific set of liabilities.
An adjustment in a floating rate of interest that marks the rate to that prevailing in the market.
The scheduled dates for the resets of the floating rate of interest on rate swaps.
Reverse Dual Currency Note
A dual currency note (DC) pays coupons in the investors’ domestic currency with the notional in the issuers’ domestic currency. A reverse dual currency note (RDC) is the reverse.
Reverse repurchase agreement
Also known as a reverse and a reverse repo. The opposite of a repurchase agreement. The purchase of a security with the simultaneous agreement to sell it back at a specific later date and at a specific price.
The change in an option’s premium for a change in interest rates.
A measure of uncertainty. Risk measures the extent of uncertainty attached to the realization of the expected return on any asset. It is generally measured through the standard deviation of returns.
Risk Adjusted Return on Capital (RAROC)
The return on an investment after taking into account the revenue and cost, both external and internal, divided by the amount of capital that is first adjusted for the riskiness of the investment. Technically speaking, it is the risk-adjusted return divided by the risk-adjusted capital.
Risk Based Capital (RBC)
The amount of capital required to be held to absorb unexpected losses when taking into account the riskiness of assets/businesses in order to protect customers, depositors and investors.
Risk Based Capital Ratio
See Capital Ratio.
Risk free rate
The return on a risk free asset. This is the guaranteed rate of return earned, when the money is invested in a security with no risk of losing capital and facing no uncertainty in realizing the returns.
Investors or lenders undertake risk while making an investment or lending money to borrowers. A risk premium is the additional rate expected or charged over and above the risk free rate in order to compensate them for accepting or undertaking the risk. The risk premium is expected or charged for various risks such as market risk, credit risk or liquidity risk.
Roller coaster swap
Any swap in which the notional principal increases for a time and then amortizes to zero over the remainder of its tenor.
A seasoned pool of mortgages is one that is outstanding for a while, generally more than 30 months, and experiences faster prepayment levels. This can be due to increased housing turnover coming from homeowners relocating due to trading up, realizing equity gains in real estate value, improved financial situation, etc.
Market where participants buy and sell securities directly with one another without dealing with the issuing company.
The process of measuring the relative investment attractiveness of one sector as compared to another. Various valuation techniques are employed to infer the relative attractiveness of the sectors. The valuation techniques depend on the way the sector is defined, for example, industry sector or yield-curve segment or credit class. Sector valuation plays a major role in the top-down approach for investment management.
Also known as Structured Finance, securitization refers to the combination or pooling of cash flows from various underlying collateral (such as mortgages, credit cards, home equity loans, commercial mortgages, bank loans), then repackaging these cash flows to create securities that are then sold to investors.
Security Market Line (SML)
SML shows the relationship between the expected returns and market risk. According to SML, at equilibrium, the return on a security is equal to the risk free return plus the excess return (over the risk free return) on the market portfolio times the beta of the security.
An annual rate of interest that is paid in two semiannual installments. Not to be confused with a “half-year rate” which is a rate of interest stated on a six-month basis.
With respect to futures, all futures listed on the same exchange and having the same terms, including the same delivery month.
1) In securities trading, the date a transaction is cleared.
2) In futures trading, the date a cash settled contract is marked to the spot price or index.
3) The date that the cash settlement is due on an interest rate contract. This may or may not coincide with the calculation date.
The price established by the clearinghouse of a futures exchange to be used as the basis of the daily marking-to-market of margin accounts
The risk that differences between market settlement hours may result in exchanges of interest and/or principals at different times or even on different days. The first paying party is exposed to the risk that the later paying party will default after the first paying party has made its required payment but before the later paying party has made its payment.
The ratio of the excess total return on a portfolio (over-and-above the risk-free rate) relative to its market risk on the portfolio.
1) A party is said to be short securities if he or she has borrowed the securities (usually for purposes of a short sale).
2) A party is said to be short futures and options if he or she has sold the contracts.
The Securities Industry and Financial Market Association, SIFMA is the combination of the Securities Industry Association (SIA) and the Bond Markets Association (BMA) and represents over 600 member firms in all financial markets in the U.S. and worldwide. SIFMA is committed to enhancing the public’s trust and confidence in the markets, offering forward-looking services and educational resources to financial professionals.
Simple rate of interest
The rate of return over a given time period, e.g., quarterly or semi-annually, without taking compounding into account.
The risk that an issuer may be barred by its government from making interest and principal payments on its debt. In the context of derivative instruments, it is the risk that a counterparty will be barred by its government from fulfilling its derivative obligations.
Special Purpose Vehicle (SPV)
Legal entity created for the sole purpose of issuing securities to investors. In a mortgage backed pass-through, the cash flows of the underlying mortgages are used to satisfy the investor’s interest and principal payments.
Trade date plus two business days.
Spot exchange rate
Also known as a spot rate. The exchange rate quoted for immediate deliver of a currency. As a practical matter, immediate delivery is understood to be two business days. See also exchange rate
1) See spot exchange rate.
2) Refers to a spot interest rate. This is also a zero coupon yield. An interest rate that represents a yield to maturity when there are no interim coupons paid between the initial payment for the instrument and the final redemption.
The amount a security is trading above a specific benchmark. Important measurement to determine bond values.
A statistical measure of dispersion around some central (mean) value. Obtained by taking the square root of the variance.
Static yield spread
The minimum amount of capital required by state regulators to conduct business within the respective state.
Strategic Asset Allocation
Long term strategy for allocating investment capital among various asset classes based on economic conditions and investor risk/return parameters and constraints. Not a trading strategy but a long term, big picture asset allocation strategy.
Also known as exercise price. The amount that must be paid (or the price that will be received) by an option owner to buy (or sell) the underlying asset from the option writer.
Stands for “Separate Trading of Registered Interest and Principle of Securities” and refers to breaking down a coupon bearing bond into its constituent parts of interest and principle payments which can be held /traded separately. These individual cash flows can be traded as zero coupon bonds.
Generally speaking regulators breakdown capital into tier 1 and tier 2 capital. Tier one is considered core capital and generally contains items such as equity and retained earnings. Tier 2 is referred to as supplemental capital and generally contains items such as allowance for loan and lease losses (limited), non-qualifying perpetual preferred stock, certain hybrid capital instruments, mandatory convertible securities, long-term preferred stock and other qualifying items.
A contractual agreement providing for a series of exchanges of principals and/or interest in the same or different currencies. At a more general level, the term includes the exchange of fixed for floating payments on a given quantity of commodity, i.e., commodity swap. See also interest-rate swaps and currency swaps.
An agent, acting on behalf of one or more principals, that finds parties with matching swap needs in exchange for a commission.
The fixed rate of interest on the fixed-rate side of a swap
Also known as a market maker. A financial intermediary that makes a market in swaps and that profits from its bid-ask spread. Unlike a swap broker, the swap dealer becomes a counterparty to each swap.
A term loosely used to describe pricing behaviors in non-swap instruments that are brought about through a linkage to the swap market. Examples include price movements in the futures and forward markets.
An option on a swap. The swaption purchaser has the right to enter a specific swap for a defined period of time.
A basket or combination of instruments that behaves, in terms of its cash flow stream, like some real instrument not included in the original basket.
The degree to which the fluctuations in the value of a financial instrument are associated with fluctuations in the value of the underlying market.
Targeted Amortization Class (TAC)
A tranche in a CMO that is similar to PACs but have a single PSA rate (not a band of PSA rates like the PAC) that protects it from fluctuations in prepayment speeds. TACs are protected against higher than expected prepayment rates but not against extension risk. If prepayments are slower than the pricing speed, then TACs have the same prepayment risk as the underlying collateral.
Tax driven swaps
Asset-based swaps that are used to alter the tax character of a cash flow stream.
The difference between the interest rate on Treasury bills and the interest rate on Eurodollar deposits of similar maturities. The definition applies to both cash instruments and futures contracts.
The length of the life (term to maturity) of a multi-period derivative instrument such as a rate cap, a rate floor, or a swap.
A repurchase agreement having a maturity more than one day.
Term structure of interest rates
Shows the relationship between interest rates on bonds of different maturities, usually depicted in the form of a graph called a yield curve.
Term to maturity
Also referred to as term. The length of time from the present until the maturity of an instrument.
Theta measures the rate of change or “time decay” in the option premium given a change in time i.e. a change in the option’s maturity.
In terms of an option contracts value, the price of the option attributable to the time remaining until expiry, volatility and interest rates. Intrinsic value + time value = premium.
Time value of money
The value of one dollar is worth more in the future than it is worth today since the money can be placed in an interest bearing instrument or deposit and earn interest. Generally refers to future value and present value.
Total Adjusted Capital
An insurance industry term that in general means the statutory capital and surplus, plus any other adjustments for risk based capital requirements or other adjustments, such as affiliates asset value reserve (AVR). It forms the numerator in the risk based capital ratio.
A tool of performance measurement defined as the change in value of an investment over a given period, taking into consideration reinvestment of dividends, interest received and capital gain distributions, expressed as a percentage of the initial investment.
Total Return Swaps
A financial contract where two parties agree to:
- Exchange predetermined cash flows over the life of the contract
- One counterparty agrees to pay on a referenced loan/bond/index/stock while the other
- One counterparty agrees to pay on a floating rate, generally LIBOR +/- spread
There is a final or intermittent settlement, based on cash, or delivery of securities/loans.
Returns are generally measured and benchmarked to a particular index. Tracking error is the difference between the performance of a particular portfolio and the benchmark.
The costs associated with engaging in a financial transaction. These include such explicit costs as commissions and front-end fees and indirect costs such as a bid-ask spread.
Also known as T-bills. Short-term securities sold at a discount from face value by the United States Treasury as part of its ongoing funding operation. Offered in maturities of 13 weeks, 26 weeks, and 52 weeks.
Also known as T-bonds. Long-term coupon-bearing securities issued by the United States government.
Also known as T-notes. Intermediate-term coupon-bearing securities sold at periodic auctions by the United States Treasury to fund its ongoing operations.
The excess total return on an asset or portfolio, over-and-above the risk-free rate, relative to its beta.
U.S. Treasury Securities
Also called Treasuries, sometimes called Governments. Debt issues of the United States Treasury consist primarily of Treasury bills (T-bills), Treasury notes (T-notes), and Treasury bonds (T-bonds).
Refers to the asset/instrument that the derivative contract derives its value from.
Diversifiable risk or residual risk, which is specific to a security and can be removed through diversification. It is the variability of a security’s total returns, which is not related to the overall market variability.
Upward sloping yield curve
Also called an ascending yield curve. The normal shape of the yield curve when short maturity instruments have lower yields than long maturity instruments.
Value at Risk (VaR)
A tool for assessing market risk. VAR measures the expected maximum loss at a given confidence interval over the holding period.
Measures the change in the option’s premium for each 1% change in the underlying instrument’s volatility.
1) Refers to the price or yield of a security or market to rise or fall. Measured by the variance and standard deviation of the security.
2) Bond price volatility refers to the change in the bond price given a change in yields. See: Dollar value of a basis point.
A curve depicting the relationship between implied volatility and time to expiration.
A graph that depicts the relationship between implied volatility and the strike prices of options with the same expiration dates. Implied volatility is on the Y-axis and the options’ strike prices are on the X-axis and the resulting curve is skewed. Different markets exhibit curves of different shapes.
A graph that depicts the relationship between implied volatility and the strike prices of options with the same expiration dates. Implied volatility is on the Y-axis and the options’ strike price is on the X-axis and the resulting curve is in the shape of a smile.
A foreign bond issued in the United States.
A graphic portrayal of the relationship between the yields to maturity of instruments of a given class and the terms to maturity of those instruments. See also term structure of interest rates.
Yield Curve Shifts
Changes in the shape of the yield curve. See parallel shifts and non-parallel shifts.
The difference of yield between various securities, of similar maturity and other features, but with different credit qualities (ratings).
Yield to call
In callable bonds, the yield calculated to the next call date. It assumes the callable bond will be called on this call date thereby contractually canceling all coupon payments past the respective call date and altering the yield earned by the investor.
Yield to maturity
Also called yield. The discount rate that equates the present value of the cash flow stream associated with an instrument and the current price of that instrument. This calculation assumes that cash flows can be reinvested to earn the same rate.
This is used in callable bonds to compare the yield to call and the yield to maturity. Whichever yield is lower is considered the yield-to-worst. (It is also used with other bonds with special features such as puttable bonds but is most frequently associated with callable bonds)
Z bond or accrual tranche, is often the last tranche in a CMO structure and receives no interest payments until the other tranches are paid off. The interest used to pay down the earlier tranches accrues to the Z bond and is added to the principal amount.
The zero-volatility spread or static yield spread. By keeping interest rate volatility at zero, the investor can use this spread to quantify other factors, such as credit risk and liquidity risk, when comparing and valuing different bonds. Uses zero rates, so no reinvestment risk and is calculated by using the entire yield curve, thus, capturing yield curve risk. Disadvantage—doesn’t take into account changes in prepayments and the optionality of the security.
A zero correlation indicates that the securities’ returns are independent of each other.
Zero coupon bond
Also called a zero. A bond that does not pay periodic coupons. In lieu of periodic coupons such bonds are sold at a steep discount from par and redeemed at par.
Zero coupon-for- floating swap
A variant of the fixed-for-floating interest rate swap in which the fixed-rate paying party pays all interest upon the termination of the swap.
Also called spot rate. An interest rate that represents a yield to maturity when there are no interim coupons paid between the initial payment for the instrument and the final redemption.
Zero Volatility Spread
Zero-coupon yield curve
A graphic portrayal of the relationship between yield and maturity when the instruments involved are zero-coupon bonds. Usually drawn for Treasury-based zeros.