Accrued interest Interest that is due on a bond or other fixed income security since the
last interest payment was made.
Additional termination event (ATE) Pre-defined event (such as a ratings downgrade)
that allows a transaction to be terminated at (mid-) market rates.
Annuity A series of payments of fixed size and frequency.
Arbitrage A transaction that generates a profit without any associated financial risk.
Asset swap A swap contract used to convert one type of investment into another.
Usually, a fixed investment such as a bond with guaranteed coupon payments is swapped
into floating payments.
At the money An option is at the money if the strike price of the option equals the
current (spot) market price of the underlying security. At-the-money forward refers to
the forward value of the underlying security and not the spot price.
Backwardation The situation where spot prices exceed futures prices. Backwardation
implies a downward-sloping (or inverted) forward curve and can imply an immediate
shortage of the underlying asset (such as an oil shortage due to political reasons).
Bankruptcy A legally declared inability of an individual or entity to pay its creditors.
The bankruptcy may be voluntary and filed by the individual or organisation concerned
or it may be involuntary and filed by the creditors. Creditors may file a bankruptcy
petition in an effort to recoup a portion of what they are owed or initiate a restructuring.
Basis The difference in price or yield between two underlying rates or indices.
Basis points per annum (bps or bp pa) A basis point is one one-hundredth of a
percentage point so, for example, 50 basis points is the same as a 0.5%. We will typically
use basis points (bps) to indicate a running premium and so 50 bps refers to a annual
premium of 50 basis points or 0.5%.
BCVA (see also CVA) CVA taking into account one’s own default as well as that of
one’s counterparty.
Bermudan option An option where the buyer has the right to exercise at a set of
discretely spaced times. It is intermediate between a European option (which allows
exercise only at expiry) and an American option (which allows exercise at any time).
Bilateral netting (see also netting and multilateral netting) A netting agreement between
two parties.
Black–Scholes formula A closed-form formula for valuing plain-vanilla options developed
by Fischer Black and Myron Scholes in 1973 that led to the birth of pricing by
replication for derivatives products.
Capital (see regulatory capital and economic capital)
Capital asset pricing model (CAPM) A model that describes the relationship between
risk and expected return in the pricing of risky securities. The CAPM postulates that
investors need to be compensated for the risk-free rate of interest and the additional
investment risk they take. The model states that an investor will require a return equal to
the risk-free rate of interest plus a risk measure (beta) that depends on the correlation
between the returns of the asset and those of the market.
Carry Net gain or expense on a position due to interest, dividends and other payments,
normally expressed in annual terms (such as basis points per annum).
Cashflow An individual fixed or floating payment made on a specific date, such as a
bond coupon.
Centralised counterparty An entity that interposes itself as the buyer to every seller and
as the seller to every buyer of a specified set of contracts.
Clean price The price of a bond without accrued interest.
Clearing To settle a trade by the seller delivering securities and the buyer delivering
funds in the proper form. A trade that does not clear is said to fail.
Clearing house A corporation, normally used in conjunction with an exchange, that
facilitates the execution of trades by transferring funds, assigning deliveries and guaranteeing
the performance of all obligations.
Collateral (or margin) agreement A contractual agreement under which one party must
supply collateral to a second counterparty when an exposure of that second counterparty
to the first counterparty exceeds a specified level.
Collateralisation The process of agreeing to and exchanging collateral or margin
between two or more parties.
Collateralised debt obligation (CDO) A broad type of instrument that repackages
individual (usually debt) securities into a product that can be sold on the secondary
market. The underlying securities may be, for example, auto loans, credit card debt,
corporate debt or even other types of CDOs.
Conduit An entity set up to assemble securities into a pool and issue other securities to
investors that are ultimately guaranteed by the original pool of securities.
Contango The situation where futures prices exceed spot prices (the opposite of backwardation).
Contango implies an upward-sloping forward curve often due to the underlying
cost of storage.
Contingent CDS (see also CDS) A CDS contract that has a notional value linked to the
value of another contract and therefore isolates counterparty credit risk arising from a
reference derivative.
Convexity A financial instrument is said to be convex if the price increases (decreases)
faster (slower) than corresponding changes in the price of the underlying.
Correlation Correlation measures linear dependence between variables. A correlation
coefficient provides a measure of the degree to which random variables are linked in a
linear fashion.Acorrelation coefficient will be positive when relative large or small values
are associated together and vice versa. Financial instruments that move together in
the same direction to the same extent have highly positive correlations. Instruments
that move in the opposite direction to the same extent have highly negative correlations.
Credit default swap (CDS) A specific swap transaction involving the transfer of a third
party’s credit risk from one party to another.
Credit event Trigger event in a credit default swap, determined at the outset of the
transaction. Markets standards include the existence of publicly available information
confirming the occurrence, with respect to the reference credit, of bankruptcy, repudiation,
restructuring, failure to pay, cross-default or cross-acceleration.
Credit exposure (see exposure)
Credit-linked note (CLN) A funded credit derivative structure which is structured as a
security with an embedded credit default swap allowing the issuer to transfer a specific
credit risk to credit investors in note form.
A CLN is therefore a synthetic bond.
Credit migration A discrete change in the credit quality of an entity such that their
credit-worthiness improves or worsens by a significant amount, often due to an up or
downgrade in the underlying credit rating.
Credit rating A published ranking, based on financial analysis that is supposed to
measure the ability of a corporate, entity or individual to meet future obligations. The
highest rating achievable is usually triple-A.
Credit spread A yield measure reflecting the cost of credit risk in a security.
Credit Support Annex (CSA) A legal document regulating collateral for derivatives
transactions. A CSA defines the terms or rules under which collateral is posted or
transferred between swap counterparties to mitigate exposure. Terms defined include
thresholds, minimum transfer amounts, eligible securities and currencies, haircuts and
rules for the settlement of disputes.
Credit support amount The total net exposure that an institution has to their counterparty
used in the context of a collateral agreement. Any independent amounts specified
by a collateral agreement would be included in the CSA.
Credit value adjustment (CVA) The difference between the risk-free and credit-risky
values of a netting set where the risky value takes into account the possibility of the
counterparty’s default. CVA is the expected loss or value of counterparty credit risk. By
convention, a positive CVA represents a cost.
Cross-currency swap (or currency swap) A foreign exchange agreement between two
parties to exchange principal and fixed rate interest payments in different currencies.
Unlike interest rate swaps, cross-currency swaps involve the exchange of the principal
amount at maturity.
Debt restructuring A process that allows a company or a sovereign entity facing
cashflow problems and in financial distress to renegotiate its debt payments (such as
extending the maturity date) in order to improve or restore liquidity so that it can
continue its operations and avoid often-impending bankruptcy.
Debt-to-equity swap A restructuring where a company reduces their leverage by
exchanging debt for equity with the original debt cancelled.
Debt value adjustment (DVA) The opposite component to CVA which stems from a
liability due to a negative exposure that would give rise to a gain if an institution were to
default. There is some debate over the relevance of institutions ‘‘pricing in’’ their own
default probability when assessing counterparty risk.
Default probability Likelihood that an entity will default a some pre-defined interval in
the future.
Dirty price (see also clean price) A quoted bond price, including accrued interest.
Distressed exchange An exchange of a security for another security or package of
securities that amounts to a reduced financial obligation (such as a lower coupon or
par amount).
Duration The change in the value of a security resulting from a 1% change in interest
rates and expressed in years. Unlike maturity, duration takes into account interest
payments that occur throughout the course of holding an instrument. Duration therefore
represents a weighted average of the cashflows from one or more securities.
Economic capital The amount of actual risk capital that a firm requires to cover the
risks that it takes, such as market risk, credit risk, operational risk and counterparty risk.
It is the amount of capital that is needed to secure survival in a worst case scenario.
Effective EE Same as EE but must be non-decreasing over a certain time period
(typically 1 year).
Effective EPE Average of effective EE over time (see also EPE).
Effective maturity Aduration-based measure for a portfolio of derivatives reflecting the
average lifetime of the transactions scaled by the exposure over time.
Exchange (or bourse) An organised market where standardised tradable securities, such
as commodities, foreign exchange, futures and options contracts, are bought and sold by
brokers and dealers who are members of the exchange.
Expected exposure (EE) Average or expected value of the exposure at some point in
time.
Expected positive exposure (EPE) Average of the expected exposure (EE) over some
pre-defined period (usually from the current time to the maximum maturity of the
transactions in question).
Expected shortfall An alternative to value-at-risk (VAR) which is more sensitive to the
shape of the loss distribution in the ‘‘tail’’ or extreme, high-loss regions. The expected
shortfall gives the expected loss on a portfolio in the worst case scenario, defined by a
quantile. Expected shortfall is also called tail VAR.
Exposure (or credit exposure) Positive value of one or more transactions with a counterparty.
Should represent a net value where netting of transactions is possible.
Exposure at default (see exposure).
Fannie Mae (Federal National Mortgage Association) The largest player in the secondary
mortgage market.
Flight to quality The flow of funds from riskier to safer investments in times of market
uncertainty.
Freddie Mac (Federal Home Loan Mortgage Association) The second largest player in
the secondary mortgage market.
Futures A standardised exchange-traded contract that requires delivery of a commodity,
bond, currency or stock index, at a specified price, on a specified future date. Futures
are typically cash-settled and so allow an investor to go long or short an underlying for
speculation or hedging purposes without ever having to deliver or take delivery of the
underlying.
Gamma Gamma (or convexity) is the degree of curvature in the financial contract’s
price curve with respect to its underlying price. It is the rate of change of the delta with
respect to changes in the underlying price.
Gaussian distribution (see normal distribution)
Haircut A deduction in the market value of a security held as collateral reflecting the
price uncertainty of the underlying security.
Hazard rate An instantaneous default probability.
Hedge An instrument traded in order to reduce the risk of adverse price movements in
another instrument or portfolio of instruments. A hedging instrument therefore has price
movements opposite to those of the underlying instruments. It may consist of cash
instruments or derivatives.
Historical volatility A measure of the actual volatility observed in the marketplace over
a given time horizon in the past.
IMM dates The four dates of each year which most credit default swaps and option
contracts use as their scheduled termination date. The dates are the third Wednesday of
March, June, September and December.
Implied volatility Volatility required to reproduce a traded price (normally an option)
in relation to a certain model (usually the Black–Scholes formula). Often thought of as
the market’s view of expected future volatility.
Independent amount Usually an upfront cash amount that is posted from one party to
another and is independent of any other collateral or margin terms. Also referred to as
initial margin.
Initial margin (see independent amount)
Interest rate cap A derivative in which the buyer effectively caps their exposure to rising
interest rates by receiving payments at the end of each period if the interest rate exceeds
an agreed strike price.
Interest rate floor A derivative in which the buyer effectively floors their exposure to
rising interest rates by receiving payments at the end of each period if the interest rate
falls below an agreed strike price.
Interest rate swap A contract requiring the exchange of interest payments on a specific
notional amount. Usually fixed payments are swapped against floating payments in a
particular currency.
In the money The situation where an option has value if exercised immediately
(although that may not be contractually possible). For a call (put) option, the current
underlying price must be above (below) the strike price. In-the-money forward refers to
the forward value of the underlying security and not the spot price.
Intrinsic value Difference between the exercise price of an option at any time and its
market price at the same time. It is therefore the value if the contract were to expire
immediately as distinct from any potential value (time value for an option).
Investment grade A bond considered ‘‘likely’’ to meet payment obligations. Corresponds
to ratings as good as or better than Baa and BBB for Moody’s and Standard
& Poor’s, respectively.
ISDA (International Swaps and Derivatives Association) A trade organisation of participants
in the market for OTC derivatives which publishes the Code of Standard
Wording, Assumptions and Provisions for Swaps.
LIBOR (London Inter-Bank Offer Rate) This is the rate of interest at which banks offer
to lend money to one another in the so-called wholesale money markets in London.
Liquidity risk The risk of not being able to trade within a reasonable tolerance in terms
of the deviation from prevailing, expected or fair prices.
Loss given default (LGD) The amount of loss on a credit instrument after the borrower
has defaulted. It is typically stated as a percentage of the debt’s par value.
Margining (see collateralisation)
Margin call frequency The contractual period between which an institution may request
collateral (or margin) from a counterparty. Can vary from a few days to continuous with
daily margin calls being most common.
Margin threshold The largest amount of an exposure that remains outstanding until
one party has the right to call for collateral.
Mark-to-market (MtM) The process of recording the price or value of a security,
usually on a daily basis, to calculate profits and losses. MtM is used to refer to the
current value of one or more derivatives instruments.
Market risk The risk of losses due to daily fluctuations in the prices of securities such as
equity, FX, interest rates and commodities.
Mean reversion The statistical tendency of an underlying financial variable to gravitate
back towards some long-term average.
Minimum transfer amount The minimum amount that can be requested to be transferred
as collateral (margin).
Monte Carlo simulation A technique for working out an integral (often in many
dimensions) by generating uniformly distributed pseudo-random numbers and
evaluating the underlying function at all of these points.
Multilateral netting (see also netting and bilateral netting) A netting agreement between
three or more parties which is typically utilised by a central counterparty.
Netting set A set of transactions with a single counterparty that are subject to a legally
enforceable bilateral netting arrangement.
Netting A legally enforceable arrangement covering two or more underlying contracts
so that, in the event of the default or insolvency of one of the parties, positive (receivable)
and negative (payable) MtM values of contracts can be netted against one another to
arrive at a total liability or claim representing the value of all underlying contracts.
Normal (Gaussian) distribution The most common of statistical distributions, which
typically results from a large sample of uncorrelated random events.
Over-the-counter (OTC) contract A privately negotiated derivatives contract that is
transacted away from an exchange.
Options A contract giving the right but not the obligation to sell or buy a commodity,
financial instrument or index, at a specified price for a certain period.
Out of the money The situation where an option has zero value if exercised immediately.
For a call (put) option, the current underlying price must be below (above) the strike
price. Out-of-the-money forward refers to the forward value of the underlying security
and not the spot price.
Par or principal value The amount of an obligation upon which interest is calculated.
Pari passu Equal in all respects or enjoying the same rights without bias or preference.
If a derivatives exposure is said to be pari passu with a senior unsecured bond then it
means that the same percentage amount can expect to be recovered on both contracts.
Path dependency A financial contract whose value depends on the path taken by the
underlying market variable(s).
P&L (profit and loss) A quantification of gains or losses on one or more financial
contracts in a given period.
Put–call parity An arbitrage relationship that must exist between the prices of European
put and call options that both have the same underlying, strike price and maturity
date.
Quantile Point on a distribution of values such that a given proportion of the values are
less than or equal to the point. For example, the 0.99 or 99% quantile represents a point
where 99% of the values fall below (and correspondingly 1% fall above).
Rating An evaluation of a corporate or municipal bond’s relative safety, according to
the issuer’s ability to make required payments. Bonds are rated by various rating agencies
such as Standard & Poor’s andMoody’s. Ratings range from triple-A (AAA or Aaa for
Standard & Poor’s and Moody’s, respectively) to D, which represents a company in
default.
Recovery rate The percentage amount that a creditor receives in relation to claims on a
defaulted counterparty.
Regulatory capital The amount of Tier I and Tier II long-term funding that commercial
banks are compelled to hold based upon the Basel Accord regulations for risk adjustment.
Remargin period Used to denote the time from when collateral (margin) is called for
until it is actually received accounting for some worst case delays. This will be equal to the
margin call frequency with some additional conservative delay added.
Replacement cost The amount it would cost to replace an asset or derivative contract at
current market rates. Accounts for liquidity and transaction costs.
Risky annuity (see also annuity) An annuity taking into account the probability of
default of the annuity payer with respect to each cashflow. A risky annuity will be worth
no more than the equivalent annuity.
SFT (structured finance transaction) A non-standard lending arrangement customised
to the needs of a specific client which is more complicated than traditional loans, bonds
and equity. Complicated leveraged products such as CDOs fall under the definition of
structured finance.
SIV (structured investment vehicle) A fund with the strategy to borrow money by
issuing short-term securities at low interest and then lend that money by buying
long-term securities at higher interest, making a profit for investors from the difference.
SIVs were a casualty of the credit crisis and ceased to exist by the end of 2008.
SPE (special purpose entity, see SPV)
SPV (special purpose vehicle) A legal entity (usually a limited company of some type or
a limited partnership) created to fulfil narrow, specific or temporary objectives. SPVs
were often used by firms to isolate a transaction for the benefit of a client and so, in
theory, they would not bear risk of default of that firm.
Standard deviation A measure used to characterise the variability of a random variable.
Stress testing Simulating different financial market conditions and assessing their
potential effects on a portfolio of financial instruments.
Strike price The price at which an option holder can buy or sell the underlying asset.
Also called exercise price.
Time value The amount by which the value of an option exceeds the intrinsic value. It
represents the potential gain from an increasing option premium in the future.
Total return swap (TRS) A financial contract which allows synthetic transfer of both
the credit and market risk of an underlying asset.
Unexpected loss A term commonly used to give an indication of the volatility of losses
around the expected loss. The unexpected loss will be defined as a worst case loss at some
confidence level. The expected loss may or may not be subtracted from this value.
Value-at-risk (VAR) For a given confidence level and time horizon, VAR is defined as a
value such that the probability that the loss on a portfolio exceeds this value in the
defined time horizon is one minus the confidence level. For example, a 99% VAR of $1m
in 10 days means that the probability of having a loss of more than $1m in 10 days is 1%.
Variation margin Additional margin required to bring an account up to the required
level due to market fluctuations. Will normally correspond to the current exposure less
any initial margin (independent amount) and previously posted margin but also accounting
for minimum transfer amount and rounding.
Volatility Standard deviation represented on an annualised basis.
Walkaway feature (or extinguisher) Contractual feature that allows an institution to
terminate (walk away from) a transaction in the event their counterparty defaults. In case
the MtM value to the institution is negative then this represents a gain from their
counterparty defaulting.
Yield curve For a particular series of fixed income instruments such as government
bonds, the graph of the yields to maturity of the series plotted by maturity.
last interest payment was made.
Additional termination event (ATE) Pre-defined event (such as a ratings downgrade)
that allows a transaction to be terminated at (mid-) market rates.
Annuity A series of payments of fixed size and frequency.
Arbitrage A transaction that generates a profit without any associated financial risk.
Asset swap A swap contract used to convert one type of investment into another.
Usually, a fixed investment such as a bond with guaranteed coupon payments is swapped
into floating payments.
At the money An option is at the money if the strike price of the option equals the
current (spot) market price of the underlying security. At-the-money forward refers to
the forward value of the underlying security and not the spot price.
Backwardation The situation where spot prices exceed futures prices. Backwardation
implies a downward-sloping (or inverted) forward curve and can imply an immediate
shortage of the underlying asset (such as an oil shortage due to political reasons).
Bankruptcy A legally declared inability of an individual or entity to pay its creditors.
The bankruptcy may be voluntary and filed by the individual or organisation concerned
or it may be involuntary and filed by the creditors. Creditors may file a bankruptcy
petition in an effort to recoup a portion of what they are owed or initiate a restructuring.
Basis The difference in price or yield between two underlying rates or indices.
Basis points per annum (bps or bp pa) A basis point is one one-hundredth of a
percentage point so, for example, 50 basis points is the same as a 0.5%. We will typically
use basis points (bps) to indicate a running premium and so 50 bps refers to a annual
premium of 50 basis points or 0.5%.
BCVA (see also CVA) CVA taking into account one’s own default as well as that of
one’s counterparty.
Bermudan option An option where the buyer has the right to exercise at a set of
discretely spaced times. It is intermediate between a European option (which allows
exercise only at expiry) and an American option (which allows exercise at any time).
Bilateral netting (see also netting and multilateral netting) A netting agreement between
two parties.
Black–Scholes formula A closed-form formula for valuing plain-vanilla options developed
by Fischer Black and Myron Scholes in 1973 that led to the birth of pricing by
replication for derivatives products.
Capital (see regulatory capital and economic capital)
Capital asset pricing model (CAPM) A model that describes the relationship between
risk and expected return in the pricing of risky securities. The CAPM postulates that
investors need to be compensated for the risk-free rate of interest and the additional
investment risk they take. The model states that an investor will require a return equal to
the risk-free rate of interest plus a risk measure (beta) that depends on the correlation
between the returns of the asset and those of the market.
Carry Net gain or expense on a position due to interest, dividends and other payments,
normally expressed in annual terms (such as basis points per annum).
Cashflow An individual fixed or floating payment made on a specific date, such as a
bond coupon.
Centralised counterparty An entity that interposes itself as the buyer to every seller and
as the seller to every buyer of a specified set of contracts.
Clean price The price of a bond without accrued interest.
Clearing To settle a trade by the seller delivering securities and the buyer delivering
funds in the proper form. A trade that does not clear is said to fail.
Clearing house A corporation, normally used in conjunction with an exchange, that
facilitates the execution of trades by transferring funds, assigning deliveries and guaranteeing
the performance of all obligations.
Collateral (or margin) agreement A contractual agreement under which one party must
supply collateral to a second counterparty when an exposure of that second counterparty
to the first counterparty exceeds a specified level.
Collateralisation The process of agreeing to and exchanging collateral or margin
between two or more parties.
Collateralised debt obligation (CDO) A broad type of instrument that repackages
individual (usually debt) securities into a product that can be sold on the secondary
market. The underlying securities may be, for example, auto loans, credit card debt,
corporate debt or even other types of CDOs.
Conduit An entity set up to assemble securities into a pool and issue other securities to
investors that are ultimately guaranteed by the original pool of securities.
Contango The situation where futures prices exceed spot prices (the opposite of backwardation).
Contango implies an upward-sloping forward curve often due to the underlying
cost of storage.
Contingent CDS (see also CDS) A CDS contract that has a notional value linked to the
value of another contract and therefore isolates counterparty credit risk arising from a
reference derivative.
Convexity A financial instrument is said to be convex if the price increases (decreases)
faster (slower) than corresponding changes in the price of the underlying.
Correlation Correlation measures linear dependence between variables. A correlation
coefficient provides a measure of the degree to which random variables are linked in a
linear fashion.Acorrelation coefficient will be positive when relative large or small values
are associated together and vice versa. Financial instruments that move together in
the same direction to the same extent have highly positive correlations. Instruments
that move in the opposite direction to the same extent have highly negative correlations.
Credit default swap (CDS) A specific swap transaction involving the transfer of a third
party’s credit risk from one party to another.
Credit event Trigger event in a credit default swap, determined at the outset of the
transaction. Markets standards include the existence of publicly available information
confirming the occurrence, with respect to the reference credit, of bankruptcy, repudiation,
restructuring, failure to pay, cross-default or cross-acceleration.
Credit exposure (see exposure)
Credit-linked note (CLN) A funded credit derivative structure which is structured as a
security with an embedded credit default swap allowing the issuer to transfer a specific
credit risk to credit investors in note form.
A CLN is therefore a synthetic bond.
Credit migration A discrete change in the credit quality of an entity such that their
credit-worthiness improves or worsens by a significant amount, often due to an up or
downgrade in the underlying credit rating.
Credit rating A published ranking, based on financial analysis that is supposed to
measure the ability of a corporate, entity or individual to meet future obligations. The
highest rating achievable is usually triple-A.
Credit spread A yield measure reflecting the cost of credit risk in a security.
Credit Support Annex (CSA) A legal document regulating collateral for derivatives
transactions. A CSA defines the terms or rules under which collateral is posted or
transferred between swap counterparties to mitigate exposure. Terms defined include
thresholds, minimum transfer amounts, eligible securities and currencies, haircuts and
rules for the settlement of disputes.
Credit support amount The total net exposure that an institution has to their counterparty
used in the context of a collateral agreement. Any independent amounts specified
by a collateral agreement would be included in the CSA.
Credit value adjustment (CVA) The difference between the risk-free and credit-risky
values of a netting set where the risky value takes into account the possibility of the
counterparty’s default. CVA is the expected loss or value of counterparty credit risk. By
convention, a positive CVA represents a cost.
Cross-currency swap (or currency swap) A foreign exchange agreement between two
parties to exchange principal and fixed rate interest payments in different currencies.
Unlike interest rate swaps, cross-currency swaps involve the exchange of the principal
amount at maturity.
Debt restructuring A process that allows a company or a sovereign entity facing
cashflow problems and in financial distress to renegotiate its debt payments (such as
extending the maturity date) in order to improve or restore liquidity so that it can
continue its operations and avoid often-impending bankruptcy.
Debt-to-equity swap A restructuring where a company reduces their leverage by
exchanging debt for equity with the original debt cancelled.
Debt value adjustment (DVA) The opposite component to CVA which stems from a
liability due to a negative exposure that would give rise to a gain if an institution were to
default. There is some debate over the relevance of institutions ‘‘pricing in’’ their own
default probability when assessing counterparty risk.
Default probability Likelihood that an entity will default a some pre-defined interval in
the future.
Dirty price (see also clean price) A quoted bond price, including accrued interest.
Distressed exchange An exchange of a security for another security or package of
securities that amounts to a reduced financial obligation (such as a lower coupon or
par amount).
Duration The change in the value of a security resulting from a 1% change in interest
rates and expressed in years. Unlike maturity, duration takes into account interest
payments that occur throughout the course of holding an instrument. Duration therefore
represents a weighted average of the cashflows from one or more securities.
Economic capital The amount of actual risk capital that a firm requires to cover the
risks that it takes, such as market risk, credit risk, operational risk and counterparty risk.
It is the amount of capital that is needed to secure survival in a worst case scenario.
Effective EE Same as EE but must be non-decreasing over a certain time period
(typically 1 year).
Effective EPE Average of effective EE over time (see also EPE).
Effective maturity Aduration-based measure for a portfolio of derivatives reflecting the
average lifetime of the transactions scaled by the exposure over time.
Exchange (or bourse) An organised market where standardised tradable securities, such
as commodities, foreign exchange, futures and options contracts, are bought and sold by
brokers and dealers who are members of the exchange.
Expected exposure (EE) Average or expected value of the exposure at some point in
time.
Expected positive exposure (EPE) Average of the expected exposure (EE) over some
pre-defined period (usually from the current time to the maximum maturity of the
transactions in question).
Expected shortfall An alternative to value-at-risk (VAR) which is more sensitive to the
shape of the loss distribution in the ‘‘tail’’ or extreme, high-loss regions. The expected
shortfall gives the expected loss on a portfolio in the worst case scenario, defined by a
quantile. Expected shortfall is also called tail VAR.
Exposure (or credit exposure) Positive value of one or more transactions with a counterparty.
Should represent a net value where netting of transactions is possible.
Exposure at default (see exposure).
Fannie Mae (Federal National Mortgage Association) The largest player in the secondary
mortgage market.
Flight to quality The flow of funds from riskier to safer investments in times of market
uncertainty.
Freddie Mac (Federal Home Loan Mortgage Association) The second largest player in
the secondary mortgage market.
Futures A standardised exchange-traded contract that requires delivery of a commodity,
bond, currency or stock index, at a specified price, on a specified future date. Futures
are typically cash-settled and so allow an investor to go long or short an underlying for
speculation or hedging purposes without ever having to deliver or take delivery of the
underlying.
Gamma Gamma (or convexity) is the degree of curvature in the financial contract’s
price curve with respect to its underlying price. It is the rate of change of the delta with
respect to changes in the underlying price.
Gaussian distribution (see normal distribution)
Haircut A deduction in the market value of a security held as collateral reflecting the
price uncertainty of the underlying security.
Hazard rate An instantaneous default probability.
Hedge An instrument traded in order to reduce the risk of adverse price movements in
another instrument or portfolio of instruments. A hedging instrument therefore has price
movements opposite to those of the underlying instruments. It may consist of cash
instruments or derivatives.
Historical volatility A measure of the actual volatility observed in the marketplace over
a given time horizon in the past.
IMM dates The four dates of each year which most credit default swaps and option
contracts use as their scheduled termination date. The dates are the third Wednesday of
March, June, September and December.
Implied volatility Volatility required to reproduce a traded price (normally an option)
in relation to a certain model (usually the Black–Scholes formula). Often thought of as
the market’s view of expected future volatility.
Independent amount Usually an upfront cash amount that is posted from one party to
another and is independent of any other collateral or margin terms. Also referred to as
initial margin.
Initial margin (see independent amount)
Interest rate cap A derivative in which the buyer effectively caps their exposure to rising
interest rates by receiving payments at the end of each period if the interest rate exceeds
an agreed strike price.
Interest rate floor A derivative in which the buyer effectively floors their exposure to
rising interest rates by receiving payments at the end of each period if the interest rate
falls below an agreed strike price.
Interest rate swap A contract requiring the exchange of interest payments on a specific
notional amount. Usually fixed payments are swapped against floating payments in a
particular currency.
In the money The situation where an option has value if exercised immediately
(although that may not be contractually possible). For a call (put) option, the current
underlying price must be above (below) the strike price. In-the-money forward refers to
the forward value of the underlying security and not the spot price.
Intrinsic value Difference between the exercise price of an option at any time and its
market price at the same time. It is therefore the value if the contract were to expire
immediately as distinct from any potential value (time value for an option).
Investment grade A bond considered ‘‘likely’’ to meet payment obligations. Corresponds
to ratings as good as or better than Baa and BBB for Moody’s and Standard
& Poor’s, respectively.
ISDA (International Swaps and Derivatives Association) A trade organisation of participants
in the market for OTC derivatives which publishes the Code of Standard
Wording, Assumptions and Provisions for Swaps.
LIBOR (London Inter-Bank Offer Rate) This is the rate of interest at which banks offer
to lend money to one another in the so-called wholesale money markets in London.
Liquidity risk The risk of not being able to trade within a reasonable tolerance in terms
of the deviation from prevailing, expected or fair prices.
Loss given default (LGD) The amount of loss on a credit instrument after the borrower
has defaulted. It is typically stated as a percentage of the debt’s par value.
Margining (see collateralisation)
Margin call frequency The contractual period between which an institution may request
collateral (or margin) from a counterparty. Can vary from a few days to continuous with
daily margin calls being most common.
Margin threshold The largest amount of an exposure that remains outstanding until
one party has the right to call for collateral.
Mark-to-market (MtM) The process of recording the price or value of a security,
usually on a daily basis, to calculate profits and losses. MtM is used to refer to the
current value of one or more derivatives instruments.
Market risk The risk of losses due to daily fluctuations in the prices of securities such as
equity, FX, interest rates and commodities.
Mean reversion The statistical tendency of an underlying financial variable to gravitate
back towards some long-term average.
Minimum transfer amount The minimum amount that can be requested to be transferred
as collateral (margin).
Monte Carlo simulation A technique for working out an integral (often in many
dimensions) by generating uniformly distributed pseudo-random numbers and
evaluating the underlying function at all of these points.
Multilateral netting (see also netting and bilateral netting) A netting agreement between
three or more parties which is typically utilised by a central counterparty.
Netting set A set of transactions with a single counterparty that are subject to a legally
enforceable bilateral netting arrangement.
Netting A legally enforceable arrangement covering two or more underlying contracts
so that, in the event of the default or insolvency of one of the parties, positive (receivable)
and negative (payable) MtM values of contracts can be netted against one another to
arrive at a total liability or claim representing the value of all underlying contracts.
Normal (Gaussian) distribution The most common of statistical distributions, which
typically results from a large sample of uncorrelated random events.
Over-the-counter (OTC) contract A privately negotiated derivatives contract that is
transacted away from an exchange.
Options A contract giving the right but not the obligation to sell or buy a commodity,
financial instrument or index, at a specified price for a certain period.
Out of the money The situation where an option has zero value if exercised immediately.
For a call (put) option, the current underlying price must be below (above) the strike
price. Out-of-the-money forward refers to the forward value of the underlying security
and not the spot price.
Par or principal value The amount of an obligation upon which interest is calculated.
Pari passu Equal in all respects or enjoying the same rights without bias or preference.
If a derivatives exposure is said to be pari passu with a senior unsecured bond then it
means that the same percentage amount can expect to be recovered on both contracts.
Path dependency A financial contract whose value depends on the path taken by the
underlying market variable(s).
P&L (profit and loss) A quantification of gains or losses on one or more financial
contracts in a given period.
Put–call parity An arbitrage relationship that must exist between the prices of European
put and call options that both have the same underlying, strike price and maturity
date.
Quantile Point on a distribution of values such that a given proportion of the values are
less than or equal to the point. For example, the 0.99 or 99% quantile represents a point
where 99% of the values fall below (and correspondingly 1% fall above).
Rating An evaluation of a corporate or municipal bond’s relative safety, according to
the issuer’s ability to make required payments. Bonds are rated by various rating agencies
such as Standard & Poor’s andMoody’s. Ratings range from triple-A (AAA or Aaa for
Standard & Poor’s and Moody’s, respectively) to D, which represents a company in
default.
Recovery rate The percentage amount that a creditor receives in relation to claims on a
defaulted counterparty.
Regulatory capital The amount of Tier I and Tier II long-term funding that commercial
banks are compelled to hold based upon the Basel Accord regulations for risk adjustment.
Remargin period Used to denote the time from when collateral (margin) is called for
until it is actually received accounting for some worst case delays. This will be equal to the
margin call frequency with some additional conservative delay added.
Replacement cost The amount it would cost to replace an asset or derivative contract at
current market rates. Accounts for liquidity and transaction costs.
Risky annuity (see also annuity) An annuity taking into account the probability of
default of the annuity payer with respect to each cashflow. A risky annuity will be worth
no more than the equivalent annuity.
SFT (structured finance transaction) A non-standard lending arrangement customised
to the needs of a specific client which is more complicated than traditional loans, bonds
and equity. Complicated leveraged products such as CDOs fall under the definition of
structured finance.
SIV (structured investment vehicle) A fund with the strategy to borrow money by
issuing short-term securities at low interest and then lend that money by buying
long-term securities at higher interest, making a profit for investors from the difference.
SIVs were a casualty of the credit crisis and ceased to exist by the end of 2008.
SPE (special purpose entity, see SPV)
SPV (special purpose vehicle) A legal entity (usually a limited company of some type or
a limited partnership) created to fulfil narrow, specific or temporary objectives. SPVs
were often used by firms to isolate a transaction for the benefit of a client and so, in
theory, they would not bear risk of default of that firm.
Standard deviation A measure used to characterise the variability of a random variable.
Stress testing Simulating different financial market conditions and assessing their
potential effects on a portfolio of financial instruments.
Strike price The price at which an option holder can buy or sell the underlying asset.
Also called exercise price.
Time value The amount by which the value of an option exceeds the intrinsic value. It
represents the potential gain from an increasing option premium in the future.
Total return swap (TRS) A financial contract which allows synthetic transfer of both
the credit and market risk of an underlying asset.
Unexpected loss A term commonly used to give an indication of the volatility of losses
around the expected loss. The unexpected loss will be defined as a worst case loss at some
confidence level. The expected loss may or may not be subtracted from this value.
Value-at-risk (VAR) For a given confidence level and time horizon, VAR is defined as a
value such that the probability that the loss on a portfolio exceeds this value in the
defined time horizon is one minus the confidence level. For example, a 99% VAR of $1m
in 10 days means that the probability of having a loss of more than $1m in 10 days is 1%.
Variation margin Additional margin required to bring an account up to the required
level due to market fluctuations. Will normally correspond to the current exposure less
any initial margin (independent amount) and previously posted margin but also accounting
for minimum transfer amount and rounding.
Volatility Standard deviation represented on an annualised basis.
Walkaway feature (or extinguisher) Contractual feature that allows an institution to
terminate (walk away from) a transaction in the event their counterparty defaults. In case
the MtM value to the institution is negative then this represents a gain from their
counterparty defaulting.
Yield curve For a particular series of fixed income instruments such as government
bonds, the graph of the yields to maturity of the series plotted by maturity.
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