| | 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 - Contractual offset of payables against receivables to reduce credit exposure to a counterparty. Netting swap payments in bankruptcy, for example, reduces credit exposure to the net obligation of a counterparty. Netting in bankruptcy or insolvency may not be enforceable in all jurisdictions, but the United States federal bankruptcy code and the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) are designed to permit netting among United States-based counterparties. Other sovereign jurisdictions are generally following this example to protect the ability of their financial intermediaries to compete in international markets. Also called Aggregation. See also Bilateral Netting.
netting:- In general, netting means to allow a positive and a negative to cancel each other out. In the context of credit risk, there are at least three specific types of netting:
- close-out netting: In the event of counterparty bankruptcy, all transactions or all of a given type are netted at market value. The alternative would allow the liquidator o choose which contracts to enforce and which not to (and thus potentially "cherry pick"). There are international jurisdictions where the enforceability of netting in bankruptcy has not been legally tested.
- netting by novation: The legal obligations of the parties to make required payments under one or more series of related transactions are canceled and a new obligation to make only the net payments is created.
- settlement or payment netting: For cash settled trades, this can be applied either bilaterally or multilaterally and on related or unrelated transactions.
Normalization:- Variables can be characterized by the central tendency (average), volatility (standard deviation), skewness (tendency to bunch up towards one end of its range), etc. These measures help describe the variable shape or distribution. In nature, many variables have a bell-shaped or Normal (a.k.a., Gaussian) distribution. If a variable is not Normally distributed, a transformation can typically be devised that will convert it to Normality. This sort of transformation is termed Normalization.
notional amount- The face amount of a transaction typically used as the basis for interest payment calculations. For swaps, this amount is not itself a cash flow. Credit exposure arises -- not against the notional -- but against the present value (market replacement cost of the in-the-money future terminal payment(s).
obligor:- A party who is in debt to another: (i) a loan borrower; (ii) a bond issuer; (iii) a trader who has not yet settled; (iv) a trade partner with accounts payable; (v) a contractor with unfinished performance, etc., See, "counterparty".
off-balance sheet derivative contracts:- Derivative contracts that generally do not involve booking assets or liabilities (i.e., swaps, futures, forwards, and options).
option theoretic:- An approach to estimating the probability of default of an obligor. The original and still popular example is Robert Merton's model-of-the-firm which states that debt can be valued as a put option on the underlying assets of the firm. This specific example is generally referred to as the "Merton model". Variants of this have been proposed and these are commonly called "structural models" referring to their assumed model/image of the firm/process.
optionsAn option is a contract giving the right to sell or buy a commodity, financial instrument or index, at a specified price for a certain period. In other words, like futures, options are derivatives which allow you to put down a small stake and give yourself exposure to a much larger investment. Like futures, they can be used to minimize or maximize risk. There is one key difference between options and futures. If you buy a futures contract, you have agreed to take delivery of a commodity (say 10 kilos of Sugar) at a given date in the future. You have no alternative (unless of course you sell the contract on to somebody else). With an option, you are not bound to take delivery. If you choose, you may decided against taking delivery and let the option 'lapse'. - Options can, and are extended beyond the commodity markets. Companies have often in the past given their top managers 'executive share options'. These enable the managers to purchase shares in the business in the future at a price fixed now. Options in this context are used as an incentive to provoke the managers into performing better.
originator:- The financial institution (usually a bank) that extends credit on a facility (usually a loan) which may later be held by another institution through, for instance, a loan sale or loan syndication.
over-the-counter derivative contracts:- Privately negotiated derivative contracts that are transacted off organized exchanges.
parThe dollar amount assigned to a security by the issuer. For an equity security, par is usually a small dollar amount that bears no relationship to the security's market price. For a debt security, par is the amount repaid to the investor when the bond matures, usually $1,000. Syn. face value; principal; stated value. See also maturity date.
principal- The amount of an obligation upon which interest is calculated. This differs somewhat from "the amount that's owed", since one owes accrued interest.
priority of claims:- A plan must classify claims into "substantially similar" groups known as "classes". Classification of claims reflects differences in the rights of creditors that call for a difference in treatment. All claims that are "substantially similar" need not be placed in the same class, but those that are placed in the same class must be alike. Unsecured creditors frequently are classified together, whereas each secured claim is generally classified separately. Claims within each class must be treated equally, and a plan must not unfairly discriminate between creditors (whether or not classified together) of equal priority.
ratingAn evaluation of a corporate or municipal bond's relative safety, according to the issuer's ability to repay principal and make interest payments. Bonds are rated by various organizations such as Standard & Poor's and Moody's. Ratings range from AAA or Aaa (the highest) to C or D, which represents a company in default.
rating serviceA company, such as Moody's or Standard & Poor's, that rates various debt and preferred stock issues for safety of payment of principal, interest or dividends. The issuing company or municipality pays a fee for the rating. See also bond rating; rating.
- The amount that a creditor would receive in final satisfaction of the claims on a defaulted credit. LossCalc states this as a percentage of the debt's par value, which is the most common practice. An alternative definition, which is commonly in the reduced form models, is to state recovery as a percentage of market value. This definition is more tractable, but is not well aligned with creditor's true claims in default.
restrictive covenantA restrictive covenant is an obligation which may be imposed on the owner of freehold property in the deeds to that property. Restrictive covenants are also likely to be included if your property is leasehold. Such clauses will prevent certain actions such as running a business or building an extension. You may even be restrained from erecting a TV aerial! The person doing your conveyance, usually a solicitor will inform you of any restrictions before you exchange contracts and complete your purchase.
securitisationAs a mortgage borrower 'securitisation' is unlikely to ever affect you or your home loan. Securitsation is a technical term describing the process of bundling a group of mortgages together such that they may be treated, for funding purposes, as a single entity and made available to prospective investors in mortgage debt. Developed in the USA, the idea came to the UK market in the 1980s. Mortgage debt is seen as a relatively attractive safe investment by many institutions, pension funds etc. Securitization allows lenders to raise money in the money markets, lend it to domestic property purchasers and then sell the resulting group of mortgages on to other institutions. This is also known as "off balance sheet lending" since the debt does not form part of the lenders assets. All you really need to know as a mortgage borrower is that this process does not affect the terms and conditions of your mortgage in any way. serial correlation- See autocorrelation.
settlementThe payment of cash for securities and, conversely, the delivery of securities against payment - the conclusion of a securities transaction by delivery. - A measure of the non-symmetry of a statistical distribution. The 3rd moment of any distribution. Symmetrical distributions have a skewness value of zero. A distribution with negative skewness has more observations in the left tail (left of the peak or mode), and a distribution with positive skewness has more observations in the right tail.
solvency- The ability of a corporation both to meet its long-term fixed expenses and to have adequate money for long-term expansion and growth.
seniority class:- We use this term to include all the various seniority grades (within any given instrument type) across all debt-types. In a bankruptcy proceeding, all credit obligations of a firm would be assigned to a seniority class and the classes would be ranked by their seniority standing. In an idealized example, all claims in the highest seniority class would be satisfied before claims below them applying the Absolute Priority Rule in a kind of stair-step "water fall".
seniority grade:- Within an instrument type (e.g., public bonds) there is often distinction in seniority such as between secured vs. unsecured or senior vs. subordinated.
special purpose vehicle (SPV)A merger of a bond and a derivatives trade into a single contract. For example, one SPV might consist of a fixed rate bond plus a Swap in which the owner of the bond pays fixed and receives floating. Thus, the SPV is equivalent to a floating rate bond. Examples include the ARGO, EX, LASER, SIRES, and STEERS - all of which (q.v.). (Source: http://emwl.oyster.co.uk/contents/publications/euromoney/em.96/em.96.04/em.96.04.12.html) spread(1) In a quotation, the difference between the bid and the ask prices of a security. (2) An options position established by purchasing one option and selling another option of the same class but of a different series. The standard deviation is one of several indices of variability that statisticians use to characterize the dispersion among the measures in a given population. To calculate the standard deviation of a population it is first necessary to calculate that population's variance. Numerically, the standard deviation is the square root of the variance. Unlike the variance, which is a somewhat abstract measure of variability, the standard deviation can be readily conceptualized as a distance along the scale of measurement. Standard deviation is a measure of the spread or dispersion of a set of data. It is calculated by taking the square root of the variance and is symbolized by s.d, or s. - The more widely the values are spread out, the larger the standard deviation. For example, say we have two separate lists of exam results from a class of 30 students; one ranges from 31% to 98%, the other from 82% to 93%, then the standard deviation would be larger for the results of the first exam.
stress testDefinition: A test of a model for pricing or risk management, using an extreme scenario or family of scenarios.
Example: For example, you might price your portfolio, using market conditions at the time of the crash of 1987, or assuming a three-standard-deviation move in prices, or a 100-year move in the forward curve.
Application: You can use a stress test to find out a model's breaking point.
Pricing: As you move a European barrier call option's barrier away from the spot price, the option's value approaches that of an ordinary European call.
Risk Management: Stress-testing of VaR systems is commonplace.
Comment: total return optionDefinition: A Put Option (q.v.) on debt with credit risk. Example: A customer fearing a default on his debt could pay a premium for a put option that allows him to sell a risky corporate bond at par if the corporation defaults on any of its debt. Application: See Credit Derivatives. Pricing: A standard model for pricing equity options would be a good starting place for pricing a Total Return Option. Risk Management: One might try to hedge this dynamically with the underlying risky debt. Comment: Pricing and hedging might be difficult, and market manipulation may be an issue for a thinly traded underlying instrument. total return swapDefinition: The synthetic purchase of risky 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 LIBOR. A swap that has a floating payment that depends on the value of the remaining payments, hence depends on how likely it appears that the payer will make good its promise to pay.
Examples: · A counterparty in a junk bond swap receives the total rate of return on a portfolio of junk bonds and pay LIBOR. · A bank loan swap might pay the total rate of return on a risky bank loan and receive LIBOR. In particular, Bankers Trust has offered swaps that pay the return on loans that fund the merger of Ralph's Supermarkets and Yucaipa Companies' Food 4 Less (Derivatives Week, 11/7/94). · A counterparty might receive the total return on some risky corporate bond and pay LIBOR minus a fixed spread. Application: See Credit Derivatives. Pricing and Risk Management: The replicating portfolio for Total Return Swap is the levered purchase or sale. Consequently, its value is the value of the replicating portfolio, and its hedge is the sale of the replicating portfolio. Thus, the dealer providing this swap could hedge his position by buying the risky corporate bond and financing the purchase with a floating-rate loan.
Comment: Why doesn't the customer just do this, directly? The customer may not be able to deal with counterparties with low credit ratings. The dealer might have a higher credit rating. Of course, this looks like a way around regulations. total risk-based capital:The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of common shareholders' equity, perpetual preferred shareholders' equity with noncumulative dividends, retained earnings, and minority interests in the equity accounts of consolidated subsidiaries. Tier 2 capital consists of subordinated debt, intermediate-term preferred stock, cumulative and long-term preferred stock, and a portion of a bank's allowance for loan and lease losses. - A square table (the number of rows equals the number of columns) of probabilities which summarizes the likelihood that a credit will migrate from its current credit rating today to any possible credit rating -- or perhaps default -- in one period.
treasury bill- A marketable U.S. government debt security with a maturity of less than one year. Treasury bills are issued through a competitive bidding process at a discount from par; there is no fixed interest rate. Syn. T bill.
treasury bond- A marketable, fixed-interest U.S. government debt security with a maturity of more than ten years. Syn. T bond.
treasury note- A marketable, fixed-interest U.S. government debt security with a maturity of between one and ten years. Syn. T note.
unexpected lossesA popular term for the volatility of losses, but it is also used when referring to the realization of a large loss. Losses might well be predicted with some statistical probability, but are almost always "unexpected" in actuality.
value-at-risk (VaR or V@R):- A measure of the...
varianceThe variance is one of several indices of variability that statisticians use to characterize the dispersion among the measures in a given population. To calculate the variance of a given population, it is necessary to first calculate the mean of the scores, then measure the amount that each score deviates from the mean and then square that deviation (by multiplying it by itself). Numerically, the variance equals the average of the several squared deviations from the mean The (population) variance of a random variable is a non-negative number which gives an idea of how widely spread the values of the random variable are likely to be; the larger the variance, the more scattered the observations on average. Stating the variance gives an impression of how closely concentrated round the expected value the distribution is; it is a measure of the 'spread' of a distribution about its average value. - Notes a) the larger the variance, the further that individual values of the random variable (observations) tend to be from the mean, on average; b) the smaller the variance, the closer that individual values of the random variable (observations) tend to be to the mean, on average; c) taking the square root of the variance gives the standard deviation. That is: d) the variance and standard deviation of a random variable are always non-negative.
volatility- The annualized standard deviation of the percentage change in a risk factor.
yieldYield is the annual return you receive from holding a stock, share or unit trust - it is expressed as a percentage of its price. In the case of shares, the yield is calculated by expressing the dividend as a percentage of the cost of the investment. To calculate a yield on a share, take the dividend paid (this will be net of the basic rate of tax), add back the tax to get the gross yield and then divide by the share price and multiply by 100. In simple terms, if you buy shares in (say) General Trading Company and the gross dividend is 5 pence and the shares are 100 pence, your yield is 5%. Yield can be an important consideration when investing. Some companies have a policy of maximizing their dividend pay outs, others are more concerned to retain all or most of the profits for re-investment. The increased popularity of personal equity plans (peps) means private shareholders, like some big institutions, can now receive dividends free of income tax. - In the case of fixed interest stock, such as gilts, the return is a specified rate of interest. But there may also be a capital gain or loss to take into account if the investor holds the stock until maturity when it is redeemed by the issuer at face value. This is why it's important to consider two gilt yield figures, the interest yield and the redemption yield.
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