Equity derivative From Wikipedia, the free encyclopedia In finance, an equity derivative is a class of derivatives whose value is at least

partly derived from one or more underlying equity securities. Options and futures are by far the most common equity derivatives, however there are many other types of equity derivatives that are actively traded. Contents [hide]

1 Equity options 2 Warrants 3 Convertible bonds 4 Equity futures, options and swaps
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4.1 Stock market index futures 4.2 Equity basket derivatives 4.3 Single-stock futures 4.4 Equity index swaps 4.5 Equity swap

5 Exchange-traded derivatives 6 References [edit]Equity options Main article: Option (finance) Equity options are the most common type of equity derivative.[1] They provide the right, but not the obligation, to buy (call) or sell (put) a quantity of stock (1 contract = 100 shares of stock), at a set price (strike price), within a certain period of time (prior to the expiration date). [edit]Warrants Main article: Warrant (finance) In finance, a warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price, which is much lower than the stock price at time of issue. Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends. They can be used to enhance the yield of the bond, and make them more attractive to potential buyers.

[edit]Convertible bonds Main article: Convertible bond Convertible bonds are bonds that can be converted into shares of stock in the issuing company, usually at some pre-announced ratio. It is a hybrid security with debt- and equity-like features. It can be used by investors to obtain the upside of equity-like returns while protecting the downside with regular bond-like coupons. [edit]Equity futures, options and swaps Investors can gain exposure to the equity markets using futures, options and swaps. These can be done on single stocks, a customized basket of stocks or on an index of stocks. These equity derivatives derive their value from the price of the underlying stock or stocks. [edit]Stock market index futures Main article: Stock market index future Stock market index futures are futures contracts used to replicate the performance of an underlying stock market index. They can be used for hedging against an existing equity position, or speculating on future movements of the index. Indices for futures include wellestablished indices such as S&P, FTSE, DAX, CAC40 and other G12 country indices. Indices for OTC products are broadly similar, but offer more flexibility. [vague]... [edit]Equity basket derivatives Equity basket derivatives are futures, options or swaps where the underlying is a non-index basket of shares. They have similar characteristics to equity index derivatives, but are always traded OTC (over the counter, i.e. between established institutional investors), [dubious discuss] as the basket definition is not standardized in the way that an equity index is. These are used normally for correlation trading. Futures contract

In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed today (the futures price or strike price) with delivery and payment occurring at a specified future date, the delivery date. The contracts are negotiated at a futures exchange, which acts as an intermediary between the two parties. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology reflects the

expectations of the partiesthe buyer hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will decrease. Option (finance)

In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price (the strike).[1] The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction. The price of an option derives from the difference between the reference price and the value of the underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the time remaining until the expiration of the option. Other types of options exist, and options can in principle be created for any type of valuable asset.

Fixed income From Wikipedia, the free encyclopedia Financial markets

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Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable. For example, if you lend money to a borrower and the borrower has to pay interest once a month, you have been issued a fixed-income security. Governments issue government bonds in their own currency andsovereign bonds in foreign currencies. Local governments issue municipal bonds to finance themselves. Debt issued by government-backed agencies is called an agency bond. Companies can issue a corporate bond or get money from a bank through a corporate loan ("preferred stock" can be "fixed income" in some contexts). Securitized bank lending (e.g. credit card debt, car loans or mortgages) can be structured into other types of fixed income products such as ABS asset-backed securities which can be traded on exchanges just like corporate and government bonds. The term fixed income is also applied to a person's income that does not vary with each period. This can include income derived from fixed-income investments such as bonds and preferred stocks or pensions that guarantee a fixed income. When pensioners or retirees are dependent on their pension as their dominant source of income, the term "fixed income" can also carry the implication that they have relatively limiteddiscretionary income or have little financial freedom to make large expenditures. Fixed-income securities can be contrasted with equity securities that create no obligation to pay dividends, such as stocks. In order for a company to grow as a business, it often must raise money; to finance an acquisition, buy equipment or land or invest in new product development. Investors will give money to the company only if they believe that they will be given something in return commensurate with the risk profile of the company. The company can either pledge a part of itself, by giving equity in the company (stock), or the

company can give a promise to pay regular interest and repay principal on the loan (bond, bank loan, or preferred stock). The term "fixed" in "fixed income" refers only to the schedule of obligatory payments, not the amount. "Fixed income securities" include inflation linked bonds, variable-interest rate notes, and the like. If an issuer misses a payment on a fixed income security, the issuer is in default, and the payees can force the issuer into bankruptcy. In contrast, if a company misses a quarterly dividend to stock (non-fixed-income) shareholders, there is no violation of any payment covenant, and no default. Contents [hide]

1 Terminology 2 Investors 3 Pricing factors 4 Inflation-linked bonds 5 Derivatives 6 Risks 7 See also 8 References 9 External links [edit]Terminology While a bond is simply a promise to pay interest on borrowed money, there is some important terminology used by the fixed-income industry:

The issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond) and pays the interest. The principal of a bond also known as maturity value, face value, par value is the amount that the issuer borrows which must be repaid to the lender.[1] The coupon (of a bond) is the interest that the issuer must pay. The maturity is the end of the bond, the date that the issuer must return the principal. The issue is another term for the bond itself. The indenture is the contract that states all of the terms of the bond.

[edit]Investors Investors in fixed-income securities are typically looking for a constant and secure return on their investment. For example, a retired person might like to receive a regular dependable

payment to live on, but not consume principal. This person can buy a bond with their money, and use the coupon payment (the interest) as that regular dependable payment. When the bond matures or is refinanced, the person will have their money returned to them. [edit]Pricing factors Fixed income investments such as bonds and loans are generally priced as a credit spread above a low-risk reference rate, such as LIBOR or U.S. or German Government Bonds of the same duration.[2] For example, if a 30 year mortgage is available for 5% and 30 year U.S. treasuries yield 3%, the credit spread is 2%. The credit spread reflects the risk of default and profits for lenders, while the low-risk reference rate reflects other factors that may drive interest rates.[2] Risk free Interest rates change over time, based on a variety of factors, particularly base rates set by central banks such as the US Federal Reserve, UK Bank of England, and Euro Zone ECB. If the coupon on the bond is lower than the prevailing interest rate, then this pushes the price down, and conversely, low interest rates increase the attractiveness of a given coupon, and so increase the price. In buying a bond, one is in effect buying a set of cash flows, which are discounted according to the buyer's perception of how interest and exchange rates will move over its life. Supply and demand affect prices, especially in the case of market participants which are constrained in the set of investments they make. Insurance companies often have long term liabilities that they wish to hedge, which requires low risk, predictable cash flows, such as long dated government bonds. [edit]Inflation-linked bonds There are also inflation-indexed bonds, fixed-income securities linked to a specific price index. The most common examples are US Treasury Inflation Protected Securities (TIPS) and UK Index Linked Gilts. This type of fixed income is adjusted to aConsumer Price Index (in the US this is the CPI-U for urban consumers), and then a real yield is applied to the adjusted principal. This means that these bonds are guaranteed to outperform the inflation rate (unless the government defaults on the bond). This allows investors of all sizes to not lose the purchasing power of their money due to inflation, which can be very uncertain at times. For example, assuming 3.88% inflation over the course of 1 year (just about the 56 year average inflation rate, through most of 2006), and a real yield of 2.61% (the fixed US Treasury real yield on October 19, 2006, for a 5 yr TIPS), the adjusted principal of the fixed income would rise from 100 to 103.88 and then the real yield would be applied to the adjusted principal, meaning 103.88 x 1.0261, which equals 106.5913; giving a total return of 6.5913%. TIPS moderately outperform conventional US Treasuries, which yielded just 5.05% for a 1 yr bill on October 19, 2006.

[edit]Derivatives Fixed income derivatives include interest rate derivatives and credit derivatives. Often inflation derivatives are also included into this definition. There is a wide range of fixed income derivative products: options, swaps, futures contracts as well asforward contracts. The most widely traded kinds are:

Credit default swaps[3] Interest rate swaps Inflation swaps Bond futures on 2/10/30-year government bonds Interest rate futures on 90-day interbank interest rates Forward rate agreements

[edit]Risks Fixed income securities from any entity have risks that may include but are not limited to:

inflationary risk that the buying power of the principal will decline during the term of the security interest rate risk that overall interest rates will change from the levels extant when the security is sold, causing an opportunity cost currency risk that exchange rates with other currencies will change during the security's term, causing loss of buying power in other countries default risk that the issuer will be unable to pay the scheduled interest payments due to financial hardship repayment of principal risk that the issuer will be unable to repay the principal due to financial hardship reinvestment risk that the purchaser will be unable to purchase another security of similar return upon the expiration of the current security liquidity risk that the buyer will require the principal funds for another purpose on short notice, prior to the expiration of the security, and be unable to exchange the security for cash in the required time period without loss of fair value

maturity risk this is another name for interest rate risk streaming income payment risk duration risk convexity risk credit quality risk

political risk that governmental actions will cause the owner to lose the benefits of the security tax adjustment risk market risk the risk of market-wide changes affecting the value of the security climate risk event risk the risk that externalities will cause the owner to lose the benefits of the security

Interest rate derivative From Wikipedia, the free encyclopedia An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate. These structures are popular for investors with customized cashflow needs or specific views on the interest rate movements (such as volatility movements or simple directional movements) and are therefore usually traded OTC; see financial engineering. The interest rate derivatives market is the largest derivatives market in the world. The Bank for International Settlements estimates that the notional amount outstanding in June 2009 [1] were US$437 trillion for OTC interest rate contracts, and US$342 trillion for OTC interest rate swaps. According to the International Swaps and Derivatives Association, 80% of the world's top 500 companies as of April 2003 used interest rate derivatives to control their cashflows. This compares with 75% for foreign exchange options, 25% for commodity options and 10% for stock options. Modeling of interest rate derivatives is usually done on a time-dependent multidimensional Lattice ("tree") built for the underlying risk drivers, usually domestic or foreign short rates and foreign exchange market rates, and incorporating delivery- and day count conventions; see Short-rate model. Specialised simulation models are also often used.

Contents [hide]

1 Types
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1.1 Vanilla 1.2 Quasi-vanilla 1.3 Exotic derivatives 2.1 Interest rate cap 2.2 Range accrual note 2.3 Bermudan swaption

2 Example of interest rate derivatives

3 See also 4 References 5 Further reading 6 External links [edit]Types [edit]Vanilla The basic building blocks for most interest rate derivatives can be described as "vanilla" (simple, basic derivative structures, usually most liquid):

Interest rate swap (fixed-for-floating) Interest rate cap or interest rate floor Interest rate swaption Bond option Forward rate agreement Interest rate future Money market instruments Cross currency swap (see Forex swap)

[edit]Quasi-vanilla The next intermediate level is a quasi-vanilla class of (fairly liquid) derivatives, examples of which are:

Range accrual swaps/notes/bonds In-arrears swap

Constant maturity swap (CMS) or constant treasury swap (CTS) derivatives (swaps, caps, floors) Interest rate swap based upon two floating interest rates

[edit]Exotic derivatives Building off these structures are the "exotic" interest rate derivatives (least liquid, traded over the counter), such as:

Power Reverse Dual Currency note (PRDC or Turbo) Target redemption note (TARN) CMS steepener [1] Snowball [2] Inverse floater Strips of Collateralized mortgage obligation Ratchet caps and floors Bermudan swaptions Cross currency swaptions

Most of the exotic interest rate derivatives are structured as swaps or notes, and can be classified as having two payment legs: a funding leg and an exotic coupon leg. [citation needed]

A funding leg usually consists of series of fixed coupons or floating coupons (LIBOR) plus fixed spread. An exotic coupon leg typically consists of a functional dependence on the past and current underlying indices (LIBOR, CMS rate, FX rate) and sometimes on its own past levels, as in Snowballs and TARNs. The payer of the exotic coupon leg usually has a right to cancel the deal on any of the coupon payment dates, resulting in the socalled Bermudan exercise feature. There may also be some range-accrual and knock-out features inherent in the exotic coupon definition.

[edit]Example of interest rate derivatives [edit]Interest rate cap An interest rate cap is designed to hedge a companys maximum exposure to upward interest rate movements. It establishes a maximum total dollar interest amount the hedger will pay out over the life of the cap. The interest rate cap is actually a series of individual interest rate caplets, each being an individual option on the underlying interest rate index. The interest rate cap is paid for upfront, and then the purchaser realizes the benefit of the cap over the life of the instrument.

[edit]Range accrual note Suppose a manager wished to take a view that volatility of interest rates will be low. He or she may gain extra yield over a regular bond by buying a range accrual note instead. This note pays interest only if the floating interest rate (i.e.London Interbank Offered Rate) stays within a pre-determined band. This note effectively contains an embedded option which, in this case, the buyer of the note has sold to the issuer. This option adds to the yield of the note. In this way, if volatility remains low, the bond yields more than a standard bond. [edit]Bermudan swaption Suppose a fixed-coupon callable bond was brought to the market by a company. The issuer however, entered into an interest rate swap to convert the fixed coupon payments to floating payments (perhaps based on LIBOR). Since it is callable however, the issuer may redeem the bond back from investors at certain dates during the life of the bond. If called, this would still leave the issuer with the interest rate swap. Therefore, the issuer also enters into Bermudan swaption when the bond is brought to market with exercise dates equal to callable dates for the bond. If the bond is called, the swaption is exercised, effectively canceling the swap leaving no more interest rate exposure for the issuer.