Glossary Down-and-out call/put Down-and-in call/put Up-and-out call/put Up-and-in call/put

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1 Glossary Alternative Investment Market (AIM): New market on London Stock Exchange for `young, dynamic and growing' companies but with fewer controls and hence greater risks American Depository Receipts (ADRs): Companies outside the USA deposit shares with a bank. The bank issues an ADR - a certificate stating that a specified number of a company's shares are in the custody of the bank. The ADR, representing the shares, is then traded in the USA and treated for legal purposes as a US security. A company may do this to broaden the geographical base of its share holding. Investors avoid British stamp duty on each trade since stamp duty is only paid when the shares are transferred to the bank which issues the ADR representing them. By March 1986, more than half the trading in some UK companies in New York took place in ADR form. Asset allocation: dividing investment funds among markets to achieve diversification or maximum return As-you-like option (or chooser option or the call-or-put option): enables the holder to convert from one style of option to a different style of option over a preset period of time Average rate option (or Asian option): an option in which the settlement is based on the difference between the given strike and the average prices of the underlying stock or index on selected dates. Backwardation: a condition in a futures market where the more distant delivery months trade at a discount to the near term delivery months (the opposite of contango) Barrier options: A family of path-dependent options whose pay-off pattern and survival to the expiration date depend not only on the final price of the underlying security but also on whether or not the underlying security sells at or goes through a predetermined barrier at any time during the life of the option. Various barrier options include: Down-and-out call/put (a knock-out option): an option which expires worthless if the market price of the underlying security drops below a predetermined price. Down-and-in call/put (a knock-in option): an option which becomes effective if the market price of the underlying security drops below a pre-determined price. Up-and-out call/put (a knock-out option): an option that expires worthless if the market price of the underlying security rises above a pre-determined price Up-and-in call/put (a knock-in option): an option that becomes effective if the market price of the underlying security rises above a pre-determined price. bed and breakfasting: selling shares one day and buying them back the next as a means of minimising liability to capital gains tax on equity sales Best-of-two option (or either-or option or alternative option): provides the option holder with a pay-off based on the independent performances of two separate and distinct securities or indices beta: A measure of systematic (market) risk of a stock. It is the percentage change in a stock price divided by the percentage change in the market index. Bonds: Interest-bearing bonds may allow investors to choose portfolios that nearly

2 match interest and amortization streams with their own nominal future requirement for funds. A portfolio is said to be perfectly immunised against interest-rate fluctuations if such matching is achieved. When transaction costs are zero, bonds are perfectly reversible. It was argued by Tobin (1963b) that the composition of outstanding interest-bearing government debt can influence the level of macroeconomic activity. If bonds are closer substitutes for physical capital in investor portfolios than are Treasury Bills, a debt management policy of selling bonds and buying an equivalent amount of bills discourages private sector capital formation since it raises long-term interest rates relative to shortterm rates. Automation in bond markets has reduced transaction costs and has made bonds more reversible. This has reduced the distinction between bonds and outside money, a distinction which is crucial for the success of central bank open market operations Borsa Valori: Italian Stock Exchange Box options: A tax efficinet method of using cash to generate capital gains, while maintaining a conservative investment approach to funds management. Instead of placing cash in a money-market instrument and generating interest income, equity options are purchased the payoffs of which create capital gains that can be offset against current capital losses. butterfly: (also dumbbell) swap effected by replacing long-term and short-term securities with a security of an intermediate maturity which produces the same or an improved yield CAC-40: Compagnie des Agents de Change 40 - a weighted index of 40 of the one hundred companies with the highest market capitalisation on the `forward' section of the Paris bourse; the subject of a futures contract offered by MATIF callable bond: a bond which can be redeemed at the option of the issuer call option: the right to buy a given stock, commodity index or futures contract at a fixed price on or before the specified date. Capital Adequacy Directive of the EU (CAD): It lays down methods of calculating risk in order to determine required levels of capital. Central banks of EU member states may allow institutions to use their own risk models to calculate risk provided they have cleared the models with the central bank. Came into effect on 31/12/95 cap: Contract between a borrower and a lender where the borrower is assured that he will not have to pay more than some maximum interest rate on borrowed funds. Certificate of Deposit (CD): A negotiable instrument which a bank may provide for a depositor and which can be traded to change ownership of the deposit CHIPS: Clearing House Interbank Payments System: computer-based US sytem for clearing forex transactions. claim a promise to pay in the future including stocks and bonds, mortgage loans, bank deposits clearing house system: a system in which everybody deals through a settlement company which

3 matches and guarantees trades and holds performance bonds posted by dealers. It acts as a counterparty to every trade, reducing credit risk. This is meant to prevent the collapse of one trader from bringing down others. It can be contrasted with a principals system. collar: a floating rate debt contract that establishes both a maximum and minimum interest rate to be paid by the borrower. Commercial Paper: short-term unsecured tradeable notes denominated in domestic currency issued by a company or by sovereign governments and their agencies, that is bought directly by investors in money markets. It is negotiable. When a commercial paper market grows, the role of banks changes. They no longer perform the role of custodian of other people's money, borrowing and lending, but become dealers or brokers whose job is to bring together issuers and investors. The development of commercial paper markets around the world is thus part of the process of disintermediation of the banking system in which banks are squeezed out of mainstream borrowing and lending by securitization. Commercial paper was once confined to the US but has expanded rapidly in other countries and in Euromarkets, especially after the debt crisis in This had two immediate effects on the balance sheet of the system as a whole: (a) it made books less liquid because a lot of loans were suddenly tied up in reschedulings and were unlikely to be repaid for many years; (b) financial markets realized that big banks were not such good credit risks as they had thought. As part of their response to the problem, banks: (i) sought to reduce their balance sheets and to make them more liquid and were thus less interested in lending especially if it meant taking on to the books assets which could not easily be sold off at a later stage & (ii) became more interested in activities such as dealing in securities on which they could earn a fee as brokers or traders. Borrowers, on the other hand, realised that banks might no longer be the cheapest source of credit - the perceived market deterioration in the standing of banks had driven up eurocurrency deposit rates (on whch most international lending was traditionally based) relative to other interest rates. Also investors wished to diversify their own risks away from the banking system by buying debt other than straightforward bank deposits. The euro commercial paper market is centred in London. In its early days the emphasis was on the establishment of loan facilities which tied the issuance of commercial paper or euronotes to a specifc back-up line of credit from commercial banks. Paper is auctioned through a tender panel of institutions which also undertakes to provide credit if paper can't be sold below a predetermined yield. Thus the system: (a) was designed to attract banks into underwriting at low fees by offering them the chance to acquire commercial paper in auctions which they could then sell to customers at a profit; (b) gave some assurance to both borrowers (who knew they could fall back on bank loans if the auction failed) & potential investors (who knew that the underwriting banks would always bail them out if the borrower could no longer sell its paper in the marketplace). However, this system has declined in popularity. The market is now more sophsticated. It is easier for borrowers to determine which banks really do have the capacity to distribute the paper and place it with end investors. Also the number of end investors prepared to buy directly has increased and it has

4 become cheaper and more convenient for borrowers simply to select a group of specially designated dealers and allow them to get on with it. The commercial paper market is part of the domestic corporate debt market which also includes the bankers' acceptances market. The first paper was issued on 19/5/86. It was intended for professional investors. There is no stamp duty. Commercial paper does not have to be backed by trade transactions as do acceptances - thus it is of particular interest to the service sector who, because they don't engage in international trade, are unable to issue bills. Commercial paper is not limited to the standard calendar periods of banks' certificates of deposit but can be issued for any maturity from 7 to 365 days. Issuers are required to have their shares listed on the stock exchange and must have net assets of at least 50mn. They must be able to verify that there has been no change in their condition since their previous financial statements. This effectively excludes a number of potential borrwers including state sector entities from the UK and abroad as well as foreign insurers. Banks also are not permitted to issue commercial paper in their own names. Thus, the market was opened to c. 300 UK companies & several dozen foreign borrowers, though regular borrowers will only be a fraction of this number. Large companies are expected to make continuous use of the market, becoming, in effect, deposit takers. The biggest users are able to borrow in their own names but many back issues with bank guarantees to ensure they can roll them over if the market is disrupted. Only banks were allowed to provide guarantees initially. Such guarantees were treated by the Bank of England as contingent liabalities and carried a 0.5 K weighting. In 1986, rival bankers' acceptances accounted for 35% of lending to UK CICs; these are a particularly cheap source of finance because of the Bank of England's use of them in executing monetary policy. Bank of England activity in 1985 drove yields below best bank borrowing rates and made it an extremely cheap source of funds for corporate borrowers. After government stopped overfunding, there was no perceptible narrowing in yield spread between London interbank rates and the eligible bill rate. Most early commercial paper paid at c. LIMEAN (the mid-point between LIBID and LIBOR and thus generally higher than the rate available on bills. Almost certainly cheaper than straightforward bank loans but some large companies say they can raise funds cheaply by borrowing in continental money markets and converting the proceeds to on the forex market. To compete with that, commercial paper which involves extra administrative and legal costs and takes up more management time would have to offer rates well below LIBID. Possible buyers: investment houses, corporate treasurers, banks, dealers; unit trusts need approval of the DTI to include commercial paper in their short-term portfolios. The market topped 1bn in April It was given a boost by the Bank of England selling off large parts of its bill mountain in order to neutralize the impact on the domestic financial system of heavy foreign exchange intervention. The bill mountain dropped from 11.7 bn at the end of 1986 to 4.8 bn by the end of April This may have pushed up yields in the commercial bill market and made it cheaper for companies to issue commercial paper. By the end of June 1987 outstanding paper had increased to 1.66bn. M4 would fall to the extent that companies substituted commercial paper for bank borrowing. commodity swap: a swap in which counterparties exchange cash flows based on a commodity price on at least one side of the transaction. compound option: an option on an option. The holder has the right to purchase another option on a

5 pre-set date, at a pre-set premium. contango: a condition in a futures market where the more distant delivery months trade at a premium to the near term delivery months. contingent contracts: where payments depend on some future event. They include futures and options, letters of credit and forward contracts. convertible bond: a bond which can be converted at the option of the holder either into another bond or into common stock corner: the acquisition of all (or more) of the supply in a market correspondent relationships: network of working balances which banks keep with each other covered call: one of the most popular option strategies, using an existing equity position. Calls are sold on the underlying security with strikes which are higher than the market price. The strike price chosen limits the profit a security holder can realise from the position and this strategy is best used when the holder is fairly certain that there will be little movement in the security's share price credit risk derivatives: products which allow banks to pass on the risk that a customer might default on a loan cross-currency basis swap: currency swap in which both streams are floaring rate interest cross-currency coupon swap: a currency swap which involves one fixed interest stream and one floating interest stream cross-currency swap: a currency swap in which at least one of the streams is a floating rate stream currency swap: an exchange of equal initial principal amounts of two currencies at the spot exchange rate. Over the term of the agreement, the counterparties exchange streams of fixed interest payments in their swapped currencies. At maturity, the principal amount is reswapped at a predetermined exchange rate so the parties endup with their original currencies. Currency swaps have not grown as fast as interest-rate swaps because currency derivatives require higher capital backing under the Basle rules. See also cross-currency swaps cylinder option: the purchase of a call option plus the simultaneous writing of a put option at a lower level. DAX: Deutsche Aktien Index: stock exchange index of thirty top blue chip German companies; the subject of a futures offered by DTB debentures: securities secured against specific assets of the firm deferred strike or deferred start option (or forward start option): allows the holder to defer the setting of the strike price until some future time, up to an agreed deadline. derivative: a contract the value of which changes in concert with the price movements in a related or underlying commodity or financial instrument. The term covers standardised, exchange-traded futures and options, as well as over-the-counter

6 swaps, options, and other customised instruments. DTB: Deutsche Terminbörse - German futures and options exchange dumbbell: (also butterfly) swap effected by replacing long-term and short-term securities with a security of an intermediate maturity which produces the same or an improved yield equity swap: a contract between two counterparties to exchange two different cashflows over time. Over the life of the swap one party agrees to pay the rate of return on an equity or the equity index while the other party agrees to pay a floating or fixed rate of interest. Eurobonds: Bonds issued and sold in a jurisdiction outside the country of the currency of denomination. exploding option (or one-touch option): a European-style call spread with an early exercise price trigger. factoring agencies specialized agencies (usually subsidiaries of banks or finance houses), which unpaid buy up invoices from firms at a discount and then seek full payment from the customer finance houses subsidiaries of banks or independent companies, which raise funds on the wholesale money market in order to lend to firms or consumers or to lease vehicles or plant and machinery. floor: an aspect of a floating rate debt contract that specifies a minimum interest rate for a borrower. foreign bonds: bonds issued within the domestic market of the currency of denomination by non-resident borrowers. forward: an over-the-counter agreement for a buyer and seller to exchange a particular good for a particular price at a specified future date. forward-forward interest rates: Interest rates for periods commencing at points of time in the future; they are implied by current rates for different maturities fungibility: interchangeability of contracts between exchanges. futures contract: an agreement between a buyer and seller to exchange a particular good for a particular price at a future date as specified in a contract common to all participants in a market on an organised futures exchange. Collateral must be posted for performance bonds, and positions are marked to market at least once a day. Gemms: Gilt-edged market makers hedge: a transaction that reduces risk of an underlying security or commodity position by making the appropriate offsetting derivative transaction. Usually limits potential reward of the underlying position. hedge fund: originally hedge funds were US equity funds which hedged against market declines by holding short, as well as long, positions. In recent years, however,

7 funds started using leverage and derivatives to enhance returns and taking large bets on the direction of markets. The picture is further complicated by managed futures funds which use similar techniques to some hedge funds but invest only in derivatives, rather than cash securities. Hedge funds can be divided into twelve sectors including: short-sellers, funds which invest in distressed securities, emerging markets funds, macro funds, convertible arbitrage funds, and merger arbitrage funds. Then there are multi-manager funds which are invested with a selection of hedge-fund managers pursuing different strategies. hedge ratio: the rate of change in the premium for a currency option for a given change in the prevailing spot rate. The lower this ratio (that is, the less sensitive changes in premium are to changes in spot rate) the more contracts that will be required to establish an offsetting relationship between losses on exchange and profits on the option position. The hedge ratio approaches zero as an option moves deeper out of the money and approaches one as an option moves deeper into the money. hybrid security: a complex security consisting of virtually any combination of two or more risk management building blocks - bond or note, forward, future, or option. interest-rate swap: the exchange between counter-parties of fixed-rate and floating-rate debt in a single currency. This gives portfolio managers indirect access to the fixed or floating capital markets or allows them to manage their asset/liability structure. An interest rate swap involves an exchange of cash flows representing interest payments/receipts on an agreed-upon principal amount, the notional principal amount. There is no transfer of principal. investment trust (investment company in the USA) publicly quoted company that specializes in the buying and selling of financial assets. They are closed funds: the total amount of the shares in the trust is fixed, unless there is an issue of new stock. This contrasts with unit trusts, which are 'open ended'. IOSCO: International Organization of Securities Commissions ISDA: International Swap and Derivatives Association Junk Bonds (JBs): were corporate debt instruments that the credit-rating agencies regarded as ` below investment grade' because they thought that the issuing companies might not have been able to meet interest or principal payments. The bonds yielded an average of basis points more than Treasury bonds of similar maturities, but the range was dizzying. LTV, a steel company that sought Chapter 11 protection from its creditors in the summer of 1986, yielded around 35 per cent. In the late 1970s the market consisted largely of debt securities of once-proud companies that were down on their luck ('fallen angels'). That was before Milken (of Drexel Burnham Lambert), who was credited with the discovery that a default rate as low as one per cent was more than discounted by high yields, started issuing JBs for companies that could not otherwise have access to term finance. After 1984, Milken transformed the market by selling high-yield bonds as a means for corporate raiders and shell companies without earnings or assets to leverage up on the assets and cash flow of target companies. He found a ready home for the bonds among insurance companies and thrift institutions desperate to maintain returns against falling interest rates, pension plans, the mutual funds and even the public directly. In 1980 there were 46 issues for a total of $1.38bn; by 1986 this had grown to 210 issues for a total of $29.83bn. The market later collapsed when it became clear that the leading people in the market were not always behaving legally. Milken was later jailed for issuing false prospectuses.

8 Ladder option (or step-lock option): provides the holder with a mechanism of locking in gains on an underlying security during the life of the option, before its expiry. LIBID: London interbank bid rate - the rate in the London market at which prime banks are willing to take Eurocurrency deposits from other prime banks at a given maturity. LIBOR: London interbank offered rate - the rate in the London market at which prime banks offer to make Eurocurrency deposits with other prime banks at a given maturity (from overnight to five years) LIMEAN: The mid-point between LIBOR and LIBID Lookback option: an option the payout of which is calculated using the highest intrinsic value of the underlying security or index over the life of the option. In the case of a Lookback call, the highest market price is used whereas for a Lookback put, the lowest market price is used. market risk: the irreducible risk which cannot be got rid of through risk-spreading or riskpooling MATIF: Marché à Terme International de France - French financial futures and options exchange MEFF: Mercado Español de Futuros Financieros - Spanish futures and options market. It has 2 divisions: Renta Fija (MEFF RF); Renta Variable (MEFF RV) mutual fund see unit trust naked dog basket: a selection of Brady bonds issued in exchange for the rescheduled debts of developing countries. The `dogs' are naked because the yield on the US long bond, which in its zero coupon form serves as collateral for these issues, is stripped from the return on the Bradies. The coupon on the `dogs' is therefore directly tied to the so-called `stripped spread' - the difference between the US long bond rate and the yield on the Bradies. nostro accounts: demand accounts held by banks in foreign countries note issuance facility: An arrangement by which a bank or group of banks agrees to act as managers underwriting a borrower's issue of short-term paper as and when required and to back the facility with medium-term bank credit should the notes not find a market. Note issuance facilities have much in common with syndicated loans in that they may require direct lending by a consortium of banks to the borrower; they differ in that they involve securitisation and the provision of a borrowing facility only part of which is taken up at any time OMX: stock exchange index of the Swedish equity market; subject of a futures contract offered by the Stockholm Options Market (OM) and also traded in London open interest: the total number of contracts outstanding at any time on a futures or options

9 market. Specifically with relation to forex options, the amount of currency which would change hands if all outstanding options were exercised open outcry: system of trading used in derivatives exchanges in which traders negotiate openly in a pit on the exchange floor and every negotiated price is heard by other traders origination: the arranging of finances by an investment bank for the investment programme of a corporate client Outperformance option: a call option which allows an investor to capitalise on diverging performances of two underlying securities, which can be individual stocks, customised baskets of stocks or a specific index. principals system: a system in which members of an exchange deal directly with each other as principals. put option: the right to sell a particular stock, bond, commodity or index at a specified future date at a specified price. puttable bond: a bond which can be redeemed at the option of the holder quanto option (or guaranteed exchange rate option or currency protected option): an option in which foreign exchange risks in an underlying security have been eliminated. repo rate: the interest rate on repurchase agreements. Repurchase agreements are agreements to sell securities on the understanding that they will be repurchased at a certain price at a later time. Most repurchase agreements are for one day (overnight repos). The repo rate is relatively low, exceeding the rate on Treasury bills by only a small amount. risk reversal: this strategy combines the purchase of a put option with the sale of a call option. The put option preserves the capital value of the shareholding while the sale of a call option reduces or eliminates the cost of this insurance, at the expense of giving up some of the upside potential of the stock. securitisation: The conversion of cash flows from specific assets into marketable securities SOFFEX: Swiss Options and Financial Futures Exchange solvency ratio: own capital divided by total liabilities specific risk: the type of risk which financial intermediaries are able to reduce through riskspreading and risk-pooling squeeze: a market manipulation in which an agent obtains market power by accumulating a position in forward trading that is large compared with supply in the underlying spot market straddle: (a) option position which is a combination of a put and a call on the same security at different strike rates for the same expiration date;

10 (b) futures position that is any combination of both long and short contracts of the same security for different delivery months; strangle: option strategy of purchasing a put option with a strike price below that of the underlying instrument and a call option with a strike price above it. If it is believed that the market is overestimating volatility, a strangle would be sold strap: combination of two calls and one put on the same security at different strike prices for the same expiration date subordinated debt: debt ranked below other liabilities in order of priority for payment swap: a contract to exchange a stream of periodic payments with a counterparty. Swaps are available in and between all active financial markets. swaption: an option to enter into a swap contract. The buyer of a receiver swaption has the right to receive a fixed interest rate and pay a floating rate. The buyer of a payer swaption has the right to receive a floating interest rate and pay a fixed rate. Swaptions are used to structure callable/puttable bond issues. SWIFT: Society for the Worldwide Interbank Financial Telecommunications Texas hedge: a transaction that increases risk; two or more related positions whose risk is additive, rather than offsetting. unit trust (known in the USA as a mutual fund) a financial institution, which raises funds from the public and invests the funds in a variety of financial assets, mostly in domestic and overseas equities but also in bonds and money market instruments. They thus provide a relatively low cost means of achieving portfolio diversification. Unit trusts are 'open ended', with the total number of units changing as additional subscriptions are made. value date: the date of actual payment (delivery) of funds in a spot forex deal (by convention two business days after the trade date) vehicle currency: a currency which acts as the exchange vehicle for others venture capital company a company set up with funds obtained from private investors or other financial institutions to provide capital and managerial expertise to new or rapidly growing small companies that have the potential for earning high profits but which are regarded as highly risky by more conservative lenders Warrant: an option to purchase or sell an underlying instrument at a given price and time or series of prices and times. A warrant differs from a put or call option in that it is ordinarily issued for longer than a year.