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Find a short explanation to the most commonly used terms in financial markets
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130/30: This term is used in fund management. It is a strategy whereby a fund manager is 100% invested in the stock market but attempts to stock select by investing in shares that he anticipates will go up in value and shorting shares that he think will fall. In simple terms the manager starts with $100 and invests it in shares of ABC. He then short sells $30 of shares in XYZ (a stock he thinks will fall in value) and invests the $30 proceeds in ABC. The net position is long $130 ABC short $30 XYX hence 130/30.
Accrual: The accounting treatment where profit and losses are taken as a steady stream over the life of the transaction. For example if you make 1% on a $10,000,000 deal that is $100,000 per annum or $273.97 per day. Often used for banking book assets. It is somewhat controversial because the daily accrual may not show the true mark-to-market value of the position.
Accrued interest: The accrued interest on a bond is the amount of interest that it has accumulated since the last coupon payment date. If you purchase a bond you will have to pay the seller the dirty price, this is the clean price plus the accrued interest.
Actual/360, Actual/365: This is the normal convention used to calculate interest payments for money market products. For example the interest due on a $1,000,000 deposit placed for 7 days at a rate of 5.00% would be $1,000,000 x 5.00% x 7/360 = $972.22. For Sterling 360 is replaced by 365.
ALCO: This means Asset Liability Committee. It is the formal senior management committee that normally meets weekly in order to discuss treasury and balance sheet issues. This will include market risk exposures, changes to limit structures, risk methodologies, new business objectives and the regulatory environment. The purpose is to ensure a widespread collective decision making process rather than leaving Treasury policy to be made by one individual.
Algorithmic Trading: Algorithms are formulae or complex mathematical models that are used by some traders in financial markets. Algorithmic trading is used to dissipate large orders into the market in order to minimise any price fluctuation that it may cause. Algorithmic trading may also refer to the electronic execution of trading strategies without human intervention. These strategies follow rules that override what the trader may think is a good trade. Sometimes this is referred to as "black box" trading.
Alpha: A term used in fund management. It refers to the return a portfolio manager makes over and above the return he would have got from a portfolio invested in an index representing the market. It is therefore a measure of how much value the fund manager is adding by active stock selection.
American style option: An option that can be exercised by the holder on any date before the expiry date.
Arbitrage:This is the process of buying something in one market and then selling it in another market for a risk free profit. If dealers are able to profit from arbitrage they will do so. This usually means that true arbitrages only last for a short period of time.
Asian option: Normally options use the price of the underlying to determine whether on expiry the option is in or out of the money. Instead of using the underlying price, Asian options use an average of the underlying price that is calculated during the option's life. Asian options generally have lower premium costs because the volatility of an average is lower.
Asset: An asset is something you own, in financial markets an investment is an asset, (see liability).
Asset swap: When a fixed coupon bond is hedged using an interest rate swap. The combined position of the bond and the swap is called an asset swap. An asset swap provides the investor with a variable rate investment.
Auction Rate Security, (ARM): A long term bond, (10 to 30 years), that offers a short term interest rate, (monthly). The investor can sell the bond back to the issuer on each interest rate refixing. They are issued in the Municipal market in the US and carry a monoline insurance that gives them a AAA rating.
Banking book: This is the portfolio where assets that are purchased for the purpose of long term investment are held. It is normally accounted for on an accrual basis, (see trading book).
Base rate: This is the interest rate set every month by the Bank of England's Monetary Policy Committee. It reflects the rate of interest that the Bank charges commercial banks to borrow money. Base rate is used as a tool by the Bank of England to manage short term interest rates and the cost of money. When Base rate is cut it makes borrowing cheaper and inflates the economy. When Base rate is increased it makes borrowing more expensive and deflates the economy.
Basis point: This is regarded as the smallest change in interest rates. 1 basis point is equal to 0.01%, (one, one hundredth of a percent).
Basis point value: (Also called PV01 and DV01). This is a measure of interest rate risk. It shows you how much money you make or lose on a trading position if interest rates change by 0.01%. (Normally it is assumed that interest rates move in a parallel fashion in the calculation of this risk measure).
Basis risk: When dealers hedge risk the process is often less than perfect. This leads to fluctuations in their profit and loss. The risk associated with this change in value is sometimes referred to by dealers as basis risk.
Basis swap: A type of swap where one floating rate payment is exchanged for another floating rate payment. For example Libor in USD is exchanged for Libor in GBP. This is an example of a cross currency basis swap. An example of a single currency basis swap would be where 6 month Libor is exchanged for 3 month Libor.
Bearer bond: A bond issued in certificated form. There is no registration of the holder's name. The person in possession has title. It should therefore be in safekeeping. Coupons are detached and presented for payment. This form of security is relatively rare.
Bermudan option: An option that can be exercised on one of several different dates before the expiry date.
Bid/Offer Spread: The difference between the price at which a dealer is prepared to buy and sell a financial instrument. Here is an example, if a share is quoted 100-101, a dealer buys low, (at 100) and sells high, (101). The dealing spread is 1. This is the profit the dealer makes if a customer crosses the bid/offer spread. It is one of the ways dealers make money.
Bond: A debt instrument normally redeeming on a known future date at par, (100%), of face value. Bond issuers are normally governments, banks or corporates. They use bonds to borrow long term money, (typically between 2 years and 20 years). The purchaser of a bond receives a regular interest payment. This is called a coupon.
Fixed rate bonds pay a known interest rate. Variable rate bonds pay an interest rate that is linked to short term interest rates like Libor. The return or yield you receive as an investor is dependent on the risk you have. The higher the risk the greater the return.
One of the major risks an investor has is credit risk, (do you get your money back)? Rating agencies frequently assign ratings to bonds and their issuers in order to help investors assess the creditworthiness of the borrower.
Book entry: Commonly associated with bonds held in electronic format. There is no paper, a central depositary records ownership. Most bonds are now issued in this format, it is secure and cost effective.
Capital markets: Generally assumed to be that sector of financial markets concerned with medium and long term borrowing using tradable financial instruments like bonds.
Caps & floors: These are options that are based on short term interest rates like Libor. They are used to trade and hedge the risk associated with changes in Libor. For example, if you borrow money on a variable rate basis the purchase of a cap may protect you against rising borrowing costs should interest rates increase.
Certificate of deposit, (CD): A bank deposit that can be bought and sold as a tradable financial instrument. Used by banks for funding purposes it provides investors with greater liquidity than normal bank deposits.
Clean price: The price at which traders buy and sell bonds is called the clean price, it excludes any accrued interest associated with the bond coupon, (see dirty price).
Collar: This is normally the purchase of an interest rate cap and the sale of an interest rate floor. Frequently it used to hedge the interest rate cost associated with floating rate, (Libor linked), funding. The cap provides a maximum funding cost and the floor a minimum cost for the borrower. If the value of the cap and floor are identical the net cost to buy the cap and sell the floor will be nil. Hence the term zero cost collar.
Collateral: Collateral is something that is used as security in order to reduce the credit risk that a party is taking when it enters into a transaction. Increasingly over the counter, (OTC), derivative transactions are being collateralized.
Collateral continued. Normally the collateral used is cash. The portfolio of OTC trades between the two parties is valued. The party that has the positive mark-to-market value on the trade portfolio calls for collateral from the party that has the negative mark-to-market value. This process is repeated at regular intervals, (daily or weekly). It is used to reduce counterparty credit exposure.
Collateralised bond obligations, (CBO): A type of collaterised debt obligation that uses bonds as the assets in the special purpose vehicle.
Collateralised debt obligation, (CDO): A CDO is a type of bond. The issuer is normally a special purpose vehicle, (SPV). The SPV contains assets that back the interest and principal repayment of the CDO. The assets can be other bonds, loans, credit derivatives or receivables eg credit card payments.
The SPV normally issues different tranches of CDO. The priority of the individual tranches to the assets contained in the SPV differ, some tranches will have priority over others. They are senior tranches. Some will be middle ranking, they are mezzanine tranches, some will be subordinated, they are called the equity or first loss tranche. The more senior a tranche, the lower will be the credit risk and the return. CDOs therefore permit the slicing up of the credit risk contained in a portfolio. The individual slices of risk can then be marketed and sold to investors attracted to the individual risk and reward attributes of the tranche.
Collaterised loan obligation, (CLO): A type of collaterised debt obligation that uses loans as the assets in the special purpose vehicle.
Commercial paper (CP): CP is a short term negotiable debt instrument. Normally the maturity does not exceed 365 days. It can be issued by a bank or a corporate under a CP programme.
The programme will have several dealers. The dealers are responsible for selling the paper to end investors on behalf of the issuer. CP is tradable and this means that investors can liquidate it before maturity if required. The return to the investor largely depends on the maturity and the credit rating of the CP. Many CP programmes are rated by rating agencies.
There is a very large domestic commercial paper market in the United States, (USCP). Issuers do not have to be US resident companies or banks. USCP is issued under a separate USCP programme. Normally USCP is rated and the maximum maturity is 270 days.
Common code: A nine digit code that identifies a security. It is used by Euroclear and Clearstream.
Credit linked note, (CLN): This is normally a bond that is issued using a medium term note programme. From the investor's perspective the CLN not only contains the credit risk of the issuer but also contains the credit risk of a third party. The investor is paid a higher return to take this risk.
CLNs are normally constructed by the issuer using credit default swaps. The CLN therefore contains an embedded CDS and the final terms of the CLN will use similar legal language to CDS transactions.
Conduit: A conduit is often used in structured finance. It is normally a company that is specially incorporated for a particular transaction. The conduit holds assets, these secure the repayment of debt that has been issued by the conduit.
Confirmation: A confirmation is a document that provides all the necessary details about a trade that has been agreed between two dealers. It normally takes a standard format. The settlements department independently check and agree confirmations. All transactions should have an agreed confirmation, (see segregation of duties.)
Contingent premium option: The premium for a contingent premium option is paid only if the option expires in the money. The premium payable will be relatively large reflecting the risk the seller is taking. The buyer has the risk that the option expires only just in the money thereby triggering a large premium payment.
Cost-of-carry: A term used by traders to describe the net profit or loss that arises from holding an asset. It is the net of the interest income less the funding expense.
Coupon: This is the interest payment on a bond. It is so called because in the past bond holders had to physically detach a coupon from a bond certificate and present it for payment of interest. Coupons are normally paid annually, semi-annually or quarterly in arrears.
Covered bond: A bond issued by a bank or mutual society that is backed by a ring fenced pool of mortgage assets (collateral). If the issuer fails to repay the bond the investor will have recourse to the collateral. These bonds are normally AAA rated and as a result the borrowing cost for the issuer is relatively low. To maintain the rating there are strict requirements on the collateral held, they include loan to value ratios, loan quality and overcollateralisation ratios. Any non performing collateral must be replaced by the issuer and in this respect the issuer does not achieve risk transfer to the investor.
Credit default swap, (CDS): A CDS is an OTC derivative transaction. It allows the parties involved to trade the credit risk on an underlying entity. One party, (the protection buyer), pays a fixed rate, this is a regular premium, to the other, (the protection seller). This payment is calculated on a quarterly actual 360 basis. If there is no credit event on the reference entity this regular fixed payment is the only payment that is made and it ceases on the maturity date. If a credit event occurs on the reference entity the fixed payment stops and the floating payment is triggered. The party that sold protection pays a cash amount equal to the principal of the CDS to the protection buyer. The protection buyer delivers a bond or loan to the protection seller. The delivered bond or loan is an obligation of the defaulted reference entity. The protection seller will therefore experience a credit loss.
Credit risk: The amount of money you could lose as the result of a default by a counterparty. When making a loan, (or bond purchase), all the principal and accrued interest is at risk. The actual loss following default will depend on the recovery rate. Over-the-counter derivative transactions that do not involve principal investments can also create credit exposures. These are any positive mark-to-market values, (MTM) on trades. Banks also measure the credit risk associated with the potential for the mark-to-market value of a derivative to increase with time and therefore increase credit risk. This is called the potential future exposure, (PFE). This means that the credit risk on OTC derivatives comprise the MTM plus the PFE.
Currency swap: A currency swap is a bilateral transaction. At the start of the deal both parties exchange principal cash amounts in two different currencies at the prevailing spot foreign exchange rate*. During the life of the deal both parties exchange interest payments related to the principal amounts. On maturity there is a re-exchange of the principal amounts, this takes place using the original spot rates.
Depending on what has been agreed the interest payments can be fixed/fixed, fixed/floating or floating/floating. The latter is sometimes referred to as a basis swap. (*In some transactions principal exchange does not occur at the start of the trade but almost always there is principal exchange on the maturity date).
Dirty price: The dirty price is the total amount you pay when you purchase a bond. It is the clean price of the bond plus any interest that has accrued since the last coupon payment date.
Discount factor: A discount factor shows how time and interest rates affect the present value of money. A simple discount factor can be calculated by using the formula 1 / (1 + interest rate x days / 360). To find the present value of a cash flow it is discounted. To do this you multiply the cash flow by the appropriate discount factor. When interest rates go up discount factors get smaller. This means the present value of future cash flows fall. It is why bond prices fall when interest rates rise.
Discount rate: This is the rate of interest that an institution is charged if it borrows money directly from the Federal Reserve.
Duration: Duration is a method that is used to measure interest rate risk. It is used by portfolio managers rather than dealers. It is the weighted average life of the present values of the cash flows that arise from a bond or financial instrument. It is measured in years. If a bond has a duration of 3 it means that for a 1% increase in interest rates that bond will lose approximately 3% of its value. Long dated bonds have higher durations than short dated bonds, that means they are more sensitive to changes in interest rates.
If a trader expects interest rates to increase he will try to reduce the portfolio duration, this can be achieved by hedging or buying short dated instruments.
Embedded risk: This term is sometimes used with structured bonds. These are bonds that contain risks over and above those you would normally expect to find. For example the interest and principal repayment may be dependent on interest rates, foreign exchange rates or credit spreads. In order to create structured bonds originators use swaps and options. These derivatives add the risk to the bond. The additional risk is said to be embedded in the bond.
Euribor: Euro Interbank Offered Rate is the interest rate that one bank charges another in the interbank market for Euro deposits. The rate is published daily at 11am Central European Time using panel of banks that contribute prices.
Fed Funds: This is the rate of interest that banks charge each other for funds that are immediately available at the Federal Reserve. The Fed targets the Fed Funds rate as a tool in its monetary policy.
Floating rate note: A bond where the coupons are variable rate. This means they are reset every three or six months using the prevailing Libor rate. Interest is paid in arrears.
Foreign exchange swap, (FX swap): This is a short term transaction involving two parties. The following example will explain a USD/GBP FX swap. There is an exchange of USD for GBP between the two parties. This occurs in two days time, (spot date) and is at the prevailing spot exchange rate. On the maturity date there is re-exchange of the currency amounts. This occurs at the forward rate that was also agreed at the start of the transaction. FX swaps are widely used to temporarily lend and borrow foreign currency.
Forward rate agreement, (FRA): An over the counter instrument that allows you to hedge or trade forward Libor fixings.
Forward transaction: Forward deals are over-the-counter bilateral transactions. They allow you to buy or sell an underlying financial instrument or commodity at a price agreed today but settlement of the deal is agreed to take place on a future date. Forwards are used for both trading and hedging purposes.
Future: Futures are exchange traded instruments. They allow you to buy or sell an underlying financial instrument or commodity at a price agreed today but for delivery on a future date. Futures contracts are standardised. That means they are for a fixed quantity and quality. They also have standard settlement or delivery dates.
Futures dealing will require you to post margins. There are two types. 1. initial margin, you post this before you can trade, and 2. variation margin, (VM), this is the mark-to-market value of the futures transaction you have. If you have a profit VM will be positive, if you have a loss it will be negative. Variation margin exists to reduce counterparty credit exposure. Futures are used for both trading and hedging purposes.
General collateral, (GC): A term that is used in repo markets to indicate the repo rate that is applicable to collateral that is not specifically in demand, (see repurchase agreement and special collateral).
The "Greeks": The Greeks are used to explain the risks associated with option positions. The delta is an equivalent underlying position that gives you the same risks as the option position itself. The gamma is how the delta changes when the underlying price moves. The theta describes the time decay of an option. The vega describes the effect of changes in the implied volatility on the value of the option. Rho is the option's sensitivity to changes in interest rates.
Haircut: A term that is used in several different markets. It normally refers to a deposit of cash or collateral that is used to secure a transaction and thereby reduce the credit exposure for one of the parties.
Hedge fund: A company that has been incorporated with the purpose of actively trading in financial markets in order to make profit. They obtain capital from investors who pay a fee which is often linked to the performance of the fund. Hedge funds frequently use leverage in order to increase their exposure to market risk. Hedge funds have fewer restrictions than traditional fund managers in the strategies that they can use. They are also not subject to the same regulatory constraints as banks.
Hedging: Hedging is about reducing risk. Traders can reduce risk by taking offsetting positions using another market or financial instrument. For example you could buy a bond, worried that the price may fall you could sell a different bond in order to hedge the price risk. Hedging is not a simple process because the offsetting instrument may not behave exactly as you anticipate.
Interest rate swap, (IRS): A transaction where one party pays a fixed rate of interest in exchange for a floating rate of interest. Both interest payments are calculated by reference to the principal or nominal size of the transaction. There is no principal exchange. IRS are typically used for hedging interest rate exposures associated with assets and liabilities.
Internal rate of return, (IRR): IRR is used to calculate the return on an investment. It is the rate of interest, that when used discounts all the cash flows, (including the initial investment), to a net present value of zero. The investment with the highest IRR, all other factors being equal, is regarded as being more attractive. Bond traders use IRR they call it yield to maturity. High yielding bonds that have the same risk are considered to be more attractive investments.
ISIN: International Securities Identification Number. Issued securities are given an ISIN. This is a unique number that is preceded by a country code. The number is used to identify securities. For example when settling a trade the ISIN number will correctly identify what has been bought and sold. It allows IT systems to retrieve the correct static data in order to complete the settlement process.
Leverage: Historically it is considered the ratio of debt to equity. It is also referred to as gearing. Leverage can be calculated in different ways and therefore direct comparisons are difficult. In banking leverage refers to the amount of risk that the equity holder is exposed to. When a firm is highly leveraged it is taking more risk with its shareholder's funds, (frequently in the form of assets purchased or loans made). The shareholders obtain the potential for greater returns but face a greater risk of loss. The term is also used with derivatives in the sense that you can take a relatively large risk with a small amount of capital by using derivatives.
Liability: A liability is something you owe. In financial markets a liability would exist if you borrow money.
Liability Driven Investment (LDI): This term is often used in the pensions industry. Pension funds have long dated liabilities (annuities to pensioners). Traditionally assets have often been equities but these can go down in value leaving a pension fund underfunded. LDI calculates the future liability of the pension fund and determines the amount of cash currently required to meet future obligations. This cash is then invested in assets with known future cash flows (like bonds). Alternatively the cash is placed on deposit with the variable rate interest being converted to fixed rate using interest rate swaps.
Libid: London interbank bid rate, this is the interest rate which a bank pays for wholesale deposits, it is normally several basis points beneath Libor.
Libor: London interbank offered rate, the interest rate at which a bank is prepared to lend wholesale money to another bank. Libid and Libor are constantly changing with the supply and demand conditions in money markets. Libor is quoted from overnight to 12 months in maturity, different interest rates apply to different maturities. These different interest rates provide you with the money market yield curve.
Limits: These are maximum amounts of risk that a dealer is permitted to take. They are set in order to protect the bank against large financial losses. A typical type of limit is a "stop loss", this is the maximum loss permitted before trading must stop.
Liquidity: Liquidity can have two meanings. 1. The ease by which you can sell a financial instrument and turn it into cash. 2. The amount of short term liquid assets a bank holds against its liabilities to ensure that it will not be insolvent.
Long position: When you own something you are "long"-you benefit from its price rising.
Margin: There are two meanings. 1, The profit you make on a deal may be referred to as a margin. 2. In futures markets margin is a sum of money that must be put up to support a trade, (see futures).
Market risk: Financial market prices constantly change. This means when you have a position you are exposed to profits or losses that can arise as a result of changes in interest rates, foreign exchange prices, commodity prices or credit spreads. This risk is called market risk.
Mark-to-market, (MTM): This is the process of valuing trading positions at current market prices. It shows you how much money you would make or lose as a result of liquidating a position.
Medium term note, (MTN): A MTN is a type of bond. It is issued under the prospectus of a MTN programme. It offers the issuer the ability to tailor make a bond for an investor. This means that the bond can be in different currencies, have different maturities, interest payments and risks. This flexibility has made MTNs very popular with issuers and investors.
Money markets: The sector of financial markets concerned with financial instruments that have a maturity shorter than one year eg wholesale deposits.
Monoline Insurance Company: An insurance company that specializes in offering investors protection against losing money from the default of a bond. The purpose is to increase the rating of the bond, normally to AAA. This reduces the borrowing cost for the bond issuer. The monoline is paid a fee by the issuer. Monolines have been in existence for three decades and started business insuring Municipal bonds before branching out to include structured products.
Minimum transfer amount, (MTA): MTAs are associated with the process of collateral management. It refers to a minimum amount of money that can be asked for when you have the right to call for additional collateral. Its purpose is to prevent the calling of nuisance amounts.
Netting: The right to net credit exposures is commonly found in legal agreements that support financial transactions. In the event of default, netting permits counterparties to add up all their positive and negative credit exposures to provide a net figure. This is important because if you do not have a netting agreement in place it is possible for a liquidator to "cherry pick" transactions. If this happens you will not be able to net out trades that have positive values with those that have negative values. This will potentially increase your credit loss.
Novation: Novation is a legal process where the rights and obligations of one of the parties to the contract are passed to a new third party. In order to do this the original parties to the contract and the new party must agree the novation. The term is often used in the over the counter derivative market, particularly where banks novate swaps to each other.
Operational Risk: The risk of loss that is a result of an inadequate or a failed internal process, people or system. It can also arise as a result of external events. Some definitions include legal risks as operational risks but exclude strategic and reputational risks.
Operations: The area of a bank that normally deals with processing a transaction after it has been agreed by a dealer. Some banks still refer to this area as the "back office" and the dealing room as the "front office". Typically operations staff are involved in confirmations, settlements and payments.
Options: There are four basic option trades:Long call - you have the right but not obligation to buy an asset at an agreed price on a future dateShort call - if the long call holder exercises the option to buy, you have the obligation to sell the asset at an agreed priceLong put - you have the right but not obligation to sell an asset at an agreed price on a future dateShort put - if the long put holder exercises the option to sell, you have the obligation to buy the asset at an agreed priceThe agreed price at which the option can be exercised is commonly referred to as the strike. The maturity date of an option is called the expiry date. Option sellers take risk and therefore receive a sum of money from the option buyer, this is called the option premium. Selling either call or put options is regarded as being risky because in theory your losses can be unlimited.
Over-the-counter, (OTC): OTC transactions are individual deals between two parties, no two transactions need be exactly the same, no third party needs to know what has been agreed. An example of an OTC transaction is an interest rate swap.
Pik notes: Payment in kind notes allow the borrower to opt to pay interest in the form of additional debt rather than in cash. Piks are generally regarded as being risky because they are associated with borrowers who are frequently highly leveraged and use the mechanism to defer interest payments.
Pool factor: Mortgage backed securities experience principal repayment before maturity. This means the outstanding principal amount declines. The pool factor is the outstanding principal amount divided by the original principal amount. A pool factor of 0.5670 would mean that for an original principal amount of $1,000,000, $567,000 remains outstanding.
Present value: This is the value of a future cash flow expressed in today's money. To calculate present value a cash flow is discounted using an appropriate rate of interest. Present values are widely used in the pricing and valuation of financial instruments, particularly derivatives.
Primary market: When a bond or equity is first distributed and sold to investors it is called a primary issue. This area of financial markets is called the primary market.
Proprietary trading: Proprietary trading is a way in which dealers can make money. It involves using your firm's capital to take risk, thereby hoping to profit from favourable movements in market prices.
Rating: A rating is an assessment of the relative safety of an investment (whether it will repay the capital and interest). Ratings are applied to bond issuers and bond issues. A bond that has a AAA rating is considered a very safe investment. Its returns are therefore low. Bonds with lower ratings carry more risk of loss for the investor and therefore a higher return. There are many firms that rate bonds but Moody's, Standard & Poors and Fitch are probably the best known. These firms undertake quantitative and qualitative analysis in order to determine ratings. Ratings are regularly reviewed and can be altered by the agencies. The rating system has become controversial. Some commentators believe therating process to be flawed. They would like to see more transparency. More accountability and segregation between the firm being rated and the fees paid to the agency.
Rating agency: Rating agencies assess the credit quality of issuers and debt instruments. The three most well known rating companies are, Standard & Poors, Moodys and Fitch. The best long term rating is AAA. In general the higher a rating the lower the risk for the investor, therefore highly rated bonds offer relatively low returns.
Recovery rate: If you make a loan or have a credit exposure to a counterparty and that party defaults you may lose some or all of your money. The recovery rate is the percentage of your money that you get back. Recovery rates for different assets, ratings and industries vary greatly and they are monitored by rating agencies on a historic basis.
Reg-144a: A private placement issued under 144a allows Non-US companies to access sophisticated domestic US investors. A non US company does not have to comply with Sarbanes-Oxley legislation when issuing under 144a. Marketing of 144a deals to general investors is prohibited.
Reg-S: Reg-S is a Securities Exchange Commission filing used for Initial Public Offerings that are targeted at non US investors. Marketing to investors in the US is therefore prohibited.
Registered bond: A bond that is issued in a certificated form. There is a register of ownership with a new certificate issued each time the bond is sold.
Repo rate: The rate of interest applied to the cash involved in a repo transaction.
Repurchase agreement: This is often referred to as a repo. A repo transaction involves two parties, the buyer and the seller. There are two exchanges that occur. One is at the start of the trade, the other is at maturity.
At the start, the seller delivers collateral, normally bonds, to the buyer. In return the buyer simultaneously pays cash to the seller. That amount is equal to the market value of the collateral, this includes any accrued interest. On the maturity date the buyer returns the collateral to the seller. Simultaneously the seller repays the original cash amount to the buyer plus a sum of interest for being able to use the cash.
Reverse repo: There are always two counterparties to a repurchase agreement. The party that buys the collateral at the start of the trade and sells it on the maturity date is entering a reverse repo.
Secondary market: A tradable financial instrument like a bond or money market instrument can be bought and sold between dealers. This market is called the secondary market.
Segregation of duties: Segregationof duties is all about separation of responsibilities. In banks it means different people are responsible for entering deals, confirming deals and arranging payments. The purpose is to prevent fraud. It is something that regulators take seriously. This is because several high profile frauds have been partly attributed to a break down in segregation.
Settlements: This is the area of a financial institution that is responsible for originating confirmations, verifying trades and arranging payments. It is outside and independent of the treasury.
Settlement risk: Settlement risk arises where a bank pays away funds before receiving funds or securities. Whilst settlement risk may arise for only a few hours the absolute size of the risk can be large. To reduce this risk many securities transactions are completed "delivery against payment". This is where the funds are released by the clearing system only when the securities are delivered.
Sharpe ratio: This is a measure of risk and return often used in fund management. It is calculated by taking the monthly return on an investment minus the risk free rate. This is then divided by the standard deviation of the monthly return. (Excess investment return divided by volatility). A low ratio indicates that volatility is relatively high in comparison with the return. This may mean the investment is not attractive.
Short position: When you sell a financial asset that you do not own you are going "short". You hope to benefit from any fall in the price of that asset.
Special collateral: When a particular bond is in demand in the repo market the repo rate can fall much lower than money market interest rates. That bond is then referred to as special collateral, (see repurchase agreement).
Special purpose vehicle, (SPV): A special purpose vehicle is a company that is normally set up in a tax and business friendly environment for example, Delaware, Jersey or the Netherlands Antilles. SPVs are used in structured finance. The sponsor of the SPV is normally a financial institution. The SPV buys assets from the sponsor or the market and can then use them for the purpose of different types of transaction. One such transaction would be a collateralized debt obligation.
Spot: This is the traditional two day settlement period. Where transactions are agreed today but the delivery and payment takes place in two days time. Increasingly financial markets are moving towards one day and real time settlement to reduce risk.
Swap: A bilateral transaction where two institutions exchange cash flows based on separate indices. A swap has a start date, a maturity date and a principal amount on which the cash flow payments are calculated. The simplest example is an interest rate swap. There are is no principal exchange only interest payments. One party pays a fixed interest rate to the other party and in return receives a variable interest rate, typically Libor. Swaps are used for both hedging and trading purposes.
Swaption: A swaption is an option on a swap. There are two types of swaption:
1. A payer's swaption, if you buy this option it gives you the right, (but not obligation), to enter into a forward starting swap where you pay fixed interest.
2. A receiver's swaption, if you buy this option it gives you the right, (but not obligation), to enter into a forward starting swap where you receive fixed interest on a swap.
Synthetic: This term is used in financial markets to describe the construction of a financial instrument or product using derivatives. For example a synthetic floating rate note is a fixed rate bond that has been converted to a floating rate bond using an interest rate swap. A synthetic CDO uses credit derivatives to create the credit risk rather than cash based assets.
Synthetic collateralised debt obligation: A type of collaterised debt obligation that uses credit default swaps as the assets in the special purpose vehicle.
Trading: Trading is the processes of buying and selling financial instruments on a frequent basis (see mark-to-market).
Trading book: When financial instruments are bought and sold on a regular basis this normally constitutes trading. The portfolio where these trading positions are held is called the trading book. It is accounted for on a mark-to-market basis. Also see banking book.
Treasury bill: A short term debt instrument, (maximum maturity 12 months), issued by a government. Treasury bills offer investors very liquid, high quality investment opportunities. They are much sought after in times of financial crises.
Value-at-risk, (VAR): VAR is a risk management technique that tells you how much money you can lose from your trading positions, for a given holding period and confidence interval. It uses statistics and works on probability. Therefore it does not show a guaranteed maximum loss figure, only an estimate. VAR is widely used by banks for risk management and in internal models that determine regulatory capital usage.
VIX:The VIX is an index of short term volatility for the S&P 500 index. The index was created by the Chicago Board Options Exchange (CBOE). The index is often seen as a barometer of fear in the stock market. The higher the index the higher is uncertainly. There are futures and options contract linked to the VIX.
Volatility: There are two types of volatility:
1. Historic volatility, this is the annualized standard deviation of a product's price. The more it goes up and down in price the higher is this measure of volatility. It is therefore a measure of price risk.
2. Implied volatility. Because volatility is a measure of risk it is used as an input in models used to price options. If the option pricing formula is reworked you can calculate the volatility from an option's market price. This is called implied volatility. It shows you how the option market currently prices risk.
Yield curve/term structure: If interest rates are plotted on a graph, with time on the x-axis and the rate on the y-axis the resultant curve is called the yield curve or term structure. The data used to construct the yield curve must be for the same currency and it should be representative of liquid financial instruments that are of the same credit quality. Positive yield curves have low short-term interest rates and higher long term interest rates. Negative yield curves have higher short-term interest rates and lower long term interest rates. Yield curves are important. They are used to price and value financial products. They also move continually. This means prices change and this leads to profits and losses for dealers.