ÖDerivatives DictionaryTM (A-J)
A B C D E F G H I J K L M N O P Q R S T U V W X Y Z # 

- A -
ABS 
Asset-Backed Security (q.v.). 
Accrual Note 
A note that accrues daily interest only when the index rate (e.g., LIBOR) falls within some range (such as under 6.5%). A Fixed (Floating) Rate Accrual Note accrues interest that is a spread over the corresponding ordinary Fixed (Floating) Note. The spread compensates for the probability that the note will accrue no interest over some day. 
AC-DC Option 
An option that the owner could choose to become at some future date either a Call or a Put. Another name for a Hermaphrodite Option (q.v.). 
Accreting Swap 
A Swap (q.v.) for which the Notional Amount (q.v.) increases during its life. 
Act-of-God Bond 
A Catastrophe Bond (q.v.). (Source: Sophie Belcher, "USAA to Try Again with Hurricane Bond, Derivatives Week, 5/5/97.) 
ADR 
American Depository Receipt (q.v.). 
All Ordinaries Index 
An index of stock prices on the Australian Stock Exchange. 
American Depository Receipt 
A receipt indicating a claim on some number (less than one, one, or more than one) of shares in a foreign corporation that a Depository Bank holds for U.S. investors. 
Amortizing Swap 
A Swap (q.v.) for which the Notional Amount (q.v.) decreases during its life. 
APO 
Average Price Option (q.v.). 
Arbitrage 
1. The act of buying something at a low price in one market and simultaneously selling it for a higher price in another. 
2. Buying something at the lowest price available in the market, rather than stupidly paying the higher price. 
3. Doing a spread trade - i.e., selling one thing and using the proceeds to buy a second thing. 
4. (Yield Curve Arbitrage) Doing a spread trade that exploits anomalies in the yield curve. 
5. (Statistical Arbitrage) Taking a calculated gamble that the two sides of a spread trade will move in your favor, back to a more normal relationship. 
Atlantic spread 
Long (short) an American option and short (long) the otherwise identical European option - hence, long (short) the value of early exercise. (Stephen R. Gould) 
ARGO 
A J.P. Morgan SPV (q.v.), originated in 1994. It hedges the swap leg with puts. (Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html) 
Asian Option 
Definition: An Average Price Option (q.v.). 
Example: Some banks offer their retail customers an equity-linked CD that repays principal, plus a form of "average return" on the S&P 500 that amounts to an Average Price Call Option. 
Application: Some hedgers use an Asian Option as a one-stop way to hedge the price risk of regular purchase or sale of a constant amount of a currency or commodity. 
Pricing: One can ordinarily price an Average Price Option satisfactorily by using an adjusted volatility and dividend yield in the Black-Scholes-Merton pricing model. If the underlying source of risk is an exchange rate, the price of gold or silver, a share price, or an equity index, then the "square root of three" rule for the volatility may apply. For underlying oil price risk that rule may not work so well. 
Risk Management: With underlying currency, precious metal, or equity risk, one can ordinarily delta hedge an Asian Option with a single position in the underlying. With underlying oil risk and averaging over a long period, delta hedging an Asian Option may require hedging in oil futures contracts with several different delivery dates. 
Comment: Rarely, the expression, Asian Option, may indicate an Average Strike Option (q.v.). 
ask (asked) 
The price at which a dealer (market maker) stands ready to sell. Ordinarily the ask exceeds the bid (q.v.), and the bid-ask spread is what the dealer stands to make by quickly turning around one unit of product. Also known as offer, offered, or offering price. 
Asset-Backed Bond 
A bond that is also an Asset-Backed Security (q.v.). An Asset-Backed Bond is to an Asset-Backed Security as a Mortgage-Backed Bond is to a Mortgage-Backed Security. 
Asset-Backed Security (ABS) 
A "fixed income" security that pays its coupon and principal from a specific revenue stream and has a specific asset as collateral. Collateral has included accounts receivable for aircraft, automobile and r.v. loans, credit card receivables, health club contracts, lottery winnings, mortgages, real property, and taxi medalions. Sources of revenue have included payments on various loans, credit card payments, mortgage payemts, rent, royalities, lotter payments, mortgage debt service, and rent from real estate. An Asset-Backed Bond may or may not have an issuer's or guarantor's full faith and credit behind it. A special case is an Asset-Backed Bond (q.v.). 

The revenue stream and collateral may support more than one "class", "piece", or "tranche", just a corporation's assets may support shares and bonds. Thus, the ABS, whose value depends on the underlying revenue stream and collateral, is a Derivative Product in the same sense that financial economists have long recognized that corporate shares and bonds are Derivatives, whose prices depend on the underlying asset value and cash flow. 
Asset Swap 
A Swap that converts a fixed- (floating-) coupon asset into a floating- (fixed-) coupon asset. This is in contrast to the more familiar (Liability) Swap that converts a fixed- (floating-) coupon liability into a floating- (fixed-) coupon liability. 
ATM 
At-the-money (q.v.). 
At-the-money 
Having a strike price that equals the spot price. 
At-the-money forward 
Having a strike price that equals the forward price. 
Average Price [Call or Put] Option 
An Option - Call or Put - whose underlying price is an average over time of a risk factor. 
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- B -
bankruptcy futures 
The futures contract based on the CME Quarterly Bankruptcy Index. The CME computes the index daily, based on personal and business bankruptcy filings, with personal bankruptcies getting 96% of the weight. (Aaron Luchetti, "Commodity Traders May Go for Broke With Novel Contract," WSJ, 4/3/98.) 
basis point 
One percent of one percent of a principal amount or Notional Value (q.v.). Also, known as "bp" - pronounced "bip". For example, the on-the-run Ten-year Treasury might have a coupon of 6.5%, and the 10-year Swap Spread over that might be 22 basis points. 
basis risk 
The name attached to the random gains or losses a hedger realizes, when he hedges with something that has an imperfect correlation with his underlying position. 
benchmark notes 
Agency notes aimed at filling the partial vacuum in the Treasury note market, now that the deficit appears somewhat under control. Fannie Mae began issuing benchmark notes, and Freddie Mac and other agencies have followed. Apparently, the U.S. Treasury is considering halting its auction of two-, three-,or five-year notes. (Guy Dixon and Ross A. Snel, "Bonds Stay Put as Traders Wait for Jobs Report; Fannie Mae to Offer Additional Benchmark Notes," WSJ, 5/5/98.) 
Bernoulli Option 
See Introducing: the Bernoulli Option in "Derivative Games". 
Best-of-Two Option 
A payoff which equals the maximum of two option payoffs, such as the maximum of a call on asset 1 and a put on asset two. Cf. Worst-of-Two Option. 
Bet Option 
A Binary Option. (q.v.) 
bid 
The price at which a dealer (market maker) stands ready to buy. Ordinarily the bid is less than the ask (q.v.), and the bid-ask spread is what the dealer stands to make by quickly turning around one unit of product. 
Binary Call (Put) Option 
Typically, a Binary Call (Put) Option (q.v.) that pays off nothing if the underlying risk factor is below (above) the strike, and a constant amount if the risk factor exceeds (is below) the strike. 
Binary Option 
An option with a payoff function that has two levels, such as zero dollars or one million dollars. 
BOBL 
German Federal Debt Obligations (BundesOBLigationen). (Source: http://www.exchange.de/dtb/BOBL-future.html) 
BOBL Futures 
The DTB Futures contract on a notional medium term (3.5 - 5 years) debt security of the German Federal Government or the Treuhandanstalt, with a notional interest rate of 6%. The BOBL (q.v.) and other instruments qualify. (Source: http://www.exchange.de/dtb/BOBL-future.html) 
BOBL Futures Option 
An American option that settles into a BOBL Futures (q.v.) contract. Payment of the option premium is "futures-style", which means none of it occurs immediately, and a piece of it occurs with each daily mark-to-market. An implication of this is that the "buyer" (really, the "long") may pay no premium and the "seller" (really, the "short") may pay all the premium! (Source: http://www.exchange.de/dtb/BOBL-future-option.html) 
Bowie Bond 
A specific, $55 million issue of 10-year Asset-Backed Bonds (q.v.) that British rock star David Bowie issued and Prudential Insurance Co. bought. The specific collateral consists of royalties from 25 of Mr. Bowie's albums that he recorded before 1990. 

Source: Bloomberg News, 2/20/97 
B-Piece 
Definition: A security from the riskier tranche of a two-tranche ABS (q.v.) deal. It receives the residual income from the underlying collateral and takes second place in line for the collateral in case of default. In terms of income and collateral, B-pieces are to the ABS's assets as common shares are to a corporation's assets. (The analogy breaks down when it comes to taxation and control.) 
Example: A bank with large credit card operations issues ABS's backed by credit card receivables. The A-piece has a AAA rating and little credit risk. If the economy heads south, then the B-piece may not pay off in full. 
Application: Dividing an ABS issue into senior and junior pieces permits the issuer to tap two types of investor. The more (less) risk averse investor that wants to avoid (place) a bet on the performance of the underlying assets can buy the A-Piece (B-Piece). 
Pricing and Risk Management: This is difficult. The whole point of having a B-piece is to have a place to put the return that is more difficult to price and the risk that is more difficult to manage. Then, people who are more talented at pricing derivatives and managing their risk will buy these pieces. Pricing the A-Pieces is nearly as easy as pricing Treasuries, and their risk is mainly market risk. 
Comment: Not for the timid or naive. 
Source: Cecile Gutscher, "SEC Is Examining Whether Some Underwriters Are Marketing Bonds at Artificially Low Yields", Wall Street Journal, 5/2/97). 
Bullet Bond 
Definition: A Bond that Amortizes (q.v.) fully on a single date. Its cash flows consist of regular coupon payments of interest and a final repayment of principal. 
Example: An ordinary, 30-year, noncallable Treasury bond with a semiannual coupon. 
Application: A Bullet Bond is a commonplace way of raising capital. 
Pricing: A Bullet Bond is a portfolio of Zero Coupon Bonds (q.v.), so its value is the value of the portfolio. 
Risk Management: A common way to measure a fixed income portfolio's risk is by its Duration (q.v.) or DV01 (q.v.), and its Convexity (q.v.). Consequently, one might combine a Bullet Bond with other fixed income instruments in a portfolio, in an effort to control the portfolio's Duration and Convexity. 
Comment: When a layman thinks of a bond, this is the bond. 
BUND 
German Federal Government Bonds (BUNDesanleihen) . (Source: http://www.exchange.de/dtb/BUND-future.html) 
BUND Futures 
The DTB Futures contract on a notional long term (8.5 - 10 years) debt security of the German Federal Government or the Treuhandanstalt, with a notional interest rate of 6%. The BUND (q.v.) and other instruments qualify. (Source: http://www.exchange.de/dtb/BUND-future.html) 
BUND Futures Option 
An American option that settles into a BUND Futures (q.v.) contract. Payment of the option premium is "futures-style", which means none of it occurs immediately, and a piece of it occurs with each daily mark-to-market. An implication of this is that the "buyer" (really, the "long") may pay no premium and the "seller" (really, the "short") may pay all the premium! (Source: http://www.exchange.de/dtb/BUND-future-option.html) 
Bundle 
A Strip (q.v.,#2) of consecutive, quarterly Eurodollar or Euroyen futures contracts. Markets, such as Simex offer a Bundle as a convenient package of futures contracts, without the execution risk inherent in building up the Strip, contract by contract. A trader can use Bundles and Packs (q.v.) to implement bets on the change in shape of the Forward Curve. 
Buy-Write 
An investment strategy that consists of buying an asset and selling a call on it. Thus, the investor sells upside potential to elevate the rest of his payoff function. 
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- C -
cabinet trade 
A trade that allows options traders to close out deep out-of-the-money options by trading at a price equal to one-half tick. (Elizabeth Lekan, Chicago Mercantile Exchange) 
calendar spread 
A spread trade (q.v.) involving one long position and one short position. 
Callable Bond 
Definition: A (noncallable) Bullet Bond (q.v.), minus (i.e., short) a Call Option (q.v.) on the bond. The Call Price as a function of calendar time is the Call Schedule. 
Example: The U.S. Treasury issued a long sequence of Callable Bonds, callable five years before maturity. 
Application: A Callable Bond is a way to make a bet about refinancing costs at the Call Date. The issuer is betting that interest rates will drop, the bond price will rise, he will call the bond, and he will refinance at a lower rate. The bondholder takes the other side of that bet. 
Pricing: The Callable Bond is equivalent to a portfolio, so its value should equal the value of the portfolio, namely, the value of the Bullet Bond minus the value of the Call Option. 
Risk Management: An issuer could offset the short position in the Bond Option (q.v.) by buying a corresponding Receiver Swaption on a Swap with the same coupon as the Bond. 
Comment: For a given coupon rate the Callable Bond will be worth less than the noncallable bond. Hence, for a given price (such as par) the Callable Bond will have a higher coupon rate. 
Call Option 
The right, but not the obligation to buy the underlying asset at the previously agreed-upon price on (European) or anytime through (American) the expiration date. 
Cap 
A strip of Caplets (q.v.) - that is, a portfolio of Caplets with sequential accrual periods. Also known as a Ceiling. 
Caplet 
An Interest Rate Option to pay fixed in an FRA (q.v.). Its payoff is proportional to that of a Call Option on a floating rate of interest. 
Caption 
An option on a Cap (q.v.). 
Catastrophe Bond 
Definition: A Bond that promises a coupon (and principal, in some cases) that starts out high, but drops after a suitable catastrophe occurs. A suitable catastrophe might be an earthquake or hurricane of sufficient magnitude and within a particular region. 
Catastrophe Bonds may be ABS's (q.v.). The underlying assets may include a pool of Treasury securities. The underlying income stream might be reinsurance premiums. The ABS issue may have two or more classes of securities. 
Example: A recently proposed (as of 5/30/97) USAA, Inc. Catastrophe issue has a principal protected class (secured by Treasury Zero Strips) and a principal variable class that would become worthless after a hurricane did $1.5 billion of damage anywhere from Maine to Texas. 
Application: The natural issuer of a Catastrophe Bond is an insurance company or a government agency such as the California Earthquake Authority - any organization exposed to claims resulting from the underlying catastrophe. The Catastrophe Bond is in theory and perhaps even in practice a highly efficient way of paying outside investors (i.e., outside the insurance industry, including the reinsurance market) to share the risk of the catastrophe with the vast general capital market. It is a simple extension of the time-honored concept of securitization. 
Pricing: Equilibrium of supply and demand. 
Risk Management: Traditional hedging is impossible. Diversification is possible. 
Comments: 
The holder of a Catastrophe Bond is short a Bet, Binary, or Digital Option (all of which q.v.). The Catastrophe Bond is an ideal instrument for an unscrupulous security salesman to present to unsuitably naive retail or even institutional customers, who lack any concept of that game's odds, or perhaps even its basic rules. Thus, it has excellent potential as a successor to the sometimes abusive or fraudulent sales of poorly understood Florida real estate, securitized receivables, mortgage-backed securities and derivatives, limited partnership interests in real estate and oil exploration, etc. 

I predict confidently three things: 
(1) Competent underwriters of Catastrophe Bonds will not play Russian roulette by holding large positions in them in their investment portfolios for long periods. They will distribute the bonds as soon as possible. 
(2) Accordingly, almost all of these Catastrophe Bonds will end up in the portfolios of institutional investors, high-rolling individual investors, and retail customers - many of whom will have no idea what they're getting into. 
(3) In at least one exceptional case, some manager of a Catastrophe Bond (or Derivatives) desk will convince his naive boss that "the market has badly underestimated the real value of certain Catastrophe Bonds (Derivatives), and we should take them into inventory, temporarily." At that point the chips are down and the outcome - "heroism" or disaster - is up to fate. 
Comment: Scholars are praising cat bonds and other derivatives for attracting low-cost capital into the industry. (Robert Hunter, "Cat Fever," Derivatives Strategy, February 1998, p. 6.) However, it's not clear that society is better off if the newcomers are paying to much for claims based on catastrophic claims. 
Catastrophe Futures 
The ill-fated futures contract that the CBOT introduced in 1993. The underlying risk factor was the Property Claims Service (PCS) index, which was too broad an index for most natural hedgers to use. (Source: Robert Clow, "Coping with catastrophe," Institutional Investor, December 1996, pp. 138.) 
Catastrophe Options 
The CBOT's option contracts on several regional indexes of losses. The option on the Eastern Catastrophic contract boomed as Hurricane Fran smashed the Carolinas in the fall of 1996. (Source: Robert Clow, "Coping with catastrophe," Institutional Investor, December 1996, pp. 138.) 
Catastrophe options come in two main varieties: (1) Property Claims Services (PCS) options pay out (European style) based on an index of all claims against property insurance companies. (2)Single-Cat options pay out (American or one-touch style) based on a single, large atmospheric or seismic disaster in a single region (northeast, southeast, east, midwest, or west) or in California, Texas, or Florida. ("A New Take on Cat Options," Derivatives Strategy, February 1998, pp. 5-6.) 
Catastrophe Swaps 
Contracts similar to standard reinsurance contracts and traded on New York's Catastrophe Exchange. (Source: Robert Clow, "Coping with catastrophe," Institutional Investor, December 1996, pp. 138.) 
CD 
Certificate of Deposit (q.v.). 
Ceiling 
A Cap (q.v.). 
Certificate of Deposit 
A sort of bank savings account that ties up the depositor's money until the certificate matures, and acts more like a bill, note, or bond than a traditional savings account. 
CFD 
Contract for Difference (q.v.). 
CHIPS 
Common-Linked Higher Income Participation Securities (sm). Bear Stearns' proprietary Equity Linked Debt Security (q.v.). 
CMO 
Collateralized Mortgage Obligation (q.v.). 
CMT Derivative 
A Derivative Product, such as a Swap or Option, based on the CMT Yield (q.v.). These are tricky to price. 
CMT Yield 
Constant Maturity Treasury Yield. Every day the Federal Reserve Board publishes the yield for a hypothetical Treasury having each standard maturity, such as two years, even though such an instrument doesn't exist. Every time the Fed issues a new, on-the-run Treasury, the CMT yield equals the observable market yield. Between those issue dates the CMT and closest on-the-run yields can differ. 
Collar 
A portfolio of two options with the same underlying risk factor and expiration date: a long call with a higher strike and a short put with a lower strike. An investor with long (short) exposure to the underlying factor can go short (long) a collar, retaining exposure to the factor within a range, while limiting downside exposure at the cost of upside potential. 
Collateralized Bond Obligation (CBO) 
Definition: An ABS (q.v.) structure similar to a CMO (q.v.), but with a portfolio of bonds as collateral, instead of a portfolio of Mortgage Backed Securities (q.v.) and/or mortgage loans. A sponsor transfers the collateral into a Special Purpose Vehicle (SPV), such as a trust or corporation, which has no other assets and which issues claims. A typical CBO has more than one "tranche" or "tier", and a more junior tranche has more risk of default. 
Example: For example, a CBO might have senior, junior (or mezzanine), and subordinated (or equity) tranches. The senior tranche, like senior debt, has first claim on the collateral's cash flows to cover its interest and principal payments. The junior tranche has second claim. The equity tranche claims the residual. 
Application: Junk bond money managers create CBOs to create highly rated bonds and highly speculative "equity" out of a portfolio of junk bonds. 
Pricing: Predicting default rates is the most difficult aspect of pricing these bonds. 
Risk Management: 
Comment: Agencies, such as Moody's Investors Service and Standard and Poor's Corp., assign credit ratings. 
Source: (Pimbley, Joseph. "LC: Evaluating Risk in Russian Roulette Notes and CBOs." DW, 7/17/95, p. 7.) 
Collateralized Loan Obligation (CLO) 
Definition: An ABS (q.v.) structure similar to a CMO (q.v.), but with a portfolio of commercial or personal loans as collateral, instead of a portfolio of Mortgage Backed Securities (q.v.) and/or mortgage loans. A sponsor transfers the collateral into a Special Purpose Vehicle (SPV), such as a trust or corporation, which has no other assets and which issues claims. A typical CLO has more than one "tranche" or "tier", and a more junior tranche has more risk of default. 
Example: A CLO might have senior, junior (or mezzanine), and subordinated (or equity) tranches. The senior tranche, like senior debt, has first claim on the collateral's cash flows to cover its interest and principal payments. The junior tranche has second claim. The equity tranche claims the residual. For example, National Westminster transferred $5 billion of loans from its balance sheet to an asset-backed trust October 1996 and created an early and large CLO. 
Application: Some commercial banks have created CLOs to create highly rated bonds and highly speculative "equity" out of a portfolio of loans. A CLO allows a bank to remove loans from its balance sheet and reduce its required reserves, yet keep contact with the borrowers and fees from servicing the loans. 
Pricing: Predicting default rates is the most difficult aspect of pricing CLOs. In the case of investment grade loans, this is less of a problem than it is with problem loans. 
Risk Management: 
Comment: Agencies, such as Moody's Investors Service and Standard and Poor's Corp., assign credit ratings. 
Source: Jodi D'Amico, "COLLATERALIZED LOAN OBLIGATIONS -CHANGING THE WAY BANKS DO BUSINESS," http://www.van-kampen.com/nz/Fixed_Income_Newsletter/23-3.htm. 
Collateralized Mortgage Obligation (CMO) 
A portfolio of claims against a portfolio of mortgages and/or Mortgage-Backed Securities. The claims separate naturally into "tranches" that differ by the rules defining their interest and principal payments. One of the charms of the CMO is the wide range of possible rules. However, the sum over all tranches of the CMO interest (principal) payouts must equal the sum over all mortages and/or MBS's of interest (principal) payments - except for any difference due to servicing or the issuer's residual. The CMO is archaic, and the REMIC (q.v.) is a more current vehicle for derivatives of a portfolio of mortgages. 
Common Share 
A sort of Call Option (q.v.) on the assets of the corporation, because the common shareholder gets those assets if he pays off everyone else with a claim against the assets. The Common Share represents a fractional ownership interest in the corporation, it has voting rights, and may receive a dividend. 
Common Stock 
A collective term for Common Shares (q.v.). 
Compound Option 
An option on an option. Also known as a Split Fee Option (q.v.). A special case of an Installment Option (q.v.). 
Confirm 
Confirmation (q.v.). 
Confirmation 
A document that defines a Derivatives contract that a dealer has just entered with a customer. The Confirmation ordinarily incorporates one or more ISDA (q.v.) documents by reference. The Confirmation comes after the oral agreement - ordinarily over the telephone - which the dealer ordinarily records and saves for months. 
Continuous Accrual Currency Option with a One-Touch Knock-out Range 
A Derivative Product that accrues nominal value at a constant rate for every day that the index exchange rate stays within the accrual range, then loses all value when the index strikes either side of the knock-out barrier range. (Source: Victor Kremer and William Rhode, "Dollar Gyrations Lead Investors to Exotics," Derivatives Week, 2/3/97.) 

The term, "Option", is a misnomer, because no one has a true option, not even one as trivial as for an ordinary European Call Option. 
The product's value is a decreasing function of volatility. Thus, during a period of high anticipated volatility it is possible to buy the product inexpensively. If the index remains within the range, then the percentage payout is relatively large. 
Contract for Difference 
Definition: An OTC Currency Forward Contract that settles for a cash amount, perhaps in a third currency, without requiring the exchange of the two underlying currencies. 
Example: Instead of settling a Forward Contract by having party A deliver 10,000,000 DEM (worth 6,000,000 USD) in Germany and party B deliver 600,000,000 JPY (worth 6,100,000 USD) in Tokyo, party B would deliver the net dollar value of the two payments (100,000 USD) in New York. 
Application: The CFD would reduce the problem of Herstatt Risk (q.v.). 
Pricing: Prices for the two legs of the transaction should be readily visible in the liquid currency markets. 
Risk Management: This tool is for managing market risk, while managing settlement risk. 
Comment: 
Source: Laure Edwards, "Chase Manhattan Offers an Answer to BIS Concerns," Financial Trader 4 (June 1997), p. 7. 
Convertible Bond 
A Bond that the owner can convert into Common Shares under specific terms. A Convertible Bond is an ordinary Bond, plus the option to exchange the Bond for the Shares. 
Convexity 
The sensitivity of a financial instrument's Modified Duration (q.v.) to its yield. 
The second derivative of a financial instrument's value with respect to its yield. 
Corridor Note 
An Accrual Note (q.v.). 
"Costless" Collar 
Definition: A Collar (q.v.) in which the proceeds of the sale of the short Call option exactly finance the purchase of the long Put option. 
Application: This strategy helps a trader get close to "flat". This can be particularly useful for a money manager who is close to having a good measurement period and doesn't want to screw it up in the last moment. Also, it may be a good tax play for an investor who really wants to sell out, but doesn't want to pay capital gains taxes. 
Comment: The term may mislead beginners in Derivatives markets, who might take it at face value. However, of course, the dealer or market maker wouldn't do the trade at no cost. In fact, the cost is roughly the bid-ask spread of one of the Collar's component options. Particularly in OTC option markets, the name, "Costly Collar", would be more appropriate, because bid-ask spreads require the buyer to give up much upside participation for little downside protection. 
Credit Default Swap 
A Swap in which A pays B the periodic fee, and B pays A the floating payment that depends on whether a predefined credit even has occurred, or not. The fee might be quarterly, semiannual, or annual. The floating payment would likely occur only once, and might be proportional to the discount of the reference loan below par. The credit event might be a declaration of bankruptcy or violation of a bond indenture or loan agreement. 
Credit Derivatives 
Derivative Products with payoffs that depend on risk factors related to credit quality, such as yield spread over Treasuries, price discount from par, or a "credit event." A credit event might be a drop in credit rating or some sort of failure, such as occurrence of default, insolvency or bankruptcy. 

One goal of Credit Derivatives is to split credit risk from market risk. The key concept here is that credit risk is an undesirable element, akin to pollution. When you allow a market for pollution, people who don't want it sell it at at market price to the parties who mind it the least or handle it the best. 

Credit Derivatives already come in a variety of flavors, and infinitely many types are possible. However, nearly all current structures are variations on Call or Put Options (q.v.) on Credit Spreads (q.v.), Binary Options (q.v.), or Knockout Options (q.v.). In the last two cases the trigger is a "credit event". Typically, the payoff depends on the state of the world some time - as much as months - after the event. Here are some examples of Credit Derivatives: 

Notes that Bankers Trust and CSFP issued in 1993, which promised large coupons if the reference asset didn't suffer a "credit event" - namely, default or sufficient deterioration in its credit rating - and small coupons if it did. The spread of the large coupon over ordinary debt depended on the reference asset's credit quality, and was sometimes 80 - 100 b.p. (over LIBOR). This is a sort of Binary Option that is a function of the credit event. 
A Binary Option that Bankers Trust offered, with a payoff that depended on the credit performance of a basket of bonds. If any of the bonds defaulted, then a counterparty paid Bankers Trust a fee. 
A Call or Put Option on a credit spread over Treasuries. 
A One-Touch (q.v.) Knockin Put (q.v.) Option on the value of a corporate bond. 
A One-Touch (q.v.) Knockin Put Option (q.v.) on the lowest value of n corporate bonds in a portfolio. 
Credit Linked Note 
Definition: A note that pays interest and repays principal that depends on a credit event, such as bankruptcy and default. 
Example: Swiss Bank Corporation issued global floating rate notes, which it would redeem for 51% of par value or 100% of the value of a reference security (a similar bond from the same issuer, less the credit exposure), if a particular credit event occurs. 
Application: The usual, speculation and hedging. 
Pricing: 
Risk Management: 
Comment: 
Source: "Swiss Bank Ready to Offer Big Note Issue," WSJ, 9/7/97. 
Credit Option 
Definition: An Option with a payoff that depends on credit quality, without bearing ordinary interest-rate risk. 
Example: The Option to Exchange private debt for U.S. Treasury debt. 
Natural Buyers and Sellers: See Credit Derivatives. 
Pricing: Pricing an Option to Exchange () private and Treasury debt would involve a hybrid option model, having characteristics of equity and debt option pricing. 
Hedging: One could try to dynamically hedge the delta risks. 
Comment: Pricing and hedging might be difficult, and market manipulation may be an issue for a thinly traded underlying instrument. 
Credit Option on Brady Bonds (COBRA) 
A credit spread option (q.v.) with a payoff that depends on the yield spread between a Brady bond and another bond - usually, a comparable maturity Treasury. (Gary L. Gastineau and Mark P. Kritzman, Dictionary of Financial Risk Management, Frank J. Fabozzi Associates, 1996.) 
Credit Risk 
The risk of loss from not receiving one's reward for being on the right side of a bet about a market move, due to the losing counterparty's failure to meet his obligations. 
Credit Spread 
1. An option spread trade - long one option, short another - that generates cash. 
2. The excess of the yield on a note with credit risk over a comparable note without credit risk. 
Credit Spread Option 
Definition: An Option with a payoff that depends on a Credit Spread (q.v.). 
Example: A one-year European Call (q.v.) on Mexican par bond credit that pays 
Max[0, 147 bp - (Mexican Brady Bond Yield - Yield on corresponding U.S. Treasury)]. 
Application: To spread credit risk associated with lending or assume credit risk without lending. 
Pricing: 
Risk management: 
Comment: 
Credit Spread Swap 
Definition: A Swap with a payoff that depends on a Credit Spread (q.v.). 
Examples: A Swap with a Floating Leg () that depends on the Credit Spread. 
Application: A lender who might share its credit exposure to a risky counterparty. 
Pricing: Requires advanced techniques or SWAG Pricing (q.v.). 
Risk management: Dynamic Hedging (q.v.) based on PV01s (q.v.), etc. 
Comment: Not for the cautious. 
Credit Swap 
Definition: A Swap whose value depends on underlying credit quality, preferably without bearing ordinary interest-rate risk. 
Examples: A Total Return Swap (q.v.) with underlying risky debt might qualify, although this has a heavy dose of interest rate risk. An Outperformance Swap, with a payoff proportional to the excess of the rate of return on the risky debt over the rate of return on a comparable Treasury bond, would be a clearer example. A Total Return Swap plus an ordinary Interest Rate Swap () that offsets the interest rate risk. The exchange of a constant fee per period versus a binary floating payment of either zero or a Credit Event Payment. A Credit Spread Swap. 
Application: See Credit Derivatives for applications. 
Pricing and Risk management: See the specific type of Credit Swap. 
Comment: Pricing and hedging might be difficult, and market manipulation may be an issue for a thinly traded underlying instrument. 
Cross Currency Option 
Definition: An option to exchange units of one currency for units of another, as seen from the point of view of a third currency. A Margrabe Option (q.v.) with underlying currency risk. 
Example: A New York trader might consider an option to pay 1.5 DEM for 100 JPY as a Cross Currency Option. A trader in Frankfurt might call that a call on yen. A trader in Tokyo might consider it a put on Deutschemarks. 
Cross Currency Swap 
A Swap (q.v.) that involves payments in two currencies. For example, the fixed payment might be in DEM and the floating payment might be proportional to JPY LIBOR. In addition, the swap involves an exchange at maturity of Notional Amounts (q.v.) in the two currencies at the original exchange rates. 
crossed market 
A market where the bid (q.v.) exceeds the ask (q.v., also known as asked, offer, offered). In a normal market the bid is less than the ask, and the difference - the bid-ask spread - would be the market maker's profit on a round trip in the stock. We would not expect to see a crossed market with a single market maker. In a market with more than one market maker, one market maker may show the best bid and another the best offer, and these may cross. However, a crossed market indicates an arbitrage opportunity and cannot last, in equilibrium. 
CUBS 
Customized Upside Basket Securities (q.v.). Bear Stearns's proprietary debt securities, with participation in moves in an average over time of the index value of a basket of securities, but with downside protection. The underlying average equals an arithmetic average of the index values on the 24th of each month from issue through maturity. Thus, the underlying price is an average, and any optionality is an option on an arithmetic average. The holder may not redeem CUBS before maturity.

For example, Bear Stearns listed a CUBS issue on 7/25/95 that matures on 7/24/98. The underlying index is a mischmasch of biotech, energy, and other stocks. The CUBS issue price is $3.33. The CUBS gives 90% participation in price moves. The minimum payoff is $3.00. 
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DAXâ 
A stock performance index (dividends added in) composed of the 30 most actively traded German blue chip stocks on the Frankfurt Stock Exchange. (Source: http://www.exchange.de/fwb/indices.html#dax) 
DAXâ Futures 
A cash-settled Futures contract based on the DAXâ (q.v.) stock performance index. (Source: http://www.exchange.de/dtb/daxfuture.html) 
DAXâ Futures Option 
An American option that settles into a DAXâ Futures (q.v.) contract. Payment of the option premium is "futures-style", which means none of it occurs immediately, and a piece of it occurs with each daily mark-to-market. An implication of this is that the "buyer" (really, the "long") may pay no premium and the "seller" (really, the "short") may pay all the premium! (Source: http://www.exchange.de/dtb/daxfuture-option.html) 
DAXâ Option 
A cash-settled, European option on the DAXâ (q.v.) stock performance index. (Source: http://www.exchange.de/dtb/daxoption.html) 
DCS 
Direct Credit Substitute (q.v.). 
Degree-Day 
A unit of measure for the deviation of a day's average temperature from the arbitrary standard of 65 degrees Fahrenheit. The U.S. Energy Information Administration publishes indexes of accumulated Degree Days. If the average temperature one day is 75 (55) degrees, then the index increases (decreases) ten Degree-Days on that day. Degree-days come in two varieties - Heating Degree-Days and Cooling Degree-Days. When the average temperature is above (below) 65 degrees, then the number of cooling (heating) Degree-Days increases. 
(Source: Victor Kremer, "Utility to Make First Use of Degree-Day Swaps, Derivatives Week, 5/5/97.) 
Degree-Day Swaps 
A Swap (q.v.) that receives (pays) a floating payment proportional to the change in Degree-Days (q.v.) over the accrual period, and pays (receives) a fixed payment. Dealers of such swaps claim that they are good hedges of heating costs, because (1) a negative number of Degree-Days over the accrual period results in (2) a positive number of Heating Degree-Days, which leads to (3) a negative floating payoff, which is (4) a hedge for the resulting positive heating costs, because (5) a large number of Heating Degree-Days translates into both a large volume of energy and a high price for it. (Source: Victor Kremer, "Utility to Make First Use of Degree-Day Swaps, Derivatives Week, 5/5/97.) 

However, this argument has some problems. First, energy cost is a U- or V-shaped function of Degree-Days. Heating Degree-Days lead to heating costs, and Cooling Degree-Days lead to cooling costs. Second, nobody knows what that function is. Consequently, Degree-Days Swaps will have some Basis Risk (q.v.). 
Delivery Point 
In a Futures Contract (q.v.) the location where the short must deliver the underlying "commodity" to the long. This can be crucial in the case of physical products, transportation bottlenecks can make it easier for the longs to squeeze the shorts. In April, 1996, the CBOT tried to eliminate Toledo, Ohio as a delivery point. Farmers and processors who favored delivery there complained to the CFTC, which delayed approval of the change in the contract. (Source: "CBOT Gets Warning Concerning Changes in Certain Contracts, WSJ, 5/6/97.) 
Digital Option 
A Binary Option (q.v.). 
Direct Credit Substitute 
The Federal Reserve Board's term for a credit enhancement, that is, a means of improving the credit quality of a loan or a bond. 
Discount rate 
The rate of interest that the Bundesbank (Buba) charges for granting "rediscount credit". Typically, the discount rate is the lowest rate at which the Buba lends. 
NEW! domestic market 
The securities market in a country where securities of that country's companies and governments trade. 
Example: Bank of America securities that trade in the U.S. trade in the domestic market. 
Source: http://www.jobs.washingtonpost.com/wp-srv/business/longterm/glossary/a_m/domestic_market.htm 
DTB 
Deutsche Terminbörse. The Futures and Options Exchange associated with the Frankfurt Stock Exchange (Frankfurter Wertpapierbörse, FWB) in Frankfurt, Germany. 
Duration 
1. A weighted average of the number of years until a financial instrument's cash flows (e.g., a bond's principal and each of its coupons) arrives. 
2. A measure of the sensitivity of the value of a financial instrument (i.e., a sequence of cash flows) to a change in its yield to maturity. The two main variants of Duration are Macaulay Duration (q.v.) and Modified Duration (q.v.). 
DV01 
The change in the dollar value of a bond (conventionally, one with a Par Value of 100) when its yield falls one basis point. Also known as PV01, PVBP, DVBP. 
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ECB 
European Central Bank (q.v.). 
ELKS 
Equity Linked Securities (sm). Salomon Brothers Inc's proprietary Equity Linked Debt Security (q.v.). A debt obligation of Corporation A, equivalent to a buy-write on one share of Corporation B. The ELKS is like a PERCS (q.v.), except that the company that issues the stock issues the PERCS, and another company issues the ELKS. Salomon Brothers Inc issued the first ELKS in 1993. 
Embeddo 
An Embedded Option. 
Endowment Warrant 
A Call Options on shares, where the strike price grows at the rate of interest, but shrinks by the amount of the dividends that the share pays. In essence, the buyer of an Endowment Call Warrant uses the dividends from the shares to pay off the strike price, but is not obligated to complete the transaction. If at expiration the balance reaches zero, then the buyer may take delivery without further payment. If the balance reaches a positive amount, then the buyer may pay that amount and take delivery. If the balance reaches a negative amount, then the buyer may settle in cash for the value of the shares plus the absolute value of the balance. 
(Source: Australian Financial Review Dictionary of Investment Terms.) 
Equity-Linked Debt Security 
Fixed-income, equity-linked debt securities of corporation A, that participate in the change in price of the "linked" common stock of corporation B. 

Four main examples, listed on the American Stock Exchange, include Salomon Brothers' ELKS (sm) (q.v.), Bear Stearns' CHIPS (sm) (q.v.), Lehman Brother's YEELDS (sm) (q.v.), and Morgan Stanley's PERQ's (sm) (q.v.). These four pay quarterly interest at a fixed percentage rate. 
(Source: http://www.amex.com) 
Equity Swap 
A Swap (q.v.) in which one of the payment streams derives from an equity instrument. For example, in one sort of ordinary Equity Swap, each period, Party A receives (and Party B pays) the capital gains on an equity investment of a given notional amount, while Party B receives (and Party A pays) a floating interest payment based on LIBOR and the same notional amount. This swap is practically equivalent to buying the underlying equity with 100% borrowing (zero margin) and realizing the gain or loss each period. 
Equity Swaps are useful for obtaining leverage, avoiding withholding taxes, and enjoying the returns from ownership without legally owning anything. 
Euribor 
Euro Interbank Offered Rate. The Brussels-based European Banking Federation's Euro-denominated counterpart to LIBOR. As of January, 1999, Euribor seems to be winning its battle for acceptance over the British Bankers Association's Euro LIBOR (q.v.), but London still hopes to win the war for the financial business. On 1/7/99 LIFFE announced plans for new contracts, based on five- and ten-year Euribor swaps. 
Euroclear 
A major system settling securities trades. 
Eurojunk 
High-yield corporate bonds of European companies. Of course, the high yield is compensation for a high probability of default.
For example, Richard Branson's Virgin Group financed its new, V2 Music Holdings PLC label with L74 million in high yield bonds, rather than using a venture capitalist. 
Euro LIBOR 
The British Bankers Association's Euro-denominated analog to dollar LIBOR. As of January, 1999, the European Banking Federation's Euribor (q.v.) seems to be winning its battle for acceptance over Euro LIBOR, but London still hopes to win the war for the financial business. On 1/7/99 LIFFE announced plans for new contracts, based on five- and ten-year Euribor swaps. 
European Central Bank 
The institution that the European Monetary Union has put in charge of maintaining the value of its currency, the euro. (Dagmar Aalund, "What's the Euro?", The Wall Street Journal, 9/28/98.) 
EX 
One of J.P. Morgan's SPVs (q.v.). Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html) 
Exchange Option 
An option to exchange one asset for another. A Margrabe Option (q.v.). 
Exotic Option 
Any Option that is well out of the ordinary, hence not a "Plain Vanilla" Option. The list of Exotic Options changes over time. It grows as dealers innovate new and marvelous options, and shrinks as a jaded market grows accustomed to products that once thrilled it. 
NEW! external market 
The market outside a country's borders for securities that its companies governments issue. The Eurosecurities market. Example: Bank of America debt that trades in Asia and Europe trades in the external market for securities of U.S. companies. Source: http://www.jobs.washingtonpost.com/wp-srv/business/longterm/glossary/a_m/external_market.htm 
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Fairway Bond or Note 
Another name for Accrual Note (q.v.), Corridor Note (q.v.), or Range Note (q.v.). It accrues interest if and only if the index rate stays within a range (analogous to a golf ball staying on the fairway). 
Fannie Mae 
Federal National Mortgage Association. The largest player in the secondary mortgage market. 
Fiona 
Frankfurt Interbank Overnight Average (q.v.). 
Flex Option 
An exchange-traded options that does not have the standard terms of listed options. The customer and the market maker can negotiate various terms, such as strike price and expiration date. 
Floor 
A strip of Floorlets (q.v.). Cf. Cap. 
Floorlet 
An Interest Rate Option to receive fixed in an FRA (q.v.). Its payoff is proportional that to that of a Put Option on a floating rate of interest. 
Floortion 
An option on a Floor (q.v.). 
NEW! foreign market 
The securities market inside a country's borders for securities of foreign companies and governments. Example: Bank of America securities trade in Tokyo in the Japanese foreign market (the Samurai market). Nomura securities trade in New York in the U.S. foreign market (the Yankee market). Further examples are the Bulldog (q.v.), Matador (q.v.), and Rembrandt (q.v.) markets. Source: http://www.jobs.washingtonpost.com/wp-srv/business/longterm/glossary/a_m/foreign_market.htm 
Forward Contract 
A contract to exchange (buy or sell) an underlying instrument for a fixed forward price at a specific, future delivery date. In certain cases - but not always - the Forward Price exceeds the spot price by the cost of carrying the underlying asset from the spot delivery date to the forward delivery date. The cost of carry is an increasing function of the rate of interest and storage costs, and a decreasing function of the rate of dividends, interest, or other cash flows from the underlying instrument. Cf. Futures Contract. 
Forward Forward Curve 
The Forward Curve at a specific future date, based on today's Forward Curve. 
Forward Rate Agreement 
A contract calling for one counterparty to receive the fixed FRA rate and pay the floating rate (e.g., LIBOR) for a particular accrual period in the future, and for the other counterparty to do the reverse. Settlement is at the beginning of the accrual period, when the markets resolve the uncertainty about the floating rate, mainly because that reduces the credit risk associated with the contract. Cf. Swaplet. 
Frankfurt Interbank Overnight Average 
An average of overnight DEM interest rates that uses the Frankfurt market's fixing system. (Source: IFR's online version of "Derivatives: Action in Japan," IFR, 5/3/97, http://www.ifrpub.com/ifrstart.htm) 
Freddie Mac 
Federal Home Loan Mortgage Association. The second largest player in the secondary mortgage market. 
Futures Contract 
An exchange-traded contract that on its last trading day settles into a Forward Contract (q.v.). The Futures Price and the corresponding Forward Price differ systematically in a world where interest rates are stochastic, and the difference depends on the correlation between the underlying spot price and the price of the zero coupon bond that matures on the last trading day. 
Futures Option 
A listed option that settles into a Futures Contract (q.v.). 
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Gilt Strip 
A Zero Coupon Bond that is either a coupon or the principal of a UK government bond, trading separately. The UK counterpart of Strips (q.v.) on U.S. Treasury notes and bonds. 
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Haircut 
The excess of an asset's market value over either (a) the regulatory capital value or (b) the loan for which it can serve as adequate capital. 
Hamster Option 
A form of Range Option that SBC created. I can describe it no better than Professor S. Trautmann explained it to me: "The German noun Hamster has the same meaning as the English noun hamster: it is the name of a small rodent. But HAMSTER is also a acronym standing for Hoffnung Auf MarktSTabilitaet in Einer Range (literally: Hope on market stability in a given range). It really is a pun as in German the verb 'hamstern' has the meaning of 'to hoard'. HAMSTER options hoard the fixed amount one gets for every day the underlying stays in the prespecified range. What is earned cannot be lost anymore." 
Hamster-Optionen 
Hamster Options (q.v.). 
Heavy Hitter List 
A list of wealthy individuals who qualify as substantial investors for the purpose of investing in hedge funds, commodity pools, etc. 
Hermaphrodite Option 
An option that the owner could choose to be either a Call or a Put. Another name for a "AC-DC" option (q.v.). 
Herstatt risk 
Definition: The risk to Counterparty A in the settlement of a foreign currency transaction with Counterparty B, that A would deliver its payment to B, but B might not pay, as agreed. If A and B deliver their payments in different time zones, then Herstatt risk occurs regularly. However, in 1994 a report indicated that Herstatt risk lasts more than one day in a significant portion of transactions. The eponymous Bankhaus Herstatt defaulted on a number of currency transactions when it failed in 1974.
Example: Bank A might agree to deliver DEM in Frankfurt at 3 p.m., in exchange for Bank B's delivery of USD in New York at 3 p.m. on the same day. Although the times appear the same, the New York delivery comes later, because of the difference in time zones.
Comment: The potential for Herstatt risk has increased enormously, over the past decades, as daily currency transactions increased from about $10 billion in 1973 and about $1.25 billion in 1995. Actual defaults have been few, but when Barings collapsed, it failed to deposit $47.8 million worth of pesetas in a Deutsche Bank branch in Spain. Efforts to avoid the problem include bilateral "netting" arrangements, extended hours for the FedWire system, and clearing houses.
References: "Ghostbusters," The Economist, 3/16/96. . 
HH List 
Heavy Hitter List. 
Hurricane Bond 
A form of Catastrophe Bond (q.v.), where the catastrophe is a hurricane. (Source: Sophie Belcher, "USAA to Try Again with Hurricane Bond, Derivatives Week, 5/5/97.) 
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Index Amortizing Swap 
A swap whose Notional Amount (q.v.) amortizes (declines) each period by an amount that depends on the level of one or more interest rates. This gives the IAS a superficial resemblance to a mortgage loan or mortgage-backed security, which has optional prepayment. This superficial similarity has been the basis for a sales pitch to institutions with a large prepayment risk to hedge. Alas, the basis risk is large enough to discourage intelligent, experienced - or even merely intelligent - professionals from hedging this way. The IAS - like the legendary House of the Rising Sun, in New Orleans - has been the ruin of many a poor boy. 
Inflation-Linked Bonds 
Inflation-Linked Bonds have coupons that depend on the rate of inflation or a related index. They have two main structures. 

1. Capital Indexed Bonds. The principal accretes according to the CPI or another price index or deflator. The bond's coupon is a fixed percent of the accreted principal. 
2. Floating Rate Bonds. The principal is fixed, but its coupon floats. The floating rate depends on inflation or something related, such as the rate of change in the CPI or on the Treasury Inflation Protected Security (TIPS) variable coupon rate. 
A flurry of issues have hit the market in 1997. Issuers include Federal Home Loan Banks, JP Morgan & Co. Inc., Sallie Mae, Salomon Brothers, Toyota Motor Credit Corporation, the U.S. Treasury. 
The two main unresolved issues of Inflation-Linked Bonds are how large and variable (1) the coupon and (2) the market price should be.The real yields on Inflation-Linked Treasury Bondsbegan large enough to surprise many observers, and has fallen little in a few months. Some observers believe that these high real rates are sustainable and have historical precedent. Others believe that they are the result of investor uncertainty about the market and will fall over time. (Jonathan Clements, "Second Thoughts: Inflation-Tied Bonds Offer an Intriguing Option for Investors," Wall Street Journal, 3/11/97.) 
Advocates for the U.S. market envisioned a bond with a variable coupon and a stable price. However, the experience with Australian Capital Indexed Bonds is that the price varies significantly. (Wesley Phoa, "Inflation-Linked Bonds; are they too safe or too exciting?", Financial Trader 4 (2), p. 30.) 
Installment Option 
An option on an option on an option ... 
Installment Warrant 
Aussie for what is simultaneously a Compound Option (q.v.) and a Warrant (q.v.), and which apparently confers some of the benefits of ownership. "They involve two payments: an initial payment followed by a second, which includes fees and interest, paid optionally about 14 months afterwards. In the meantime, depending on the issuer, the instalments confer full dividends, franking credits and voting rights." (Source: Australian Financial Review Dictionary of Investment Terms.) 
interest bought/sold date 
The "value date" (q.v.). (J.P. Morgan Glossary of terms for global sovereign bond markets.) 
Interest-Only (IO) Tranche 
A CMO (q.v.) Tranche (q.v.) that receives a portion of only the CMO's underlying principal payments. 
NEW! internal market 
The securities market within the boundaries of a particular country, consisting of the domestic market (q.v.) and the foreign market (q.v.). Example: Most Daimler Chrysler debt trades in the German internal market. Source: http://www.jobs.washingtonpost.com/wp-srv/business/longterm/glossary/a_m/internal_market.htm 
International Swaps and Derivatives Association 
The principal trade association for Swap and Derivatives dealers, as well as allied organizations. 
ISDA 
International Swaps and Derivatives Association (q.v.). 
Inverse Floater 
A Floating Rate Note with a coupon that decreases as the underlying index rate increases (e.g., a simple Inverse Floater's coupon rate might be 11.5% minus LIBOR). The Replicating Portfolio (q.v.) for a simple Inverse Floater is long a pair of Fixed Rate Notes and short a Floating Rate Note. Commonly, an Inverse Floater's coupon has a ceiling and a floor, (e.g., no more than ten percent, never negative). Thus, its replicating portfolio is the same as for a simple Inverse Floater, plus long a Cap and short a Floor. 
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Jamming 
Definition: Executing a large sell (buy) order in stages by asking for a market on a small size, hitting the bid (offer), then repeating the process with a different market maker, ultimately driving the price considerably lower (higher). 
Application: "It is entirely against proper market etiquette in foreign exchange and gold, but somewhat permissible in fixed income trading. You never jam a friend." (Nassim Taleb) 
Jelly Roll 
A roll that a trader does using synthetic Forward Contracts (q.v.). Each synthetic Forward Contract consists of a long call and a short put, on the same underlying instrument, with the same strike and expiration. 
Jump Z 
A last-pay "companion" (sort of residual) tranche of a REMIC (q.v.) that "jumps" into first-pay status if interest rates fall or prepayments are rapid. The desired effect of the jump provision is to promote positive convexity (like a bond), rather than negative convexity (like a mortgage) in another tranche. 
(Source: "Derivative Mortgage Securities Glossary," Dean Witter, Mortgage Backed 
Securities Department, Derivative Products Group, January 1995.) 
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Kitchen Sink Bond or MBS 
A bond or CMO into which issuers have dumped "everything but the kitchen sink," including "garbage" such as miscellaneous MBSs, CMO tranches, and derivatives. Some people call the contents of the KSB the "toxic waste" of derivatives transactions. 
Issuers include agencies such as Fannie Mae or Freddie Mac and securities firms such as Bear Stearns and CS First Boston. 
One selling point has been that their components are so diverse that some will increase in value while others decrease, thus reducing overall risk. However, in fact, in the middle of 1994 enough of the components went south to seriously hurt investors in some kitchen sink bonds. 
Knockin Option 
An option that "comes to life" when a trigger event occurs. Typically when a price crosses a particular barrier it pulls the trigger. (Cf. Knockout Option.) 
Knockout Option 
An option that "dies" when a trigger event occurs. Typically when a price crosses a particular barrier it pulls the trigger. (Cf. Knockin Option.) 
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Ladder Option 
An option somewhere between a Lookback (q.v.) and a European Option. A Ladder Call Option has one or more "Rungs" (price levels) above the initial spot level. The Call's payoff equals the greater of a European Call's payoff or the excess over Strike (q.v.) of the highest Rung that the underlying price reaches. 
For example, suppose that the Underlying Price is 100 and a Ladder Call has a Strike at 105 and Rungs at 115 and the Underlying Price reaches 120 before Expiration, then falls back to 98, the Ladder Call pays 15 = 120 - 105. If the Underlying price never gets above 109, then falls back to 98, the Ladder Call expires worthless.125. If 
Ladder Periodic Cap 
A Periodic Cap (q.v.) that depends not on LIBOR at the end of the previous period, but on the highest or lowest rung of the Ladder that LIBOR reached during that period. The Ladder is a predetermined set of LIBOR levels, such as 4.00%, 3.50%, 3.00%, etc. The Ladder can change from period to period. The Ladder Periodic Cap is a special case of the Lookback Periodic Cap (q.v.). (Source: Dehnad, Kosrow. "Learning Curve; Lookback and Ladder Periodic Caps." DW, October 25, 1993.) 
LASER 
Paribas Capital Markets' Liquid Asset Swap with Enhanced Return. A kind of SPV (q.v.) that Moody's rated A1. The initial US dollar one-year issue contained a repackaged Swiss franc private placement priced at six-month Libor plus 25bp. In the event of a failure of the Laser security, holders receive the underlying coupon and principal payments. (Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html) 
LEAPS 
Long-term Equity AnticiPation Securities. Listed Call and Put Options on shares and indexes, with expirations out as much as two years. Ordinary listed Calls and Puts expire within nine months. LEAPS permit investors to express longer-term views, without buying the underlying instruments. 
LEPO 
In a normal market the bid is less than the ask, and the difference - the bid-ask spread - would be the market maker's profit on a round trip in the stock. In a crossed market, the bid price exceeds the ask (offer) price. In an OTC market one market maker may show the best bid and another the best offer, and these may cross. A crossed market cannot last, in equilibrium. 
A Low Exercise Price Option (q.v.) traded on the Australian Stock Exchange (q.v.) or SOFFEX (Switzerland). (Source: Australian Stock Exchange.) 
LIPS and TRIPs 
Indexed Principal Swaps, i.e., Amortizing Swaps, where amortization depends on the change in LIBOR (LIPS) or some Treasury yield (TRIPS). 
life assurance [insurance] bonds 
Bonds backed by life insurance policies. The idea is that life insurance companies are good at underwriting insurance risks, collecting premiums, and servicing the policies, but needn't tie up their money for the duration. 
Examples: USAA, Swiss Winterthur, Swiss Re, and Tokio Marine & Fire have issued such bonds. CSFB, Goldman Sachs, Lehman Brothers, and Merrill Lynch have brought the issues to investors. Good news: This is a logical next step in disintermediation. The cash flows are relatively predictable, in contrast to cash flows on "catastrophe bonds" (q.v.). 
Bad news: Investors will be dealing against experts in adverse selection (q.v.) and moral hazard (q.v.). 
Source: "An earthquake in insurance," The Economist, 2/28/98. 
locked market 
A market where the bid (q.v.) equals the ask (q.v., also known as asked, offer, offered). In a normal market the bid is less than the ask, and the difference - the bid-ask spread - would be the market maker's profit on a round trip in the stock. We would not expect to see a locked market with a single market maker. In a market with more than one market maker, one market maker may show the best bid and another the best offer, and these may lock. However, savvy customers would not let the market makers cover their costs, and a locked market could not last, in equilibrium. 
Lombard rate 
The rate of interest charged on a Lombard loan. 
Lombard loan 
A secured loan the Bundesbank makes, based on the pledge of high grade securities, intended for emergencies, with limited availability. 
Lookback Option 
An option with a payoff based on the path of some risk factor from the option's inception until its expiration. Examples of lookback options include a Call (Put) with (a) underlying price equal to the maximum (minimum) of the reference price during the option's life, and a given strike, or (b) underlying price equal to the reference price at the option's expiration, and strike equal to the minimum (maximum) of the reference price during the option's life. 
Lookback Periodic Cap 
A Periodic Cap (q.v.) that depends not on LIBOR at the end of the previous period, but on the highest or lowest level that LIBOR reached during that period. (Source: Dehnad, Kosrow. "Learning Curve; Lookback and Ladder Periodic Caps." DW, October 25, 1993.) 
Low Exercise Price Option 
An extremely deep in-the-money European Call Option traded on the ASX (q.v.) options market, with strike price between one and ten cents. Since the strike price is so low, the LEPO's owner is extremely likely to exercise it, and it is roughly equivalent to a Forward Contract (q.v.) with a low price. The LEPO owner receives no dividends, but has nearly the same exposure to a move in the underlying stock price as if he owned a share. I.e., the LEPO's delta is nearly unity. (Source: Australian Stock Exchange.) 
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Macaulay Duration 
1. A measure of the sensitivity of a financial instrument's value to a change in its yield. Macaulay Duration is an overestimate, and Modified Duration (q.v.) is a more precise measure. 
2. The weighted average of time until a financial instrument pays its cash flows. Each weight is proportional to the present value of the associated cash flow. 
3. Modified Duration (q.v.), times 1 + y/n , where y is the yield and n is the number of coupon payments per year. 
NEW! market 
A real or virtual place where people trade things. For example, people trade securities in the securities market, bonds in the bond market, commodities in the commodities market, currency in the foreign exchange market, futures contracts in the futures market, options in the options market, and shares in the stock market.Cf. domestic market and foreign market, internal market and external market. 
Market Risk 
The risk of loss from being on the wrong side of a bet about a market move. 
Margrabe Option 
The option to exchange one asset for another. Margrabe (1978) showed several applications for this sort of option (margin account, corporate exchange offer, and standby commitment) and derived a model for pricing this option. Other people discovered numerous additional examples of this option. The Cross Currency Option (q.v.) is a prime example. The option goes also by the names Exchange Option (q.v.) and Outperformance Option (q.v.).
Source: Gary L. Gastineau and Mark P. Kritzman, Dictionary of Financial Risk Management, Frank Fabozzi, 1996. 
Market Index Target-Term Securities 
Merrill Lynch's registered derivative product, with a payoff that is the greater of (a) some minimum and (b) issue price times the sum of unity and the rate of increase in value of the underlying price. MITTS don't allow the owners to redeem, nor the issuers to call early. The MITTS is equivalent to a position in the underlying index, plus a protective put. 
For example, Merrill Lynch has listed on the American Stock Exchange an issue of MITTS with an underlying index proportional to an average of the prices of the ten highest-yielding Dow-Jones Industrials, and maturity on 8/15/06. The minimum payoff of this issue is 124% of the issue price. 
Marché à Terme Internationale de France (MATIF) 
The French derivatives exchange, which dominates trading in contracts based on instruments denominated in the French Franc. 
NEW! Matador market 
Spain's foreign market (q.v.). Example: Some Exxon debt trades in the Matador market. 
Maus-Optionen 
Markt Aufstehen Und Sicherheit Optionen. Range Options that pay off like Call Options when the market rises securely within a narrow, upward sloping corridor, but otherwise expire worthless. 
MBS 
Mortgage Backed Security (q.v.). 
Mid-Curve Option 
A short-term American option on a CME-listed Eurodollar Futures Contract with delivery in one or two years. The crucial innovation here is that an ordinary CME Futures Option on the ED contract with delivery in one year (two years) expires in one year (two years), while the Mid-Curve Option initially expires in six months. Thus, the Mid-Curve provides a more focused (and less expensive) way to express a view on the news that develops in the next six months about the level of short-term interest rates that we will observe one or two years into the future. (Sources: Aaron Lucchetti, "Exotic Option Wins Followers on Wall Street," Wall Street Journal, 5/6/97. http://www.cme.com/market/interest/serialmc.html) 
Millenium Bond 
Definition: A Bond that matures in 1000 years. 
Example: Lehman Brothers underwrote a 1000-year issue for Safra Republic Holdings SA. 
Application: A Millenium Bond reduces the need for refinancing and reinvesting. 
Pricing: The Safra issue yielded 98 basis points over the 30-year U.S. Treasury bond. Price and yield should be nearly reciprocals. 
Risk Management: One might hedge them by shorting Safra's previous 100-year maturity bonds. However, as a practical matter their duration should be close to that of the U.S. Treasury's Long Bond. 
Comment: If the British government could issue perpetuities ("consols") to consolidate its debt, then why can't a corporation issue bonds maturing in 1000 years? 
Source: "Ratings & Briefs," Financial Trader 4 (11), p. 8. 
MIPS 
Monthly Income Preferred Shares (q.v.). 
MITTS 
Market Index Target-Term Securities (q.v.). 
Model Risk 
The risk of loss due to weakness of the financial model(s) that a business uses for pricing inventory and managing risk. 
Modified Duration 
A measure of the sensitivity of a financial instrument's value to a change in its yield. 
The first derivative of a financial instrument's value with respect to a change in its yield. 
Macaulay Duration (q.v.), divided by 1 + y/n , where y is the bond yield and n is the number of coupon payments per year. 
Monte Carlo Simulation 
A technique for approximating a probability distribution by generating uniformly distributed pseudo random numbers and transforming them into the required sort of random numbers. In option pricing one ordinarily works with lognormal random interest rates, prices, and indexes. If one constructs the probability distributions correctly, then a Derivative Product's value equals the expected discounted value of its payoff (in the limit as the number of random paths approaches infinity). (See http://www.sbcm.com/hot/current.htm for more information) 
Monthly Income Preferred Shares. 
Monthly Income Preferred Shares (or Stock) - which most people call MIPS or Mips, for short - are Preferred Shares (q.v.) that pay monthly dividends. MIPS are callable after some period of call protection, and convertible into common shares. Some observers see MIPS as tax-deductible equity, in effect. Some in the Treasury department see this as abusive, and want a crackdown. Goldman, Sachs & Co. pioneered them circa October 1993. Cf. Step-Down Preferred Stock. 
The parent corporation (Parent) creates a subsidiary (Sub) or limited partnership to issue the MIPS. Sub sells MIPS for cash and lends the cash to Parent or buys Parent's notes. Parent pays interest to Sub, which pays monthly preferred dividends to its security holders. In at least one case Parent had the option to defer interest for up to five years. That would mean that MIPS holders might receive no dividends for five years. 
One variation on the MIPS structure involves an offshore Sub, which pays dividends to investors without withholding tax. 
Part of the motivation for MIPS seems to be reduction of taxes paid by the issuer and its direct or indirect security holders. Parent issues debt and pays interest, so Parent may deduct interest expense. Subsidiary issues preferred shares and pays dividends, so corporations that buy MIPS get a dividend exclusion. This shifts the tax burden to parties besides security holders of Parent and Sub. 
Texaco, Inc., USX Corp., ConAgra Inc., and others issued more than $2.5 billion in the first year MIPS existed. Merrill Lynch and Smith Barney have issued similar securities. 
The masochistic or meticulous among you may like to view legal documents from Edgar, pertaining to a proposed offering of MIPS, by Capital Holding Corp., with help from Goldman, Sachs. See also U.K. Mips. 
Monster ABS 
An enormous Asset-Backed Security (q.v.). (For example, see "Natwest Prepares Monster Loan-Backed ABS," BondWeek, 3/10/97. This one was worth about $1.65 billion.) 
Morgan Stanley - Capital International 
The Morgan Stanley unit that maintains a wide range of global stock market indexes for approximately 20 countries and a variety of regions. 
Mortgage Backed Security 
A security, such as a bond, pass-through, CMO, or REMIC that derives its cash flows and market value from underlying Mortgage Backed Securities and/or Mortgage Bonds, Loans, and/or Notes. 
Mortgage Bond, Loan, or Note 
A Bond, Loan, or Note plus a security interest in a piece of property, commonly real property (land and/or buildings). A residential mortgage loan typically contains a prepayment option, which is the borrower's call option on the loan and which becomes valuable when interest rates decline. Also, in practice, the lender sells the homeowner a put option on the pledged home, struck at the loan's balance. 
MSCI 
Morgan Stanley - Capital International (q.v.). 
M-squared 
A way of measuring the performance of an investment portfolio, namely the average rate of return on a portfolio that (a) consists of investment in T-bills and the investment portfolio and (b) has the same standard deviation as the relevant benchmark portfolio. Thus, if an investment portfolio's M-squared is greater (less) than the return on the benchmark portfolio, then the investment portfolio's risk-adjusted return is better (worse) than that of the benchmark. (Noelle Knox, "Slice, Dice and Scrutinize: Risk Measurements Draw a Crowd," NYT, 4/5/98, p. 45.) 
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Naked Dog Basket 
The "Basket" is a portfolio of Brady Bonds that someone issued in exchange for rescheduled debt of certain developing countries. One might suppose that some people consider such a bond to be a "Dog". The "Dog Basket" is "Naked", because the terms of the contract call for stripping the yield on U.S. long bond from the gross return on the portfolio. So the coupon on the "dogs" depends on the "stripped spread" between the long bond rate the the Brady Bond yield. (Described in the Financial Times, 11/16/94, p. V.) 
Nondeliverable Forward 
A cash-settled, forward contract, typically on a nonconvertible or thinly traded foreign currency (probably from an emerging or submerging (q.v.) market) or two such currencies, that settles into a convertible currency (typically the USD). The cash value is a function of the contract's reference rate(s) on the fixing date, typically, two business days before the value date. Its main atraction is avoiding currency controls. (Source: William Rhode, "Learning Curve: Nondeliverable Swaps, Derivatives Week, 5/5/97.) 
Nondeliverable Swaps 
A Swap (q.v.) that would be equivalent ideally to a Cross-Currency Swap (q.v.), except that it settles instead in USD. Typically, the NDS omits delivery of the underlying currency at maturity. In simpler cases, the parties offset this omission with the appropriate Nondeliverable Forward (q.v.). In more complicated cases, the parties don't offset it, and pricing is more difficult. "One player at a U.S. bank uses a combination of risk tolerance, onshore interest rate levels and her own currency forecast to price NSDs." The NDS's appeal stems largely from its ability to circumvent prohibitions against converting currencies at market prices. (Source: William Rhode, "Learning Curve: Nondeliverable Swaps, Derivatives Week, 5/5/97.) 
Notional Amount 
A stated amount in a Derivatives Contract, on which the Derivative's payments depend. The Notional Amount is most analogous to the principal amount of a bond. 
[le] Notionnel 
"Notional bonds", the long-term, French bond futures contract on the MATIF (q.v.). 
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OATS 
Order Audit Trail System. The NASD's new (as of 1998), SEC-approved system for keeping detailed, *time-stamped records of every trade. (http://investor.nasd.com/notices/9833ntm.txt) 
Obligations assimilables du trésor. French government bonds, with either fixed and floating coupons, available in book-entry form. Not traded overseas, but available as ADRs in the U.S. (http://www.rcmfinancial.com/o.htm) 
Obligations Assimilables du Trésor (OATs) 
French government bonds with original maturities of 5-30 years, the underlying assets for French bond futures and option contracts. (http://www.cean.caisse-epargne.fr:5281/html/obligassi.html) 
Off-the-Run Treasury 
A former On-the-Run Issues (q.v.), after the Treasury issues the new On-the-Run. 
OIS 
Overnight Indexed Swaps (q.v.). 
One-Touch Option 
An Option that pays off as soon as the trigger price touches the barrier. Often, it is a Binary Option (q.v.). 
One Way Collared Note 
A One Way Floating Rate Note (q.v.). 
One Way Floater 
A One Way Floating Rate Note (q.v.). 
One Way Floating Rate Note 
Definition: A Floating Rate Note whose rates can only ratchet up (usually) or down. Also known as One Way Collared Note, One Way Floater, Ratchet Floater, and Sticky Floater. (Source: Peng, Scott, and Dattatreya, Ravi, The Structured Note Market.) 
Example: A Floating Rate Note that pays a quarterly coupon that is at least the previous period's LIBOR, at most 50 bips (q.v.) above the previous LIBOR, and equals LIBOR if LIBOR falls between these bounds. 
Application: This is mainly a vehicle for speculation, because it is difficult to name something that it hedges. 
Pricing: The payoff is path dependent, and the most obvious way to price it is with Monte Carlo simulation. (See Peter Fink's discussion at http://www.sbcm.com/hot/current.htm) 
On-the-run Treasury 
Definition: The most recently issued U.S. Treasury note or bond of a given initial Maturity. Also known as the Current Coupon issue. 
Example: For example, when the Treasury auctions a new two-year note it becomes the new On-the-Run two-year note. 
Risk Management: The On-the-Run issues tend to be the most liquid - i.e., they have the smallest bid-ask spreads. That makes them most attractive as hedging instruments. 
Comment: After the Treasury announces that it will auction a specific security (defined by maturity and coupon), but before the auction, the bond may trade in the When Issued Market (). After the auction, this security becomes the new On-the-Run Issue for its maturity. The previous On-the-Run becomes an Off-the-Run issue. 
OTM 
Out-of-the-Money. Having an Intrinsic Value of zero. 
Outperformance Option 
An option on the performance of one asset in excess of the performance of another. Typically, one measures the outperformance by the excess of the one return or rate of retun over the other. One might also measure the outperformance as the excess of the ratio of the two final price over a benchmark ratio. 
Overnight Indexed Swaps 
Swaps with a floating rate based on Sonia (q.v.). 
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Pack 
A Forward (q.v.) Strip (q.v.,#2), each corresponding to a particular year, of four consecutive, quarterly Eurodollar or Euroyen futures contracts. Markets, such as Simex offer a Pack as a convenient package of futures contracts, without the execution risk inherent in building up the Strip, contract by contract. A trader can use Packs and Bundles (q.v.) to implement bets on the change in shape of the Forward Curve. 
PCS Options 
The CBOT's option contracts with the underlying Property Claims Service (PCS) index. Apparently, they operate more or less as a call option on the underlying index, which could be any one of nine indexes. (Source: Robert Clow, "Coping with catastrophe," Institutional Investor, December 1996, pp. 138.) 
PEEQS 
Protected Exchangeable EQuity-linked Securities (q.v.). 
PERCS 
Preference Equity Redemption Cumulative Stock. Preferred stock in Corporation A that behaves on the downside like common stock in Corporation A, but contains an embedded short Call Option on that stock. The PERCS is a descendant of the Prime of the early 1980s, which was itself a descendant of the hoary Buy-Write (q.v.) strategy. (See Pratt, Tom. "You can't keep a lid on public derivatives." IDD, Oct. 24, 1994, pp. 12-18.) The PERCS is like a ELKS (q.v.), except that the company that the company that issues the stock issues the PERCS, and another company issues the ELKS. Morgan Stanley issued the first PERCS in 1991.3.375 
Periodic Cap 
An Interest Rate Cap (q.v.) for which the strike for each Caplet (q.v.) can differ from strikes on other Caplets. Typically, the strike depends on LIBOR, as in a Ladder Periodic Cap (q.v.) or Lookback Periodic Cap (q.v.). 
PERQS 
Performance Equity-Linked Redemption Quarterly-Pay Securities (sm). Morgan Stanley's proprietary Equity Linked Debt Security (q.v.). 
Pfandbriefe 
German asset backed bonds, backed by private mortgages or public sector loans. The Association of German Mortgage Banks claims that for at least 100 years, through 1998, no investor who has held a Pfandbriefe issue to maturity has ever failed to receive full principal and interest. This claim suggests that some of the payments may not have been timely. Better late than never! 
Pfandbriefe, Jumbo 
Straight bonds with face value of at least DEM 1 billion, which at least three market makers have pledged to quote continuous, two-way markets during normal market hours, for size up to DEM 25 million. Cf. Pfandbriefe. 
Pfandbriefe, Public 
Bonds backed by loans to the public sector. Cf. Pfandbriefe. 
Pibor 
Paris Interbank Offered Rate. The French counterpart of LIBOR. 
Planned Amortization Class 
An indexed amortizing structure with an amortizing rate that is nearly flat over a large range of values for the underlying rate of interest. 
Price 
Clean Price = Quoted Price. What the broker or dealer tells you is the price of a bond = Dirty Price - Accrued Interest. 
Dirty Price = Invoice Price = Full Price. The size of the check you write to buy a bond = Clean Price + Accrued Interest 
Principal-Only (PO) Tranche 
A CMO (q.v.) Tranche (q.v.) that receives a portion of only the CMO's underlying principal payments. 
Preferred Share 
A share that pays a fixed dividend and has preferences over Common Stock (q.v.) with regard to dividends and in case of bankruptcy. 
Protected Exchangeable EQuity-linked Securities 
The Morgan Stanley Group, Inc.'s proprietary, listed (American Stock Exchange) equity index derivative product, which pays off at maturity (4/20/01) the greater of issue price ($69.55) or 10% of the S&P 500 Index value on that date. The owner may from 11/17/97 to seven trading days before 4/20/01) exchange 100 PEEQS for ten times the S&P 500 Index level. Thus, at each dividend date, the owner has the option to forgo the dividend in return for a compound option that ultimately pays off as mentioned. (Cf. SPINs.) 
Putable Bond 
Definition: A Bullet Bond (q.v.) that the bondholder can force the issuer to buy back at a scheduled price. The Put Price as a function of calendar time is the Put Schedule. A Bullet Bond plus a Put Option (q.v.) on the Bond. AKA Retractable Bond. 
Example: A corporation might issue a ten-year Note (q.v.) with a five-year Put Option. 
Application: A Putable Bond is a bet on the cost of refinancing at the Put Date. The issuer is betting that the Put Option will expire worthless - i.e., that interest rates will be low at the Put Date. The bondholder is betting that interest rates will rise, the bond price will fall, he will be able to sell the bond back to the issuer at a profit, and he will be able to reinvest the proceeds of that sale in a bond with a higher coupon. 
Pricing: You can price it as a bond, plus a put option on the bond. For it to sell near par requires a low coupon. 
Risk Management: For example, suppose that a corporation issues a ten-year bond with an embedded five-year European Put Option. It is exposed to the danger of rising interest rates, in which case the bondholder will put the bond back to the issuer. However, if the issuer also buys a Payer Swaption, struck at the same coupon as the bond, then it will be able to issue floating rate debt to repay the principal on the bond and exercise the Swaption to continue paying the same fixed rate. The floating rate receipts from the Swaption will roughly cover the new floating rate debt interest. 
Comment: Cf. Callable Bond, Extendible Bond. 
Put Option 
The right, but not not the obligation, to sell the underlying asset at the strike price. Cf. Call Option. 
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Quanto 
Goldman Sachs's copyrighted (but not enforced) term for a "quantity-adjusting" option or forward. In 1986 Lee Thomas, then of Goldman Sachs, introduced the term. See also Quanto Forward (q.v.), Option (q.v.), and Swap (q.v.). ("Quanto swap challenge: the results," Euromoney, October 1994, p. 30.) 
Quanto Forward 
A forward contract in which the buyer receives a random number of units of the underlying , and that number depends on another price. For example, consider a Quanto Forward contract on the Nikkei. The forward price might be a fixed number of dollars, while the number of units of the Nikkei would depend proportional to the yen/dollar exchange rate. This is equivalent to a cash-settled forward contract with a nominal dollar value of the Nikkei proportional to the ratio of its true dollar value to the dollar value of one yen. 
Quanto Option 
An option in which the payoff is the greater of zero or the value of a Quanto Forward (q.v.) contract. 
Quanto Swap 
A swap in which the underlying price is quantity adjusted, as with the Quanto Forward and Quanto Option. 
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Rainbow Option 
Definition: An option that has several risk factors of the same type, e.g., two stock prices or three exchange rates. 
Examples: The earliest Rainbow Option in the derivatives literature was probably Margrabe's Option to Exchange One Asset for Another, an Outperformance Option (q.v.), with a payoff that depends on the difference between two prices. An Equity Index Option (q.v.) has a payoff that depends on the average of underlying share prices. 
Pricing: Margrabe (1976) published the first pricing model for a Rainbow Option, namely the "Margrabe Option." In some cases one can price a Rainbow Option with a Black-Scholes-Merton model by computing the appropriate adjusted volatility and dividend yield. The most common way to price a general Rainbow Option is with Monte Carlo pricing. Next most common is with a multinomial model (a generalization of the binomial model). Explicit finite difference pricing is easily feasible, but rarely seen. 
Risk Management: Rainbow options with n sources of risk have n Deltas, n Kappas, n(n+1)/2 Gammas, and sensitivity to n dividend yields and n(n-1)/2 correlations. With large n this can get complicated. 
Comment: If the several risk factors are of two or more types, e.g., a stock price and an exchange rate, then the option is a Hybrid Option (q.v.). 
Range Accrual Option 
An Option that accrues value for each day that the index rate remains within the specified range. See Range Note, Hamster Option. 
Range Binary Option 
An Option that pays off a fixed amount at expiration if and only if the underlying price remains in the range the option's entire life. . 
Range Note 
An Accrual Note (q.v.). 
Ratchet Floater 
A One Way Floating Rate Note (q.v.). 
real option 
Definition: An option that involves tangible objects - such as bricks and mortar, pipelines and equipment - rather than financial instruments and cash flows, and physical actions - such as excavation, construction, demolition, physical movement, and hard work - rather than simply tendering notice of the exercise of an option. 
Examples: Examples include the following decisions to: 
- build a plant today, rather than wait until next year
- choose a more flexible and more expensive production process, rather than a cheaper one with fewer applications
- decline a marriage proposal and play the field, looking for a better proposal
- go for an MBA, rather than a law degree 
Applications: The main business application for real options seems to be capital budgeting, i.e., business investment. The idea is that one investment may open doors to other opportunities that may grow or not, and that traditional net present value methods are not up to the task of evaluating such investments. 
Comment: Although the real option approach is theoretically sound, the challenge of applying it correctly to get out a useful value is daunting. I have waited 30 years to see widespread use of the capital asset pricing model for capital budgeting. We may have to wait as long to see widespread use of real option theory. 
Real Estate Mortgage Investment Conduit (REMIC) 
A relatively new vehicle for passing the cash flows from a portfolio of mortgages and MBS's through to holders of REMIC certificates. The REMIC legislation took effect on 1/1/87. Since REMICs appear, new issues of CMOs have nearly disappeared. 
Red Chip Stocks 
Shares listed on the Hong Kong Stock Exchange of companies with headquarters and operations in the People's Republic of China. 
Rediscount credit 
Bundesbank (Buba) credit to institutions "against the purchase of bills of exchange". This is typically the lowest rate at which the Buba lends, and the Buba's Central Bank Council limits the total amount of such credit. 
NEW! Rembrandt market 
Holland's foreign market (q.v.). Example: Some Exxon debt trades in the Rembrandt market. 
REMIC 
Real Estate Mortgage Investment Conduit (q.v.). 
Replicating Portfolio 
A portfolio of securities (ordinarily more "basic" and from a more liquid market) that either (1) mimics the returns on a derivative security (static replication) or (2) is part of a trading strategy that mimics those returns (dynamic replication). 
Residual Tranche 
The "equity" portion of a CMO (q.v.). The Tranche (q.v.) that receives what's left over after satisfying all other claims against the underlying cash flow. 
REXâ 
A price index for all fixed-income bonds, debt obligations, and Treasury bills of the German federal government, Treuhandanstalt, and the German Unity Fund. The REXâ bond index is a weighted price average based on 30 synthetic, notional bonds with a constant integer life to maturity periods of one to 10 years and three different coupon types of 6, 7.5, and 9 percent. (Source: http://www.exchange.de/fwb/indices.html#rex). 
REXPâ 
A performance index corresponding to the REXâ (q.v.). (Source: http://www.exchange.de/fwb/indices.html#rex). 
Right 
A Call Warrant (q.v.) - ordinarily in the money - that a corporation grants to current shareholders to buy additional shares. 
Roller Coaster Swap 
A Swap (q.v.) that is a hybrid of an Accreting Swap (q.v.)and an Amortizing Swap (q.v.). The Notional amount both increases and decreases during the Swap's life. (Source: http://www.snowgold.demon.co.uk/webrisk/) 
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NEW! Samurai market 
Japan's foreign market (q.v.). The market in Japan for securities that non Japanese companies and governments issue. Example: Some shares of General Motors trade in the Samurai market. 
SCHATZ 
German Federal Treasury Bills (BundesSCHATZanweisungen). (Source: http://www.exchange.de/dtb/SCHATZ-future.html) 
SCHATZ Futures 
The DTB Futures contract on a notional short term (1 3/4 - 2 1/4 years) debt security of the German Federal Government or the Treuhandanstalt, with a notional interest rate of 6%. The SCHATZ (q.v.) and other instruments qualify. (Source: http://www.exchange.de/dtb/SCHATZ-future.html) 
Section 215 
"Section 215 of the U.S. penal code says those found to have given or received improper financial incentives of more than $1,000 'in connection with any business or transaction' of an institution 'shall be fined not more than $1 million or three times the value of the thing given, offered, promised, solicited, demanded, accepted or agreed to be accepted, whichever is greater, or imprisoned not more than 30 years, or both."
(Michael Siconolfi, " 'Spinning' Of Hot IPOs Is Probed", WSJ, 4/16/98. ) 
Securitization Conduit 
A Special Purpose Vehicle (SPV) (q.v.), with a remote chance of bankruptcy, that a bank forms. The Conduit purchases or originates loans and finances them with various sorts of Asset Backed Securities (q.v.). The underlying loans provide the collateral for the ABS's. Typically, the sponsoring bank guarantees the payments of the ABS's, which the security holders demand. The guarantee may come from a standby letter of credit or from the bank's purchase of the Conduit's junior securities. In return for its guarantees, the bank receives the residual coupon spread of the underlying securities over that of the conduit's securities. 
settlement date 
The date on which the buyer pays (the seller receives) cash and the seller delivers (the buyer receives) property. In the Eurobond market, this is the "value date" (q.v.). (J.P. Morgan Glossary of terms for global sovereign bond markets.) 
short-short rule 
A part of the U.S. federal tax code (from 1936 to 1997) that imposed corporate income tax (hence double taxation of income) on a mutual fund that received more than 30 percent of its gross income (i.e., before deducting losses) from gains on positions held less than three months. A mutual fund that violated the short-short rule would owe corporate income tax on all its income for that year. Also known as the 30% Rule. 
Its advocates argued that the rule would discourage funds from short-term trading that might destabilize the markets. Its opponents pointed out that it discouraged short selling and trading in derivatives. 
SIRES 
Merrill Lynch's Secured Individually Repackaged Exchangeable SecuritieS), denominated in several currencies, for international investors. A kind of SPV (q.v.). Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html) 
SLOB 
Secured Lease Obligation Bond. A bond, backed by a portfolio of leases. (Source: Gastineau and Kritzman, Dictionary of Financial Risk Management, Frank J. Fabozzi Associates, 1996.) 
SOES 
Small Order Execution System. NASDAQ's computerized way for a customer to enter a small order to buy or sell shares of a NASDAQ stock. Under old NASDAQ "order handling rules", market makers had to fill orders for up to 1000 shares. The new (as of 1/24/97) rules - which tend to protect market makers from so-called "SOES Bandits" (q.v.) - reduce this size to only 100 shares. A trader can use SOES for a given stock once every five minutes. Source: Cory Johnson, "Easy Money: Is the NASD's SOES Attack a Ticking Time Bomb?" TheStreet.com (3/3/97). 
Sonia 
Sterling Overnight Interbank Average (q.v.). An average of the rates that London's largest money brokers pay for overnight deposits on a given day. 
Special Purpose Vehicle (SPV) 
A merger of a bond and a derivatives trade into a single contract. For example, one SPV might consist of a fixed rate bond plus a Swap in which the owner of the bond pays fixed and receives floating. Thus, the SPV is equivalent to a floating rate bond. Examples include the ARGO, EX, LASER, SIRES, and STEERS - all of which (q.v.). (Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html) 
Spiders 
Essentially, shares in a trust that owns shares of stock in the same proportion as the S&P 500 stock index portfolio. Spiders are a.k.a. Standard & Poor's Depositary Receipts (SPDRS), and have ticker symbol SPY. The Spider portfolio contains one-tenth of the S&P 500 index portfolio, so it sells for about a dollar amount equal to about one-tenth of the S&P 500 index level. Spiders trade on the American Stock Exchange like ordinary shares, which gives then continuous liquidity while the market is open, the ability to sell short, and ordinary stock transaction costs. Spider's distribute dividends of their underlying stocks quarterly, and do not reinvest them in the meantime, which costs shareholders in rising markets and profits them when the market tumbles. 
Spiders compete directly with S&P 500 index funds. Investors are stuck in these funds until after each day's market closes. However, transaction costs may be zero. No-load mutual funds often reinvest dividends promptly and without transaction costs. 
(Source: Vanessa O'Connell, "'Spiders' Offer Another Way to Scale S&P 500's Heights", Wall Street Journal, 3/11/95.) 
SPINs 
Standard & Poor's 500 Index Notes (q.v.). 
Split Fee Option 
An option on an option, in which the buyer makes from one to three payments. The buyer may pay a premium up front, may make a second payment (the second premium, hence the name Split Fee, also known as the first strike price) to keep the option alive, and may make a third payment (the second strike price) to exercise the final option. Also known as a Compound Option (q.v.). A special case of an Installment Option (q.v.). 
SPOOs or SPUs 
S&P 500 index futures - from its ticker symbol: SPU. 
spread trade 
Definition: A trade that profits from a positive move in one risk factor and a negative move in another. 
Examples: Long September gold futures and short December gold futures is a calendar spread trade that highlights the difference between gold delivered at the two dates. Other spread trades include: stereo trade (q.v.) , tailed calendar spread (q.v.) , tandem spread (q.v.) , and turtle trade (q.v.). 
Pricing: A calendar spread trade can be the basis for cash-and-carry arbitrage, which establishes a relationship between two forward prices. 
Risk Management: A simple calendar spread trade cannot establish the relationship between two futures prices, despite the popular belief that it can. 
Comment: 
Reference: Geoffrey Poitras, "Turtles, Tails and Stereos: Arbitrage and the Design of Futures Spread Trade Strategies," Journal of Derivatives 5, Winter 1997, pp. 71-87. 
Standard & Poor's Index Notes (SPINs) 
One of Salomon Inc's proprietary, listed (American Stock Exchange) debt securities. SPINs pay no interest and settle in cash. At maturity they pay the maximum of par and an amount equal to K times the current value of the S&P 500 Index level. Throughout most of a SPINs' life the owner can exchange it for cash equal to K times the value of the current S&P 500 Index level. (C.f. PEEQS.) 
State and Local Government Series (SLGS or Slugs) 
Definition: Special U.S. Treasury bonds with low yields and high prices that the Treasury issues for municipalities to use in advanced refundings of their municipal securities. 
Application: The idea is to provide securities that will allow the municipalities to benefit from a drop in market interest rates, without giving them an excuse to engage in "tax arbitrage" by issuing tax-exempt debt, investing the proceeds in taxable debt, and keeping the spread without paying tax on it. 
Source: Charles Gasparino, "Cities Have a Headache Thanks to Wall Street: It's 'Yield Burning'," WSJ, 8/26/97. 
STEERS 
Merrill Lynch's STructured Enhanced Return TrustS, originated in 1990. A kind of SPV (q.v.). (Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html) 
Step-Down Preferred Stock 
Corporate Preferred Stock that a REIT issues, as part of a tax avoidance plan that the IRS declared abusive in 2/97. The parent corporation would set up a REIT that issued preferred shares and lent the proceeds to the parent. The parent then paid tax-deductible interest on the loan to the REIT, which paid tax-deductible preferred dividends (unique to REITs) to its shareholders, who were ordinarily tax exempt. The tax treatment is similar to that of interest on debt that a taxable corporation pays a tax exempt investor. The preferred dividend was typically large, initially and for up to about ten years, then much smaller. Cf. MIPS. 
The arrangement exploded in popularity during February 1997, with Freddie Mac the most prolific issuer. Morgan Stanley and Bear, Stearns were major underwriters of such issues. The IRS responded to this growth by shutting down this type of security, claiming that it abused the federal tax system. 
(Robert D. Hershey, Jr., "Newly Popular Corporate Investment Banned as Tax Dodge," New York Times, pp. D1 et seq.) 
Step-Payment Option 
A "free" ordinary European Option, minus a portfolio of Binary Options with successively higher or lower Strikes. For example, for no premium paid up front, party A receives a European Call Option struck at 100 in return for making one payment if the underlying price goes to 98, another if the price goes to 96, etc. 
Step Up Bond 
Definition: A bond with a coupon that increases over time on schedule - unless the issuers call it. Ordinarily, the coupon begins slightly above the going rate for short-term bonds and the bond is callable at par on each coupon reset date. 
Example: FHLBB issued in December 1997 a bond that matures in 1/03. Its first coupon is 6%, and the coupon increases to 6 3/8 % in 1/99, 6.5% in 1/00, 7% in 1/01, then 8% in 1/02 through maturity. 
Application: At the start of each coupon accrual period, the investor bets that the next oversize coupon compensates for the possibility that the issuer may call the bond. 
Pricing: At the last reset date, the issuer has an option to call the bond. At each previous reset date, the issuer can either call the bond or pay a forward premium (the excess of the next coupon(s) over the going market coupon) for the current installment of a compound option. Thus, the Step Up Bond has a sort of embedded Chooser Option (q.v.). 
Risk Management: The Step Up Bond embodies two kinds of market risk (interest rate risk and exposure to the volatility of the rates), and may embody credit risk. 
Comment: Step Up Bonds are available with different credit qualities. Issuers include federal agencies, blue chip corporations, and lesser corporations. Credit risk can be a significant issue. 
Source: For a thorough, nontechnical description and analysis, see Marilyn Cohen, "Step up to the plate," Forbes, 1/26/98, p. 112. 
Sterling Overnight Average 
An index of overnight GBP interest rates that weights its components by volume. (Source: IFR's online version of "Derivatives: Action in Japan," IFR, 5/3/97, http://www.ifrpub.com/ifrstart.htm) 
stereo trade 
A tailed tandem trade (q.v.), with tails designed to produce calendar spread payoffs that depend on the implied repo rates. 
Sticky Floater 
A One Way Floating Rate Note (q.v.). 
Stock Market CD 
A CD (q.v.) that pays a rate of interest that depends on the rate of return on an underlying equity instrument. 
Stock Upside Note Securtiies 
Lehman Brothers' listed, senior debt securities that offer upside participation in the value of a basket of shares, with limited downside risk. The SUNS is equivalent to a position in the underlying basket, plus a protective put. 
For example, Lehman offered SUNS with an underlying basket of 20 regional bank stocks, and offers SUNS with an underlying basket of 24 international telecommunication stocks. 
Straddle 
An option portfolio consisting of one Call Option and one Put Option, both with the same underlying, direction (long or short), strike, and expiration date. 
Strap 
A Straddle (q.v.) plus another one of the Call Options. 
Strip 
A Straddle (q.v.) plus another one of the Put Options. 
A portfolio of similar options, but with different expiration dates and each with an underlying that depends on the expiration date. E.g., an Interest Rate Cap is a Strip of Call Options on LIBOR for consecutive, nonoverlapping accrual periods. 
A cash flow at a single date, stripped from a note or bond. The Strip could be all or part of either a coupon payment or a principal payment. 
Structured Product 
Essentially a portfolio of securities and other (often, Vanilla) Derivative Products, although the dealer that creates it hopes the customer doesn't realize this. A Financial Engineer assembles a Structured Product from readily available Swaps, Options, etc., much the way a designer might assemble a prototype PC from components imported from all over the world. 
STRYPES (sm) 
Structured Yield Product Exchangeable for Stock (sm) (q.v.). A debt product that 
* Merrill Lynch and DLJ underwrote, 
* is listed on the American Stock Exchange, 
* pays a quarterly interest payment, and 
* converts at maturity into a number of shares (between 0.8403 and one) that a mathematical formula defines. 
For example, let the initial price be X(0)=$14.00 and the "Threshold Appreciation Price" equal $16.66. Then the number of shares upon conversion is
Terminal Price X(T)
# of Shares upon Conversion
X(T)<$14.00 
1.0000 
$14.00<X(T)<$16.66 
14.00/X(T) 
$16.66<X(T) 
0.8403 
(Source: American Stock Exchange Press release.)
Stub Risk 
"[T]he risk that interest rate outlooks based on the performance of the front contract in any given futures strip will prove premature." (Source: IFR's online version of "Derivatives: Action in Japan," IFR, 5/3/97, http://www.ifrpub.com/ifrstart.htm) 
SUNS 
Stock Upside Note Securities (q.v.). 
Swap 
The exchange of a sequence of cash flows that derive from two difference financial instruments. For example, the party receiving fixed in an ordinary Interest Rate Swap receives the excess of the fixed coupon payment over the floating rate payment. Of course, each payment depends on the rate, the relevant day count convention, the length of the accrual period, and the notional amount. 
Synthetic IO-ette 
A REMIC (q.v.) bond with a small principal amount and a huge coupon rate. It absorbs some of the interest payment when market conditions demand that most REMIC bonds have a lower coupon than the collateral. (Its coupon must be less than 1200% for an Agency IO-ette, because of limitations of the Fed's Book Entry sytem). 
(Source: "Derivative Mortgage Securities Glossary," Dean Witter, Mortgage Backed Securities Department, Derivative Products Group, January 1995.) 
Swaplet 
A Swap (q.v.) that has a single payment. 
Swaption 
An option on a Swap (q.v.). 
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tailed calendar spread 
A calendar spread trade (q.v.) involving one long position and one short position of different sizes (in contracts). 
tandem spread 
A spread (q.v.) consisting of calendar spreads in two commodities. 
Tanker Freight Swap 
A Swap (q.v.) with payoffs that depend on an average of tanker shipping rates. Citibank and Mallory Jones introduced the OTC product ca. 1996 November. (Source: Hampton, Michael. "The shipping forecast." FOW (November 1996): 12-13.) 
TED Spread 
Definition: The U.S. T-Bill futures price minus the Eurodollar futures price, the premium that lenders require hold Eurodollar deposits, rather than Treasury bills. 
Example: For example, if the T-bill futures price is 93.60 (corresponding to a T-bill yield of 6.40%) and the Eurodollar futures price is 92.80 (corresponding to a Eurodollar deposit rate of 7.20%), then the TED Spread is 93.60 - 92.80 = 0.80. One would say that the TED Spread is 80. 
Application: If you think the Eurodollar credit quality will improve, hence the TED Spread will narrow, then you would sell the spread, going short T-Bill futures and long ED futures. 
Total Return Swap 
Definition: The synthetic purchase of risky debt with 100% leverage. One of the counterparties receives (and the other pays) the excess of the risky debt's total rate of return (interest plus capital gain) over LIBOR. A swap that has a floating payment that depends on the value of the remaining payments, hence depends on how likely it appears that the payer will make good its promise to pay. 
Examples: 
* A counterparty in a junk bond swap receives the total rate of return on a portfolio of junk bonds and pay LIBOR. 
* A bank loan swap might pay the total rate of return on a risky bank loan and receive LIBOR. In particular, Bankers Trust has offered swaps that pay the return on loans that fund the merger of Ralph's Supermarkets and Yucaipa Companies' Food 4 Less (Derivatives Week, 11/7/94). 
* A counterparty might receive the total return on some risky corporate bond and pay LIBOR minus a fixed spread. 
Application: See Credit Derivatives. 
Pricing and Risk Management: The replicating portfolio for Total Return Swap is the levered purchase or sale. Consequently, its value is the value of the replicating portfolio, and its hedge is the sale of the replicating portfolio. Thus, the dealer providing this swap could hedge his position by buying the risky corporate bond and financing the purchase with a floating-rate loan. 
Comment: Why doesn't the customer just do this, directly? The customer may not be able to deal with counterparties with low credit ratings. The dealer might have a higher credit rating. Of course, this looks like a way around regulations. 
Total Return Option 
Definition: A Put Option (q.v.) on debt with credit risk. 
Example: A customer fearing a default on his debt could pay a premium for a put option that allows him to sell a risky corporate bond at par if the corporation defaults on any of its debt. 
Application: See Credit Derivatives. 
Pricing: A standard model for pricing equity options would be a good starting place for pricing a Total Return Option. 
Risk Management: One might try to hedge this dynamically with the underlying risky debt. 
Comment: Pricing and hedging might be difficult, and market manipulation may be an issue for a thinly traded underlying instrument. 
Tranche 
One of the classes of claims making up a CMO (q.v.). 
TruPS Units 
Trust Preferred Stock Units (q.v.). 
Trust Preferred Stock Units 
Each unit of Salomon's TruPS issue of 7/3/96 consists of a 9.25%, mandatorily redeemable preferred security of the SI Financing Trust I ("the Trust") and a contract requiring the holder to purchase in 2021 (or earlier, at Salomon's option) 1/20 of a share of Salomon's 9.5% Series F Preferred Stock.

Salomon set up the Trust to issues the TruPS and common shares and invest the proceeds in Salomon's 9.25% secured debt. Also, Salomon contributes 0.25% each year under the terms of the purchase contract. This structure allows Salomon to deduct interest coupon payments to the trust, which pays preferred dividends to investors who would prefer dividends to coupons. 
turtle trade 
A tailed spread (q.v.) in a commodity, plus a position in interest rate futures. 
ÖDerivatives DictionaryTM (U-Z,#)
A B C D E F G H I J K L M N O P Q R S T U V W X Y Z # 

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U.K. Mips 
Goldman, Sachs's variation on its Mips (q.v.) structure, tailored to maximize its advantages for the UK market in ways that the U.S. government wouldn't allow. Grand Metropolitan Delaware (limited partnership) issued 20 million "preferred securities" paying quarterly dividends at $25, lending the proceeds to Grand Metropolitan plc via a perpetual, subordinated loan with the seniority of preferred stock. (Source: Pratt, Tom. "Goldman modifies 'Mips' to land Grant Met deal." IDD, Nov. 7, 1994, p. 11.) 
Up-and-in Option 
An option that pays off nothing, unless the underlying price rises to an upper barrier. Cf. Up-and-out Option. 
Up-and-out Option 
An option that pays off as the corresponding ordinary option, unless the underlying price rises to an upper barrier. Cf. Up-and-in Option. 
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value date 
The date on which a bond buyer begins accruing interest on the bond. This may be the same as the settlement date (q.v.). (J.P. Morgan Glossary of terms for global sovereign bond markets. 
Variable Common Right 
Viacom issued VCRs in connection with its takeover of Blockbuster. (Source: Falloon, William. "The $48 and $52 Questons." Risk 8 (April 1995), pp. 48 ff.) 
Such a VCR is basically equivalent to a bearish Put Spread (long a Put struck at 52, short a Put struck at 48). The underlying price is the highest of four 30-day Arithmetic Averages for the price of Viacom Class B shares. The four 30-day averaging periods are distinct periods during the pricing period, May 23 - Sep. 28, 1995. To make manipulation more difficult, Viacom agreed not to buy its Class B shares during the pricing period. (Source: Bary, Andrew. "Drama at Viacom." Barron's, August 21, 1995, p. MW10.) 
VDAXâ 
The DAXâ (q.v.) volatility index, which measures the Black-Scholes implied volatility of a basket of DAXâ options. The Deutsche Börse has published it since 7/97. (Source: http://www.exchange.de/fwb/indices.html#volind). 
VIX 
The ticker symbol for the Chicago Board Options Exchange Volatility Index. 
Vol-Vol 
The volatility of volatility. This presupposes that volatility is a random market risk factor, which is a lot more reasonable than the original assumption of the incredibly robust Black-Scholes model, that it is known and constant. 
Volatility 
The annualized standard deviation of the percentage change in a risk factor. 
VOLAXâ Future 
A futures contract based on the VDAXâ (q.v.) volatility index for the DAXâ stock index. 
vulnerable option 
1. "[An option] on a defaultable instrument, subject also to their issuer's default risk. Ex: A put issued by a shaky bank on a corporate bond issued by a third party." 
(Giovanni Barone-Adesi, private email correspondence, 9/10/98.) 
2. An option "subject to the additional risk that the writer of the [option] might default." 
(Robert J. Jarrow and Stuart Turnbull, Derivative Securities, Cincinnatti, South-Western, 1996, p. 575.) 
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Warrant 
An option that a corporation issues, with its own shares as the underlying asset. The crucial implication is that exercise of the option changes the number of claims against the corporation's assets. Thus, the pricing equations for Call (Put) Warrants and ordinary Call (Put) Options differ by the dilution (antidilution) effect. Empirically, warrants are options with a long time to expiration, which may be several or many years, or even decades or an infinite time. An option on asset A that party B issues and lists on an exchange. Party B might a corporation, a government, etc. Endowment Warrants (q.v.). Installment Warrants (q.v.). 
WEBS 
World Equity Benchmark Shares (q.v.). 
When Issued Market 
The market for forthcoming On-the-Run (q.v.) securities. 
widget 
A brand of listed security representing a claim against a share or basket of shares. A widget with an underlying index or basket is comparable to SPDRS (q.v.) or WEBS (q.v.) listed on the American Stock Exchange, but can have a different underlying portfolio. A widget with an underlying share is comparable to an ADR (q.v.). W.I. Carr Indosuez of Hong Kong created and listed widgets on the Luxembourg Stock Exchange. (Rachel Horsewood, "What's in a Name - Introducing the Widget," AsiaRisk, August 1997.) The main advantage is reducing the transaction cost for investing in a basket of shares. 
World Equity Benchmark Shares 
Each WEBS share is a claim on a portfolio of publicly traded shares in a particular country. That portfolio corresponds more or less to the MSCI portfolio for that country. All WEBS shares are listed on the American Stock Exchange and trade in dollars. Roughly speaking, each WEBS is to an MSCI Indexes of foreign stocks what Spiders (q.v.) are to the S&P 500 Index of U.S. stocks. 
Foreign Fund, Inc. issues all WEBS shares. Any investor can create (redeem) a "Creation Unit" - i.e., a fixed number - of WEBS shares by depositing the appropriate underlying shares, plus cash expenses (WEBS shares) with an "Authorized Participant" in exchange for WEBS shares (underlying shares, less cash expenses). That makes a WEBS share like a share in an open end investment company (mutual fund). 
WEBS are listed and trade exactly like shares in a closed end fund and other ordinary shares. A trader can sell them whenever the American Exchange is open, and can sell them short. However, it is possible to create or redeem shares continuously, as with mutual fund shares. 
Any of the underlying shares may pay a dividend. The country that is the source of dividends for the underlying shares of WEBS may withhhold dividend income. Foreign Fund, Inc. retains dividend income temporarily, deducts expenses, and distributes the remainder at least each year. 
The I.R.S. treats dividends and capital gains in a manner similar to the way it treats them for a mutual fund holding foreign shares. 
(Funds Distributor, Inc. World Equity Benchmark Shares; Questions and Answsers. 1996.) 
WEBS and a competitive family of international mutual funds, CountryBaskets hit the market in the first half of March, 1996. (Peter C. Du Boi, "Deutsche Bank, Morgan Stanley Offer Ways to Play Foreign Indexes on U.S. Exchanges," Barron's, 3/11/96.) Apparently, WEBS won the battle in the marketplace, and Deutsche Morgan Grenfell plans to dissolve the CountryBasket funds in March, 1997. (Maureen Nevin Duffy, "Deutsche MG Dumps Baskets," Financial Trader, 3/97.) 
Worst-of-Two Option 
A payoff which equals the minimum of two option payoffs, such as the minimum of a call on asset 1 and a put on asset two. Cf. Best-of-Two Option. 
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Xerxes 
* The sensitivity of Convexity (q.v.) to a change in yield. 
* The "Convexity" of Modified Duration (q.v.). 
* The third derivative of a financial instrument's value with respect to its yield. 
(Source: "Derivative Mortgage Securities Glossary," Dean Witter, Mortgage Backed Securities Department, Derivative Products Group, January 1995.) 
Hedging so that Xerxes equals zero is one step beyond Convexity hedging, which is itself one step beyond matching durations of one's investment and (short) hedge portfolio. In theory, such a hedge would require relatively little rebalancing. 
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NEW! Yankee market 
The U.S. foreign market (q.v.). The market in the U.S. for securities that non U.S . companies and governments issue. Example: Some shares of Nomura Securities trade in New York in the U.S. foreign market. 
YEELDS 
Yield Enhanced Equity Linked Debt Securities (sm). Lehman Brothers' proprietary synthetic Equity Linked Debt Security (q.v.). Lehman issues the security, which pays a high coupon until maturity, then pays the value of the underlying common stock (not Lehman's) - up to a cap, such as 150% of the issue price. (Pratt, Tom. "Lehman's new 'Yeelds' trade on the Amex - or do they?" IDD, Aug. 22, 1994, p. 10.) 
Yield Burning 
Definition: The IRS's name for the dealer's crime of overcharging state and local governments and authorities for Treasury securities that they use in "advanced refunding", where they replace old, high-yielding municipal bond issues with new, low-yielding ones. 
Application: After interest rates decline, the tax-exempt entities issue new bonds with low coupons and use the proceeds to buy just enough Treasury bonds to cover the higher coupons on the old bonds. 
Comment: While charging what the market will bear may come naturally to a competent dealer, it is against the law in many cases. Woe be to the dealer who charges an excessive markup in the OTC stock market or to municipal refunders in the market for Treasury securities. 
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Z-Bond 
A CMO (q.v.) tranche (q.v.) that resembles a Zero Coupon Bond (q.v.) and ordinarily has neither the first, nor the last claim on the CMO's underlying cash flows and asset value. Hence, the Z-Bond has significant Credit Risk (q.v.) and Market Risk (q.v.). 
ZEPO 
A Zero Exercise Price Option (q.v.). 
Zero Cost Collar 
Aka "Costless Collar". A howlingly funny misnomer. "Hidden-cost Collar" would be more accurate. Think about it. A dealer won't do a transaction for you if it doesn't cost you something, because his revenue is your transaction cost. The purchase of a put option financed by the sale of a call. 
Zero Coupon Bond 
A bond that pays no coupon, just par at maturity. 
Zero Exercise Price Option 
A European Call Option with strike price of zero. The owner will certainly exercise it, so it is equivalent to owning the underlying asset without receiving the cash flow (dividends or interest) through expiration. (Source: Australian Financial Review Dictionary of Investment Terms.) 
Zero Gain Collar 
A Costless Collar (q.v.) consisting of a short Call (q.v.) and long Put (q.v.), where the short Call's strike is ATM (q.v.). Hence, when owned in combination with a long position in the underlying, the Zero Gain Collar gives up all the underlying's upside gain, and the combined position can never show a profit.