Treasury
Termen en
Begrippen Geld- en Kapitaalmarkt
Accrued Interest
The amount which the buyer of a fixed-income security must pay the seller of
the security to compensate the seller for holding the security between the last
coupon payment date and settlement date.
How this accrued interest is calculated varies from security to security.
Depending on the type of bond, the accrued interest calculation uses one of
several day count conventions for calculating the difference between two dates.
The most common day count conventions are Actual/Actual ISMA or 30/360.
Amortisation
The reduction of principal or debt at regular intervals. This can be achieved
via purchase or sinking fund.
Ask
A market maker's price to sell a security, currency or any financial
instrument. Also known as offer, a two way price comprises the bid and ask. The
difference between the two quotations is spread. >>see also Bid.
At Par
When a security is selling at a price that is equal to its face value.
Average Life
The weighted average time to receipt of principal payments (including
scheduled paydowns and repayments).
Back Office
The department in a financial institution that processes deals and
handles delivery, settlement and regulatory procedures.
Basis Point
One hundredth of one per cent (of yield) or 0.01.
BBA
British
Bankers Association -
The leading trade association that represents the views of those involved in
the banking and financial services industry within the
Bear
(bearish)
Someone who expects the price of a given financial instrument or the overall
value of a given financial marketplace to decline in value and thereby is a
seller of the instrument(s). This individual is said to be bearish on the
instrument / marketplace. Opposite of bull (bullish).
Benchmark
A bond whose terms set a standard for the market. The benchmarks usually have
the greatest liquidity, the highest turnover and is usually the most frequently
quoted.
Bid
A market maker's price to buy a security or instrument.
Bid offer spread
1.) There is a buying price (“offer” or “ask” price) and a selling price
(“bid” price). The difference is known as the “bid-offer spread” or “the
spread”.
2.) The
difference between the buy (bid) and sell (ask) price. In the following currency
example - 0.8423/28 the spread is 0.0005 or 5 PIP’s.
BIS
Bank for International Settlements. An association of central banks from the
G10 countries. The BIS is concerned with safeguarding the stability of international
financial markets and ensuring that all banks have sufficient capital to
support their operational risk. www.bis.org
Bonds
Bonds are long term debt instruments traded in a market. A legal contract in
which an issuer promises to pay holders a specific rate of interest and redeem
the contract at face value. Usually bonds are considered to be those debt
securities with terms to maturity of more than one year. >>see also
Bullet Bonds and Fixed Income.
Bonds are boring, which is basically a virtue
You loan
money to a corporation or government agency and the borrower agrees to pay it
back at a fixed rate of interest (sometimes known as the coupon) over a fixed
period of time (the term or maturity).
Typically, the longer the maturity
of a bond, the higher the coupon. For example, the spread between five-year
Treasury notes and 30-year bonds is often a full percentage point or two.
Why? Because the longer the term
of the bond, the greater the chance that inflation can erode the value of the
investment. Also, a bond's interest is fixed, so if rates rise in general the
long-term bond holder can't take advantage of that move. The greater the risk,
the greater the reward.
Treasuries Similarly, the interest
rate a bond pays is directly related to the riskiness of the bond. Treasury
bonds, for example, are as close to a sure thing as you can get in the world of
bonds, since Uncle Sam can always print more money to pay them off. (Even the
feds aren't immune to the laws of economics, though. If the government ever did
print lots of extra cash to pay off its bonds, that would cause inflation to
soar and make the bonds worth less.)
Junk At the other end of the
spectrum, however, are low-grade corporate bonds, known as high-yield or junk
bonds, which have coupons that are several percentage points higher because of
the risk that the corporations that issue them might stumble.
How Bonds work
Although bond
prices tend to fluctuate less than stock prices, they aren't risk-free. If interest
rates rise, bond prices will fall. Why? As new bonds paying higher rates become
available on the market, the price of older bonds falls proportionately so that
the interest they pay is the same as that of a comparable new bond.
That's worth remembering in the
current environment, in which interest rates in the
Here's a simplified example of how
it works: Let's say that you paid $1,000 for a 30-year bond that yielded 7
percent interest, or $70 a year. A year later, the rate for a comparable new
bond falls to 5 percent, which means it yields just $50 a year.
Your old bond is now going to be
worth more, because investors are willing to pay more to get a $70-a-year
income stream than they will to get $50 a year.
Since the interest rate of your
bond is now 40 percent higher than the bonds put on the market when interest
rates fell, its new price will be about $1,400, or 40 percent more than you
paid for it.
And its yield? Exactly 5 percent,
since $70 a year is 5 percent of the new price of your bond, $1,400.
(Note: the equation is not quite
so simple, since your bond now has only 29 years left until maturity and will
be matched to other 29-year bonds, not new 30-year issues.)
Conversely, if rates jump from 7
percent to 9 percent, meaning new bonds are paying $90 a year interest, the
value of your bond will fall to about $778 -- because your bond's $70 annual
interest is 9 percent of $778.
Eventually, of course, when the
bond matures, it will be worth $1,000 again. However, its value will move up
and down in the meantime, depending on what interest rates do. The longer the
time to maturity of a bond, the more dramatically its price moves in response
to rate changes. That is, long-term bonds get hit harder than short-term bonds
when rates climb, and gain the most in value when rates fall.
As a result, bond buyers tend to
divide into two classes: investors (or speculators), who hope to make money
thanks to a decline in interest rates that sends bond prices higher; and
savers, who buy bonds and hold them to maturity as a way to earn a guaranteed
rate of return.
Bullet Bond
Also known as a straight or fixed bond because it has no special features. It
pays a fixed rate of interest and is redeemed in full on maturity. Interest is
usually paid annually.
Bull
(bullish)
Someone who
expects the price of a given financial instrument or the overall value of a
given financial marketplace to rise in value and thereby is a purchaser of the
instrument(s). This individual is said to be bullish on the instrument /
marketplace. Opposite of bear (bearish).
Bunds
German Federal government bonds issued with maturities of up to 30 years.
Cap
1.) An interest rate cap is a derivative in which the buyer received money at
the end of each period in which an interest rate exceeded the agreed strike
price. An example of a cap would be an agreement to receive money for each
month the Euribor rate exceeds 2.5%.
The interest rate cap can
be analyzed as a series of European call options or caplets which exists for
each period the cap agreement is in existence.
In formulas a caplet payoff
on a rate L struck at K is
where N is the notional value exchanged and
is the day count fraction corresponding to the period to which L
applies. For example suppose you own a caplet on the six month Euribor rate
with an expiry of 1st February 2005 struck at 2.5% with a notional of 1 million
EUR. Then if the Euribor rate sets at 3% on 1st February you receive
1m*0.5*max(0.03-0.025,0) = EUR 2500. Customarily the payment is made at the end
of the rate period, in this case on 1st August.
2.)
An interest-rate cap is an OTC derivative that
protects the holder from rises in short-term interest rates by making a payment
to the holder when an underlying interest rate (the "index" or
"reference" interest rate) exceeds a specified strike rate (the
"cap rate"). Caps are purchased for a premium and typically have
expirations between 1 and 7 years. They may make payments to the holder on a
monthly, quarterly or semi annual basis, with the period generally set equal to
the maturity of the index interest rate.
Each
period, the payment is determined by comparing the current level of the index
interest rate with the cap rate. If the index rate exceeds the cap rate, the
payment is based upon the difference between the two rates, the length of the
period, and the contract's notional amount. Otherwise, no payment is made for
that period. If a payment is due on a USD Libor cap, it is calculated as
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For example, Exhibit 1
illustrates a 3-year, USD 200MM notional cap with 6-month Libor as its index
rate, struck at 7.5%. The exhibit shows what the cap's payments would be under
a hypothetical interest rate scenario.
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Example:
Cap Payments |
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Payments made under a
hypothetical interest rate scenario by a 3-year USD 200MM notional cap linked
to 6-month USD Libor with strike rate of 7.5%. Values for the index rate are
6.25%, 7.75%, 7.00%, 8.50%, 8.00%, and 6.25%. These result in payments of USD
0MM, USD .25MM, USD 0MM, USD 1MM, USD .5MM, and USD 0MM. |
Caps are frequently
purchased by issuers of floating rate debt who wish to protect themselves from
the increased financing costs that would result from a rise in interest rates.
To reduce the up-front cost of such protection, a long cap may be combined with
a short floor to form a collar.
A cap can be thought of as
a series of interest rate options called caplets. Caps are
priced by valuing the individual caplets and summing the values. The Black '76 option
pricing formula is the market convention for quoting implied volatilities
for caps.
Caps are usually quoted
with an up-front premium. If they are quoted with an implied volatility, it is
with a flat implied volatility across all caplets.
Cashloan, starting
A cash loan is a loan that commences immediately. A spot loan is a loan that commences spot.
A forward loan is one that commences on some date
later than spot. For example, in the Eurodollar markets a three-month spot loan
commences in two business days (spot) and matures three months after that. A 2
7
forward loan commences two months from the spot date and lasts for five months.
With either type of loan, interest can be paid periodically or it can be
accumulated and paid at maturity.
CEDEL
Centrale de Livraison de Valeurs Mobilièrs , provides
clearance/settlement and borrowing/lending of securities and funds through a
computerized book-entry system. CEDEL is now part of Deutsche Boerse. www.cedelinternational.com
Clean Price
Present value of cash flow of a bond excluding accrued interest, the quoted
price of a bond. >>see also Dirty Price.
Clearing House
A clearing house is the administrative centre of the market through which all
transactions are cleared. In addition to administering trades, the clearing
house guarantees the performance of contracts. It becomes the counterparty to
both the buyer and seller of a contract when a trade has been matched, treaty
reducing counterparty risk.
Clearing System
A system that facilitates the transfer of ownership for securities and arranges
custody. >>See also CEDEL and Euroclear.
Collateral
Assets used as a form of security for bond issuances. In case of default by the
borrowers, the lenders (bondholders) have the legal right to claim those assets
and sell them off to repay the loan.
Commercial Paper
1.) Commercial paper is an unsecured promissory note issued for a
specified amount. This security may carry a maturity of up to 270 days.
However, the bulk of the issues mature within 30 days or shorter. Among the
entities that issue commercial paper are industrial and manufacturing firms,
most especially those with good credit ratings. While these firms can readily
turn to banks to finance their short-term capital needs, they sometimes choose
to sell paper, an alternative and cheaper source of funds. These firms together
with finance companies, bank holding companies, municipalities, and municipal
authorities have become the major issuers of commercial paper. Through the
years, foreign entities such as sovereigns and corporations have joined this
list as well. Typically, issuers cannot raise sufficient funds quick enough to
pay back maturing paper. To get around this problem, they normally roll over
the paper. They sell new paper to pay off the others.
The rates offered on commercial paper depend on several factors: the credit
rating of the issuer, the paper's maturity, the total amount of money sought by
the issuer, and the general level of interest rates. To provide the potential
borrowers an idea of how much credit risk is involved with each issue, rating
agencies such as Standard & Poor's and Moody's rate almost all paper. Top
credit ratings, however, do not preclude the possibility of default. Hence, to
compensate investors for this risk, yields on commercial paper are generally
higher than on government securities of similar maturities and most issuers
today back their paper with lines of credit from banks.
2.) Commercial paper is a short-term unsecured promissory note issued by
corporations and foreign governments. For many large, creditworthy issuers,
commercial paper is a low-cost alternative to bank loans. Issuers are able to
efficiently raise large amounts of funds quickly and without expensive
Securities and Exchange Commission (SEC) registration by selling paper, either
directly or through independent dealers, to a large and varied pool of
institutional buyers. Investors in commercial paper earn competitive,
market-determined yields in notes whose maturity and amounts can be tailored to
their specific needs.
Because
of the advantages of commercial paper for both investors and issuers,
commercial paper has become one of America's most important debt markets.
Commercial paper is typically a discount security: the investor purchases notes
at less than face value and receives the face value at maturity. The difference
between the purchase price and the face value, called the discount, is the
interest received on the investment. Occasionally, investors request that paper
be issued as an interest-bearing note. The investor pays the face value and, at
maturity, receives the face value and accrued interest. All commercial paper
interest rates are quoted on a discount basis.
Common Code
Cedel and Euroclear clearing security code. Nine digit code with XS prefix.
Coupon/ Coupon Rate
1.) Coupon is the interest paid on a bond expressed as a percentage of the face
value. If a bond carries a fixed coupon, the interest is paid on an annual or
semi-annual basis. The term also describes the detachable certificate entitling
the bearer to payment of the interest. >> see also Bullet Bond and Bearer
Forms.
2.) The coupon rate is the annual rate of interest on the bond's face value
that the issuer agrees to pay the holder until maturity.
The term "coupon" comes from the manner by which bonds were redeemed
historically. Attached to older bond certificates were a series of coupons, one
for each coupon payment date stipulated in the bond's indenture. At each coupon
payment date, the bondholder would clip the appropriate coupon, and present it
for payment. Such issues were known as "coupon" or "bearer"
bonds. Today, most issuers no longer issue bearer bonds. Instead, almost all
bonds are now offered in book-entry registered form.
Most U.S. bonds pay interest on a semi-annual basis. For example, the Treasury
8 1/8% due 5/15/2021 will pay coupons of 4.0625% of face value on 5/15 and
11/15 of each year until maturity. Most non-US domestic bond issues pay annual
coupons. Exceptions are Japanese Government Bonds, UK Gilts, Canadian bonds,
and Australian bonds, which pay coupons semi-annually.
In addition to bonds, many money market instruments pay coupons. But unlike
bonds, they typically pay a single coupon which occurs at maturity. Short dated
Certificates of Deposit (CD's) are an example of these one-coupon securities.
Coupon Stripping
Detaching the coupons from a bond and trading the principal repayment and
coupon amounts separately, thus forming zero coupon bonds. >>see also
Zero Coupon Bonds.
Credit Rating
Credit ratings measure a borrower's creditworthiness and provide an international
framework for comparing the credit quality of issuers and rated debt
securities. Rating agencies allocate three kinds of rating: issuer credit
rating, long-term debt and short-term debt. The top credit rating issued by the
main agencies – Standard and Poor's, Moody's and Fitch IBCA is AAA or Aaa. This
is reserved for a few sovereign and corporate issuers. Rating are divided into
two broad groups: investment grade and speculative grade. see
www.moodys.com;
http://www2.standardandpoors.com/NASApp/cs/ContentServer?pagename=sp/Page/HomePg;
www.fitchibca.com
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D&P |
Fitch |
Moody's |
S&P |
Summary Description |
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Investment Grade : High
Creditworthiness |
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AAA |
AAA |
Aaa |
AAA |
Gilt edged, prime,
maximum safety, lowest risk |
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Speculative – Lower
Creditworthiness |
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BB+ |
BB+ |
Ba1 |
BB+ |
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Predominately
speculative, Substantial Risk or in Default |
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CCC+ |
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CCC+ |
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Credit Watch
A credit rating agency announces that it is putting a company on credit
watch, meaning that it expects shortly to issue a lower or higher credit
rating. >> See also Credit Rating
Credit Risk
Credit risk is the risk that an issuer of a debt security or a borrower
may default on its obligations. In a slightly different context, it is also
defined as the risk that payment may not be made on the sale of a negotiable
instrument (i.e. counter-party risk).
Current Maturity
The time remaining to maturity, an important factor in bond valuation.
>>see also Maturity.
Current Yield
1.) A measure of the return a bondholder calculated as a ration of the coupon
to the market price. It is simply the annual coupon rate divided by the clean
price of the bond.
2.)
The current yield of a bond is the annual coupon divided by the market price of
the bond. It is an inadequate measure of yield because it takes into account
neither the entire amount nor the timing of the cash flows of a bond
Daycount Conventions
Every bond market has its own system of determining the number of days in year
and even the number of days between two coupon dates. These different methods
are referred as daycount conventions and are important when calculating accrued
interest and present value (when the next coupon is less than a full coupon
period away).
Day
Count Basis
In the
capital markets, there are a number of ways that days between dates are
computed for interest rate calculations. Many of these conventions were
developed before the wide spread introduction of computers. The historical
rationale for many of these calculations was to simplify the math involved in
performing normally complex financial calculations. And as in most industries
with a long history, many of these conventions have stayed with us despite
considerable advances in computers and computational methods.
The day count basis indicates the manner by which the days in a month and the
days in a year are to be counted. The notation utilized to indicate the day
count basis is (days in month)/(days in year).
For example, 30/360 assumes that each of the twelve months in a year consists
of exactly 30 days. On the other hand, Actual/Actual considers the actual
number of days in a month and the actual number of days in a year. Other types
of day count basis are Actual/360, Actual/365, and 30/360 European. The 30/360
European day count basis differs from 30/360 basis in the algorithm used to
handle the end of the month.
The five basic day count basis are the following:
- Actual/360
- Actual/365
- Actual/365 ISDA
- Actual/Actual
- Actual/Actual ISMA/SIA
- 30/360 ISDA
- 30/360 European
Each of these
are explained in their own section.
1.
Actual/360
This calculates the actual number of days between two dates and assumes the
year has 360 days. Many money market calculations with less than a year to
maturity use this day count basis.
For example, a $1MM six month CD issued on 4/15/92 and maturing on 10/15/92,
with an 8% coupon would pay an interest payment of:
Actual days
between 4/15/92 to 10/15/92 = 183 days
Interest = 0.08 x 1,000,000 x (183/360) = $40,666.67
2.
Actual/365
This calculates the actual number of days between two dates and assumes the
year has 365 days.
Using an Actual/365 day count basis, a $1MM six month CD issued on 4/15/92 and
maturing on 10/15/92, with an 8% coupon would pay an interest payment of:
Actual days
between 4/15/92 to 10/15/92 = 183 days
Interest = 0.08 x 1,000,000 x (183/365) = $40,109.59
3.
Actual/365 ISDA
The DayCount fraction (the proportion of a year) is calculated using the
following formula:
Result = Days1
/366 + Days2 / 365
Days1 =
Actual number of days in period that fall in a leap year.
Days2 = Actual number of days in period that fall in a normal year.
This
contrasts the Actual/365 DayCount fraction which is determined by
dividing the actual number of days in the period (regardless if there is a leap
year) by 365.
4.
Actual/Actual
This day count basis calculates the actual number of days between two dates and
assumes the year has either 365 or 366 days depending on whether the year is a
leap year.
More accurately, if the range of the date calculation includes February 29 (the
leap day), the divisor is 366, otherwise the divisor is 365.
Again using our CD example, the interest payment would be:
Actual days
between 4/15/92 to 10/15/92 = 183 days
Interest = 0.08 x 1,000,000 x (183/365) = $40,109.59
Notice that even though 1992 is a
leap year, the denominator used for this calculation was 365 because February
29, 1992 does not fall into the date range of the calculation. If the issue
date was before February 29, the divisor would have been 366 instead.
5.
Actual/Actual ISMA/ SIA
1). Each month is treated normally, and the year is the number of days in the
current coupon period multiplied by the number of coupons in a year.
E.g. if the coupon is payable 1st February and August then on April 1, 2005 the
days in the year is 362 i.e. 181 (the number of days between 1 February and 1
August 2005) x 2 (semi-annual)
2). The number of days in a period is equal to the actual number of days, but
the number of days in a year is the actual number of days in the relevant
coupon period multiplied by the coupon frequency.
E.g., if a bond has semi-annual coupon payments and the current coupon period
is 181 days, the assumed number of days in a year will be 362.
6.
30/360 ISDA
The number of days in every month is set to 30 except for February where it is
the actual number of days. If the start date of the period is the 31st of a
month, the start date is set to the 30th while if the start date is the 30th of
a month and the end date is the 31st, the end date is set to the 30th. The
number of days in a year is 360 (12 months x 30 days per month).
The formula for the 30/360 day calculation is as follows:
Assume Date 1 is of the form M1/D1/Y1 and Date 2 is of the form M2/D2/Y2. Let
Date 2 be later than Date 1.
Then:
If D1 = 31,
change D1 to 30
If D2 = 31 and D1 = 30, change D2 to 30
Days between dates = (Y2-Y1) x 360 + (M2-M1) x 30 + (D2-D1)
7.
30/360 European
The 30/360 day count basis is different outside of the United States. They
further simplified this calculation.
The formula for the 30/360 European day calculation follows:
Assume Date 1 is of the form M1/D1/Y1 and Date 2 is of the form M2/D2/Y2. Let
Date 2 be later than Date 1.
Then:
If D1 = 31,
change D1 to 30
If D2 = 31, change D2 to 30
Days between dates = (Y2-Y1) x 360 + (M2-M1) x 30 + (D2-D1)
Default
Failure to meet an obligation such as payment of interest or principal.
Technically the borrower does not default. The initiative comes from the lender
who declares the borrower in default.
Deflation
1.) A decline
in general price levels, often caused by a reduction in the supply of money or
credit.
2.) A persistent decrease in the level of consumer prices or a persistent
increase in the purchasing power of money because of a reduction in available
currency and credit.
Deflation can also be brought about by direct contractions in spending, either
in the form of a reduction in government spending, personal spending or
investment spending. Deflation has often had the side effect of increasing
unemployment in an economy, since the process often leads to a lower level of
demand in the economy.
Declining prices, if they persist, generally create a vicious spiral of
negatives such as falling profits, closing factories, shrinking employment and
incomes, and increasing defaults on loans by companies and individuals. To
counter deflation, the Federal Reserve (or ECB) can use monetary policy to
increase the money supply and deliberately induce rising prices, causing
inflation. Rising prices provide an essential lubricant for any sustained
recovery because businesses increase profits and take some of the depressive
pressures off wages and debtors of every kind.
Derivative
A financial instrument whose characteristics and value depend upon the
characteristics and value of an underlier, typically a commodity, bond, equity
or currency. Examples of derivatives include futures and options. Advanced
investors sometimes purchase or sell derivatives to manage the risk associated
with the underlying security, to protect against fluctuations in value, or -
not Bouwfonds! -to profit from periods of inactivity or decline. These
techniques can be quite complicated and quite risky.
Dirty Price
Present value of the cash flow of a bond including accrued interest. Also known
as gross price. >> See also Clean Price.
Discount Basis
Discount basis refers to the practice of quoting a security in terms of
a discount from its par value. For example, a discount of 5% means 100% - 5% =
95%. In this case 95 would be the quoted dollar price of this discount
security. Discount securities are non-interest-bearing money market instruments
that are issued and traded on a discount basis. They are quoted using either an
Actual/360 or an Actual/365 day count convention.
Discount Rate
Interest Rate at which a central bank will discount government paper or lend
money against government paper collateral.
Downgrade
The reduction of credit rating for a borrowing institution or its debt
instruments. Opposite to Upgrade. >> See also Credit Rating and Upgrade.
Duration
1.) A measure of the average maturity of a bond’s cash flows – the coupon
payments and principal. Quoted in years, duration indicates the average
exposure to market risk. It allows bonds with different coupons and maturities
to be compared. Also known as Macauley Duration. >> See also Coupon.
2.) The common objective
behind the different definitions of duration is to measure the price
sensitivity (and, therefore market risk) of a fixed-income security to changes
in its yield. In general, one can distinguish between the following duration or
duration-related concepts:
- Macaulay's duration
- Modified duration
- Dollar duration, dPdY, or "risk"
- Price value of an 01
- Yield value of a 32nd
Macaulay's
Duration
If a bond is
viewed as a series of cash flows, this concept measures sensitivity (in years)
as the present value-weighted average of the cash flows of the bond. As such,
it is a good measure for ranking different bonds as to their price sensitivity,
and for constructing portfolios which will fully decease a future series of
cash flows (see Immunization).
Modified
Duration
The exact measurement of the price sensitivity of a fixed-income
security to a very small change in yield, expressed as a % change in price to a
1% change in yield. Since the price/yield relationship is not linear, the
calculation is only exact for very small changes around the initial yield.
Dollar
Duration, dPdY, or Risk
Essentially a tool for calculating the hedge ratio between different
securities, this measurement of duration
is defined to be the product of the modified duration of the bond and its
full price (dollar price plus accrued interest).
Price
value of an 01, Yield value of a 32nd
The concept of duration is frequently used by market participants to
"immunize" portfolios (see Immunization).
Since many institutional investors have liabilities that must be met on
schedule with the proceeds of a bond portfolio, immunization attempts to ensure
that regardless of what happens to interest rate levels between the present and
the due date of one's liabilities, enough cash will be available to meet them.
Duration and convexity are risk estimation tools which allow the manager to
structure the portfolio so as to offset the two counterbalancing risks in the
fixed-income world: market risk, whereby prices and yields move inversely in
proportion to "long ness"; and reinvestment risk, whereby as prices
rally securities sold and new cash flows are reinvested at lower yield levels,
and conversely.
Duration
(Macaulay's)
If a bond is viewed as a series of cash flows, this concept of duration
measures price sensitivity (in years) as the present value-weighted average of
the cash flows of the bond, according to the formula:
Derma = (
Formula to be represented at a later date)
where
N = total
number of compounding periods to maturity
P$ = dollar price of the bond
As such, it
is a good measure for ranking different bonds as to their price sensitivity,
and for constructing portfolios which will fully decease a future series of
cash flows (see Immunization).
Duration
(Modified)
The exact measurement of the price sensitivity of a fixed-income security
to a very small change in yield, expressed as a % change in price to a 1%
change in yield. Since the price/yield relationship is not linear, the
calculation is only exact for very small changes around the initial yield.
The main difference between modified duration and dollar duration, dPdY or risk
lies in that modified duration is expressed as a percentage, whereas the
modified duration is expressed in terms of actual dollar price values.
Its relationship to Macaulay's duration (DurMac) can be stated as follows:
DurMod=(-DurMac)/(1+(Yield/2))
Early Redemption
The repurchase of a bond before maturity by the issuer.
Effective Margin
The coupon rate for a floating-rate security periodically changes based
on a predetermined index such as the prime rate or the three-month Treasury
bill. Given this uncertainty, the true value of the cash flows cannot be
determined, and hence, yield to maturity cannot be calculated.
A security's effective margin measures the potential return for a floating-rate
security. It measures the average spread or margin over the underlying index
that an investor can earn over the life of the security.
While this measure has its merits, it nevertheless overlooks two important
aspects that may affect the potential return from investing in a floating-rate
security. First, effective margin assumes that the index will remain constant.
Second, this measure does not take into account the cap or floor on the
security, if any exists.
EMTN
Euro Medium-Term Notes. >> see also MTN.
EONIA (euro overnight index average)
EONIA is a measure of the effective interest rate prevailing in the euro
interbank overnight market. It is computed as a weighted average of the
interest rates on unsecured overnight contracts on deposits denominated in
euro, as reported by a panel of contributing banks.
EURIBOR
1.) The
EURIBOR (or euro interbank offered rate) is the rate at which a prime bank is
willing to lend funds in euro to another prime bank. The EURIBOR is computed
daily for interbank deposits with a maturity of one week and one to 12 months
as the average of the daily offer rates of a representative panel of prime
banks, rounded to three decimal places.
1A.)
EURIBOR (Bloomberg Definition). The euro area inter-bank offered rate for the
euro, sponsored by the EBF and the ACI. It is the onshore (domestic) price
source covering dealings from 57 prime banks – 47 from the 11 ‘in’ countries,
four from the EU countries not participating in the euro area, ‘pre-ins’, and
six large international banks from non-EU countries but which are active in the
euro area.
There
is also a ‘London Euribor’, which Bouwfonds not uses:
2.)
Euro-Denominated Interbank Offered Rate. The Europe -wide version of the London
interbank offered rates that serves as a benchmark short-term interest rate for
European money markets, rounded to five decimal places.
2A.)
Euro LIBOR (Bloomberg Definition). The London inter-bank offered rate for the
euro is sponsored by the BBA. While the UK does not participate in EMU, this
will be an offshore (xeno) price source. Euro LIBOR will be calculated at
11:00am London time using the rates from 16 major banks active in the euro
market. It will replace the BBA’s ECU Libor form January 1, 1999.
Euroclear
International clearing organisation in Brussels, founded in 1968 that provides
clearance/settlement and borrowing/lending of securities and funds through computerised
book-entry system. Euroclear is managed by Morgan Guaranty Trust company. www.euroclear.com >>
see also Cedel.
Face Value/Par Amount
1.) Apparent worth. The nominal value that appears on the face value of the
document recording an entitlement, generally a certificate of bond. For debt
instruments, the amount to be repaid at maturity. Known also as par value or
nominal value.
2.)
The face amount, or face value, of a security is the amount the issuer pays the
holder at maturity. Different security types have different face value
denominations. Most bonds are quoted in multiples of $1,000 face value. For
example, 50 bonds would be equivalent to holding $50,000 face value of a bond.
First Coupon Date
The first coupon date is the date on which the first cash coupon payment
will be made. Since most bond issues in the US pay semi-annually, normally
their first coupons are paid exactly 6 months after they are issued. Such
issues are said to have normal first coupons.
Sometimes, however, the amount of the first coupon is not equal to 1/2 the
issue's coupon rate, because for some reason the bonds were issued before or
after the date 6 months prior to the first coupon date. Such issues are said to
have "short" (first coupon < normal coupon) or "long"
(first coupon > normal coupon) first coupon periods.
For example, the U.S. Treasury 7 3/4% due 3/31/96 were originally 5-year notes
with a short first coupon. The Federal Reserve would have normally issued the
note on 3/31/91. But, since 3/31/91 was a Sunday, the actual issue date was
4/1/91. Therefore, the first coupon was less than the normal 3.875% since the
first coupon period was one day less than a normal coupon period.
In order to calculate the odd first coupon correctly, both the issue date and
the first coupon date must be specified (the first coupon date may be deduced).
However, if the settlement date (or valuation date) is beyond the first coupon
date, both the issue date and the first coupon date become irrelevant for
analytical purposes, since all remaining coupons will be normal.
Fixed/Floating Bonds
Bonds that pay both fixed- and floating-rating interest at different periods
during their life.
Fixed Income
The generic term for debt instruments, such as bonds and loans, which pay
interest in the form of a coupon. The rate of interest is often fixed, hence
the term fixed income.
Floating Rate Bond
A bond with a variable interest rate as opposed to fixed.
Floating Rate Note
>> See FRN.
Floors
1.) In FRN’s the coupon cannot fall below a
specified minimum rate.
2.) Interest rate floors compare to interest rate caps in
the same way that puts compare
to calls. They are OTC derivatives that protect the holder from declines in
short-term interest rates by making a payment to the holder when an underlying
interest rate (the "index" or "reference" interest rate) falls
below a specified strike rate (the "floor rate"). Floors are
purchased for a premium and typically have maturities between 1 and 7 years.
They may make payments to the holder on a monthly, quarterly or semi annual
basis, with the period generally set equal to the maturity of the index
interest rate.
Each period, the payment is
determined by comparing the current level of the index interest rate with the
floor rate. If the index rate is below the floor rate, the payment is based
upon the difference between the two rates, the length of the period, and the
contract's notional amount. Otherwise, no payment is made for that period. In
US markets, if a payment is due on a USD Libor floor, it is calculated as
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|
|
example, Exhibit 1
illustrates for a 3-year, USD 200MM notional floor with 6-month Libor as its
index rate, struck at 5.5%. The exhibit shows what the floor's payments would
be under a hypothetical interest rate scenario.
|
Example: Floor Payments Exhibit 1 |
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|
|
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|
Payments made under a hypothetical
interest rate scenario by a 3-year USD 200MM notional floor linked to 6-month
USD Libor with strike rate of 5.5%. Values for the index rate are 6.75%,
5.25%, 6.25%, 4.50%, 5.00%, 6.75%. These result in payments of USD 0MM, USD
.25MM, USD 0MM, USD 1MM, USD .5MM, and USD 0MM. |
Floors are used by
purchasers of floating rate debt
who wish to protect themselves from the loss of income that would result from a
decline in interest rates. End users may also short
a floor against a cap to construct an inexpensive or costless collar.
Just as a cap can be thought
of as a series of caplets, a floor can be thought of as a series of interest
rate options called floorlets. Floors are priced by
valuing the individual floorlets and summing the values. The Black ’76 option
pricing formula is the market convention for quoting implied volatilities
for floors.
Floors are usually quoted
with an up-front premium. If they are quoted with an implied volatility, it is
typically with a flat implied volatility across all floorlets.
Force Majeure
A force majeure clause is written into contracts to allow contracting parties
to be freed from their obligations in the event of an occurrence such as
earthquake, hurricane or a serious labour dispute, which is outside their
control.
Forward
Points
The PIPS added to or subtracted from the current exchange rate to calculate a
forward price. If points are added, then the forward is priced at a premium. If
points subtracted, then the forward is priced at a discount.
Forward
Forward refers to delivery beyond two days and usually quoted one year out in
increments of 30 days (i.e. 1 month, 2 month, etc.).
FRA
A forward rate agreement (FRA) is a cash-settled forward contract on a short-term
loan. For example, a 2-5 FRA is a 2-month forward on a 3-month loan. The
interest rate on the loan, called the FRA rate, is set when the contract is
first entered into.
Because
FRA’s are cash settled, no loan is ever actually extended. Instead, contracts
settle with a single cash payment made on the first day of the underlying loan,
which is called the settlement date. The formula for the payment is
|
|
where
notional
is the notional amount of the loan,
the
reference rate is typically a Libor rate or Euribor,
days
is the number of days the loan is for, and
basis
is the day count basis applicable to money market transactions in the currency
of the loan—usually either 360 or 365 days.
Consider
an example. A 410
USD 20MM FRA is transacted with an FRA rate of 3.4%. The four month forward
period starts on the spot date and extends to the settlement date. Typically,
the spot date is two business days after the trade date. Two business days
before the settlement date is the fixing date. This is the date on which the
value of the reference rate is determined. For this FRA, the reference rate is
6-month USD Libor. Suppose 6-month Libor is 3.7% on the fixing date. The USD
money market uses a 360 day basis. On the settlement date, the borrower (the
party that is long
the FRA) receives from the lender (the party that is short the FRA) the amount
|
|
[2] |
Suppose
for this example that there are 186 days in the loan period. In that case, the
payment would be USD 30,418.
Although
they are traded OTC, FRA’s have fairly standardized contract provisions.
FRN
Floating rate note. A medium-term debt instrument that pays regular coupons but
those coupons are not fixed. Instead the coupon rates are adjusted periodically
in line with short-term interest rates such as LIBOR or EURIBOR. >> See
also Coupon and Euribor.
Going short – going long
When you buy e.g. a currency, you are said to be “long” in that
currency. Long positions are entered into at the offer price. Thus if you are
buying one EUR/USD lot quoted at 1.1847/52, then you will buy 1,000,000 EUR at
1.1852 USD.
When you sell a currency, you are said to be “short” in that currency. Short
positions are entered into at the bid price, which is 1.1847 USD in our
example.
Because of the symmetry of currency transactions, you are always simultaneously
long in one currency and short in another. For example if you exchange
1,000,000 EUR for USD you are short in euro’s and long in US dollars.
Gross Price
>> See Dirty Price.
Hedging
A strategy
used to offset market risk, whereby one position protects another. Traders and
investors in e.g. foreign exchange hedge to protect their investment or
portfolio against currency price fluctuations.
IAS39
IAS means
International Accounting Standard.
The key requirements of IAS39 are as follows:
- All financial assets and liabilities (including
derivatives) must be recognised in the Statement of Financial Position.
e.g. interest rate swaps & options, foreign exchange swaps, futures
and forward rate agreements.
- Derivatives must be accounted for at fair value
at each reporting date with changes in fair value taken to the Statement
of Financial Performance unless hedge accounting is achieved.
- If the financial instrument qualifies for hedge
accounting, then changes in the instrument value are recognised in a
manner consistent with the recognition of gains and losses on the hedged
item.
Inflation
1.) Inflation is an increase in the price of a basket
of goods and services that is representative of the economy as a whole.
2.) A persistent increase in the
level of prices (including consumer products and wages). Traders closely watch
inflation because the primary way to fight inflation is to raise interest rates
which, in turn, supports the currency of the affected country.
3.) Inflation is defined as
a sustained increase in the general level of prices for goods and services. It
is measured as an annual percentage increase. As inflation rises, every dollar
you own buys a smaller percentage of a good or service.
The value of a dollar does not stay constant when there is inflation. The value
of a dollar is observed in terms of purchasing power, which is the real,
tangible goods that money can buy. When inflation goes up, there is a decline
in the purchasing power of money. For example, if the inflation rate is 2%
annually, then theoretically a $1 pack of gum will cost $1.02 in a year. After
inflation, your dollar can't buy the same goods it could beforehand.
Inflation is a sign that an
economy is growing. The lack of inflation may be an indication that the economy
is weakening.
In some situations, little inflation (or even deflation) can be just as bad as
high inflation.
Inflation, Causes of
Economists
wake up in the morning hoping for a chance to debate the causes of inflation.
There is no one cause that's universally agreed upon, but at least two theories
are generally accepted:
Demand-Pull Inflation - This theory can be summarized as "too much money
chasing too few goods." In other words, if demand is growing faster than
supply, then prices will increase. This usually occurs in growing economies.
Cost-Push Inflation - When companies’ costs go up, they need to increase prices
to maintain their profit margins. Increased costs can include things such as
wages, taxes, or increased costs of imports.
Inflation, Evil of
Let's say the market takes a 30 percent dive over the next year. Every time you
check your stocks or stock mutual funds, you're going to feel the pain.
Likewise, if interest rates rise, your bonds won't let you forget it.
Nowhere on your bank or brokerage
statement, however, are you likely to get a report on what inflation is doing
to the real value of your holdings.
If your money is stowed in a
"safe" investment, like a low-yielding savings or money market
account, you'll never see how inflation is gobbling up virtually all of your
return. Here are some points to bear in mind:
- At an average annual growth rate of 10.4 percent
a year, stocks will double your money about every seven years. Factor in
inflation, which has historically run at about 3.1 percent annually, and
it will take more than 10 years to double your actual buying power.
- Likewise, bonds, which have historically grown at
5.4 percent annually, will double your money every 12 1/2 years. After
inflation, however, it will take 26 years.
- If your money is in cash, you'll have to wait 23
years for the nominal value of your account to double, assuming the cash
earns the historical 3.1 percent annual return. But even your
grandchildren won't see the real value of your money double.
That's why, whenever you add up
your gains or losses for a given period of time, you have to add in the effects
of inflation to understand how much further ahead or behind you really are.
Inflation,
Problems caused by
- Creditors lose and debtors gain if the lender
does not anticipate inflation correctly. For those who borrow, this is
similar to getting an interest-free loan.
- Uncertainty about what will happen next makes
corporations and consumers less likely to spend. This hurts economic
output in the long run.
- People living off a fixed-income, such as
retirees, see a decline in their purchasing power and, consequently, their
standard of living.
- The entire economy must absorb repricing costs
("menu costs") as price lists, labels, menus and more have to be
updated.
- If the inflation rate is greater than that of
other countries, domestic products become less competitive.
Interest Rate
>> See Coupon Rate.
Interest Rate Risk
Risk associated with fluctuations of bond prices in response to the
general movement of the interest rates and to changes in investor perceptions
of government monetary policy and economic data.
ISIN
International Securities Identification Number consisting of twelve characters.
The first two characters are taken up by the alpha-2 country code as issued in
accordance with the international standard ISO 6166 of the country where the
issuer of securities, other than debt securities, is legally registered or in
which it has legal domicile. For debt securities, the relevant country is the
one of the ISIN - allocating NNA. In the case of depository receipts, such as ADR's,
the country code is that of the organisation who issued the receipt instead of
the one who issued the underlying security. The next nine characters are taken
up by the local number of the security concerned. Where the national number
consists of fewer than nine characters, zeros are inserted in front of the
number so that the full nine spaces are used. The final character is a check
digit computed according to the modulus 10 "Double-Add-Double"
formula. >> See www.anna-web.com
ISDA
The International Swaps and Derivatives Association (ISDA) is a trade
organization of participants in the market for over-the-counter derivatives. It is headquartered in New York, and has
created a standardized contract (the ISDA Master Agreement), that two parties
sign before they trade derivatives with each other. This Master Agreement is a bilateral
agreement. It contains general terms and conditions that apply to all the
individual derivative contracts that the two parties may enter into later.
The
ISDA Master Agreement is designed to mitigate the credit risk inherent in
derivatives by defining different types of credit triggers that indicate a
"default"and the consequences of the "default". http://www.isda.org/
ISMA
International Securities Market Association. A self regulatory body and trade
association of International bond Dealers with a remit of establishing a
structure for the Eurobond market. www.icma-group.org/
Interest Rate
Compensation that the borrower pays to lender for use of the funds. It may be
payable monthly, quarterly, half-yearly, annually or bi-annually.
Issue Date
1.) The date from where the bond accumulates the interest or becomes alive.
2.) The issue date is the first day a fixed income security begins accruing
interest. Most issues have issue dates that occur on a six month anniversary
date of maturity. But some bonds are issued on odd dates. These odd-first
coupon bonds pay a different coupon amount during their first coupon period. See
First Coupon Date.
Issue Price
Percentage amount of the denomination that a bondholder is required to pay in
order to purchase the bond.
Jumbos
CD's denominated at a $100000 minimum, usually bought and sold by large
financial institutions.
Junk Bonds
High-yield bonds, which are rated below investment grade by credit agencies.
Also known as speculative grade bonds.
Lead Manager/Underwriter
The institution awarded the mandate by a borrower to raise money via a bond or
loan. The lead manager guarantees the liquidity of the deal, arranges the
syndication of the issue and undertakes a major underwriting and distribution
commitment. The lead manager forms a syndicate of co-lead managers, co-managers
and underwriters.
LIBOR
The London Interbank Offered Rate. The rate at which banks are prepared to lend
money market funds to each other. LIBOR is a key interest rate level and used
for setting rates on loans and floating rate notes.
Liquidity
The ability to convert a security or asset quickly into cash. A much
desired quality in investing.
Market Risk
Market risk is synonymous to the classic price/yield behaviour of bonds.
As yields fall, bond prices rise; as yields rise, bond prices fall. In some
contexts, this phenomenon may be called "interest rate risk" or
"price risk".
Maturity
A length of time between the issue of a security and date on which it becomes
payable in full. Most bonds are issued with a fixed maturity date. Those
without are known as perpetuals.
Maturity Date
The date when a security becomes payable in full.
Maturity Value
The amount to be paid back at maturity; in bond trading also called principal.
Medium-term Notes.
>> See MTN.
Moody’s
A premier credit rating agency. Moody’s assessments of creditworthiness of
borrowers are widely watched in the capital markets. www.moodys.com
Mortgage-backed
Securities
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
investors' principal and interest on the MBS. Also known as "mortgage
pass-through."
When you invest in a mortgage-backed security you are lending money to a
homebuyer or business. An MBS is a way for a smaller regional bank to lend
mortgages to its customers without having to worry if the customers have the
assets to cover the loan. Instead, the bank acts as a middleman between the
homebuyer and the investment markets.
Mortgage-backed securities
In between are several varieties of mortgage-backed security -- Fannie Maes,
Ginnie Maes, and so forth -- as well as investment-grade corporate bonds from
large, blue-chip companies. The grades come from outfits like Standard &
Poor's and Moody's, which rate the riskiness of most non-Treasury bonds.
MTN
Medium-term notes. Borrowings out to about five years typically issued under a
similar borrowing facility for commercial paper. MTN's issued in the
Euromarkets are known as EMTN's.
Negative Pledge
Clause in bond agreement which prevents the borrower from pledging greater
security of collateral to other lenders.
Net Amount
The amount which appears on a trade confirmation is the amount the buyer
has to pay, or equivalently, the amount the seller has to receive. It is
computed as the follows:
Net Amount = Par Amount * Dollar Price + Accrued Interest
Synonyms for net amount include net proceeds and invoice price.
New Issue
A security that is being offered for sale in the primary market.
Nominal Interest Rates
The interest rate expressed in money terms. >> See also Real Interest
Rate.
Notional Bonds
A standardised bond with hypothetical terms (coupon and maturity), which
represents the basis for a bond futures contact.
Notional Principal (Amount)
The hypothetical amount on which interest payments are based in products such
as interest rate swaps, FRA's, caps and floors.
Odd Coupon
This occurs when the firs or last coupon period is longer or shorter than the
nominal coupon period.
Over-The-Counter (OTC)
An instrument is traded
over-the-counter (OTC) if it trades in some context other than a formal
exchange. Most debt instruments are traded OTC with investment banks making
markets in specific issues. If someone wants to buy or sell a bond, they call
the bank that makes a market in that bond and ask for quotes. Many derivative
instruments, including forwards, swaps and most exotic derivatives are also
traded OTC. In these markets, large financial institutions serve as derivatives
dealers, customizing derivatives for the needs of clients.
Par Value
>> See Face Value.
Pari Passu
Securities issued with pari passu clause rank equally with existing securities
of the same class.
Pay Date
The date when the interest is due to a bondholder.
Paying Agent
Institution appointed to supervise payment and, for floating rate notes, sets
interest rates.
Payment Date
The date on which a coupon payment is due to be made.
Payment
netting
Payment netting reduces settlement risk: If
counterparties are to exchange multiple cash flows during a given day, they can
agree to net those cash flows to one payment per currency. Not only does such
payment netting reduce settlement risk, it also streamlines processing.
PIP
PIP typically
stands for the smallest unit of measurement denoting price movement. One basis
point (0.0001 or .01%) but depends on currency pair in reference.
Pfandbriefe
German bonds issued to refinance mortgages or public projects. Can only be
issued by specially authorised banks, which are also fully liable for each
issue. They are secured by mortgage or public sector loans. Pfandbriefe are
officially quoted on German stock exchanges, while issuers maintain a secondary
market.
Premium
Generally used to describe when something is trading above its normal price.
Price
The price of a security is typically quoted as a percentage of face
value. It is also sometimes referred to as the "clean price". The
actual payment that is exchanged between two parties may be different from the
quoted price. For example, bonds between coupon payments accrue interest that
is proportional to the coupon period. Therefore, the buyer has to pay the
seller the quoted price of the security plus any accrued interest. This sum is
known as the invoice price of the bond.
Most securities are quoted as a percent in decimal. For example, a corporate
bond quoted as 101.125 is equal to 101 and 1/8th percent. Almost all securities
are quoted in decimal.
Treasury and federal agency securities are quoted in 32nds and halves of a
32nd.
Prospectus
Document provided by the issuing company giving detailed terms and conditions
of a new stock or debt offering.
Quoted Price
The price at which the last sale and purchase of a security took place.
Real Interest Rates
The actual rate of return calculated by deducing the inflation rate from the
current interest rate. Also known as real yield. >> See also Nominal
Interest Rates.
Reconvention
Change of Daycount convention; mainly due to Euro conversion.
Record Date
The date on which a bondholder must be the official owner of bonds to be
entitled to the interest payment.
S&P
Standard & Poor’s. A premier credit rating agency. S&P assessments of
the creditworthiness of borrowers are widely watched in the capital markets. www.standardandpoors.com
Secured Bonds
A corporate that is seeking lower cost debt, or that does not have
significantly high credit rating, may issue secured debt. The security offered
may be fixed to a specific asset tied to the loan or floating, meaning that the
general assets of the company are offered as security for the loan, but not any
specific asset.
Securitisation
Generally, the process of bringing lenders and borrowers together via the
traded securities markets rather than through the banking system. The term
refers to the process of creating a specific class of debt securities for which
the coupon and principal payments are generated by a designated asset, where
the asset in question has usually been removed from the balance sheet of the
institution, which made it.
Securitisation was introduced into the US market which remains the dominant
market for this types of securities. In the sterling market all public
mortgage-backed and asset backed securities are explicitly rated by Moody's and
/or Standard and Poor's.
Settlement Date
1.) Settlement date is the date when a security and the payment for it
are actually exchanged between buyer and seller. It is also commonly known as
the valuation date.
Settlement
date is sometimes confused with trade date. The latter is the date on which the
buyer and seller agree to the amount, price, and other terms of the trade,
while settlement is the date on which the terms of the transaction are
executed. Historically, settlement date occurred several days after the trade
date, thus allowing for physical delivery and payment of the agreed upon
transaction. As technology improved and bonds were registered in book entry
form, this time delay has been shortened.
Most
bonds settle with either next day settlement or five business day settlement.
Holidays and weekends are excluded from the count. Five day settlement is
frequently called "corporate settlement", since most corporate bonds
still settle this way. Occasionally, especially among dealers, some securities
can be traded for same day settlement, known as "cash settlement".
Book entry registration and payment occur electronically on trade date.
2.)
A trade is settled when the trade and its counterparts have been entered into
the books/records.
3.)
In finance, a contract settles when one or both parties perform on an
obligation under that contract. The term is commonly used in trading and
derivatives markets.
In
trading, a trade settles when the instrument being traded actually changes
hands and/or is paid for. Both events typically occur on the same date, which
is called the settlement date.
Because
of mistakes or events beyond the control of counterparties, transactions
sometimes fail to settle on the intended date. For this reason, it is useful to
distinguish between a transaction's settlement date and its value date. The
former is the date on which the transaction actually settles. The latter is the
date on which it is intended to settle at the time of the trade.
When
a market value is calculated for an instrument, this is typically as of the
value date. In this way, the market value reflects the value that the
instrument would command in the market for payment and delivery on the value
date. If an entire portfolio must be marked to market, some common value date
is assumed for all instruments.
A
trade is spot settled if the settlement date occurs on a specific date shortly
after the trade date. The actual date depends upon the market. In foreign
exchange markets, spot transactions settle in two trading days. Corporate debt
generally trades for settlement on the third trading day following the trade
date. This is called regular-way settlement.
Spot
settlement generally reflects the earliest date that transactions typically
settle in a given market. However, in some markets, it reflects convention more
than practical limitations on how quickly a given transaction can settle. In
such markets, pre-spot settlement may be possible, including settlement on the
trade date. A trade is said to be cash settled if settlement occurs on the
trade date.
A
trade is forward settled if it settles on some date after spot. Forward
transactions, called forward contracts of forwards, routinely have settlement
dates up to a year after the trade date.
If
a trade has a cash, spot or forward value date, it may be called a cash, spot
or forward trade. Prices at which cash, spot and forward trades transact are
called cash prices, spot prices and forward prices.
In
the debt markets, a loan is agreed to on one date, but it is said to settle on
the date the loan commences. Analogous to trading, there are cash loans, spot
loans and forward loans. For example, in the Eurodollar markets, spot loans
settle in two trading days. Forward loans settle after that. If interest rates
are fixed at the time loans are agreed to, interest rates will differ for spot
or forward loans. For example, the interest rate on a 3-month spot loan will
generally differ from that on a 3-month forward loan commencing in a year.
Accordingly, the markets distinguish between spot interest rates and forward
interest rates. See also the article forward rate agreement.
In
the money markets and foreign exchange markets, very short-term loans are used
to manage short-term cash flows. An overnight loan commences immediately and
lasts for one trading day. A tom-next ("tomorrow-next") loan
commences in one trading day and lasts for one trading day. A spot-next loan
commences in two trading days (spot) and lasts for one trading day.
SIA
Securities Industry Association. The principal trade association and
lobbying group for broker/dealers. SIA members include most members of the New
York Stock Exchange, and many members of other exchanges and the
over-the-counter market. www.sia.com/
Spot
Spot refers to any delivery within two business days.
Swap
A swap is a cash-settled OTC derivative under which two counterparties
exchange two streams of cash flows. It is called an interest rate swap if both
cash flow streams are in the same currency and are defined as cash flow streams
that might be associated with some fixed income obligations.
The
most popular interest rate swaps are fixed-for-floating swaps under which cash
flows of a fixed rate loan are exchanged for those of a floating rate loan.
Among these, the most common use a 3-month or 6-month Libor rate (or Euribor,
if the currency is the Euro) as their floating rate. These are called vanilla
interest rate swaps. There is also a liquid market for floating-floating interest
rate swaps—what are known as basis swaps.
To
keep things simple (and minimize settlement risk), concurrent cash flows are
netted. In a typical arrangement. both loans have an initial payment (loan) of
principal, but those net to 0. Both loans have a final return of the same
principal, but those also net to 0. Also, the periodic interest payments are
generally scheduled to occur on concurrent dates, so they too can be netted.
The principal amount is called the notional amount of the swap.
Consider
an example. Two banks enter into a vanilla interest rate swap. The term is four
years. They agree to swap fixed rate USD payments at 4.6% in exchange for
6-month USD Libor payments. At the outset, the fixed rate payments are known.
The first floating rate payment is also known, but the ret will depend on
future values of Libor. Exhibit 1 calculates the swap payments under a
hypothetical scenario for Libor rates over the life of the swap. These are
illustrated graphically in Exhibit 2.
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Cash Flows During the Life of a
USD 100MM 4.6% Four-Year Swap |
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Cash flows under a
hypothetical four-year vanilla swap. Fixed payments are based on a 4.6%
semi-annual rate. Floating payments are based on 6-month Libor. The initial
Libor rate is known to be 2.8% at the outset, so the swap's first payment is
certain. Subsequent Libor rates are not known at the outset. The last column
indicates cash flows to the receive-fixed party. Cash flows to the
receive-floating party are the negatives of these. All cash flows are in
millions of dollars. Note that the final Libor rate at 4.0 years is not used
to calculate any of the swap's cash flows. Note also how all USD 100MM
principal payments net to zero. |
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Illustrative Swap Cash Flows |
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Graphical presentation of
the results in Exhibit 1. Swap cash flows are indicated as those received by
the receive-fixed party. |
In addition to being the
financial equivalent of an exchange of loans, a vanilla fixed income swap is
also mathematically equivalent to a strip of FRA's.
Interest rate swaps are
used for many purposes. If a corporation has borrowed money at a floating rate
of interest but would prefer to lock in a fixed rate, it can swap its floating
rate payments into fixed rate payments. This is illustrated in Exhibit 3.
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Swapping Floating Debt into Fixed |
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By entering into a swap
with a third party, a corporation can convert floating rate payments into
fixed rate payments. |
Swaption
A swaption is an OTC option on a swap. Usually, the underlying swap is a
vanilla interest rate swap. Unless stated otherwise, that is how we will use
the tem in this article. However, the term "swaption" might be used
to refer to an option on any type of swap.
In
case you are wondering why anyone would want to buy a swaption, the answer is
often that they don't want to. Frequently, they want to sell a swaption.
Consider a corporation that has issued debt in the form of callable bonds
paying a fixed semi annual interest rate. The corporation would like to swap
the debt into floating rate debt. The corporation enters into a
fixed-for-floating swap with a derivatives dealer. To liquidate the call
feature of the debt, it also sells the dealer a swaption. For derivatives
dealers, clients often want to sell them swaptions while other clients want to
buy caps from them. The dealers then face the challenge of hedging the short
caps with the long swaptions.
Swaptions
can be for American, European or Bermudan exercise. They can be physically
settled, in which case an option is actually entered into upon exercise. They
can also be cash settled, in which case the market value of the underlying swap
changes hands upon exercise.
To
specify a swaption, we must indicate three things:
-
the expiration date of the option
-
the fixed rate on the underlying swap
-
the tenor (time to maturity at exercise of the option) of the swap.
The
purchaser of the swaption pays an up front premium. If she exercises, there is
no strike price to pay. The two parties simply put on the prescribe swap. Note,
however, the fixed rate specified for the swaption plays a role very similar to
that of a strike price. The holder of the swaption will decide whether or not
to exercise based on whether swap rates rise above or fall below that fixed
rate. For this reason, the fixed rate is often called the strike rate.
By
symmetry, a call on a pay-fixed swap is the same thing as a put on a
receive-fixed swap. Similarly, a call on a receive fixed swap is the same as a
put on a pay fixed swap. For this reason, it is often more convenient to speak
in terms of two basic forms of swaption:
-
A payer swaption is a call on a pay-fixed swap—the swaption holder has the
option to pay fixed on a swap.
-
A receiver swaption is a call on a receive fixed swap—the swaption holder has
the option to receive fixed on a swap.
Suppose
a party purchases a 1x5 payer swaption struck at 5%. A year later, if the
four-year swap rate is 6%, she will exercise the swaption and pay 5% fixed for
Libor flat on a four-year swap. If instead, the four-year swap rate is 4%, she
will not exercise the swaption.
Short First Coupon
The first interest payment on a recently issued bond that includes less
than the normal semi-annual or annual payment.
SoxA
In 2002, Accounting firm Arthur Andersen was convicted of a single charge
stemming from its lackluster auditing of Enron. That action forced Andersen,
one of the largest and most respected auditors in the world, to go out of
business.
There
was plenty of blame to go around. Corporate executives had cooked books while
lining their pockets. Analysts at investment banks had recommended stocks they
knew were dogs in a quid pro quo that ensured banking business from those same
firms. Accounting firms had been cross-selling consulting services to audit
clients. Increasingly, their auditors had shied away from challenging
management of firms so as to not jeopardizing those lucrative consulting
engagements.
Amidst
the gloom and finger-pointing, Congress passed the 2002 Sarbanes-Oxley Act, fondly
known as "sox." This is a sweeping law that increases management
accountability, mandates a variety of internal controls at firms, and
strengthens the role of auditors. Accounting firms are largely prohibited from
simultaneously auditing and consulting to any given client. A new federal
agency, called the Public Company Accounting Oversight Board, (PCAOB or
Peek-a-Boo), is to oversee accounting firms. Corporations must test internal
controls regularly. To avoid conflicts, those tests must be performed by an
outside firm other than the external auditor. Sarbanes-Oxley has been variously
described as ineffective, overly costly to corporations, or too demanding.
Maybe some of the criticism is reasonable—or maybe not. Time will tell.
Standard and Poor’s
>> See S&P.
Stripping
>>see Coupon Stripping.
Term to Maturity
A time period from issue date to maturity date.
Tick
A price
movement.
Tombstone
A public notice such as a newspaper advertisement announcing the details of a
new issue including the names of investment and finance houses who have
organised and provided the funds. A tombstone appears as a matter of record and
is not an invitation to subscribe.
Tom Next
Tom next or "tomorrow next" refers to a transaction in the
interbank market in Eurodollar deposits and the foreign exchange market with a
next business day value or delivery date.
Tranche
Term used to describe portion allocation or installment. One of a series of two
or more issues with the same coupon rate and maturity date. The tranches
becomes fungible at a future date, usually just after the first coupon date.
Upgrade
Upward regrade of credit status for a borrowing institution or its debt
instruments. Opposite of downgrade >> See also Downgrade.
Variable Rate
A periodically adjusted rate, usually based on a standard market rate.
Volatility
A measure by which an interest rate is expected to fluctuate or has
fluctuated over a given period. Volatility figures are often expressed as a
percentage per annum.
Yield
Also known as "yield to maturity", yield is defined as the
internal rate of return of a security's cash flows. It is that discount rate
which equates a bond's invoice price (principal + accrued interest) with the
present value of its coupon and principal payments.
For
most securities, this rate is quoted in terms of the compounding convention of
the security. Money market instruments quote yield on a simple interest basis,
whereas bonds are quoted on a semi-annual, compounded basis. Except in the case
of zero-coupon instruments, "yield" is not an assured rate. In
addition, it suffers from the inherent limitations of any internal rate of
return. This is one of the reasons why there exist other frameworks within
which to compare securities.
Yield to Maturity
1.)
Yield to maturity (YTM) is the internal rate of return of a bond. In
calculating YTM, coupon income, redemption value, interest earned on interest,
as well as the timing of each cash flow, are all taken into account from
settlement to maturity. All intermediate cash flows are reinvested at the YTM
itself. The YTM may only be realized when the bond is held to maturity and all
cash flows are reinvested at exactly the YTM rate.
2.) A key consideration when comparing bond investments. It is annualised rate
of return of a bond, namely the interest rate that makes the present value of
the bond’s future cash equal to the present price of eh bond. It assumes the
bond will be held to maturity and that the coupon will be reinvested at the
same rate.
Zero Coupon Bond
A bond that pays no periodic interest but is issued at a deep discount to face
value. The difference between the issue and redemption price creates a hefty
capital gain, which boosts the yield close to the market levels. As it does not
pay a coupon, investors do not run the risk of reinvesting interest aid at a
lower rate if interest rates fall during the life of the bond.
