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| Useful Financial Dictionaries and Glossaries Web TermsFinancial TermsThe following 3 sections represent a glossary of many of the most used terms in the world of derivatives and hybrid financial contracting. The glossary assumes that the user has a basic level of understanding about options, futures, and forward contracts and mortgage-backed securities. Mortgage Derivatives and Hybrid TermsAdditional Derivative and Hybrid Terms |
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Arbitrage (pure): A transaction in which an investor holds a basket of financial contracts which cost nothing to hold, involve no risk and result in a profit. A realistic arbitrage transaction is based on the observation that an asset, or derivative of an asset, trades at two different prices. The transaction involves selling the high priced asset and buying the low priced asset.
Arbitrageur: An individual who engages in arbitrage transactions.
Beta: A measure of the responsiveness of the return (or price) of a security to changes in a broader market index.
Binomial model: An option pricing model which is based on the assumption that at any point in time the price of the underlying asset can change to one of only two possible values.
Black model: A pricing model for an option on a forward or futures contract.
Black-Scholes option pricing model: A mathematical model developed in a semianl paper by Myron Scholes and Fisher Black in 1973. The model explains the prices on European options. Many variations of the model have been developed over the years. The model requires adhering to several strong assumptions:
Call risk: The possibility that mortgage prepayments will increase above an anticipated rate, causing earlier-than-expected return of principal, usually during an time of falling open-market interest rates.
Charm: A measure of the change in delta as time passes while other variables in the option valuation model remain constant.
Circuit breaker: A provision in the operation of an organized exchange designed to limit the length of the trading period, limit the maximum price change during a given period, or correct an order imbalance.
On the New York Stock Exchange there are three circuit breakers in effect:
50-Point Collar: Slows down computer-aided trading - by forcing trades to go against the tide of price changes - whenever the Dow Jones Industrial Average rises or falls by 50 points.
100-Point Sidecar: Program trades are denied whenever the Standard and Poor's 500-stock index declines by 12 points, or about 100 Dow points.
Trading Halts: Exchange is shut down for one hour whenever the Dow falls 350 points. For a 550 point drop, the exchange closes for two hours.
Clearing house: An affiliate of a futures or options exchange which matches and guarantees trades and holds performance bonds posted by dealers. Acts as a counter-party to every trade.
Close (price,, range): The officially-designated period at the end of the trading session during which all transactions are considered to be made. The closing price is the price of the transaction at the close and the price range is the high and low prices at which transaction occurred a the close.
Contract month: The month in which futures contracts may be implemented by making or accepting delivery.
Convergence: The move to equality of spot and futures prices as the delivery date approaches.
Convexity: Convexity relates to the dollar change in the value of a bond for a given change in the market (discount) rate. The duration calculation incorrectly treats this relationship as the tangent, or as a linear relationship, when in fact it is convex. Convexity is calculated by taking the second derivative of the functional relationship between the value of a bond in relation to market interest rates.
Counterparty risk: The exposure of one party to the risk that a trade might default or fail due to the actions of the other party to the transaction.
Cox-Ingersoll-Ross option pricing model: A model for pricing interest rate options.
Daily price limits: The maximum and minimum prices at which a futures contract can trade. These limits are established by the clearinghouse and are expressed in relation to the previous day’s settlement price.
Daily settlement: The process in a futures market in which the daily price changes are paid by the parties incurring losses to the parties making profits. The profits and losses are generally settled with a clearing corporation.
Day order: An order to purchase or sell a financial claim that is canceled if unfilled by the end of the day.
Day trader: A trader in financial claims who closes out all positions by the end of the trading session.
Deferred futures: The more distant delivery months in which futures trading takes place.
Deferred pay out option: An American option where settlement is at expiration.
Deferred start option: An option purchased before it life begins.
Deferred strike option: An option in which the exercise price is established at a future date based on a prescribed formula.
Delivery: The process in which a futures contract can be terminated at the expiration of the contract through the sales of the asset by the short to the long.
Delivery day: The day on which an asset is delivered to terminate a futures contract.
Delivery month: A calendar month during which delivery can be made in a futures contract.
Delivery notice: The written notice given by a seller indicating his intention to make delivery against an open contract.
Delivery price: The price fixed by the clearinghouse at which deliveries on futures contracts are invoiced.
Delta: The mathematical relationship between the change in value of a call option on a bond and the change in market price of the underlying bond. Delta increases as the value of the market price of the bond rises relative to the strike price of the option. An out-of-the-money option has a delta near zero, while a significantly in-the-money option has a delta near one.
Delta hedge: An options hedge in which the number of contracts is based on the reciprocal of the option delta.
Delta neutral: A option position in which the delta is zero.
Derivatives: Financial instruments or arrangements that derive their value from some underlying stock, bond, commodity or other asset. Futures, swaps, some forwards, options, warrants, and certain mortgage-backed securities are the most common derivatives.
Duration: The weighted average period over which an investment pays its cash flows.
DUR = [å nt=1 Ct x t ¸ (1+r)t] / [å nt=1 Ct ¸ (1+r)t]
where:
Dynamic hedge: A hedging strategy in which an asset is hedged by selling futures in such as manner that the position is adjusted frequently to take into consideration changes in basis between the prices of futures contract and asset being hedged.
Early exercise: Exercise of an option before its expiration date.
Exercise: The process by which a call option is used to buy or a put option used to sell the underlying according to the contractual terms of the contract.
Exercise limit: The maximum number of option contracts that one investor can exercise over a specific period.
Exercise notice: A notice in writing delivered to a clearinghouse on or by a specific time giving notice of intent to make or take delivery of the underlying.
Exercise price: The price that the underlying may be bought or sold as called for under a call or put contract.
Expiration: A date after which an option or futures contract no longer is in effect.
Extension risk: The possibility that prepayments will be slower than an anticipated rate causing later-than-expected return of principal. This usually occurs during times of rising interest rates.
Fair value: The value of an option derived from an option pricing model.
Financial futures: A futures contact on a financial claim such as a bond, currency or deposit.
Foreign currency futures: A futures contact on a currency.
Forward contract: A contractual agreement between two parties to exchange a commodity or asset at a set price on a future date.
Foreign discount or premium: The relationship between the spot and forward exchange rates of a foreign currency in which the forward exchange rate of a currency is less, in the case of a discount, or more, in the case of a premium, than the spot rate.
Forward (implied) rate: The rate agreed upon in a forward contract for a loan or implied by the relationship between short and long-term rates.
Gamma: The rate at which the delta of an option moves up or down in response to changes in the price of the underlying. Gamma is positive for calls and negative for puts.
Garman-Kohlhagen model: A model for pricing European foreign currency options.
Generic swap: An interest rate swap involving the exchange of fixed interest payments for floating interest payments.
GLOBEX: A international automated market for trading futures contracts operated by the Chicago Mercantile Exchange.
Good-till-canceled order: An order that is in effect until canceled as is used most often with stop orders and limit orders that may take time to execute.
Haircut: The discount applied by the clearing house to assets such as government bonds used a margin or loan collateral.
Hedge: A transaction in which a participant seeks to offset a prospective price change on an asset owned or owed using an offsetting futures or forward contract.
Hedge ratio: The ratio of options or futures contracts needed to achieve a desired relationship between the price change of an assets owned or owed in the spot or cash market with hedging contracts in the futures or forward market.
Hedged portfolio: A portfolio being hedged.
Hedger: The person who hedges.
Historical volatility: The standard deviation of the underlying’s volatility measure for an option pricing model calculated using historical data.
Implied delta: Delta of an option calculated using an option pricing model using the option’s implied volatility as the model’s input.
Implied volatility: The underlying price volatility at which the option’s fair value equals its market value.
Immunization: A bond portfolio strategy in which the return is protected against changes in interest rates. Typically the duration of the portfolio is used to determine the sensitivity of the bonds to changes in interest rates.
Implied volatility: A derived value based on one of the many option valuation models. Knowing the option's market and exercise prices, risk-free interest rate, term to maturity, and type of option, the valuation model is solved for å, the standard deviation, of the expected rate of return on the underlying instrument on which the option is written.
Initial margin: The minimum amount of money that must be in an investment account on the day the transaction takes place. On futures contracts, the initial margin must be met on any day in which the opening balance starts off below the maintenance margin requirement.
Intrinsic value: The profit, if any, from the assumed exercise of an option at its current price.
Inverse floater: A security whose rate is set by a market index which pays an initial rate of interest which decreases by the spread between the initial rate and the floating index. If the market index rises, the rate on the inverse floater will decline.
Kitchen-sink bond: Bonds are created by bundling up various tranches (generally difficult-to-sell tranches) of CMO and REMIC transactions. They are composed of different underlying pools with a variety of expected cash flows. The possible patterns of price behavior is virtually impossible to model with a high level of confidence.
Limit down: An situation in which the futures price moves down to the lower daily price limit.
Limit move: A situation in which a futures price hits the upper or lower daily price limit.
Limit order: An order to purchase or sell a security, option, or futures contract that specifies the maximum price to pay or the minimum price to receive.
Limit up: A situation in which the futures price moves up to the upper daily limit.
Long: A position in the cash or futures market in which the investor owns or has contracted to own the underlying.
Long hedge: A hedge involving a short position in the spot market and a long position in the futures market.
Macro hedging: The process of hedging a portfolio of assets and/or liabilities as a group with offsetting futures or options. There is no attempt to tie each hedge vehicle to each asset being hedged.
Maintenance margin: The minimum amount of money that must be kept in a margin account on any day other than the day of the transaction.
Margin: Funds kept on account with a clearinghouse or in trust for the purpose of covering losses on positions in the cash or futures market.
Margin call: A request from a broker or clearinghouse for additional funds to cover losses on an outstanding futures position.
Mark-to-the-market: To debit or credit on a periodic basis the market value of the firm's position in a portfolio of financial assets.
Market-on-close-order: An order to purchase or sell securities, options, or futures that requests the broker to execute the transaction at a price as close as possible to the closing price.
Micro hedging: A strategy in which a hedger using a futures or forward contract to offset price changes of a specified number and type of cash market positions.
Naked call: A option written by an investor who does not own the underlying.
Notional: A amount used to compute interest for such financial claims as interest-only mortgage securities and swaps.
OAS (option-adjusted spread): The amount of the spread over a similar risk bond with a duration equal to the CMO tranche. An investor's required yield on a CMO tranche with cash flow uncertainty should be above the yield on a bond with similar duration but with no cash flow uncertainty. The equation expressing this yield for an annual interest paying bond with a three-year maturity is shown below.
P = [ E( CF1)/(1+ d1 + Os)] + [ E(CF2)/(1+ d2 + Os)] + [ E( CF3)/(1+ d3 + Os)]
Offsetting order: A futures or option transaction that is the exact opposite of a previously established long or short position.
Open interest: The number of futures or options contracts that have been established that have not yet been offset or exercised.
Open outcry: The execution process used in organized exchanges in which bids and offers are indicated by humans communicating by voice.
Option: A financial contract giving the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in a case of a put option) a fixed amount of a given asset at a specific price within or by a specified period of time.
Option premium: The price of an option.
OTC derivatives: Derivatives that are transacted "over-the-counter" through dealers and not through organized exchanges.
Performance bond: A good-faith deposit (type of margin) to ensure performance of financial obligations in futures contracts and short options contracts on regulated commodity exchanges. Established and monitored in organized exchanges by a clearinghouse.
Physical delivery: Settlement of a contract by the delivery or receipt of the underlying.
Pit: A multi-tiered area on the trading floor of some organized exchanges to facilitate communication of traders in futures and options markets.
Plain vanilla swap: An interest rate swap in which one party exchanges fixed payments on a specified amount of notional principal with another party who receives floating interest payments.
Portfolio insurance: A strategy employing combinations of securities, options, and/or futures contracts that is designed to provide a minimum or floor value of the portfolio at some future date.
Position: The holding of a long or short contact (open contract) in a market.
Position day: The first day of a three-day sequence leading to delivery in which the holder of a short position notifies the clearinghouse of the intention to make delivery two business days later.
Position limit: The maximum number of options or futures contracts that any one investor can hold.
Position trader: A futures trader who normally holds open positions for periods longer than one day.
Price sensitivity hedge ratio: The number of futures contracts used in a hedge that leaves the value of a portfolio unaffected by a change in some variable such as interest rates.
Put: An option to sell an asset, usually at a specified price on or before a specified date.
Put-call parity: The relationship between the price of a put and call on the same security with the same strike price can be calculated if the theoretical value of the put or call is known.
Retail Automatic Execution System (RAES): A computerized system used by the Chicago Board Options Exchange to expedite the filing of public orders.
Rho: The rate at which the price of an option changes in response to a given move in interest rates.
Series: All options of a given class with the same exercise price and expiration date.
Settlement price: The official price established by the clearinghouse at the end of each day for use in the daily settlement.
Short: A term used to refer to holding a short position or to the party holding the short position. A short position involves a firm who has sold a futures contract or owes the asset to someone for future delivery.
Short hedge: A hedge transaction involving a long position in the spot market and a short position in the futures market.
Short sale: A transaction in which securities are borrowed form a broker and sold and later repurchased to be paid back.
Speculator: A person who buys or sells contracts in hope of profiting from a subsequent price changes.
Spot market: The market for assets that involves immediate sale and settlement. The settlement for spot market purchases of stock on the New York Stock Exchange is two days.
Spot price: The price of an asset on the spot market.
Spot rate: An interest rate on a loan or bond created in the spot market.
Spread: An option or futures transaction consisting of a long position in one contract and a short position in another similar contract.
Spread delta: A measure of the sensitivity of a spread to a change in the price of the underlying.
Stock index future: A future on an stock index. The futures trade at a fixed price per point of the index.
Straddle: An option transaction that involves a long position in a put and a call and with the same exercise price and expiration.
Strangle: A long put at one exercise price and a long call at a higher exercise price.
Strap: An option transaction involving a long position in two calls and one put, or two calls for every put, with the same exercise price and expiration.
Strike price: Exercise price.
Stress testing: Using a variety of scenarios and assumptions, the value of a given position in derivatives and hybrids is put through a sensitivity test (a stress test) to determine the loss exposure of the firm to changes in market conditions.
Strip: An option transaction that involves a long position in two puts and one call, or two puts for every call, with the same exercise price and expiration.
Structured notes: Debt instruments whose payments and effective yields are linked to the price performance of some other financial asset, such as the issuing company's stock price, an index, or an interest rate benchmark.
Swaps: A forward contractual agreement to exchange one type of cash flow or asset for another, according to predetermined rules.
Synthetics: A customized hybrid instrument created by blending an underlying bond or note with a futures contact or option. Synthetics are typically used to change the effective yield or maturity of bonds or notes.
Synthetic call: A combination of a long put and long assets, futures, or currency that replicates the price behavior of a call.
Synthetic futures: A combination of a long call and a short put that replicates the price behavior of a long futures contract.
Synthetic put: An combination of a long call and short asset, currency, or futures that replicates the price behavior of a put.
TED spread: The spread between U.S. Treasury and eurodollar futures.
Texas "hedge": A transaction (not a hedge) involving owning the underlying and buying a long call or having a short position in the underlying and owning a long put.
Theta: The rate at which the price of an option changes because of the passage of time. This is also known as time decay.
Tick: The minimum permissible price fluctuation established by an organized market.
Time decay: The rate at which the price of an option changes because of the passage of time. This is also known as theta.
Traded options: Option contracts traded on the floor of an organized exchange.
Uncovered call: An option strategy in which the writer of the option does not own the underlying.
Underlying: The asset on which a futures or option is written.
Vega (sometimes termed Lambda): The rate at which the price of an option changes because of a change in the volatility of the underlying.
Warrant: A security convertible into a specified number of shares of stock, a call option.
Wild card option: The right to deliver on the Chicago Board of Trade’s Treasury bond futures contact after the close of trading.
Writer: The person or institution that sells an option.
Yield curve arbitrage: The buying or selling of Treasury securities of one maturity while taking the opposite position on futures or options with either longer or shorter maturities, in the expectation that the yield curve will either deepen or flatten over the life of the position.
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Mortgage Derivatives and Hybrid Terms
Adjustable-Rate mortgage: A mortgage loan with an interest rate and payments that change periodically over the life of the loan.
Adjustable-Rate class: A REMIC class with an interest rate that changes periodically over the life of the class.
Average weighted life (Maturity): = å t=1 T t times (Principal received at time t)/Total principal received. T = period of last cashflow.
Collateralized mortgage obligations (CMOs): Mortgage pass-through securities or a pool of mortgages whose principal and interest cashflows have been directed into new classes or tranches of securities. REMIC is a CMO structure that can be created off-balance sheet.
Constant Maturity Treasury (CMT): An index published by the Federal Reserve Board calculated from the average yield of a range of Treasury securities adjusted to constant maturities of various time periods (e.g., 6 months,, 1 year, ten years, etc.). CMO fixed-rate class: A CMO (REMIC) class with an interest rate that does not change over the life of the class.
CMO floaters: A CMO (based on the following: Pac, Tac, scheduled, sequential and support) whose rate floats at a fixed spread over the index.
CMO index allocation class (XAC): A CMO class whose principal payment allocation is based on the value of an index.
CMO planned amortization class (PAC) or planned principal class: Pays principal on certain tranches on a specific payment schedule. A payment schedule might be based on a slow pay assumption such as 80% PSA. Faster payment would result in companion classes being paid off faster. A CMO might have three or four PAC classes.
CMO residual: The excess of the cash flow generated by the underlying collateral over the amount needed to pay interest, retire the bond tranches, and pay administrative expenses. Cash flows on CMO residuals are not known and depend on host of factors including future interest rates, prepayment rates, and CMO structure. Investors in residuals typically demand high expected yields to compensate for the high risk they accept.
CMO sequential class (SEQ): A CMO tranche that pays principal in a prescribed sequence, that do not have predetermined schedules and that under all circumstances receive payments of principal continuously from the first distribution date until they are retired.
CMO support class (SUP): A CMO class that receives principal payments on any distribution date only if the scheduled payments have been made on the related PAC, TAC or/or scheduled class.
CMO targeted amortization class (TAC): TAC classes are not permitted to be paid off more quickly if higher than expected prepayments occur. TACs only protect against faster than expected prepayments. If cash prepayments are slower than expected the TAC will amortize slower than expected.
Cost of funds index (COFI): An interest rate index based on the weighted-average interest paid by members of the 11th Federal Home Loan Bank District or some other Federal Home Loan Bank or group of banks.
CPR constant prepayment rate: An assumed rate of prepayment of principal on a mortgage pool. CPR increases as coupon rate increases and as market mortgage rates decline.
Current face class: The current amount of principal outstanding on a security, which is calculated by multiplying the original face value by the most recent factor.
CUSIP Number: A unique, nine-digit number assigned to each publicly traded security maintained and transferred 0n the Federal Reserve’s book-entry system.
Effective prepayment range: The range of upper and lower constant prepayment speeds at which a PAC schedule will hold. The effective range can change over time depending on the prepayment experience of the securities backing the REMIC and can widen or narrow in relation to the original stated PAC band.
Factor: The decimal value, calculated monthly, that represents the proportion of the original principal amount outstanding at a given time.
Interest-only security (IO): A security paying out only the interest received on a mortgage pass-through or mortgage pool.
Interest strip: Interest payments made on a mortgage pass-though security or pool of mortgages that are subject to prepayment. An interest rate strip is also the servicing spread earned by the servicer of a pool of mortgages sold to third-party investors.
Mortgage-Backed Security (MBS): An investment instrument that represents ownership of an undivided interest in a group of mortgages. Principal and interest from the individual mortgages are used to pay principal and interest on the MBS.
No payment residual: A residual class of a CMO that pays no principal.
Non-sticky jump class: A CMO class whose principal payment priorities change temporarily upon the occurrence of one or more "trigger events." A non-sticky jump class "jumps" to its new priority on each distribution data when the trigger condition is met and reverts to its original priority on each distribution date when the trigger condition is not met.
PAC band or range: A range of constant prepayment speeds defined by a minimum and maximum under which the PACs scheduled repayment will remain unchanged. There can be multiple levels of PACs in a REMIC, each having successively narrower PAC bands. The widest band PACs are PAC Is; the next are PAC IIs.
PAC schedule: The planned monthly principal balances of a PAC class in which the underlying securities prepay at a constant prepayment rate within the stated PAC band.
PAC window: The time period during which a PAC class is scheduled to receive principal payments.
PAC floater: A CMO PAC that has been broken into a floating-rate security whose rate floats at a fixed spread over an index rate plus some premium over the index. The CMO floater has a ceiling over which the PAC floater will not pay additional interest. Common floaters are the 1-month LIBOR rate (London Interbank Offered Rate) and 11th District COF (weighted cost of funds of saving and loans and banks in San Francisco FHLB).
Prepayment assumptions:
Principal-only security (PO): A security paying out only the principal payments received on a mortgage pass-through or mortgage pool.
Private label MBS: A mortgage-backed security issued by other than the government instrumentality's Fannie Mae and Freddie Mac, usually by a mortgage banker, commercial bank, thrift institution, or finance company.
PSA prepayment rates: A rate of prepayments for pool of mortgages developed by the Public Securities Association.
Public Securities Association (PSA): The national trade association of banks, dealers and brokers that underwrite, trade and distribute mortgage-backed securities, U.S. government and federal agency securities, and municipal securities.
Real Estate Mortgage Investment Conduit (REMIC): A multiple-class mortgage cash flow security. Similar to CMO except it is issued by a trust.
Secondary mortgage market: The market in which existing mortgage and mortgage securities are bought and sold.
Stripped mortgage-backed security (SMBS): A mortgage security that separates principal and interest payments from the underlying mortgage-backed securities.
Sticky jump: A CMO class whose principal payment priorities change permanently upon the occurrence of one or more "trigger events." A sticky jump class "jumps" to it new priority on the first distribution date when the trigger condition is met and retains that priority until retired.
Super floater: A floating-rate class that pays a rate of interest that resets periodically as a multiple of the benchmark index.
Tranche (class): A portion of investment interest in a CMO (REMIC). French word for “slice.”
Value of CMO floater: Value of floater cashflows assuming no ceiling + IO component (interest amount cashflow spread over the index) - the cost of a CAP to offset the ceiling cap of the floater.
Weighted average calculated loan age (CAGE): The weighted average calculated loan age of the mortgage loans collateralizing a mortgage security. The CAGE is calculated by subtracting the original WAM for the pool from the original term to maturity (in months) of the mortgage loans and adding, thereto, the number of months elapsed since the issue date on the security.
Weighted average coupon (WAC): The weighted average coupon on the mortgage loans collateralizing a mortgage pool.
Weighted average maturity (WAM): The weighted average remaining term to maturity (expressed in months) of the mortgage loans collateralizing a mortgage pool.
Adjusted WAM: The WAM of the mortgage loans in a pool at the date of the issuance of a mortgage security, less the number of months elasped from the issue date.
Z class: A CMO or REMIC class that pays no cash flow to the investor until certain other classes are paid off or some other specified event occurs. The interest earned, but not paid, increases the principal balance of the class. Once the previous classes have paid off, or the specified event occurs, the Z class becomes an interest-paying amortizing class.
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