Derivatives Terms and Definitions Vademecum

Transcription

1 Derivatives Terms and Definitions Vademecum 1st Edition

2 This Vademecum is as of January 2011 and provides initial guidance on certain derivatives terms and definitions. The terms and definitions used in this Vademecum are of generic nature and do not refer to any specific law or regulation. Therefore, terms in this Vademecum may be defined differently in a different context. Nothing in this Vademecum shall constitute or shall be construed or understood as legal advice. Please seek specialist advice from your counsel for any specific issue or question you may have. 2

3 A ABS Asset-Backed Security. AC-DC Option An option that the owner could choose to become at some future date either a Call or a Put option. ADR American Depository Receipt. alpha The amount that an investment s average rate of return exceeds the riskless rate, adjusted for the inherent systematic risk. One way to compute alpha is to regress an investment s excess rate of return (rate of return minus the riskless rate) against the market portfolio s excess rate of return. The intercept in this regression is an estimate of the risk-adjusted excess rate of return. American option An option that can be exercised at any time during the term of the option, up to and including the expiration date of the option. Derivatives Terms and Definitions Vademecum 3

4 Arbitrage The simultaneous purchase and sale of related products in two different markets in order to profit from a discrepancy between the purchase price (undervalued) and the sale price (overvalued), i.e. riskless profit. Asset-Backed Security (ABS) A fixed income security that is typically issued by a Special Purpose Vehicle (SPV) and that pays its coupon and principal from a specific revenue stream and has a specific asset or a pool of assets as collateral. The principal and interest generated by the underlying pool of assets service the principal and interest obligations of the bonds or notes. Thus, the ABS, whose value depends on the underlying revenue stream and collateral, is a Derivative Product in the same sense that financial economists have long recognized that corporate shares and bonds are Derivatives, whose prices depend on the underlying asset value and cash flow. Automatic Early Termination Termination provision which can be elected by the parties under an ISDA Master Agreement pursuant to which the ISDA Master Agreement is automatically terminated upon the occurrence of bankruptcy or insolvency of a counterparty. 4

5 B Barrier Options An option contract for which the maturity, strike price and underlying are specified at inception in addition to a trigger price. The trigger price determines whether or not the option actually exists. In the case of a knock-in option, the barrier option does not exist until the trigger is touched. For a knockout option, the option exists until the trigger is touched. Basis Point One hundredth of one percent per annum, i.e. 1 bp = 0.01%. When applied to a price rather than a rate, the term is often expressed as annualized basis points. Benchmarking A benchmark is a reference point. Benchmarking in financial risk management refers to the practice of comparing the performance of an individual instrument, a portfolio or an approach to risk management to a predetermined alternative approach. Bermudan Option Call or put option which can be exercised on a number of pre-specified days during the life of the option. It is a hybrid between an American and European option. Derivatives Terms and Definitions Vademecum 5

6 Beta A multiplier that measures the movement of an investment in relation to a movement of a benchmark. For example, if an investment has a beta of 1, then the investment will move in parallel to the index as any number times 1 is that number. However, if the beta is 1.5 and the index moves by 10%, then the investment should be expected to move by 15% as 10% times 1.5 is 15%. Bid-Ask Spread The difference between the price that an investor is willing to pay for a security and the price at which the investor is willing to sell the same security. Bond A certificate of debt, generally long-term, under the terms of which an issuer contracts to pay the holder a fixed principal amount on a stated future date and, usually, a series of interest payments during its life. Bond Market Association The former international trade association for the bond market industry. On November 1, 2006 the Bond Market Association merged with the Securities Industry Association to form the Securities Industry and Financial Markets Association. 6

7 Butterfly An option strategy involving three call or put options with strike prices that are equally apart. Buy or sell the option with the lowest strike price, sell or buy twice the quantity at the central strike price and buy or sell the option at the highest strike price. The payoff diagram for this option strategy resembles a picture of a butterfly. C Calculation Agent The party designated as such in relation to an OTC derivative transaction. The calculation agent acts in good faith and a commercially reasonable manner to make determinations relating to any adjustments, disruptions, valuations and settlements that occur throughout the life of the transaction. In most cases the calculation agent will be one of the parties to the transaction. Call Option A call option is a financial contract giving the owner the right but not the obligation to buy a preset amount of the underlying financial instrument at a preset price with a preset maturity date. Derivatives Terms and Definitions Vademecum 7

8 Callable Bond A (noncallable) bullet bond, minus (i.e., short) a Call Option on the bond. The Call Price as a function of calendar time is the call schedule. Cap A cap is a financial contract giving the owner the right but not the obligation to borrow a preset amount of money at a preset interest rate with a preset maturity date. Caption An option on a Cap. Carry The difference between the cost of financing the purchase of an asset and the cash yield of the asset. Positive carry means that the yield earned is greater than the financing cost; negative carry means that the financing cost exceeds the yield earned. Carry trade A trade or strategy where the investor sells a certain currency with a relatively low investment rate and uses the funds to purchase a different currency yielding a higher investment rate. 8

9 Cash market The market where the physical (non derivative) asset trades, e.g., foreign exchange, bonds or equities. Cash Settlement Some derivatives contracts are settled at maturity (or before maturity at close-out) by an exchange of cash from the party who is out-of-the-money to the party who is in-the-money. Central Counterparty (CCP) A Central Counterparty (CCP) is an entity that interposes itself between transacting counterparties as seller vis-à-vis the original buyer and as buyer vis-à-vis the original seller to guarantee execution of the transaction. Thus, the original transacting parties substitute their contractual relationships with each other with contracts with the CCP for the purpose of clearing and settlement of the transaction. Central Counterparty clearing will become mandatory in Europe and the U.S. for certain (standardized) derivatives transactions but is also used in equities markets. Clean price The price of a bond net of accrued interest. Derivatives Terms and Definitions Vademecum 9

10 Close-out A transaction that leaves a zero net position in the market. Usually used in reference to the process following a default. Collar A type of spread option strategy where an investor purchases (or sells) a call option while at the same time sells (or purchases) a put option both of which are out-of-the-money with the same expiry date. If the strikes are chosen so that the purchase price of the call option and the sale price of the put option exactly match, then this is called a costless collar. Collateral An acceptable asset posted to / by a counterparty used as a form of credit protection. Collateralized Debt Obligation (CDO) A security that is linked to a diversified pool of credits which are mostly backed by corporate bonds or other corporate debt. The credits can be assets, such as bonds or loans, or simply defaultable names, such as companies or countries. Collateralized Loan Obligation (CLO) An ABS structure similar to a CMO, but with a portfolio of commercial or personal loans as collateral, instead of a portfolio of Mortgage-Backed Securities and /or mortgage 10

11 loans. A sponsor transfers the collateral into a Special Purpose Vehicle (SPV), such as a trust or corporation, which has no other assets and which issues claims. A typical CLO has more than one tranche or tier, and a more junior tranche has more risk of default. Collateralized Mortgage Obligations (CMO) A type of Mortgage-Backed Security that gives investors the right to receive cash flows from an underlying pool of mortgages in a predetermined order based on priority. Commercial Mortgage-Backed Security (CMBS) A type of bond or note issued by a Special Purpose Vehicle (SPV) where the bond or note is backed by an underlying pool of mortgages on commercial real estate. The principal and interest generated by the underlying pool of assets effectively services the principal and interest obligations of the bonds or notes. Commodity Any raw material or food that can be bought and sold, which includes goods traded on a commodity exchange. Examples of commonly traded commodities include oil, natural gas, gold, beef and grains. Commodity Forward A forward contract which is very similar to a futures contract, Derivatives Terms and Definitions Vademecum 11

12 except that the terms and conditions can be specified to meet the particular needs of the counterparty. These contracts are primarily on agricultural or precious metal commodities and can be used for hedging, arbitraging and speculating against the future price of the underlying asset. Commodity Swap A contract in which counterparties agree to exchange payments related to indices, at least one of which (and possibly both of which) is a commodity index. Confirmation A document that defines a derivatives contract in writing that a dealer has entered into with a customer. The Confirmation ordinarily incorporates one or more ISDA documents by reference. Constant Maturity Derivatives A derivative where the payoffs are based on swap rates or bond yields (multiple payments) but the payoffs are calculated as if the rates or yields were zero coupon rates. The term constant maturity swap (CMS) is used when the derivative is based on swap rates and the term constant maturity treasury (CMT) is used when the derivative is based on bond yields. 12

13 Constant Maturity Swap (CMS) An interest rate derivative with a payoff that is based on a swap rate of a specific maturity. For example, while a regular floating rate note might pay semi-annual coupons based on semi-annual fixings of 6-month EURIBOR, a CMS note might pay semi-annual coupons based on semi-annual fixings of the 10-year semi-annual swap rate. Note, however, that the coupon frequency need not match that of the underlying swap rate: the note might pay semi-annual coupons based on fixings of the 10-year annual swap rate, for example. Contingent Swap Generic term for a swap that is activated when rates reach a certain level or a specific event occurs. Swaptions are often considered to be contingent swaps the specific event in this case being the exercise of the option. Other types of swaps, e.g., droplock or spreadlock swaps, are activated only if rates drop to a certain level or if a specified level over a benchmark is achieved. Contract for Difference A cash settled total return swap or forward where the parties agree to exchange on the maturity of the contract the difference between the opening price and closing price of the underlying. Derivatives Terms and Definitions Vademecum 13

14 Convertible Bond A bond that can be converted into a predetermined amount of the entity s (issuer) equity at certain times during its life; giving the bondholder the option to exchange the bond for shares in the entity. Basically, this is a bond with an embedded call option. By including the call option, issuers can issue the debt at lower interest rates. Counterparty Risk The risk posed by the possibility the other party with which an investor has entered into a financial arrangement may fail to make their required payments. Coupon The agreed upon interest rate that the issuer must pay the purchaser of a bond during the life of the bond. Covered Bond A debt security backed by cashflows from mortgages or public sector loans. They are similar to asset-backed securities created in securitization, however, covered bond assets remain on the issuer s consolidated balance sheet. Credit Default Swap (CDS) A credit derivative where the seller agrees, for an upfront or continuing premium or fee, to compensate the buyer when a 14

15 specified event, such as default, restructuring of the issuer of the reference entity, or failure to pay, occurs. The value of the swap depends on two default probabilities and the correlation between them: that of the reference entity and that of the counterparty. Credit Default Swap Options Also known as a credit default swaption, it is an option on a credit default swap (CDS). A CDS option gives its holder the right, but not the obligation, to buy (call) or sell (put) protection on a specified reference entity for a specified future time period for a certain spread. The option is knocked out if the reference entity defaults during the life of the option. This knock-out feature marks the fundamental difference between a CDS option and a vanilla option. Most commonly traded CDS options are European style options. Credit Derivatives Derivative Products with payoffs that depend on risk factors related to credit quality, price discount from par, or a credit event. Credit Event An event linked to the deteriorating credit worthiness of an underlying reference entity in a credit derivative, usually a default or, possibly, a credit downgrade by a rating agency of Derivatives Terms and Definitions Vademecum 15

16 an entity. The reference entity may be a name, a bond, a loan, a trade receivable or some other type of liability. Credit Linked Note (CLN) A note that pays interest and repays principal that depends on a credit event. Credit Risk Credit risk is the risk of loss from a counterparty in default or from a negative change in the credit status of a counterparty that causes the value of their obligations to decrease. Credit Support Annex (CSA) The legal document which regulates credit support (collateral) for derivative transactions. A standard CSA for OTC derivatives transactions has been developed by the ISDA. It is one of the four parts that make up an ISDA contract but is not mandatory. It is possible to have an ISDA agreement without a CSA but normally not a CSA without an ISDA. Commonly used are the English law CSA and the New York law CSA that are published by ISDA. Credit Support Deed (CSD) The English law legal document which regulates credit support (collateral) for derivative transactions. A standard CSD for OTC derivatives transactions has been developed by the 16

17 ISDA. Different from the ISDA CSA under the CSD no title is transferred but a security interest over the collateral is created. The CSD must be registered at Companies House in the UK. Currency Swap An exchange of interest rate payments in different currencies on a preset notional amount and in reference to predetermined interest rate indices in which the notional amounts are exchanged at inception of the contract and then exchanged again at the termination of the contract at preset exchange rates. D Definitions The market standard provisions by which the terms of a derivatives transaction are described. Definitions are published and maintained by ISDA. Deliverable Obligation An asset that is eligible to be delivered to the protection seller following a credit event or that can be used to provide the reference price for cash settlement of a credit derivative. Delta The sensitivity of the change in the financial instrument s price to changes in the price of the underlying asset. Derivatives Terms and Definitions Vademecum 17

18 Derivative A financial instrument that transfers risk from one party to the other. It derives its value from the price or rate of some underlying assets such as bonds, loans, equities, currencies, commodities, indices, published rates or combinations of such assets. Dirty price The quoted bond price, including the accrued interest. E Effective Day The date on which obligations under a derivative transaction begin to accrue or take effect. Equity Swap A contract in which counterparties agree to exchange payments related to indices, at least one of which (and possibly both of which) is an equity index. European Banking Federation (EBF) An organization of the European banking sector, representing the interests of over 5000 European banks in 31 countries. 18

19 European Master Agreement (EMA) European Master Agreement for Financial Transactions is a standard master agreement for multi-product transactions (e.g., repos, security loans) that is published and maintained by the Banking Federation of the EU in cooperation with the European Savings Banks Group and the European Association of Co-operative Banks. The EMA consolidates various master agreements used within the euro area and neighbouring countries into a single set of harmonised documents. European Style Option An option that can be exercised only at expiry as opposed to an American Style option that can be exercised at any time from inception of the contract. European Style option contracts can be closed out early, mimicking the early exercise property of American style options in most cases. Exercise price The fixed price, per share or unit, at which an option buyer (holder) has the right to buy (call) or sell (put) the underlying asset. Expiration date The last date on which an option can be exercised. After this date the option is deemed to lapse or be abandoned. Derivatives Terms and Definitions Vademecum 19

20 F Floor A floor is a financial contract giving the owner the right but not the obligation to lend a preset amount of money at a preset interest rate with a preset maturity date. Forward Contracts An over-the-counter obligation to buy or sell a financial instrument or to make a payment at some point in the future, the details of which were settled privately between the two counterparties. Forward contracts generally are arranged to have zero mark-to-market value at inception, although they may be off market. Examples include forward foreign exchange contracts in which one party is obligated to buy foreign exchange from another party at a fixed rate for delivery on a preset date. Off market forward contracts are used often in structured combinations, with the value on the forward contract offsetting the value of the other instrument(s). Futures Contracts An exchange-traded obligation to buy or sell a financial instrument or to make a payment at one of the exchange s fixed delivery dates. 20

21 G Gamma Gamma (or convexity) is the degree of curvature in the financial contract s price curve with respect to its underlying price. It is the rate of change of the delta with respect to changes in the underlying price. Positive gamma is favorable. Negative gamma is damaging in a sufficiently volatile market. The price of having positive gamma (or owning gamma) is time decay. Only instruments with time value have gamma. Global Master Securities Lending Agreement (GMSLA) A standard repurchase agreement published and maintained by ISLA (also known as a repo or Sale and Repurchase Agreement) that allows a borrower to use a financial security as collateral for a cash loan at a fixed rate of interest. In a repo, the borrower agrees to sell immediately a security to a lender and also agrees to buy the same security from the lender at a fixed price at some later date. A repo is equivalent to a cash transaction combined with a forward contract. The cash transaction results in the transfer of money to the borrower in exchange for the legal transfer of the security to the lender, while the forward contract ensures repayment of the loan to the lender and the return of the borrower s collateral. The difference between the forward price and the spot price is the Derivatives Terms and Definitions Vademecum 21

22 interest on the loan while the settlement date of the forward contract is the maturity date of the loan. Green Shoe option An underwriter s right to issue more than the stated number of shares of an issue. Named after the Green Shoe Company, which was the first issuer to grant an underwriter such an option. Gross A derivative or asset position expressed without netting bought and sold trades. H Haircut The excess of an asset s market value over either (a) the regulatory capital value or (b) the loan for which it can serve as adequate capital. Hedge A transaction that offsets an exposure to fluctuations in financial prices of some other contract or business risk. It may consist of cash instruments or derivatives. 22

23 I Interest Rate Swap An exchange of cash flows based upon different interest rate indices denominated in the same currency on a preset notional amount with a predetermined schedule of payments and calculations. Usually, one counterparty will receive fixed flows in exchange for making floating payments. International Securities Lending Association (ISLA) An independent trade association established in 1989 to represent the interests of the securities lending industry, headquartered in the United Kingdom. International Swaps Dealers Association (ISDA) The global trade organization which represents participants in the OTC derivatives industry. Intrinsic value The amount that would be realized if an option were immediately exercised. ISDA Master Agreement A standard agreement for OTC derivatives transactions that is published and maintained by ISDA. There are two basic forms of Master Agreement: single jurisdiction / currency and multiple Derivatives Terms and Definitions Vademecum 23

24 jurisdiction / currency. One of these documents is generally combined with a Schedule to set out the basic trading terms between the parties; each subsequent trade is then recorded in a Confirmation which references the Master Agreement and Schedule. The terms of the Schedule are often negotiated, and many firms have preferred versions of the Schedule. Issue price The percentage of principal value at which the price of a new issue of securities is fixed. itraxx indices A family of credit derivative indices, where the underlying reference entities are a defined basket of European credits. The underlying reference entities are reassessed every 6 months, following dealer liquidity polls. The indices are highly liquid and traded using ISDA standard documentation, to standard maturities. They are used by both buy side and sell side institutions for creating credit exposure as well as hedging. K Knock-in Option An option the existence of which is conditional upon a preset trigger price trading before the option s designated maturity. 24

25 If the trigger is not touched before maturity, then the option is deemed not to exist. Knock-out Option An option the existence of which is conditional upon a preset trigger price trading before the option s designated maturity. The option is deemed to exist unless the trigger price is touched before maturity. L Ladder option An option that locks in gains once the underlying asset reaches certain price levels. Legal Risk The general potential for loss due to the legal and regulatory interpretation of contracts relating to financial market transactions. Leverage The magnification of gains and losses by only paying for part of the underlying value of the instrument or asset. Liquidity Risk The risk that an entity will not be able to find a price (or a price Derivatives Terms and Definitions Vademecum 25

26 within a reasonable tolerance in terms of the deviation from prevailing or expected prices) for one or more of its financial contracts in the secondary market. Long form confirmation A confirmation that is independent of any master agreement incorporated by reference. M Margin A credit enhancement provision to master agreements and individual transactions in which one counterparty agrees to post a deposit of cash or other liquid financial instruments with the entity selling it a financial instrument that places some obligation on the entity posting the margin. Mark to Market The process of daily adjustment of a financial instrument value to reflect its current market value as the prices go up and down in the market. Market Maker A dealer who is prepared to make a market by quoting simultaneous bid and offer prices. 26

27 Market Risk The exposure to potential loss from fluctuations in market prices (as opposed to changes in credit status). Master Confirmation Agreement (MCA) An agreement between two counterparties which sets out the terms and conditions that will apply between them in relation to a particular type of derivative transaction. The MCA is supplemented by a Transaction Supplement which records the economic terms specific to each transaction. A variety of MCA templates is published and maintained by ISDA. N Netting When there are cash flows in two directions between two counterparties, they can be consolidated into one net payment from one counterparty to the other thereby reducing the settlement risk involved. Notional amount The amount of principal underlying the derivative contract, to which interest rates are applied in order to calculate periodic payment obligations. Derivatives Terms and Definitions Vademecum 27

28 Novation The process by which one counterparty (transferor) agrees to transfer to a third party (transferee) its obligations under an existing transaction they have with another counterparty (remaining party). Novation protocol A document published by ISDA that defines market standard procedures for novating interest rate and credit derivative transactions. O Open Interest Exchanges are required to post the number of outstanding long and short positions in their listed contracts. This constitutes the open interest in each contract. Operational Risk The potential for loss attributable to procedural errors or failures in internal control. Option The right but not the obligation to buy (sell) some underlying cash instrument at a predetermined rate on a predetermined expiration date in a preset notional amount. 28

29 Over the counter (OTC) transaction A derivative transaction between two counterparties where the terms of such transaction are freely negotiated (as distinct from an exchange traded transaction where the terms are prescribed by the rules of the relevant exchange). P Partial cash settlement The cash amount paid by a buyer to a seller when a buyer of protection is unable to deliver all of the deliverable obligations. Partial cash settlement allows the obligation to be settled as a combination of both cash and physical settlement. The cash value is determined by the calculation agent seeking quotations from dealers. Partial termination A reduction of the notional amount of a derivative contract. Par value The principal amount of a bond. Also known as the face value. Physical Settlement The meeting of a settlement obligation under a derivative contract through the receipt or delivery of the actual underlying instead of through cash settlement. Derivatives Terms and Definitions Vademecum 29

30 Plain Vanilla Swap The most common interest swap involving one party, the fixed rate payer, making fixed payments, and the other party, the floating rate payer making payments which depend on the level of future interest rates. Interest rate payments are made on a notional amount and there is no exchange of principal. Premium The cost associated with a derivative contract, referring to the combination of intrinsic value and time value. It usually applies to options contracts. However, it also applies to off market forward contracts. Protection buyer The credit default swap counterparty that pays another counterparty to compensate them in the event that the reference entity suffers a credit event. Protection seller The credit default swap counterparty that takes on credit risk of a reference entity in return for appropriate compensation. Put Option A put option is a financial contract giving the owner the right but not the obligation to sell a preset amount of the underlying financial instrument at a preset price with a preset maturity date. 30

31 Q Quant Fund A group of securities that has been selected, bought, sold and analyzed according to a computer which has been programmed to meet specific investment criteria. Quantitative Analysis A type of measurement tool that uses mathematical and statistical modelling by applying numerical data such as earned interest, market share etc. in order to determine the price of financial instruments. Quanto A product where the underlying is denominated in one currency but settled at a fixed rate in another currency. It uses a floating rate of a currency but applies this to a notional amount in another currency. Quanto Derivative A cash settled derivative that has an underlying asset denominated in one currency, but its payoff is in another currency which is often multiplied by a constant and is considered as a fixed exchange rate. Derivatives Terms and Definitions Vademecum 31

32 R Regulatory Risk The potential for loss stemming from changes in the regulatory environment pertaining to derivatives and financial contracts, the utility of these instruments for different counterparties, etc. Reference entity The underlying company or sovereign which issues the debt obligation or obligations which constitute the reference obligations under a credit derivative. Reference obligation A bond, loan or other payment obligation, issued by the reference entity. A failure by the reference entity to comply with the material terms of a reference obligation will constitute a credit event under a credit derivative. Residential Mortgage-Backed Security (RMBS) A type of bond or note issued by a Special Purpose Vehicle (SPV) where the bond or note is backed by an underlying pool of residential mortgages, home equity loans and subprime mortgages. The principal and interest generated by the underlying pool of assets effectively services the principal and interest obligations of the bonds or notes. 32

33 Rho The rate at which the price of a derivative changes relative to change in the risk-free rate of interest. S Scheduled termination date The scheduled date on which a derivative contract ceases to be effective. Securities Industry and Financial Markets Association (SIFMA) The securities industry trade association representing securities firms, banks, and asset management companies in the U.S. and Hong Kong. SIFMA was formed on November 1, 2006, from the merger of The Bond Market Association and the Securities Industry Association Settlement The process whereby obligations arising under a derivative transaction are discharged through payment or delivery or a combination of both. Settlement Risk The risk of non-payment of an obligation by a counterparty to a transaction, exacerbated by mismatches in payment timings. Derivatives Terms and Definitions Vademecum 33

34 Special Purpose Vehicle (SPV) A corporate entity used for a wide variety of purposes including to securitize loans in order to help spread the credit and interest rate risk of their loan portfolios over a number of investors. SPVs are typically ring-fenced for the purposes of insolvency to provide investors with recourse to a specific portfolio of assets. Spot The price in the Cash Market for delivery using the standard market convention. In the foreign exchange market, spot is delivered for value two days from the transaction date or for the next day in the case of the Canadian dollar exchanged against the US dollar. Spread The difference in price or yield between two assets that differ by type of financial instrument, maturity, strike or some other factor. A credit spread is the difference in yield between a corporate bond and the corresponding government bond. A yield curve spread is the spread between two government bonds of differing maturity. Strike Price The price at which the holder of a derivative contract exercises his right if it is economic to do so at the appropriate point in time as delineated in the financial product s contract. 34

35 Swap A derivative where two counterparties exchange streams of cashflow with each other. These streams are known as the legs of a swap and are calculated by reference to a notional amount. Swaption An option to enter into a predetermined swap transaction. Synthetic CDO A structure which typically has a non-physical asset portfolio. This structure is often issued as single tranche deal. The risk profile of the tranche will be bespoke, in line with investor requirements. T Time value The amount by which the premium of an option exceeds its intrinsic value. Where an option has no intrinsic value the premium consists entirely of time value. Total Return Swap The synthetic purchase of debt with 100% leverage. One of the counterparties receives (and the other pays) the excess of the risky debt s total rate of return (interest plus capital gain) over a floating rate, such as EURIBOR. Derivatives Terms and Definitions Vademecum 35

36 Trade date The date on which the terms of a derivative transaction are agreed. Transaction Supplement The short confirmation that evidences a transaction under a Master Confirmation Agreement (MCA), referred to commonly as short form. U Underlying An asset or financial instrument upon which a derivative depends. The price of the underlying determines the price of the derivative that is linked to it. As the underlying s price fluctuates so will the value of the derivative. V Value at Risk or VaR The calculated value of the maximum expected loss for a given portfolio over a defined time horizon (typically one day) and for a preset statistical confidence interval, under normal market conditions. 36

37 Variance swap A contract that pays off an amount proportional to the difference between the realized variance over a specific period of time and the contractual variance. Vega The measure of volatility in option theory. Volatility In finance, the standard deviation of the continuously compounded returns of a financial instrument within a specific time horizon. It is used to qualify the risk of the financial instrument over the specified time period. W Warrant An option on an underlying asset which is in the form of a transferable security and which can be listed on an exchange. Waterfall Payment allocation of principal and interest cash flows to debt holders in order of priority in a multi-tranche security such as a CDO. Derivatives Terms and Definitions Vademecum 37

38 Weather Derivatives A derivative where the underlying is weather related (rain, snow, temperature) and the payoff is dependent on the weather. These instruments are used by companies to reduce risk associated with adverse (not disastrous) weather conditions resulting in losses. Y Yield Curve For a particular series of fixed income instruments such as government bonds, the graph of the yields to maturity of the series plotted by maturity. Yield to maturity The amount of interest on an annual compound basis, which a bond would pay if held until redemption or the maturity date. Also, the interest rate that, if used to discount all cash flows, would yield the current price. Z Zero Coupon Instruments Fixed income instruments that do not pay a coupon but only pay principal at maturity; trade at a discount to 100% of 38

39 principal before maturity with the difference being the interest accrued. Derivatives Terms and Definitions Vademecum 39

40 Morgan Lewis is a leading international law firm with approximately 1,300 lawyers in 23 offices worldwide. For further information on derivatives or other financial issues please contact Dr. Torsten Schwarze or Dr. Jens-Dietrich Mitzlaff at: finance@morganlewis.de Morgan, Lewis & Bockius LLP OpernTurm Frankfurt am Main Tel Fax: frankfurtoffice@morganlewis.de