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Accelerated Share Repurchase
Accelerated Share Repurchase comes under SEC Rule 10b–18,1 which in effect provides issuers with a safe harbour from market manipulation liability under the federal securities laws. When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, they often repurchase their shares. This action comes under SEC regulation Rule 10b–8 which applies to bids for and purchases of an issuer’s common stock by or for an issuer or an "affiliated purchaser" of an issuer. Purchases of any other type of security are not covered – even if related to the common stock (e.g., preferred stock, warrants, rights, convertible debt securities, options, or security futures products).
Accounting Arbitrage
Attempt to exploit the difference between accounting standards around the world when their interpretations lead to different presentations of financial statements of the same or even different companies.
Affiliates
Affiliates are parties that, directly or indirectly through one or more intermediaries are controlled by, or are under common control with the transferor (FASB 57, paragraph 24(a)). Control is the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of an enterprise through ownership, by contract, or otherwise (FASB 57, paragraph 24(b)).
American–style and European–style options
The market recognizes two fundamental types of options; American–style option: gives the holder the right to exercise on or before the expiry date and because of this flexibility, they are generally more valuable. European–style option: gives the holder the right to exercise on the expiry date only.
Anti-dilutive
Term used to describe a convertible security which could increase a corporation’s earnings per share if exercised or converted into common stock. Such conversions are not considered when calculating earnings per share. The opposite is dilutive. With application to convertible securities, the dilutive effect could increase a corporation’s earnings per share if exercised or converted into common stock.
Arbitrage
The simultaneous purchase of a derivatives contract in one market and the sale of a derivatives contract in the same or a different market where the objective is to profit from a discrepancy in the price relationship between them.
Available–For–Sale Security
Derivatives accounting standards require firms to classify its investment in debt (bonds) and equity (stocks) securities into one of three categories when they are purchased: (1) held–to–maturity, (2) trading, or (3) available–for–sale. This classification is based on the Company’s intended use of that security and the classification dictates the accounting treatment.
Securities not classified either as held–to–maturity or trading are considered available–for–sale and are reported at fair value. Changes in the fair value from period to period are not reported as a component of net income but are charged or credited directly to equity.
Basis swaps
Basis swaps are derivative instruments that are used to modify the receipts or payments associated with a recognized, variable–rate asset or liability from one variable amount to another variable amount. They do not eliminate the variability of cash flows; instead, they change the basis or index of variability. (FAS 133, Par. 391).
Basket option
A basket option is a type of option whose underlying asset is a basket of commodities, securities, or currencies. In currency derivatives, a currency basket option provides a cheaper method for multinational corporations to buy and or sell a several currencies for one specified currency instantaneously. This financial instrument is often used by multinationals with operations in several countries and currencies.
Benchmark interest rate
The minimum interest rate investors will demand for investing in a non–Treasury security. It is also tied to the yield to maturity offered on a comparable–maturity Treasury security that was most recently issued ("on-the-run"). The Benchmark interest rate is also called the base interest rate. Since Treasury securities are backed by the United State’s full backing, they are considered risk–free, any investment security (cash saving, stock, corporate bond or option) will tend to offer a return above the risk-free, base interest rate. The risk free rate is also used in derivatives pricing and valuation.
Beneficial Interests
The beneficial interests are issued in the form of securities. The transferor is required to consolidate the SPE under applicable generally accepted accounting principles. Paragraph 35 of Statement 140 stipulates that a qualifying special-purpose entity (QSPE) may only hold passive derivative financial instruments pertaining to beneficial interests of the QSPE issued or sold to parties other than the transferor. Paragraph 40 of Statement 140 specifies certain criteria that must be met for a QSPE to hold derivative financial instruments and maintain qualifying status.
Best Execution
The obligation on a broker to obtain the best possible result for a customer with reference to price, size and the nature of the transaction, but taking into account the state of the relevant market(s) at the time of execution and the nature of the customer’s order. The relevant market is usually the market which offers the most favorable trading conditions in terms of transparency, liquidity and clearing and settlement arrangements to the envisaged transaction.
Bond
A bond is a borrowing arrangement in which the borrower issues (sells) an IOU (I owe you) to the investor. Bonds have four basic but fundamental components.
• The Issuer or the legal entity which undertakes to comply with all the terms and conditions of the bonds.
• The principal or the face value of the bond which is the amount which the borrower will repay at maturity.
• The maturity date which corresponds to the final date by which bond holders receive the principal due plus the last coupon payment when applicable.
• Finally, most bonds tend to have the coupon or the rate of interest on a debt security that the borrower promises to pay the holder.
The coupon is expressed as an annual percentage rate of the face value but depending on the market in which a bond is issued, coupons may be payable annually, semi annually, quarterly or monthly.
Bond portfolio
When an investor buys many bonds s/he has a portfolio. This is a typical situation with fixed income funds where managers only invest in instruments that have all the four components of a bond listed above. Such investors have a wide range of choice of bonds which include domestic government bonds, domestic corporate bonds, foreign bonds, Eurobonds (including Medium Term Notes) global bonds. In purchasing these bonds fixed income fund managers may opt to diversify between different economic sectors or even countries and geographical regions. Typically fund managers start with four criteria:
• The type of issuer: government, supranational or corporate
• The place of issue: domestic market, foreign market, "Euro" or global market.
• The terms of the issue: fixed or floating coupons, bullet or amortised repayment
• The method of distribution: public, private, tranche, continuously-offered (MTNs).
When many bonds are put together any change in their respective four basic components will affect the portfolio as a whole. Some other changes which affect the portfolio of bonds are outside of the investor’s control; for example macro economic factors (for government bonds), rating (for corporate bonds) and most importantly interest rates.
Bifurcation
Bifurcation is the separation of a host contract from the embedded derivatives in order to account for the latter as derivatives pursuant SFAS 133. The following conditions must apply. First the economic characteristics and risk of the embedded derivatives are not closely and clearly related to the economic characteristics and risk of the host contract. The hybrid instrument is not re–measured at fair value. A separate instrument with the same terms would be subject to SFAS 133.
Business combination
Business combination as the bringing together of separate entities or businesses into one reporting entity (IFRS 3 defines). In determining whether a transaction should be accounted for in accordance with IFRS 3 the entity should consider whether the items acquired or assumed meet the definition of a business. A business in IFRS 3 is an integrated set of activities and assets conducted and managed for the purpose of providing a return to investors or lower of costs or other economic benefits directly and proportionately to policy holders or participants.
Call option
A call option or simply "call" is a financial contract between two parties: the buyer and the seller. The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price).
The seller (or "writer") is obligated to sell the underlying (commodity or financial instrument) should the buyer so decide. The buyer pays a fee (called a premium) for this right.
Cash flow hedge
A cash flow hedge is a hedging relationship in which the variability of the hedged item’s cash flow is offset by the cash flows of the hedging instrument. In addition, the hedged item is a forecasted transaction or balance sheet item with variable cash flows.
Current accounting standards states that the effective portion of the gain or loss on a derivative instrument designated and qualifying as a cash flow hedging instrument shall be reported as a component of other comprehensive income (outside earnings) and reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings. The remaining gain or loss on the derivative instrument, if any, shall be recognized currently in earnings.
This cash flow hedge treatment is often applied when using floating to fixed interest rate swaps in conjunction with variable rate loans.
Chinese Wall
An independent arrangement within a financial institution which is designed to contain and segment the flow of inside information between clearly identified business areas in order to prevent the misuse and abuse of that information and manage the institution’s conflicts of interest.
Clearly–and–closely–related
In discussing whether a hybrid instrument contains an embedded derivative instrument, that warrants separate accounting, current standards focus on whether the economic characteristics and risks of the embedded derivative are clearly and closely related to the economic characteristics and risks of the host contract(FAS. 133, paragraph 60).
As a practical matter, the FASB decided that not all embedded derivative features should be required to be accounted for separately from the host contract. Many hybrid instruments with embedded derivatives that bear a close economic relationship to the host contract were developed many years ago, for reasons that clearly were not based on achieving a desired accounting result. Prepayable mortgages and other prepayable debt instruments are examples of such familiar compound instruments with embedded derivatives.
The accounting for those types of hybrid instruments is well established and generally has not been questioned. However, other embedded derivatives, such as an equity- or commodity-linked return included in a debt instrument that may cause the value of the instrument to vary inversely with changes in interest rates, do not bear a close economic relationship to the host contract. Even though conceptually all embedded derivatives should be accounted for separately, the FASB decided, as a practical accommodation, that only an embedded derivative that is not considered to be clearly and closely related to its host contract should be accounted for separately.
Collateral
Assets provided by one party (or a third party acting as a credit support provider) to the other party to secure payment of the first party’s obligations in relation to derivative or other transactions in the event of default. Collateral may also take other forms such as the provision of a guarantee by a parent organization.
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Conversion price
The dollar value at which convertible bonds, debentures, or preferred stock can be converted into common stock as announced with the convertible is issued.
Conversion ratio
Relationship that determines how many shares of common stock will be received in exchange for each convertible bond or preferred share when conversion takes place. It is determined at the time of issue and is expressed either as a ratio or as a conversion price from which the ratio can be figured by dividing the par value of the convertible by the conversion price. The indentures of most convertible securities contain an antidilution clause whereby the conversion ratio may be raised (or the conversion price lowered) by the percentage amount of any stock dividend or split, to protect the convertible holder against dilution.
Covered call
A covered call is a combination of owning shares of a stock or other securities and selling (or writing) a call option on those shares in corresponding amounts. It has essentially the same payoffs as a short put option on the stock, and thus should have essentially the same price (or premium) as that of a short put. A covered call strategy provides income that helps cushion, but does not eliminate, the downside risk of stock ownership. As a tradeoff for providing premium income, the strategy limits the potential upside return.
Comprehensive income
Comprehensive income is the sum of net income and other items that must bypass the income statement because they have not been realized, including items like an unrealized holding gain or loss from available for sale securities and foreign currency translation gains or losses. These items are not part of net income, yet are important enough to be included in comprehensive income, giving the user a bigger, more comprehensive picture of the organization as a whole.
In other words, comprehensive income cane be seen as the change in equity (net assets) of a business enterprise during a period of after actions, events and changes in circumstances. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.
Items included in comprehensive income, but not net income are reported under the accumulated other comprehensive income section of shareholder’s equity.
Combination of options
This is generally a combination of a written option and a purchased option, whether in separate option contracts or embodied in a single contract. A combination of options (for example, an interest rate collar) entered into contemporaneously shall be considered a written option if either at inception or over the life of the contracts a net premium is received in cash or as a favorable rate or other term. (Thus, a collar can be designated as a hedging instrument in a fair value hedge without regard to the test in paragraph 20(c) unless a net premium is received.) Furthermore, a derivative instrument that results from combining a written option and any other non-option derivative shall be considered a written option.
Commercial paper
A commercial paper (CP) is a short-term negotiable debt instrument, with maturity ranging from one day to one year. In legal terms, it is a promissory note, whose ownership is freely transferable and evidenced by the fact that the buyer is holding the note (as opposed to requiring the ownership to be registered in someone’s name.
A CP can also be seen as a bearer security which typically entitles its holder to receive a capital payment at the maturity of the bill, which means that it is also classified as capital. There is no payment of income. Coupon bearing CP are also available. Although CP are negotiable securities there is usually no active secondary market. Instead, liquidity is typically provided by agreeing a short term to maturity.
There are domestic markets for CP and since (1984) a euromarket in CP. A domestic commercial paper is written by the issuer in its own national currency, subject to local regulations. Euro-commercial paper is the non domestic version, or offshore version of a commercial paper.
Confirmations
A derivatives transaction is typically initiated by a party over the phone. The oral terms of the transaction are documented in a Confirmation by the initiating party (or the counterparty) and forwarded to the other party for its acceptance. According to market practice, the latter is expected to respond within 48 hours (’exchange of Confirmation’). But the parties may not always finalise the Confirmation within 48 hours.
Each transaction rquires a confirmation. The ISDA has provided several ’standard’ Confirmations (ranging from ’plain vanilla’ derivatives such as interest rate swaps, FX currency swaps, equity swaps, etc, to complex Confirmations such as credit derivatives swaps). For ’structured’ deals (non-standard transactions), the standard ISDA Confirmations will not fit, hence the parties will have to ask their lawyers to draft one for each transaction.
A Confirmation consists of mainly economic and financial payment terms. It is typically brief (usually two to three pages), hence it is sometimes referred to as a ’ticket’. However, for complex derivatives (such as credit derivatives), the Confirmation can be as long as 19 pages or more. All Confirmations form part of the Schedule, which in turn forms part of the Master Agreement. Hence, whilst a Confirmation contains mainly the economic and financial payment terms, the legal aspects of the Confirmation are governed by the Master Agreement via the Schedule.
Contingent interest features
Certain financial instruments (e.g., contingently convertible instruments) contain a feature that requires additional interest to be paid to the holder if certain events occur. (e.g., payment of dividends to common stockholders, failure of the common stock to reach certain target prices, etc.). The may be treated as derivatives instruments under FAS 133 and IAS 39.
Conversion price
The dollar value at which convertible bonds, debentures, or preferred stock can be converted into common stock as announced with the convertible is issued.
Conversion ratio
Relationship that determines how many shares of common stock will be received in exchange for each convertible bond or preferred share when conversion takes place. It is determined at the time of issue and is expressed either as a ratio or as a conversion price from which the ratio can be figured by dividing the par value of the convertible by the conversion price. The indentures of most convertible securities contain an antidilution clause whereby the conversion ratio may be raised (or the conversion price lowered) by the percentage amount of any stock dividend or split, to protect the convertible holder against dilution.
Cross hedge
Cross hedging is a risk management strategy which consists in hedging a position by taking an offsetting position in another transaction with similar price movements. This may involve for example hedging with a futures contract that is different from the underlying being hedged or use of a hedging instrument different from the security being hedged. In such cases, hedging Instruments are usually selected to have the highest price Correlation to the underlying.
Currency Swaps
A currency swap is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and, after a specified period of time, to give back the original amounts swapped. Currency swaps can be negotiated for a variety of maturities up to at least 10 years.
Currency swaps are often combined with interest rate swaps. For example, one company would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a floating-rate debt denominated in Euro. This is especially common in Europe where companies "shop" for the cheapest debt regardless of its denomination and then seek to exchange it for the debt in desired currency.
Defeasance
Defeasance of debt can be either legal or in-substance. A legal defeasance occurs when debt is legally satisfied on the basis of certain provisions in the debt instrument even though the debt is not actually paid. An in-substance defeasance occurs when debt is considered defeased for accounting and financial reporting purposes, even though a legal defeasance has not occurred. When debt is defeased, it is no longer reported as a liability on the face of the balance sheet; only the new debt, if any, is presented in the financial statements.
Delta
The Delta can be approached in many ways. First Delta could be seen as expected change in option position value (in ticks) for a one tick upward movement in the underlying futures contract price. Second it is the number of underlying contracts equivalent to the position in options or the probability that the option will finish in-the-money.
Delta hedging
Delta hedging is the process in finance of setting or keeping the delta of a portfolio of financial instruments zero, or as close to zero as possible - where delta is the sensitivity of the value of a derivative to changes in the price of its underlying instrument. This is achieved by entering into positions with offsetting positive and negative deltas such that these balance out to bring the net delta to zero.
Derecognition
Derecognition in the context of financial assets is the removal of the financial asset from the balance sheet through sale, payment, renegotiation, or default of the counter-party (IAS 39 R.9).
Derivative instrument
A financial instrument or other contract with all three of the following characteristics: first it has one or more underlyings. In has one or more notional amounts and or contains payment provisions. Those terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. Its terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
Detachable stock purchase warrants
Unlike convertible debt, debt with detachable warrants to purchase stock is usually issued with the expectation that the debt will be repaid when it matures. The provisions of the debt agreement are usually more restrictive on the issuer and more protective of the investor than those for convertible debt. The terms of the warrants are influenced by the desire for a successful debt financing. Detachable warrants often trade separately from the debt instrument. Thus, the two elements of the security exist independently and may be treated as separate securities (Accounting Principles Board (APB) Opinion No. 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants, paragraph 13).
Dollar offset method
The dollar-offset method compares the changes in the fair value or cash flows of the hedged item that are attributable to the hedged risk and the changes in the fair value or cash flows of the hedging instrument.
Documentation
IAS 39 requires key information about the hedging relationships to be formally documented prior to hedge accounting treatment being applied, this may be at the date of inception of the hedging instrument or a subsequent date. Failure to establish this documentation will mean hedge accounting cannot be adopted and what level of detail there should be. IAS 39 sets out the areas that hedge documentation should cover, but does not go as far as giving specific examples of proforma documentation. Many banks develop their own pro-forma documentation that can be used for all types of hedge.
The advantage the pro-forma approach brings is that it ensures a consistent standard of documentation for all of an organisation’s hedges and that the key information is captured each time.
The standard is specific about the timing and types of documentation required for an entity to apply hedge accounting. These requirements are detailed here in bullet point form and discussed in greater detail below. (IAS 39.88)
• Formal documentation of the hedging relationship.
• Formal documentation of the risk management objective and strategy for undertaking the hedge.
• Identification of the hedged item.
• Identification of the hedging instrument.
• The nature of the risk being hedged.
• How the entity will assess effectiveness.
Documentation ISDA
Most derivatives transactions in the global derivatives market are documented under the International Swaps and Derivatives Association (ISDA) documentation. ISDA documentation is highly complex and technical. Unlike other legal documentation, the ISDA documentation of derivatives involves a mosaic of documents.
At the heart of the ISDA documentation is the ISDA Master Agreement (’Master Agreement’). As its name suggests, it is a ’master’ agreement. Once signed, it governs all past and future individual transactions entered into between the parties. Hence, the Master Agreement must be negotiated with care and prudence. The types of derivatives that may be documented under the Master Agreements are rate swaps, basis swaps, forward rates, commodity swaps, commodity options, equity/equity index swaps, equity/equity index options, bond options, interest rate options, foreign exchange, caps, floors, collars, swaptions, currency swaps, cross currency swaps, currency options, credit derivatives and combinations of the above.
Effectiveness
The effectiveness test requires an analysis of the changes in fair value of the hedging instrument and the hedged item for the designated risk. The purpose of this analysis is to determine whether the fair value changes are expected to "almost fully offset" on a prospective basis (the prospective test) and actually offset within a 80–125% range (the retrospective test).
Embedded Derivative Instruments
Contracts that do not in their entirety meet the definition of a derivative instrument such as bonds, insurance policies, and leases, may contain "embedded" derivative instruments’ implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by the contract in a manner similar to a derivative instrument. The effect of embedding a derivative instrument in another type of contract ("the host contract") is that some or all of the cash flows or other exchanges that otherwise would be required by the contract, whether unconditional or contingent upon the occurrence of a specified event, will be modified based on one or more underlyings. An embedded derivative instrument shall be separated from the host contract and accounted for as a derivative instrument pursuant to this Statement if and only if all of the following criteria are met:
• The economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract.
• The contract ("the hybrid instrument") that embodies both the embedded derivative instrument and the host contract is not remeasured at fair value with changes in fair value reported in earnings as they occur
• A separate instrument with the same terms as the embedded derivative instrument would be a derivative instrument subject to the requirements of this Statement. Also the initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.
Equity related contracts
Contracts that are indexed to and potentially settled in equity shares. Examples of these contracts include written put options, written call options (and warrants), purchased put options, purchased call options, forward sale contracts, and forward purchase contracts. These contracts may be settled using a variety of settlement methods, or the issuing company or counterparty may have a choice of settlement methods (EITF Issue No. 00–19).
Exchange rate
An exchange rate is the rate at which one currency can be exchange against another (this is often quoted differently depending on whether it is a tourist rate or the FX market rate). In financial markets an exchange rate is the cost of a unit of one currency expressed in units of another. It is also the price of one currency expressed in units of another.
Execution (futures contracts)
The investor may close out contracts at any time up to expiration date. Subject to the type of contract and the relevant stock exchange regulations, the contract may be closed out either by selling the contract or by entering into an identical contract with a converse buying or selling commitment. In the latter case, the buying or selling obligation arising from the first contract is neutralized by the converse contract. Unless closed out prior to the expiration date, the contracts must be exercised on expiration date according to the following principles:
Futures contracts on assets may be exercised by physical delivery of the underlying assets or by cash settlement. These contracts are usually exercised by physical delivery, unless the possibility of cash settlement is exceptionally provided by the contract or the relevant stock exchange regulations. Other particulars of the exercise, in particular the place of exercise, are subject to individual contract details. Futures contracts on benchmarks (except currencies) cannot be exercised by physical delivery of the underlying instrument. The method of exercise is invariably cash settlement.
In the case of physical delivery of the underlying instrument, the full value of the contract is due, whereas cash settlement is limited to the difference between the price agreed at the outset of the contract and the current market value at the time of exercise. Consequently, the investor must hold more liquidity for physical delivery contracts than for cash settlement contracts.
In practice, most futures contracts are settled before maturity by liquidation: the holder of a long (short) futures position sells (buys) an identical number of futures contracts to cancel out the position. Those futures contracts held until maturity are either cash settled or settled by physical delivery. When a futures contract is cash settled, it is marked-to-market, and the net difference between the original trading price and settlement price represents the settlement amount. Physical delivery of the underlying asset is specified by the futures contract. Normally, the seller is given the choice of which asset to deliver and when to deliver it.
Fair Value
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Valuation techniques that are appropriate in the circumstances and for which sufficient data are available shall be used to measure fair value. Valuation technique shall be consistently applied while maximizing the use of observable inputs (priority to quoted prices (unadjusted) in active markets for identical assets or liabilities) and minimizing non-observable inputs
Fair Value Hedge
A fair value hedge is a hedge of the exposure to a change in fair value of a recognized asset, or liability, or of an unrecognized firm commitment attributable to a particular risk. For a highly effective hedge there must be offsetting fair value changes for the hedged item and the hedging instrument. Changes in fair value of the hedged item and the hedging instrument are recorded in earnings.
FpML (Financial products Markup Language)
Financial products Markup Language is a financial industry-standard protocol for complex financial products. It is based on XML (Extensible Markup Language), the standard meta-language for describing data shared between applications.
Firm commitment
Agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics: a. The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity’s functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield. b. The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable (FAS 138, Par. 40)
Forecasted transaction
A transaction that is expected to occur for which there is no firm commitment. Because no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or a present obligation for future sacrifices (FAS 133, Par. 540).
Foreign exchange
The price of one currency in terms of another. Although exchange rates are affected by many factors, in the end, currency prices are a result of supply and demand forces. The world’s currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange. Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.
Freestanding financial instrument
A financial instrument that is entered into separately and apart from any of the entity’s other financial instruments or equity transactions, or that is entered into in conjunction with some other transaction and is legally detachable and separately exercisable.
Futures
Contract to buy or sell a standard quantity of a specific asset (or, in some cases, receive or pay cash based on the performance of an underlying asset, instrument or index at a pre-determined future date and at a price agreed through a transaction undertaken on an exchange.
Foreign Currency fair value hedge
A derivative instrument or a nonderivative financial instrument that may give rise to a foreign currency transaction gain or loss can be designated as hedging changes in the fair value of an unrecognized firm commitment, or a specific portion thereof, attributable to foreign currency exchange rates (FAS 133, Paragraph 37).
Forward Transactions
In FX, a way of eliminating exchange rate risk when you are to receive or make a foreign currency payment in the future. A forward transaction enables you to buy or sell a currency at a fixed rate on a specified future date. By linking this date to the date of your currency payment, you in effect lock in the exchange rate you want and eliminate the risk of future volatility.
In general a forward contract is a purchase or sale of a specific quantity of a commodity, security, foreign currency, or other financial instrument at the current or spot price, with delivery and settlement at a specified future date. Because it is a completed contract, as opposed to an options contract where, the owner has the choice of completing or not completing, a forward contract can be a cover for the sale of a futures contract.
Functional currency
Functional currency is the currency of the primary economic environment in which the entity operates (IAS 21 R.8). The functional currency is important because all foreign currency transactions and items are measured in the functional currency of an entity. The functional currency drives the exchange gains and losses. The term ’functional currency’ is used in the 2003 revision of IAS 21 in place of ’measurement currency’ but with essentially the same meaning.
Gamma
The Gamma can be interpreted as the expected change in Delta or the expected change in Future equivalents for a one tick upward movement in the underlying Future contract price. For example, if an option has a delta of 0.55 and a gamma of 0.05, its delta will be expected to move up (down) by 0.05 points for each tick upward (decrease) movement in the price of the underlying contract (with all other variables held constant). A small gamma means that delta changes only slowly and adjustments to keep a portfolio delta neutral need only be made relatively infrequently. A large means that delta is highly sensitive to the price of the underlying future contract and the option position has to be adjusted as soon as the underlying price has changed.
Guaranteed investment contract (GIC)
In a GIC, the issuer of the contract takes deposits from a benefit plan or other institutional customer and purchases investments that are held in its general account (Equity investments may also be acquired, although they are less common than fixed income investments). The benefit plan is a creditor of the issuing company and therefore has credit risk, although generally the GIC issuers have a high credit-quality rating. The issuer is contractually obligated to repay the principal and specified interest guaranteed to the benefit plan. The plan’s provisions typically permit the participant to withdraw funds from the fund at book value (also referred to as account or contract value) for specified reasons such as loans, hardship withdrawals and transfers to other investment options offered by the plan.
Gearing (or Leverage)
In the context of a derivatives transaction, gearing is a generic term used to describe the situation where a party may be required at the time a transaction is executed to put up only a small proportion of the total price of the transaction. This element of gearing has the effect of enhancing the risks and rewards involved in transacting derivatives.
Hedging
A generic term that describes the use of derivatives or other financial instruments for the purpose of reducing or modifying risk exposure in, for example, interest rates, exchange rates, commodity prices or equity prices.
Hedging is the attempt to mitigate the impact of economic risks on an entity’s performance. Many businesses will engage in hedging activity to limit economic risk. Hedging activity can be as simple as borrowing in a foreign currency where an entity has a usual revenue stream in that currency. Many economic hedges will not meet the criteria to qualify for the special accounting treatment identified in IFRS as hedge accounting.
Hedge accounting modifies the usual accounting treatment of a hedging instrument and/or a hedged item, so as to recognise their offsetting changes in fair value or cash flows in profit or loss at the same time. Hedge accounting requires that a hedging instrument, normally a derivative, is designated as an offset to changes in the fair value or cash flows of a hedged item. Non-derivative financial instruments may be used as hedging instruments in certain limited circumstances. A hedged item can be an asset, liability, firm commitment, highly probable forecast transaction, or net investment in a foreign operation that exposes the entity to the risk of changes in fair value or future cash flows and is designated as being hedged (IAS39 R.9). A hedged item can be a single item or a group of items with similar risk characteristics.
Highest and best
The concept of highest and best is used is a valuation context (e.g. application the fair value concept) and refers to the use of an asset that would maximize the fair value of the asset or the group of assets in which the asset would be used by market participants. Highest and best use is determined based on the use of the asset by market participants, even if the intended use of the asset by the reporting entity is different.
HTM Held–to–Maturity
Securities that the company has the positive intent and ability to hold to maturity are classified as held–to–maturity securities. The impact of temporary fluctuations in fair value of some debt securities may not reflected in the Company’s financial statements. Equity securities that have no maturity date may not classified as held–to–maturity.
Host contract
A contract, whether or not itself a financial instrument within the scope of IAS 39, whose contractual provisions contain an embedded derivative. Examples of non–financial hosts include leases, insurance contracts and sale or purchase agreements.
Initial net investment
Many derivative instruments require no initial net investment. Some require an initial net investment as compensation for time value (for example, a premium on an option) or for terms that are more or less favorable than market conditions (for example, a premium on a forward purchase contract with a price less than the current forward price). Others require a mutual exchange of currencies or other assets at inception, in which case the net investment is the difference in the fair values of the assets exchanged. A derivative instrument does not require an initial net investment in the contract that is equal to the notional amount (or the notional amount plus a premium or minus a discount) or that is determined by applying the notional amount to the underlying.
Insider Trading
Wrongful use (including dealing) of information, which has not been made public, of a precise nature relating to one or more issuers of financial instruments or to one or more financial instruments, which, if it were made public, would be likely to have a significant effect on the price of those financial instruments or on the price of related derivative financial instruments. In the context of commodity derivatives, the information must also be of a kind that a user of markets on which such derivatives are traded would expect to receive in conformity of expected market practice on those markets.
Intercompany Derivatives
A derivative instrument contract between two members of a consolidated group. A foreign currency derivative contract that has been entered into with another member of a consolidated group (such as a treasury center) can be a hedging instrument in a foreign currency cash flow hedge of a forecasted borrowing, purchase, or sale or an unrecognized firm commitment.
Intramarket spread
An intramarket spread also called a time spread, comprises a long position in one contract month against a short position in another contract month in the same futures contract on the same exchange. An example would be long March world sugar futures vs. short July sugar futures on the Coffee, Sugar and Cocoa Exchange (CME) or short October cotton futures vs. long December cotton futures on the New York Cotton Exchange. The spread, or difference, between the prices of various futures delivery months reflects supply, demand and carrying costs. Because carrying costs generally increase over time, in many futures markets the price of each succeeding delivery month is higher than that of the preceding delivery month.
This is called a carrying–charge, or contango market. In contrast, in some futures markets the highest price is for the nearby or spot month, and each successive delivery month is priced lower than the preceding month. This is called an inverted market, or backwardation. Inverted markets sometimes occur when demand for the cash commodity is strong relative to its current supply. Inverted markets also occur when the income from holding the cash position exceeds the costs of carrying the position; for example a U.S. Treasury bond futures position when long–term interest rates (the underlying bonds’s yield) exceed short-term rates (the cost of financing the cash bond portfolio).
Interest rate swaps
One party exchanges a stream of interest for another party’s stream. Interest rate swaps are normally ’fixed against floating’, but can also be ’floating against floating’ rate.
Interest rate swaps are often used by companies to alter their exposure to interest–rate fluctuations, by swapping fixed–rate obligations for floating rate obligations, or swapping floating rate obligations to fixed-rate obligations. By swapping interest rates, a company is able to alter their interest rate exposures and bring them in line with management’s appetite for interest rate risk.
Interpolation
Market data needed to develop the different pricing curves are not always complete. For example rates for some of the maturity points may not be available due to lack of liquidity. As a consequence, not all discount factors will be known for all maturities. In some circumstances, the cash deposit rates plus, the futures rates plus, the swaps rates have to be joined together in order to produce a curve that covers the short end and also the long end of the market rate (for example from O/N to 13 years where the rate for 13 year swaps does not exist).
Intrinsic value
Difference between the exchange price or strike price of an option and the market value of the underlying security. For example if the strike price is $53 on a call option to purchase a stock with a market price of $55, the option has an intrinsic value of $2. Or, in the case of a put option, if the strike price was $55 and the market price of the underlying stock was $53, the intrinsic value of the option would also be $2. Options at-the-money or out-of-the-money have no intrinsic value.
LIBOR
London Interbank Offered Rate (LIBOR). LIBOR is the rate on dollar-denominated deposits, also know as Eurodollars, traded between banks in London. The index is quoted for one month, three months, six months as well as one-year periods. LIBOR is the base interest rate paid on deposits between banks in the Eurodollar market.
A Eurodollar is a dollar deposited in a bank in a country where the currency is not the dollar. The Eurodollar market has been around for over 40 years and is a major component of the International financial market. London is the center of the Euromarket in terms of volume. Traditionally, the LIBOR rate quoted in the Wall Street Journal has been an average of rate quotes from five major banks: Bank of America, Barclays, Bank of Tokyo, Deutsche Bank and Swiss Bank.
LIBOR swap rate
The fixed rate on a single–currency, constant–notional interest rate swap that has its floating–rate leg referenced to the London Interbank Offered Rate (LIBOR) with no additional spread over LIBOR on that floating–rate leg. That fixed rate is the derived rate that would result in the swap having a zero fair value at inception because the present value of fixed cash flows, based on that rate, equate to the present value of the floating cash flows (FAS 138, Par. 40).
Margin requirement and margin cover
A margin is a cash or securities deposited with a firm or clearing house both as a form of collateral and a way of settling realised profit and loss on positions. Margin payments are designed to ensure that clearing members have sufficient resources to support open positions (that is, positions not matched by offsetting transactions or satisfied by delivery). For this reason, margin is calculated and adjusted on a daily basis according to present market movement. An initial margin is agreed at the outset of the contract for both, the forward purchase and the forward short sale of an underlying instrument.
The initial margin is usually expressed in terms of a percentage of the purchase price of eligible instruments for example some fraction perhaps 75% of initial margin for a position. The calculation method of the variation margin during the life of the contract or in the event of its closing out is subject to the relevant stock exchange regulations and the details of the contract.
Throughout the life of the contract the investor must maintain a sufficient margin cover with the securities dealer, as required for the initial and variation margins. An additional variation margin is determined periodically throughout the life of the contract. The variation margin represents the accounting profit or loss resulting from the fluctuation of the futures contract or the underlying instrument. The variation margin may amount to a multiple of the initial margin.
Market Manipulation
Transactions or orders to trade which give or are likely to give false or misleading signals as to the supply, demand or price of financial instruments, or which secure, by one or more persons acting in collaboration, the price of one or several financial instruments at an abnormal or artificial level, or which employ fictitious devices or any other form of deception or contrivance.
Market Participants
Market participants are buyers and sellers in the principal (or most advantageous) market for the asset or liability that are:
• Independent of the reporting entity; that is, they are not related parties
• Knowledgeable, having a reasonable understanding about the asset or liability and the transaction based on all available information, including information that might be obtained through due diligence efforts that are usual and customary
• Able to transact for the asset or liability
• Willing to transact for the asset or liability; that is, they are motivated but not forced or otherwise compelled to do so.
Among their many functions, markets are systems that transmit information in the form of prices. Marketplace participants attribute prices to assets and, in doing so, distinguish the risks and rewards of one asset from those of another. Stated differently, the market’s pricing mechanism ensures that unlike things do not appear alike and that like things do not appear to be different (a qualitative characteristic of accounting information). An observed market price encompasses the consensus view of all marketplace participants about an asset or liability’s utility, future cash flows, the uncertainties surrounding those cash flows, and the amount that marketplace participants demand for bearing those uncertainties.
Master Agreement
A master agreement setting out the terms (including the terms as to netting) of the various transactions covered by it.
Matrix pricing
In security valuation, matrix pricing is a mathematical technique used principally to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities’ relationship to other benchmark quoted securities.
Marked–to–market
In finance and accounting, mark–to–market is the act of assigning a value to a position held in a financial instrument based on the current market price for that instrument or similar instruments. For example, the final value of a futures contract that expires in 9 months will not be known until it expires. If it is marked to market, for accounting purposes it is assigned the value that it would fetch in the open market currently.
Most advantageous (or Principal) Markets
The most advantageous market is the market in which the reporting entity would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability, considering transaction costs in the respective markets.
Net settlement
Settlement provisions meet one of the following criteria:
First, neither party is required to deliver an asset that is associated with the underlying or that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount (or the notional amount plus a premium or minus a discount). For example, most interest rate swaps do not require that either party deliver interest-bearing assets with a principal amount equal to the notional amount of the contract (FAS 133, Paragraph 6).
Second, One of the parties is required to deliver an asset of the type described in paragraph 9(a), but there is a market mechanism that facilitates net settlement, for example, an exchange that offers a ready opportunity to sell the contract or to enter into an offsetting contract.
One of the parties is required to deliver an asset of the type described in paragraph 9(a), but that asset is readily convertible to cash or is itself a derivative instrument. An example of that type of contract is a forward contract that requires delivery of an exchange–traded equity security. Even though the number of shares to be delivered is the same as the notional amount of the contract and the price of the shares is the underlying, an exchange–traded security is readily convertible to cash. Another example is a swaption which is an option to require delivery of a swap contract, which is a derivative.
Netting
The process by which a single payment obligation is derived from a number of sums owing between the parties. There are two types of netting. First close-out netting which is the netting of payment obligations produced upon termination of a master agreement governing such obligations. Second, is payment netting which is the netting of payment obligations denominated in the same currency under the same transaction or a specified group of transactions (as the parties may agree). In contrast to close–out netting which only applies upon termination of the master agreement, payment netting operates on an on-going basis, during the life of the relevant master agreement.
Netting risk
According to the FAO (Futures and Options Association) netting risk is the risk that firms’ netting arrangements with their customers may be susceptible to challenge by a liquidator in the event of customer default with the result that the liquidator could be entitled to claim and realise customers’ profitable transactions for the benefit of creditors, while leaving the firm to claim for the gross amount of the losses on unprofitable transactions in the liquidation. Effective netting arrangements, on the other hand, mean that a firm may net off profitable and losing transactions against each other, thereby limiting their loss in the event of a default.
Nonrecourse financing
This is lending or borrowing activities in which the creditor does not have general recourse to the debtor but rather has recourse only to the property used for collateral in the transaction or other specific property.
Non–Deliverable Forwards
A way to hedge exposures in emerging market currencies where a conventional forward market does not exist or is restricted. Like a conventional forward, a non-deliverable forward makes it possible to hedge future currency exposure. However, in contrast to a conventional forward, a non-deliverable forward is settled in U.S. dollars and involves no physical exchange of foreign currencies at maturity.
Normal purchases and normal sales
Normal purchases and normal sales are contracts with no net settlement provision and no market mechanism to facilitate net settlement (as described in FAS 133 paragraphs 9(a) and 9(b)). They provide for the purchase or sale of something other than a financial instrument or derivative instrument that will be delivered in quantities expected to be used or sold by the reporting entity over a reasonable period in the normal course of business.
Off–balance sheet financing
A form of financing in which large capital expenditures are kept off of a company’s balance sheet through various classification methods. Companies will often use off–balance–sheet financing to keep their debt to equity (D/E) and leverage ratios low, especially if the inclusion of a large expenditure would break negative debt covenants.
Examples of off–balance–sheet financing include joint ventures, research and development partnerships, and operating leases (rather than purchases of capital equipment).
Operating leases are one of the most common forms of off–balance–sheet financing. In these cases, the asset itself is kept on the lessor’s balance sheet, and the lessee reports only the required rental expense for use of the asset.
Option
An option is the right and not the obligation to buy or sell an amount of a specified financial instrument (the underlying) for delivery on or before a specified date in the future (the expiry) and at a price which is agreed on the trade date (the strike) Options are bought and sold on the following products:
• Treasury bills
• Three month Eurocurrency rates
• Treasury bonds
• Equity indices
• Currencies
• Commodities
Alongside these traditional underlying instruments, many markets players (i.e. brokers, bank and securities houses) make OTC market exotic options which incorporate complex payoffs. In many cases these options are embedded in structured securities such as:
• Warrants
• Callable or putable bonds
• Asset–backed securities
• Convertible bonds
• Capped floating rate notes
• Capital protected notes
• Corridor notes
• Cliquet bonds
• Options on options
• Swaptions (options on swaps)
Options are widely used by fund managers, corporate treasurers and traders to create or modify market exposures. In addition, it is also possible to invest in fund options notably in the US. This type of fund specializes in writing call options against the stocks held in their portfolio. Such funds can of course only operate when regulations allow them to conduct such derivatives activities.
Over–the–Counter (OTC)
A security or other instrument that is not traded on a "regulated market" (i.e. an exchange) but by way of private negotiation between counterparties. OTC instruments can be created by and under any provisions acceptable to the parties and permitted by law.
Physical settlement
A form of settling a financial instrument under which (1) the party designated in the contract as the buyer delivers the full stated amount of cash or other financial instruments to the seller and (2) the seller delivers the full stated number of shares of stock or other financial instruments or nonfinancial instruments to the buyer.
Pricing
Pricing means determining the value of a financial instrument at a point in time. It requires the gathering of information that is likely to affect the instrument during its lifetime. In the case of call options pricing the information needed can be seen from a typical exchange-traded contract. It includes the underlying, the time to expiration (which is expressed as a decimal fractional of a year). The contract also provides the volume or size of the contract. Other necessary information come from the market for example the risk free rate (This could be the rate earned on riskless investment typically a 90 days US Treasury Bill) over a time period equal to the option’s remaining life.
Put option
A put option is a financial contract between two parties, the buyer and the writer of the option. The put allows the buyer the right but not the obligation to sell a commodity or financial instrument (the underlying instrument) to the writer of the option at a certain time for a certain price (the strike price). The writer has the obligation to purchase the underlying asset at that strike price, if the buyer exercises the option. The writer of the option is agreeing to buy the underlying asset if the put holder exercises the option. In exchange for having this option, the buyer pays the writer a fee (the premium).
Although option writers are frequently referred to as sellers, because they initially sell the option that they create, thus, taking a short position in the option, they are not the only sellers.
An option holder can also sell his long position in the option. However, the difference between the two sellers is that the option writer takes on the legal obligation to buy the underlying asset at the strike price, whereas, the option holder is merely selling his long position, and is not contractually obligated by the sold option.)
A put option in the context of a debt instrument is the right for the holder of the instrument to force the issuer to redeem in the instrument. This is also called redeemable or puttable debt.
Put warrants
Put warrants are instruments with characteristics of both warrants and put options. The holder of the instrument is entitled to exercise:
• the warrant feature to acquire the common stock of the company at a specified price
•the put option feature to put the instrument back to the company for a cash payment, or, in some cases,
•both the warrant feature to acquire the common stock and the put option feature to put that stock back to the company for a cash payment.
Put warrants are frequently issued concurrently with debt securities of the company, are detachable from the debt, and may be exercisable only under specified conditions. The put feature of the instrument may expire under varying circumstances, for example, with the passage of time or if the company has a public stock offering.
Stock volatility
A measure of the changes in a financial instrument’s price over a specified period of time. Higher volatility which is generally measure in terms of standard deviation is what makes call options attractive and investors are willing to pay high premium for them.
Regular–way security trades
Regular–way security trades are generally contracts with no net settlement provision and no market mechanism to facilitate net settlement. They may sometime provide for delivery of a security within the time generally established by regulations or conventions in the marketplace or exchange in which the transaction is being executed (as described in FAS 133 paragraphs 9(a) and 9(b)).
Regulated Market
A market which provides a multi–lateral dealing facility for the buying and selling, clearing and settling of financial instruments and which operates according to non–discretionary rules set by the operator; and which is licensed and regulated by a public body.
Reload options
Options that are granted upon exercise of previously granted options whose original terms provide for the use of shares of stock that the employee has held for a specified period of time, referred to as mature shares, rather than cash to satisfy the exercise price. At the time of exercise using mature shares, the employee is automatically granted a reload option for the same number of shares used to exercise the original option. The exercise price of the reload option is the market price of the stock at the date the reload option is granted; its term is equal to the remainder of the term of the original options.
Reverse/Repo
Repurchase agreement (repo or RP) and reverse repurchase agreement refers to a type of transaction in which a money market participant acquires funds which are immediately available by selling securities and simultaneously agreeing to repurchase the same or similar securities after a specified time at a given price, interest at an agreed-upon rate incurred.
The term to be used whether a repro or reverse agreement, usually depends on which party initiated the transaction, with a few exceptions: RP transactions between a dealer and a retail customer or between a dealer and the Federal Reserve, for example, are generally described from the dealer’s perspective.
Rollover Risk
In the context of exchange–traded transactions, rollover is the process by which a transaction entered into in respect of a particular settlement date is replaced by a new transaction which is to be settled on the next succeeding settlement date. Rollover risk is the risk that the market price for the new transaction may deviate from its fair value.
Schedule
The Schedule is an integral part of the Master Agreement. It is used to customise the Master Agreement by amending the Standard Terms and specifying certain details for the Standard Terms. For instance, the Threshold Amount for the Cross Default clause in section 5(a)(vi) of the Master Agreement is specified in Part 1(C) of the Schedule. Since all the negotiation of the Master Agreement is documented here, it is also the most contentious part of the ISDA documentation.
Contrary to the notion that documenting the Master Agreement is merely filling in the blanks, its negotiation and documentation is more like a game of chess. It requires negotiation skill, precision drafting and experience to anticipate a move by your counterparty.
How good an agreement a legal counsel can negotiate for his client would also, in part, depend on the relative credit rating of the client. The negotiation of the Schedule typically takes weeks, months or sometimes (based on the writer’s own experience) even more than a year. It is also challenging that some jurisdictions (eg Malaysia) even impose a ’two months rule’ to sign the Master Agreement (ie to finalise the Schedule).
Securitization
Securitization is a financing technique that allows a corporation to separate credit origination and funding activities. The technique comes under the umbrella of structured finance as it applies to assets that typically are illiquid contracts. It has evolved from tentative beginnings in the late 1970s to a vital funding source.
Black’s Law Dictionary (7th ed.): Securitization is the process of homogenizing and packaging financial instruments into a new fungible one. Acquisition, classification, collateralization, composition, pooling and distribution are functions within this process
Securitization (Mark Fisher and Zoe Shaw, eds., Euromoney Books, London 2003): Securitization is the packaging of designated pools of loans or receivables with an appropriate level of credit enhancement and the redistribution of these packages to investors. Investors buy the repackaged assets in the form of securities or loans which are collateralized (secured) on the underlying pool and its associated income stream. Securitization thereby converts illiquid assets into liquid assets.
Securitization has two prototypical transaction types: cash and synthetic. In cash securitization, the corporation pools assets together for purchase by a bankruptcy-remote special purpose vehicle (SPV) or special purpose entity (SPE); purchase is effected by issuing multiple tranches of securities based on the cash flow generating capacity of the asset pool. (For more on the capital structure of SPEs please consult the section on asset-backed securities.) In synthetic securitization, the corporation buys a credit default swap (or, less commonly, a total return swap) on certain asset exposures as a kind of default insurance for credits that remain on balance sheet; the swap can be an outright trade or it can be embedded in the balance sheet of an SPE against which liabilities are issued.
Financial institutions and businesses of all kinds use cash securitization to immediately realize the cash value of their illiquid contracts or remove assets from the balance sheet.
Short cut method
An accounting mechanism that allows an entity to assume no ineffectiveness in a hedge of interest rate risk using an interest rate swap as the hedging instrument, provided specified criteria are met. The shortcut method is not permitted under IAS 39. As explained in paragraph BC135 of IAS 39, one of the main reasons for not permitting the shortcut method in IAS 39 is the ability of an entity to hedge portions of financial assets and liabilities leading, in many cases, to no ineffectiveness being recognised.
IAS 39 Assume perfect effectiveness of a hedge if critical terms match. SFAS 133 Allows for hedge of interest rate risk in a debt instrument if certain conditions are met.
Special purpose entity (Vehicle)
A special purpose entity (SPE) (sometimes, especially in Europe special purpose vehicle) is a body corporate (usually a limited company of some type or, sometimes, a limited partnership) created to fulfill narrow, specific or temporary objectives, primarily to isolate financial risk, usually bankruptcy but sometimes a specific taxation or regulatory risk.
A special purpose entity may be owned by one or more other entities and certain jurisdictions may require ownership by certain parties in specific percentages. Often it is important that the SPE not be owned by the entity on whose behalf the SPE is being set up (the sponsor). For example, in the context of a loan securitisation, if the SPE securitisation vehicle were owned or controlled by the bank whose loans were to be secured, the SPE would be consolidated with the rest of the bank’s group for regulatory and accounting purposes, which would defeat the point of the securitisation. Therefore many SPEs are set up as ’orphan’companies with their shares settled on charitable trust and with professional directors provided by an administration company to ensure there is no connection with the sponsor.
Short sales (sales of borrowed securities)
Short sales typically involve a number of transactions. First Selling a security (by the short seller to the purchaser), second borrowing a security (by the short seller from the lender) and third delivery of the borrowed security (by the short seller to the purchaser). In the fourth step the short seller buys the security in the open market which she finally delivers to the lender. The five activities involve three separate contracts (buying, borrowing and replacing the security by delivering an identical security). (FAS 133, Par. 59)
Spot foreign
A spot foreign transaction is a contract to exchange two currencies typically in two business days at an exchange rate agreed today. The day on which the exchange rate is agreed is called the transaction date while the actual date of the exchange is called the spot value date. When currencies are exchanged on the business day following the transaction date, this is known as value tomorrow or next day transaction. When the currencies are exchanged on the transaction date itself, this is known as value today or same day transaction.
Spot Contracts
A spot contract allows you to buy or sell foreign currency at today’s exchange rate, with final settlement occurring, in most cases, two business days later.
Swap
A swap is a contractual agreement evidenced by a single document in which the two parties known as counterparties, agree to make periodic payments to each other. Contained in the swap agreement are the specification of the currencies to be exchanged (which may or not be the same), the rate of interest applicable to each (which may or may not be fixed), the time table by which the payments are to be made and any other provisions bearing on the relationship between the two.
Theta
In option instruments Theta is the expected change in option position value for a one day decrease in time to maturity, ceteris paribus. The theta is sometimes referred to as an option’s time decay. Theta is usually negative. This is because as time-to-maturity decreases; the option tends to become less valuable. Example: If an option (or a portfolio) has a theta of -0.02, its price (value) will be expected to lose 2 ticks in value for each day that passes.
Total Return Swap
A Total Rate of Return Swap (or TRS) is a bilateral financial contract designed to transfer credit risk between parties, but a TR Swap is importantly distinct from a Credit Swap in that it exchanges the total economic performance of a specified asset for another cash flow. That is, payments between the parties to a TR Swap are based upon changes in the market valuation of a specific credit instrument, irrespective of whether a credit event has occurred.
Underlying, notional amount, and payment provision.
An underlying is a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable. An underlying may be a price or rate of an asset or liability but is not the asset or liability itself. A notional amount is a number of currency units, shares, bushels, pounds, or other units specified in the contract. The settlement of a derivative instrument with a notional amount is determined by interaction of that notional amount with the underlying. The interaction may be simple multiplication, or it may involve a formula with leverage factors or other constants. A payment provision specifies a fixed or determinable settlement to be made if the underlying behaves in a specified manner (FAS 133, Par. 57).
Value–at–risk (VAR)
A measure of quantifying market risk based on an estimated probable (generally within a 95 percent to 99 percent confidence level) loss over a given period of time in the value of an asset or portfolio of assets.
Valuation Techniques
Valuation techniques consistent with the market approach, income approach, and/or cost approach shall be used to measure fair value.
In the market approach, factors to consider include, quoted prices, benchmarks used, multiples used, asset classes and how they correlate, are asset classes identical or have strong similarities.
In the income approach techniques includes present value techniques; option-pricing models, such as the Black-Scholes-Merton formula (a closed-form model) and a binomial model (a lattice model), monte carlo simulation.
The cost approach involves calculating the replacement or obsolescence cost instead of depreciation generally used for financial reporting purposes.
Vega
Vega is the expected change in option position value for a one percent increase in volatility. If vega is high in absolute terms, the option’s (or portfolio’s) value is very sensitive to small changes in volatility. The vega of an option is always positive.
Window Forwards
A window forward contract gives you a range of days (a "window" of time) on which to buy or sell the foreign currency. Window forwards are often used when there is uncertainty regarding the actual payment date.
Warrant
A type of security, usually issued together with a bond or preferred stock that entitles the holder to buy a proportionate amount of common stock at a specified price, usually higher than the market price at the time of issuance, for a period of years or to perpetuity. Weather derivatives.
Yield curve
The yield curve is a graphical display of the relationship between interest rate and term to maturity (this is known as the term structure of interest rates) for borrowers (that is the issuer or the company) with comparable credit rating. The shape of the yield curve is indicative of market expectation about future interest rates.
A yield curve could be drawn for any bond market but it is most commonly drawn for government bonds and particularly the U.S. Treasury market, which offers securities of every maturity, and where all issues bear the same top credit quality.
Journal of Derivatives Accounting (JDA) www.jofda.com