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Financial Markets Dictionary
A B C D E F G H I J K L M N O P Q R S T U V W X Y Z

Browse terms by letter:

A
AAA
The top rating accorded by ratings agencies such as Moody's Investor Services and Standard & Poor's.
Above Par
A bond, debenture, share or other security that is at a price higher than its face value is said to be above par. If a bond has a face value above $100 and it's market price is quoted at $103, then it is well above par. Securities carrying coupons -such as Commonwealth bonds - are above par if their market yield is below their coupon rate.
Accrued Interest
Interest accounted for but not yet due for payment; a receivable not yet due.
Activity Indicators
Indicators that show which stage of the business cycle the economy may be in. Activity indicators include industrial production, capacity utilization, and volume of retail sales.
Alpha
In the context of stock returns, alpha measures the risk-adjusted performance of a security or fund. It is the return on a security in excess of what would be predicted by a risk/return model. In a regression equation, alpha gives the value of the dependent variable when the independent variable has a value of zero, i.e. it gives the intercept of the line with the y-axis.
Analytical Model
One of the three main classes of option pricing model (along with analytical approximation and numerical models) which, like the Black-Scholes model, finds an explicit solution to the problem of pricing a particular option using mathematical functions. While these models are simple they cannot handle the early exercise features of American style options and become inaccurate as tenor increases because they cannot easily take into account time dependency of volatility or interest rates. These models are also known as closed-form solutions.
Arbitrage
The action of profiting from the correction of price or yield anomalies in markets. Often this will involve taking a position in one market or instrument and an offsetting position in another. As prices or yields move back into line, all positions may be profitably closed out. An arbitrageur is an individual or institution practicing arbitrage.
Asset Backed Security
Financial instrument secured by a pool of assets such as property, a mortgage or credit card receivables.
Asymmetric Payoff
The skewed profit pattern associated with options that gives profit sharing on one side of the payoff (upside) and limited loss potential on the downside.
At-the-Money (ATM)
At-the-money is a term used to describe the relationship between the strike price of the option and the current market rate. Options can be either:

At-the-Money (ATM): At the Money Spot (ATMS)

An option which has it's strike set equal to the prevailing spot exchange rate. The delta of this option will be affected by the extent and direction of the interest rate differential (forward points).

At-the-Money (ATM): At the Money Forward (ATMF)

An option which has it's strike set equal to the prevailing forward exchange rate. At inception the delta of this option will be very close to 50.
Average Options
These are options where settlement involves taking an average of the underlying spot price series. There are two types of average options. Average rate options are similar to vanilla options except that they are settled with reference to an average of the spot price over the option period and not the spot price at maturity. The extent of averaging is determined by the buyer of the option. Average rate options are generally cheaper than equivalent vanilla options because the averaging process has the effect of lowering the volatility of the underlying price series. The greater the number of averaging dates the lower will be the price of the option.

B
Backwardation
In commodity markets, backwardation is a situation where the cash or near delivery price is at a premium to the price for forward delivery. It is the opposite of contango. Generally in futures markets backwardation is used to describe when a futures price that falls below the cash equivalent. Shortage of supply is often to blame, because demand for the spot or cash product rises sharply, but the futures price stays steady because more supplies are expected in the future.
Balloon Option
An option where the face value increases if a trigger level is breached. Simply a combination of a vanilla and a knock-in option.
Bank Bill of Exchange
A bill of exchange on which the name of a bank appears, either as acceptor or endorser. When the bank is the acceptor, the bill ranks as a bank accepted bill; where the bank has endorsed the bill on the back, either through buying the bill in the market or for a fee to raise the bank's status, it ranks as a bank-endorsed bill of exchange
Barrier Options
The most common barrier option is one where the barrier is triggered when the option is out-of-the-money. For example, an AUD Call / USD Put struck at 0.7900 could have either a knock-out or knock-in at 0.7600 attached. At a spot level of 0.7600 the AUD Call option is out-of-the-money and therefore has no intrinsic value. This is referred to as a Conventional Barrier. However, it is also possible to attach barriers which are in-the-money relative to the strike of the option. Using the above example, the barrier would need to be set above 0.7900. In this case the option would have intrinsic value at the time the barrier was triggered. This is generally referred to as a Reverse Barrier. The value of a Reverse Barrier is a function of two factors - the probability of the spot rate breaching the barrier level, and the amount of intrinsic value in the option at the barrier level. These two factors will generally have offsetting influences on the option price with one or the other dominating depending upon the probability of reaching the barrier.

Barrier Options: Conventional and Reverse

The most common barrier option is one where the barrier is triggered when the option is out-of-the-money. For example, an AUD Call / USD Put struck at 0.7900 could have either a knock-out or knock-in at 0.7600 attached. At a spot level of 0.7600 the AUD Call option is out-of-the-money and therefore has no intrinsic value. This is referred to as a Conventional Barrier. However, it is also possible to attach barriers which are in-the-money relative to the strike of the option. Using the above example, the barrier would need to be set above 0.7900. In this case the option would have intrinsic value at the time the barrier was triggered. This is generally referred to as a Reverse Barrier. The value of a Reverse Barrier is a function of two factors - the probability of the spot rate breaching the barrier level, and the amount of intrinsic value in the option at the barrier level. These two factors will generally have offsetting influences on the option price with one or the other dominating depending upon the probability of reaching the barrier.

Barrier Options: Description

These are similar to vanilla options in all respects except that at a certain level of the spot rate the option may cease to exist (with a knock-out) or come into being (with a knock-in). Barrier options still have an associated premium, payable two business days after inception of the option. These options will never be more expensive than the comparable vanilla option because there is a certain probability that the option will cease to exist or never actually knock in. The price discount to the comparable standard option is a function of the probability that the option will knock out or not knock in and is dependent upon the level of volatility and time to maturity. It is possible to have more than one barrier attached (double barrier), and operation of the barrier can be time dependent.

Barrier Options: Down, Up, In, and Out

These terms are used to describe the direction and implication of the barrier attached to an option. For example the terms Up and Down refer to the direction that the spot must take to reach the barrier level. A single barrier will have only an up or a down barrier whereas a double barrier will have an up and a down barrier. The terms In and Out simply indicate whether the option knocks in or out when the barrier is breached. A double barrier may have two In Barriers, two Out Barriers, or one of each.>

Barrier Options: Pricing

Because of the additional risk associated with barrier options (for example the slippage and time decay risk discussed elsewhere) the theoretical price given by the market volatility for vanilla options may need to be adjusted. In this case the option trader will use the theoretical price as a starting point but then try to assess the risk in the deal which is not priced under Black Scholes assumptions. The hedging risk associated with barrier options, sometimes referred to as slippage, arises due to one of the major assumptions made under the BS pricing theory - that of continuous hedging in the underlying market. The very fact that hedging is not continuous, combined with the risk of discrete changes in the delta, creates the additional risk in a barrier or digital option.As a result the level of volatility implied from a barrier or digital price can be significantly different to the level of implied volatility trading for a comparable vanilla option. The conventional pricing model does not take into account additional risk that may be built into the dealing price for the barrier option.

Barrier Options: Two Barriers

The most common type of barrier option involves just one barrier level. However, it is also possible to attach two barrier levels. Consider an AUD Call struck at 0.7800 with a knockout at 0.7700 attached. The probability of reaching the barrier level would result in a reduction in the price of the barrier option relative to the vanilla option. Further, by attaching another knockout barrier at say 0.7900 the probability of knocking out is increased and the premium could be reduced even further. The option would now knockout if eitherbarrier( 0.7700or 0.7900) is breached. This double knockout option now has risk characteristics associated with both conventional and reverse barrier options (see appropriate section). The same principle can be applied to knock-in options. The addition of an extra knock-in level can increase the probability of the option knocking in and so increase the price of the knock-in option. Once again the double barrier has risk characteristics associated with both conventional and reverse barrier options.
Basis Risk
The possibility that an imperfectly matched hedge could produce a loss, eg, a hedger has taken offsetting positions in two related markets but not perfectly matched markets such as using bank bill futures to hedge a position in two year bonds.
Basket Options
Basket options are part of the correlation based family of options. They are designed to work along the same lines as standard currency options except that the strike of the basket option is based on the weighted value of the component currencies expressed in the buyer's base currency. The weightings attached to the currencies in the basket usually reflect the buyer's actual foreign exchange exposures.The holder of the basket option has the right, without the obligation, to buy (or sell) the specified basket of foreign currencies in exchange for a fixed amount (the strike) of the base currency on a specific date in the future. The decision to exercise a basket option at expiry will be based on a comparison between the spot value of the fixed foreign currency amounts making up the basket and the strike value of the option (both expressed in base currency terms).One of the key advantages of using a basket option lies in its lower premium when compared with the cost of the series of equivalent standard options. This premium saving derives from the lower volatility of the underlying basket of currencies. As the volatility of a basket of currencies will always be less than the average of the individual volatilities (provided the currencies are less than perfectly positively correlated) it will always be cheaper to create a single basket option than to buy a basket of options to protect each individual currency. The crucial factor determining the extent of this premium saving is the degree of correlation between the currency pairs that constitute the basket. In general the lower the correlation between the individual currency pairs the lower the premium for the basket option compared to the total price of the equivalent individual options.
Below Par
Trading at less than face value.
Bid and Ask
Buy and sell prices. Traders also speak of a bid price, the price offered; the asking price is the price requested. These usually indicate the top price a purchaser will pay and the lower price a seller will accept.
Bid-Ask Spread
The difference between the bid and offer prices. This can say a great deal about a market - about it's liquidity, volume, depth and enthusiasm or otherwise of its participants.
Bills of Exchange
Defined in the Bills of Exchange Act 1909 as an unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable future time, a sum certain in money to or to the order of a specified person, or to bearer.

At a more practical level a bill of exchange is generally described as a negotiable instrument maturing within six months (at which time it will be redeemed at its face value), sold at a discount to face value, which the market believes to be the obligation (ie. debt) of a first class credit.

Bills of Exchange (Bank Accepted/Endorsed)

A bill of exchange is a negotiable instrument on which the name of a bank appears either as acceptor or endorser. Where the bank is the acceptor, the bill ranks as a bank accepted bill. Where the bank has endorsed the bill on the back, either through buying the bill in the market or for a fee to raise the bill's status, it ranks as a bank endorsed bill.

Defined in the Bills of Exchange Act as an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay on demand or at a fixed or determinable future time a sum in money for or to the order of a specified person or to bearer.
Binomial Option Pricing Model
This is an option pricing model which uses the binomial tree to model the price of the FX spot rate. It is the most common type of numerical model. The key to the binomial (or lattice) based model is the division of the time to expiry into discrete intervals or steps. By working backward through the lattice from expiration, at which time the value of the option is known, options can be evaluated by discounting the terminal payoff through the tree. The lattice based model gives rise to a procedural method rather than a closed formula for determining the option value.
Binomial Tree
This is a model which describes movements in the spot exchange rate, and is used commonly in pricing currency options. This model is based upon the premise that an exchange rate, starting at a given point, can either move up or down with each step assigned a defined probability and size. Taking each of the two outcomes we can again step each rate either up or down, the up-down steps and the down-up steps meeting at the same rate so that we now have 3 possible outcomes. Continuation of this movement will result in the building of a "tree", the branches of the tree defined by the steps taken by the exchange rate.
Black Scholes and Garman Kohlhagen
The Black Scholes (BS) model was the first formalised pricing model which attempted to find the theoretical price of a European style option. This model was devised by Fischer Black and Myron Scholes in 1973 and was designed initially to price options on equities. It is a closed form solution and makes a number of assumptions, including; the ability to hedge continuously, that price returns are normally distributed, no transaction costs, constant interest rates, constant volatility, and that price action follows a diffusion model.
Bond
A statement of debt similar to an IOU. Bonds are issued by governments, companies and other entities and individuals in return for cash from lenders and investors. The borrower pays interest to the lender or investor through the life of the bond. Borrowers seeking funds from the public through bond issues usually announce the issues through the financial press and electronic media, and spell out the details in a prospectus available from stockbrokers, banks and in the case of Commonwealth securities, the Reserve Bank. Bonds are generally medium to long term fixed interest securities. An early definition of a bond was a "coupon security offering more than one interest payment" but the emergence of zero coupon bonds has complicated the picture.
Bond Equivalent Yield
The calculation which converts the yield of a money market instrument such as a Treasury bill into the equivalent yield of a Treasury bond.
Bond Market
The market trading bonds - Commonwealth, State Government & Corporate. Bond trading is carried out via phone and screen by organisations such as professional bond brokers and dealers, banks, investment banks and fund managers.
Bond Relative Value Rank
The relative value rank indicates the relative position of today's bond spread vs the range traded over the last 6 months. For example, if a bond issue is currently trading at 47 and the last 5 days spreads were 43,44,49,44 and 47, then the relative value rank would be 80% in this case. A higher(lower) value generally denotes that the bond is cheaper (more expensive) relative to its trading history.
Bond Tender
A form of auction through which Commonwealth Treasury bonds have been sold since July 1982.
Bond Washing
Selling a security-cum-interest and buying it back after the coupon is paid so as to convert the interest income into a capital gain. This is worthwhile only where lower tax rates apply to capital gains.
Book Building
An exercise by an investment bank lead-managing a new issue to ascertain the likely levels of demand for a security at different prices. It is designed to prevent an issue being undersubscribed because of a large discrepancy between the issue price and the price at which the security starts trading on the secondary market.
Breakout
Term used in technical analysis to describe when a price climbs above a resistance level (usually its previous high) or falls below a support level (usually its previous low). Breakouts usually occur when a trend line or formation is broken.
Bulldogs
Bonds issued by non-British issuers but documented under British law for sale to UK investors
Butterflies
A butterfly is a hedging strategy that involves a bull (bear) spread combined with a sold put (call) to offset the premium cost. The currency hedger is able to sell the put or call because it is against an open exposure and only provides potential for opportunity loss. For example, consider the exporter who buys the bull spread and sells a put option to fund it. If the AUD falls to below the strike of the sold put option the exporter will be forced to purchase AUD at that level, removing any ability to take advantage of a lower AUD. However, the exporter has an underlying need to purchase AUD and so does not open up a new underlying risk.

C
Calendar Spread
Generally a trading strategy which involves the simultaneous buying and selling of options with the same strike but different maturities. A trader would use this strategy to take advantage of expected changes in the shape of the volatility curve (see section on Term Structure). For example a trader who expected the volatility curve to change from upward sloping to flat would buy the shorter date option and sell the longer date option, usually in face value amounts which create a vega neutral position over the curve. If they are correct the profit made on one option will more than offset any loss on the other and the strategy will generate a profit.
Capital Gain
The result of selling a capital asset at a higher price than it cost. Whether an investor makes a capital gain or not depends on the purchase price of an asset compared to its selling price, the effect of depreciation on its value and whether inflation has bitten into the investor's profit margin.
Capped Note
A floating rate instrument with an embedded cap that places a maximum coupon rate on the issue.
Chooser Option
An option which in most respects is the same as a vanilla option except that it is neither a put nor a call until a decision is made at a predetermined point after the start date and before the maturity date.
Collars and Ratio Collars
A collar is a simple option structure involving the simultaneous sale of a call (put) option and purchase of a put (call) option, with the same expiry dates and face values. This structure is generally referred to as a risk reversal when traded in the interbank market. The strikes of the two options will generally be set out-of-the-money, and usually a similar distance from the prevailing forward rate. In this case the premiums will offset each other, providing for a zero-cost structure. In general the client will choose one of the option strikes and the bank will solve for the strike of the other option to make the structure zero cost.
Commercial Paper
The technical term used to describe domestic short-term promissory notes issued as evidence of debt. The issuer/ seller/ borrower raises the funds for a fairly short period (one to six months) most likely with periodic rollovers. Funds raised this way are usually used for working capital and liquidity. In Australia, promissory notes, commercial bills and non-bank certificates of deposit are types of commercial paper.
Commonwealth Bond
A security issued by the Commonwealth government as borrower, in return for cash from investors who buy the bonds. Investors are lending their money to the government for a given period (the life of the bond, unless they sell the bond before it matures) in return for interest paid, usually half yearly, by the government. Commonwealth bonds are sold through periodic tenders or auctions.
Compound Option
A compound option is an option to buy or sell another option at a predetermined date and premium. There are two components making up the whole compound option - the underlying option and the compound component - details of which must be specified at commencement of the contract. The underlying option is normally a vanilla option and is the subject of the decision to exercise. The compoundcomponent specifies the period over which the decision to exercise remains valid, along with the compound strike price. The compound strike price is the premium that will be paid (received) if the option to buy (sell) the underlying option is exercised. In return, the buyer of the compound option must pay an upfront premium. Because the premium of the compound option will be lower than the premium of the underlying option compounds will provide greater leverage to a given market move.
Contingent Premiums and Rebates
A contingent premium option is a path-dependent option which has a known premium but which only becomes payable if a given market event occurs. The first contingent premium option to appear required the premium to be paid only if the option contained intrinsic value at maturity, i.e. the option was in-the-money at expiry. However, it is possible to make a premium contingent upon any given market event. It is also possible to have a premium which is contingent upon a number of events occurring. For example, some contingent options are structured so that half the premium becomes payable when the spot rate hits a certain exchange rate, with the other half becoming payable if the spot rate hits another exchange rate level. A contingent option premium will be higher than the comparable standard premium with the difference between the two premiums a function of the probability of the required market event occurring or not.
Contract Note
Confirmation sent from broker to client detailing the purchase or sale of securities carried out on a client's behalf.
Convertible Call
This is a hedging strategy which (when used by an exporter) involves the purchase of an AUD call option and simultaneous sale of a knock-in AUD put option (with the same expiry date and face value). In most cases the strikes are set at the same rate and the knock in level for the knock-in option is solved such that the structure is premium offsetting. The client has purchased a call option but has sold a put option which only comes into being if the spot trades at the knock-in level.
Convexity
A measure showing the sensitivity of a change in the price of a fixed income security in response to a change in interest rates.
Corporate Bond
A security issued by a party which is a company rather than an individual.
Correlation
Correlation at its most simplest refers to the degree of linear interdependence between the prices of two assets. While the co-efficient of determination (r2) tells us the degree to which movements in one asset can be explained by movements in the corresponding asset, the correlation co-efficient (r) measures the strength of this relationship. Correlation is the square root of the co-efficient of determination.Correlation can be assessed in general terms from looking at a scatter diagram which plots observations for each variable against two axes. The tighter the cluster of observations the higher will be the correlation. Correlation can be measured statistically and is usually expressed as a co-efficient between -1.0 and +1.0. A co-efficient of +1.0 implies perfect positive correlation where the two asset prices are moving in the same direction in the same order of magnitude. A co-efficient of -1.0 implies that the asset prices are always moving in the opposite direction but with the same order of magnitude.It is important to note that correlation is usually measured and recorded in terms of relative changes in the value of two assets priced against a common base.

Correlation: Description

Correlation at its most simplest refers to the degree of linear interdependence between the prices of two assets. While the co-efficient of determination (r2) tells us the degree to which movements in one asset can be explained by movements in the corresponding asset, the correlation co-efficient (r) measures the strength of this relationship. Correlation is the square root of the co-efficient of determination.Correlation can be assessed in general terms from looking at a scatter diagram which plots observations for each variable against two axes. The tighter the cluster of observations the higher will be the correlation. Correlation can be measured statistically and is usually expressed as a co-efficient between -1.0 and +1.0. A co-efficient of +1.0 implies perfect positive correlation where the two asset prices are moving in the same direction in the same order of magnitude. A co-efficient of -1.0 implies that the asset prices are always moving in the opposite direction but with the same order of magnitude.It is important to note that correlation is usually measured and recorded in terms of relative changes in the value of two assets priced against a common base.

Correlation: Measurement

Correlation can be measured using two general approaches. A historical measurement based on historical price data, or implied measurement using implied volatilities quoted in the currency option market.The historical approach involves collecting historical prices over a sample period and then measuring the degree of association between the daily returns (log relatives) of the data. The degree of correlation between returns on currency X and currency Y is defined as follows:>Cov(X,Y)Pxy =--------Vx Vy>where:Cov(X,Y) = covariance of returns on currencies X and YVx = volatility of returns on currency XVy = volatility of returns on currency Y>Historical correlation is just that, it provides a picture of past events. One of the shortcomings associated with using historical correlation as a predictor of future correlation is that historical relationships are prone to breaking down. However, correlation is not yet an actively traded market variable and as such historical measurement plays an important part in the pricing those financial market instruments which are correlation based.The implied approach involves using market implied volatilities to assess the markets implied view of future correlation. The use of implied correlation derives from the fact that the volatility of any cross currency (e.g. JPY-AUD) is a function of the volatility of the two base currency pairs ( JPY-USD and AUD-USD), and the degree of correlation between the values of those underlying currency pairs. While it is possible that the actual volatility of the two base currency pairs may be quite high, if the correlation between the two prices is strongly positive the volatility of the cross currency pair could in fact be quite low.>To derive the implied level of correlation we need only find the traded (implied) volatilities of the two underlying currency pairs and the cross currency pair. We can then solve to determine the level of correlation between the two base currency pairs that is being implied by the market. For example, if the implied volatilities for JPY-USD, AUD-USD and JPY-AUD are 8%, 10% and 14% respectively we can say that the market is therefore implying a level of correlation between JPY-USD and AUD-USD of -0.2. The implied level of correlation can be determined from the following formula:CVxy = [(Vx2 + Vy2) - 2 PxyVxVy]where:CVxy = volatility of returns on the cross currencyVx = volatility of returns on currency XVy = volatility of returns on currency YPxy = correlation between returns on currencies X and Y.>In the same manner, if we have implied volatility levels for the base currency pairs and an acceptable measure of correlation between the two currency values, we can use the above formula to solve for the implied level of volatility for the cross currency pair.
Correlation Based Options
Correlation based options are options where the premium value and payoff are influenced by the level of correlation between two or more market prices, either within or between asset classes. Correlation plays an important role in the pricing of many derivative instruments, including quantity adjusting options, spread options, basket options, outperformance options and dual currency options. The impact of correlation in the pricing of these instruments appears in two ways. A first-order effect occurs when the level of correlation has a direct impact on the option payoff, as in the case of a spread option. A second-order effect occurs when the level of correlation modifies the payoff of the option, as with a basket option or diff swap, by modifying the relationship between the underlying asset prices.
Coupon
The annual rate of interest promised to the buyer of bonds. A 10 percent coupon entitles the holder to receive $10 a year for each $100 invested, for the life of the bond, paid in two half yearly instalments.
Credit
Is the power to buy without money on condition that you pay later. Those using credit benefit from the immediate possession of the goods they desire; those giving credit benefit usually by charging interest on the deferred payments.
Credit Rating
A measurement of the credit worthiness of an individual or business. The ratings are based on the opinions of banks, financial institutions and financial analysis to investigate stability and credit history. The computer age has seen the development of "banks" of such information providing instant references.
Credit Risk
The danger that a borrower will not repay a loan. This risk always exists; the degree of risk is assessed by credit analysts and is normally reflected in the interest charged and other conditions imposed by the lender.
Credit Risk Premium
An additional amount included in a security's yield (or discounted price) which reflects what could be lost if the issuer were to default. A company rated AAA would not pay a risk premium when issuing securities; a company rated BB or less would.
Credit Spread
The difference between two securities' yields based solely on differences in credit quality.
Credit Watch
A warning issued by a credit rating agency regarding a bank or company whose credit rating it expects to downgrade - that organisation has been "placed on credit watch".
Cross Barrier Options
A previous section discussed barrier options where the barriers were based on the same underlying asset class or currency. It also possible to structure barrier options when the barrier is linked to the price of an asset in another market. For example, it may be advantageous for an Australian investor with futures on the Nikkei to buy an AUD Call / JPY Put option with a knock-out barrier where the out barrier is set as a level of the Nikkei Index. It may be the case that at that level of the Nikkei index the investor no longer needs the option. The degree of correlation between the AUD/JPY exchange rate and the Nikkei Index will influence the price of the option.
Cum Interest
- securities traded "cum interest" carry the right to the next interest payment.
Currency Immunised Options
These are options on a given asset which are denominated in another currency. An example would include an option on the SPI Index in the US which has a payoff denominated in AUD. An Australian buyer of such an option would therefore be able to buy an option over the SPI but have the payoff converted back to AUD at a fixed rate, removing any additional exposure to the AUD-USD exchange rate.
Currency Linked Note
This is a deposit note with an embedded currency option which alters the potential return profile of the note. Usually an investor will forgo a portion of interest in return for the potential to increase the total return achieved on the note (should there be a positive payoff from the imbedded option). Essentially the investor is using part of the present value of their interest flow to purchase a currency option. In some cases the investor is prepared to pay away the entire present value of the interest flow in premium to achieve the potential to achieve a relatively higher return on the note. The greater the option payoff the higher the total return of the note. It is possible to embed any type of option(s) in a note, depending upon the investor's desired risk/reward trade-off and preferred payoff profile.
Currency Options
A currency option is a legally binding contract which gives the buyer the right, but not the obligation, to buy or sell a fixed amount of currency in exchange for another currency at a specified exchange rate on or before a fixed date in the future in return for payment of a premium. Options can be likened to insurance and in some cases are referred to as currency insurance. The basic terms which need to be specified to describe a currency option are: strike price, expiry date, put/call, face value, currency pair.

D
Deep Discount Bonds
Those bonds, sold at a large (deep) discount from face value, pay low cash coupons . They are beneficial for investors keen to fix their return over the life of the bond. An investor buys deep discount bonds at substantially less than face value and receives the capital gain on the investment when the bonds mature. There is no tax benefit attached for investors because tax has to be paid on interest as it is accrued rather than received. Zero coupon bonds are the ultimate example of deep discount bonds.
Default
Failure to do what was legally or morally required, often referring to the failure to pay a debt that has fallen due. Since anything is better for a lender than not being paid at all, banks, which have advanced loans to organisations, or even countries, facing liquidity difficulties may avert default by reorganising the loans over a longer term.
Deferred Coupon
A bond that delays coupon (interest) payment for the first few years, by paying it in a lump sum at maturity. It is aimed at investors who want delayed cash flow and who also seek a lower tax bill in early years when their income might be higher than in later years.
Delta Turnaround
Delta turnaround refers to the amount of delta (currency) that needs to be unwound for a particular barrier/digital option if the spot rate reaches the option's barrier/trigger rate. For example, a knock-out option will have a particular delta at the time of inception, and while it is a "live" option. However, if the spot rate breaches the knock-out level the option immediately expires worthless, the delta drops to zero and the delta hedge is no longer required. Any spot hedge held against this option will therefore need to be unwound. A second example can be seen using a reverse knock-in option. As the spot approaches the knock-in level the delta will be increasing, to say 600, (6 times the option face value). However, when the spot hits the barrier level the option knocks-in to become an in-the-money vanilla option. The maximum delta a vanilla option can have is 100. The trader, if fully hedged close to the barrier, would therefore have to unwind 5 times the face value of the option to now be delta neutral.
Derivatives
Instruments such as futures, options and swaps are based on underlying cash assets and, in part, derive their value from those assets. In practice, derivatives often drive the underlying market and the volume traded in certain futures and options contacts can outstrip that seen in the underlying cash market. Derivatives can be traded on an investment exchange or over the counter.
Diffusion Process
Diffusion refers to the process used in the Black-Scholes model describing the process by which the spot rate moves from one level to another. The spot rate under this process is assumed to move from one level to another on a continuous basis. The consequence of this assumption is that the terminal distribution of rates is lognormal.
Digital (Binary) Options
Digital Options are the general class of options which have a fixed, and known, payoff which becomes payable only if a predetermined condition is satisfied. They are also known as bet options, binary options or all-or-nothing options. Digital options come in a number of different forms and include the following:

Digital (Binary) Options: Adding a Barrier

A digital option is an option which will provide a known payout, conditional upon a given market event either occurring or not occurring. It is also possible to attach a barrier to this digital payout. In the case of a knock-out barrier, the payoff condition of the digital option would become inoperable once the out barrier was breached. The opposite would occur with a knock-in, with the payoff condition not operable until the in barrier was triggered.The addition of a barrier may act to reduce the premium of the option.

Digital (Binary) Options: Impact on a quiet spot market

Currency markets have witnessed a significant increase in the use of structures involving digital options over the past five or so years. The use of these structures has ballooned during periods of quiet, ranging foreign exchange markets with many corporates and speculators happy to bet on the market staying within defined boundaries (triggers). The increase in use of these structures has in turn had an impact on the actual behaviour of the underlying foreign exchange market.>This impact derives from the delta properties of digital options. At the option trigger level(s) the option delta can change significantly, leaving the option trader with a spot fx position equal to a multiple of the option face value which needs to be traded, often on a stop loss basis. In summary the option dealer will not need to rehedge while the spot stays within the pre-determined range but must trade out of the full spot position if the spot breaches the trigger level. The risk to the fx market, the results of which were witnessed for example in the AUD-USD market of 3/4 December 1996, is that after a quiet period in the market there is a build up of triggers congregating at key levels of the spot exchange rate, usually major support or resistance points. This is fine while the market remains rangebound but can severely exacerbate volatility if external factors result in the spot market moving to a level where there are a number of digital triggers in place. Banks with digital options which are triggered will be unwinding spot delta positions (generally in the same direction), all in potentially large parcels of currency. This may drive the currency further, breaching even more digital triggers, along with other unrelated market stop loss orders.Greater future use of these digital structures may create a more stop-start" environment, with markets quiet and rangebound for long periods but then extremely volatile for short periods when key triggers are breached.
Discontinuous (The Digital Function)
Barrier and digital options can be distinguished from vanilla options in their payoff functions. Rather than a smooth and continuous payoff function digital and barrier options can have a payoff function which contains discrete jumps or gaps. Take for example an AUD Put option struck at 0.7900 which knocks in at expiry if the spot is below 0.7600. The option has a zero payoff at 0.7601 but immediately gains intrinsic value of 0.0300 points if the spot hits 0.7600. A touch and pay digital option which has a payout only if the spot hits a certain level also has a discrete jump in the payoff. The payoff is not linear and can be said to be discontinuous. This discontinuous nature of the payoff results from the digital (or all-or-nothing) characteristic of the option. It is possible for some options to contain elements of both the digital and ramp function payoffs. Consider again the 0.7900 knock-in above; it has a digital function at 0.7600, but once this is triggered the payoff becomes a digital plus a continuous ramp function.
Discount
In the long-term money market, securities such as bonds have an initial offering price. If the current price of the bond falls below its initial offering price, the bond is said to be trading at a discount. Discount is the opposite of premium.
Discount Securities
Non-interest bearing money market instruments, issued at a discountfrom face value, with the holder receiving face value when the security matures. Discount securities carry no coupon; examples are bills of exchange, promissory notes and treasury notes
Distribution of Prices
Underlying all option pricing is a distribution which describes the probabilities associated with possible outcomes of the spot exchange rate. The terminal value of the option is a function of the individual probability assigned to each possible "in-the-money" outcome. In general, the larger and flatter the distribution of outcomes the greater the chance of a positive terminal value and so the higher the premium of the option. The size of the distribution is a function of the level of implied volatility used to price the option, and time to maturity. The mean of the distribution will be the outright forward price.
Domestic bonds
Bonds issued in the country where the issuer is domiciled.

E
Eurobonds
A branch of the euromarkets, eurocurrencies and eurobonds - currencies and securities held in Europe and outside their country of origin (euro is equivalent to external in this context). The euromarkets took off in the 1950's partly, it is said, as a reaction to the cold war between the US and the Soviet Union. This left the Soviet Union anxious about holding dollars in the US and so it placed them with European banks, which lent them to customers. At the same time, US banks were operating under restrictions which led to their holding $US balances in Europe, particularly London. The UK capital was the first euromarket centre and is still the largest.
European, American and Bermudan Options
These are terms used to describe the exercise pattern of an option. Americanoptions may be exercised at any time, with settlement of principal for spot value, i.e. the date which is trading for spot value on the day the option is exercised. On the other hand a European option can be exercised at any time, however, settlement of principal will occur for value on the originally specified value date, i.e. that date that will be traded for spot on the day the option expires. A Bermudan option is a combination of these exercise patterns, and is essentially a European option which can be exercised for spot value only at certain periods over it's life.
Ex Interest
Without interest. Bonds are quoted ex-interest seven days before coupon date so that interest can be paid to the registered holder.
Exchange Traded Option
As opposed to over-the-counter options, an exchange traded option is one which is traded on, and subject to, the rules of an exchange. Options traded on the Philadelphia Exchange are an example of such. The option may be over a physical or futures contract. For more detail see section titled Option Trading - OTC and Exchange Traded.
Exotic Options
An exotic option is any option which has a payoff (or exercise condition) which involves conditions in addition to the simple ramp function of a vanilla option.
Extendible Bond
A bond that has it's terms reset for a further period beyond the initial maturity date. However, both the borrower and the investor will typically have the right to redeem the bonds at these refixings.

F
Finite Difference Methodology
An option pricing approach which is a type of numerical model. As such it is based on finding a numerical solution to the differential equation that the option valuation must satisfy. It does this by converting the differential equation into a series of difference equations which are then solved iteratively.
First, Second and Third Generation options
These are terms used to describe the various product development phases through which the currency option market has passed. First generation options include simple puts and calls and basic combinations of these, including collars and range forwards. Second generation options include the range of exotic options where an additional factor is included in the option description, resulting in a modified payoff profile. Factors used to modify the option payoff profile are generally based on either, time, exchange rate path, premium contingency or the use of limit conditions. Examples of second generation options include lookbacks, average rates, barriers, digitals and contingent premiums.
Fixed Interest
Interest paid on investments such as bonds and debentures, paid at a predetermined and unchanging rate for a specified period (the life of the bond or debenture).
Floating Rate Note
A form of security, popular in the euromarkets and developed elsewhere, issued for three years and longer and carrying a variable interest rate which is adjusted regularly (at one to six monthly intervals - whatever is preferred by the issuer) by a margin against a benchmark rate such as LIBOR. Increased volatility in interest rates helped by the popularity of FRN's as borrowers and lenders became reluctant to commit funds for a fixed period at a fixed rate.
Floor
An interest rate derivative which protects the holder from a fall in interest rates. The holder, by exercising, receives a cash settlement representing the difference between the strike level and the underlying interest rate, should the latter be lower. Floors normally have a life of between two and five years. The option can be exercised at regular interval (every six months, for example) during the life of the floor.
Foreign Bond
A bond issued on the domestic capital market by a foreign borrower and denominated in the domestic currency. These bonds have different names according to the currency of issue such as bulldog bond, matador bond, samurai bond and yankee bond.
Fungible
The term used to describe when one instrument is identical to, and therefore interchangeable with another. A fungible bond is a new issue which is attached to an existing issue in the sense that it has the same specifications, other than price. If a bond is fungible, it can be exchanged for an existing bond with the same characteristics.

G
Gamma
It was described in the section on delta hedging how option traders generally hold a physical spot position which offsets the spot equivalent position of the option or option portfolio. This offsetting physical position is only valid (assuming the trader wishes to be delta neutral) however, at a particular level of the spot rate. As the spot rate changes so also will the delta of the individual option, or option portfolio. As the delta of the option portfolio changes a trader wishing to remain delta neutral (or maintain the same net spot position) will need to adjust their physical spot position accordingly. The amount by which the delta changes when the spot exchange rate changes is referred to as gamma.

Gamma: When an option trader becomes a spot trader

Gamma refers to the change in the delta of an option due to a change in the underlying spot price. When generalised to an entire portfolio of options gamma tells a trader how much the total portfolio delta (equivalent spot position) changes for a given change in the exchange rate, and as such, what spot position the trader will be holding at various levels of the exchange rate. To maintain a delta neutral position at any particular exchange rate level the trader would need to close out the delta position with an offsetting trade in the spot market. Some refer to gamma as the "power" of an option portfolio because it indicates the amount of spot trading that will be required for given movements in the exchange rate.In option theory it is assumed that the delta position of an option is rehedged continuously. In reality this is not the case. Consider an option trader who has sold an AUD Call / USD Put option and is delta neutral at a spot of 0.7900. If the spot rate goes to 0.8000 and we assume the delta goes from 50 to 70, the trader will now be short AUD 2m. To close out this position the trader could buy AUD 2m in the spot market at 0.8000. However, if this was done and the spot retraced to 0.7900 the trader would have locked in a loss of .0100 points on AUD 2m (USD 20,000), because they will now have a long spot position of AUD2m carried from 0.8000 down to 0.7900. By taking a "spot view" and not closing the position at 0.8000 the trader could save this realised loss. On the other hand, if the trader does not buy the AUD 2m at 0.8000 and the spot continued to rise (to say 0.8100) not only does he/she have the original AUD 2m to buy, now at a higher rate, but an additional amount of AUD to buy because with the spot move to 0.8100 the delta of the option will have also increased. If the AUD fails to retrace the trader will realise a larger loss than if they had chosen to rehedge along the way.The option trader has to work through this decision process every time the portfolio delta changes and a spot position is generated. A spot position which derives from an option portfolio has exactly the same risk profile as a spot position run on the spot desk by a spot trader. As a result of this process the option trader takes on the same risk as a spot trader and must go through the same decision process as a spot trader whenever the delta position requires rehedging.

Gamma: Positive and Negative

As described in a previous section, gamma indicates the change in the equivalent spot position of an option portfolio due to a change in the exchange rate. It is also possible to attach a sign to the gamma which gives us more information about how the delta will change for a given change in the exchange rate. Gamma can be either positive or negative.If the trader has net long options in the portfolio he/she will be paying away time value (long options lose value as they move closer to expiry, all else being equal) on a daily basis. An option portfolio which is net long options will behave differently though to a portfolio which is net short options. The delta of the long portfolio will change such that whenever the spot moves the change in delta will allow the option trader the opportunity to realise profits, i.e., if the AUD appreciates (depreciates) the trader will automatically go longer (shorter) AUD. This gives the trader the opportunity to sell into an appreciating AUD and buy back in a falling market, generating trading profits which offset the time decay realised as a result of being net long options. This is referred to as being long gamma. An option trader will build a long gamma position whenever they expect the market to be volatile. The long gamma position enables them to trade the spot whenever it moves, always in a position to realise profits. The trader is betting that the profits from trading the long gamma position more than offset the time decay cost of holding the position. Of course a long option position in a quiet market will lose money because the trader will not have the opportunity to trade the spot sufficiently to offset time decay.>A trader who expects a quiet market would take the opposite position and be a net seller of options. In this case the trader would be earning time decay (short options will create profits as the options come closer to expiry and lose value) on a daily basis. However, the delta of that portfolio will change such that whenever the spot moves the option trader will have to stop loss spot positions resulting in realised losses, i.e. if the AUD appreciates (depreciates) this trader will automatically go shorter (longer) AUD and will thus need to buy (sell) AUD at a higher (lower) level. If the trader is correct and the market is quiet he/she will not need to adjust spot positions (and not realise losses) giving the trader the opportunity to retain the time value profit generated as a result of being net short options. This is referred to as being short gamma.
Garman-Kohlhagen Pricing Model
Black Scholes and Garman Kohlhagen
Global bonds