Options

Risk Management in Finance

Contents
1

Introduction

1.1

Financial risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.1

Types of risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.2

Diversication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.3

Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.4

Financial / Credit risk related acronyms . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.5

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.6

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.1.7

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Financial risk management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.2.1

When to use nancial risk management . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.2.2

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.2.3

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.2.4

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.2.5

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Derivative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.1

Collateralised debt obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.2

Credit default swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.3

Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.4

Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.5

Mortgage-backed securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.6

Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.7

Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.8

Financial derivative trading companies . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.9

Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.10 Size of market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.11 Usage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.3.12 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

1.3.13 Economic function of the derivative market . . . . . . . . . . . . . . . . . . . . . . . . .

12

1.3.14 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12

1.3.15 Criticisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

13

1.3.16 Financial Reform and Government Regulation . . . . . . . . . . . . . . . . . . . . . . . .

14

1.2

1.3

ii

CONTENTS

1.4

1.5

1.6

1.7

1.8
1.9

1.3.17 Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15

1.3.18 Financial derivative trading companies . . . . . . . . . . . . . . . . . . . . . . . . . . . .

16

1.3.19 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

17

1.3.20 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

17

1.3.21 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

20

1.3.22 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

20

Call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

20

1.4.1

Example of a call option on a stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

21

1.4.2

Example of valuing a stock option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

22

1.4.3

Value of a call . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

22

1.4.4

Price of options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23

1.4.5

Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23

1.4.6

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23

Put option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23

1.5.1

Instrument models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

24

1.5.2

Example of a put option on a stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

24

1.5.3

Payo of a put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

25

1.5.4

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

25

1.5.5

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

25

Strike price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

26

1.6.1

Moneyness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

26

1.6.2

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

26

1.6.3

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

26

Expiration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

26

1.7.1

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27

1.7.2

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27

Underlying . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27

1.8.1

Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27

Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27

1.9.1

History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27

1.9.2

Valuation overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

28

1.9.3

Contract specications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

28

1.9.4

Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

28

1.9.5

Valuation models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

29

1.9.6

Model implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

30

1.9.7

Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

31

1.9.8

Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

31

1.9.9

The basic trades of traded stock options (American style) . . . . . . . . . . . . . . . . . .

32

1.9.10 Option strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

33

1.9.11 Historical uses of options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

34

1.9.12 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

34

CONTENTS

iii

1.9.13 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

34

1.9.14 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

35

1.10 Short . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

35

1.10.1 Concept

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

36

1.10.2 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

37

1.10.3 Mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

38

1.10.4 Fees

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

40

1.10.5 Dividends and voting rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

40

1.10.6 Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

40

1.10.7 Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

41

1.10.8 Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

41

1.10.9 Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

42

1.10.10 Views of short selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

43

1.10.11 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

43

1.10.12 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

43

1.10.13 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45

1.10.14 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45

1.11 Long . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45

1.11.1 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45

1.11.2 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45

1.11.3 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45

Interest and Yield

46

2.1

Risk-free rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

46

2.1.1

Risk components . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

46

2.1.2

Theoretical measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

46

2.1.3

Proxies for the Risk-free Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

47

2.1.4

Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

47

2.1.5

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

47

2.1.6

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

47

Basis point . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

2.2.1

Permyriad

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

2.2.2

Basis point . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

2.2.3

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

2.2.4

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

LIBOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

48

2.3.1

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

49

2.3.2

Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

49

2.3.3

Denition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

50

2.3.4

Technical features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

50

2.3.5

Fixed rates in USD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

50

2.3.6

Libor-based derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

51

2.2

2.3

iv

CONTENTS

2.4

2.3.7

Reliability and scandal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

51

2.3.8

Reforms

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

52

2.3.9

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

53

2.3.10 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

53

2.3.11 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

53

2.3.12 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

53

Continuous Compounding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

55

2.4.1

Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

55

2.4.2

Mathematics of interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

56

2.4.3

Mathematics of interest rate on loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

58

2.4.4

Example of compound interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

59

2.4.5

History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

59

2.4.6

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

59

2.4.7

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

59

Valuation

60

3.1

Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

60

3.1.1

Valuation overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

60

3.1.2

Business valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

60

3.1.3

Usage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

62

3.1.4

Valuation of a suering company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

62

3.1.5

Valuation of a startup company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

62

3.1.6

Valuation of intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

62

3.1.7

Valuation of mining projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

63

3.1.8

Asset pricing models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

63

3.1.9

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

63

3.1.10 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

63

3.1.11 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

64

Valuation of options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

64

3.2.1

Intrinsic value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

64

3.2.2

Time value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

64

3.2.3

Pricing models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

64

3.2.4

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

65

Black-Scholes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

65

3.3.1

The Black-Scholes world . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

65

3.3.2

Notation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

66

3.3.3

The BlackScholes equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

66

3.3.4

Black-Scholes formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

66

3.3.5

The Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

68

3.3.6

Extensions of the model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

69

3.3.7

BlackScholes in practice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

70

3.3.8

Criticism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

71

3.2

3.3

CONTENTS
3.3.9

3.4

3.5

3.6

3.7

3.8

v
See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

72

3.3.10 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

72

3.3.11 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

72

3.3.12 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

73

Putcall parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

74

3.4.1

Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

74

3.4.2

Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

74

3.4.3

Derivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

75

3.4.4

History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

76

3.4.5

Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

76

3.4.6

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

76

3.4.7

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

76

3.4.8

Additional Sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

76

3.4.9

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

76

In the money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

77

3.5.1

Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

77

3.5.2

Intrinsic value and time value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

77

3.5.3

Moneyness terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

77

3.5.4

Spot versus forward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

78

3.5.5

Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

78

3.5.6

Denition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

78

3.5.7

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80

3.5.8

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80

Option time value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80

3.6.1

Intrinsic value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

81

3.6.2

Option value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

81

3.6.3

Time value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

81

3.6.4

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

81

3.6.5

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

3.6.6

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

Intrinsic value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

3.7.1

Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

3.7.2

Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

3.7.3

Real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

3.7.4

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

3.7.5

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

3.7.6

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

82

Black model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

83

3.8.1

The Black formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

83

3.8.2

Derivation and assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

83

3.8.3

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

83

vi

CONTENTS
3.8.4

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

83

3.8.5

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

83

Finite dierence methods for option pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

84

3.9.1

Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

84

3.9.2

Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

84

3.9.3

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

84

3.9.4

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

85

3.10 Variance gamma process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

85

3.10.1 Moments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

85

3.10.2 Option pricing

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

86

3.10.3 Applications to Credit Risk Modeling . . . . . . . . . . . . . . . . . . . . . . . . . . . .

86

3.10.4 Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

86

3.10.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

86

3.11 Heath-Jarrow-Morton framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

87

3.11.1 Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

87

3.11.2 Mathematical formulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

87

3.11.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

88

3.11.4 External links and references . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

88

3.12 Heston model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

89

3.9

3.12.1 Basic Heston model

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

89

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

89

3.12.3 Risk-neutral measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

90

3.12.4 Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

90

3.12.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

90

3.12.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

90

3.13 Monte Carlo methods for option pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

91

3.13.1 Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

91

3.13.2 Least Square Monte Carlo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

92

3.13.3 Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

92

3.13.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

92

3.13.5 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

93

3.14 Fuzzy Pay-O Method for Real Option Valuation . . . . . . . . . . . . . . . . . . . . . . . . . .

93

3.14.1 Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

93

3.14.2 Use of the method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

94

3.14.3 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

94

3.14.4 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

94

3.12.2 Extensions

Volatility and Risk Measurement

95

4.1

Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

95

4.1.1

Volatility terminology

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

95

4.1.2

Volatility and liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

95

4.1.3

Volatility for investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

96

CONTENTS

4.2

4.3

vii

4.1.4

Volatility versus direction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

96

4.1.5

Volatility over time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

96

4.1.6

Mathematical denition

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

96

4.1.7

Implied Volatility parametrisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

97

4.1.8

Crude volatility estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

97

4.1.9

Estimate of compound annual growth rate (CAGR) . . . . . . . . . . . . . . . . . . . . .

97

4.1.10 Criticisms of volatility forecasting models . . . . . . . . . . . . . . . . . . . . . . . . . .

97

4.1.11 Volatility Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

98

4.1.12 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

98

4.1.13 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

98

4.1.14 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

98

4.1.15 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

99

Volatility smile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

99

4.2.1

Volatility smiles and implied volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . .

99

4.2.2

Implied volatility and historical volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

4.2.3

Term structure of volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

4.2.4

Implied volatility surface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

4.2.5

Evolution: Sticky . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

4.2.6

Modeling volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

4.2.7

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

4.2.8

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

4.2.9

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

Implied volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

4.3.1

Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

4.3.2

Solving the inverse pricing model function . . . . . . . . . . . . . . . . . . . . . . . . . . 102

4.3.3

Implied volatility as measure of relative value . . . . . . . . . . . . . . . . . . . . . . . . 102

4.3.4

Implied volatility as a price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

4.3.5

Non-constant implied volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

4.3.6

Volatility instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

4.3.7

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

4.3.8

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

4.3.9

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

4.3.10 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

4.4

4.5

Net volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

4.4.1

Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

4.4.2

Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

4.4.3

Interpretation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

4.4.4

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

Value at risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

4.5.1

Details

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

4.5.2

Varieties of VaR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

viii

CONTENTS
4.5.3

Mathematical denition

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

4.5.4

Risk measure and risk metric . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

4.5.5

VaR risk management

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

4.5.6

Computation methods

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107

4.5.7

History of VaR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107

4.5.8

Criticism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

4.5.9

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109

4.5.10 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109

4.5.11 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
4.6

Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
4.6.1

Use of the Greeks

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

4.6.2

Names . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

4.6.3

First-order Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

4.6.4

Second-order Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

4.6.5

Third-order Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

4.6.6

Greeks for multi-asset options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114

4.6.7

Formulas for European option Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114

4.6.8

Related measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114

4.6.9

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

4.6.10 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

4.6.11 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.6.12 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.7

4.8

4.9

Convenience yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

4.7.1

Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

4.7.2

Why should a convenience yield exist? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

Monte Carlo method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117

4.8.1

Introduction

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117

4.8.2

History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118

4.8.3

Denitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118

4.8.4

Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

4.8.5

Use in mathematics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

4.8.6

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

4.8.7

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

4.8.8

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

4.8.9

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125

Local volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

4.9.1

Formulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

4.9.2

Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

4.9.3

Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

4.9.4

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

4.10 Stochastic volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

CONTENTS

ix

4.10.1 Basic model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

4.10.2 Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
4.10.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
4.10.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
4.10.5 Additional Sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
4.11 SABR Volatility Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
4.11.1 Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
4.11.2 Asymptotic solution

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130

4.11.3 SABR for the negative rates

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

4.11.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

4.11.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
5

Basic Types of Options

5.1

5.2

5.3

5.4

5.5

5.6

5.7

133

Foreign exchange option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133

5.1.1

Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133

5.1.2

Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133

5.1.3

Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

5.1.4

Valuation: the GarmanKohlhagen model . . . . . . . . . . . . . . . . . . . . . . . . . . 134

5.1.5

Risk management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

5.1.6

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

Chooser option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

5.2.1

Replication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

5.2.2

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

5.2.3

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
5.3.1

Basis of futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

5.3.2

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

5.3.3

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

Callable bull/bear contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

5.4.1

Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

5.4.2

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136

5.4.3

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136

Contingent value rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136

5.5.1

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136

5.5.2

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136

Bond option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136

5.6.1

Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136

5.6.2

Embedded options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

5.6.3

Relationship with caps and oors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

5.6.4

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

5.6.5

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

Warrant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138

CONTENTS
5.7.1

Structure and features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138

5.7.2

Secondary market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139

5.7.3

Comparison with call options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139

5.7.4

Traded warrants

5.7.5

Uses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140

5.7.6

Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140

5.7.7

Types of warrants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140

5.7.8

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

5.7.9

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139

5.7.10 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

5.8

5.9

Option screener . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

5.8.1

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

5.8.2

Screening criterion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141

5.8.3

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142

Reverse convertible securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142

5.9.1

Description . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142

5.9.2

Maturity options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

5.9.3

Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

5.9.4

Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

5.9.5

Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

5.9.6

Investor benets

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

5.9.7

Risk to consider

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

5.9.8

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144

5.9.9

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144

Options Style
6.1

6.2

145

European option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145

6.1.1

American and European options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145

6.1.2

Non-vanilla exercise rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

6.1.3

Exotic options with standard exercise styles . . . . . . . . . . . . . . . . . . . . . . . . 147

6.1.4

Non-vanilla path dependent exotic options . . . . . . . . . . . . . . . . . . . . . . . . . 147

6.1.5

Related . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

6.1.6

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

6.1.7

Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

6.1.8

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

6.1.9

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

European option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

6.2.1

American and European options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

6.2.2

Non-vanilla exercise rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149

6.2.3

Exotic options with standard exercise styles . . . . . . . . . . . . . . . . . . . . . . . . 150

6.2.4

Non-vanilla path dependent exotic options . . . . . . . . . . . . . . . . . . . . . . . . . 151

6.2.5

Related . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

CONTENTS

6.3

6.4

xi

6.2.6

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

6.2.7

Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

6.2.8

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

6.2.9

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

European option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

6.3.1

American and European options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

6.3.2

Non-vanilla exercise rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

6.3.3

Exotic options with standard exercise styles . . . . . . . . . . . . . . . . . . . . . . . . 154

6.3.4

Non-vanilla path dependent exotic options . . . . . . . . . . . . . . . . . . . . . . . . . 154

6.3.5

Related . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

6.3.6

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

6.3.7

Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

6.3.8

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

6.3.9

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

Asian option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156

6.4.1

Etymology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156

6.4.2

Permutations of Asian option

6.4.3

Types of averaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156

6.4.4

Pricing of Asian options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156

6.4.5

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

Embedded Options
7.1

7.2

7.3

7.4

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156

158

Callable bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158

7.1.1

Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158

7.1.2

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158

7.1.3

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158

Puttable bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158

7.2.1

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

7.2.2

Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

7.2.3

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

7.2.4

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

Exchangeable bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

7.3.1

Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

7.3.2

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

7.3.3

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

Convertible bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

7.4.1

Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

7.4.2

Additional features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

7.4.3

Structure and terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161

7.4.4

Markets and Investor proles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

7.4.5

Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

7.4.6

Uses for investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163

xii

CONTENTS
7.4.7

Redemption options/strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164

7.4.8

Uses for issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164

7.4.9

2010 U.S. Equity-Linked Underwriting League Table . . . . . . . . . . . . . . . . . . . . 165

7.4.10 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

7.4.11 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
7.4.12 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
8

Trading in Derivatives
8.1

166

Futures exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166

8.1.1

Denition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166

8.1.2

History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166

8.1.3

Nature of contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

8.1.4

Standardization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168

8.1.5

Clearing and settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168

8.1.6

Central counterparty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168

8.1.7

Margin and Mark-to-Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168

8.1.8

Regulators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169

8.1.9

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169

8.1.10 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169

8.1.11 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
8.2

Margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
8.2.1

Margin buying . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170

8.2.2

Types of margin requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170

8.2.3

Initial and maintenance margin requirements

8.2.4

Margin call . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171

8.2.5

Price of stock for margin calls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171

8.2.6

Reduced margins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

8.2.7

Margin-equity ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

8.2.8

Return on margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

8.2.9

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

. . . . . . . . . . . . . . . . . . . . . . . . 171

8.2.10 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

8.3

8.4

Spread trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

8.3.1

Margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

8.3.2

Types of spread trades . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

8.3.3

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

8.3.4

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

8.3.5

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

Bid-oer spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174

8.4.1

Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174

8.4.2

Percent spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174

8.4.3

Example: Currency spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174

8.4.4

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174

CONTENTS

8.5

8.6

xiii

8.4.5

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174

8.4.6

Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174

Over-the-counter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
8.5.1

OTC-traded stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175

8.5.2

OTC contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175

8.5.3

Counterparty risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175

8.5.4

Importance of OTC derivatives in modern banking

8.5.5

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

8.5.6

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

8.5.7

Citations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

8.5.8

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

8.5.9

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

Normal backwardation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

8.6.1

Occurrence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

8.6.2

Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

8.6.3

Origin of term: London Stock Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

8.6.4

Normal backwardation vs. backwardation . . . . . . . . . . . . . . . . . . . . . . . . . . 178

8.6.5

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178

Credit Derivatives
9.1

9.2

9.3

. . . . . . . . . . . . . . . . . . . . . 175

179

Credit risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

9.1.1

Types of credit risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

9.1.2

Assessing credit risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

9.1.3

Mitigating credit risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180

9.1.4

Credit risk related acronyms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181

9.1.5

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181

9.1.6

Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181

9.1.7

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181

9.1.8

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181

Credit derivative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

9.2.1

History and participants

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

9.2.2

Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

9.2.3

Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184

9.2.4

Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184

9.2.5

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184

9.2.6

Notes and references . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184

9.2.7

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184

Credit default swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184

9.3.1

Description . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185

9.3.2

Uses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187

9.3.3

History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190

9.3.4

Terms of a typical CDS contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

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CONTENTS
9.3.5

Credit default swap and sovereign debt crisis . . . . . . . . . . . . . . . . . . . . . . . . . 194

9.3.6

Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194

9.3.7

Pricing and valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195

9.3.8

Criticisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196

9.3.9

Tax and accounting issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198

9.3.10 LCDS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198

9.3.11 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
9.3.12 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
9.3.13 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
9.3.14 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
9.4

9.5

9.6

9.7

9.8

9.9

Credit linked note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204

9.4.1

Explanation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204

9.4.2

Emerging Market CLN . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204

9.4.3

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204

9.4.4

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204

Collateralized debt obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205

9.5.1

Market history . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205

9.5.2

Concept, structures, varieties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

9.5.3

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213

9.5.4

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214

9.5.5

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216

Collateralized loan obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217

9.6.1

Leveraging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217

9.6.2

Rationale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217

9.6.3

Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217

9.6.4

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217

9.6.5

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218

Single-tranche CDO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218

9.7.1

Full-capital-structure CDOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218

9.7.2

Bespoke portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219

9.7.3

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219

Total return swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219

9.8.1

Contract denition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219

9.8.2

Advantage of using Total Return Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . 219

9.8.3

Users . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

9.8.4

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

9.8.5

External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

9.8.6

See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

Constant maturity credit default swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

9.9.1

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

9.10 Collateralized mortgage obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

CONTENTS

xv

9.10.1 Purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221

9.10.2 Credit protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
9.10.3 Prepayment tranching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
9.10.4 Coupon tranching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
9.10.5 Attributes of IOs and POs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
9.10.6 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
9.10.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
10 Interest Rate Derivatives

226

10.1 Interest rate risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226

10.1.1 Calculating interest rate risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
10.1.2 Interest rate risk at banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
10.1.3 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226
10.2 Interest rate derivative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
10.2.1 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
10.2.2 Example of interest rate derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
10.2.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
10.2.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
10.2.5 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
10.2.6 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
10.3 Forward rate agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
10.3.1 Payo formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
10.3.2 FRAs Notation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
10.3.3 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
10.3.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
10.4 Interest rate future . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
10.4.1 Uses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
10.4.2 STIRS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
10.4.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
10.4.4 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
10.4.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
10.5 Interest rate option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
10.5.1 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
10.6 Interest rate swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
10.6.1 Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
10.6.2 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
10.6.3 Uses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232
10.6.4 Valuation and pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
10.6.5 Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
10.6.6 Market size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
10.6.7 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
10.6.8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234

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10.6.9 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
10.7 Interest rate cap and oor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
10.7.1 Interest rate cap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
10.7.2 Interest rate oor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
10.7.3 Valuation of interest rate caps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
10.7.4 Implied Volatilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
10.7.5 Interest rate caps and their impact on nancial inclusion . . . . . . . . . . . . . . . . . . . 237
10.7.6 The use of interest rate caps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
10.7.7 The impact of interest caps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
10.7.8 Alternative methods of reducing interest rate spreads . . . . . . . . . . . . . . . . . . . . . 240
10.7.9 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
10.7.10 Compare . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
10.7.11 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
10.7.12 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
10.7.13 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
10.8 Interest rate basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
10.8.1 Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
10.8.2 Denitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
10.8.3 30/360 methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
10.8.4 Actual methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
10.8.5 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
10.8.6 Footnotes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
10.8.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
10.8.8 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
10.8.9 Related information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
10.9 Basis swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
10.9.1 Usage of basis swaps for hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
10.9.2 Basis swaps in energy commodities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
10.9.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
10.10Range accrual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
10.10.1 Payo description

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249

10.10.2 Valuation and risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249

10.10.3 Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
10.10.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
10.11Overnight indexed swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
10.11.1 Risk barometer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
10.11.2 Historical levels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
10.11.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
10.11.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
10.11.5 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
11 Currency Derivatives

251

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11.1 Foreign exchange market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251

11.1.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252
11.1.2 Market size and liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
11.1.3 Market participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254
11.1.4 Trading characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
11.1.5 Determinants of exchange rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
11.1.6 Financial instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258
11.1.7 Speculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
11.1.8 Risk aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
11.1.9 Carry trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
11.1.10 Forex signals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
11.1.11 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
11.1.12 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
11.1.13 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
11.2 Exchange rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
11.2.1 Retail exchange market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
11.2.2 Quotations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
11.2.3 Exchange rate regime . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
11.2.4 Fluctuations in exchange rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
11.2.5 Purchasing power of currency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
11.2.6 Bilateral vs. eective exchange rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265
11.2.7 Uncovered interest rate parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265
11.2.8 Balance of payments model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265
11.2.9 Asset market model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265
11.2.10 Manipulation of exchange rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
11.2.11 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
11.2.12 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
11.3 Currency risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
11.3.1 Types of exposure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
11.3.2 Measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
11.3.3 Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
11.3.4 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
11.3.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
11.3.6 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
11.4 Real exchange rate puzzles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
11.4.1 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
11.4.2 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
11.5 Interest rate parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
11.5.1 Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
11.5.2 Uncovered interest rate parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
11.5.3 Covered interest rate parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271

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11.5.4 Empirical evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
11.5.5 Real interest rate parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
11.5.6 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
11.5.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273

11.6 Foreign exchange derivative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274

11.7 Forex swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
11.7.1 Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
11.7.2 Uses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
11.7.3 Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
11.7.4 Related instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
11.7.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
11.7.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
11.8 Eective Exchange Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
11.8.1 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
12 Option Strategies

277

12.1 Covered call . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277

12.1.1 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
12.1.2 Marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
12.1.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
12.1.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
12.1.5 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
12.1.6 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
12.2 Naked put . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
12.2.1 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
12.2.2 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
12.3 Straddle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
12.3.1 Long straddle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
12.3.2 Short straddle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
12.3.3 Tax straddle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
12.3.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
12.3.5 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
12.4 Buttery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
12.4.1 Long buttery

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282

12.4.2 Short buttery

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282

12.4.3 Margin Requirements

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283

12.4.4 Buttery Variations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283

12.4.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
12.5 Collar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
12.5.1 Equity Collar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
12.5.2 Interest Rate Collar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
12.5.3 Why do this? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284

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12.5.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284

12.6 Iron condor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
12.6.1 Long iron condor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
12.6.2 Short iron condor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
12.6.3 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
12.7 Strangle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
12.7.1 Long strangle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
12.7.2 Short strangle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
12.7.3 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
12.7.4 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
13 Options Spread

288

13.1 Options spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288

13.1.1 Call and put spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
13.1.2 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
13.1.3 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
13.2 Bull spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
13.2.1 Bull call spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
13.2.2 Bull put spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
13.2.3 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
13.3 Box spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
13.3.1 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
13.3.2 The Box Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
13.3.3 An Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
13.3.4 Prevalence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
13.3.5 The box spread in futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
13.3.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291
13.4 Backspread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
13.4.1 Call backspread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
13.4.2 Put backspread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
13.4.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
13.4.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
13.5 Calendar spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
13.5.1 Uses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
13.5.2 Futures Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
13.5.3 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
13.5.4 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
13.6 Ratio spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
13.6.1 Purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
13.6.2 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
13.6.3 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
13.7 Vertical spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294

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13.7.1 Bull vertical spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
13.7.2 Bear vertical spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
13.7.3 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
13.8 Credit Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
13.8.1 Bullish strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
13.8.2 Bearish strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
13.8.3 Breakeven . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
13.8.4 Maximum potential . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
13.8.5 Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
13.8.6 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
13.8.7 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
13.8.8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
13.9 Debit spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
13.9.1 Bullish & Bearish Debit Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
13.9.2 Breakeven Point . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
13.9.3 Maximum Potential . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
13.9.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
13.9.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297

14 Combinations, Exotic Options, Other Derivatives, etc.

298

14.1 Exotic option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298

14.1.1 Etymology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
14.1.2 Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
14.1.3 Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
14.1.4 Barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
14.1.5 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
14.1.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
14.1.7 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
14.1.8 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
14.2 Barrier option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
14.2.1 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
14.2.2 Barrier events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
14.2.3 Variations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
14.2.4 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
14.2.5 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
14.3 Compound option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
14.3.1 Variants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
14.3.2 Compound Option Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
14.3.3 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
14.3.4 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
14.4 Swaption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
14.4.1 The swaption market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302

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14.4.2 Swaption styles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302

14.4.3 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
14.4.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
14.4.5 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
14.4.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
14.4.7 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
14.5 Bond plus option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
14.6 Cliquet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
14.6.1 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
14.6.2 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
14.6.3 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
14.7 ELN . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
14.7.1 Payout . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
14.7.2 Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
14.7.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
14.7.4 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
14.8 Commodore option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
14.8.1 Example

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304

14.9 Delta neutral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

14.9.1 Nomenclature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
14.9.2 Mathematical interpretation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
14.9.3 Creating the position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
14.9.4 Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
14.9.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
14.9.6 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
14.10Basket Options (Rainbow) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
14.10.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
14.10.2 Pricing and valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
14.10.3 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
14.10.4 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
14.11Low Exercise Price Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
14.11.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
14.11.2 Dierences from standard options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
14.11.3 Pricing of Low Exercise Price Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
14.11.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
14.12Forward start option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
14.12.1 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
14.12.2 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
14.13Binary option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
14.13.1 Regulation and compliance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
14.13.2 Criticism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309

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14.13.3 Exchange-traded binary options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
14.13.4 Example of a binary options trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
14.13.5 BlackScholes valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
14.13.6 Relationship to vanilla options Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
14.13.7 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
14.13.8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
14.13.9 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311

14.14Chooser option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311

14.14.1 Replication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
14.14.2 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
14.14.3 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
14.15Lookback option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
14.15.1 Lookback option with oating strike . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
14.15.2 Lookback option with xed strike . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
14.15.3 Arbitrage-free price of lookback options with oating strike . . . . . . . . . . . . . . . . . 312
14.15.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
14.16Mountain range . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
14.16.1 Everest Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
14.16.2 Atlas Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
14.16.3 Himalayan Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
14.17CPPI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
14.17.1 Some denitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
14.17.2 Dynamic trading strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
14.17.3 Practical CPPI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
14.17.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
14.17.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
14.18ELN . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
14.18.1 Payout . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
14.18.2 Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
14.18.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
14.18.4 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
14.19Equity derivative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
14.19.1 Equity options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
14.19.2 Warrants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
14.19.3 Convertible bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
14.19.4 Equity futures, options and swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
14.19.5 Exchange-traded derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
14.19.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
14.20Fund derivative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
14.20.1 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
14.20.2 Features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317

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14.20.3 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317

14.20.4 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
14.21Ination derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
14.21.1 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
14.22PRDC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
14.22.1 Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
14.22.2 Payo and cashows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
14.22.3 Model

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319

14.22.4 Computation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319

14.22.5 Hedging

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319

14.22.6 PRDC during the Subprime Crisis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320

14.22.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
14.23Real estate derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
14.23.1 Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
14.23.2 Derivative eciencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
14.23.3 Market growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
14.23.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
14.24Synthetic underlying position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
14.24.1 Synthetic long put

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321

14.24.2 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321

14.25Synthetic underlying position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
14.25.1 Synthetic long put

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322

14.25.2 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322

15 Swaps

323

15.1 Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323

15.1.1 Swap market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
15.1.2 Types of swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324
15.1.3 Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
15.1.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
15.1.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
15.1.6 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
15.2 Swap rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
15.2.1 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
15.3 Variance swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
15.3.1 Structure and features . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
15.3.2 Pricing and valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
15.3.3 Uses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
15.3.4 Related instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
15.3.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
15.4 Forex swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
15.4.1 Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328

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15.4.2 Uses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
15.4.3 Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
15.4.4 Related instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
15.4.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
15.4.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329

15.5 Basis swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329

15.5.1 Usage of basis swaps for hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
15.5.2 Basis swaps in energy commodities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
15.5.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
15.6 Constant maturity swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
15.6.1 Example

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330

15.6.2 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330

15.6.3 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
15.7 Currency swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
15.7.1 Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
15.7.2 Uses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
15.7.3 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
15.7.4 Abuses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
15.7.5 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331
15.7.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
15.7.7 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
15.8 Equity swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
15.8.1 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
15.8.2 Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
15.8.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
15.9 Ination swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
15.9.1 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
15.9.2 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
15.10Total return swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
15.10.1 Contract denition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
15.10.2 Advantage of using Total Return Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
15.10.3 Users . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
15.10.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
15.10.5 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
15.10.6 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
15.11Volatility swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
15.11.1 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
15.11.2 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
15.11.3 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
15.12Correlation swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
15.12.1 Payo Denition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335

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15.12.2 Pricing and valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336

15.12.3 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
15.12.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
15.13Conditional variance swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
15.13.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
15.13.2 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336
16 Asset Based Securities

337

16.1 Asset-backed security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337

16.1.1 Denition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
16.1.2 Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
16.1.3 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
16.1.4 Trading asset-backed securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
16.1.5 Securitization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
16.1.6 ABS indices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
16.1.7 Advantages and disadvantages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
16.1.8 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342
16.1.9 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342
16.1.10 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342
16.1.11 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
16.2 Mortgage-backed security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
16.2.1 Securitization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
16.2.2 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344
16.2.3 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
16.2.4 Uses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
16.2.5 Criticisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
16.2.6 Market size and liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
16.2.7 Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
16.2.8 Recording and Mortgage Electronic Registration Systems . . . . . . . . . . . . . . . . . . 349
16.2.9 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
16.2.10 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
16.2.11 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
16.2.12 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
16.3 Collateralized mortgage obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
16.3.1 Purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
16.3.2 Credit protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
16.3.3 Prepayment tranching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
16.3.4 Coupon tranching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355
16.3.5 Attributes of IOs and POs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
16.3.6 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
16.3.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356

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17 Other Risks

357

17.1 Market Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357

17.1.1 Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
17.1.2 Risk management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
17.1.3 Measuring the potential loss amount due to market risk . . . . . . . . . . . . . . . . . . . 357
17.1.4 Use in annual reports of U.S. corporations . . . . . . . . . . . . . . . . . . . . . . . . . . 357
17.1.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
17.1.6 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
17.1.7 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
17.2 Financial risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
17.2.1 Types of risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358
17.2.2 Diversication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
17.2.3 Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
17.2.4 Financial / Credit risk related acronyms . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
17.2.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
17.2.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360
17.2.7 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360
17.3 Liquidity risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360
17.3.1 Types of liquidity risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360
17.3.2 Causes of liquidity risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
17.3.3 Pricing of liquidity risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
17.3.4 Measures of liquidity risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
17.3.5 Measures of asset liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
17.3.6 Managing liquidity risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
17.3.7 Case studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
17.3.8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
17.3.9 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
17.3.10 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
17.4 Systemic risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
17.4.1 Explanation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364
17.4.2 Measurement of systemic risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
17.4.3 Valuation of assets and derivatives under systemic risk . . . . . . . . . . . . . . . . . . . . 366
17.4.4 Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
17.4.5 Diversication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
17.4.6 Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
17.4.7 Project risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
17.4.8 Systemic risk and insurance
17.4.9 Discussion

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368

17.4.10 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368

17.4.11 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368
17.4.12 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369

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17.5 Systematic risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370

17.5.1 Properties of systematic risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
17.5.2 Systematic risk in nance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
17.5.3 Aggregate risk in economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
17.5.4 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
17.5.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
17.6 Basis risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
17.6.1 Denition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
17.6.2 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
17.6.3 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
17.7 Pin risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
17.7.1 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
17.7.2 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
17.7.3 Management of pin risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
17.7.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374
17.7.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374
18 Regulation

375

18.1 Financial regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375

18.1.1 Aims of regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
18.1.2 Structure of supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
18.1.3 Authority by country . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
18.1.4 Regulatory reliance on credit rating agencies . . . . . . . . . . . . . . . . . . . . . . . . . 377
18.1.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
18.1.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
18.1.7 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
18.1.8 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
18.2 US Federal Reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377
18.2.1 Purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378
18.2.2 Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382
18.2.3 Monetary policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385
18.2.4 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
18.2.5 Measurement of economic variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393
18.2.6 Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 394
18.2.7 Net worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395
18.2.8 Criticism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396
18.2.9 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396
18.2.10 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396
18.2.11 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402
18.2.12 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403
18.3 Securities and Exchange Commission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403
18.3.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403

xxviii

CONTENTS
18.3.2 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404
18.3.3 Organizational structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405
18.3.4 SEC communications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
18.3.5 Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
18.3.6 Relationship to other agencies

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409

18.3.7 Related legislation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409

18.3.8 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409
18.3.9 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410
18.3.10 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411
18.4 Securities and Exchange Board of India . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411
18.4.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411
18.4.2 Organization structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 412
18.4.3 Functions and responsibilities
18.4.4 Major achievements

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 412

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 412

18.4.5 Controversies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413

18.4.6 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413
18.4.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413
18.4.8 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413
18.5 Forward Markets Commission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
18.5.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
18.5.2 Responsibilities and functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414
18.5.3 Commission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
18.5.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
18.5.5 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
18.6 Freddie Mac . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
18.6.1 History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
18.6.2 Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416
18.6.3 Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417
18.6.4 Related legislation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419
18.6.5 See also . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419
18.6.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419
18.6.7 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421
18.6.8 External links . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421
19 Text and image sources, contributors, and licenses

422

19.1 Text . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422

19.2 Images . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 442
19.3 Content license . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 448

Chapter 1

Introduction
1.1 Financial risk

auditing standards; nationalization, expropriation or conscatory taxation; economic conict; or political or diploFinancial risk is an umbrella term for multiple types of matic changes. Valuation, liquidity, and regulatory issues
risk associated with nancing, including nancial trans- may also add to foreign investment risk.
actions that include company loans in risk of default.[1][2]
Risk is a term often used to imply downside risk, meaning Liquidity risk
the uncertainty of a return and the potential for nancial
loss.[3][4]
Main article: Liquidity risk
See also: Liquidity

A science has evolved around managing market and nancial risk under the general title of modern portfolio
theory initiated by Dr. Harry Markowitz in 1952 with
his article, Portfolio Selection.[5] In modern portfolio
theory, the variance (or standard deviation) of a portfolio
is used as the denition of risk.

1.1.1

This is the risk that a given security or asset cannot be

traded quickly enough in the market to prevent a loss (or
make the required prot). There are two types of liquidity
risk:
Asset liquidity - An asset cannot be sold due to lack
of liquidity in the market - essentially a sub-set of
market risk. This can be accounted for by:

Types of risk

Asset-backed risk

Widening bid-oer spread

Risk that the changes in one or more assets that support an

asset-backed security will signicantly impact the value
of the supported security. Risks include interest rate,
term modication, and prepayment risk.

Making explicit liquidity reserves

Lengthening holding period for VaR calculations
Funding liquidity - Risk that liabilities:

Credit risk

Cannot be met when they fall due

Can only be met at an uneconomic price

Main article: Credit risk

Can be name-specic or systemic

Credit risk, also called default risk, is the risk associated
with a borrower going into default (not making payments
as promised). Investor losses include lost principal and
interest, decreased cash ow, and increased collection
costs. An investor can also assume credit risk through
direct or indirect use of leverage. For example, an investor may purchase an investment using margin. Or an
investment may directly or indirectly use or rely on repo,
forward commitment, or derivative instruments.

Market risk
Main article: Market risk
The four standard market risk factors are equity risk, interest rate risk, currency risk, and commodity risk:

Foreign investment risk

Equity risk is the risk that stock prices in general

(not related to a particular company or industry) or
the implied volatility will change.

Risk of rapid and extreme changes in value due to:

smaller markets; diering accounting, reporting, or

Interest rate risk is the risk that interest rates or the

implied volatility will change.
1

CHAPTER 1. INTRODUCTION
Currency risk is the risk that foreign exchange rates
or the implied volatility will change, which aects,
for example, the value of an asset held in that currency.

many bonds and many equities can be constructed in order to further narrow the dispersion of possible portfolio
outcomes.

A key issue in diversication is the correlation between

assets, the benets increasing with lower correlation.
Commodity risk is the risk that commodity prices
However this is not an observable quantity, since the fu(e.g. corn, copper, crude oil) or implied volatility
ture return on any asset can never be known with comwill change.
plete certainty. This was a serious issue in the Late-2000s
recession when assets that had previously had small or
even negative correlations[8] suddenly starting moving in
Operational risk
the same direction causing severe nancial stress to market participants who had believed that their diversication
Main article: Operational risk
would protect them against any plausible market conditions, including funds that had been explicitly set up to
avoid being aected in this way [9]
Other risks
Diversication has costs. Correlations must be identied
and understood, and since they are not constant it may be
Reputational risk
necessary to rebalance the portfolio which incurs transaction costs due to buying and selling assets. There is
Legal risk
also the risk that as an investor or fund manager diversies their ability to monitor and understand the assets may
IT risk
decline leading to the possibility of losses due to poor decisions or unforeseen correlations.
Model risk
Main article: Model risk

1.1.3 Hedging

Hedging is a method for reducing risk where a combination of assets are selected to oset the movements of each
other. For instance when investing in a stock it is possible to buy an option to sell that stock at a dened price
Main article: Diversication (nance)
at some point in the future. The combined portfolio of
stock and option is now much less likely to move below
Financial risk, market risk, and even ination risk, can at
a given value. As in diversication there is a cost, this
least partially be moderated by forms of diversication.
time in buying the option for which there is a premium.
The returns from dierent assets are highly unlikely to be Derivatives are used extensively to mitigate many types
perfectly correlated and the correlation may sometimes of risk.[10]
be negative. For instance, an increase in the price of
oil will often favour a company that produces it,[6] but
negatively impact the business of a rm such an airline
whose variable costs are heavily based upon fuel.[7] How- 1.1.4 Financial / Credit risk related
ever, share prices are driven by many factors, such as the
acronyms
general health of the economy which will increase the
correlation and reduce the benet of diversication. If
ACPM Active credit portfolio management
one constructs a portfolio by including a wide variety of
equities, it will tend to exhibit the same risk and return EAD Exposure at default
characteristics as the market as a whole, which many in- EL Expected loss
vestors see as an attractive prospect, so that index funds
have been developed that invest in equities in proportion ERM Enterprise risk management
to the weighting they have in some well known index such LGD Loss given default
as the FTSE.
PD Probability of default
However, history shows that even over substantial periods
of time there is a wide range of returns that an index fund KMV quantitative credit analysis solution developed by
may experience; so an index fund by itself is not fully di- credit rating agency Moodys
versied. Greater diversication can be obtained by di- VaR value at risk, a common methodology for measuring
versifying across asset classes; for instance a portfolio of risk due to market movements

1.1.2

Diversication

1.2. FINANCIAL RISK MANAGEMENT

1.1.5

See also

Beta
Capital asset pricing model
Cost of capital
Downside beta
Downside risk
Insurance
Macro risk
Modern portfolio theory
Optimism bias
Reinvestment risk
Risk attitude
Risk measure
RiskLab
Risk premium
Systemic risk

1.1.7 External links

Bartram, Shnke M.; Brown, Gregory W.; Waller,
William (August 2013). How Important is Financial Risk?". Journal of Financial and Quantitative
Analysis. forthcoming.
Risk.net Financial Risk Management News &
Analysis
MacroRisk Analytics Patented and proprietary
macro risk measurements and tools for investors
since 1999.
Elements of Financial Risk Management, 2nd Edition
Quantitative Risk Management: A Practical Guide
to Financial Risk
Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank of Chicago, Financial
Markets Group
Financial Risks Management of International Investments in Forex

Upside beta
Upside risk

1.2 Financial risk management

Value at risk
Financial risk management is the practice of economic
value in a rm by using nancial instruments to manage
1.1.6 References
exposure to risk, particularly credit risk and market risk.
Other types include Foreign exchange, Shape, Volatility,
[1] Financial Risk: Denition. Investopedia. Retrieved
Sector, Liquidity, Ination risks, etc. Similar to genOctober 2011.
eral risk management, nancial risk management requires
[2] In Wall Street Words. Credo Reference. 2003. Re- identifying its sources, measuring it, and plans to address
trieved October 2011.
them.
Financial risk management can be qualitative and quantitative. As a specialization of risk management, nancial
risk management focuses on when and how to hedge using nancial instruments to manage costly exposures to
[4] Horcher, Karen A. (2005). Essentials of nancial risk risk.
management. John Wiley and Sons. pp. 13. ISBN 978- In the banking sector worldwide, the Basel Accords
0-471-70616-8.
are generally adopted by internationally active banks for
[5] Markowitz, H.M. (March 1952). Portfolio Selec- tracking, reporting and exposing operational, credit and
tion.
The Journal of Finance 7 (1): 7791. market risks.
[3] McNeil, Alexander J.; Frey, Rdiger; Embrechts, Paul
(2005). Quantitative risk management: concepts, techniques and tools. Princeton University Press. pp. 23.
ISBN 978-0-691-12255-7.

doi:10.2307/2975974.
[6] Another record prot for Exxon. BBC News. 31 July
2008.
[7] Crawley, John (16 May 2011). U.S. airline shares up as
oil price slides. Reuters.
[8] http://www.eurojournals.com/irjfe_35_14.pdf
[9] http://web.mit.edu/alo/www/Papers/august07.pdf
[10] http://www.chicagofed.org/webpages/publications/
understanding_derivatives/index.cfm

1.2.1 When to use nancial risk management

Finance theory (i.e., nancial economics) prescribes
that a rm should take on a project when it increases
shareholder value. Finance theory also shows that rm
managers cannot create value for shareholders, also called
its investors, by taking on projects that shareholders could
do for themselves at the same cost.

CHAPTER 1. INTRODUCTION

When applied to nancial risk management, this implies

Risk and Interest Rate Risk Management. John Withat rm managers should not hedge risks that investors
ley. ISBN 978-0-470-82126-8.
can hedge for themselves at the same cost. This notion
was captured by the hedging irrelevance proposition: In
a perfect market, the rm cannot create value by hedging 1.2.4 References
a risk when the price of bearing that risk within the rm
is the same as the price of bearing it outside of the rm. [1] http://www.emeraldinsight.com/Insight/
viewContentItem.do;jsessionid=
In practice, nancial markets are not likely to be perfect
EFA8D4FB63329F2C94F48279646551BF?
markets.
(concontentType=Article&contentId=1649008
This suggests that rm managers likely have many opportunities to create value for shareholders using nancial
risk management. The trick is to determine which risks
are cheaper for the rm to manage than the shareholders.
A general rule of thumb, however, is that market risks that
result in unique risks for the rm are the best candidates
for nancial risk management.

trary to conventional wisdom it may be rational to hedge

translation exposure. Empirical evidence of agency
costs and the managerial tendency to report higher levels
of translated income, based on the early adoption of
Financial Accounting Standard No. 52).
[2] Aggarwal, Raj, The Translation Problem in International
Accounting: Insights for Financial Management. Management International Review 15 (Nos. 2-3, 1975): 6779. (Proposed accounting framework for evaluating and
developing translation procedures for multinational corporations).

The concepts of nancial risk management change dramatically in the international realm. Multinational Corporations are faced with many dierent obstacles in
overcoming these challenges. There has been some research on the risks rms must consider when operat- [3] http://www.iijournals.com/doi/abs/10.3905/jpm.1997.
409611 (Discusses the benets for hedging in foreign
ing in many countries, such as the three kinds of forcurrencies for MNCs).
eign exchange exposure for various future time horizons:
[1]
[2]
transactions exposure, accounting exposure, and economic exposure.[3]
1.2.5 External links

1.2.2

See also

CERA - The Chartered Enterprise Risk Analyst

Credential - Society of Actuaries (SOA)

1.2.3

Bibliography

Financial Risk Manager Certication Program Global Association of Risk Professional (GARP)

Crockford, Neil (1986). An Introduction to Risk

Management (2nd ed.). Woodhead-Faulkner. ISBN
0-85941-332-2.
Charles, Tapiero (2004). Risk and Financial Management: Mathematical and Computational Methods. John Wiley & Son. ISBN 0-470-84908-8.

Professional Risk Manager Certication Program Professional Risk Managers International Association (PRMIA)
Managing a portfolio of stock and risk-free investments: a tutorial for risk-sensitive investors

Conti, Cesare & Mauri, Arnaldo (2008). Corporate Financial Risk Management: Governance and 1.3 Derivative
Disclosure post IFRS 7, Icfai Journal of Financial
Risk Management, ISSN 0972-916X, Vol. V, n. 2, In nance, a derivative is a contract that derives its value
pp.20-27.
from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate,
Lam, James (2003). Enterprise Risk Management:
and is often called the underlying.[1][2] Derivatives can
From Incentives to Controls. John Wiley. ISBN 978be used for a number of purposes, including insuring
0-471-43000-1.
against price movements (hedging), increasing exposure
McNeil, Alexander J.; Frey, Rdiger; Embrechts, to price movements for speculation or getting access to
[3]
Paul (2005), Quantitative Risk Management. Con- otherwise hard-to-trade assets or markets. Some of
cepts, Techniques and Tools, Princeton Series the more common derivatives include forwards, futures,
in Finance, Princeton, NJ: Princeton University options, swaps, and variations of these such as synPress, ISBN 0-691-12255-5, MR 2175089, Zbl thetic collateralized debt obligations and credit default
swaps. Most derivatives are traded over-the-counter (o1089.91037
exchange) or on an exchange such as the Chicago Mer van Deventer, Donald R., Kenji Imai and Mark cantile Exchange, while most insurance contracts have
Mesler (2004). Advanced Financial Risk Manage- developed into a separate industry. Derivatives are one
ment: Tools and Techniques for Integrated Credit of the three main categories of nancial instruments, the

1.3. DERIVATIVE

other two being stocks (i.e., equities or shares) and debt takes possession of the defaulted loan.[12] However, any(i.e., bonds and mortgages).
one can purchase a CDS, even buyers who do not hold
the loan instrument and who have no direct insurable interest in the loan (these are called naked CDSs). If
there are more CDS contracts outstanding than bonds in
1.3.1 Collateralised debt obligation
existence, a protocol exists to hold a credit event aucA collateralised debt obligation (CDO) is a type of tion; the payment received is usually substantially less
structured asset-backed security (ABS).[4] Originally de- than the face value of the loan.[13] Credit default swaps
veloped for the corporate debt markets, over time CDOs have existed since the early 1990s, and increased in use
evolved to encompass the mortgage and mortgage-backed after 2003. By the end of 2007, the outstanding CDS
security (MBS) markets.[5] Like other private-label secu- amount was $62.2 trillion,[14] falling to $26.3 trillion by
rities backed by assets, a CDO can be thought of as a mid-year 2010[15] but reportedly $25.5[16] trillion in early
promise to pay investors in a prescribed sequence, based 2012. CDSs are not traded on an exchange and there
on the cash ow the CDO collects from the pool of is no required reporting of transactions to a government
bonds or other assets it owns. The CDO is sliced into agency.[17] During the 2007-2010 nancial crisis the lack
tranches, which catch the cash ow of interest and of transparency in this large market became a concern
principal payments in sequence based on seniority.[6] If to regulators as it could pose a systemic risk.[18][19][20][21]
some loans default and the cash collected by the CDO is In March 2010, the [DTCC] Trade Information Wareinsucient to pay all of its investors, those in the lowest, house (see Sources of Market Data) announced it would
most junior tranches suer losses rst. The last to lose give regulators greater access to its credit default swaps
payment from default are the safest, most senior tranches. database.[22] CDS data can be used by nancial profesConsequently coupon payments (and interest rates) vary sionals, regulators, and the media to monitor how the
by tranche with the safest/most senior tranches paying the market views credit risk of any entity on which a CDS
lowest and the lowest tranches paying the highest rates is available, which can be compared to that provided by
to compensate for higher default risk. As an example, a credit rating agencies. U.S. courts may soon be following
CDO might issue the following tranches in order of safe- suit.[12] Most CDSs are documented using standard forms
ness: Senior AAA (sometimes known as super senior); drafted by the International Swaps and Derivatives Association (ISDA), although there are many variants.[18] In
Junior AAA; AA; A; BBB; Residual.[7]
addition to the basic, single-name swaps, there are basket
Separate special purpose entitiesrather than the pardefault swaps (BDSs), index CDSs, funded CDSs (also
ent investment bankissue the CDOs and pay interest to
called credit-linked notes), as well as loan-only credit
investors. As CDOs developed, some sponsors repackdefault swaps (LCDS). In addition to corporations and
aged tranches into yet another iteration called CDOgovernments, the reference entity can include a special
[7]
squared or the CDOs of CDOs. In the early 2000s,
purpose vehicle issuing asset-backed securities.[23] Some
[8]
CDOs were generally diversied, but by 20062007
claim that derivatives such as CDS are potentially danwhen the CDO market grew to hundreds of billions of
gerous in that they combine priority in bankruptcy with a
dollarsthis changed. CDO collateral became domilack of transparency.[19] A CDS can be unsecured (withnated not by loans, but by lower level (BBB or A) tranches
out collateral) and be at higher risk for a default.
recycled from other asset-backed securities, whose assets
[9]
were usually non-prime mortgages. These CDOs have
been called the engine that powered the mortgage supply chain for nonprime mortgages,[10] and are credited 1.3.3 Forwards
with giving lenders greater incentive to make non-prime
loans[11] leading up to the 2007-9 subprime mortgage cri- In nance, a forward contract or simply a forward
sis.
is a non-standardized contract between two parties to
buy or to sell an asset at a specied future time at a
price agreed upon today, making it a type of derivative
1.3.2 Credit default swap
instrument.[24][25] This is in contrast to a spot contract,
which is an agreement to buy or sell an asset on its spot
A credit default swap (CDS) is a nancial swap agree- date, which may vary depending on the instrument, for
ment that the seller of the CDS will compensate the buyer example most of the FX contracts have Spot Date two
(the creditor of the reference loan) in the event of a loan business days from today. The party agreeing to buy the
default (by the debtor) or other credit event. The buyer underlying asset in the future assumes a long position,
of the CDS makes a series of payments (the CDS fee and the party agreeing to sell the asset in the future asor spread) to the seller and, in exchange, receives a sumes a short position. The price agreed upon is called
payo if the loan defaults. It was invented by Blythe the delivery price, which is equal to the forward price at
Masters from JP Morgan in 1994. In the event of de- the time the contract is entered into. The price of the
fault the buyer of the CDS receives compensation (usu- underlying instrument, in whatever form, is paid before
ally the face value of the loan), and the seller of the CDS control of the instrument changes. This is one of the

CHAPTER 1. INTRODUCTION

many forms of buy/sell orders where the time and date of gins, sometimes set as a percentage of the value of the
trade is not the same as the value date where the securities futures contact needs to be proportionally maintained at
themselves are exchanged.
all times during the life of the contract to underpin this
The forward price of such a contract is commonly con- mitigation because the price of the contract will vary in
trasted with the spot price, which is the price at which keeping with supply and demand and will change daily
the asset changes hands on the spot date. The dierence and thus one party or the other will theoretically be makbetween the spot and the forward price is the forward pre- ing or losing money. To mitigate risk and the possibilmium or forward discount, generally considered in the ity of default by either party, the product is marked to
market on a daily basis whereby the dierence between
form of a prot, or loss, by the purchasing party. Forwards, like other derivative securities, can be used to the prior agreed-upon price and the actual daily futures
price is settled on a daily basis. This is sometimes known
hedge risk (typically currency or exchange rate risk), as a
means of speculation, or to allow a party to take advan- as the variation margin where the futures exchange will
draw money out of the losing partys margin account and
tage of a quality of the underlying instrument which is
put it into the other partys thus ensuring that the correct
time-sensitive.
daily loss or prot is reected in the respective account.
A closely related contract is a futures contract; they dier If the margin account goes below a certain value set by
in certain respects. Forward contracts are very similar the Exchange, then a margin call is made and the account
to futures contracts, except they are not exchange-traded, owner must replenish the margin account. This process is
or dened on standardized assets.[26] Forwards also typi- known as marking to market. Thus on the delivery date,
cally have no interim partial settlements or true-ups in the amount exchanged is not the specied price on the
margin requirements like futuressuch that the parties contract but the spot value (i.e., the original value agreed
do not exchange additional property securing the party upon, since any gain or loss has already been previously
at gain and the entire unrealized gain or loss builds up settled by marking to market). Upon marketing the strike
while the contract is open. However, being traded over price is often reached and creates lots of income for the
the counter (OTC), forward contracts specication can caller.
be customized and may include mark-to-market and daily
margin calls. Hence, a forward contract arrangement A closely related contract is a forward contract. A formight call for the loss party to pledge collateral or addi- ward is like a futures in that it species the exchange
tional collateral to better secure the party at gain. In other of goods for a specied price at a specied future date.
words, the terms of the forward contract will determine However, a forward is not traded on an exchange and thus
does not have the interim partial payments due to markthe collateral calls based upon certain trigger events relevant to a particular counterparty such as among other ing to market. Nor is the contract standardized, as on
the exchange. Unlike an option, both parties of a futures
things, credit ratings, value of assets under management
contract
must fulll the contract on the delivery date. The
or redemptions over a specic time frame (e.g., quarterly,
seller delivers the underlying asset to the buyer, or, if it
annually).
is a cash-settled futures contract, then cash is transferred
from the futures trader who sustained a loss to the one
who made a prot. To exit the commitment prior to the
1.3.4 Futures
settlement date, the holder of a futures position can close
out its contract obligations by taking the opposite position
In nance, a futures contract (more colloquially, fu- on another futures contract on the same asset and settletures) is a standardized contract between two parties to ment date. The dierence in futures prices is then a prot
buy or sell a specied asset of standardized quantity and or loss.
quality for a price agreed upon today (the futures price)
with delivery and payment occurring at a specied future date, the delivery date, making it a derivative prod- 1.3.5 Mortgage-backed securities
uct (i.e. a nancial product that is derived from an underlying asset). The contracts are negotiated at a futures A mortgage-backed security (MBS) is a asset-backed
exchange, which acts as an intermediary between buyer security that is secured by a mortgage, or more comand seller. The party agreeing to buy the underlying as- monly a collection (pool) of sometimes hundreds of
set in the future, the buyer of the contract, is said to mortgages. The mortgages are sold to a group of indibe "long", and the party agreeing to sell the asset in the viduals (a government agency or investment bank) that
future, the seller of the contract, is said to be "short".
"securitizes", or packages, the loans together into a seWhile the futures contract species a trade taking place
in the future, the purpose of the futures exchange is to act
as intermediary and mitigate the risk of default by either
party in the intervening period. For this reason, the futures exchange requires both parties to put up an initial
amount of cash (performance bond), the margin. Mar-

curity that can be sold to investors. The mortgages of

an MBS may be residential or commercial, depending on
whether it is an Agency MBS or a Non-Agency MBS;
in the United States they may be issued by structures
set up by government-sponsored enterprises like Fannie
Mae or Freddie Mac, or they can be private-label, is-

1.3. DERIVATIVE
sued by structures set up by investment banks. The structure of the MBS may be known as pass-through, where
the interest and principal payments from the borrower or
homebuyer pass through it to the MBS holder, or it may
be more complex, made up of a pool of other MBSs.
Other types of MBS include collateralized mortgage obligations (CMOs, often structured as real estate mortgage
investment conduits) and collateralized debt obligations
(CDOs).[27]
The shares of subprime MBSs issued by various structures, such as CMOs, are not identical but rather issued as
tranches (French for slices), each with a dierent level
of priority in the debt repayment stream, giving them different levels of risk and reward. Tranchesespecially
the lower-priority, higher-interest tranchesof an MBS
are/were often further repackaged and resold as collaterized debt obligations.[28] These subprime MBSs issued
by investment banks were a major issue in the subprime
mortgage crisis of 20062008 . The total face value of
an MBS decreases over time, because like mortgages, and
unlike bonds, and most other xed-income securities, the
principal in an MBS is not paid back as a single payment
to the bond holder at maturity but rather is paid along with
the interest in each periodic payment (monthly, quarterly,
etc.). This decrease in face value is measured by the
MBSs factor, the percentage of the original face that
remains to be repaid.

1.3.6

Options

In nance, an option is a contract which gives the buyer

(the owner) the right, but not the obligation, to buy or
sell an underlying asset or instrument at a specied strike
price on or before a specied date. The seller has the
corresponding obligation to fulll the transactionthat
is to sell or buyif the buyer (owner) exercises the
option. The buyer pays a premium to the seller for this
right. An option that conveys to the owner the right to
buy something at a certain price is a "call option"; an option that conveys the right of the owner to sell something
at a certain price is a "put option". Both are commonly
traded, but for clarity, the call option is more frequently
discussed. Options valuation is a topic of ongoing research in academic and practical nance. In basic terms,
the value of an option is commonly decomposed into two
parts:
The rst part is the intrinsic value, dened as
the dierence between the market value of the
underlying and the strike price of the given option.
The second part is the time value, which depends
on a set of other factors which, through a multivariable, non-linear interrelationship, reect the
discounted expected value of that dierence at expiration.

7
Although options valuation has been studied since the
19th century, the contemporary approach is based on
the BlackScholes model, which was rst published in
1973.[29][30]
Options contracts have been known for many centuries,
however both trading activity and academic interest increased when, as from 1973, options were issued with
standardized terms and traded through a guaranteed
clearing house at the Chicago Board Options Exchange.
Today many options are created in a standardized form
and traded through clearing houses on regulated options
exchanges, while other over-the-counter options are written as bilateral, customized contracts between a single
buyer and seller, one or both of which may be a dealer or
market-maker. Options are part of a larger class of nancial instruments known as derivative products or simply
derivatives.[24][31]

1.3.7 Swaps
A swap is a derivative in which two counterparties
exchange cash ows of one partys nancial instrument
for those of the other partys nancial instrument. The
benets in question depend on the type of nancial instruments involved. For example, in the case of a swap
involving two bonds, the benets in question can be the
periodic interest (coupon) payments associated with such
bonds. Specically, two counterparties agree to exchange one stream of cash ows against another stream.
These streams are called the swaps legs. The swap
agreement denes the dates when the cash ows are to be
paid and the way they are accrued and calculated. Usually
at the time when the contract is initiated, at least one of
these series of cash ows is determined by an uncertain
variable such as a oating interest rate, foreign exchange
rate, equity price, or commodity price.[24]
The cash ows are calculated over a notional principal
amount. Contrary to a future, a forward or an option,
the notional amount is usually not exchanged between
counterparties. Consequently, swaps can be in cash or
collateral. Swaps can be used to hedge certain risks such
as interest rate risk, or to speculate on changes in the expected direction of underlying prices.
Swaps were rst introduced to the public in 1981
when IBM and the World Bank entered into a swap
agreement.[32] Today, swaps are among the most heavily traded nancial contracts in the world: the total
amount of interest rates and currency swaps outstanding is more thn $348 trillion in 2010, according to the
Bank for International Settlements (BIS). The ve generic
types of swaps, in order of their quantitative importance,
are: interest rate swaps, currency swaps, credit swaps,
commodity swaps and equity swaps (there are many other
types).

CHAPTER 1. INTRODUCTION

1.3.8

Financial derivative trading companies

Alpari

Oanda Corporation

OptionsXpress

Pepperstone

Anyoption

Plus 500

AvaTrade

Saxo Bank

Banc de Binary

Spreadex

Cantor Fitzgerald

Sucden

CitiFXPro

TeleTrade

City Index Group

TFI Markets

CMC Markets

Thinkorswim

CommexFX

Varengold

Currenex

Wizetrade

Darwinex

Worldspreads

DBFX

XM.com

EToro

X-Trade Brokers

ETX Capital

Zulu Trade

Finspreads

First Prudential Markets

FXCM

FXdirekt Bank

FXOpen

FXPro

Gain Capital

Hirose Financial

I-Access Investors

IDealing

IG

InstaForex

Interactive Brokers

Intregal Forex

InterTrader

IronFX

Marex Spectron

MF Global

MFX Broker

MRC Markets

1.3.9 Basics
Derivatives are contracts between two parties that specify
conditions (especially the dates, resulting values and definitions of the underlying variables, the parties contractual obligations, and the notional amount) under which
payments are to be made between the parties.[24][33] The
most common underlying assets include commodities,
stocks, bonds, interest rates and currencies, but they can
also be other derivatives, which adds another layer of
complexity to proper valuation. The components of a
rms capital structure, e.g., bonds and stock, can also
be considered derivatives, more precisely options, with
the underlying being the rms assets, but this is unusual
outside of technical contexts.
From the economic point of view, nancial derivatives
are cash ows, that are conditionally stochastically and
discounted to present value. The market risk inherent in
the underlying asset is attached to the nancial derivative through contractual agreements and hence can be
traded separately.[34] The underlying asset does not have
to be acquired. Derivatives therefore allow the breakup of
ownership and participation in the market value of an asset. This also provides a considerable amount of freedom
regarding the contract design. That contractual freedom
allows to modify the participation in the performance of
the underlying asset almost arbitrarily. Thus, the participation in the market value of the underlying can be
eectively weaker, stronger (leverage eect), or implemented as inverse. Hence, specically the market price

1.3. DERIVATIVE

risk of the underlying asset can be controlled in almost mated much lower, at $21 trillion. The credit risk equivevery situation.[34]
alent of the derivative contracts was estimated at $3.3
[37]
There are two groups of derivative contracts: the pri- trillion.
vately traded over-the-counter (OTC) derivatives such as
swaps that do not go through an exchange or other intermediary, and exchange-traded derivatives (ETD) that are
traded through specialized derivatives exchanges or other
exchanges.

Still, even these scaled down gures represent huge

amounts of money. For perspective, the budget for total
expenditure of the United States government during 2012
was $3.5 trillion,[38] and the total current value of the U.S.
stock market is an estimated $23 trillion.[39] The world
[40]
Derivatives are more common in the modern era, but their annual Gross Domestic Product is about $65 trillion.
origins trace back several centuries. One of the oldest And for one type of derivative at least, Credit Default
derivatives is rice futures, which have been traded on the Swaps (CDS), for which the inherent risk is considered
Dojima Rice Exchange since the eighteenth century.[35] high, the higher, nominal value, remains relevant. It was
Derivatives are broadly categorized by the relationship this type of derivative that investment magnate Warren
between the underlying asset and the derivative (such Buett referred to in his famous 2002 speech in which he
as forward, option, swap); the type of underlying as- warned against weapons of nancial mass destruction.
set (such as equity derivatives, foreign exchange deriva- CDS notional value in early 2012 amounted to $25.5 triltives, interest rate derivatives, commodity derivatives, or lion, down from $55 trillion in 2008.[41]
credit derivatives); the market in which they trade (such
as exchange-traded or over-the-counter); and their pay1.3.11 Usage
o prole.
Derivatives may broadly be categorized as lock or op- Derivatives are used for the following:
tion products. Lock products (such as swaps, futures,
or forwards) obligate the contractual parties to the terms
Hedge or mitigate risk in the underlying, by entering
over the life of the contract. Option products (such as
into a derivative contract whose value moves in the
interest rate caps) provide the buyer the right, but not the
opposite direction to their underlying position and
obligation to enter the contract under the terms specied.
cancels part or all of it out[42][43]
Derivatives can be used either for risk management (i.e.
Create option ability where the value of the derivato hedge by providing osetting compensation in case
tive is linked to a specic condition or event (e.g.,
of an undesired event, a kind of insurance) or for specthe underlying reaching a specic price level)
ulation (i.e. making a nancial bet). This distinction is
important because the former is a prudent aspect of op Obtain exposure to the underlying where it is not
erations and nancial management for many rms across
possible to trade in the underlying (e.g., weather
many industries; the latter oers managers and investors
derivatives)[44]
a risky opportunity to increase prot, which may not be
properly disclosed to stakeholders.
Provide leverage (or gearing), such that a small
movement in the underlying value can cause a large
Along with many other nancial products and services,
dierence in the value of the derivative[45]
derivatives reform is an element of the DoddFrank Wall
Street Reform and Consumer Protection Act of 2010.
Speculate and make a prot if the value of the underThe Act delegated many rule-making details of regulalying asset moves the way they expect (e.g. moves in
tory oversight to the Commodity Futures Trading Coma given direction, stays in or out of a specied range,
mission (CFTC) and those details are not nalized nor
reaches a certain level)
fully implemented as of late 2012.
Switch asset allocations between dierent asset
classes without disturbing the underlying assets, as
part of transition management
1.3.10 Size of market
To give an idea of the size of the derivative market, The
Economist has reported that as of June 2011, the over-thecounter (OTC) derivatives market amounted to approximately $700 trillion, and the size of the market traded
on exchanges totaled an additional $83 trillion.[36] However, these are notional values, and some economists
say that this value greatly exaggerates the market value
and the true credit risk faced by the parties involved. For
example, in 2010, while the aggregate of OTC derivatives
exceeded $600 trillion, the value of the market was esti-

Avoid paying taxes. For example, an equity swap

allows an investor to receive steady payments, e.g.
based on LIBOR rate, while avoiding paying capital
gains tax and keeping the stock.
Mechanics and Valuation Basics
Lock products are theoretically valued at zero at the time
of execution and thus do not typically require an up-front
exchange between the parties. Based upon movements in

10
the underlying asset over time, however, the value of the
contract will uctuate, and the derivative may be either
an asset (i.e. "in the money") or a liability (i.e. "out of
the money") at dierent points throughout its life. Importantly, either party is therefore exposed to the credit
quality of its counterparty and is interested in protecting
itself in an event of default.
Option products have immediate value at the outset because they provide specied protection (intrinsic value)
over a given time period (time value). One common form
of option product familiar to many consumers is insurance for homes and automobiles. The insured would pay
more for a policy with greater liability protections (intrinsic value) and one that extends for a year rather than
six months (time value). Because of the immediate option value, the option purchaser typically pays an up front
premium. Just like for lock products, movements in the
underlying asset will cause the options intrinsic value to
change over time while its time value deteriorates steadily
until the contract expires. An important dierence between a lock product is that, after the initial exchange,
the option purchaser has no further liability to its counterparty; upon maturity, the purchaser will execute the
option if it has positive value (i.e. if it is in the money)
or expire at no cost (other than to the initial premium)
(i.e. if the option is out of the money).

Hedging
Main article: Hedge (nance)
Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another.
For example, a wheat farmer and a miller could sign a
futures contract to exchange a specied amount of cash
for a specied amount of wheat in the future. Both parties
have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of
wheat. However, there is still the risk that no wheat will
be available because of events unspecied by the contract,
such as the weather, or that one party will renege on the
contract. Although a third party, called a clearing house,
insures a futures contract, not all derivatives are insured
against counter-party risk.
From another perspective, the farmer and the miller both
reduce a risk and acquire a risk when they sign the futures contract: the farmer reduces the risk that the price
of wheat will fall below the price specied in the contract and acquires the risk that the price of wheat will rise
above the price specied in the contract (thereby losing
additional income that he could have earned). The miller,
on the other hand, acquires the risk that the price of wheat
will fall below the price specied in the contract (thereby
paying more in the future than he otherwise would have)
and reduces the risk that the price of wheat will rise above
the price specied in the contract. In this sense, one party

CHAPTER 1. INTRODUCTION
is the insurer (risk taker) for one type of risk, and the
counter-party is the insurer (risk taker) for another type
of risk.
Hedging also occurs when an individual or institution
buys an asset (such as a commodity, a bond that has
coupon payments, a stock that pays dividends, and so on)
and sells it using a futures contract. The individual or
institution has access to the asset for a specied amount
of time, and can then sell it in the future at a specied
price according to the futures contract. Of course, this
allows the individual or institution the benet of holding
the asset, while reducing the risk that the future selling
price will deviate unexpectedly from the markets current
assessment of the future value of the asset.

Derivatives traders at the Chicago Board of Trade

Derivatives trading of this kind may serve the nancial interests of certain particular businesses.[46] For example, a
corporation borrows a large sum of money at a specic interest rate.[47] The interest rate on the loan reprices every
six months. The corporation is concerned that the rate of
interest may be much higher in six months. The corporation could buy a forward rate agreement (FRA), which is
a contract to pay a xed rate of interest six months after
purchases on a notional amount of money.[48] If the interest rate after six months is above the contract rate, the
seller will pay the dierence to the corporation, or FRA
buyer. If the rate is lower, the corporation will pay the
dierence to the seller. The purchase of the FRA serves
to reduce the uncertainty concerning the rate increase and
stabilize earnings.

Speculation and arbitrage

Derivatives can be used to acquire risk, rather than to
hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on
the value of the underlying asset, betting that the party
seeking insurance will be wrong about the future value
of the underlying asset. Speculators look to buy an asset in the future at a low price according to a derivative
contract when the future market price is high, or to sell an

1.3. DERIVATIVE

11

asset in the future at a high price according to a derivative June 2007, 135% higher than the level recorded in 2004.
contract when the future market price is less.
the total outstanding notional amount is US$708 trillion
[55]
Individuals and institutions may also look for arbitrage (as of June 2011). Of this total notional amount, 67%
opportunities, as when the current buying price of an asset are interest rate contracts, 8% are credit default swaps
falls below the price specied in a futures contract to sell (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are
the asset.
other. Because OTC derivatives are not traded on an exSpeculative trading in derivatives gained a great deal of change, there is no central counter-party. Therefore, they
notoriety in 1995 when Nick Leeson, a trader at Barings are subject to counterparty risk, like an ordinary contract,
Bank, made poor and unauthorized investments in futures since each counter-party relies on the other to perform.
contracts. Through a combination of poor judgment, lack
of oversight by the banks management and regulators,
Exchange-traded derivatives (ETD) are those
and unfortunate events like the Kobe earthquake, Leederivatives instruments that are traded via specialson incurred a US$1.3 billion loss that bankrupted the
ized derivatives exchanges or other exchanges. A
[49]
centuries-old institution.
derivatives exchange is a market where individuals
trade standardized contracts that have been dened
by the exchange.[24] A derivatives exchange acts as
Proportion Used for Hedging and Speculation
an intermediary to all related transactions, and takes
initial margin from both sides of the trade to act as
The true proportion of derivatives contracts used for
a guarantee. The worlds largest[56] derivatives exhedging purposes is unknown[50] (and perhaps unknow[51][52]
changes (by number of transactions) are the Korea
able), but it appears to be relatively small.
Also,
Exchange (which lists KOSPI Index Futures & Opderivatives contracts account for only 36% of the metions), Eurex (which lists a wide range of European
dian rms total currency and interest rate exposure.[53]
products such as interest rate & index products),
Nonetheless, we know that many rms derivatives activand CME Group (made up of the 2007 merger of
ities have at least some speculative component for a varithe Chicago Mercantile Exchange and the Chicago
ety of reasons.[53]
Board of Trade and the 2008 acquisition of the New
York Mercantile Exchange). According to BIS, the
1.3.12 Types
combined turnover in the worlds derivatives exchanges totaled USD 344 trillion during Q4 2005.
OTC and exchange-traded
By December 2007 the Bank for International Settlements reported[54] that derivatives traded on exIn broad terms, there are two groups of derivative conchanges surged 27% to a record $681 trillion.[54]
tracts, which are distinguished by the way they are traded
in the market:
Common derivative contract types
Over-the-counter (OTC) derivatives are contracts
Some of the common variants of derivative contracts are
that are traded (and privately negotiated) directly
as follows:
between two parties, without going through an exchange or other intermediary. Products such as
1. Forwards: A tailored contract between two parties,
swaps, forward rate agreements, exotic options and
where payment takes place at a specic time in the
other exotic derivatives are almost always traded in
future at todays pre-determined price.
this way. The OTC derivative market is the largest
market for derivatives, and is largely unregulated
2. Futures: are contracts to buy or sell an asset on a fuwith respect to disclosure of information between
ture date at a price specied today. A futures conthe parties, since the OTC market is made up of
tract diers from a forward contract in that the fubanks and other highly sophisticated parties, such as
tures contract is a standardized contract written by a
hedge funds. Reporting of OTC amounts is dicult
clearing house that operates an exchange where the
because trades can occur in private, without activity
contract can be bought and sold; the forward conbeing visible on any exchange.
tract is a non-standardized contract written by the
parties themselves.
According to the Bank for International Settlements, who
rst surveyed OTC derivatives in 1995,[54] reported that
3. Options are contracts that give the owner the right,
the "gross market value, which represent the cost of rebut not the obligation, to buy (in the case of a call
placing all open contracts at the prevailing market prices,
option) or sell (in the case of a put option) an asset.
The price at which the sale takes place is known as
... increased by 74% since 2004, to $11 trillion at the end
the strike price, and is specied at the time the parof June 2007 (BIS 2007:24).[54] Positions in the OTC
derivatives market increased to $516 trillion at the end of
ties enter into the option. The option contract also

12

CHAPTER 1. INTRODUCTION

species a maturity date. In the case of a European 1.3.13 Economic function of the derivative
option, the owner has the right to require the sale
market
to take place on (but not before) the maturity date;
in the case of an American option, the owner can Some of the salient economic functions of the derivative
require the sale to take place at any time up to the market include:
maturity date. If the owner of the contract exercises this right, the counter-party has the obligation
1. Prices in a structured derivative market not only
to carry out the transaction. Options are of two
replicate the discernment of the market particitypes: call option and put option. The buyer of a
pants about the future but also lead the prices of
Call option has a right to buy a certain quantity of
underlying to the professed future level. On the
the underlying asset, at a specied price on or before
expiration of the derivative contract, the prices of
a given date in the future, he however has no obligaderivatives congregate with the prices of the undertion whatsoever to carry out this right. Similarly, the
lying. Therefore, derivatives are essential tools to
buyer of a Put option has the right to sell a certain
determine both current and future prices.
quantity of an underlying asset, at a specied price
on or before a given date in the future, he however
2. The derivatives market reallocates risk from the peohas no obligation whatsoever to carry out this right.
ple who prefer risk aversion to the people who have
an appetite for risk.
4. Binary options are contracts that provide the owner
with an all-or-nothing prot prole.
3. The intrinsic nature of derivatives market associates
them to the underlying Spot market. Due to deriva5. Warrants: Apart from the commonly used shorttives there is a considerable increase in trade voldated options which have a maximum maturity peumes of the underlying Spot market. The dominant
riod of 1 year, there exists certain long-dated options
factor behind such an escalation is increased particias well, known as Warrant (nance). These are genpation by additional players who would not have otherally traded over-the-counter.
erwise participated due to absence of any procedure
to transfer risk.
6. Swaps are contracts to exchange cash (ows) on
or before a specied future date based on the
4. As supervision, reconnaissance of the activities of
underlying value of currencies exchange rates,
various participants becomes tremendously dicult
bonds/interest rates, commodities exchange, stocks
in assorted markets; the establishment of an orgaor other assets. Another term which is commonly
nized form of market becomes all the more imperassociated to Swap is Swaption which is basically
ative. Therefore, in the presence of an organized
an option on the forward Swap. Similar to a Call
derivatives market, speculation can be controlled,
and Put option, a Swaption is of two kinds: a reresulting in a more meticulous environment.
ceiver Swaption and a payer Swaption. While on
one hand, in case of a receiver Swaption there is an
5. Third parties can use publicly available derivative
option wherein you can receive xed and pay oatprices as educated predictions of uncertain future
ing, a payer swaption on the other hand is an option
outcomes, for example, the likelihood that a corpoto pay xed and receive oating.
ration will default on its debts.[58]
Swaps can basically be categorized
into two types:
Interest rate swap: These basically necessitate swapping only
interest associated cash ows
in the same currency, between
two parties.
Currency swap: In this kind
of swapping, the cash ow
between the two parties includes both principal and interest. Also, the money which
is being swapped is in dierent
currency for both parties.[57]
Some common examples of these derivatives are the following:

In a nutshell, there is a substantial increase in savings and

investment in the long run due to augmented activities by
derivative Market participant.[59]

1.3.14 Valuation
Market and arbitrage-free prices
Two common measures of value are:
Market price, i.e. the price at which traders are willing to buy or sell the contract
Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts (see
rational pricing)

1.3. DERIVATIVE

13
designate upfront (when signing the contract).

1.3.15 Criticisms
Derivatives are often subject to the following criticisms:
Hidden tail risk

Total world derivatives from 1998 to 2007[60] compared to total

world wealth in the year 2000[61]

Determining the market price

According to Raghuram Rajan, a former chief economist

of the International Monetary Fund (IMF), "... it may
well be that the managers of these rms [investment
funds] have gured out the correlations between the various instruments they hold and believe they are hedged.
Yet as Chan and others (2005) point out, the lessons of
summer 1998 following the default on Russian government debt is that correlations that are zero or negative in
normal times can turn overnight to one a phenomenon
they term phase lock-in. A hedged position can become
unhedged at the worst times, inicting substantial losses
on those who mistakenly believe they are protected.[63]

For exchange-traded derivatives, market price is usually

transparent (often published in real time by the exchange,
based on all the current bids and oers placed on that
particular contract at any one time). Complications can
arise with OTC or oor-traded contracts though, as trading is handled manually, making it dicult to automatically broadcast prices. In particular with OTC contracts, Risks
there is no central exchange to collate and disseminate
prices.
See also: List of trading losses
Determining the arbitrage-free price
See List of nance topics# Derivatives pricing.
The arbitrage-free price for a derivatives contract can be
complex, and there are many dierent variables to consider. Arbitrage-free pricing is a central topic of nancial
mathematics. For futures/forwards the arbitrage free
price is relatively straightforward, involving the price of
the underlying together with the cost of carry (income
received less interest costs), although there can be complexities.
However, for options and more complex derivatives, pricing involves developing a complex pricing model: understanding the stochastic process of the price of the underlying asset is often crucial. A key equation for the theoretical valuation of options is the BlackScholes formula,
which is based on the assumption that the cash ows from
a European stock option can be replicated by a continuous
buying and selling strategy using only the stock. A simplied version of this valuation technique is the binomial
options model.
OTC represents the biggest challenge in using models
to price derivatives. Since these contracts are not publicly traded, no market price is available to validate the
theoretical valuation. Most of the models results are
input-dependent (meaning the nal price depends heavily on how we derive the pricing inputs).[62] Therefore it
is common that OTC derivatives are priced by Independent Agents that both counterparties involved in the deal

The use of derivatives can result in large losses because

of the use of leverage, or borrowing. Derivatives allow
investors to earn large returns from small movements in
the underlying assets price. However, investors could
lose large amounts if the price of the underlying moves
against them signicantly. There have been several instances of massive losses in derivative markets, such as
the following:
American International Group (AIG) lost
more than US$18 billion through a subsidiary over the preceding three quarters
on credit default swaps (CDSs).[64] The
United States Federal Reserve Bank announced the creation of a secured credit
facility of up to US$85 billion, to prevent
the companys collapse by enabling AIG
to meet its obligations to deliver additional collateral to its credit default swap
trading partners.[65]
The loss of US$7.2 Billion by Socit
Gnrale in January 2008 through misuse of futures contracts.
The loss of US$6.4 billion in the failed
fund Amaranth Advisors, which was long
natural gas in September 2006 when the
price plummeted.
The loss of US$4.6 billion in the failed
fund Long-Term Capital Management in
1998.

14

CHAPTER 1. INTRODUCTION
The loss of US$1.3 billion equivalent
in oil derivatives in 1993 and 1994 by
Metallgesellschaft AG.[66]
The loss of US$1.2 billion equivalent
in equity derivatives in 1995 by Barings
Bank.[67]
UBS AG, Switzerlands biggest bank,
suered a $2 billion loss through unauthorized trading discovered in September
2011.[68]

This comes to a staggering $39.5 billion, the majority in

the last decade after the Commodity Futures Modernization Act of 2000 was passed.
Counter party risk
Some derivatives (especially swaps) expose investors to
counterparty risk, or risk arising from the other party in a
nancial transaction. Dierent types of derivatives have
dierent levels of counter party risk. For example, standardized stock options by law require the party at risk
to have a certain amount deposited with the exchange,
showing that they can pay for any losses; banks that help
businesses swap variable for xed rates on loans may do
credit checks on both parties. However, in private agreements between two companies, for example, there may
not be benchmarks for performing due diligence and risk
analysis.
Large notional value

to derivatives counterparties, in combination with their

complexity and lack of transparency however, can cause
capital markets to underprice credit risk. This can contribute to credit booms, and increase systemic risks.[69]
Indeed, the use of derivatives to conceal credit risk from
third parties while protecting derivative counterparties
contributed to the nancial crisis of 2008 in the United
States.[69][70]
In the context of a 2010 examination of the ICE Trust, an
industry self-regulatory body, Gary Gensler, the chairman of the Commodity Futures Trading Commission
which regulates most derivatives, was quoted saying that
the derivatives marketplace as it functions now adds up
to higher costs to all Americans. More oversight of the
banks in this market is needed, he also said. Additionally, the report said, "[t]he Department of Justice is looking into derivatives, too. The departments antitrust unit
is actively investigating 'the possibility of anticompetitive
practices in the credit derivatives clearing, trading and information services industries,' according to a department
spokeswoman.[71]
For legislators and committees responsible for nancial
reform related to derivatives in the United States and elsewhere, distinguishing between hedging and speculative
derivatives activities has been a nontrivial challenge. The
distinction is critical because regulation should help to
isolate and curtail speculation with derivatives, especially
for systemically signicant institutions whose default
could be large enough to threaten the entire nancial system. At the same time, the legislation should allow for
responsible parties to hedge risk without unduly tying up
working capital as collateral that rms may better employ elsewhere in their operations and investment.[72] In
this regard, it is important to distinguish between nancial
(e.g. banks) and non-nancial end-users of derivatives
(e.g. real estate development companies) because these
rms derivatives usage is inherently dierent. More importantly, the reasonable collateral that secures these different counterparties can be very dierent. The distinction between these rms is not always straight forward
(e.g. hedge funds or even some private equity rms do
not neatly t either category). Finally, even nancial users
must be dierentiated, as 'large' banks may classied
as systemically signicant whose derivatives activities
must be more tightly monitored and restricted than those
of smaller, local and regional banks.

Derivatives typically have a large notional value. As

such, there is the danger that their use could result in
losses for which the investor would be unable to compensate. The possibility that this could lead to a chain
reaction ensuing in an economic crisis was pointed out
by famed investor Warren Buett in Berkshire Hathaway's 2002 annual report. Buett called them 'nancial
weapons of mass destruction.' A potential problem with
derivatives is that they comprise an increasingly larger notional amount of assets which may lead to distortions in
the underlying capital and equities markets themselves.
Investors begin to look at the derivatives markets to make
a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes
a leading indicator.(See Berkshire Hathaway Annual Re- Over-the-counter dealing will be less common as the
DoddFrank Wall Street Reform and Consumer Protecport for 2002)
tion Act comes into eect. The law mandated the clearing of certain swaps at registered exchanges and imposed
1.3.16 Financial Reform and Government various restrictions on derivatives. To implement DoddFrank, the CFTC developed new rules in at least 30 areas.
Regulation
The Commission determines which swaps are subject to
Under US law and the laws of most other developed mandatory clearing and whether a derivatives exchange is
countries, derivatives have special legal exemptions that eligible to clear a certain type of swap contract.
make them a particularly attractive legal form to ex- Nonetheless, the above and other challenges of the ruletend credit.[69] The strong creditor protections aorded

1.3. DERIVATIVE

15

making process have delayed full enactment of aspects of

the legislation relating to derivatives. The challenges are
further complicated by the necessity to orchestrate globalized nancial reform among the nations that comprise
the worlds major nancial markets, a primary responsibility of the Financial Stability Board whose progress is
ongoing.[73]

participants with sucient clarity on laws and regulations

by avoiding, to the extent possible, the application of conicting rules to the same entities and transactions, and
minimizing the application of inconsistent and duplicative rules.[77] At the same time, they noted that complete
harmonization perfect alignment of rules across jurisdictions would be dicult, because of jurisdictions diftiming,
In the U.S., by February 2012 the combined eort of the ferences in law, policy, markets, implementation
and legislative and regulatory processes.[77]
SEC and CFTC had produced over 70 proposed and nal
derivatives rules.[74] However, both of them had delayed On December 20, 2013 the CFTC provided information
adoption of a number of derivatives regulations because on its swaps regulation comparability determinations.
of the burden of other rulemaking, litigation and oppo- The release addressed the CFTCs cross-border complisition to the rules, and many core denitions (such as ance exceptions. Specically it addressed which entity
the terms swap, security-based swap, swap dealer, level and in some cases transaction-level requirements in
security-based swap dealer, major swap participant six jurisdictions (Australia, Canada, the European Union,
and major security-based swap participant) had still not Hong Kong, Japan, and Switzerland) it found comparable
been adopted.[74] SEC Chairman Mary Schapiro opined: to its own rules, thus permitting non-US swap dealers,
At the end of the day, it probably does not make sense major swap participants, and the foreign branches of US
to harmonize everything [between the SEC and CFTC Swap Dealers and major swap participants in these jurisrules] because some of these products are quite dierent dictions to comply with local rules in lieu of Commission
and certainly the market structures are quite dierent.[75] rules.[78]
On February 11, 2015, the Securities and Exchange
Commission (SEC) released two nal rules toward establishing a reporting and public disclosure framework for Reporting
security-based swap transaction data.[76] The two rules
are not completely harmonized with the requirements Mandatory reporting regulations are being nalized in
with CFTC requirements.
a number of countries, such as Dodd Frank Act in
the US, the European Market Infrastructure Regulations
(EMIR) in Europe, as well as regulations in Hong Kong,
Japan, Singapore, Canada, and other countries.[79] The
OTC Derivatives Regulators Forum (ODRF), a group
of over 40 world-wide regulators, provided trade repositories with a set of guidelines regarding data access to
regulators, and the Financial Stability Board and CPSS
IOSCO also made recommendations in with regard to
reporting.[79]
DTCC, through its Global Trade Repository (GTR)
service, manages global trade repositories for interest
rates, and commodities, foreign exchange, credit, and
equity derivatives.[79] It makes global trade reports to
the CFTC in the U.S., and plans to do the same for
Country leaders at the 2009 G-20 Pittsburgh summit
ESMA in Europe and for regulators in Hong Kong, Japan,
and Singapore.[79] It covers cleared and uncleared OTC
In November 2012, the SEC and regulators from Ausderivatives products, whether or not a trade is electronitralia, Brazil, the European Union, Hong Kong, Japan,
cally processed or bespoke.[79][80][81]
Ontario, Quebec, Singapore, and Switzerland met to discuss reforming the OTC derivatives market, as had been
agreed by leaders at the 2009 G-20 Pittsburgh summit
in September 2009.[77] In December 2012, they released 1.3.17 Glossary
a joint statement to the eect that they recognized that
Bilateral netting: A legally enforceable arrangement
the market is a global one and rmly support the adopbetween a bank and a counter-party that creates a
tion and enforcement of robust and consistent standards
single legal obligation covering all included individin and across jurisdictions, with the goals of mitigating
ual contracts. This means that a banks obligation,
risk, improving transparency, protecting against market
abuse, preventing regulatory gaps, reducing the potential
in the event of the default or insolvency of one of the
for arbitrage opportunities, and fostering a level playing
parties, would be the net sum of all positive and negeld for market participants.[77] They also agreed on the
ative fair values of contracts included in the bilateral
need to reduce regulatory uncertainty and provide market
netting arrangement.

16
Counterparty: The legal and nancial term for the
other party in a nancial transaction.
Credit derivative: A contract that transfers credit
risk from a protection buyer to a credit protection
seller. Credit derivative products can take many
forms, such as credit default swaps, credit linked
notes and total return swaps.

CHAPTER 1. INTRODUCTION
uity 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 banks allowance for loan and lease
losses.

Derivative: A nancial contract whose value is de1.3.18 Financial derivative trading comparived from the performance of assets, interest rates,
nies
currency exchange rates, or indexes. Derivative
transactions include a wide assortment of nancial
Alpari Group
contracts including structured debt obligations and
deposits, swaps, futures, options, caps, oors, col Anyoption
lars, forwards and various combinations thereof.
Banc de Binary
Exchange-traded derivative contracts: Standardized derivative contracts (e.g., futures contracts and
Cantor Fitzgerald
options) that are transacted on an organized futures
CitiFXPro
exchange.
[Gross negative fair value: The sum of the fair values of contracts where the bank owes money to
its counter-parties, without taking into account netting. This represents the maximum losses the banks
counter-parties would incur if the bank defaults and
there is no netting of contracts, and no bank collateral was held by the counter-parties.
Gross positive fair value: The sum total of the fair
values of contracts where the bank is owed money
by its counter-parties, without taking into account
netting. This represents the maximum losses a bank
could incur if all its counter-parties default and there
is no netting of contracts, and the bank holds no
counter-party collateral.
High-risk mortgage securities: Securities where the
price or expected average life is highly sensitive to
interest rate changes, as determined by the U.S.
Federal Financial Institutions Examination Council
policy statement on high-risk mortgage securities.
Notional amount: The nominal or face amount that
is used to calculate payments made on swaps and
other risk management products. This amount generally does not change hands and is thus referred to
as notional.

City Index Group

CMC Markets
Currenex
DBF
EToro
ETX Capital
Finspreads
First Prudential Markets
FXCM
FXdirekt Bank
FXOpen
FXPro
Gain Capital
Henyep
Hirose Financial UK Ltd.
HXPM Gold

Over-the-counter (OTC) derivative contracts: Privately negotiated derivative contracts that are transacted o organized futures exchanges.

I-Access Investors

Structured notes: Non-mortgage-backed debt securities, whose cash ow characteristics depend on one
or more indices and / or have embedded forwards or
options.

IG Group

Total risk-based capital: The sum of tier 1 plus tier

2 capital. Tier 1 capital consists of common shareholders equity, perpetual preferred shareholders eq-

InterTrader

IDealing

InstaForex
Interactive Brokers

Marex Spectron

1.3. DERIVATIVE
MF Global
MRC Markets
Oanda Corporation
OptionsXpress
Pepperstone
Plus 500
Saxo Bank
Spread Co.
Spreadex
Sucden
TeleTrade
TFI Markets
Thinkorswim
Varen Gold
Wizetrade
Worldspreads
X-Trade Brokers
Zulu Trade

1.3.19

See also

Credit derivative
Equity derivative
Exotic derivative
Financial engineering
Foreign exchange derivative
Freight derivative
Ination derivative
Interest rate derivative

17

1.3.20 References
[1] Derivatives (Report). Oce of the Comptroller of the
Currency, U.S. Department of Treasury. Retrieved
February 2013. A derivative is a nancial contract whose
value is derived from the performance of some underlying
market factors, such as interest rates, currency exchange
rates, and commodity, credit, or equity prices. Derivative
transactions include an assortment of nancial contracts,
including structured debt obligations and deposits, swaps,
futures, options, caps, oors, collars, forwards, and various combinations thereof.
[2] Derivative Denition, Investopedia
[3] Koehler, Christian. The Relationship between the Complexity of Financial Derivatives and Systemic Risk.
Working Paper: 1011.
[4] An asset-backed security is used as an umbrella term for
a type of security backed by a pool of assetsincluding
collateralized debt obligations and mortgage-backed securities (Example: The capital market in which assetbacked securities are issued and traded is composed of
three main categories: ABS, MBS and CDOs. (source:
Vink, Dennis. ABS, MBS and CDO compared: An empirical analysis (PDF). August 2007. Munich Personal
RePEc Archive. Retrieved 13 July 2013.)
and sometimes for a particular type of that security
one backed by consumer loans (example: As a rule
of thumb, securitization issues backed by mortgages are
called MBS, and securitization issues backed by debt obligations are called CDO, [and] Securitization issues backed
by consumer-backed productscar loans, consumer loans
and credit cards, among othersare called ABS. source
Vink, Dennis. ABS, MBS and CDO compared: An empirical analysis (PDF). August 2007. Munich Personal
RePEc Archive. Retrieved 13 July 2013.,
see also What are Asset-Backed Securities?". SIFMA.
Retrieved 13 July 2013. Asset-backed securities, called
ABS, are bonds or notes backed by nancial assets. Typically these assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans,
manufactured-housing contracts and home-equity loans.)
[5] Lemke, Lins and Picard, Mortgage-Backed Securities,
5:15 (Thomson West, 2014).
[6] Koehler, Christian. The Relationship between the Complexity of Financial Derivatives and Systemic Risk.
Working Paper: 17.
[7] Lemke, Lins and Smith, Regulation of Investment Companies (Matthew Bender, 2014 ed.).
[8] Bethany McLean and Joe Nocera, All the Devils Are Here,
the Hidden History of the Financial Crisis, Portfolio, Penguin, 2010, p.120
[9] Final Report of the National Commission on the Causes
of the Financial and Economic Crisis in the United
States, a.k.a. The Financial Crisis Inquiry Report,
p.127

Property derivatives

[10] The Financial Crisis Inquiry Report, 2011, p.130

Weather derivative

[11] The Financial Crisis Inquiry Report, 2011, p.133

18

[12] Michael Simkovic, Leveraged Buyout Bankruptcies, the

Problem of Hindsight Bias, and the Credit Default Swap
Solution, Columbia Business Law Review (Vol. 2011, No.
1, pp. 118), 2011.
[13] Lisa Pollack (January 5, 2012). Credit event auctions:
Why do they exist?". FT Alphaville.
[14] Chart; ISDA Market Survey; Notional amounts outstanding at year-end, all surveyed contracts, 1987present (PDF). International Swaps and Derivatives Association (ISDA). Retrieved April 8, 2010.
[15] ISDA 2010 Mid-Year Market Survey. Latest available
a/o 2012-03-01.
[16] ISDA: CDS Marketplace. Isdacdsmarketplace.com.
December 31, 2010. Retrieved March 12, 2012.
[17] Ki, John; Jennifer Elliott; Elias Kazarian; Jodi Scarlata;
Carolyne Spackman (November 2009). Credit Derivatives: Systemic Risks and Policy Options (PDF). IMF
Working Papers (WP/09/254). Retrieved April 25, 2010.
[18] Christian Weistroer; Deutsche Bank Research (December 21, 2009). Credit default swaps: Heading towards
a more stable system (PDF). Deutsche Bank Research:
Current Issues. Retrieved April 15, 2010.

CHAPTER 1. INTRODUCTION

[31] Brealey, Richard A.; Myers, Stewart (2003), Principles of

Corporate Finance (7th ed.), McGraw-Hill, Chapter 20
[32] Ross, Westereld, & Jordan (2010). Fundamentals of
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[33] Mark Rubinstein (1999). Rubinstein on Derivatives. Risk
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[34] Koehler, Christian. The Relationship between the Complexity of Financial Derivatives and Systemic Risk.
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[35] Kaori Suzuki and David Turner (December 10, 2005).
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[36] Clear and Present Danger; Centrally cleared derivatives.(clearing houses)". The Economist (Economist
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[37] Liu, Qiao; Lejot, Paul (2013). Debt, Derivatives and
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[19] Michael Simkovic, Secret Liens and the Financial Crisis

of 2008.

[38] The Budget and Economic Outlook: Fiscal Years 2013 to

2023 (PDF). Congressional Budget Oce. February 5,
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[20] Erik Sirri, Director, SEC Division of Trading and Markets. Testimony Concerning Credit Default Swa[s Before
the House Committee on Agriculture October 15, 2008.
Retrieved April 2, 2010.

[39] Swapping bad ideas: A big battle is unfolding over an

even bigger market. The Economist. 2013-04-27. Retrieved 2013-05-10.

[21] Frank Partnoy; David A. Skeel, Jr. (2007). The Promise

And Perils of Credit Derivatives. University of Cincinnati
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[40] World GDP: In search of growth. The Economist

(Economist Newspaper Ltd.). 2011-05-25. Retrieved
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[22] Media Statement: DTCC Policy for Releasing CDS Data

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[41] Sheridan, Barrett (April 2008). 600,000,000,000,000?".

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[23] Mengle, David (2007).

Credit Derivatives: An
Overview (PDF). Economic Review (FRB Atlanta) 92 (4).
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[42] Khullar, Sanjeev (2009). Using Derivatives to Create Alpha. In John M. Longo. Hedge Fund Alpha: A Framework for Generating and Understanding Investment Performance. Singapore: World Scientic. p. 105. ISBN
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[24] John C. Hull, Options, Futures and Other Derivatives (6th

edition), Prentice Hall: New Jersey, 2006.
[25] Understanding Derivatives: Markets and Infrastructure,
Federal Reserve Bank of Chicago
[26] Forward Contract on Wikinvest
[27] Lemke, Lins and Picard, Mortgage-Backed Securities,
Chapters 4 and 5 (Thomson West, 2013 ed.).
[28] Josh Clark, How can mortgage-backed securities bring
down the U.S. economy?", How Stu Works

[43] Lemke and Lins, Soft Dollars and Other Trading Activities,
2:47 - 2:54 (Thomson West, 2013-2014 ed.).
[44] Don M. Chance; Robert Brooks (2010). Advanced
Derivatives and Strategies. Introduction to Derivatives
and Risk Management (8th ed.). Mason, OH: Cengage
Learning. pp. 483515. ISBN 978-0-324-60120-6. Retrieved September 14, 2011.

[29] Benhamou, Eric. Options pre-Black Scholes (PDF).

[45] Shirre, David (2004). Derivatives and leverage.

Dealing With Financial Risk. The Economist. p. 23.
ISBN 1-57660-162-5. Retrieved September 14, 2011.

[30] Black, Fischer; Scholes, Myron (1973). The Pricing of

Options and Corporate Liabilities. Journal of Political
Economy 81 (3): 637654. doi:10.1086/260062. JSTOR
1831029.

[46] Peterson, Sam (2010).

The Atlantic.
Theres
a
Derivative
in
Your
Cereal
http://www.
theatlantic.com/business/archive/2010/07/
theres-a-derivative-in-your-cereal/60582/

1.3. DERIVATIVE

[47] Chisolm, Derivatives Demystied (Wiley 2004)

[48] Chisolm, Derivatives Demystied (Wiley 2004) Notional
sum means there is no actual principal.
[49] News.BBC.co.uk, How Leeson broke the bank BBC
Economy
[50] Chernenko, Sergey and Faulkender, Michael. The Two
Sides of Derivatives Usage: Hedging and Speculating
with Interest Rate Swaps http://www.rhsmith.umd.edu/
faculty/faulkender/swaps_JFQA_final.pdf
[51] Knowledge@Wharton (2012).
The Changing Use
of Derivatives: More Hedging, Less Speculation
http://knowledge.wharton.upenn.edu/article.cfm?
articleid=709
[52] Guay, Wayne R. and Kothari, S.P. (2001). How Much do
Firms Hedge with Derivatives?" http://papers.ssrn.com/
sol3/papers.cfm?abstract_id=253036
[53] Knowledge@Wharton (2006). The Role of Derivatives in Corporate Finances: Are Firms Betting the
Ranch?" http://knowledge.wharton.upenn.edu/article.
cfm?articleid=1346
[54] Ryan Stever; Christian Upper; Goetz von Peter (December 2007). BIS Quarterly Review (PDF) (Report). Bank
for International Settlements.
[55] BIS survey: The Bank for International Settlements (BIS)
semi-annual OTC [derivatives market report, for end
of June 2008, showed US$683.7 trillion total notional
amounts outstanding of OTC derivatives with a gross market value of US$20 trillion. See also Prior Period Regular
OTC Derivatives Market Statistics.
[56] Futures and Options Week: According to gures published
in F&O Week October 10, 2005. See also FOW Website.
[57] Financial Markets: A Beginners Module.
[58] Michael Simkovic and Benjamin Kaminetzky (August 29,
2010). Leveraged Buyout Bankruptcies, the Problem of
Hindsight Bias, and the Credit Default Swap Solution.
Columbia Business Law Review, Vol. 2011, No. 1, p.
118, 2011. Retrieved March 5, 2013.
[59] Currency Derivatives: A Beginners Module.
[60] Bis.org. Bis.org. May 7, 2010. Retrieved August 29,
2010.
[61] Launch of the WIDER study on The World Distribution
of Household Wealth: 5 December 2006. Retrieved June
9, 2009.
[62] Boumlouka,
Makrem
(2009),"Alternatives
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com/hedge-funds-review/news/1560286/
otc-pricing-deal-struck-fitch-solutions-pricing-partners
[63] Raghuram G. Rajan (September 2006). Has Financial
Development Made the World Riskier?". European Financial Management (EUROPEAN FINANCIAL MANAGEMENT) 12 (4): 499533. doi:10.1111/j.1468036X.2006.00330.x. Retrieved January 17, 2012.

19

[64] Kelleher, James B. (September 18, 2008). ""Buetts

Time Bomb Goes O on Wall Street by James B. Kelleher of Reuters. Reuters.com. Retrieved August 29,
2010.
[65] Feds $85 billion Loan Rescues Insurer
[66] Edwards, Franklin (1995). Derivatives Can Be Hazardous To Your Health: The Case of Metallgesellschaft
(PDF). Derivatives Quarterly (Spring 1995): 817
[67] Whaley, Robert (2006). Derivatives: markets, valuation,
and risk management. John Wiley and Sons. p. 506.
ISBN 0-471-78632-2.
[68] UBS Loss Shows Banks Fail to Learn From Kerviel, Leeson. Businessweek. September 15, 2011. Retrieved
March 5, 2013.
[69] Michael Simkovic, Secret Liens and the Financial Crisis
of 2008.. American Bankruptcy Law Journal, Vol. 83,
p. 253. 2009. Retrieved March 5, 2013.
[70] Michael Simkovic (January 11, 2011). Bankruptcy
Immunities,
Transparency,
and Capital Structure, Presentation at the World Bank. Ssrn.com.
doi:10.2139/ssrn.1738539. Retrieved March 5, 2013.
[71] Story, Louise, A Secretive Banking Elite Rules Trading
in Derivatives, The New York Times, December 11, 2010
(December 12, 2010, p. A1 NY ed.). Retrieved December 12, 2010.
[72] Zubrod, Luke (2011).
The Atlantic.
Will the
'Cure' for Systemic Risk Kill the Economy?"
http://www.theatlantic.com/business/archive/2011/
06/will-the-cure-for-systemic-risk-kill-the-economy/
240600/
[73] Financial Stability Board (2012). OTC Derivatives
Market Reforms Third Progress Report on Implementation June 15, 2012 http://www.financialstabilityboard.
org/publications/r_120615.pdf
[74] Proskauer Rose LLP. SEC and CFTC oversight of
derivatives: a status report. Lexology. Retrieved March
5, 2013.
[75] Younglai, Rachelle. INTERVIEW Not all SEC, CFTC
rules must be harmonized. Reuters. Retrieved March 5,
2013.
[76] First take: Ten key points from the SECs swaps
reporting and disclosure rules (PDF). http://www.
pwc.com/us/en/financial-services/regulatory-services/
publications/sec-swap-reporting-and-disclosure.jhtml''.
PwC Financial Services Regulatory Practice, February,
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[77] Joint Press Statement of Leaders on Operating Principles
and Areas of Exploration in the Regulation of the CrossBorder OTC Derivatives Market; 2012-251. Sec.gov.
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[78] Derivatives: A rst take on cross-border comparability
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20

CHAPTER 1. INTRODUCTION

[79] DTCCs Global Trade Repository for OTC Derivatives

(GTR)". Dtcc.com. Retrieved March 5, 2013.

European Union proposals on derivatives regulation 2008 onwards

[80] U.S. DTCC says barriers hinder full derivatives picture.

Reuters. February 12, 2013. Retrieved March 5, 2013.

" Derivatives Regulatory Roulette, PwC Financial

Services Regulatory Practice (December 2013)

[81] Release, Press (August 5, 2010). Derivatives trades will

be tracked by Depository Trust. Futuresmag.com. Retrieved March 5, 2013.

1.4 Call option

1.3.21

This article is about nancial options. For call options in

general, see Option (law).

Further reading

Shnke M. Bartram; Brown, Gregory W.; Conrad, Jennifer C. (August 2011). The Eects of
Derivatives on Firm Risk and Value. Journal of Financial and Quantitative Analysis 46 (4): 967999.
doi:10.1017/s0022109011000275.

A call option, often simply labeled a call, is a nancial contract between two parties, the buyer and the seller
of this type of option.[1] The buyer of the call option has
the right, but not the obligation to buy an agreed quantity of a particular commodity or nancial instrument (the
Shnke M. Bartram; Kevin Aretz (Winter 2010). underlying) from the seller of the option at a certain time
Corporate Hedging and Shareholder Value. Jour- (the expiration date) for a certain price (the strike price).
nal of Financial Research 33 (4): 317371. The seller (or writer) is obligated to sell the commodity or nancial instrument to the buyer if the buyer so
doi:10.1111/j.1475-6803.2010.01278.x.
decides. The buyer pays a fee (called a premium) for this
Shnke M. Bartram; Gregory W. Brown; Frank right.
R. Fehle (Spring 2009). International Evidence When you buy a call option, you are buying the right to
on Financial Derivatives Usage. Financial Man- buy a stock at the strike price, regardless of the stock price
agement 38 (1): 185206. doi:10.1111/j.1755- in the future before the expiration date. Conversely, you
053x.2009.01033.x.
can short or write the call option, giving the buyer the
right to buy that stock from you anytime before the option
expires. To compensate you for that risk taken, the buyer
pays you a premium, also known as the price of the call.
Institute for Financial Markets (2011). Futures and The seller of the call is said to have shorted the call option,
Options (2nd ed.). Washington, D.C.: Institute for and keeps the premium (the amount the buyer pays to buy
the option) whether or not the buyer ever exercises the
Financial Markets. ISBN 978-0-615-35082-0.
option.
John C. Hull (2011). Options, Futures and Other
For example, if a stock trades at $50 right now and you
Derivatives (8th ed.). Harlow: Pearson Education.
buy its call option with a $50 strike price, you have the
ISBN 978-0-13-260460-4.
right to purchase that stock for $50 regardless of the curMichael Durbin (2011). All About Derivatives (2nd rent stock price as long as it has not expired. Even if the
ed.). New York: McGraw-Hill. ISBN 978-0-07- stock rises to $100, you still have the right to buy that
stock for $50 as long as the call option has not expired.
174351-8.
Since the payo of purchased call options increases as the
Mehraj Mattoo (1997). Structured Derivatives: New stock price rises, buying call options is considered bullish.
Tools for Investment Management: A Handbook of When the price of the underlying instrument surpasses
Structuring, Pricing & Investor Applications. Lon- the strike price, the option is said to be "in the money".
On the other hand, If the stock falls to below $50, the
don: Financial Times. ISBN 978-0-273-61120-2.
buyer will never exercise the option, since he would have
Andrei N. Soklakov (2013). Elasticity Theory of to pay $50 per share when he can buy the same stock for
Structuring (PDF).
less. If this occurs, the option expires worthless and the
option seller keeps the premium as prot. Since the payAndrei N. Soklakov (2013). Deriving Derivatives. o for sold (or written) call options increases as the stock
price falls, selling call options is considered bearish.

Lins Lemke (20132014). Soft Dollars and Other

Trading Activities. Thomson West.

1.3.22

External links

Understanding Derivatives: Markets and Infrastructure (Federal Reserve Bank of Chicago)

Derivatives simple guide, BBC News

All call options have the following three characteristics:

1. Strike price: this is the price at which you can buy
the stock (if you have bought a call option) or the
price at which you must sell your stock (if you have
sold a call option).

1.4. CALL OPTION

21

2. Expiry date: this is the date on which the option

expires, or becomes worthless, if the buyer doesn't
exercise it.
Premium

Profit

it

Payoff

of

Pr

3. Premium: this is the price you pay when you buy

an option and the price you receive when you sell an
option.

The initial transaction in this context (buying/selling a call

option) is not the supplying of a physical or nancial asset
Share Price at Maturity
(the underlying instrument). Rather it is the granting of
the right to buy the underlying asset, in exchange for a fee
the option price or premium.
Prots from writing a call.

Strike
Price

Short Call

Exact specications may dier depending on option style.

A European call option allows the holder to exercise the
option (i.e., to buy) only on the option expiration date. An
American call option allows exercise at any time during
the life of the option.

strike price. Typically, if the price of the underlying instrument has surpassed the strike price, the buyer pays
the strike price to actually purchase the underlying instrument, and then sells the instrument and pockets the
Call options can be purchased on many nancial instru- prot. Of course, the investor can also hold onto the unments other than stock in a corporation. Options can be derlying instrument, if he feels it will continue to climb
purchased on futures or interest rates, for example (see even higher.
interest rate cap), and on commodities like gold or crude An investor typically 'writes a call' when he expects the
oil. A tradeable call option should not be confused with price of the underlying instrument to stay below the calls
either Incentive stock options or with a warrant. An in- strike price. The writer (seller) receives the premium up
centive stock option, the option to buy stock in a particu- front as his or her prot. However, if the call buyer delar company, is a right granted by a corporation to a par- cides to exercise his option to buy, then the writer has the
ticular person (typically executives) to purchase treasury obligation to sell the underlying instrument at the strike
stock. When an incentive stock option is exercised, new price. Often the writer of the call does not actually own
shares are issued. Incentive options are not traded on the the underlying instrument, and must purchase it on the
open market. In contrast, when a call option is exercised, open market in order to be able to sell it to the buyer of
the underlying asset is transferred from one owner to an- the call. The seller of the call will lose the dierence beother.
tween his purchase price of the underlying instrument and

Example of a call option on a stock

Pr
of
it

Pa

yo

ff

1.4.1

Profit

Premium

Share Price at Maturity

Strike
Price

Long Call

Prots from buying a call.

An investor typically 'buys a call' when he expects the

price of the underlying instrument will go above the calls
'strike price,' hopefully signicantly so, before the call
expires. The investor pays a non-refundable premium
for the legal right to exercise the call at the strike price,
meaning he can purchase the underlying instrument at the

the strike price. This risk can be huge if the underlying

instrument skyrockets unexpectedly in price.
The current price of ABC Corp stock is $45 per
share, and investor 'Greg R.' expects it will go up signicantly. Greg buys a call contract for 100 shares
of ABC Corp from 'Terence R.,' who is the call
writer/seller. The strike price for the contract is $50
per share, and Greg pays a premium up front of $5
per share, or $500 total. If ABC Corp does not go
up, and Greg does not exercise the contract, then
Greg has lost $500.
ABC Corp stock subsequently goes up to $60 per
share before the contract expires. Greg exercises the
call option by buying 100 shares of ABC from Terence for a total of $5,000. Greg then sells the stock
on the market at market price for a total of $6,000.
Greg has paid a $500 contract premium plus a stock
cost of $5,000, for a total of $5,500. He has earned
back $6,000, yielding a net prot of $500.
If, however, the ABC stock price drops to $40 per
share by the time the contract expires, Greg will not

22

CHAPTER 1. INTRODUCTION
exercise the option (i.e., Greg will not buy a stock at
Vol how many options traded today.
$50 per share from Terence when he can buy it on
Open Int how many options are available, i.e. the
the open market at $40 per share). Greg loses his
option oat.
premium, a total of $500. Terence, however, keeps
the premium with no other out-of-pocket expenses,
Notes:
making a prot of $500.

The break-even stock price for Greg is $55 per

share, i.e., the $50 per share for the call option price
plus the $5 per share premium he paid for the option. If the stock reaches $55 per share when the
option expires, Greg can recover his investment by
exercising the option and buying 100 shares of ABC
Corp stock from Terence at $50 per share, and then
immediately selling those shares at the market price
of $55. His total costs are then the $5 per share premium for the call option, plus $50 per share to buy
the shares from Greg, for a total of $5,500. His total
earnings are $55 per share sold, or $5,500 for 100
shares, yielding him a net $0. (Note that this does
not take into account broker fees or other transaction costs.) Note, however, that the $5 per share
premium is a sunk cost that he has already paid regardless of whether he chooses to exercise the call.
Thus, while he breaks even at $55 per share, actually, he makes a $5 per share prot that covers the
earlier expense of $5 per share. Thus it is in his interest to exercise the call if the price goes above $50,
even if it does not reach $55, because the prot he
makes will reduce his net loss.

1. The bid/ask price is more relevant in ascertaining

the value of the option than the last price since options are not frequently traded. Meaning the value
is usually the Ask/Bid Price.
2. An option usually covers 100 shares. So the bid/ask
price is multiplied by 100 to get the total cost.
Lets say we bought 3 PNC strike $45, January 2012 call
options in August for $11.75. That means we paid $3,525
(11.75 * 3 options for 100 shares each) for the right to buy
300 (3*100) PNC shares for $45 per share between now
and January 2012.
The stock at that time traded at $50.65 meaning the theoretical call premium was $6.1 as shown by our formula:
(current price + theoretical time/volatility premium)
strike price, (50.65 + 6.1 45 = 11.75).

Today the stock is trading at $64 making the call option

worth $19.45 with a theoretical call premium now of 45
cents above its in-the-money intrinsic value $19 (the $64
market price minus the call option $45 strike price). The
call premium tends to go down as the option gets closer
to the call date. And it goes down as the option price rises
relative to the stock price, i.e. the 19.45 the option is now
worth 30% (19.45/ $64) of the price per PNC shares. In
1.4.2 Example of valuing a stock option
August it was 23% (11.75/$50.65). The lower percentage
A company issues an option for the right to buy their of the options price is based on the stocks price, the more
stock. An investor buys this option and hopes the stock upside the investor has, therefore the investor will pay a
premium for it.
goes higher so their option will increase in value.
This option could be used to buy 300 PNC shares today at
$45, it can be sold on the option market for $19.45 or for
Theoretical option price = (current price + the$5,835 (19.45 * 3 options for 100 shares each). Or it can
oretical time/volatility premium) strike price
be held as the investor bets that the price will continue to
Lets look at an actual example, PNC options for Jan- increase. The investor must make a decision by January
uary 2012: http://finance.yahoo.com/q/op?s=PNC&m= 2012: he will either have to sell the option or buy the 300
shares. If the stock price drops below the strike price on
2012-01.
this date the investor will not exercise his right since it
will be worthless.
Strike price the price the investor can buy the stock
at through the option.
Symbol like a stock symbol but for options it incorporates the date.

1.4.3 Value of a call

This example leads to the following formal reasoning. Fix

Last like the last stock price, it is the last price O an underlying nancial instrument. Let be a call
option for this instrument, purchased at time 0 , expiring
traded between two parties.
at time T R+ , with exercise (strike) price K R ;
Change how much it went up and down today.
and let S : [0, T ] R be the price of the underlying
instrument.
Bid what a person is bidding for the option.
Assume the owner of the option , wants to make no
Ask what someone wants to sell the option for.
loss, and does not want to actually possess the underlying

1.5. PUT OPTION

instrument, O . Then either (i) the person will exercise
the option and purchase O , and then immediately sell it;
or (ii) the person will not exercise the option (which subsequently becomes worthless). In (i), the pay-o would
be K + ST ; in (ii) the pay-o would be 0 . So if
ST K 0 (i) or (ii) occurs; if ST K < 0 then (ii)
occurs.
Hence the pay-o, i.e. the value of the call option at expiry, is

23
Binary option
Bond option
Credit default option
Exotic option
Foreign exchange option
Interest rate cap and oor
Options on futures

which is also written (ST K) 0 or (ST K)+ .

Stock option
Swaption

1.4.4

Price of options

Option values vary with the value of the underlying instrument over time. The price of the call contract must
reect the likelihood or chance of the call nishing
in-the-money. The call contract price generally will be
higher when the contract has more time to expire (except
in cases when a signicant dividend is present) and when
the underlying nancial instrument shows more volatility.
Determining this value is one of the central functions of
nancial mathematics. The most common method used
is the BlackScholes formula. Importantly, the BlackScholes formula provides an estimate of the price of
European-style options.[2]
Whatever the formula used, the buyer and seller must
agree on the initial value (the premium or price of the
call contract), otherwise the exchange (buy/sell) of the
call will not take place.
Adjustment to Call Option: When a call option is in-themoney i.e. when the buyer is making prot, she has many
options. Some of them are as follows:
1. She can sell the call and book her prot
2. If she still feels that there is scope of making more
money she can continue to hold the position.
3. If she is interested in holding the position but at the
same time would like to have some protection,she
can buy a protective put of the strike that suits her.
4. She can sell a call of higher strike price and convert
the position into call spread and thus limiting her
loss if the market reverses.

1.4.6 See also

1.5 Put option

In nance, a put or put option is a stock market device
which gives the owner of the put the right, but not the obligation, to sell an asset (the underlying), at a specied price
(the strike), by a predetermined date (the expiry or maturity) to a given party (the buyer of the put). Put options
are most commonly used in the stock market to protect
against the decline of the price of a stock below a specied price. If the price of the stock declines below the
specied price of the put option, the owner/buyer of the
put has the right, but not the obligation, to sell the asset
at the specied price, while the seller of the put has the
obligation to purchase the asset at the strike price if the
owner uses the right to do so (the owner/buyer is said to
exercise the put or put option). In this way the buyer of the
put will receive at least the strike price specied, even if
the asset is currently worthless.
If the strike is K, and at time t the value of the underlying
is S(t), then in an American option the buyer can exercise
the put for a payout of K-S(t) any time up until the options
maturity time T. The put yields a positive return only if
the security price falls below the strike when the option
is exercised. A European option can only be exercised at
time T rather than any time up until T, and a Bermudan
option can be exercised only on specic dates listed in the
terms of the contract. If the option is not exercised by
maturity, it expires worthless. (Note that the buyer will
not exercise the option at an allowable date if the price of
the underlying is greater than K.)

Similarly if the buyer is making loss on her position i.e. The most obvious use of a put is as a type of insurance. In
the call is out-of-the-money, she can make several adjust- the protective put strategy, the investor buys enough puts
to cover his holdings of the underlying so that if a drastic
ments to limit her loss or even make some prot.
downward movement of the underlyings price occurs, he
has the option to sell the holdings at the strike price. Another use is for speculation: an investor can take a short
1.4.5 Options
position in the underlying stock without trading in it di Put option
rectly.

24

CHAPTER 1. INTRODUCTION

Puts may also be combined with other derivatives as part

of more complex investment strategies, and in particular,
may be useful for hedging. Note that by put-call parity, a
European put can be replaced by buying the appropriate
call option and selling an appropriate forward contract.

1.5.1

Instrument models

The terms for exercising the options right to sell it dier

depending on option style. A European put option allows
the holder to exercise the put option for a short period
of time right before expiration, while an American put
option allows exercise at any time before expiration.
The most widely-traded put options are on
stocks/equities, but they are traded on many other
instruments such as interest rates (see interest rate oor)
or commodities.

between the stocks market price and the options strike

price. But if the stocks market price is above the options strike price at the end of expiration day, the option
expires worthless, and the owners loss is limited to the
premium (fee) paid for it (the writers prot).
The sellers potential loss on a naked put can be substantial. If the stock falls all the way to zero (bankruptcy), his
loss is equal to the strike price (at which he must buy the
stock to cover the option) minus the premium received.
The potential upside is the premium received when selling the option: if the stock price is above the strike price
at expiration, the option seller keeps the premium, and
the option expires worthless. During the options lifetime, if the stock moves lower, the options premium may
increase (depending on how far the stock falls and how
much time passes). If it does, it becomes more costly to
close the position (repurchase the put, sold earlier), resulting in a loss. If the stock price completely collapses
before the put position is closed, the put writer potentially can face catastrophic loss. In order to protect the
put buyer from default, the put writer is required to post
margin. The put buyer does not need to post margin because the buyer would not exercise the option if it had a
negative payo.

The put buyer either believes that the underlying assets

price will fall by the exercise date or hopes to protect a
long position in it. The advantage of buying a put over
short selling the asset is that the option owners risk of
loss is limited to the premium paid for it, whereas the
asset short sellers risk of loss is unlimited (its price can
rise greatly, in fact, in theory it can rise innitely, and such
a rise is the short sellers loss). The put buyers prospect
1.5.2
(risk) of gain is limited to the options strike price less the
underlyings spot price and the premium/fee paid for it.

it
of

ff

yo
Pa

Pr

The put writer believes that the underlying securitys price

will rise, not fall. The writer sells the put to collect the
premium. The put writers total potential loss is limited
to the puts strike price less the spot and premium already
received. Puts can be used also to limit the writers portfolio risk and may be part of an option spread.

Example of a put option on a stock

Premium

Premium

Strike
Price

Long Put

Payoff

Profit

A naked put, also called an uncovered put, is a put option

whose writer (the seller) does not have a position in the
underlying stock or other instrument. This strategy is best
used by investors who want to accumulate a position in
the underlying stock, but only if the price is low enough.
If the buyer fails to exercise the options, then the writer
keeps the option premium as a gift for playing the game.

Pr
of
it

Profit

The put buyer/owner is short on the underlying asset of

the put, but long on the put option itself. That is, the buyer
wants the value of the put option to increase by a decline
in the price of the underlying asset below the strike price.
Share Price at Maturity
The writer (seller) of a put is long on the underlying asset
and short on the put option itself. That is, the seller wants
the option to become worthless by an increase in the price Payo from buying a put.
of the underlying asset above the strike price. Generally,
a put option that is purchased is referred to as a long put
and a put option that is sold is referred to as a short put.

If the underlying stocks market price is below the opShare Price at Maturity
tions strike price when expiration arrives, the option
owner (buyer) can exercise the put option, forcing the
writer to buy the underlying stock at the strike price. That Payo from writing a put.
allows the exerciser (buyer) to prot from the dierence

Strike
Price

Short Put

1.5. PUT OPTION

Buying a put

25

1.5.3 Payo of a put

These examples lead to the following formal reasoning.

A buyer thinks the price of a stock will decrease. He pays
Fix O an underlying nancial instrument. Let be a put
a premium which he will never get back, unless it is sold
option for this instrument, purchased at time 0 , expiring
before it expires. The buyer has the right to sell the stock
at time T R+ , with exercise (strike) price of K R
at the strike price.
; and let S : [0, T ] R be the price of the underlying
instrument.
Writing a put
Assume the owner of the option , wants to not take a
loss, and does not want to actually possess the underlying
The writer receives a premium from the buyer. If the instrument, O . Then either (i) the person will purchase
buyer exercises his option, the writer will buy the stock at O at expiry, and then immediately exercise the selling opthe strike price. If the buyer does not exercise his option, tion; or (ii) the person will not exercise the option (which
subsequently becomes worthless).
the writers prot is the premium.
Trader A (Put Buyer) purchases a put contract to
sell 100 shares of XYZ Corp. to Trader B (Put
Writer) for $50 per share. The current price is
$50 per share, and Trader A pays a premium of $5
per share. If the price of XYZ stock falls to $40 a
share right before expiration, then Trader A can exercise the put by buying 100 shares for $4,000 from
the stock market, then selling them to Trader B for
$5,000.
Trader As total earnings (S) can be calculated
at $500. The sale of the 100 shares of stock at
a strike price of $50 to Trader B = $5,000 (P).
The purchase of 100 shares of stock at $40 =
$4,000 (Q). The put option premium paid to
trader B for buying the contract of 100 shares
at $5 per share, excluding commissions = $500
(R). Thus S = ( P - Q ) - R = ($5,000 - $4,000
) - $500 = $500.

In (i), the pay-o would be ST + K ; in (ii) the payo would be 0 . So if K ST 0 (i) or (ii) occurs; if
K ST < 0 then (ii) occurs.
Hence the pay-o, i.e. the value of the put option at expiry, is

which is alternatively written (K ST )0 or (K ST )+

.

1.5.4 See also

Call option
CBOE S&P 500 PutWrite Index (PUT)
Married put

If, however, the share price never drops below the

Naked put
strike price (in this case, $50), then Trader A would
not exercise the option (because selling a stock to
Trader B at $50 would cost Trader A more than that Options
to buy it). Trader As option would be worthless
and he would have lost the whole investment, the
Credit default option
fee (premium) for the option contract, $500 ($5 per
share, 100 shares per contract). Trader As total loss
Interest rate cap and oor
is limited to the cost of the put premium plus the
sales commission to buy it.
Options on futures
A put option is said to have intrinsic value when the un Real option
derlying instrument has a spot price (S) below the options
strike price (K). Upon exercise, a put option is valued at
K-S if it is "in-the-money", otherwise its value is zero.
Prior to exercise, an option has time value apart from 1.5.5 External links
its intrinsic value. The following factors reduce the time
Basic Options Concepts: Put Options at Yahoo! Fivalue of a put option: shortening of the time to expire,
nance
decrease in the volatility of the underlying, and increase
of interest rates. Option pricing is a central problem of
nancial mathematics.
Put Writing Strategy Example

26

CHAPTER 1. INTRODUCTION

1.6 Strike price

In nance, the strike price (or exercise price) of an
option is the xed price at which the owner of the option can buy (in the case of a call), or sell (in the case of
a put), the underlying security or commodity. The strike
price may be set by reference to the spot price (market
price) of the underlying security or commodity on the day
an option is taken out, or it may be xed at a discount or
at a premium.

(S K)+
where

(x)+ = {x0

x0
x<0

A put option has positive monetary value at expiration

when the underlying has a spot price below the strike
The strike price is a key variable in a derivatives contract price; it is "out-the-money" otherwise, and will not be
between two parties. Where the contract requires delivery exercised. The payo is therefore:
of the underlying instrument, the trade will be at the strike
price, regardless of the market price of the underlying
instrument at that time.
max [(K S); 0]
For example, an IBM May Call a strike price of $50 a
or
share. When the option is exercised, the owner of the
option will buy 100 shares of IBM stock for $50 per share.
(K S)+

1.6.1

Moneyness

For a digital option payo is 1SK , where 1{} is the

Moneyness is the value of a nancial contract if the con- indicator function.
tract settlement is nancial. More specically, it is the
dierence between the strike price of the option and the
1.6.2 See also
current trading price of its underlying security.
In options trading, terms such as in-the-money, at-themoney and out-of-the-money describe the moneyness of
options.
A call option is in-the-money if the strike price is
below the market price of the underlying stock.
A put option is in-the-money if the strike price
is above the market price of the underlying
stock.
A call or put option is at-the-money if the stock price
and the exercise price are the same (or close).
A call option is out-of-the-money if the strike price
is above the market price of the underlying stock.

Option time value

Intrinsic value
Option screener

1.6.3 References
McMillan, Lawrence G. (2002). Options as a Strategic Investment (4th ed. ed.). New York : New York
Institute of Finance. ISBN 0-7352-0197-8.

1.7 Expiration

A put option is out-of-the-money if the strike In nance, the expiration date of an option contract is the
price is below the market price of the under- last date on which the holder of the option may exercise
it according to its terms. In the case of options with aulying stock.
tomatic exercise the net value of the option is credited
to the long and debited to the short position holders.
Mathematical formula
Typically, exchange-traded option contracts expire according to a pre-determined calendar. For instance, for
A call option has positive monetary value at expiration
U.S. exchange-listed equity stock option contracts, the
when the underlying has a spot price (S) above the strike
expiration date is always the Saturday that follows the
price (K). Since the option will not be exercised unless it
third Friday of the month, unless that Friday is a maris in-the-money, the payo for a call option is
ket holiday, in which case the expiration is on Thursday
right before that Friday.
max [(S K); 0]
also written as

The clearing rm may automatically exercise by exception any option that is in the money at expiration to preserve its value for the holder of the option and at the same

1.9. OPTIONS

27

time, benet from the commission fees collected from the Euro-Bund options (OGBL) are traded on Eurex and their
account holder. However the holder or the holders bro- underlying is the Euro-Bund futures contract (FGBL).
ker may request that the options are not exercised automatically. Out of the money options are not exercised
automatically.

1.9 Options

Upon expiration any margin charged held by the clearing

rm of the holder or writer of the option is released back Stock option redirects here. For the employee incento the free balance of the traders account.
tive, see Employee stock option.
In nance, an option is a contract which gives the buyer
(the owner or holder) the right, but not the obligation, to
The Options Clearing Corporation - Option Expira- buy or sell an underlying asset or instrument at a specied strike price on or before a specied date. The seller
tion Calendar
has the corresponding obligation to fulll the transaction
that is to sell or buy if the buyer (owner) exercises
the option. An option that conveys to the owner the right
1.7.2 See also
to buy something at a specic price is referred to as a call;
an option that conveys the right of the owner to sell some Option screener
thing at a specic price is referred to as a put. Both are
commonly traded, but for clarity, the call option is more
frequently discussed.

1.7.1

External links

1.8 Underlying

For the phonological term, see Underlying representation.

In nance, the underlying of a derivative is an asset,
basket of assets, index, or even another derivative, such
that the cash ows of the (former) derivative depend on
the value of this underlying. There must be an independent way to observe this value to avoid conicts of interest.
According to the Financial Accounting Standards Board
(FASB)'s Statement of Financial Accounting Standards
No. 133 (FAS 133) - Accounting for Derivative Instruments and Hedging Activities, an underlying is a specied interest rate, security price, commodity price, foreign
exchange rate, index of prices or rates, or other variable
(including the occurrence or nonoccurrence of a specied
event such as a scheduled payment under a contract). An
underlying may be a price or rate of an asset or liability
but is not the asset or liability itself.

The seller may grant an option to a buyer as part of another transaction, such as a share issue or as part of an
employee incentive scheme, otherwise a buyer would pay
a premium to the seller for the option. A call option
would normally be exercised only when the strike price
is below the market value of the underlaying asset at that
time, while a put option would normally be exercised only
when the strike price is above the market value. When an
option is exercised, the cost to the buyer of the asset acquired is the strike price plus the premium, if any. When
the option expiration date passes without the option being
exercised, then the option expires and the buyer would
forfeit the premium to the seller. In any case, the premium is income to the seller, and normally a capital loss
to the buyer.
The owner of an option may on-sell the option to a third
party, in either an over-the-counter transaction or on an
options exchange, depending on the type of option and its
terms.

1.9.1 History
1.8.1

Examples

For example, in a stock option to buy 100 shares of Nokia

at EUR 50 in April 2011, the underlying is a Nokia share.
In a futures contract to buy EUR 10 million 10-year German Government Bonds, the underlying are the German
Government bonds. Other examples are stock market
indexes such as the Dow Jones Industrial Average and
Nikkei 225, for which the underlying are the common
stocks of 30 large U.S. companies and 225 Japanese companies, respectively.

Options contracts have been known for many centuries.

The Chicago Board Options Exchange was established
in 1973 which set up a regime using standardized forms
and terms and trade through a guaranteed clearing house.
Trading activity and academic interest increased since
then.

Today, many options are created in a standardized form

and traded through clearing houses on regulated options
exchanges, while other over-the-counter options are written as bilateral, customized contracts between a single
Options on futures derivatives are an example of deriva- buyer and seller, one or both of which may be a dealer or
tives whose underlying is also a derivative. For example, market-maker. Options are part of a larger class of nan-

28

CHAPTER 1. INTRODUCTION

cial instruments known as derivative products, or simply, According to the option rights
derivatives.[1][2]
Call options give the holder the rightbut not the
obligationto buy something at a specic price for
1.9.2 Valuation overview
a specic time period.
Options valuation is a topic of ongoing research in academic and practical nance. In basic terms, the value of
an option is commonly decomposed into two parts:

Put options give the holder the rightbut not the

obligationto sell something at a specic price for
a specic time period.

The rst part is the intrinsic value, which is dened According to the underlying assets
as the dierence between the market value of the
underlying and the strike price of the given option.
Equity option
The second part is the time value, which depends on a set of other factors which, through a
multi-variable, non-linear interrelationship, reect
the discounted expected value of that dierence at
expiration.
Although options valuation has been studied at least since
the nineteenth century, the contemporary approach is
based on the BlackScholes model which was rst published in 1973.[3][4]

Bond option
Future option
Index option
Commodity option
Currency option
According to the trading markets

1.9.3

Contract specications

A nancial option is a contract between two counterparties with the terms of the option specied in a term
sheet. Option contracts may be quite complicated; however, at minimum, they usually contain the following
specications:[5]
whether the option holder has the right to buy (a call
option) or the right to sell (a put option)
the quantity and class of the underlying asset(s) (e.g.,
100 shares of XYZ Co. B stock)
the strike price, also known as the exercise price,
which is the price at which the underlying transaction will occur upon exercise
the expiration date, or expiry, which is the last date
the option can be exercised
the settlement terms, for instance whether the writer
must deliver the actual asset on exercise, or may simply tender the equivalent cash amount
the terms by which the option is quoted in the market
to convert the quoted price into the actual premium
the total amount paid by the holder to the writer

Exchange-traded options (also called listed options) are a class of exchange-traded derivatives.
Exchange traded options have standardized contracts, and are settled through a clearing house with
fulllment guaranteed by the Options Clearing Corporation (OCC). Since the contracts are standardized, accurate pricing models are often available.
Exchange-traded options include:[6][7]
stock options,
bond options and other interest rate options
stock market index options or, simply, index
options and
options on futures contracts
callable bull/bear contract
Over-the-counter options (OTC options, also
called dealer options) are traded between two private parties, and are not listed on an exchange. The
terms of an OTC option are unrestricted and may be
individually tailored to meet any business need. In
general, at least one of the counterparties to an OTC
option is a well-capitalized institution. Option types
commonly traded over the counter include:
1. interest rate options

1.9.4

Types

Options can be classied in a few ways.

2. currency cross rate options, and

3. options on swaps or swaptions.

1.9. OPTIONS

29

Other option types

These models are implemented using a variety of numerical techniques.[10] In general, standard option valuation
Another important class of options, particularly in the models depend on the following factors:
U.S., are employee stock options, which are awarded by a
company to their employees as a form of incentive com The current market price of the underlying security,
pensation. Other types of options exist in many nan the strike price of the option, particularly in relation
cial contracts, for example real estate options are often
to the current market price of the underlying (in the
used to assemble large parcels of land, and prepayment
money vs. out of the money),
options are usually included in mortgage loans. However,
many of the valuation and risk management principles ap the cost of holding a position in the underlying seply across all nancial options. There are two more types
curity, including interest and dividends,
[8]
of options; covered and naked.
Option styles

the time to expiration together with any restrictions

on when exercise may occur, and

Main article: Option style

an estimate of the future volatility of the underlying

securitys price over the life of the option.

Naming conventions are used to help identify properties More advanced models can require additional factors,
common to many dierent types of options. These in- such as an estimate of how volatility changes over time
clude:
and for various underlying price levels, or the dynamics
of stochastic interest rates.
European option an option that may only be The following are some of the principal valuation techexercised on expiration.
niques used in practice to evaluate option contracts.
American option an option that may be exercised
on any trading day on or before expiry.
BlackScholes
Bermudan option an option that may be exercised Main article: BlackScholes
only on specied dates on or before expiration.
Asian option an option whose payo is deter- Following early work by Louis Bachelier and later work
mined by the average underlying price over some by Robert C. Merton, Fischer Black and Myron Scholes
made a major breakthrough by deriving a dierential
preset time period.
equation that must be satised by the price of any deriva Barrier option any option with the general charac- tive dependent on a non-dividend-paying stock. By emteristic that the underlying securitys price must pass ploying the technique of constructing a risk neutral porta certain level or barrier before it can be exercised. folio that replicates the returns of holding an option,
Black and Scholes produced a closed-form solution for
Binary option An all-or-nothing option that pays a European options theoretical price.[11] At the same
the full amount if the underlying security meets the time, the model generates hedge parameters necessary
dened condition on expiration otherwise it expires for eective risk management of option holdings. While
worthless.
the ideas behind the BlackScholes model were groundbreaking and eventually led to Scholes and Merton re Exotic option any of a broad category of options
ceiving the Swedish Central Bank's associated Prize for
that may include complex nancial structures.[9]
Achievement in Economics (a.k.a., the Nobel Prize in
Economics),[12] the application of the model in actual op Vanilla option any option that is not exotic.
tions trading is clumsy because of the assumptions of continuous trading, constant volatility, and a constant interest
rate. Nevertheless, the BlackScholes model is still one
1.9.5 Valuation models
of the most important methods and foundations for the
existing nancial market in which the result is within the
Main article: Valuation of options
reasonable range.[13]
The value of an option can be estimated using a variety of quantitative techniques based on the concept of Stochastic volatility models
risk neutral pricing and using stochastic calculus. The
most basic model is the BlackScholes model. More so- Main article: Heston model
phisticated models are used to model the volatility smile.

30
Since the market crash of 1987, it has been observed that
market implied volatility for options of lower strike prices
are typically higher than for higher strike prices, suggesting that volatility is stochastic, varying both for time and
for the price level of the underlying security. Stochastic
volatility models have been developed including one developed by S.L. Heston.[14] One principal advantage of
the Heston model is that it can be solved in closed-form,
while other stochastic volatility models require complex
numerical methods.[14]

CHAPTER 1. INTRODUCTION
Trinomial tree is a similar model, allowing for an up,
down or stable path; although considered more accurate,
particularly when fewer time-steps are modelled, it is less
commonly used as its implementation is more complex.

Monte Carlo models

Main article: Monte Carlo methods for option pricing

See also: SABR Volatility Model

For many classes of options, traditional valuation techniques are intractable because of the complexity of the
instrument. In these cases, a Monte Carlo approach may
1.9.6 Model implementation
often be useful. Rather than attempt to solve the dierential equations of motion that describe the options value in
Further information: Valuation of options
relation to the underlying securitys price, a Monte Carlo
model uses simulation to generate random price paths of
Once a valuation model has been chosen, there are a num- the underlying asset, each of which results in a payo
ber of dierent techniques used to take the mathematical for the option. The average of these payos can be discounted to yield an expectation value for the option.[17]
models to implement the models.
Note though, that despite its exibility, using simulation
for American styled options is somewhat more complex
than for lattice based models.
Analytic techniques
In some cases, one can take the mathematical model
and using analytical methods develop closed form solutions such as BlackScholes and the Black model. The
resulting solutions are readily computable, as are their
Greeks. Although the Roll-Geske-Whaley model applies to an American call with one dividend, for other
cases of American options, closed form solutions are not
available; approximations here include Barone-Adesi and
Whaley, Bjerksund and Stensland and others.
Binomial tree pricing model
Main article: Binomial options pricing model
Closely following the derivation of Black and Scholes,
John Cox, Stephen Ross and Mark Rubinstein developed the original version of the binomial options pricing model.[15] [16] It models the dynamics of the options
theoretical value for discrete time intervals over the options life. The model starts with a binomial tree of discrete future possible underlying stock prices. By constructing a riskless portfolio of an option and stock (as in
the BlackScholes model) a simple formula can be used
to nd the option price at each node in the tree. This
value can approximate the theoretical value produced by
Black Scholes, to the desired degree of precision. However, the binomial model is considered more accurate
than BlackScholes because it is more exible; e.g., discrete future dividend payments can be modeled correctly
at the proper forward time steps, and American options
can be modeled as well as European ones. Binomial models are widely used by professional option traders. The

Finite dierence models

Main article: Finite dierence methods for option pricing
The equations used to model the option are often expressed as partial dierential equations (see for example
BlackScholes equation). Once expressed in this form,
a nite dierence model can be derived, and the valuation obtained. A number of implementations of nite
dierence methods exist for option valuation, including:
explicit nite dierence, implicit nite dierence and the
Crank-Nicholson method. A trinomial tree option pricing model can be shown to be a simplied application of
the explicit nite dierence method. Although the nite
dierence approach is mathematically sophisticated, it is
particularly useful where changes are assumed over time
in model inputs for example dividend yield, risk free
rate, or volatility, or some combination of these that
are not tractable in closed form.

Other models
Other numerical implementations which have been used
to value options include nite element methods. Additionally, various short rate models have been developed
for the valuation of interest rate derivatives, bond options
and swaptions. These, similarly, allow for closed-form,
lattice-based, and simulation-based modelling, with corresponding advantages and considerations.

1.9. OPTIONS

1.9.7

31

Risks

for a delta neutral portfolio, whereby the trader had also

sold 44 shares of XYZ stock as a hedge, the net loss under
As with all securities, trading options entails the risk of the same scenario would be ($15.86).
the options value changing over time. However, unlike
traditional securities, the return from holding an option
varies non-linearly with the value of the underlying and Pin risk
other factors. Therefore, the risks associated with holding
options are more complicated to understand and predict. Main article: Pin risk
In general, the change in the value of an option can be
A special situation called pin risk can arise when the underived from It's lemma as:
derlying closes at or very close to the options strike value
on the last day the option is traded prior to expiration.
The option writer (seller) may not know with certainty
dS 2
whether or not the option will actually be exercised or be
dC = dS +
+ d + dt
2
allowed to expire worthless. Therefore, the option writer
may end up with a large, unwanted residual position in
where the Greeks , , and are the standard hedge the underlying when the markets open on the next trading
parameters calculated from an option valuation model, day after expiration, regardless of his or her best eorts
such as BlackScholes, and dS , d and dt are unit to avoid such a residual.
changes in the underlyings price, the underlyings volatility and time, respectively.
Counterparty risk
Thus, at any point in time, one can estimate the risk inherent in holding an option by calculating its hedge parameA further, often ignored, risk in derivatives such as opters and then estimating the expected change in the model
tions is counterparty risk. In an option contract this risk
inputs, dS , d and dt , provided the changes in these
is that the seller won't sell or buy the underlying asset as
values are small. This technique can be used eectively
agreed. The risk can be minimized by using a nancially
to understand and manage the risks associated with stanstrong intermediary able to make good on the trade, but
dard options. For instance, by osetting a holding in an
in a major panic or crash the number of defaults can overoption with the quantity of shares in the underlying,
whelm even the strongest intermediaries.
a trader can form a delta neutral portfolio that is hedged
from loss for small changes in the underlyings price. The
corresponding price sensitivity formula for this portfolio 1.9.8 Trading
is:
The most common way to trade options is via standardized options contracts that are listed by various futures
and options exchanges. [18] Listings and prices are
dS 2
dS 2
+d+dt =
+d+dt tracked and can be looked up by ticker symbol. By pubd = dS +
2
2
lishing continuous, live markets for option prices, an exchange enables independent parties to engage in price disExample
covery and execute transactions. As an intermediary to
both sides of the transaction, the benets the exchange
A call option expiring in 99 days on 100 shares of XYZ provides to the transaction include:
stock is struck at $50, with XYZ currently trading at $48.
With future realized volatility over the life of the option
fulllment of the contract is backed by the credit of
estimated at 25%, the theoretical value of the option is
the exchange, which typically has the highest rating
$1.89. The hedge parameters , , , are (0.439,
(AAA),
0.0631, 9.6, and 0.022), respectively. Assume that on
the following day, XYZ stock rises to $48.5 and volatility
counterparties remain anonymous,
falls to 23.5%. We can calculate the estimated value of
enforcement of market regulation to ensure fairness
the call option by applying the hedge parameters to the
and transparency, and
new model inputs as:
maintenance of orderly markets, especially during
fast trading conditions.

(
)
0.52
dC = (0.4390.5)+ 0.0631
+(9.60.015)+(0.0221) = 0.0614
Over-the-counter options contracts are not traded on ex2
changes, but instead between two independent parties.
Under this scenario, the value of the option increases by Ordinarily, at least one of the counterparties is a well$0.0614 to $1.9514, realizing a prot of $6.14. Note that capitalized institution. By avoiding an exchange, users

32

CHAPTER 1. INTRODUCTION

of OTC options can narrowly tailor the terms of the option contract to suit individual business requirements. In
addition, OTC option transactions generally do not need
to be advertised to the market and face little or no regulatory requirements. However, OTC counterparties must
establish credit lines with each other, and conform to each
others clearing and settlement procedures.

and premium paid is 10, then if the spot price of 100

raises to only 110 the transaction is breakeven; and an
increase in stock price above 110 produces a prot.
Long put

it
of

The basic trades of traded stock options (American style)

Premium

Profit

1.9.9

ff
yo
Pa

Pr

With few exceptions,[19] there are no secondary markets

for employee stock options. These must either be exercised by the original grantee or allowed to expire worthless.

it

Pr
of

Profit

Pa

yo
ff

These trades are described from the point of view of a

Share Price at Maturity
Strike
Long Put
speculator. If they are combined with other positions,
Price
they can also be used in hedging. An option contract in
US markets usually represents 100 shares of the underly- Payo from buying a put.
ing security.[20]
A trader who expects a stocks price to decrease can buy
a put option to sell the stock at a xed price at a later
Long call
date. The trader will be under no obligation to sell the
stock, but has the right to do so until the expiration date.
If the stock price at expiration is below the exercise price
by more than the premium paid, he will make a prot. If
the stock price at expiration is above the exercise price,
he will let the put contract expire worthless and only lose
the premium paid. In the transaction, the premium also
0
plays a major role as it enhances the break-even point.
Premium
For example, if exercise price is 100, premium paid is
10, then a spot price of 100 to 90 is not protable. He
would make a prot if the spot price is below 90.
Share Price at Maturity

Strike
Price

Long Call

Short call

Payo from buying a call.

Premium

Profit

it

Payoff

of

Pr

A trader who expects a stocks price to increase can buy

a call option to purchase the stock at a xed price at a
later date, rather than just purchase the stock itself immediately. The cash outlay on the option is the premium,
which is much lower than what would be required for a
stock purchase. The trader would have no obligation to
buy the stock, but has only the right to do so until the
expiration date. If the stock price (spot price, S) at expiration date is above the exercise price (X) then the trader
would exercise the option; but he will make a prot if the
increase is by more than the premium paid (P) i.e. if
S-X>P. If the stock price at expiration is lower than the
exercise price, he will let the call contract expire worthless, and only lose the amount of the premium. The risk
of loss would be limited to the premium paid, unlike the
possible loss had the stock been bought. A trader would
make a prot if the spot price of the shares raises by more
than the premium. For example, if exercise price is 100

Share Price at Maturity

Strike
Price

Short Call

Payo from writing a call.

A trader who expects a stock price to decrease can sell

the stock short or instead sell, or write, a call. The
trader selling a call has an obligation to sell the stock to
the call buyer, at the buyers option. If the stock price
decreases, the buyer of the short call will make a prot in

1.9. OPTIONS

33

Premium

Pr

of

it

the amount of the premium. If the stock price increases

over the exercise price by more than the amount of the
premium, the buyer will lose money, with the potential
loss being unlimited.

Pa
yo

ff

Profit

Short put

Short Straddle

Payoff

Payos from selling a straddle.

Profit

Pr
o

Premium

fit

Share Price at Maturity

Share Price at Maturity

Short Put

Strike
Price

Payo from writing a put.

A trader who expects a stock price to increase can sell

the stock or instead sell, or write, a put. The trader
selling a put has an obligation to buy the stock from the
put buyer, at the buyers option. If the stock price at expiration is above the exercise price, the buyer of the short
put will make a prot in the amount of the premium. If
the stock price at expiration is below the exercise price
by more than the amount of the premium, the trader will
lose money, with the potential loss being up to the full
value of the stock. A benchmark index for the performance of a cash-secured short put option position is the
CBOE S&P 500 PutWrite Index (ticker PUT).

Payos from a covered call.

usually combine only a few trades, while more complicated strategies can combine several.

Strategies are often used to engineer a particular risk prole to movements in the underlying security. For example, buying a buttery spread (long one X1 call, short two
X2 calls, and long one X3 call) allows a trader to prot if
1.9.10 Option strategies
the stock price on the expiration date is near the middle
exercise price, X2, and does not expose the trader to a
Main article: Option strategies
Combining any of the four basic kinds of option trades large loss.
An Iron condor is a strategy that is similar to a buttery
spread, but with dierent strikes for the short options
oering a larger likelihood of prot but with a lower net
credit compared to the buttery spread.
Payoff

Premium

Profit

Profit

Share Price at Maturity

Long Butterfly

Selling a straddle (selling both a put and a call at the same

exercise price) would give a trader a greater prot than a
buttery if the nal stock price is near the exercise price,
but might result in a large loss.
Similar to the straddle is the strangle which is also constructed by a call and a put, but whose strikes are dierent, reducing the net debit of the trade, but also reducing
the risk of loss in the trade.

One well-known strategy is the covered call, in which

a trader buys a stock (or holds a previously-purchased
(possibly with dierent exercise prices and maturities) long stock position), and sells a call. If the stock price
and the two basic kinds of stock trades (long and short) rises above the exercise price, the call will be exercised
allows a variety of options strategies. Simple strategies and the trader will get a xed prot. If the stock price
Payos from buying a buttery spread.

34

CHAPTER 1. INTRODUCTION

falls, the call will not be exercised, and any loss incurred
to the trader will be partially oset by the premium received from selling the call. Overall, the payos match
the payos from selling a put. This relationship is known
as put-call parity and oers insights for nancial theory.
A benchmark index for the performance of a buy-write
strategy is the CBOE S&P 500 BuyWrite Index (ticker
symbol BXM).

Euronext.lie
International Securities Exchange
NYSE Arca
Philadelphia Stock Exchange
LEAPS (nance)
Real options analysis

1.9.11

Historical uses of options

PnL Explained

Contracts similar to options have been used since ancient

Pin risk (options)
times.[21] The rst reputed option buyer was the ancient
Greek mathematician and philosopher Thales of Miletus.
On a certain occasion, it was predicted that the seasons 1.9.13 References
olive harvest would be larger than usual, and during the
o-season he acquired the right to use a number of olive [1] Brealey, Richard A.; Myers, Stewart (2003), Principles of
Corporate Finance (7th ed.), McGraw-Hill, Chapter 20
presses the following spring. When spring came and the
olive harvest was larger than expected he exercised his [2] Hull, John C. (2005), Options, Futures and Other Derivaoptions and then rented the presses out at much higher
tives (excerpt by Fan Zhang) (6th ed.), Pg 6: Prentice-Hall,
price than he paid for his 'option'.[22][23]
ISBN 0-13-149908-4
In London, puts and refusals (calls) rst became wellknown trading instruments in the 1690s during the reign
of William and Mary.[24] Privileges were options sold over
the counter in nineteenth century America, with both puts
and calls on shares oered by specialized dealers. Their
exercise price was xed at a rounded-o market price
on the day or week that the option was bought, and the
expiry date was generally three months after purchase.
They were not traded in secondary markets.
In the real estate market, call options have long been used
to assemble large parcels of land from separate owners;
e.g., a developer pays for the right to buy several adjacent
plots, but is not obligated to buy these plots and might not
unless he can buy all the plots in the entire parcel. Film
or theatrical producers often buy the right but not the
obligation to dramatize a specic book or script.
Lines of credit give the potential borrower the right
but not the obligation to borrow within a specied time
period.

[3] Benhamou, Eric. Options pre-Black Scholes (PDF).

[4] Black, Fischer; Scholes, Myron (1973). The Pricing of
Options and Corporate Liabilities. Journal of Political
Economy 81 (3): 637654. doi:10.1086/260062. JSTOR
1831029.
[5] Characteristics and Risks of Standardized Options (PDF),
Options Clearing Corporation, retrieved June 21, 2007
[6] Trade CME Products, Chicago Mercantile Exchange, retrieved June 21, 2007
[7] ISE Traded Products, International Securities Exchange,
archived from the original on May 11, 2007, retrieved
June 21, 2007
[8] Lawrence G. McMillan (15 February 2011). McMillan
on Options. John Wiley & Sons. pp. 575. ISBN 978-1118-04588-6.
[9] Fabozzi, Frank J. (2002), The Handbook of Financial Instruments (Page. 471) (1st ed.), New Jersey: John Wiley
and Sons Inc, ISBN 0-471-22092-2

Many choices, or embedded options, have traditionally

been included in bond contracts. For example many
bonds are convertible into common stock at the buyers [10] Reilly, Frank K.; Brown, Keith C. (2003), Investment
Analysis and Portfolio Management (7th ed.), Thomson
option, or may be called (bought back) at specied prices
Southwestern, Chapter 23
at the issuers option. Mortgage borrowers have long had
the option to repay the loan early, which corresponds to a [11] Black, Fischer and Myron S. Scholes. The Pricing of Opcallable bond option.
tions and Corporate Liabilities, Journal of Political Economy, 81 (3), 637654 (1973).

1.9.12

See also

American Stock Exchange

Chicago Board Options Exchange
Eurex

[12] Das, Satyajit (2006), Traders, Guns & Money: Knowns

and unknowns in the dazzling world of derivatives (6th
ed.), London: Prentice-Hall, Chapter 1 'Financial WMDs
derivatives demagoguery,' p.22, ISBN 978-0-27370474-4
[13] Hull, John C. (2005), Options, Futures and Other Derivatives (6th ed.), Prentice-Hall, ISBN 0-13-149908-4

1.10. SHORT

[14] Jim Gatheral (2006), The Volatility Surface, A Practitioners Guide, Wiley Finance, ISBN 978-0-471-79251-2
[15] Cox JC, Ross SA and Rubinstein M. 1979. Options pricing: a simplied approach, Journal of Financial Economics, 7:229263.
[16] Cox, John C.; Rubinstein, Mark (1985), Options Markets,
Prentice-Hall, Chapter 5
[17] Crack, Timothy Falcon (2004), Basic BlackScholes: Option Pricing and Trading (1st ed.), pp. 91102, ISBN 09700552-2-6
[18] Harris, Larry (2003), Trading and Exchanges, Oxford
University Press, pp.2627
[19] Elinor Mills (December 12, 2006), Google unveils unorthodox stock option auction, CNet, retrieved June 19,
2007
[20] invest-faq or Law & Valuation for typical size of option
contract
[21] Abraham, Stephan (May 13, 2010). History of Financial
Options - Investopedia. Investopedia. Retrieved Jun 2,
2014.
[22] Mattias Sander. Bondessons Representation of the Variance Gamma Model and Monte Carlo Option Pricing.
Lunds Tekniska Hgskola 2008
[23] Aristotle. Politics.
[24] Smith, B. Mark (2003), History of the Global Stock Market from Ancient Rome to Silicon Valley, University of
Chicago Press, p. 20, ISBN 0-226-76404-4

1.9.14

35
Moran, Matthew. Risk-adjusted Performance for
Derivatives-based Indexes Tools to Help Stabilize
Returns. The Journal of Indexes. (Fourth Quarter,
2002) pp. 34 40.
Reilly, Frank and Keith C. Brown, Investment
Analysis and Portfolio Management, 7th edition,
Thompson Southwestern, 2003, pp. 9945.
Schneeweis, Thomas, and Richard Spurgin. The
Benets of Index Option-Based Strategies for Institutional Portfolios The Journal of Alternative Investments, (Spring 2001), pp. 44 52.
Whaley, Robert. Risk and Return of the CBOE
BuyWrite Monthly Index The Journal of Derivatives, (Winter 2002), pp. 35 42.
Bloss, Michael; Ernst, Dietmar; Hcker Joachim
(2008): Derivatives An authoritative guide to
derivatives for nancial intermediaries and investors
Oldenbourg Verlag Mnchen ISBN 978-3-48658632-9
Espen Gaarder Haug & Nassim Nicholas Taleb
(2008): Why We Have Never Used the Black
ScholesMerton Option Pricing Formula

1.10 Short

Further reading

Fischer Black and Myron S. Scholes. The Pricing of Options and Corporate Liabilities, Journal
of Political Economy, 81 (3), 637654 (1973).
Feldman, Barry and Dhuv Roy. Passive OptionsBased Investment Strategies: The Case of the
CBOE S&P 500 BuyWrite Index. The Journal of
Investing, (Summer 2005).
Kleinert, Hagen, Path Integrals in Quantum Mechanics, Statistics, Polymer Physics, and Financial
Markets, 4th edition, World Scientic (Singapore,
2004); Paperback ISBN 981-238-107-4 (also available online: PDF-les)

Schematic representation of short selling in two steps. The short

seller borrows shares and immediately sells them. The short seller
then expects the price to decrease, when the seller can prot by
purchasing the shares to return to the lender.

In nance, short selling (also known as shorting or going short) is the practice of selling securities or other
nancial instruments that are not currently owned, and
subsequently repurchasing them (covering). In the
event of an interim price decline, the short seller will
Millman, Gregory J. (2008), Futures and Options prot, since the cost of (re)purchase will be less than the
Markets, in David R. Henderson (ed.), Concise proceeds which were received upon the initial (short) sale.
Encyclopedia of Economics (2nd ed.), Indianapo- Conversely, the short position will be closed out at a loss
lis: Library of Economics and Liberty, ISBN 978- in the event that the price of a shorted instrument should
0865976658, OCLC 237794267
rise prior to repurchase. The potential loss on a short sale
Hill, Joanne, Venkatesh Balasubramanian, Krag
(Buzz) Gregory, and Ingrid Tierens. Finding Alpha via Covered Index Writing. Financial Analysts
Journal. (Sept.-Oct. 2006). pp. 2946.

36

CHAPTER 1. INTRODUCTION

is theoretically unlimited in the event of an unlimited rise

in the price of the instrument, however in practice the
short seller will be required to post margin or collateral
to cover losses, and any inability to do so on a timely basis would cause its broker or counterparty to liquidate the
position. In the securities markets, the seller generally
must borrow the securities in order to eect delivery in
the short sale. In some cases, the short seller must pay a
fee to borrow the securities and must additionally reimburse the lender for cash returns the lender would have
received had the securities not been loaned out.
Short selling is most commonly done with instruments
traded in public securities, futures or currency markets,
due to the liquidity and real-time price dissemination
characteristic of such markets and because the instruments dened within each class are fungible.

The act of buying back the securities that were sold short
is called covering the short or covering the position.
A short position can be covered at any time before the
securities are due to be returned. Once the position is
covered, the short seller will not be aected by any subsequent rises or falls in the price of the securities, as he
already holds the securities required to repay the lender.
Short selling refers broadly to any transaction used by
an investor to prot from the decline in price of a borrowed asset or nancial instrument. However some short
positions, for example those undertaken by means of
derivatives contracts, are not technically short sales because no underlying asset is actually delivered upon the
initiation of the position. Derivatives contracts include
futures, options, and swaps.[2][3]

In practical terms, going short can be considered the Worked examples

opposite of the conventional practice of "going long",
whereby an investor prots from an increase in the price Protable trade Shares in C & Company currently
of the asset. Mathematically, the return from a short po- trade at $10 per share.
sition is equivalent to that of owning (being long) a negative amount of the instrument. A short sale may be mo1. A short seller investor borrows 100 shares of C &
tivated by a variety of objectives. Speculators may sell
Company and immediately sells them for a total of
short in the hope of realizing a prot on an instrument
$1,000.
which appears to be overvalued, just as long investors
or speculators hope to prot from a rise in the price of
2. Subsequently, the price of the shares falls to $8 per
an instrument which appears undervalued. Traders or
share.
fund managers may hedge a long position or a portfolio
3. Short seller now buys 100 shares of C & Company
through one or more short positions.
for $800.

1.10.1

Concept

4. Short seller returns the shares to the lender, who

must accept the return of the same number of shares
as was lent despite the fact that the market value of
the shares has decreased.

The following example describes the short sale of a security. In order to prot from a decrease in the price of a se5. Short seller retains as prot the $200 dierence (micurity, a short seller can borrow the security and sell it exnus borrowing fees) between the price at which he
pecting that it will be cheaper to repurchase in the future.
sold the shares he borrowed and the lower price at
When the seller decides that the time is right (or when the
which he was able to purchase the shares he relender recalls the securities), the seller buys equivalent seturned.
curities and returns them to the lender. The process relies
on the fact that the securities (or the other assets being
sold short) are fungible; the term borrowing is there- Protable covered trade Shares in C & Company curfore used in the sense of borrowing cash, where dierent rently trade at $10 per share.
bank notes or coins can be returned to the lender (as opposed to borrowing a car, where the same car must be
1. A short seller investor owns 100 shares of C & Comreturned).
pany and sells them for a total of $1,000.
A short seller typically borrows through a broker, who
2. Subsequently, the price of the shares falls to $8 per
is usually holding the securities for another investor who
share.
owns the securities; the broker himself seldom purchases
[1]
the securities to lend to the short seller. The lender does
3. Short seller now buys 100 shares of C & Company
not lose the right to sell the securities while they have been
for $800, or alternatively, purchases 125 shares for
lent, as the broker will usually hold a large pool of such
$1,000.
securities for a number of investors which, as such securi4. Short seller retains as prot the $200 dierence beties are fungible, can instead be transferred to any buyer.
tween the price at which he sold the shares he owned
In most market conditions there is a ready supply of seand the lower price at which he was able to repurcurities to be borrowed, held by pension funds, mutual
chase the shares.
funds and other investors.

1.10. SHORT

37

Loss-making trade Shares in C & Company currently Short sellers were blamed for the Wall Street Crash of
trade at $10 per share.
1929.[8] Regulations governing short selling were implemented in the United States in 1929 and in 1940. Political fallout from the 1929 crash led Congress to en1. A short seller borrows 100 shares of C & Company
act a law banning short sellers from selling shares durand immediately sells them for a total of $1,000.
ing a downtick; this was known as the uptick rule, and
this was in eect until July 3, 2007 when it was removed
2. Subsequently the price of the shares rises to $25.
by the Securities and Exchange Commission (SEC Release No. 34-55970).[9] President Herbert Hoover con3. Short seller is required to return the shares, and is
demned short sellers and even J. Edgar Hoover said he
compelled to buy 100 shares of C & Company for
would investigate short sellers for their role in prolong$2,500.
ing the Depression. A few years later, in 1949, Alfred
Winslow Jones founded a fund (that was unregulated)
4. Short seller returns the shares to the lender who acthat bought stocks while selling other stocks short, hence
cepts the return of the same number of shares as was
hedging some of the market risk, and the hedge fund was
lent.
born.[10]
5. Short seller incurs as a loss the $1,500 dierence
between the price at which he sold the shares he borrowed and the higher price at which he had to purchase the shares he returned (plus borrowing fees).

Negative news, such as litigation against a company, may

also entice professional traders to sell the stock short in
hope of the stock price going down.

The term short was in use from at least the midnineteenth century. It is commonly understood that
short is used because the short-seller is in a decit position with his brokerage house. Jacob Little was known as
The Great Bear of Wall Street who began shorting stocks
in the United States in 1822.[7]

2008.[11] Germany placed a ban on naked short selling of

certain euro zone securities in 2010.[15] Spain and Italy introduced short selling bans in 2011 and again in 2012.[16]
Worldwide, economic regulators seem inclined to restrict
short selling to decrease potential downward price cascades. Investors continue to argue this only contributes

During the Dot-com bubble, shorting a start-up company

could backre since it could be taken over at a price higher
than the price at which speculators shorted. Short-sellers
1.10.2 History
were forced to cover their positions at acquisition prices,
while in many cases the rm often overpaid for the startSome hold that the practice was invented in 1609 by up.
Dutch merchant Isaac Le Maire, a sizeable shareholder
of the Vereenigde Oostindische Compagnie (VOC).[4]
Edward Stringham has written extensively on the de- Naked short selling restrictions
velopment of sophisticated contracts on the Amsterdam
Stock Exchange in the seventeenth century, including During the 2008 nancial crisis, critics argued that inshort sale contracts.[5] Short selling can exert downward vestors taking large short positions in struggling nancial
pressure on the underlying stock, driving down the price rms like Lehman Brothers, HBOS and Morgan Stanof shares of that security. This, combined with the seem- ley created instability in the stock market and placed adingly complex and hard-to-follow tactics of the practice, ditional downward pressure on prices. In response, a
has made short selling a historical target for criticism.[6] number of countries introduced restrictive regulations on
At various times in history, governments have restricted short-selling in 2008 and 2009. Naked short selling is
or banned short selling.
the practice of short-selling a tradable asset without rst
The London banking house of Neal, James, Fordyce and borrowing the security or ensuring that the security can
Down collapsed in June 1772, precipitating a major crisis be borrowed it was this practice that was commonly
which included the collapse of almost every private bank restricted.[11][12] Investors argued that it was in the weakin Scotland, and a liquidity crisis in the two major bank- ness of nancial institutions, not short-selling, that drove
ing centres of the world, London and Amsterdam. The stocks to fall.[13] In September 2008, the Securities Exbank had been speculating by shorting East India Com- change Commission in the United States abruptly banned
pany stock on a massive scale, and apparently using cus- short sales, primarily in nancial stocks, to protect comtomer deposits to cover losses. It was perceived as having panies under siege in the stock market. That ban expired
a magnifying eect in the violent downturn in the Dutch several weeks later as regulators determined the ban was
tulip market in the eighteenth century. In another well- not stabilizing the price of stocks.[13][12]
referenced example, George Soros became notorious for Temporary short-selling bans were also introduced in the
breaking the Bank of England" on Black Wednesday of United Kingdom, Germany, France, Italy and other Eu1992, when he sold short more than $10 billion worth of ropean countries in 2008 to minimal eect.[14] Australia
pounds sterling.
moved to ban naked short selling entirely in September

38

CHAPTER 1. INTRODUCTION

to market ineciency.[11]

borrower. The interest that is kept by the lender is the

compensation to the lender for the stock loan.

1.10.3

Brokerage rms can also borrow stocks from the accounts

of their own customers. Typical margin account agreements give brokerage rms the right to borrow customer
shares without notifying the customer. In general, brokerage accounts are only allowed to lend shares from accounts for which customers have debit balances, meaning they have borrowed from the account. SEC Rule
15c3-3 imposes such severe restrictions on the lending of
shares from cash accounts or excess margin (fully paid
for) shares from margin accounts that most brokerage
rms do not bother except in rare circumstances. (These
restrictions include that the broker must have the express
permission of the customer and provide collateral or a
letter of credit.)

Mechanism

See also: Securities lending

Short selling stock consists of the following:
The speculator instructs the broker to sell the shares
and the proceeds are credited to his brokers account
at the rm upon which the rm can earn interest.
Generally, the short seller does not earn interest on
the short proceeds and cannot use or encumber the
proceeds for another transaction.[17]
Upon completion of the sale, the investor has 3 days
(in the US) to borrow the shares. If required by law,
the investor rst ensures that cash or equity is on
deposit with his brokerage rm as collateral for the
initial short margin requirement. Some short sellers, mainly rms and hedge funds, participate in the
practice of naked short selling, where the shorted
shares are not borrowed or delivered.
The speculator may close the position by buying
back the shares (called covering). If the price has
dropped, he makes a prot. If the stock advanced,
he takes a loss.
Finally, the speculator may return the shares to the
lender or stay short indenitely.
At any time, the lender may call for the return of
his shares e.g. because he wants to sell them. The
borrower must buy shares on the market and return
them to the lender (or he must borrow the shares
from elsewhere). When the broker completes this
transaction automatically, it is called a 'buy-in'.

Most brokers will allow retail customers to borrow shares

to short a stock only if one of their own customers has
purchased the stock on margin. Brokers will go through
the locate process outside their own rm to obtain borrowed shares from other brokers only for their large institutional customers.
Stock exchanges such as the NYSE or the NASDAQ typically report the short interest of a stock, which gives
the number of shares that have been legally sold short
as a percent of the total oat. Alternatively, these can
also be expressed as the short interest ratio, which is the
number of shares legally sold short as a multiple of the
average daily volume. These can be useful tools to spot
trends in stock price movements but in order to be reliable, investors must also ascertain the number of shares
brought into existence by naked shorters. Speculators are
cautioned to remember that for every share that has been
shorted (owned by a new owner), a 'shadow owner' exists
(i.e. the original owner) who also is part of the universe
of owners of that stock, i.e. Despite not having any voting rights, he has not relinquished his interest and some
rights in that stock.

Shorting stock in the U.S.

Securities lending
In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to conrm that it is able to make
delivery of the shorted securities. This is referred to as a
locate. Brokers have a variety of means to borrow stocks
in order to facilitate locates and make good delivery of
the shorted security.
The vast majority of stocks borrowed by U.S. brokers
come from loans made by the leading custody banks and
fund management companies (see list below). Institutions often lend out their shares in order to earn a little extra money on their investments. These institutional loans
are usually arranged by the custodian who holds the securities for the institution. In an institutional stock loan, the
borrower puts up cash collateral, typically 102% of the
value of the stock. The cash collateral is then invested by
the lender, who often rebates part of the interest to the

Main article: Securities lending

When a security is sold, the seller is contractually obligated to deliver it to the buyer. If a seller sells a security
short without owning it rst, the seller needs to borrow the
security from a third party to fulll its obligation. Otherwise, the seller will fail to deliver, the transaction will
not settle, and the seller may be subject to a claim from
its counterparty. Certain large holders of securities, such
as a custodian or investment management rm, often lend
out these securities to gain extra income, a process known
as securities lending. The lender receives a fee for this
service. Similarly, retail investors can sometimes make
an extra fee when their broker wants to borrow their securities. This is only possible when the investor has full

1.10. SHORT

39

title of the security, so it cannot be used as collateral for ized 55%, indicating that a short seller would need to pay
margin buying.
the borrower more than half the price of the stock over
the course of the year, essentially as interest for borrowing a stock in limited supply.[21] This has important imSources of short interest data
plications for derivatives pricing and strategy, as the borrow cost itself can become a signicant convenience yield
Time delayed short interest data (for legally shorted for holding the stock (similar to additional dividend) - for
shares) is available in a number of countries, including instance, put-call parity relationships are broken and the
the US, the UK, Hong Kong, and Spain. The amount of early exercise feature of American call options on nonstocks being shorted on a global basis has increased in re- dividend paying stocks can become rational to exercise
cent years for various structural reasons (e.g. the growth early, which otherwise would not be economical.[22]
of 130/30 type strategies, short or bear ETFs). The data is
typically delayed; for example, the NASDAQ requires its
broker-dealer member rms to report data on the 15th of Major lenders
each month, and then publishes a compilation eight days
State Street Corporation (Boston, United States)
later.[18]
Some market data providers (like Data Explorers and
SunGard Financial Systems[19] ) believe that stock lending data provides a good proxy for short interest levels
(excluding any naked short interest). SunGard provides
daily data on short interest by tracking the proxy variables
based on borrowing and lending data which it collects.[20]
Short selling terms

Merrill Lynch (New Jersey, United States)

JP Morgan Chase (New York, United States)
Northern Trust (Chicago, United States)
Fortis (Amsterdam, Netherlands, now defunct)
ABN AMRO (Amsterdam, Netherlands, formerly
Fortis)

Citibank (New York, United States)

Days to Cover (DTC) is a numerical term that describes
the relationship between the amount of shares in a given
Bank of New York Mellon Corporation (New York,
equity that have been legally short sold and the number of
United States)
days of typical trading that it would require to 'cover' all
UBS AG (Zurich, Switzerland)
legal short positions outstanding. For example, if there
are ten million shares of XYZ Inc. that are currently
Barclays (London, United Kingdom)
legally short sold and the average daily volume of XYZ
shares traded each day is one million, it would require ten
days of trading for all legal short positions to be covered Naked short selling
(10 million / 1 million).
Short Interest is a numerical term that relates the num- Main article: Naked short selling
ber of shares in a given equity that have been legally
shorted divided by the total shares outstanding for the
company, usually expressed as a percent. For example, if
there are ten million shares of XYZ Inc. that are currently
legally short sold, and the total number of shares issued by
the company is one hundred million, the Short Interest is
10% (10 million / 100 million). If however, shares are being created through naked short selling, fails data must
be accessed to assess accurately the true level of short interest.
Borrow cost is the fee paid to a securities lender for borrowing the stock or other security. The cost of borrowing
the stock is usually negligible compared to fees paid and
interest accrued on the margin account - in 2002, 91% of
stocks could be shorted for less than a 1% fee per annum,
generally lower than interest rates earned on the margin
account. However, certain stocks become hard to borrow as stockholders willing to lend their stock become
more dicult to locate. The cost of borrowing these
stocks can become signicant - in February 2001, the cost
to borrow (short) Krispy Kreme stock reached an annual-

A naked short sale occurs when a security is sold short

without borrowing the security within a set time (for example, three days in the US.) This means that the buyer of
such a short is buying the short-sellers promise to deliver
a share, rather than buying the share itself. The shortsellers promise is known as a hypothecated share.
When the holder of the underlying stock receives a dividend, the holder of the hypothecated share would receive
an equal dividend from the short seller.
Naked shorting has been made illegal except where allowed under limited circumstances by market makers. It
is detected by the Depository Trust & Clearing Corporation (in the US) as a failure to deliver or simply fail.
While many fails are settled in a short time, some have
been allowed to linger in the system.
In the US, arranging to borrow a security before a short
sale is called a locate. In 2005, to prevent widespread
failure to deliver securities, the U.S. Securities and Exchange Commission (SEC) put in place Regulation SHO,

40

CHAPTER 1. INTRODUCTION

intended to prevent speculators from selling some stocks As noted earlier, victims of Naked Shorting sometimes
short before doing a locate. Requirements that are more report that the number of votes cast is greater than the
stringent were put in place in September 2008, ostensi- number of shares issued by the company.[24]
bly to prevent the practice from exacerbating market declines. The rules were made permanent in 2009.

1.10.6 Markets

1.10.4

Fees

When a broker facilitates the delivery of a clients short

sale, the client is charged a fee for this service, usually a
standard commission similar to that of purchasing a similar security.

Futures and options contracts

When trading futures contracts, being 'short' means having the legal obligation to deliver something at the expiration of the contract, although the holder of the short
position may alternately buy back the contract prior to expiration instead of making delivery. Short futures transactions are often used by producers of a commodity to
x the future price of goods they have not yet produced.
Shorting a futures contract is sometimes also used by
those holding the underlying asset (i.e. those with a long
position) as a temporary hedge against price declines.
Shorting futures may also be used for speculative trades,
in which case the investor is looking to prot from any
decline in the price of the futures contract prior to expiration.

If the short position begins to move against the holder of

the short position (i.e., the price of the security begins to
rise), money will be removed from the holders cash balance and moved to his or her margin balance. If short
shares continue to rise in price, and the holder does not
have sucient funds in the cash account to cover the position, the holder will begin to borrow on margin for this
purpose, thereby accruing margin interest charges. These
are computed and charged just as for any other margin
debit. Therefore, only margin accounts can be used to
An investor can also purchase a put option, giving that
open a short position.
investor the right (but not the obligation) to sell the unWhen a securitys ex-dividend date passes, the dividend
derlying asset (such as shares of stock) at a xed price. In
is deducted from the shortholders account and paid to the
the event of a market decline, the option holder may experson from whom the stock is borrowed.
ercise these put options, obliging the counterparty to buy
For some brokers, the short seller may not earn interest on the underlying asset at the agreed upon (or strike) price,
the proceeds of the short sale or use it to reduce outstand- which would then be higher than the current quoted spot
ing margin debt. These brokers may not pass this benet price of the asset.
on to the retail client unless the client is very large. The
interest is often split with the lender of the security.
Currency

Selling short on the currency markets is dierent from

selling short on the stock markets. Currencies are traded
Where shares have been shorted and the company which in pairs, each currency being priced in terms of another.
issues the shares distributes a dividend, the question arises In this way, selling short on the currency markets is idenas to who receives the dividend. The new buyer of the tical to going long on stocks.
shares, who is the holder of record and holds the shares Novice traders or stock traders can be confused by the
outright, will receive the dividend from the company. failure to recognize and understand this point: a contract
However, the lender, who may hold its shares in a margin is always long in terms of one medium and short another.
account with a prime broker and is unlikely to be aware
that these particular shares are being lent out for short- When the exchange rate has changed, the trader buys the
ing, also expects to receive a dividend. The short seller rst currency again; this time he gets more of it, and pays
will therefore pay to the lender an amount equal to the back the loan. Since he got more money than he had bordividend in order to compensate, though as this payment rowed initially, he makes money. Of course, the reverse
does not come from the company it is not technically a can also occur.
dividend as such. The short seller is therefore said to be An example of this is as follows: Let us say a trader wants
short the dividend.
to trade with the US dollar and the Indian rupee currenA similar issue comes up with the voting rights attached to cies. Assume that the current market rate is USD 1 to
the shorted shares. Unlike a dividend, voting rights can- Rs.50 and the trader borrows Rs.100. With this, he buys
not legally be synthesized and so the buyer of the shorted USD 2. If the next day, the conversion rate becomes
share, as the holder of record, controls the voting rights. USD 1 to Rs.51, then the trader sells his USD 2 and gets
The owner of a margin account from which the shares Rs.102. He returns Rs.100 and keeps the Rs.2 prot (miwere lent will have agreed in advance to relinquish vot- nus fees).

1.10.5

Dividends and voting rights

ing rights to shares during the period of any short sale.[23]

One may also take a short position in a currency using

1.10. SHORT

41

futures or options; the preceding method is used to bet on to avoid margin calls.
the spot price, which is more directly analogous to selling Another risk is that a given stock may become hard to
a stock short.
borrow. As dened by the SEC and based on lack of
availability, a broker may charge a hard to borrow fee
daily, without notice, for any day that the SEC declares
1.10.7 Risks
a share is hard to borrow. Additionally, a broker may be
required to cover a short sellers position at any time (buy
Note: this section does not apply to currency markets. in). The short seller receives a warning from the broker
is failing to deliver stock, which will lead to the
Short selling is sometimes referred to as a negative in- that he [25]
buy-in.
come investment strategy because there is no potential
for dividend income or interest income. Stock is held
only long enough to be sold pursuant to the contract,
and ones return is therefore limited to short term capital
gains, which are taxed as ordinary income. For this reason, buying shares (called going long) has a very dierent risk prole from selling short. Furthermore, a longs
losses are limited because the price can only go down to
zero, but gains are not, as there is no limit, in theory, on
how high the price can go. On the other hand, the short
sellers possible gains are limited to the original price of
the stock, which can only go down to zero, whereas the
loss potential, again in theory, has no limit. For this reason, short selling probably is most often used as a hedge
strategy to manage the risks of long investments.

Because short sellers must deliver the shorted securities

to their broker eventually, and will need money to buy
them, there is a credit risk for the broker. The penalties
for failure to deliver on a short selling contract inspired
nancier Daniel Drew to warn: He who sells what isn't
hisn, Must buy it back or go to prisn. To manage its
own risk, the broker requires the short seller to keep a
margin account, and charges interest of between 2% and
8% depending on the amounts involved.[26]
In 2011, the eruption of the massive China stock frauds
on North American equity markets brought a related risk
to light for the short seller. The eorts of researchoriented short sellers to expose these frauds eventually
prompted NASDAQ, NYSE and other exchanges to impose sudden, lengthy trading halts that froze the values
of shorted stocks at articially high values. Reportedly in
some instances, brokers charged short sellers excessively
large amounts of interest based on these high values as the
shorts were forced to continue their borrowings at least
until the halts were lifted.[27]

Many short sellers place a "stop order" with their stockbroker after selling a stock short. This is an order to the
brokerage to cover the position if the price of the stock
should rise to a certain level, in order to limit the loss and
avoid the problem of unlimited liability described above.
In some cases, if the stocks price skyrockets, the stockbroker may decide to cover the short sellers position imShort sellers tend to temper overvaluation by selling into
mediately and without his consent, in order to guarantee
exuberance. Likewise, short sellers are said to provide
that the short seller will be able to make good on his debt
price support by buying when negative sentiment is exof shares.
acerbated after a signicant price decline. Short selling
Short sellers must be aware of the potential for a short can have negative implications if it causes a premature or
squeeze. When the price of a stock rises signicantly, unjustied share price collapse when the fear of cancelsome people who are shorting the stock will cover their lation due to bankruptcy becomes contagious.[28]
positions to limit their losses (this may occur in an automated way if the short sellers had stop-loss orders in place
with their brokers); others may be forced to close their 1.10.8 Strategies
position to meet a margin call; others may be forced to
cover, subject to the terms under which they borrowed the Hedging
stock, if the person who lent the stock wishes to sell and
take a prot. Since covering their positions involves buy- Further information: Hedge (nance)
ing shares, the short squeeze causes an ever further rise
in the stocks price, which in turn may trigger additional Hedging often represents a means of minimizing the risk
covering. Because of this, most short sellers restrict their from a more complex set of transactions. Examples of
activities to heavily traded stocks, and they keep an eye this are:
on the short interest levels of their short investments.
Short interest is dened as the total number of shares that
A farmer who has just planted his wheat wants to
have been legally sold short, but not covered. A short
lock in the price at which he can sell after the harsqueeze can be deliberately induced. This can happen
vest. He would take a short position in wheat futures.
when large investors (such as companies or wealthy indi A market maker in corporate bonds is constantly
viduals) notice signicant short positions, and buy many
trading bonds when clients want to buy or sell. This
shares, with the intent of selling the position at a prot to
can create substantial bond positions. The largest
the short sellers who will be panicked by the initial uptick
risk is that interest rates overall move. The trader
or who are forced to cover their short positions in order

42

CHAPTER 1. INTRODUCTION

can hedge this risk by selling government bonds United States

short against his long positions in corporate bonds.
In this way, the risk that remains is credit risk of the The Securities and Exchange Act of 1934 gave the
Securities and Exchange Commission the power to regcorporate bonds.
ulate short sales.[30] The rst ocial restriction on short
An options trader may short shares in order to re- selling came in 1938, when the SEC adopted a rule known
main delta neutral so that he is not exposed to risk as the uptick rule that dictated that a short sale could only
from price movements in the stocks that underlie his be made when the price of a particular stock was higher
than the previous trade price. The uptick rule aimed to
options
prevent short sales from causing or exacerbating market
price declines.[31] In January 2005, The Securities and
Exchange Commission enacted Regulation SHO to tarArbitrage
get abusive naked short selling. Regulation SHO was the
SECs rst update to short selling restrictions since the
Further information: Arbitrage
uptick rule in 1938.[32][33]
A short seller may be trying to benet from market inef- The regulation contains two key components: the lociencies arising from the mispricing of certain products. cate and the close-out. The locate component attempts
to reduce failure to deliver securities by requiring a broExamples of this are
ker possess or have arranged to possess borrowed shares.
The close out component requires that a broker be able
An arbitrageur who buys long futures contracts on a to deliver the shares that are to be shorted.[31][34] In the
US Treasury security, and sells short the underlying US, initial public oers (IPOs) cannot be sold short for
US Treasury security.
a month after they start trading. This mechanism is in
place to ensure a degree of price stability during a companys initial trading period. However, some brokerage
Against the box
rms that specialize in penny stocks (referred to colloquially as bucket shops) have used the lack of short sellOne variant of selling short involves a long position. ing during this month to pump and dump thinly traded
Selling short against the box consists of holding a long IPOs. Canada and other countries do allow selling IPOs
position on which the shares have already risen, where- (including U.S. IPOs) short.[35]
upon one then enters a short sell order for an equal amount
of shares. The term box alludes to the days when a safe The Securities and Exchange Commission initiated a
deposit box was used to store (long) shares. The purpose temporary ban on short selling on 799 nancial stocks
of this technique is to lock in paper prots on the long from 19 September 2008 until 2 October 2008. Greater
position without having to sell that position (and possi- penalties for naked shorting, by mandating delivery of
bly incur taxes if said position has appreciated). Once stocks at clearing time, were also introduced. Some state
the short position has been entered, it serves to balance governors have been urging state pension bodies to refrain
[36]
An assessthe long position taken earlier. Thus, from that point in from lending stock for shorting purposes.
ment
of
the
eect
of
the
temporary
ban
on
short-selling
time, the prot is locked in (less brokerage fees and short
nancing costs), regardless of further uctuations in the in the United States and other countries in the wake of
underlying share price. For example, one can ensure a the nancial crisis showed that it had only little impact
prot in this way, while delaying sale until the subsequent on the movements of stocks, with stock prices moving in
the same way as they would have moved anyhow, but the
tax year.
ban reduced volume and liquidity.[14]
U.S. investors considering entering into a short against
the box transaction should be aware of the tax consequences of this transaction. Unless certain conditions are Europe, Australia and China
met, the IRS deems a short against the box position to
be a constructive sale of the long position, which is a In the UK, the Financial Services Authority had a morataxable event. These conditions include a requirement torium on short selling 29 leading nancial stocks, efthat the short position be closed out within 30 days of the fective from 2300 GMT, 19 September 2008 until 16
end of the year and that the investor must hold their long January 2009.[37] After the ban was lifted, John McFall,
position, without entering into any hedging strategies, for chairman of the Treasury Select Committee, House of
a minimum of 60 days after the short position has been Commons, made clear in public statements and a letter
closed.[29]
to the FSA that he believed it ought to be extended. Between 19 and 21 September 2008, Australia temporarily
banned short selling,[38] and later placed an indenite ban
on naked short selling.[39] Australias ban on short sell1.10.9 Regulations
ing was further extended for another 28 days on 21 Oc-

1.10. SHORT
tober 2008.[40] Also during September 2008, Germany,
Ireland, Switzerland and Canada banned short selling
leading nancial stocks,[41] and France, the Netherlands
and Belgium banned naked short selling leading nancial
stocks.[42] By contrast with the approach taken by other
countries, Chinese regulators responded by allowing short
selling, along with a package of other market reforms.[43]

1.10.10

Views of short selling

Advocates of short selling argue that the practice is an essential part of the price discovery mechanism.[44] Financial researchers at Duke University said in a study that
short interest is an indicator of poor future stock performance (the self-fullling aspect) and that short sellers exploit market mistakes about rms fundamentals.[45]

43
Manuel P. Asensio
James Chanos
Anthony Elgindy
Joseph Parnes
Margin

1.10.12 Notes
[1] Understanding Short Selling - A Primer.
set.com. Retrieved 2012-05-24.

Langas-

[2] Larry Harris (2002). Trading and Exchange: Market Microstructure for Practitioners. Oxford University Press.
p. 41. ISBN 0195144708.

Such noted investors as Seth Klarman and Warren Buffett have said that short sellers help the market. Klarman
argued that short sellers are a useful counterweight to the
widespread bullishness on Wall Street,[46] while Buett
believes that short sellers are useful in uncovering fraudulent accounting and other problems at companies.[47]

[3] Don M. Chance and Robert Brooks. An Introduction to

Derivatives and Risk Management. South-Western College. p. 6. ISBN 0324601204.

Shortseller James Chanos received widespread publicity

when he was an early critic of the accounting practices
of Enron.[48] Chanos responds to critics of short-selling
by pointing to the critical role they played in identifying
problems at Enron, Boston Market and other nancial
disasters over the years.[49] In 2011, research oriented
short sellers were widely acknowledged for exposing the
China stock frauds.[50]

[5] Stringham, Edward (2003). The Extralegal Development of Securities Trading in Seventeenth Century Amsterdam. Quarterly Review of Economics and Finance 43
(2): 321. Retrieved 12 January 2015.

[4] NRC Handelsblad - Naked short selling is an old-Dutch

trick (in Dutch only)

[6] Moritz College of Law (PDF). osu.edu.

[7] Scripophily - PSTA - Professional Scripophily Trade Association. Encyberpedia.com. Retrieved 2012-05-24.

Commentator Jim Cramer has expressed concern about [8] Short sellers have been the villain for 400 years. Reuters.
2008-09-26. Retrieved 2008-09-28.
short selling and started a petition calling for the reintroduction of the uptick rule.[51] Books like Don't Blame [9] SEC Release No. 34-55970 (PDF). Retrieved 2012-05the Shorts by Robert Sloan and Fubarnomics by Robert
24.
E. Wright suggest Cramer exaggerated the costs of short
selling and underestimated the benets, which may in- [10] Lindgren, Hugo (2007-04-09). New York Magazine The Creation of the Hedge Fund. Nymag.com. Reclude the ex ante identication of asset bubbles.
trieved 2012-05-24.

Individual short sellers have been subject to criticism and

even litigation. Manuel P. Asensio, for example, engaged [11] Lavinio, Stefano (1999). The Hedge Fund Handbook:
A Denitive Guide for Analyzing and Evaluating Alterin a lengthy legal battle with the pharmaceutical manufacnative Investments. McGraw-Hill. pp. 442443. ISBN
[52]
turer Hemispherx Biopharma.
0071350306.
Several studies of the eectiveness of short selling bans
[12] Madura, Je (2009). Financial Markets and Instituindicate that short selling bans do not contribute to more
tions. South-Western College Publishing. p. 308. ISBN
[53][54][55][56]
moderate market dynamics.
1439038848.

1.10.11

See also

Inverse exchange-traded fund

Magnetar Capital
Repurchase agreement
Socially responsible investing
Straddle

[13] Harris, Larry (7 October 2008). A Debate as a Ban on

Short-Selling Ends: Did It Make Any Dierence?". The
New York Times. Retrieved 12 September 2012. Check
date values in: |year= / |date= mismatch (help)
[14] Oakley, David (18 December 2008). Short-selling ban
has minimal eect. Financial Times. Retrieved 12
September 2012.
[15] Crawford, Alan (18 May 2010). Germany to Temporarily Ban Naked Short Selling, Some Swaps of Euro Bonds.
Bloomberg. Retrieved 13 September 2012.

44

CHAPTER 1. INTRODUCTION

[16] Tracy Rucinski and Stephen Jewkes (23 July 2012).

Spain, Italy reinstate short-selling ban. Reuters. Retrieved 12 September 2012.

[37] BBC (2008-09-18). FSA clamps down on short-selling.

BBC News. Retrieved 2010-01-04.

[17] Federal Reserve Board. Regulation T 220.12

[39] ASX ban on short selling is indenite. The Sydney

Morning Herald. 2008-10-03.

[18] NASDAQ. About the Short Interest Page.

[19] SunGards ShortSide.com discusses the product.
[20] SunGard. SunGard Launches Borrow Indices; First Proxy
for Measuring Short Interest on a Daily Basis. Business
Wire.
[21] The market for borrowing stock (PDF). Retrieved 201212-25.
[22] Lecture 13: Hard to Borrow Securities (PDF). Retrieved 2012-12-25.
[23] What happens to the voting rights on shares when the
shares are used in a short sale transaction?". Investopedia.
Retrieved 4 December 2008.
[24] Greg LandContactAll Articles (2009-05-15). Overvoting at Taser in 2005. Law.com. Retrieved 2012-0524.
[25] Arnold, Roger (2000-01-14). Knowing the Rules of the
Shorting Game. TheStreet. Retrieved 2012-05-24.
[26] margin account rates schedule. ScotTrade. 2011-06-18.
[27] Even Short-Sellers Burned by Chinese Shares. Barrons.
2011-06-18.
[28] The Theory and Practice of Short Selling, Chapter 9,
Conclusions and Implications for Investors by Frank J.
Fabozzi, Editor. Books.google.com. Retrieved 2012-0524.
[29] United States IRS Publication 550 Investment Income
and Expenses. Irs.gov. Retrieved 2012-05-24.
[30] Securities Exchange Act of 1934 (PDF). Securities and
Exchange Commission. 1934.
[31] Lavinio, Stefano (1999). The Hedge Fund Handbook:
A Denitive Guide for Analyzing and Evaluating Alternative Investments. McGraw-Hill. pp. 8595. ISBN
0071350306.
[32] S.K. Singh (2009). Bank Regulations. Discovery Publishing House. pp. 122123. ISBN 818356447X.
[33] U.S. SEC (April 11, 2005). Division of Market Regulation: Key Points about Regulation SHO.
[34] Young, Matthew G. (2010). The Complete Guide to
Selling Stocks Short: Everything You Need to Know Explained Simply. Atlantic Publishing Group Inc. pp.
178179. ISBN 1601383266.
[35] Mahipal Singh (2011). Security Analysis with Investment and Portfolio Management. Gyan Books. p. 233.
ISBN 8182055199.
[36] Tsang, Michael (19 September 2008). Short Sellers under Fire in U.S., U.K. After AIG Fall. bloomberg.com.

[38] The Australian. 2008-10-02.

[40] Australian Securities and Investments Commission 08-210 ASIC extends ban on covered short selling.
Asic.gov.au. Retrieved 2012-05-24.
[41] McDonald, Sarah (22 September 2008). Australian short
selling ban goes further than other bourses. National
Business Review. Retrieved 9 November 2011.
[42] Ram, Vidya (2008-09-22). Europe Spooked By Revenge
Of The Commodities. Forbes.
[43] Shen, Samuel (2008-10-05). UPDATE 2-China to
launch stocks margin trade, short sales. Reuters.
[44] Short Sale Constraints And Stock Returns by C.M
Jones and O.A. Lamont. Papers.ssrn.com. 2001-09-20.
doi:10.2139/ssrn.281514. Retrieved 2012-05-24.
[45] Do Short Sellers Convey Information About Changes in
Fundamentals or Risk?" (PDF). Retrieved 2012-05-24.
[46] Margin of safety (1991), by Seth Klarman. ISBN 088730-510-5
[47] Casterline, Rick (2006-06-01). 2006 Berkshire Hathaway Annual Meeting Q&A with Warren Buett.
Fool.com. Retrieved 2012-05-24.
[48] Peterson, Jim (2002-07-06). Balance Sheet : The silly
season isn't over yet. The New York Times. Retrieved
2009-08-09.
[49] Contrarian Investor Sees Economic Crash in China
[50] Alpert, Bill (2011-06-18). B. Alpert Even Short Sellers
Burned by Chinese Shares (Barrons 20110618)". Online.barrons.com. Retrieved 2012-05-24.
[51] TheStreet. TheStreet. Retrieved 2012-05-24.
[52] Nelson, Brett (2001-11-26). Short Story. Forbes. Retrieved 2009-08-09.
[53] Marsh I and Niemer N (2008) The impact of short
sales restrictions. Technical report, commissioned and
funded by the International Securities Lending Association (ISLA) the Alternative Investment Management Association (AIMA) and London Investment Banking Association (LIBA).
[54] Lobanova O, Hamid S. S. and Prakash A. J. (2010) The
impact of short-sale restrictions on volatility, liquidity, and
market eciency: the evidence from the short-sale ban in
the u.s. Technical report, Florida International University
- Department of Finance.
[55] Beber A. and Pagano M. (2009) Short-selling bans
around the world: Evidence from the 2007-09 crisis.
CSEF Working Papers 241, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
[56] Kerbl S (2010) Regulatory Medicine Against Financial Market Instability: What Helps And What Hurts?"
arXiv.org.

1.11. LONG

1.10.13

References

Sloan, Robert. Don't Blame the Shorts: Why

Short Sellers Are Always Blamed for Market Crashes
and Why History Is Repeating Itself, (New York:
McGraw-Hill Professional, 2009). ISBN 978-0-07163686-5
Wright, Robert E. Fubarnomics: A Lighthearted,
Serious Look at Americas Economic Ills, (Bualo,
N.Y.: Prometheus, 2010). ISBN 978-1-61614-1912
Fleckner, Andreas M. 'Regulating Trading Practices' in The Oxford Handbook of Financial Regulation (Oxford: Oxford University Press, 2015). ISBN
978-0-19-968720-6

1.10.14

External links

Porsche VW Shortselling Scandal

Short-Selling Bans Dampen 130/30 Strategies
Worldwide, Global Investment Technology, Sept.
29, 2008
Short Selling Introduction
Short Interest: What it tells us
SEC Discussion of Naked Short Selling
What is Short Selling

1.11 Long
In nance, a long position in a security, such as a stock
or a bond, or equivalently to be long in a security, means
the holder of the position owns the security and will prot
if the price of the security goes up. Going long[1] is the
more conventional practice of investing and is contrasted
with going short. An options investor goes long on the
underlying instrument by buying call options or writing
put options on it.
In contrast, a short position in a futures contract or similar derivative means that the holder of the position will
prot if the price of the futures contract or derivative goes
down.

1.11.1

See also

Short (nance)
Position (nance)

1.11.2

Notes

[1] Bloomberg: Bond buyers getting burned by going long

September 2010

45

1.11.3 References
Harrington, Shannon D. and Tim Catts, Sep 13,
2010, Bond Buyers Getting Burned by Going Long
as Yields Climb: Credit Markets, Bloomberg News

Chapter 2

Interest and Yield

2.1 Risk-free rate
Risk-free interest rate is the theoretical rate of return
of an investment with no risk of nancial loss. One interpretation is that the risk-free rate represents the interest
that an investor would expect from an absolutely risk-free
investment over a given period of time.[1]

the expected risk-free rate is an institutional convention

this is analogous to the argument that Tobin makes on
page 17 of his book Money, Credit and Capital. In a system with endogenous money creation and where production decisions and outcomes are decentralized and potentially intractable to forecasting, this analysis provides support to the concept that the risk-free rate may not be directly observable.

Since the risk free rate can be obtained with no risk, any
However, it is commonly observed that for people applyother investment will have additional risk.
ing this interpretation, the value of supplying currency
In practice to work out the risk-free interest rate in a par- is normally perceived as being positive. It is not clear
ticular situation, a risk-free bond is usually chosen that what is the true basis for this perception, but it may be reis issued by a government or agency where the risks of lated to the practical necessity of some form of (credit?)
default are so low as to be negligible.
currency to support the specialization of labour, the perceived benets of which were detailed by Adam Smith in
The Wealth of Nations. However, Smith did not provide
2.1.1 Risk components
an 'upper limit' to the desirable level of the specialization of labour and did not fully address issues of how this
Risks that may be included are default risk, currency risk,
should be organised at the national or international level.
and ination risk.
An alternative (less well developed) interpretation is that
the risk-free rate represents the time preference of a rep2.1.2 Theoretical measurement
resentative worker for a representative basket of consumption. Again, there are reasons to believe that in this
As stated by Malcolm Kemp in Chapter ve of his book situation the risk-free rate may not be directly observable.
Market Consistency: Model Calibration in Imperfect Markets, the risk-free rate means dierent things to dierent A third (also less well developed) interpretation is that inpeople and there is no consensus on how to go about a stead of maintaining pace with purchasing power, a representative investor may require a risk free investment to
direct measurement of it.
keep pace with wages.
One interpretation of the theoretical risk-free rate is
aligned to Fishers concept of inationary expectations, Given the theoretical 'fog' around this issue, in practice
described in his treatise The Theory of Interest (1930), most industry practitioners rely on some form of proxy
which is based on the theoretical costs and benets of for the risk-free rate, or use other forms of benchmark
holding currency. In Fishers model, these are described rate which are presupposed to[2]incorporate the risk-free
rate plus some risk of default. However, there are also
by two potentially osetting movements:
issues with this approach, which are discussed in the next
1. Expected increases in the money supply should re- section.
sult in investors preferring current consumption to
future income.
2. Expected increases in productivity should result in
investors preferring future income to current consumption.

Further discussions on the concept of a 'stochastic discount rate' are available in The Econometrics of Financial
Markets by Campbell, Lo and MacKinley.

The correct interpretation is that the risk-free rate could

be either positive or negative and in practice the sign of
46

2.1. RISK-FREE RATE

2.1.3

Proxies for the Risk-free Rate

The return on domestically held short-dated government

bonds is normally perceived as a good proxy for the risk
free rate. In Business valuation the long-term yield on
the US Treasury coupon bonds is generally accepted as
the risk free rate of return. However, theoretically this
is only correct if there is no perceived risk of default associated with the bond. Government bonds are conventionally considered to be relatively risk-free to a domestic
holder of a government bond, because there is by denition no risk of default - the bond is a form of government obligation which is being discharged through the
payment of another form of government obligation (i.e.
the domestic currency).[3] Of course, default on government debt does happen, so if in theory this is impossible,
then this points out a deciency of the theory.

47
to provide an 'observable' risk free rate is to have some
form of international guaranteed asset which would provide a guaranteed return over an indenite time period
(possibly even into perpetuity). There are some assets in
existence which might replicate some of the hypothetical properties of this asset. For example, one potential
candidate is the 'consul' bonds which were issued by the
British government in the 18th century.

2.1.4 Application
The risk-free interest rate is highly signicant in the context of the general application of modern portfolio theory
which is based on the capital asset pricing model. There
are numerous issues with this model, the most basic of
which is the reduction of the description of utility of stock
holding to the expected mean and variance of the returns
of the portfolio. In reality, there may be other utility of
stock holding, as described by Shiller in his article 'Stock
Prices and Social Dynamics.[4]

There is also the risk of the government 'printing more

money' to meet the obligation, thus paying back in lesser
valued currency. This may be perceived as a form of tax,
rather than a form of default, a concept similar to that of
'seigniorage'. But the result to the investor is the same, The risk free rate is also a required input in nancial calloss of value according to his measurement, so focusing culations, such as the BlackScholes formula for pricing
strictly on default does not include all risk.
stock options and the Sharpe ratio. Note that some The same consideration does not necessarily apply to a nance and economic theories assume that market particforeign holder of a government bond, since a foreign ipants can borrow at the risk free rate; in practice, of
holder also requires compensation for potential foreign course, very few (if any) borrowers have access to nance
exchange movements in addition to the compensation re- at the risk free rate.
quired by a domestic holder. Since the risk free rate The risk free rate of return is the key input into the Cost
should theoretically exclude any risk, default or other- of capital calculations such as those performed using the
wise, this implies that the yields on foreign owned gov- Capital asset pricing model. The cost of capital at risk
ernment debt cannot be used as the basis for calculating then is the sum of the risk free rate of return and certain
the risk free rate.
risk premia.
Since the required return on government bonds for domestic and foreign holders cannot be distinguished in an
international market for government debt, this may mean 2.1.5 See also
that yields on government debt are not a good proxy for
the risk free rate.
Short-rate model
Another possibility used to estimate the risk free rate is
the inter-bank lending rate. Again appears to be premised
Capital asset pricing model
on the basis that these institutions benet from an implicit
guarantee, underpinned by the role of the monetary au Beta (nance)
thorities as 'the lending of last resort.' (It should be appreciated that in a system with endogenous money supply
the 'monetary authorities may be private agents as well
as the Central Bank - refer to Graziani 'The Theory of 2.1.6 References
Monetary Production'.) Again, the same observation applies to banks as a proxy for the risk free rate - if there [1] Risk-Free Rate of Return. Investopedia. Retrieved 7
September 2010.
is any perceived risk of default implicit in the interbank
lending rate, it is not appropriate to this rate as a proxy
[2] Malcolm Kemp, Market Consistency: Model Calibration
for the risk free rate.
Similar conclusions can be drawn from other potential
benchmark rates, including short rated AAA rated corporate bonds of institutions deemed 'too big to fail.'
One solution that has been proposed for solving the issue of not having a good 'proxy' for the risk free asset,

in Imperfect Markets, chapter 5

[3] Tobin, Money, Credit and Capital, page 16
[4] Stock Prices and Social Dynamics, Brooking Papers on
Economic Activity (1984), pages 457-511

48

CHAPTER 2. INTEREST AND YIELD

2.2 Basis point

It is common practice in the nancial industry to use basis

points to denote a rate change in a nancial instrument,
A basis point (often denoted as bp, often pronounced as or the dierence (spread) between two interest rates, inbip or beep[1] ) is a unit equal to one hundredth of a cluding the yields of xed-income securities.
percentage point.[2][3]
Since certain loans and bonds may commonly be quoted
in relation to some index or underlying security, they will
often be quoted as a spread over (or under) the index.
2.2.1 Permyriad
For example, a loan that bears interest of 0.50% per annum above the London Interbank Oered Rate (LIBOR)
A related concept is one part per ten thousand, 1/10,000. is said to be 50 basis points over LIBOR, which is comThe same unit is also (rarely) called a permyriad, lit- monly expressed as L+50bps or simply L+50.
erally meaning 'for (every) myriad (ten thousand)'. If
used interchangeably, the permyriad is potentially con- The term basis point has its origins in trading the basis
fusing because an increase of one basis point to a 10 basis or the spread between two interest rates. Since the basis
point value is generally understood to mean an increase is usually small, these are quoted multiplied up by 10000,
to 11 basis points; not an increase of one part in ten thou- and hence a full point movement in the basis is a basis
sand, meaning an increase to 10.001 basis points. This is point. Contrast with pips in FX forward markets.
akin to the dierence between percentage and percentage
point. A permyriad is written with U+2031 per ten
thousand sign (HTML &#8241;)[4] which looks like a 2.2.3 See also
percent sign (%) with three zeroes to the right of the slash.
Percentage point
(It can be regarded as a stylized form of the four zeros in
the denominator of 1/10,000, although it originates as
Percent (%) 1 part in 100
a natural extension of the percent (%) and permille ()
signs).
Permille () 1 part in 1000

2.2.2

Basis point

A basis point (bp) is dened as:

Parts-per notation
Percentage in point
Tick size

1 basis point = 1 permyriad = one onehundredth percent

1 bp = 1 = 0.01% = 0.1 = 104 = 1 10000
= 0.0001
1% = 100 bp = 100
Basis points are used as a convenient unit of measurement
in contexts where percentage dierences of less than 1%
are discussed. The most common example is interest
rates, where dierences in interest rates of less than 1%
per year are usually meaningful to talk about. For example, a dierence of 0.10 percentage points is equivalent to
a change of 10 basis points (e.g., a 4.67% rate increases
by 10 basis points to 4.77%). In other words, an increase
of 100 basis points means a rise by 1%.
Like percentage points, basis points avoid the ambiguity
between relative and absolute discussions about interest
rates by dealing only with the absolute change in numeric
value of a rate. For example, if a report says there has
been a 1% increase from a 10% interest rate, this could
refer to an increase either from 10% to 10.1% (relative,
1% of 10%), or from 10% to 11% (absolute, 1% plus
10%). If, however, the report says there has been a 100
basis point increase from a 10% interest rate, then it is
obvious that the interest rate of 10% has increased by
1.00% (the absolute change) to an 11% rate.

2.2.4 References
[1] Beep in Investopedia.
[2] What is a basis point (BPS)?". Investopedia. Retrieved
21 May 2010.
[3] Basis point. reference.com. Retrieved 4 Jul 2010.
[4] General Punctuation (PDF). The Unicode Consortium.
Retrieved 17 Sep 2011.

2.3 LIBOR
For libor scandal and manipulation, see Libor scandal.
For the personal name, see Libor (name).
The London Interbank Oered Rate is the average interest rate estimated by leading banks in London
that the average leading bank would be charged if borrowing from other banks.[1] It is usually abbreviated to
Libor (/labr/) or LIBOR, or more ocially to ICE
LIBOR (for Intercontinental Exchange Libor). It was
formerly known as BBA Libor (for British Bankers
Association Libor or the trademark bbalibor) before
the responsibility for the administration was transferred

2.3. LIBOR

49

2.3.1 Introduction
In 1984, it became apparent that an increasing number of
banks were trading actively in a variety of relatively new
market instruments, notably interest rate swaps, foreign
currency options and forward rate agreements. While
recognizing that such instruments brought more business and greater depth to the London Interbank market,
bankers worried that future growth could be inhibited
unless a measure of uniformity was introduced. In October 1984, the British Bankers Association (BBA)
working with other parties, such as the Bank of Englandestablished various working parties, which eventually culminated in the production of the BBA standard
The Libor gets its name from the London Interbank Oered Rate, for interest rate swaps, or BBAIRS terms. Part of this
from the City of London, one of the largest nancial centres in standard included the xing of BBA interest-settlement
the world.
rates, the predecessor of BBA Libor. From 2 September 1985, the BBAIRS terms became standard market
practice. BBA Libor xings did not commence ocially
to Intercontinental Exchange. It is the primary bench- before 1 January 1986. Before that date, however, some
mark, along with the Euribor, for short-term interest rates rates were xed for a trial period commencing in December 1984.
around the world.[2][3]
Libor rates are calculated for 5 currencies and 7 borrowing periods ranging from overnight to one year and
are published each business day by Thomson Reuters.[4]
Many nancial institutions, mortgage lenders and credit
card agencies set their own rates relative to it. At least
$350 trillion in derivatives and other nancial products
are tied to the Libor.[5]

Member banks are international in scope, with more than

sixty nations represented among its 223 members and
37 associated professional rms as of 2008. Eighteen
banks for example currently contribute to the xing of
US Dollar Libor. The panel contains the following member banks:[18]

In June 2012, multiple criminal settlements by Barclays

Bank revealed signicant fraud and collusion by member
banks connected to the rate submissions, leading to the
Libor scandal.[6][7][8] The British Bankers Association
said on 25 September 2012 that it would transfer
oversight of LIBOR to UK regulators, as proposed by
Financial Services Authority managing director Martin
Wheatley's independent review recommendations.[9]
Wheatleys review recommended that banks submitting
rates to LIBOR must base them on actual inter-bank
deposit market transactions and keep records of those
transactions, that individual banks LIBOR submissions
be published after three months, and recommended
criminal sanctions specically for manipulation of
benchmark interest rates.[10] Financial institution
customers may experience higher and more volatile
borrowing and hedging costs after implementation of the
recommended reforms.[11] The UK government agreed
to accept all of the Wheatley Reviews recommendations
and press for legislation implementing them.[12]

2.3.2 Scope

Signicant reforms, in line with the Wheatley Review,

came into eect in 2013 and a new administrator will
take over in early 2014.[13][14] The UK controls Libor
through laws made in the UK Parliament.[15][16] In particular, the Financial Services Act 2012 brings Libor under
UK regulatory oversight and creates a criminal oence
for knowingly or deliberately making false or misleading
statements relating to benchmark-setting.[13][17]

The Libor is widely used as a reference rate for many

nancial instruments in both nancial markets and commercial elds. There are three major classications of
interest rate xings instruments, including standard interbank products, commercial eld products, and hybrid
products which often use the Libor as their reference
rate.[19]
Standard interbank products:
Forward rate agreements
Interest rate futures, e.g. Eurodollar futures
Interest rate swaps
Swaptions
Overnight indexed swaps, e.g. LIBOROIS spread
Interest rate options, Interest rate cap and oor
In the United States in 2008, around 60 percent of prime
adjustable-rate mortgages and nearly all subprime mortgages were indexed to the US dollar Libor.[20][21] In 2012,
around 45 percent of prime adjustable rate mortgages and
more than 80 percent of subprime mortgages were indexed to the Libor.[20][22] American municipalities also

50

CHAPTER 2. INTEREST AND YIELD

borrowed around 75 percent of their money through nancial products that were linked to the Libor.[23][24] In
the UK, the three-month British pound Libor is used
for some mortgagesespecially for those with adverse
credit history. The Swiss franc Libor is also used by the
Swiss National Bank as their reference rate for monetary
policy.[25]

index that measures the cost of funds to large global banks

operating in London nancial markets or with Londonbased counterparties. Each day, the BBA surveys a panel
of banks (18 major global banks for the USD Libor), asking the question, At what rate could you borrow funds,
were you to do so by asking for and then accepting interbank oers in a reasonable market size just prior to 11
The usual reference rate for euro denominated interest am?" The BBA throws out the highest 4 and lowest 4 responses, and averages the remaining middle 10, yielding
rate products, however, is the Euribor compiled by the
trimmed mean. The average is reported at 11:30
European Banking Federation from a larger bank panel. a 23%
a.m.[27]
A euro Libor does exist, but mainly, for continuity purposes in swap contracts dating back to pre-EMU times. LIBOR is actually a set of indexes. There are separate
The Libor is an estimate and is not intended in the bind- LIBOR rates reported for 7 dierent maturities (length of
ing contracts of a company. It is, however, specically time to repay a debt) for each of 5 currencies.[4][28] The
mentioned as a reference rate in the market standard shortest maturity is overnight, the longest is one year. In
International Swaps and Derivatives Association docu- the United States, many private contracts reference the
mentation, which are used by parties wishing to transact three-month dollar LIBOR, which is the index resulting
in over-the-counter interest rate derivatives.
from asking the panel what rate they would pay to borrow
dollars for three months.[29]

2.3.3

Denition

Libor is dened as:

The rate at which an individual Contributor Panel bank
could borrow funds, were it to do so by asking for and
then accepting inter-bank oers in reasonable market size,
just prior to 11.00 London time.
This denition is amplied as follows:

Currency
In 1986, the Libor initially xed rates for three currencies. These were the U.S. dollar, British pound sterling
and Japanese yen. In the years following its introduction
there were sixteen currencies. After a number of these
currencies in 2000 merged into the euro there remained
ten currencies.[30] Following reforms of 2013 Libor rates
are calculated for 5 currencies.[4][13][28][31]

The rate which each bank submits must be formed

from that banks perception of its cost of funds in
Maturities
the interbank market.

Contributions must represent rates formed in Lon- Until 1998, the shortest duration rate was one month, afdon and not elsewhere.
ter which the rate for one week was added. In 2001,
[30][32]
Fol Contributions must be for the currency concerned, rates for a day and two weeks were introduced
lowing
reforms
of
2013
Libor
rates
are
calculated
for
7
not the cost of producing one currency by borrow[4][13][28][31]
maturities.
ing in another currency and accessing the required
currency via the foreign exchange markets.
The rates must be submitted by members of sta at a 2.3.5 Fixed rates in USD
bank with primary responsibility for management of
a banks cash, rather than a banks derivative book. There are four money markets in the world having interbank oered rate xings in USD, including:
The denition of funds is: unsecured interbank
cash or cash raised through primary issuance of in Libor xed in London
terbank Certicates of Deposit.
Mibor, or MIBOR (Mumbai Interbank Oered
Rate) xed in India
The British Bankers Association publishes a basic guide
to the BBA Libor which contains a great deal of detail as
Sibor, or SIBOR (Singapore Interbank Oered
to its history and its current calculation.[26]
Rate) xed in Singapore

2.3.4

Technical features

Hibor, or HIBOR (Hong Kong Interbank Oered

Rate) xed in Hong Kong

The USD Libor in London is the most recognised and

predominant one. The USD Sibor was established in JanLibor is calculated and published by Thomson Reuters on uary 1988, and the USD Hibor was launched in Decembehalf of the British Bankers Association (BBA). It is an ber 2006. Although these xings in USD use similar
Calculation

2.3. LIBOR

51

methodology by xing at 11:00 am at their local times, Bank of America Corp., Citigroup Inc. and UBS AG.[39]
the results of the three xings are dierent.[33]
Making a case would be very dicult because determining the Libor rate does not occur on an open exchange.
According to people familiar with the situation, subpoe2.3.6 Libor-based derivatives
nas have been issued to the three banks.
Eurodollar contracts
The Chicago Mercantile Exchange's Eurodollar contracts
are based on three-month US dollar Libor rates. They are
the worlds most heavily traded short-term interest rate
futures contracts and extend up to ten years. Shorter maturities trade on the Singapore Exchange in Asian time.
Interest rate swaps
Interest rate swaps based on short Libor rates currently
trade on the interbank market for maturities up to 50
years. In the swap market a ve year Libor rate refers
to the 5-year swap rate where the oating leg of the swap
references 3 or 6 month Libor (this can be expressed
more precisely as for example 5 year rate vs 6 month
Libor). Libor + x basis points", when talking about a
bond, means that the bonds cash ows have to be discounted on the swaps zero-coupon yield curve shifted by
x basis points in order to equal the bonds actual market
price. The day count convention for Libor rates in interest rate swaps is Actual/360, except for the GBP currency
for which it is Actual/365 (xed).[34]

2.3.7

Reliability and scandal

Main article: Libor scandal

On Thursday, 29 May 2008, The Wall Street Journal (WSJ) released a controversial study suggesting that
banks might have understated borrowing costs they reported for Libor during the 2008 credit crunch.[35] Such
underreporting could have created an impression that
banks could borrow from other banks more cheaply than
they could in reality. It could also have made the banking system or specic contributing bank appear healthier
than it was during the 2008 credit crunch. For example,
the study found that rates at which one major bank (Citigroup) said it could borrow dollars for three months were
about 0.87 percentage point lower than the rate calculated
using default-insurance data.
In September 2008, a former member of the Bank of
England's Monetary Policy Committee, Willem Buiter,
described Libor as the rate at which banks don't lend
to each other, and called for its replacement.[36] The
former Governor of the Bank of England, Mervyn King
later used the same description before the Treasury Select
Committee.[37][38]

In response to the study released by the WSJ, the British

Bankers Association announced that Libor continues to
be reliable even in times of nancial crisis. According
to the British Bankers Association, other proxies for nancial health, such as the default-credit-insurance market, are not necessarily more sound than Libor at times
of nancial crisis, though they are more widely used in
Latin America, especially the Ecuadorian and Bolivian
markets.
Additionally, some other authorities contradicted the
Wall Street Journal article. In its March 2008 Quarterly Review, The Bank for International Settlements has
stated that available data do not support the hypothesis
that contributor banks manipulated their quotes to prot
from positions based on xings.[40] Further, in October
2008 the International Monetary Fund published its regular Global Financial Stability Review which also found
that Although the integrity of the U.S. dollar Liborxing process has been questioned by some market participants and the nancial press, it appears that U.S. dollar
Libor remains an accurate measure of a typical creditworthy banks marginal cost of unsecured U.S. dollar term
funding.[41]
On 27 July 2012, the Financial Times published an article by a former trader which stated that Libor manipulation had been common since at least 1991.[42] Further
reports on this have since come from the BBC[43][44] and
Reuters.[45] On 28 November 2012, the Finance Committee of the Bundestag held a hearing to learn more
about the issue.[46]
In late September 2012, Barclays was ned 290m because of its attempts to manipulate the Libor, and other
banks are under investigation of having acted similarly.
Wheatley has now called for the British Bankers Association to lose its power to determine Libor and for the
FSA to be able to impose criminal sanctions as well as
other changes in a ten-point overhaul plan.[47][48][49]
The British Bankers Association said on 25 September
that it would transfer oversight of LIBOR to UK regulators, as proposed by Financial Services Authority Managing Director Martin Wheatley and CEO-designate of the
new Financial Conduct Authority.[9]

On 28 September, Wheatleys independent review was

published, recommending that an independent organization with government and regulator representation, called
the Tender Committee, manage the process of setting LIBOR under a new external oversight process for transparency and accountability. Banks that make submissions to LIBOR would be required to base them on actual
To further bring this case to light, The Wall Street Journal inter-bank deposit market transactions and keep records
reported in March 2011 that regulators were focusing on of their transactions supporting those submissions. The

52
review also recommended that individual banks LIBOR
submissions be published, but only after three months,
to reduce the risk that they would be used as a measure of the submitting banks creditworthiness. The review left open the possibility that regulators might compel additional banks to participate in submissions if an
insucient number do voluntarily. The review recommended criminal sanctions specically for manipulation
of benchmark interest rates such as the LIBOR, saying that existing criminal regulations for manipulation of
nancial instruments were inadequate.[10] LIBOR rates
may be higher and more volatile after implementation of
these reforms, so nancial institution customers may experience higher and more volatile borrowing and hedging
costs.[11] The UK government agreed to accept all of the
Wheatley Reviews recommendations and press for legislation implementing them.[12]
Bloomberg LP CEO Dan Doctoro told the European
Parliament that Bloomberg LP could develop an alternative index called the Bloomberg Interbank Oered Rate
that would use data from transactions such as marketbased quotes for credit default swap transactions and corporate bonds.[50][51]

Criminal investigations
On 28 February 2012, it was revealed that the U.S. Department of Justice was conducting a criminal investigation into Libor abuse.[52] Among the abuses being investigated were the possibility that traders were in direct
communication with bankers before the rates were set,
thus allowing them an advantage in predicting that days
xing. Libor underpins approximately $350 trillion in
derivatives. One traders messages indicated that for each
basis point (0.01%) that Libor was moved, those involved
could net about a couple of million dollars.[53]

CHAPTER 2. INTEREST AND YIELD

cial programs that attempted to explain the importance
of the scandal.[61] On 6 July, it was announced that the
UK Serious Fraud Oce had also opened a criminal investigation into the attempted manipulation of interest
rates.[62]
On 4 October 2012, Republican U.S. Senators Chuck
Grassley and Mark Kirk announced that they were investigating Treasury Secretary Tim Geithner for complicity
with the rate manipulation scandal. They accused Geithner of knowledge of the rate-xing, and inaction which
contributed to litigation that threatens to clog our courts
with multi-billion dollar class action lawsuits alleging
that the manipulated rates harmed state, municipal and
local governments. The senators said that an Americanbased interest rate index is a better alternative which they
would take steps towards creating.[63]
Aftermath
Early estimates are that the rate manipulation scandal cost U.S. states, counties, and local governments at
least $6 billion in fraudulent interest payments, above
$4 billion that state and local governments have already
had to spend to unwind their positions exposed to rate
manipulation.[64] An increasingly smaller set of banks are
participating in setting the LIBOR, calling into question
its future as a benchmark standard, but without any viable
alternative to replace it.[65]

2.3.8 Reforms

The administration of Libor has itself become a regulated

activity overseen by the UKs Financial Conduct Authority.[31] Furthermore, knowingly or deliberately making
false or misleading statements in relation to benchmarksetting was made a criminal oence in UK law under the
[13][15][17]
On 27 June 2012, Barclays Bank was ned $200m by the Financial Services Act 2012.
Commodity Futures Trading Commission,[6] $160m by The Danish, Swedish, Canadian, Australian and New
the United States Department of Justice[7] and 59.5m Zealand Libor rates have been terminated.[13][31]
by the Financial Services Authority[8] for attempted
manipulation of the Libor and Euribor rates.[54] The From the end of July 2013, only ve currencies and seven
maturities will be quoted every day (35 rates), reduced
United States Department of Justice and Barclays ocially agreed that the manipulation of the submissions from 150 dierent Libor rates 15 maturities for each
that the rates subaected the xed rates on some occasions.[55][56] On of ten currencies, making it more likely[13][31]
mitted
are
underpinned
by
real
trades.
2 July 2012, Marcus Agius, chairman of Barclays, resigned from the position following the interest rate rig- Since the beginning of July 2013, each individual submisging scandal.[57] Bob Diamond, the chief executive of- sion that comes in from the banks is embargoed for three
cer of Barclays, resigned on 3 July 2012. Marcus Ag- months to reduce the motivation to submit a false rate to
ius will ll his post until a replacement is found.[58][59] portray a attering picture of creditworthiness.[13][66]
Jerry del Missier, Chief Operating Ocer of Barclays, A new code of conduct, introduced by a new interim overalso resigned, as a casualty of the scandal. Del Missier sight committee, builds on this by outlining the systems
subsequently admitted that he had instructed his subordi- and controls rms need to have in place around Libor.
nates to submit falsied LIBORs to the British Bankers For example, each bank must now have a named person
Association.[60]
responsible for Libor, accountable if there is any wrongBy 4 July 2012 the breadth of the scandal was evident doing. The banks must keep records so that they can be
and became the topic of analysis on news and nan- audited by the regulators if necessary.[13][67][68]

2.3. LIBOR

53

In early 2014, NYSE Euronext will take over the ad- 2.3.11 External links
ministration of Libor from the British Bankers Associa 1 year LIBOR rate at MoneyCafe.com with historition.[69] The new administrator is NYSE Euronext Rates
cal data and graph
Administration Limited,[70] a London-based, UK registered company, regulated by the UKs Financial Conduct
The Wheatley Review of LIBOR: Final Report
Authority.[13]
Financial Times: article list
On 13 November 2013, the IntercontinentalExchange
(ICE) Group announced the successful completion of its
acquisition of NYSE Euronext. As a result of this acqui2.3.12 References
sition, NYSE Euronext Rate Administration Limited was
renamed ICE Benchmark Administration Limited. The [1] Q&A: what is Libor and what did Barclays do to it?
appointment of a new administrator is a major step forCityWire 29 June 2012 at 17:05. Note in particular that
ward in the reform of LIBOR.[71]
it is an estimated borowing rate, not an estimated lending
rate.

The scandal also led to the European Commission proposal of EU-wide benchmark regulation,[72] that may affect Libor as well.

[2] Zibel, Alan (30 September 2008). Q&A: What is Libor,

and how does it aect you?". The Seattle Times.

2.3.9

[3] Barclays ned for attempts to manipulate key bank

rates. BBC News. 27 June 2012. Retrieved 27 June
2012.

See also

Interbank lending market

[4] ICE Benchmark Administration (IBA) ICE LIBOR. IntercontinentalExchange. Retrieved 2015-04-06.

Euribor

[5] Behind the Libor Scandal. The New York Times. 10 July
2012.

JIBAR
LIBID
Libor-OIS spread
SHIBOR
SONIA
Ted spread
TIBOR
SIBOR
HIBOR

2.3.10

Further reading

Carrick Mollenkamp and Mark Whitehouse, Study

Casts Doubt on Key Rate: WSJ Analysis Suggests
Banks May Have Reported Flawed Interest Data for
Libor, The Wall Street Journal, Thursday, 29 May
2008, p. 1.

[6] CFTC Orders Barclays to pay $200 Million Penalty for

Attempted Manipulation of and False Reporting concerning LIBOR and Euribor Benchmark Interest Rates.
[7] Barclays Bank PLC Admits Misconduct Related to Submissions for the London Interbank Oered Rate and the
Euro Interbank Oered Rate and Agrees to Pay $160 Million Penalty.
[8] Barclays ned 59.5 million for signicant failings in relation to LIBOR and EURIBOR.
[9] Main, Carla (26 September 2012). Libor Spurned,
Credit Score Review, Germanys Audit: Compliance.
Bloomberg. Retrieved 26 September 2012.
[10] Alexis Levine and Michael Harquail (5 October 2012)
Wheatley Review May Mean Big Changes for LIBOR
Blakes Business (Blake, Cassels & Graydon LLP)
[11] Karen Brettell (28 September 2012) Libor reform may
add volatility, increase some funding costs Reuters
[12] Ainsley Thomson (17 October 2012) UK Treasury Minister: Government Accepts Recommendations Of Wheatley Libor Review In Full Dow Jones Newswires / Fox
Business
[13] Anthony Browne, chief executive of the British Bankers
Association (11 July 2013). Libor now has a new administrator but our reforms have gone much further. City
A.M. Retrieved 20 July 2013.

Donald MacKenzie, Whats in a Number?",

London Review of Books, 25 September 2008, pp.
[14] BBA Libor Benchmark Administrators News. The
1112.
British Bankers Association. Retrieved 25 July 2013.

Matt Taibbi: Everything Is Rigged: The Biggest [15] UK Government Policy: Creating stronger and safer
Price-Fixing Scandal Ever, Rolling Stone 25 April
banks. UK Government. 17 July 2013. Retrieved 21
2013
July 2013.

54

[16] UK Parliament General Committee Debates. UK Parliament. 27 February 2013. Retrieved 22 July 2013.
[17] Financial Services Bill receives Royal Assent (Press release). UK Government. 19 December 2012. Retrieved
27 July 2013.
[18] http://www.bbalibor.com/panels/usd
[19] Wilson F. C. Chan (June 2011). An Analysis of
the Relationship between Choice of Interest Rate Reference & Interest Rate Risks of Corporate Borrowers, page 12. http://lbms03.cityu.edu.hk/theses/c_ftt/
dba-cb-b40856562f.pdf
[20] Schweitzer, Mark and Venkatu, Guhan (21 January 2009).
Adjustable-Rate Mortgages and the Libor Surprise.
Federal Reserve Bank of Cleveland. Archived from the
original on 24 January 2009.
[21] Matthews, Dylan (5 July 2012). Ezra Kleins WonkBlog:
Explainer: Why the LIBOR scandal is a bigger deal than
JPMorgan. The Washington Post.
[22] http://www.clevelandfed.org/research/trends/2012/
0712/01banfin.cfm
[23] LIBOR: Frequently Asked Questions https://fas.org/sgp/
crs/misc/R42608.pdf
[24] Popper, Nathaniel (10 July 2012). Rate Scandal Stirs
Scramble for Damages. The New York Times.
[25]

CHAPTER 2. INTEREST AND YIELD

[35] Mollenkamp, Carrick; Whitehouse, Mark (29 May 2008).

Study Casts Doubt on Key Rate. The Wall Street Journal. Archived from the original on 30 May 2008.
[36] Osborne, Alistair (11 September 2008).
MPC man calls for Libor to be replaced.
telegraph.co.uk. Retrieved 10 August 2012.

Former
London:

[37] Flanders, Stephanie (4 July 2012). Inconvenient truths

about Libor. BBC News. It is in many ways the rate at
which banks do not lend to each other, ... it is not a rate
at which anyone is actually borrowing.
[38] http://www.publications.parliament.uk/pa/cm200708/
cmselect/cmtreasy/1210/8112503.htm Q34
[39] Enrich, David; Mollenkamp, Carrick; and Eaglesham,
Jean (18 March 2011). U.S. Libor Probe Includes BofA,
Citi, UBS. Wall Street Journal.
[40] Gyntelberg, Jacob; Wooldridge, Philip (March 2008).
Interbank rate xings during the recent turmoil (PDF).
BIS Quarterly Review (Bank for International Settlements): 70. ISSN 1683-0121. Retrieved 10 July 2012.
[41] Global Financial Stability Report (PDF). World economic and nancial surveys (International Monetary
Fund): 76. October 2008. ISSN 1729-701X. Retrieved
11 July 2012.
[42] Keenan, Douglas (27 July 2012), "My thwarted attempt to
tell of Libor shenanigans". Financial Times. (An extended
version of this article is on the authors web site.)

[26] Welcome to bbalibor: The Basics. The British Bankers

Association. Archived from the original on 13 October
2010.

[43] BBC News (10 August 2012), "Libor scandal: Review

nds system 'no longer viable'".

[27] bbalibor: The Basics. The British Bankers Association.

[44] BBC News Online (10 August 2012), "Libor review:

Wheatley says system must change".

[28] Hou, David; Skeie, David (2014-03-01), LIBOR: Origins, Economics, Crisis, Scandal, and Reform (sta report)
(PDF), New York: Federal Reserve Bank of New York,
p. 4, Sta Report No. 667, retrieved 2015-04-06

[45] Reuters (7 August 2012), "Libor collusion was rife, culture went right to the top".

[29] https://fas.org/sgp/crs/misc/R42608.pdf
[30] Welcome to bbalibor: Frequently Asked Questions
(FAQs)". The British Bankers Association. Archived
from the original on 12 November 2010.
[31] LIBOR becomes a regulated activity (Press release).
The British Bankers Association. 2 April 2013. Retrieved 25 July 2013.
[32] Welcome to bbalibor: BBA Repo Rates. The British
Bankers Association. Archived from the original on 3
September 2010.
[33] Wong Michael C S and Wilson F C Chan (2010), Disparity of USD Interbank Interest Rates in Hong Kong and
Singapore: Is There Any Arbitrage Opportunity?", a book
chapter in Handbook of Trading: Strategies for Navigating and Proting from Currency, Bond, and Stock (edited
by Greg N. Gregoriou), McGraw-Hill.
[34] http://www.bbalibor.com/technical-aspects/
calculating-interest

[46] Britischer Finanzexperte berichtet von langjhrigen

Zinssatz-Manipulationen - in German. More information, in English, is on the traders web site.
[47] Treanor, Jill (28 September 2012). Libor: government
urged to implement reforms. The Guardian (London).
[48] Libor interest rate riggers 'should face prosecution'".
BBC News. 28 September 2012.
[49] UPDATE 4-UK seeks to mend broken Libor, not end
it. Reuters. 28 September 2012.
[50] Michelle Price Libor tender puts focus on data
providers, Financial News, 28 September 2012
[51] Ben Moshinsky and Lindsay Fortado U.K. Lawmakers Seek Speedy Overhaul of Libor Following Review,
Bloomberg News, 28 September 2012
[52] U.S. conducting criminal Libor probe. Reuters. 28
February 2012.
[53] Libor: Eagle fried. The Economist. 30 June 2012.

2.4. CONTINUOUS COMPOUNDING

[54] Pollock, Ian (28 June 2012). Libor scandal: Who might
have lost?". BBC News (BBC). Retrieved 28 June 2012.
[55] Statement of Facts (PDF). United States Department of
Justice. 26 June 2012. Retrieved 11 July 2012.

55

2.4 Continuous Compounding

Dollars

Compounding Frequency
7000

Continuously
Monthly

[56] Taibbi, Matt, Why is Nobody Freaking Out About the LIBOR Banking Scandal?, Rolling Stone, 3 July 2012
[57] Reuters (2 July 2012). Barclays chairman resigns over
interest rate rigging scandal. NDTV prot. Retrieved 2
July 2012.

Quarterly

6000

Yearly

5000

4000

3000

2000

[58] Barclays boss Bob Diamond resigns amid Libor scandal

1000

[59] Bob Diamond. 4 July 2012.

1

[60] Scott, Mark (16 July 2012). Former Senior Barclays

Executive Faces Scrutiny in Parliament. The New York
Times.

10

Years

The eect of earning 20% annual interest on an initial $1,000

investment at various compounding frequencies

[61] Capitalism Without Failure coverage of a discussion

among Matt Taibbi, Eliott Spitzer, and Dennis Kelleher
on Viewpoint with Eliot Spitzer on 4 July 2012 regarding
the emerging LIBOR Scandal

Compound interest is interest added to the principal of a

deposit or loan so that the added interest also earns interest from then on. This addition of interest to the principal is called compounding. A bank account, for example,
[62] http://www.businessweek.com/news/2012-07-09/
may have its interest compounded every year: in this case,
libor-criminal-probe-cftc-bank-exemptions-canada-compliance
an account with $1000 initial principal and 20% interest
[63] HITC Business (4 October 2012) Senators Launch Inves- per year would have a balance of $1200 at the end of the
tigation Into Treasury Secretary Geithners Involvement rst year, $1440 at the end of the second year, $1728 at
the end of the third year, and so on.
In Libor Manipulation (FOX Business)
To dene an interest rate fully, allowing comparisons with
other interest rates, both the interest rate and the compounding frequency must be disclosed. Since most peoJohn Glover (8 October 2012) Libor, Set by Fewer
ple prefer to think of rates as a yearly percentage, many
Banks, Losing Status as a Benchmark Bloomberg Busigovernments require nancial institutions to disclose the
ness Week
equivalent yearly compounded interest rate on deposits or
Announcement of LIBOR changes (Press release). The advances. For instance, the yearly rate for a loan with 1%
British Bankers Association. 12 June 2013. Retrieved 25 interest per month is approximately 12.68% per annum
July 2013.
(1.0112 1). This equivalent yearly rate may be referred
Code of Conduct for Contributing Banks becomes In- to as annual percentage rate (APR), annual equivalent
dustry Guidance and Whistleblowing policy issued (Press rate (AER), eective interest rate, eective annual rate,
release). The British Bankers Association. 15 July 2013. and other terms. When a fee is charged up front to obtain
a loan, APR usually counts that cost as well as the comRetrieved 25 July 2013.
pound interest in converting to the equivalent rate. These
BBA Libor Limited has established the Interim LIgovernment requirements assist consumers in comparing
BOR Oversight Committee (ILOC)" (Press release). The
British Bankers Association. 5 July 2013. Retrieved 25 the actual costs of borrowing more easily.
July 2013.
For any given interest rate and compounding frequency,
an equivalent rate for any dierent compounding freNYSE EURONEXT SUBSIDIARY TO BECOME
NEW ADMINISTRATOR OF LIBOR (Press release). quency exists.

[64] Darrell Preston (10 October 2012) Rigged LIBOR costs

states, localities $6 billion Bloomberg
[65]

[66]

[67]

[68]

[69]

NYSE Euronext. 9 July 2013. Retrieved 21 July 2013.

Compound interest may be contrasted with simple inter[70] BBA to hand over administration of LIBOR to NYSE est, where interest is not added to the principal (there is
Euronext Rate Administration Limited (Press release). no compounding). Compound interest is standard in The British Bankers Association. 9 July 2013. Retrieved nance and economics, and simple interest is used infrequently (although certain nancial products may contain
20 July 2013.
elements of simple interest).
[71] ICE Benchmark Administration Ltd take responsibility
for administrating LIBOR,

[72] New measures to restore condence in benchmarks following LIBOR and EURIBOR scandals (Press release).
European Commission. 18 September 2013. Retrieved
18 December 2013.

2.4.1 Terminology
The eect of compounding depends on the frequency
with which interest is compounded and the periodic inter-

56
est rate which is applied. Therefore, to accurately dene
the amount to be paid under a legal contract with interest,
the frequency of compounding (yearly, half-yearly, quarterly, monthly, daily, etc.) and the interest rate must be
specied. Dierent conventions may be used from country to country, but in nance and economics the following
usages are common:
The periodic rate is the amount of interest that is charged
(and subsequently compounded) for each period divided
by the amount of the principal. The periodic rate is used
primarily for calculations and is rarely used for comparison.
The nominal annual rate or nominal interest rate is dened as the periodic rate multiplied by the number of
compounding periods per year. For example, a monthly
rate of 1% is equivalent to an annual nominal interest rate
of 12%.

CHAPTER 2. INTEREST AND YIELD

semi-annually with monthly (or more frequent)
payments.[1]
U.S. mortgages use an amortizing loan, not compound interest. With these loans, an amortization
schedule is used to determine how to apply payments
toward principal and interest. Interest generated on
these loans is not added to the principal, but rather
is paid o monthly as the payments are applied.
It is sometimes mathematically simpler, e.g. in
the valuation of derivatives, to use continuous compounding, which is the limit as the compounding period approaches zero. Continuous compounding in
pricing these instruments is a natural consequence
of It calculus, where nancial derivatives are valued at ever increasing frequency, until the limit is
approached and the derivative is valued in continuous time.

The eective annual rate is the total accumulated interest

that would be payable up to the end of one year divided
2.4.2
by the principal.
Economists generally prefer to use eective annual rates
to simplify comparisons, but in nance and commerce
the nominal annual rate may be quoted. When quoted
together with the compounding frequency, a loan with a
given nominal annual rate is fully specied (the amount of
interest for a given loan scenario can be precisely determined), but the nominal rate cannot be directly compared
with that of loans that have a dierent compounding frequency.

Mathematics of interest rates

Compound Interest
A formula for calculating annual compound interest is as
follows:

S=P

(
)nt
j
1+
n

Loans and nancing may have charges other than inter- where
est, and the terms above do not attempt to capture these
dierences. Other terms such as annual percentage rate
S = value after t periods
and annual percentage yield may have specic legal denitions and may or may not be comparable, depending on
P = principal amount (initial investment)
the jurisdiction.
j = annual nominal interest rate (not reecting the
The use of the terms above (and other similar terms)
compounding)
may be inconsistent and vary according to local custom or
marketing demands, for simplicity or for other reasons.
n = number of times the interest is compounded per
year
Exceptions
US and Canadian T-Bills (short term Government
debt) have a dierent convention. Their interest is
calculated as (100 P)/Pbnm, where P is the price
paid. Instead of normalizing it to a year, the interest
is prorated by the number of days t: (365/t)100.
(See day count convention).

t = number of years the money is borrowed for

As an example, suppose an amount of 1500.00 is deposited in a bank paying an annual interest rate of 4.3%,
compounded quarterly.
Then the balance after 6 years is found by using the formula above, with P = 1500, j = 0.043 (4.3%), n = 4, and
t = 6:

The interest on corporate bonds and government

bonds is usually payable twice yearly. The amount
)46
(
0.043
of interest paid (each six months) is the disclosed in= 1938.84
S = 1500 1 +
4
terest rate divided by two and multiplied by the principal. The yearly compounded rate is higher than the
So, the balance after 6 years is approximately 1938.84.
disclosed rate.
The amount of interest received can be calculated by sub Canadian mortgage loans are generally compounded tracting the principal from this amount.

2.4. CONTINUOUS COMPOUNDING

57

Periodic compounding
The amount function for compound interest is an expo- r0 = n ln(1 + r)
nential function in terms of time.
(
)nt
which will also hold true for any other interest rate and
A(t) = A0 1 + nr
compounding frequency. All formulas involving specic
interest rates and compounding frequencies may be ex t = Total time in years
pressed in terms of the continuous interest rate and the
compounding frequencies.
n = Number of compounding periods per year (note
that the total number of compounding periods is nt
)
Force of interest
r = Nominal annual interest rate expressed as a dec- In mathematics, the accumulation functions are often eximal. e.g.: 6% = 0.06
pressed in terms of e, the base of the natural logarithm.
This facilitates the use of calculus to manipulate interest
nt means that nt is rounded down to the nearest formulae.
integer.
For any continuously dierentiable accumulation function a(t) the force of interest, or more generally the
As n, the number of compounding periods per year, inlogarithmic or continuously compounded return is a funccreases without limit, we have the case known as continua (t)
ous compounding, in which case the eective annual rate tion of time dened as follows: t = a(t)
approaches an upper limit of er 1.

which is the rate of change with time of the natural logafunction.

Since the principal A(0) is simply a coecient, it is of- rithm of the accumulation
n
ten dropped for simplicity, and the resulting accumulation Conversely: a(n) = e 0 t dt , (since a(0) = 1 ; this can
function is used in interest theory instead. Accumulation be viewed as a particular case of a product integral)
functions for simple and compound interest are listed beWhen the above formula is written in dierential equation
low:
format, the force of interest is simply the coecient of
amount of change: da(t) = t a(t) dt
a(t) = 1 + tr
(
r )nt
a(t) = 1 +
n
Note: A(t) is the amount function and a(t) is the accumulation function.
Continuous compounding
Continuous compounding can be thought of as making
the compounding period innitesimally small, achieved
by taking the limit as n goes to innity. See denitions
of the exponential function for the mathematical proof of
this limit. The amount after t periods of continuous compounding can be expressed in terms of the initial amount
A0 as
A(t) = A0 ert .

It has been shown that the mathematics of continuous

compounding is not limited to the valuation of continuously compounded nancial instruments and ow annuities, but rather that the exponential equation is a versatile
model that may be used for valuation of all nancial contracts normally encountered.[2] In particular, any given interest rate (r) and compounding frequency (n) can be expressed in terms of a continuously compounded rate r0
:

For compound interest with a constant annual interest rate

r, the force of interest is a constant, and the accumulation
function of compounding interest in terms of force of interest is a simple power of e: = ln(1+r) or a(t) = et
The force of interest is less than the annual eective interest rate, but more than the annual eective discount
rate. It is the reciprocal of the e-folding time. See also
notation of interest rates.
A way of modeling the force of ination is with Stoodleys
s
formula: t = p+ 1+rse
st where p, r and s are estimated.
Compounding basis
See also: Day count convention
To convert an interest rate from one compounding basis
to another compounding basis, use
[(
]
) n1
r1 n2
r2 =
1+
1 n2 ,
n1
where r1 is the interest rate with compounding frequency
n1 , and r2 is the interest rate with compounding frequency
n2 .
When interest is continuously compounded, use

58

CHAPTER 2. INTEREST AND YIELD

In Excel, the function PMT() function is used. The syntax for the PMT function is:

R = n ln (1 + r/n),

= - PMT( interest_rate, number_payments, PV,

where R is the interest rate on a continuous compounding [FV],[Type] )
basis, and r is the stated interest rate with a compounding See
http://office.microsoft.com/en-au/excel-help/
frequency n.
pmt-HP005209215.aspx for more details.
For example, for interest rate of 6% (0.06/12 p.m.), 25
2.4.3 Mathematics of interest rate on loans years * 12 p.a., PV of $150,000, FV of 0, type of 0 gives:
= - PMT( 0.06/12, 25 * 12, 150000, 0, 0 )
Monthly amortized loan or mortgage payments
= $966.45 p.m.
See also:
formula

Mortgage calculator Monthly payment

Approximate formula for monthly payment

The interest on loans and mortgages that are amortized

that is, have a smooth monthly payment until the loan has
been paid ois often compounded monthly. The formula for payments is found from the following argument.
Exact formula for monthly payment
An exact formula for the monthly payment is

P =

1
(1+i)n

Li

This can be derived by considering how much is left to be

repaid after each month. After the rst month L1 = (1+
i)L P is left, i.e. the initial amount has increased less
the payment. If the whole loan was repaid after a month
P
then L1 = 0 so L = 1+i
After the second month L2 =
(1+i)L1 P is left, that is L2 = (1+i)((1+i)LP )P
. If the whole loan was repaid after two months L2 = 0
P
P
this gives the equation L = 1+i
+ (1+i)
2 . This equation
n
1
generalises for a term of n months, L = P j=1 (1+i)
j
. This is a geometric series which has the sum

L=

P
i

(
1

1
(1 + i)n

Li
1

L
n

1
(1+i)n

It will prove convenient then to dene

X = 12 Y = 12 IT
so that P P0 1e2X
2X which can be expanded: P
(
)
1
X2
P0 1 + X + 3 45
X 4 + ...
where the ellipses indicate terms that are higher order in
even powers of X . The expansion
)
(
2
P P0 1 + X + X3

Example of mortgage payment

Li
1

It follows immediately that 1eYY can be expanded in

even powers of Y plus the single term: Y /2

is valid to better than 1% provided X 1 .

which can be rearranged to give

P =

P0

The function f (Y ) 1eYY Y2 is even: f (Y ) =

f (Y ) implying that it can be expanded in even powers
of Y .

en ln(1+i)

Y ni = T I

P P0 1eYY

or equivalently

P =

which suggests dening auxiliary variables

P0 is the monthly payment required for a zero interest

loan paid o in n installments. In terms of these variables
the approximation can be written

Li
1

A formula that is accurate to within a few percent can be

found by noting that for typical U.S. note rates ( I < 8%
and terms T=1030 years), the monthly note rate is small
compared to 1: i << 1 so that the ln(1 + i) i which
ni
yields a simplication so that P 1eLini = L
n 1eni

en ln(1+i)

For a mortgage with a term of 30 years and a note rate of

4.5% we nd:
T =3
I = .178

This formula for the monthly payment on a U.S. mortgage which gives
X = 12 IT = .675
is exact and is what banks use.

2.4. CONTINUOUS COMPOUNDING

so that

P P0 1 + X +
.6752 /3) = $608.96

1 2
3X

59

2.4.7 References
= $333.33(1 + .675 +

The exact payment amount is P = $608.02 so the approximation is an overestimate of about a sixth of a percent.

[1] http://laws.justice.gc.ca/en/showdoc/cs/I-15/bo-ga:
s_6//en#anchorbo-ga:s_6 Interest Act (Canada), Department of Justice. The Interest Act species that interest
is not recoverable unless the mortgage loan contains
a statement showing the rate of interest chargeable,
calculated yearly or half-yearly, not in advance. In
practice, banks use the half-yearly rate.

2.4.4

[2] Munshi, Jamal. A New Discounting Model. ssrn.com.

Example of compound interest

[3] This article incorporates text from a publication now in

Suppose that one cent had been invested in a bank

the public domain: Chambers, Ephraim, ed. (1728).
2012 years ago at a 5% interest rate maintained to the
"article name needed ". Cyclopdia, or an Universal Dictionary
of Arts and Sciences (rst ed.). James and John Knapton,
present. After the rst year the capital would be worth
et al.
5% more than one cent, or 1.05 cents. In the second
year the interest earned would be 5% times 1.05 cents,
[4] Lewin, C G (1970). An Early Book on Compound Intergiving the amount of 1.051.05. After three years it
est - Richard Witts Arithmeticall Questions. Journal of
would have grown to (1.05)3 . After 2012 years the
the Institute of Actuaries 96 (1): 121132.
original one cent contribution would have grown to
(1.05)2012 cents, or 4.29 1042 cents (more precisely, [5] Lewin, C G (1981). Compound Interest in the Seven4,294,076,020,320,707,300,374,777,820,338,841,725,938,314 teenth Century. Journal of the Institute of Actuaries 108
(3): 423442.
cents).

2.4.5

History

Compound interest was once regarded as the worst kind

of usury and was severely condemned by Roman law and
the common laws of many other countries.[3]
Richard Witt's book Arithmeticall Questions, published in
1613, was a landmark in the history of compound interest. It was wholly devoted to the subject (previously
called anatocism), whereas previous writers had usually
treated compound interest briey in just one chapter in a
mathematical textbook. Witts book gave tables based
on 10% (the then maximum rate of interest allowable
on loans) and on other rates for dierent purposes, such
as the valuation of property leases. Witt was a London
mathematical practitioner and his book is notable for its
clarity of expression, depth of insight and accuracy of calculation, with 124 worked examples.[4][5]

2.4.6

See also

Credit card interest

Exponential growth
Fisher equation
Rate of return on investment
Yield curve
e (mathematical constant)

Chapter 3

Valuation
3.1 Valuation

The International Valuation Standards include denitions

for common bases of value and generally accepted pracIn nance, valuation is the process of estimating what tice procedures for valuing assets of all types.
something is worth.[1] Items that are usually valued are
a nancial asset or liability. Valuations can be done on
assets (for example, investments in marketable securities 3.1.2 Business valuation
such as stocks, options, business enterprises, or intangible
assets such as patents and trademarks) or on liabilities Businesses or fractional interests in businesses may be
(e.g., bonds issued by a company). Valuations are needed valued for various purposes such as mergers and acquisifor many reasons such as investment analysis, capital bud- tions, sale of securities, and taxable events. An accurate
geting, merger and acquisition transactions, nancial re- valuation of privately owned companies largely depends
porting, taxable events to determine the proper tax liabil- on the reliability of the rms historic nancial information. Public company nancial statements are audited
ity, and in litigation.
by Certied Public Accountants (USA), Chartered Certied Accountants (ACCA) or Chartered Accountants
3.1.1 Valuation overview
(UK and Canada) and overseen by a government regulator. Alternatively, private rms do not have government
Valuation of nancial assets is done using one or more of oversightunless operating in a regulated industryand
these types of models:
are usually not required to have their nancial statements
audited. Moreover, managers of private rms often pre1. Absolute value models that determine the present pare their nancial statements to minimize prots and,
value of an assets expected future cash ows. These therefore, taxes. Alternatively, managers of public rms
kinds of models take two general forms: multi- tend to want higher prots to increase their stock price.
period models such as discounted cash ow models Therefore, a rms historic nancial information may not
or single-period models such as the Gordon model. be accurate and can lead to over- and undervaluation. In
These models rely on mathematics rather than price an acquisition, a buyer often performs due diligence to
observation.
verify the sellers information.
2. Relative value models determine value based on the Financial statements prepared in accordance with
generally accepted accounting principles (GAAP) show
observation of market prices of similar assets.
many assets based on their historic costs rather than at
3. Option pricing models are used for certain types their current market values. For instance, a rms balance
of nancial assets (e.g., warrants, put options, call sheet will usually show the value of land it owns at what
options, employee stock options, investments with the rm paid for it rather than at its current market value.
embedded options such as a callable bond) and are But under GAAP requirements, a rm must show the
a complex present value model. The most com- fair values (which usually approximates market value) of
mon option pricing models are the BlackScholes- some types of assets such as nancial instruments that
Merton models and lattice models.
are held for sale rather than at their original cost. When
a rm is required to show some of its assets at fair value,
Common terms for the value of an asset or liability are some call this process "mark-to-market". But reporting
market value, fair value, and intrinsic value. The mean- asset values on nancial statements at fair values gives
ings of these terms dier. For instance, when an analyst managers ample opportunity to slant asset values upward
believes a stocks intrinsic value is greater (less) than its to articially increase prots and their stock prices.
market price, an analyst makes a buy (sell) recom- Managers may be motivated to alter earnings upward
mendation. Moreover, an assets intrinsic value may be so they can earn bonuses. Despite the risk of manager
subject to personal opinion and vary among analysts.
bias, equity investors and creditors prefer to know
60

3.1. VALUATION

61

the market values of a rms assetsrather than their Guideline companies method
historical costsbecause current values give them better
information to make decisions.
Main article: Comparable company analysis
There are commonly three pillars to valuing business entities: comparable company analyses, discounted cash ow This method determines the value of a rm by observing
analysis, and precedent transaction analysis
the prices of similar companies (called guideline companies) that sold in the market. Those sales could be shares
of stock or sales of entire rms. The observed prices
serve as valuation benchmarks. From the prices, one calculates price multiples such as the price-to-earnings or
price-to-book ratiosone or more of which used to value
the
rm. For example, the average price-to-earnings mulDiscounted Cash Flow Method
tiple of the guideline companies is applied to the subject
rms earnings to estimate its value.
Main article: Valuation using discounted cash ows
Many price multiples can be calculated. Most are based
on a nancial statement element such as a rms earnings
This method estimates the value of an asset based on its (price-to-earnings) or book value (price-to-book value)
expected future cash ows, which are discounted to the but multiples can be based on other factors such as pricepresent (i.e., the present value). This concept of discount- per-subscriber.
ing future money is commonly known as the time value
of money. For instance, an asset that matures and pays $1
in one year is worth less than $1 today. The size of the Net asset value method
discount is based on an opportunity cost of capital and it
is expressed as a percentage or discount rate.
Main article: Cost method
In nance theory, the amount of the opportunity cost is
based on a relation between the risk and return of some
sort of investment. Classic economic theory maintains
that people are rational and averse to risk. They, therefore, need an incentive to accept risk. The incentive in
nance comes in the form of higher expected returns after buying a risky asset. In other words, the more risky
the investment, the more return investors want from that
investment. Using the same example as above, assume
the rst investment opportunity is a government bond that
will pay interest of 5% per year and the principal and interest payments are guaranteed by the government. Alternatively, the second investment opportunity is a bond
issued by small company and that bond also pays annual
interest of 5%. If given a choice between the two bonds,
virtually all investors would buy the government bond
rather than the small-rm bond because the rst is less
risky while paying the same interest rate as the riskier
second bond. In this case, an investor has no incentive
to buy the riskier second bond. Furthermore, in order to
attract capital from investors, the small rm issuing the
second bond must pay an interest rate higher than 5%
that the government bond pays. Otherwise, no investor
is likely to buy that bond and, therefore, the rm will be
unable to raise capital. But by oering to pay an interest
rate more than 5% the rm gives investors an incentive to
buy a riskier bond.
For a valuation using the discounted cash ow method,
one rst estimates the future cash ows from the investment and then estimates a reasonable discount rate after
considering the riskiness of those cash ows and interest
rates in the capital markets. Next, one makes a calculation to compute the present value of the future cash ows.

The third-most common method of estimating the value

of a company looks to the assets and liabilities of the
business. At a minimum, a solvent company could shut
down operations, sell o the assets, and pay the creditors.
Any cash that would remain establishes a oor value for
the company. This method is known as the net asset
value or cost method. In general the discounted cash
ows of a well-performing company exceed this oor
value. Some companies, however, are worth more dead
than alive, like weakly performing companies that own
many tangible assets. This method can also be used to
value heterogeneous portfolios of investments, as well as
nonprots, for which discounted cash ow analysis is not
relevant. The valuation premise normally used is that of
an orderly liquidation of the assets, although some valuation scenarios (e.g., purchase price allocation) imply an
"in-use" valuation such as depreciated replacement cost
new.
An alternative approach to the net asset value method is
the excess earnings method. This method was rst described in ARM34, and later rened by the U.S. Internal
Revenue Service's Revenue Ruling 68-609. The excess
earnings method has the appraiser identify the value of
tangible assets, estimate an appropriate return on those
tangible assets, and subtract that return from the total return for the business, leaving the excess return, which
is presumed to come from the intangible assets. An appropriate capitalization rate is applied to the excess return, resulting in the value of those intangible assets. That
value is added to the value of the tangible assets and any
non-operating assets, and the total is the value estimate
for the business as a whole.

62

3.1.3

CHAPTER 3. VALUATION

Usage

Users of valuations benet when key information, assumptions, and limitations are disclosed to them. Then
In nance, valuation analysis is required for many rea- they can weigh the degree of reliability of the result and
sons including tax assessment, wills and estates, divorce make their decision.
settlements, business analysis, and basic bookkeeping and
accounting. Since the value of things uctuates over time,
valuations are as of a specic date like the end of the 3.1.4 Valuation of a suering company
accounting quarter or year. They may alternatively be
mark-to-market estimates of the current value of assets Additional adjustments to a valuation approach, whether
or liabilities as of this minute or this day for the purposes it is market-, income-, or asset-based, may be necessary
of managing portfolios and associated nancial risk (for in some instances like:
example, within large nancial rms including investment
banks and stockbrokers).
Excess or restricted cash
Some balance sheet items are much easier to value than
others. Publicly traded stocks and bonds have prices that
are quoted frequently and readily available. Other assets
are harder to value. For instance, private rms that have
no frequently quoted price. Additionally, nancial instruments that have prices that are partly dependent on
theoretical models of one kind or another are dicult to
value. For example, options are generally valued using
the BlackScholes model while the liabilities of life assurance rms are valued using the theory of present value.
Intangible business assets, like goodwill and intellectual
property, are open to a wide range of value interpretations.
It is possible and conventional for nancial professionals
to make their own estimates of the valuations of assets
or liabilities that they are interested in. Their calculations are of various kinds including analyses of companies
that focus on price-to-book, price-to-earnings, price-tocash-ow and present value calculations, and analyses of
bonds that focus on credit ratings, assessments of default
risk, risk premia, and levels of real interest rates. All
of these approaches may be thought of as creating estimates of value that compete for credibility with the prevailing share or bond prices, where applicable, and may or
may not result in buying or selling by market participants.
Where the valuation is for the purpose of a merger or acquisition the respective businesses make available further
detailed nancial information, usually on the completion
of a non-disclosure agreement.

Other non-operating assets and liabilities

Lack of marketability discount of shares
Control premium or lack of control discount
Above- or below-market leases
Excess salaries in the case of private companies
There are other adjustments to the nancial statements
that have to be made when valuing a distressed company.
Andrew Miller identies typical adjustments used to recast the nancial statements that include:
Working capital adjustment
Deferred capital expenditures
Cost of goods sold adjustment
Non-recurring professional fees and costs
Certain non-operating income/expense items[2]

3.1.5 Valuation of a startup company

Startup companies such as Uber, which was valued at $50

billion in early 2015, have a valuation based on what investors, for the most part venture capital rms, are willing
to pay for a share of the rm. They are not listed on any
It is important to note that valuation requires judgment
stock market, nor is the valuation based on their assets
and assumptions:
or prots, but on their potential for success, growth, and,
eventually, possible prots. The professional investors
There are dierent circumstances and purposes to who fund startups are experts, but hardly infallible, see
value an asset (e.g., distressed rm, tax purposes, Dot-com bubble.[3]
mergers and acquisitions, nancial reporting). Such
dierences can lead to dierent valuation methods
3.1.6 Valuation of intangible assets
or dierent interpretations of the method results
All valuation models and methods have limitations Valuation models can be used to value intangible as(e.g., degree of complexity, relevance of observa- sets such as for patent valuation, but also in copyrights,
software, trade secrets, and customer relationships. Since
tions, mathematical form)
few sales of benchmark intangible assets can ever be ob Model inputs can vary signicantly because of nec- served, one often values these sorts of assets using either
essary judgment and diering assumptions
a present value model or estimating the costs to recreate

3.1. VALUATION
it. Regardless of the method, the process is often timeconsuming and costly.
Valuations of intangible assets are often necessary for nancial reporting and intellectual property transactions.

63
Business valuation standard
Depreciation
Earnings response coecient

Stock markets give indirectly an estimate of a corporations intangible asset value. It can be reckoned as the
dierence between its market capitalisation and its book
value (by including only hard assets in it).

Ecient-market hypothesis

3.1.7

Intellectual property valuation

Valuation of mining projects

In mining, valuation is the process of determining the

value or worth of a mining property. Mining valuations
are sometimes required for IPOs, fairness opinions, litigation, mergers and acquisitions, and shareholder-related
matters. In valuation of a mining project or mining property, fair market value is the standard of value to be used.
The CIMVal Standards ("Canadian Institute of Mining,
Metallurgy and Petroleum on Valuation of Mineral Properties) are a recognised standard for valuation of mining
projects and is also recognised by the Toronto Stock Exchange (Venture).
The standards, spearheaded by K. Spence & Dr. W.
Roscoe,[4] stress the use of the cost approach, market approach, and the income approach, depending on the stage
of development of the mining property or project.
Depending on context, Real options valuation techniques
are also sometimes employed; for further discussion
here see Business valuation: Option pricing approaches,
Corporate nance: Valuing exibility, as well as Mineral
economics in general.

3.1.8

Asset pricing models

See also Modern portfolio theory

Capital asset pricing model
Arbitrage pricing theory
BlackScholes (for options)
Fuzzy pay-o method for real option valuation
Single-index model
Markov switching multifractal

3.1.9

See also

Applied information economics

Appraisal (disambiguation)
Asset price ination
Business valuation

Equity investment
Fundamental analysis

Investment management
Lipper average
Market-based valuation
Paper valuation
Patent valuation
Present value
Pricing
Real estate appraisal
Stock valuation
Price discovery
Real options valuation
Technical analysis
Terminal value
Chepakovich valuation model

3.1.10 References
[1] http://financial-dictionary.thefreedictionary.com/
valuation
[2] Joseph Swanson and Peter Marshall, Houlihan Lokey
and Lyndon Norley, Kirkland & Ellis International LLP
(2008). A Practitioners Guide to CorRestructuring, Andrew Millers Valuation of a Distressed Company p. 24.
ISBN 978-1-905121-31-1
[3] Andrew Ross Sorkin (May 11, 2015). Main Street Portfolios Are Investing in Unicorns (DEALBOOK BLOG).
The New York Times. Retrieved May 12, 2015. There is
no meaningful stock market for these shares. Their values
are based on what a small handful of investors usually
venture capital rms, private equity rms or other corporations are willing to pay for a stake.
[4] Standards and Guidelines for Valuation of Mineral Properties. Special committee of the Canadian Institute Of
Mining, Metallurgy and Petroleum on Valuation of Mineral Properties (CIMVAL), February 2003.

64

CHAPTER 3. VALUATION

3.1.11

External links

Time value = option premium intrinsic value

Valuation lter for public companies Allows free There are many factors which determine option premium.
look up of current enterprise values
These factors aect the premium of the option with varying intensity. Some of these factors are listed here:

3.2 Valuation of options

Further information: Option: Model implementation
In nance, a price (premium) is paid or received for purchasing or selling options. This price can be split into two
components.
These are:
Intrinsic value
Time value

3.2.1

Intrinsic value

Price of the underlying: Any uctuation in the price

of the underlying (stock/index/commodity) obviously has the largest impact on premium of an option contract. An increase in the underlying price
increases the premium of call option and decreases
the premium of put option. Reverse is true when
underlying price decreases.
Strike price: How far is the strike price from spot
also has an impact on option premium. Say, if
NIFTY goes from 5000 to 5100 the premium of
5000 strike and of 5100 strike will change a lot compared to a contract with strike of 5500 or 4700.
Time till expiry: Lesser the time to expiry, option
premium follows the intrinsic value more closely.
On the expiry date Time Value approaches zero.

The intrinsic value is the dierence between the underlying price and the strike price, to the extent that this is
in favor of the option holder. For a call option, the option is in-the-money if the underlying price is higher than
the strike price; then the intrinsic value is the underlying
price minus the strike price. For a put option, the option
is in-the-money if the strike price is higher than the underlying price; then the intrinsic value is the strike price
minus the underlying price. Otherwise the intrinsic value
is zero.

Volatility of underlying: Underlying security is a

constantly changing entity. The degree by which
its price uctuates can be termed as volatility. So
a share which uctuates 5% on either side on daily
basis is said to have more volatility than lets say a
stable blue chip shares whose uctuation is more benign at 23%. Volatility aects calls and puts alike.
Higher volatility increases the option premium because of greater risk it brings to the seller.

For example, if you are holding DJI 18,000 Call

(Bullish/Long) option and the underlying DJI Index is
priced at $18,050 then you already have $50 advantage
even if the option expires today. This $50 is the intrinsic
value of option.

Apart from above, other factors like bond yield (or

interest rate) also aect the premium. This is due to the
fact that the money invested by the seller can earn this
risk free income in any case and hence while selling option; he has to earn more than this because of higher risk
he is taking.

In summary, intrinsic value:

= current stock price strike price (call option)

3.2.3 Pricing models

= strike price current stock price (put option)

Because the values of option contracts depend on a number of dierent variables in addition to the value of the
underlying asset, they are complex to value. There are
3.2.2 Time value
many pricing models in use, although all essentially inThe option premium is always greater than the intrinsic corporate the concepts of rational pricing, moneyness,
value. This extra money is for the risk which the op- option time value and put-call parity.
tion writer/seller is undertaking. This is called the Time Amongst the most common models are:
Value.
Time value is the amount the option trader is paying for a
contract above its intrinsic value, with the belief that prior
to expiration the contract value will increase because of
a favourable change in the price of the underlying asset.
Obviously, the longer the amount of time until the expiry
of the contract, the greater the time value. So,

BlackScholes and the Black model

Binomial options pricing model
Monte Carlo option model
Finite dierence methods for option pricing

3.3. BLACK-SCHOLES
Other approaches include:

65
option, is also important as it enables pricing when an explicit formula is not possible.

Heston model

The BlackScholes formula has only one parameter that

cannot be observed in the market: the average future
HeathJarrowMorton framework
volatility of the underlying asset. Since the formula is increasing in this parameter, it can be inverted to produce
Variance gamma model (see variance gamma pro- a "volatility surface" that is then used to calibrate other
cess)
models, e.g. for OTC derivatives.

3.2.4

References

3.3.1 The Black-Scholes world

The BlackScholes model assumes that the market consists of at least one risky asset, usually called the stock,
and one riskless asset, usually called the money market,
The BlackScholes /blkolz/[1] or BlackScholes cash, or bond.
Merton model is a mathematical model of a nancial Now we make assumptions on the assets (which explain
market containing certain derivative investment instru- their names):
ments. From the model, one can deduce the Black
Scholes formula, which gives a theoretical estimate of
(riskless rate) The rate of return on the riskless asset
the price of European-style options. The formula led to
is constant and thus called the risk-free interest rate.
a boom in options trading and legitimised scientically
the activities of the Chicago Board Options Exchange
(random walk) The instantaneous log returns of the
and other options markets around the world.[2] lt is widely
stock price is an innitesimal random walk with
used, although often with adjustments and corrections, by
drift; more precisely, it is a geometric Brownian mooptions market participants.[3]:751 Many empirical tests
tion, and we will assume its drift and volatility is conhave shown that the BlackScholes price is fairly close
stant (if they are time-varying, we can deduce a suitto the observed prices, although there are well-known disably modied BlackScholes formula quite simply,
crepancies such as the "option smile".[3]:770771
as long as the volatility is not random).
The BlackScholes model was rst published by Fischer
The stock does not pay a dividend.[Notes 1]
Black and Myron Scholes in their 1973 paper, The Pricing of Options and Corporate Liabilities, published in
the Journal of Political Economy. They derived a partial Assumptions on the market:
dierential equation, now called the BlackScholes equation, which estimates the price of the option over time.
There is no arbitrage opportunity (i.e., there is no
The key idea behind the model is to hedge the option by
way to make a riskless prot).
buying and selling the underlying asset in just the right
way and, as a consequence, to eliminate risk. This type
It is possible to borrow and lend any amount, even
of hedging is called delta hedging and is the basis of more
fractional, of cash at the riskless rate.
complicated hedging strategies such as those engaged in
It is possible to buy and sell any amount, even fracby investment banks and hedge funds.
tional, of the stock (this includes short selling).
Robert C. Merton was the rst to publish a paper expanding the mathematical understanding of the options pricing
The above transactions do not incur any fees or costs
model, and coined the term BlackScholes options pric(i.e., frictionless market).
ing model. Merton and Scholes received the 1997 Nobel
Prize in Economics for their work. Though ineligible for With these assumptions holding, suppose there is a
the prize because of his death in 1995, Black was men- derivative security also trading in this market. We specify
tioned as a contributor by the Swedish Academy.[4]
that this security will have a certain payo at a specied

3.3 Black-Scholes

The models assumptions have been relaxed and generalized in many directions, leading to a plethora of models that are currently used in derivative pricing and risk
management. It is the insights of the model, as exemplied in the Black-Scholes formula, that are frequently
used by market participants, as distinguished from the actual prices. These insights include no-arbitrage bounds
and risk-neutral pricing. The Black-Scholes equation, a
partial dierential equation that governs the price of the

date in the future, depending on the value(s) taken by the

stock up to that date. It is a surprising fact that the derivatives price is completely determined at the current time,
even though we do not know what path the stock price
will take in the future. For the special case of a European
call or put option, Black and Scholes showed that it is
possible to create a hedged position, consisting of a long
position in the stock and a short position in the option,
whose value will not depend on the price of the stock.[5]

66

CHAPTER 3. VALUATION

Their dynamic hedging strategy led to a partial dierential equation which governed the price of the option. Its
solution is given by the BlackScholes formula.
Several of these assumptions of the original model have
been removed in subsequent extensions of the model.
Modern versions account for dynamic interest rates (Merton, 1976), transaction costs and taxes (Ingersoll, 1976),
and dividend payout.[6]

3.3.2

Notation

Let
S , be the price of the stock, which will sometimes be a random variable and other times a
constant (context should make this clear).
V (S, t) , the price of a derivative as a function
of time and stock price.
C(S, t) the price of a European call option and
P (S, t) the price of a European put option.
K , the strike price of the option.
r , the annualized risk-free interest rate,
continuously compounded (the force of interest).

Simulated geometric Brownian motions with parameters from

market data

V
1
2V
V
+ 2 S 2 2 + rS
rV = 0
t
2
S
S
The key nancial insight behind the equation is that one
can perfectly hedge the option by buying and selling the
underlying asset in just the right way and consequently
eliminate risk. This hedge, in turn, implies that there
is only one right price for the option, as returned by the
BlackScholes formula (see the next section).

, the drift rate of S , annualized.

, the standard deviation of the stocks returns;
this is the square root of the quadratic variation
of the stocks log price process.

3.3.4 Black-Scholes formula

t , a time in years; we generally use: now=0,

expiry=T.
, the value of a portfolio.
Finally we will use N (x) to denote the standard normal
cumulative distribution function,

1
N (x) =
2

z2
2

dz

N (x) will denote the standard normal probability density

function,

x2
1
N (x) = e 2
2

3.3.3

The BlackScholes equation

A European call valued using the Black-Scholes pricing equation

for varying asset price S and time-to-expiry T. In this particular
example, the strike price is set to unity.

The BlackScholes formula calculates the price of

European put and call options. This price is consistent
with the BlackScholes equation as above; this follows
since the formula can be obtained by solving the equation
for the corresponding terminal and boundary conditions.

Main article: BlackScholes equation

As above, the BlackScholes equation is a partial dif- The value of a call option for a non-dividend-paying unferential equation, which describes the price of the option derlying stock in terms of the BlackScholes parameters
over time. The equation is:
is:

3.3. BLACK-SCHOLES

67

C(S, t) = N (d1 )S N (d2 )Ker(T t)

C P = D(F K) = S DK
)
]
[ ( ) (
2
1
S

d1 =
ln
+ r+
(T t) the price of a put option is:
K
2
T t
[ ( ) (
)
]
1
S
2
d2 =
ln
+ r
(T t)
K
2
T t
P (F, ) = D [N (d )K N (d+ )F ]

= d1 T t
The price of a corresponding put option based on putcall Interpretation
parity is:
The BlackScholes formula can be interpreted fairly
handily, with the main subtlety the interpretation of the
r(T t)
N (d ) (and a fortiori d ) terms, particularly d+ and
P (S, t) = Ke
S + C(S, t)
why there are two dierent terms.[7]
= N (d2 )Ker(T t) N (d1 )S
The formula can be interpreted by rst decomposing a
call option into the dierence of two binary options: an
For both, as above:
asset-or-nothing call minus a cash-or-nothing call (long
N () is the cumulative distribution function of the an asset-or-nothing call, short a cash-or-nothing call). A
call option exchanges cash for an asset at expiry, while
standard normal distribution
an asset-or-nothing call just yields the asset (with no cash
T t is the time to maturity
in exchange) and a cash-or-nothing call just yields cash
(with no asset in exchange). The BlackScholes formula
S is the spot price of the underlying asset
is a dierence of two terms, and these two terms equal
the value of the binary call options. These binary options
K is the strike price
are much less frequently traded than vanilla call options,
r is the risk free rate (annual rate, expressed in terms but are easier to analyze.
of continuous compounding)
Thus the formula:
is the volatility of returns of the underlying asset
Alternative formulation

C = D [N (d+ )F N (d )K]

breaks up as:
Introducing some auxiliary variables allows the formula
to be simplied and reformulated in a form that is often
more convenient (this is a special case of the Black '76 C = DN (d )F DN (d )K
+

formula):
where DN (d+ )F is the present value of an asset-ornothing call and DN (d )K is the present value of a
C(F, ) = D (N (d+ )F N (d )K)
cash-or-nothing call. The D factor is for discounting, be[ ( )
]
cause the expiration date is in future, and removing it
F
1
1 2
d = ln

changes present value to future value (value at expiry).
K
2

Thus N (d+ ) F is the future value of an asset-or-nothing

d = d
call and N (d ) K is the future value of a cash-or-nothing
call. In risk-neutral terms, these are the expected value of
The auxiliary variables are:
the asset and the expected value of the cash in the riskneutral measure.
= T t is the time to expiry (remaining time,
The naive, and not quite correct, interpretation of these
backwards time)
terms is that N (d+ )F is the probability of the option ex D = er is the discount factor
piring in the money N (d+ ) , times the value of the unS
r
F = e S = D is the forward price of the under- derlying at expiry F, while N (d )K is the probability
of the option expiring in the money N (d ), times the
lying asset, and S = DF
value of the cash at expiry K. This is obviously incorrect,
as either both binaries expire in the money or both exwith d = d1 and d = d2 to clarify notation.
pire out of the money (either cash is exchanged for asset
Given put-call parity, which is expressed in these terms or it is not), but the probabilities N (d+ ) and N (d ) are
as:
not equal. In fact, d can be interpreted as measures of

68
moneyness (in standard deviations) and N (d ) as probabilities of expiring ITM (percent moneyness), in the respective numraire, as discussed below. Simply put, the
interpretation of the cash option, N (d )K , is correct,
as the value of the cash is independent of movements of
the underlying, and thus can be interpreted as a simple
product of probability times value, while the N (d+ )F
is more complicated, as the probability of expiring in
the money and the value of the asset at expiry are not
independent.[7] More precisely, the value of the asset at
expiry is variable in terms of cash, but is constant in terms
of the asset itself (a xed quantity of the asset), and thus
these quantities are independent if one changes numraire
to the asset rather than cash.

CHAPTER 3. VALUATION
market price of risk.
Derivations See also: Martingale pricing
A standard derivation for solving the BlackScholes PDE
is given in the article Black-Scholes equation.
The Feynman-Kac formula says that the solution to this
type of PDE, when discounted appropriately, is actually
a martingale. Thus the option price is the expected value
of the discounted payo of the option. Computing the
option price via this expectation is the risk neutrality approach and can be done without knowledge of PDEs.[7]
Note the expectation of the option payo is not done under the real world probability measure, but an articial
risk-neutral measure, which diers from the real world
measure. For the underlying logic see section risk neutral valuation under Rational pricing as well as section
Derivatives pricing: the Q world" under Mathematical
nance; for detail, once again, see Hull.[9]:307309

If one uses spot S instead

) F, in d instead of
( of forward
the 12 2 term there is r 21 2 , which can be interpreted as a drift factor (in the risk-neutral measure for appropriate numraire). The use of d for moneyness
)
( F rather
1
than the standardized moneyness m =
ln
K in

other words, the reason for the 12 2 factor is due to

the dierence between the median and mean of the lognormal distribution; it is the same factor as in It's lemma
applied to geometric Brownian motion. In addition, an- 3.3.5 The Greeks
other way to see that the naive interpretation is incorrect
is that replacing N(d) by N(d) in the formula yields a "The Greeks" measure the sensitivity of the value of a
derivative or a portfolio to changes in parameter value(s)
negative value for out-of-the-money call options.[7]:6
while holding the other parameters xed. They are partial
In detail, the terms N (d1 ), N (d2 ) are the prob- derivatives of the price with respect to the parameter valabilities of the option expiring in-the-money under ues. One Greek, gamma (as well as others not listed
the equivalent exponential martingale probability mea- here) is a partial derivative of another Greek, delta in
sure (numraire=stock) and the equivalent martin- this case.
gale probability measure (numraire=risk free asset),
respectively.[7] The risk neutral probability density for the The Greeks are important not only in the mathematical
theory of nance, but also for those actively trading. Fistock price ST (0, ) is
nancial institutions will typically set (risk) limit values for
each of the Greeks that their traders must not exceed.
Delta is the most important Greek since this usually conN [d2 (ST )]

p(S, T ) =
fers the largest risk. Many traders will zero their delta at
ST T
the end of the day if they are not speculating and followwhere d2 = d2 (K) is dened as above.
ing a delta-neutral hedging approach as dened by Black
Specically, N (d2 ) is the probability that the call will Scholes.
be exercised provided one assumes that the asset drift The Greeks for BlackScholes are given in closed form
is the risk-free rate. N (d1 ) , however, does not lend below. They can be obtained by dierentiation of the
itself to a simple probability interpretation. SN (d1 ) is BlackScholes formula.[10]
correctly interpreted as the present value, using the riskfree interest rate, of the expected asset price at expiration, Note that from the formulae, it is clear that the gamma is
given that the asset price at expiration is above the exer- the same value for calls and puts and so too is the vega
cise price.[8] For related discussion and graphical rep- the same value for calls and put options. This can be seen
resentation see section Interpretation under Datar directly from putcall parity, since the dierence of a put
and a call is a forward, which is linear in S and indepenMathews method for real option valuation.
dent of (so a forward has zero gamma and zero vega).
The equivalent martingale probability measure is also
called the risk-neutral probability measure. Note that In practice, some sensitivities are usually quoted in
both of these are probabilities in a measure theoretic scaled-down terms, to match the scale of likely changes
sense, and neither of these is the true probability of expir- in the parameters. For example, rho is often reported diing in-the-money under the real probability measure. To vided by 10,000 (1 basis point rate change), vega by 100
calculate the probability under the real (physical) prob- (1 vol point change), and theta by 365 or 252 (1 day decay
ability measure, additional information is requiredthe based on either calendar days or trading days per year).
drift term in the physical measure, or equivalently, the (Vega is not a letter in the Greek alphabet; the name arises

3.3. BLACK-SCHOLES
from reading the Greek letter (nu) as a V.)

69
Instruments paying discrete proportional dividends

It is also possible to extend the BlackScholes framework to options on instruments paying discrete proportional dividends. This is useful when the option is struck
The above model can be extended for variable (but de- on a single stock.
terministic) rates and volatilities. The model may also
be used to value European options on instruments paying A typical model is to assume that a proportion of the
dividends. In this case, closed-form solutions are avail- stock price is paid out at pre-determined times t1 , t2 , . . .
able if the dividend is a known proportion of the stock . The price of the stock is then modelled as
price. American options and options on stocks paying a
known cash dividend (in the short term, more realistic
than a proportional dividend) are more dicult to value, St = S0 (1 )n(t) eut+Wt
and a choice of solution techniques is available (for exwhere n(t) is the number of dividends that have been paid
ample lattices and grids).
by time t .

3.3.6

Extensions of the model

Instruments paying continuous yield dividends

The price of a call option on such a stock is again

For options on indices, it is reasonable to make the simplifying assumption that dividends are paid continuously, C(S0 , T ) = erT [F N (d1 ) KN (d2 )]
and that the dividend amount is proportional to the level
where now
of the index.
The dividend payment paid over the time period [t, t+dt]
is then modelled as

qSt dt

F = S0 (1 )n(T ) erT
is the forward price for the dividend paying stock.

for some constant q (the dividend yield).

American options
Under this formulation the arbitrage-free price implied by
the BlackScholes model can be shown to be
The problem of nding the price of an American option
is related to the optimal stopping problem of nding the
time to execute the option. Since the American option
C(S0 , t) = er(T t) [F N (d1 ) KN (d2 )]
can be exercised at any time before the expiration date,
the BlackScholes equation becomes an inequality of the
and
form
P (S0 , t) = er(T t) [KN (d2 ) F N (d1 )]
where now
F = S0 e(rq)(T t)

V
t

[12]
+ 21 2 S 2 SV2 + rS V
S rV 0

with the terminal and (free) boundary conditions:

V (S, T ) = H(S) and V (S, t) H(S) where H(S)
denotes the payo at stock price S .

In general this inequality does not have a closed form

is the modied forward price that occurs in the terms solution, though an American call with no dividends is
equal to a European call and the Roll-Geske-Whaley
d 1 , d2 :
method provides a solution for an American call with one
dividend.[13][14]
]
[ ( )
1
1
F
Barone-Adesi and Whaley[15] is a further approximation
+ (r q + 2 )(T t)
d1 =
ln
K
2
T t
formula. Here, the stochastic dierential equation (which
is valid for the value of any derivative) is split into two
components: the European option value and the early
exercise premium. With some assumptions, a quadratic

equation that approximates the solution for the latter is

d2 = d1 T t
then obtained. This solution involves nding the critical
[11]
Extending the Black Scholes formula Adjusting for value, s , such that one is indierent between early expayouts of the underlying.
ercise and holding to maturity.[16][17]
and

70

CHAPTER 3. VALUATION

Bjerksund and Stensland[18] provide an approximation

based on an exercise strategy corresponding to a trigger
price. Here, if the underlying asset price is greater than
or equal to the trigger price it is optimal to exercise, and
the value must equal S X , otherwise the option boils
down to: (i) a European up-and-out call option and (ii)
a rebate that is received at the knock-out date if the option
is knocked out prior to the maturity date. The formula is
readily modied for the valuation of a put option, using
put call parity. This approximation is computationally inexpensive and the method is fast, with evidence indicating
that the approximation may be more accurate in pricing
long dated options than Barone-Adesi and Whaley.[19]

3.3.7

BlackScholes in practice

the assumption of a stationary process, yielding

volatility risk, which can be hedged with volatility
hedging;
the assumption of continuous time and continuous
trading, yielding gap risk, which can be hedged with
Gamma hedging.
In short, while in the BlackScholes model one can perfectly hedge options by simply Delta hedging, in practice
there are many other sources of risk.
Results using the BlackScholes model dier from real
world prices because of simplifying assumptions of the
model. One signicant limitation is that in reality security prices do not follow a strict stationary log-normal process, nor is the risk-free interest actually known (and is
not constant over time). The variance has been observed
to be non-constant leading to models such as GARCH to
model volatility changes. Pricing discrepancies between
empirical and the BlackScholes model have long been
observed in options that are far out-of-the-money, corresponding to extreme price changes; such events would be
very rare if returns were lognormally distributed, but are
observed much more often in practice.
Nevertheless, BlackScholes pricing is widely used in
practice,[3]:751[21] because it is:
easy to calculate
a useful approximation, particularly when analyzing
the direction in which prices move when crossing
critical points
a robust basis for more rened models
reversible, as the models original output, price, can
be used as an input and one of the other variables
solved for; the implied volatility calculated in this
way is often used to quote option prices (that is, as
a quoting convention)
The rst point is self-evidently useful. The others can be
further discussed:

The normality assumption of the BlackScholes model does not

capture extreme movements such as stock market crashes.

Useful approximation: although volatility is not constant,

results from the model are often helpful in setting up
hedges in the correct proportions to minimize risk. Even
The BlackScholes model disagrees with reality in a numwhen the results are not completely accurate, they serve as
ber of ways, some signicant. It is widely employed as a
a rst approximation to which adjustments can be made.
useful approximation, but proper application requires understanding its limitations blindly following the model Basis for more rened models: The BlackScholes model
exposes the user to unexpected risk.[20] Among the most is robust in that it can be adjusted to deal with some of its
failures. Rather than considering some parameters (such
signicant limitations are:
as volatility or interest rates) as constant, one considers
the underestimation of extreme moves, yielding tail them as variables, and thus added sources of risk. This is
risk, which can be hedged with out-of-the-money reected in the Greeks (the change in option value for
a change in these parameters, or equivalently the paroptions;
tial derivatives with respect to these variables), and hedg the assumption of instant, cost-less trading, yielding ing these Greeks mitigates the risk caused by the nonliquidity risk, which is dicult to hedge;
constant nature of these parameters. Other defects cannot

3.3. BLACK-SCHOLES
be mitigated by modifying the model, however, notably
tail risk and liquidity risk, and these are instead managed
outside the model, chiey by minimizing these risks and
by stress testing.
Explicit modeling: this feature means that, rather than
assuming a volatility a priori and computing prices from
it, one can use the model to solve for volatility, which
gives the implied volatility of an option at given prices,
durations and exercise prices. Solving for volatility over
a given set of durations and strike prices one can construct an implied volatility surface. In this application
of the BlackScholes model, a coordinate transformation from the price domain to the volatility domain is obtained. Rather than quoting option prices in terms of dollars per unit (which are hard to compare across strikes
and tenors), option prices can thus be quoted in terms of
implied volatility, which leads to trading of volatility in
option markets.

The volatility smile

Main article: Volatility smile
One of the attractive features of the BlackScholes model
is that the parameters in the model other than the volatility (the time to maturity, the strike, the risk-free interest
rate, and the current underlying price) are unequivocally
observable. All other things being equal, an options theoretical value is a monotonic increasing function of implied volatility.

71
right price.[22] This approach also gives usable values for
the hedge ratios (the Greeks). Even when more advanced
models are used, traders prefer to think in terms of BlackScholes implied volatility as it allows them to evaluate
and compare options of dierent maturities, strikes, and
so on. For a discussion as to the various alternate approaches developed here, see Financial economics #Challenges and criticism.
Valuing bond options
BlackScholes cannot be applied directly to bond securities because of pull-to-par. As the bond reaches its maturity date, all of the prices involved with the bond become
known, thereby decreasing its volatility, and the simple
BlackScholes model does not reect this process. A
large number of extensions to BlackScholes, beginning
with the Black model, have been used to deal with this
phenomenon.[23] See Bond option: Valuation.
Interest-rate curve
In practice, interest rates are not constant they vary by
tenor, giving an interest rate curve which may be interpolated to pick an appropriate rate to use in the Black
Scholes formula. Another consideration is that interest
rates vary over time. This volatility may make a significant contribution to the price, especially of long-dated
options.This is simply like the interest rate and bond price
relationship which is inversely related.

By computing the implied volatility for traded options

with dierent strikes and maturities, the BlackScholes
model can be tested. If the BlackScholes model held,
then the implied volatility for a particular stock would
be the same for all strikes and maturities. In practice,
the volatility surface (the 3D graph of implied volatility
against strike and maturity) is not at.

Short stock rate

Despite the existence of the volatility smile (and the violation of all the other assumptions of the BlackScholes
model), the BlackScholes PDE and BlackScholes formula are still used extensively in practice. A typical approach is to regard the volatility surface as a fact about the
market, and use an implied volatility from it in a Black
Scholes valuation model. This has been described as using the wrong number in the wrong formula to get the

nomic theory.[24] They also assert that Boness in 1964

had already published a formula that is actually identical to the BlackScholes call option pricing equation.[25]
Edward Thorp also claims to have guessed the Black
Scholes formula in 1967 but kept it to himself to make
money for his investors.[26] Emanuel Derman and Nassim Taleb have also criticized dynamic hedging and state
that a number of researchers had put forth similar models

It is not free to take a short stock position. Similarly, it

may be possible to lend out a long stock position for a
small fee. In either case, this can be treated as a continuous dividend for the purposes of a BlackScholes valuation, provided that there is no glaring asymmetry between
The typical shape of the implied volatility curve for a the short stock borrowing cost and the long stock lending
given maturity depends on the underlying instrument. income.
Equities tend to have skewed curves: compared to atthe-money, implied volatility is substantially higher for
3.3.8 Criticism
low strikes, and slightly lower for high strikes. Currencies tend to have more symmetrical curves, with implied Espen Gaarder Haug and Nassim Nicholas Taleb arvolatility lowest at-the-money, and higher volatilities in gue that the BlackScholes model merely recasts exboth wings. Commodities often have the reverse behav- isting widely used models in terms of practically imior to equities, with higher implied volatility for higher possible dynamic hedging rather than risk, to make
strikes.
them more compatible with mainstream neoclassical eco-

72

CHAPTER 3. VALUATION

prior to Black and Scholes.[27] In response, Paul Wilmott

has defended the model.[21][28]
British mathematician Ian Stewart published a criticism
in which he suggested that the equation itself wasn't the
real problem and he stated a possible role as one ingredient in a rich stew of nancial irresponsibility, political
ineptitude, perverse incentives and lax regulation due to
its abuse in the nancial industry.[29]

3.3.9

See also

Binomial options model, which is a discrete

numerical method for calculating option prices.
Black model, a variant of the BlackScholes option
pricing model.
Black Shoals, a nancial art piece.
Brownian model of nancial markets

[6] Merton, Robert. Theory of Rational Option Pricing.

Bell Journal of Economics and Management Science 4 (1):
141183. doi:10.2307/3003143.
[7] Nielsen, Lars Tyge (1993). Understanding N(d1 ) and
N(d2 ): Risk-Adjusted Probabilities in the Black-Scholes
Model (PDF). Revue Finance (Journal of the French
Finance Association) 14 (1): 95106. Retrieved Dec
8, 2012, earlier circulated as INSEAD Working Paper
92/71/FIN (1992); abstract and link to article, published
article.
[8] Don Chance (June 3, 2011). Derivation and Interpretation of the BlackScholes Model (PDF). Retrieved
March 27, 2012.
[9] Hull, John C. (2008). Options, Futures and Other Derivatives (7 ed.). Prentice Hall. ISBN 0-13-505283-1.
[10] Although with signicant algebra; see, for example,
Hong-Yi Chen, Cheng-Few Lee and Weikang Shih
(2010). Derivations and Applications of Greek Letters:
Review and Integration, Handbook of Quantitative Finance and Risk Management, III:491503.

Financial mathematics, which contains a list of related articles.

[11] http://finance.bi.no/~{}bernt/gcc_prog/recipes/recipes/
node9.html

Heat equation, to which the BlackScholes PDE can

be transformed.

[12] Andr Jaun. The Black-Scholes equation for American

options. Retrieved May 5, 2012.

Jump diusion

[13] Bernt degaard (2003). Extending the Black Scholes

formula. Retrieved May 5, 2012.

Monte Carlo option model, using simulation in the

valuation of options with complicated features.
Real options analysis
Stochastic volatility

3.3.10

Notes

[1] Although the original model assumed no dividends, trivial

extensions to the model can accommodate a continuous
dividend yield factor.

3.3.11

References

[1] Scholes. Retrieved March 26, 2012.

[2] MacKenzie, Donald (2006). An Engine, Not a Camera:
How Financial Models Shape Markets. Cambridge, MA:
MIT Press. ISBN 0-262-13460-8.
[3] Bodie, Zvi; Alex Kane; Alan J. Marcus (2008). Investments (7th ed.). New York: McGraw-Hill/Irwin. ISBN
978-0-07-326967-2.

[14] Don Chance (2008). Closed-Form American Call Option Pricing: Roll-Geske-Whaley (PDF). Retrieved May
16, 2012.
[15] Giovanni Barone-Adesi and Robert E Whaley (June
1987). Ecient analytic approximation of American
option values. Journal of Finance 42 (2): 30120.
doi:10.2307/2328254.
[16] Bernt degaard (2003). A quadratic approximation to
American prices due to Barone-Adesi and Whaley. Retrieved June 25, 2012.
[17] Don Chance (2008). Approximation Of American Option Values: Barone-Adesi-Whaley (PDF). Retrieved
June 25, 2012.
[18] Petter Bjerksund and Gunnar Stensland, 2002. Closed
Form Valuation of American Options
[19] American options
[20] Yalincak, Hakan, Criticism of the Black-Scholes Model:
But Why Is It Still Used? (The Answer is Simpler than the Formula)" <<http://papers.ssrn.com/sol3/
papers.cfm?abstract_id=2115141>>

[4] Nobel Prize Foundation, 1997 Press release. October

14, 1997. Retrieved March 26, 2012.

[21] Paul Wilmott (2008): In defence of Black Scholes and

Merton, Dynamic hedging and further defence of BlackScholes

[5] Black, Fischer; Scholes, Myron. The Pricing of Options

and Corporate Liabilities. Journal of Political Economy
81 (3): 637654. doi:10.1086/260062.

[22] Riccardo Rebonato (1999). Volatility and correlation in

the pricing of equity, FX and interest-rate options. Wiley.
ISBN 0-471-89998-4.

3.3. BLACK-SCHOLES

[23] Kalotay, Andrew (November 1995). The Problem with

Black, Scholes et al. (PDF). Derivatives Strategy.
[24] Espen Gaarder Haug and Nassim Nicholas Taleb (2011).
Option Traders Use (very) Sophisticated Heuristics,
Never the BlackScholesMerton Formula. Journal of
Economic Behavior and Organization, Vol. 77, No. 2,
2011
[25] Boness, A James, 1964, Elements of a theory of stockoption value, Journal of Political Economy, 72, 163-175.
[26] A Perspective on Quantitative Finance: Models for Beating the Market, Quantitative Finance Review, 2003. Also
see Option Theory Part 1 by Edward Thorpe
[27] Emanuel Derman and Nassim Taleb (2005). The illusions
of dynamic replication, Quantitative Finance, Vol. 5, No.
4, August 2005, 323326
[28] See also: Doriana Runno and Jonathan Treussard
(2006). Derman and Talebs The Illusions of Dynamic
Replication: A Comment, WP2006-019, Boston University - Department of Economics.
[29] Ian Stewart (2012) The mathematical equation that caused
the banks to crash, The Observer, February 12.

Primary references

73
MacKenzie, Donald (2006). An Engine, not a Camera: How Financial Models Shape Markets. MIT
Press. ISBN 0-262-13460-8.
Szpiro, George G. Pricing the Future: Finance,
Physics, and the 300-Year Journey to the BlackScholes Equation; A Story of Genius and Discovery
(New York: Basic, 2011) 298 pp.
Further reading
Haug, E. G (2007). Option Pricing and Hedging
from Theory to Practice. Derivatives: Models on
Models. Wiley. ISBN 978-0-470-01322-9. The
book gives a series of historical references supporting the theory that option traders use much more robust hedging and pricing principles than the Black,
Scholes and Merton model.
Triana, Pablo (2009). Lecturing Birds on Flying:
Can Mathematical Theories Destroy the Financial
Markets?. Wiley. ISBN 978-0-470-40675-5. The
book takes a critical look at the Black, Scholes and
Merton model.

3.3.12 External links

Black, Fischer; Myron Scholes (1973). The Discussion of the model

Pricing of Options and Corporate Liabilities.
Ajay Shah. Black, Merton and Scholes: Their
Journal of Political Economy 81 (3): 637654.
work and its consequences. Economic and Political
doi:10.1086/260062. (Black and Scholes original
Weekly, XXXII(52):33373342, December 1997
paper.)
Merton, Robert C. (1973). Theory of Rational Option Pricing. Bell Journal of Economics and Management Science (The RAND Corporation) 4 (1):
141183. doi:10.2307/3003143. JSTOR 3003143.

The mathematical equation that caused the banks to

crash by Ian Stewart in The Observer, February 12,
2012

Hull, John C. (1997). Options, Futures, and Other

Derivatives. Prentice Hall. ISBN 0-13-601589-1.

The Skinny On Options TastyTrade Show (archives)

When You Cannot Hedge Continuously: The Corrections to BlackScholes, Emanuel Derman

Derivation and solution

Historical and sociological aspects
Bernstein, Peter (1992). Capital Ideas: The Improbable Origins of Modern Wall Street. The Free Press.
ISBN 0-02-903012-9.
MacKenzie, Donald (2003). An Equation and
its Worlds:
Bricolage, Exemplars, Disunity
and Performativity in Financial Economics.
Social Studies of Science 33 (6): 831868.
doi:10.1177/0306312703336002.
MacKenzie, Donald; Yuval Millo (2003). Constructing a Market, Performing Theory: The Historical Sociology of a Financial Derivatives Exchange.
American Journal of Sociology 109 (1): 107145.
doi:10.1086/374404.

Derivation of the BlackScholes Equation for Option Value, Prof. Thayer Watkins
Solution of the BlackScholes Equation Using the
Greens Function, Prof. Dennis Silverman
Solution via risk neutral pricing or via the PDE approach using Fourier transforms (includes discussion of other option types), Simon Leger
Assumptions for Black Scholes Model, blackscholes.co.uk
Step-by-step solution of the BlackScholes PDE,
planetmath.org.
The BlackScholes Equation Expository article by
mathematician Terence Tao.

74
Computer implementations

CHAPTER 3. VALUATION

3.4.1 Assumptions

Calculator for vanilla call and put based on Black- Putcall parity is a static replication, and thus requires
minimal assumptions, namely the existence of a forward
Sholes model
contract. In the absence of traded forward contracts, the
BlackScholes in Multiple Languages
forward contract can be replaced (indeed, itself replicated) by the ability to buy the underlying asset and Black-Scholes in Java -moving to link belownance this by borrowing for xed term (e.g., borrowing
bonds), or conversely to borrow and sell (short) the un Black-Scholes in Java
derlying asset and loan the received money for term, in
Chicago Option Pricing Model (Graphing Version) both cases yielding a self-nancing portfolio.
These assumptions do not require any transactions be Black-Scholes-Merton Implied Volatility Surface tween the initial date and expiry, and are thus signiModel (Java)
cantly weaker than those of the BlackScholes model,
which requires dynamic replication and continual trans Online Black-Scholes Calculator
action in the underlying.
On-line nancial calculator with Black-Scholes

Replication assumes one can enter into derivative transactions, which requires leverage (and capital costs to back
this), and buying and selling entails transaction costs, noHistorical
tably the bid-ask spread. The relationship thus only holds
exactly in an ideal frictionless market with unlimited liq Trillion Dollar BetCompanion Web site to a Nova uidity. However, real world markets may be suciently
episode originally broadcast on February 8, 2000. liquid that the relationship is close to exact, most signifThe lm tells the fascinating story of the inven- icantly FX markets in major currencies or major stock
tion of the BlackScholes Formula, a mathematical indices, in the absence of market turbulence.
Holy Grail that forever altered the world of nance
and earned its creators the 1997 Nobel Prize in Eco3.4.2 Statement
nomics.
BBC Horizon A TV-programme on the so-called Putcall parity can be stated in a number of equivalent
Midas formula and the bankruptcy of Long-Term ways, most tersely as:
Capital Management (LTCM)
C P = D(F K)
BBC News Magazine BlackScholes: The maths
formula linked to the nancial crash (April 27, 2012
where C is the (current) value of a call, P is the (current)
article)
value of a put, D is the discount factor, F is the forward
price of the asset, and K is the strike price. Note that the
spot price is given by D F = S (spot price is present
3.4 Putcall parity
value, forward price is future value, discount factor relates
these). The left side corresponds to a portfolio of long a
In nancial mathematics, putcall parity denes a rela- call and short a put, while the right side corresponds to a
tionship between the price of a European call option and forward contract. The assets C and P on the left side are
European put option, both with the identical strike price given in current values, while the assets F and K are given
and expiry, namely that a portfolio of a long call option in future values (forward price of asset, and strike price
and a short put option is equivalent to (and hence has the paid at expiry), which the discount factor D converts to
same value as) a single forward contract at this strike price present values.
and expiry. This is because if the price at expiry is above Using spot price S instead of forward price F yields:
the strike price, the call will be exercised, while if it is
below, the put will be exercised, and thus in either case
C P = S D K.
one unit of the asset will be purchased for the strike price,
exactly as in a forward contract.
Rearranging the terms yields a dierent interpretation:
The validity of this relationship requires that certain assumptions be satised; these are specied and the relaC + D K = P + S.
tionship derived below. In practice transaction costs and
nancing costs (leverage) mean this relationship will not
exactly hold, but in liquid markets the relationship is close In this case the left-hand side is a duciary call, which is
to exact.
long a call and enough cash (or bonds) to pay the strike

3.4. PUTCALL PARITY

price if the call is exercised, while the right-hand side is
a protective put, which is long a put and the asset, so the
asset can be sold for the strike price if the spot is below
strike at expiry. Both sides have payo max(S(T), K) at
expiry (i.e., at least the strike price, or the value of the
asset if more), which gives another way of proving or interpreting putcall parity.
In more detail, this original equation can be stated as:
C(t) P (t) = S(t) K B(t, T )
where
C(t) is the value of the call at time t ,
P (t) is the value of the put of the same expiration date,
S(t) is the spot price of the underlying asset,
K is the strike price, and
B(t, T ) is the present value of a zero-coupon
bond that matures to $1 at time T. This is the
present value factor for K.

75

3.4.3 Derivation
We will suppose that the put and call options are on traded
stocks, but the underlying can be any other tradeable asset. The ability to buy and sell the underlying is crucial
to the no arbitrage argument below.
First, note that under the assumption that there are no
arbitrage opportunities (the prices are arbitrage-free), two
portfolios that always have the same payo at time T must
have the same value at any prior time. To prove this suppose that, at some time t before T, one portfolio were
cheaper than the other. Then one could purchase (go
long) the cheaper portfolio and sell (go short) the more
expensive. At time T, our overall portfolio would, for any
value of the share price, have zero value (all the assets and
liabilities have canceled out). The prot we made at time
t is thus a riskless prot, but this violates our assumption
of no arbitrage.
We will derive the put-call parity relation by creating two
portfolios with the same payos (static replication) and
invoking the above principle (rational pricing).
Consider a call option and a put option with the same
strike K for expiry at the same date T on some stock S,
which pays no dividend. We assume the existence of a
bond that pays 1 dollar at maturity time T. The bond price
may be random (like the stock) but must equal 1 at maturity.

Note that the right-hand side of the equation is also the

price of buying a forward contract on the stock with delivery price K. Thus one way to read the equation is that
a portfolio that is long a call and short a put is the same
as being long a forward. In particular, if the underlying
is not tradeable but there exists forwards on it, we can Let the price of S be S(t) at time t. Now assemble a portreplace the right-hand-side expression by the price of a folio by buying a call option C and selling a put option P
of the same maturity T and strike K. The payo for this
forward.
portfolio is S(T) - K. Now assemble a second portfolio
If the bond interest rate, r , is assumed to be constant then by buying one share and borrowing K bonds. Note the
payo of the latter portfolio is also S(T) - K at time T,
B(t, T ) = er(T t) .
since our share bought for S(t) will be worth S(T) and the
borrowed bonds will be worth K.
Note: r refers to the force of interest, which is approxiBy our preliminary observation that identical payos immately equal to the eective annual rate for small interest
ply that both portfolios must have the same price at a genrates. However, one should take care with the approximaeral time t , the following relationship exists between the
tion, especially with larger rates and larger time periods.
value of the various instruments:
To nd r exactly, use r = ln(1 + i) , where i is the
eective annual interest rate.
C(t) P (t) = S(t) K B(t, T )
When valuing European options written on stocks with
known dividends that will be paid out during the life of
the option, the formula becomes:
Thus given no arbitrage opportunities, the above relationship, which is known as put-call parity, holds, and for
any three prices of the call, put, bond and stock one can
C(t) P (t) + D(t) = S(t) K B(t, T )
compute the implied price of the fourth.
where D(t) represents the total value of the dividends In the case of dividends, the modied formula can be defrom one stock share to be paid out over the remaining rived in similar manner to above, but with the modicalife of the options, discounted to present value. We can tion that one portfolio consists of going long a call, going
rewrite the equation as:
short a put, and D(T) bonds that each pay 1 dollar at maturity T (the bonds will be worth D(t) at time t); the other
C(t) P (t) = S(t) K B(t, T ) D(t),
portfolio is the same as before - long one share of stock,
short K bonds that each pay 1 dollar at T. The dierence
and note that the right-hand side is the price of a forward is that at time T, the stock is not only worth S(T) but has
contract on the stock with delivery price K, as before.
paid out D(T) in dividends.

76

3.4.4

CHAPTER 3. VALUATION

History

Forms of put-call parity appeared in practice as early as

medieval ages, and was formally described by a number
of authors in the early 20th century.

3.4.6 See also

Spot-future parity
Vinzenz Bronzin

Michael Knoll, in The Ancient Roots of Modern Financial

Innovation: The Early History of Regulatory Arbitrage,
describes the important role that put-call parity played in 3.4.7 References
developing the equity of redemption, the dening char[1] Cited for instance in "The illusions of dynamic replicaacteristic of a modern mortgage, in Medieval England.
In the 19th century, nancier Russell Sage used put-call
parity to create synthetic loans, which had higher interest
rates than the usury laws of the time would have normally
allowed.

tion", Emanuel Derman and Nassim Nicholas Taleb, 2005

[2] Hull, John C. (2002). Options, Futures and Other Derivatives (5th ed.). Prentice Hall. pp. 330331. ISBN 0-13009056-5.

Nelson, an option arbitrage trader in New York, published a book: The A.B.C. of Options and Arbitrage
in 1904 that describes the put-call parity in detail. His 3.4.8 Additional Sources
book was re-discovered by Espen Gaarder Haug in the
early 2000s and many references from Nelsons book are
Stoll, Hans R. (December 1969). The Relationship
given in Haugs book Derivatives Models on Models.
Between Put and Call Option Prices. The Journal
of Finance 24 (5): 801824. doi:10.2307/2325677.
Henry Deutsch describes the put-call parity in 1910 in his
JSTOR 2325677.
book Arbitrage in Bullion, Coins, Bills, Stocks, Shares
and Options, 2nd Edition. London: Engham Wilson but
in less detail than Nelson (1904).
Mathematics professor Vinzenz Bronzin also derives the
put-call parity in 1908 and uses it as part of his arbitrage argument to develop a series of mathematical option models under a series of dierent distributions. The
work of professor Bronzin was just recently rediscovered
by professor Wolfgang Hafner and professor Heinz Zimmermann. The original work of Bronzin is a book written
in German and is now translated and published in English
in an edited work by Hafner and Zimmermann (Vinzenz
Bronzins option pricing models, Springer Verlag).
Its rst description in the modern academic literature appears to be (Stoll 1969).[1]

3.4.5

Implications

Putcall parity implies:

Equivalence of calls and puts: Parity implies that a
call and a put can be used interchangeably in any
delta-neutral portfolio. If d is the calls delta, then
buying a call, and selling d shares of stock, is the
same as selling a put and buying 1 d shares of
stock. Equivalence of calls and puts is very important when trading options.
Parity of implied volatility: In the absence of dividends or other costs of carry (such as when a stock is
dicult to borrow or sell short), the implied volatility of calls and puts must be identical.[2]

3.4.9 External links

Put-Call parity
Put-call parity, tutorial by Salman Khan (educator)
Put-Call Parity of European Options, putcallparity.net
Put-Call Parity and Arbitrage Opportunity, investopedia.com
The Ancient Roots of Modern Financial Innovation: The Early History of Regulatory Arbitrage, Michael Knolls history of Put-Call Parity
Other arbitrage relationships
Arbitrage Relationships for Options, Prof.
Thayer Watkins
Rational Rules and Boundary Conditions for
Option Pricing (PDFDi), Prof. Don M.
Chance
No-Arbitrage Bounds on Options, Prof.
Robert Novy-Marx
Tools
Option Arbitrage Relations, Prof. Campbell
R. Harvey

3.5. IN THE MONEY

77

3.5 In the money

of Forward Reference Rate instead of Current Market

Price. For example the option will be In The Money if
In the money redirects here. For the poker term, see Strike Price of Buy PUT on[2]underlying is greater than
the Forward Reference Rate.
In the money (poker).
In nance, moneyness is the relative position of the current price (or future price) of an underlying asset (e.g.,
a stock) with respect to the strike price of a derivative,
most commonly a call option or a put option. Moneyness
is rstly a three-fold classication: if the derivative would
make money if it were to expire today, it is said to be in
the money, while if it would not make money it is said to
be out of the money, and if the current price and strike
price are equal, it is said to be at the money. There are
two slightly dierent denitions, according to whether
one uses the current price (spot) or future price (forward),
specied as at the money spot or at the money forward, etc.
This rough classication can be quantied by various
denitions to express the moneyness as a number, measuring how far the asset is in the money or out of the
money with respect to the strike or conversely how far
a strike is in or out of the money with respect to the spot
(or forward) price of the asset. This quantied notion of
moneyness is most importantly used in dening the relative volatility surface: the implied volatility in terms of
moneyness, rather than absolute price. The most basic of
these measures is simple moneyness, which is the ratio
of spot (or forward) to strike, or the reciprocal, depending on convention. A particularly important measure of
moneyness is the likelihood that the derivative will expire
in the money, in the risk-neutral measure. It can be measured in percentage probability of expiring in the money,
which is the forward value of a binary call option with the
given strike, and is equal to the auxiliary N(d2 ) term in
the BlackScholes formula. This can also be measured in
standard deviations, measuring how far above or below
the strike price the current price is, in terms of volatility; this quantity is given by d2 . Another closely related
measure of moneyness is the Delta of a call or put option, which is often used by traders but actually equals
N(d1 ), not N(d2 ), and there are others, with convention
depending on market.[1]

3.5.2 Intrinsic value and time value

The intrinsic value (or monetary value) of an option is
its value assuming it were exercised immediately. Thus
if the current (spot) price of the underlying security (or
commodity etc.) is above the agreed (strike) price, a call
has positive intrinsic value (and is called in the money),
while a put has zero intrinsic value (and is out of the
money).
The time value of an option is the total value of the option, less the intrinsic value. It partly arises from the uncertainty of future price movements of the underlying.
A component of the time value also arises from the unwinding of the discount rate between now and the expiry
date. In the case of a European option, the option cannot
be exercised before the expiry date, so it is possible for
the time value to be negative; for an American option if
the time value is ever negative, you exercise it (ignoring
special circumstances such as the security going ex dividend): this yields a boundary condition.

3.5.3 Moneyness terms

At the money
An option is at the money (ATM) if the strike price is the
same as the current spot price of the underlying security.
An at-the-money option has no intrinsic value, only time
value.[3]
For example, with an at the money call stock option,
the current share price and strike price are the same. Exercising the option will not earn the seller a prot, but any
move upward in stock price will give the option value.

Since an option will rarely be exactly at the money, except for when it is written (when one may buy or sell an
ATM option), one may speak informally of an option being near the money or close to the money.[4] Similarly,
given standardized options (at a xed set of strikes, say
every $1), one can speak of which one is nearest the
3.5.1 Example
money; near the money may narrowly refer specically to the nearest the money strike. Conversely, one
Suppose the current stock price of IBM is $100. A call or may speak informally of an option being far from the
put option with a strike of $100 is at-the-money. A call money.
option with a strike of $80 is in-the-money (100 80 =
20 > 0). A put option with a strike at $80 is out-of-themoney (80 100 = 20 < 0). Conversely, a call option In the money
with a $120 strike is out-of-the-money and a put option
with a $120 strike is in-the-money. Though the above An in the money (ITM) option has positive intrinsic
is a traditional way of calculating ITM, OTM and ATM, value as well as time value. A call option is in the money
some new authors nd the comparison of strike price with when the strike price is below the spot price. A put opcurrent market price meaningless and recommend the use tion is in the money when the strike price is above the spot

78

CHAPTER 3. VALUATION

price.

implied volatility (concretely the ATM implied volatilWith an in the money call stock option, the current ity), yielding a function:
share price is greater than the strike price so exercising
the option will give the owner of that option a prot. That
will be equal to the market price of the share, minus the M (S, K, , r, ),
option strike price, times the number of shares granted
where S is the spot price of the underlying, K is the strike
by the option (minus any commission).
price, is the time to expiry, r is the risk-free rate, and
is the implied volatility. The forward price F can be comOut of the money
puted from the spot price S and the risk-free rate r. All
of these are observables except for the implied volatility,
An out of the money (OTM) option has no intrinsic which can computed from the observable price using the
value. A call option is out of the money when the strike BlackScholes formula.
price is above the spot price of the underlying security.
In order for this function to reect moneyness i.e., for
A put option is out of the money when the strike price is
moneyness to increase as spot and strike move relative to
below the spot price.
each other it must be monotone in both spot S and in
With an out the money call stock option, the current strike K (equivalently forward F, which is monotone in S),
share price is less than the strike price so there is no reason with at least one of these strictly monotone, and have opto exercise the option. The owner can sell the option, or posite direction: either increasing in S and decreasing in
wait and hope the price changes.
K (call moneyness) or decreasing in S and increasing in K
(put moneyness). Somewhat dierent formalizations are
possible.[5] Further axioms may also be added to dene a
3.5.4 Spot versus forward
valid moneyness.
Assets can have a forward price (a price for delivery in
future) as well as a spot price. One can also talk about
moneyness with respect to the forward price: thus one
talks about ATMF, ATM Forward, and so forth. For
instance, if the spot price for USD/JPY is 120, and the
forward price one year hence is 110, then a call struck at
110 is ATMF but not ATM.

3.5.5

Use

Buying an ITM option is eectively lending money in the

amount of the intrinsic value. Further, an ITM call can be
replicated by entering a forward and buying an OTM put
(and conversely). Consequently, ATM and OTM options
are the main traded ones.

3.5.6

Denition

Moneyness function
Intuitively speaking, moneyness and time to expiry form
a two-dimensional coordinate system for valuing options
(either in currency (dollar) value or in implied volatility),
and changing from spot (or forward, or strike) to moneyness is a change of variables. Thus a moneyness function is a function M with input the spot price (or forward,
or strike) and output a real number, which is called the
moneyness. The condition of being a change of variables is that this function is monotone (either increasing
for all inputs, or decreasing for all inputs), and the function can depend on the other parameters of the Black
Scholes model, notably time to expiry, interest rates, and

This denition is abstract and notationally heavy; in practice relatively simple and concrete moneyness functions
are used, and arguments to the function are suppressed
for clarity.

Conventions
When quantifying moneyness, it is computed as a single
number with respect to spot (or forward) and strike, without specifying a reference option. There are thus two conventions, depending on direction: call moneyness, where
moneyness increases if spot increases relative to strike,
and put moneyness, where moneyness increases if spot
decreases relative to strike. These can be switched by
changing sign, possibly with a shift or scale factor (e.g.,
the probability that a put with strike K expires ITM is
one minus the probability that a call with strike K expires
ITM, as these are complementary events). Switching spot
and strike also switches these conventions, and spot and
strike are often complementary in formulas for moneyness, but need not be. Which convention is used depends
on the purpose. The sequel uses call moneyness as spot
increases, moneyness increases and is the same direction as using call Delta as moneyness.
While moneyness is a function of both spot and strike,
usually one of these is xed, and the other varies. Given
a specic option, the strike is xed, and dierent spots
yield the moneyness of that option at dierent market
prices; this is useful in option pricing and understanding the BlackScholes formula. Conversely, given market
data at a given point in time, the spot is xed at the current market price, while dierent options have dierent
strikes, and hence dierent moneyness; this is useful in

3.5. IN THE MONEY

79

constructing an implied volatility surface, or more simply pendent of time to expiry.[6]

plotting a volatility smile.[1]
This measure does not account for the volatility of the
underlying asset. Unlike previous inputs, volatility is not
directly observable from market data, but must instead
Simple examples
be computed in some model, primarily using ATM implied volatility in the BlackScholes model. Dispersion
This section outlines moneyness measures from simple is proportional to volatility, so standardizing by volatility
but less useful to more complex but more useful.[6] Sim- yields:[9]
pler measures of moneyness can be computed immediately from observable market data without any theoretiln (F /K)
cal assumptions, while more complex measures use the

m=
.
implied volatility, and thus the BlackScholes model.

The simplest (put) moneyness is xed-strike moneyness,[5] where M=K, and the simplest call moneyness
is xed-spot moneyness, where M=S. These are also
known as absolute moneyness, and correspond to not
changing coordinates, instead using the raw prices as
measures of moneyness; the corresponding volatility surface, with coordinates K and T (tenor) is the absolute
volatility surface. The simplest non-trivial moneyness is
the ratio of these, either S/K or its reciprocal K/S, which
is known as the (spot) simple moneyness,[6] with analogous forward simple moneyness. Conventionally the xed
quantity is in the denominator, while the variable quantity
is in the numerator, so S/K for a single option and varying spots, and K/S for dierent options at a given spot,
such as when constructing a volatility surface. A volatility surface using coordinates a non-trivial moneyness M
and time to expiry is called the relative volatility surface
(with respect to the moneyness M).

This is known as the standardized moneyness (forward), and measures moneyness in standard deviation
units.
In words, the standardized moneyness is the number of
standard deviations the current forward price is above the
strike price. Thus the moneyness is zero when the forward price of the underlying equals the strike price, when
the option is at-the-money-forward. Standardized moneyness is measured in standard deviations from this point,
with a positive value meaning an in-the-money call option and a negative value meaning an out-of-the-money
call option (with signs reversed for a put option).
BlackScholes formula auxiliary variables

The standardized moneyness is closely related to the auxiliary variables in the BlackScholes formula, namely the
While the spot is often used by traders, the forward is terms d = d1 and d = d2 , which are dened as:
preferred in theory, as it has better properties,[6][7] thus
F/K will be used in the sequel. In practice, for low interest
rates and short tenors, spot versus forward makes little
ln (F /K) ( 2 /2)

d =
.
dierence.[5]

In (call) simple moneyness, ATM corresponds to moneyThe standardized moneyness is the average of these:
ness of 1, while ITM corresponds to greater than 1, and
OTM corresponds to less than 1, with equivalent levels
of ITM/OTM corresponding to reciprocals. This is linln(F /K)

earized by taking the log, yielding the log simple money- m =

= 12 (d + d+ ) ,

ness ln (F /K) . In the log simple moneyness, ATM corresponds to 0, while ITM is positive and OTM is negative, and they are ordered as:
and corresponding levels of ITM/OTM corresponding to
switching sign. Note that once logs are taken, moneyness
in terms of forward or spot dier by an additive factor
d < m < d+ ,
(log of discount factor), as ln (F /K) = ln(S/K) + rT.

The above measures are independent of time, but for a diering only by a step of /2 in each case. This is
given simple moneyness, options near expiry and far for often small, so the quantities are often confused or conexpiry behave dierently, as options far from expiry have ated, though they have distinct interpretations.
more time for the underlying to change. Accordingly,
As these are all in units of standard deviations, it makes
one may incorporate time to maturity into moneyness.
sense to convert these to percentages, by evaluating the
Since dispersion of Brownian motion is proportional to
standard normal cumulative distribution function N for
the square root of time, one may divide the log/simthese values. The interpretation of these quantities is

. somewhat subtle, and consists of changing to a riskple moneyness by this factor, yielding:[8] ln (F /K)
This eectively normalizes for time to expiry with this neutral measure with specic choice of numraire. In
measure of moneyness, volatility smiles are largely inde- brief, these are interpreted (for a call option) as:

80

CHAPTER 3. VALUATION

N(d) is the (Future Value) price of a binary call 3.5.7 References

option, or the risk-neutral likelihood that the option
will expire ITM, with numraire cash (the risk-free [1] (Neftci 2008, 11.2 How Can We Dene Moneyness? pp.
458460)
asset);
N(m) is the percentage corresponding to standardized moneyness;
N(d) is the Delta, or the risk-neutral likelihood that
the option will expire ITM, with numraire asset.
These have the same ordering, as N is monotonic (since
it is a CDF):

[2] Chugh, Aman (2013). Financial Derivatives- The Currency and Rates Factor (First ed.). New Delhi: Dorling
Kindersly (India) Pvt Ltd, licensees of Pearson Education
in South Asia. p. 60. ISBN 978-81-317-7433-5. Retrieved 18 August 2014.
[3] At the Money Denition, Cash Bauer 2012
[4] "Near The Money", Investopedia
[5] (Hfner 2004, Denition 3.12, p. 42)

N (d ) < N (m) < N (d+ ) = .

Of these, N(d) is the (risk-neutral) likelihood of expiring in the money, and thus the theoretically correct
percent moneyness, with d the correct moneyness. The
percent moneyness is the implied probability that the
derivative will expire in the money, in the risk-neutral
measure. Thus a moneyness of 0 yields a 50% probability of expiring ITM, while a moneyness of 1 yields an
approximately 84% probability of expiring ITM.
This corresponds to the asset following geometric Brownian motion with drift r, the risk-free rate, and diusion ,
the implied volatility. Drift is the mean, with the corresponding median (50th percentile) being r2 /2, which
is the reason for the correction factor. Note that this is
the implied probability, not the real-world probability.

[6] (Hfner 2004, Section 5.3.1, Choice of Moneyness Measure, pp. 8587)
[7] (Natenberg 1994, pp. 106110)
[8] (Natenberg 1994)
[9] (Tompkins 1994), who uses spot rather than forward.

Hfner, Reinhold (2004). Stochastic Implied Votality: A Factor-Based Model. Lecture Notes in Economics and Mathematical Systems (545) (Paperback ed.). Berlin: Springer-Verlag. ISBN 978-3540-22183-8.
McMillan, Lawrence G. (2002). Options as a Strategic Investment (4th ed. ed.). New York : New York
Institute of Finance. ISBN 0-7352-0197-8.

The other quantities (percent) standardized moneyness

Natenberg, Sheldon (1994). Option Volatility &
and Delta are not identical to the actual percent monPricing: Advanced Trading Strategies and Techeyness, but in many practical cases these are quite close
niques. McGraw-Hill. ISBN 978-1-55738486-7.
(unless volatility is high or time to expiry is long), and
Delta is commonly used by traders as a measure of (per Nefti, Salih N. (2008). Principles of Financial Encent) moneyness.[5] Delta is more than moneyness, with
gineering (2nd ed.). Academic Press. ISBN 978-0the (percent) standardized moneyness in between. Thus
12-373574-4.
a 25 Delta call option has less than 25% moneyness, usually slightly less, and a 50 Delta ATM call option has
Tompkins, Robert (1994). Options Explained2 .
less than 50% moneyness; these discrepancies can be obMacmillan Business: Finance and Capital Markets
served in prices of binary options and vertical spreads.
(2nd ed.). Palgrave. ISBN 978-0-33362807-2.
Note that for puts, Delta is negative, and thus negative
Delta is used more uniformly, absolute value of Delta
3.5.8 External links
is used for call/put moneyness.
The meaning of the factor of (2 /2) is relatively subtle.
For d and m this corresponds to the dierence between
the median and mean (respectively) of geometric Brownian motion (the log-normal distribution), and is the same
correction factor in It's lemma for geometric Brownian
motion. The interpretation of d, as used in Delta, is
subtler, and can be interpreted most elegantly as change
of numraire. In more elementary terms, the probability
that the option expires in the money and the value of the
underlying at exercise are not independent the higher
the price of the underlying, the more likely it is to expire
in the money and the higher the value at exercise, hence
why Delta is higher than moneyness.

Renicker, Ryan, Devapriya Mallick. "Enhanced

Call Overwriting." Lehman Brothers Equity Derivatives Strategy. (Nov 17, 2005).

3.6 Option time value

In nance, the time value (TV) (extrinsic or instrumental value) of an option is the premium a rational investor
would pay over its current exercise value (intrinsic value),
based on the probability it will increase in value before
expiry. For an American option this value is always

3.6. OPTION TIME VALUE

81

greater than zero in a fair market, thus an option is always worth more than its current exercise value.[1] For
a European option, the extrinsic value can be negative.
As an option can be thought of as price insurance (e.g.,
an airline insuring against unexpected soaring fuel costs
caused by a hurricane), TV can be thought of as the risk
premium the option seller charges the buyer the higher
the expected risk (volatility time), the higher the premium. Conversely, TV can be thought of as the price an
investor is willing to pay for potential upside.
TV decays to zero at expiration, with a general rule that it
will lose of its value during the rst half of its life and
in the second half. As an option moves closer to expiry,
moving its price requires an increasingly larger move in
the price of the underlying security.[2]

3.6.1

Intrinsic value
Option Value

The intrinsic value (IV) of an option is the value of exercising it now. If the price of the underlying stock is above
a call option strike price, the option has a positive monetary value, and is referred to as being in-the-money. If the
underlying stock is priced cheaper than the call options
strike price, the call option is referred to as being out-ofthe-money. If an option is out-of-the-money at expiration, its holder simply abandons the option and it expires
worthless. Hence, a purchased option can never have a
negative value.[3] This is because a rational investor would
choose to buy the underlying stock at market rather than
exercise an out-of-the-money call option to buy the same
stock at a higher-than-market price.

thus the higher the option price; for an in-the-money option the chance of being in the money decreases; however
the fact that the option cannot have negative value also
works in the owners favor. The sensitivity of the option
value to the amount of time to expiry is known as the options theta. The option value will never be lower than its
IV.
As seen on the graph, the full call option value (IV + TV),
at a given time t, is the red line.[4]

3.6.3 Time value

For the same reasons, a put option is in-the-money if it

allows the purchase of the underlying at a market price Time value is, as above, the dierence between option
below the strike price of the put option. A put option is value and intrinsic value, i.e.
out-of-the-money if the underlyings spot price is higher
Time Value = Option Value - Intrinsic Value.
than the strike price.
As shown in the below equations and graph, the Intrinsic
More specically, TV reects the probability that the opValue (IV) of a call option is positive when the underlying
tion will gain in IV become (more) protable to exassets spot price S exceeds the options strike price K.
ercise before it expires.[5] An important factor is the options volatility. Volatile prices of the underlying instrument can stimulate option demand, enhancing the value.
Value of a call option: max[(S K), 0] , or
Numerically, this value depends on the time until the
(S K)+
expiration date and the volatility of the underlying instruValue of a put option: max[(K S), 0] , or
ments price. TV of American option cannot be negative
(K S)+
(because the option value is never lower than IV), and
converges to zero at expiration. Prior to expiration, the
change in TV with time is non-linear, being a function of
3.6.2 Option value
the option price.[6]
Option value (i.e.,. price) is estimated via a predictive formula such as Black-Scholes or using a numerical 3.6.4 See also
method such as the Binomial model. This price incorpo Intrinsic value (nance)
rates the expected probability of the option nishing "inthe-money". For an out-of-the-money option, the further
Naked call
in the future the expiration date i.e. the longer the time
Time value of money
to exercise the higher the chance of this occurring, and

82

3.6.5

CHAPTER 3. VALUATION

References

[1] Note, however, that there is also a cost component of holding an option (or any asset), based on the time value of
money.
[2] Understanding Option Pricing Hans Wagner
[3] Understanding Option Pricing Hans Wagner
[4] Note that the X axis is not time the graph represents the
relationship between price and value at a particular time.
With more time left to expiration, the red curve would
be higher; the closer to expiration, the more it would approach the blue intrinsic value line.
[5] Option premium valuation 22 August 2007
[6] Options: Time Value, wolfram.com

The value of an option is the sum of its intrinsic and its

time value.

3.7.2 Equity
See also: Valuation using discounted cash ows and John
Burr Williams Theory
In valuing equity, securities analysts may use fundamental
analysisas opposed to technical analysisto estimate
the intrinsic value of a company. Here the intrinsic
characteristic considered is the expected cash ow production of the company in question. Intrinsic value is
therefore dened to be the present value of all expected
future net cash ows to the company; it is calculated via
discounted cash ow valuation.

An alternative, though related approach, is to view intrinsic value as the value of a business ongoing operations, as
Basic Options Concepts: Intrinsic Value and Time opposed to its accounting based book value, or break-up
value. Warren Buett is known for his ability to calculate
Value, biz.yahoo.com
the intrinsic value of a business, and then buy that business when its price is at a discount to its intrinsic value.

3.6.6

External links

3.7 Intrinsic value

3.7.3 Real estate

This article is about the valuation of nancial assets. For

the philosophy of economic value, see Intrinsic theory In valuing real estate, a similar approach may be used.
of value.
The intrinsic value of real estate is therefore dened as
the net present value of all future net cash ows which
In nance, intrinsic value refers to the value of a com- are foregone by buying a piece of real estate instead of
pany, stock, currency or product determined through renting it in perpetuity. These cash ows would include
fundamental analysis without reference to its market rent, ination, maintenance and property taxes. This calvalue.[1] It is also frequently called fundamental value. culation can be done using the Gordon model.
It is ordinarily calculated by summing the discounted future income generated by the asset to obtain the present
value. It is worthy to note that this term may have dier- 3.7.4 See also
ent meanings for dierent assets.
Net realizable value

3.7.1

Options

An option is said to have intrinsic value if the option is inthe-money. When out-of-the-money, its intrinsic value is
zero.

Option time value

Option (nance)
Expected value

The intrinsic value for an in-the-money option is calcu- 3.7.5 References

lated as the absolute value of the dierence between the
current price (S) of the underlying and the strike price (K) [1] An Introduction to Fundamental Analysis and the US
of the option.
Economy. InformedTrades.com. 2008-02-14. Retrieved 2009-07-27.

IVoutofthemoney = 0
IVinthemoney = |S K| = |K S|
For example, if the strike price for a call option is USD
$1 and the price of the underlying is USD 1.20, then the
option has an intrinsic value of USD 0.20.

3.7.6 External links

Investopedia
http://www.svtuition.org/2014/01/
intrinsic-value-analysis.html

3.8. BLACK MODEL

83

Stock Fair Value calculator after applying Intrinsic 3.8.2 Derivation and assumptions
value
The Black formula is easily derived from use of
Intrinsic Value Calculator
Margrabes formula, which in turn is a simple, but clever,
application of the BlackScholes formula.

3.8 Black model

The Black model (sometimes known as the Black-76
model) is a variant of the BlackScholes option pricing
model. Its primary applications are for pricing options on
future contracts, bond options, interest rate caps / oors,
and swaptions. It was rst presented in a paper written by
Fischer Black in 1976.

The payo of the call option on the futures contract is

max (0, F(T) - K). We can consider this an exchange
(Margrabe) option by considering the rst asset to be
er(T t) F (t) and the second asset to be the riskless bond
paying o $1 at time T. Then the call option is exercised
at time T when the rst asset is worth more than K riskless bonds. The assumptions of Margrabes formula are
satised with these assets.

The only remaining thing to check is that the rst asset is

Blacks model can be generalized into a class of models indeed an asset. This can be seen by considering a portknown as log-normal forward models, also referred to as folio formed at time 0 by going long a forward contract
LIBOR market model.
with delivery date T and short F(0) riskless bonds (note
that under the deterministic interest rate, the forward and
futures prices are equal so there is no ambiguity here).
3.8.1 The Black formula
Then at any time t you can unwind your obligation for
the forward contract by shorting another forward with the
The Black formula is similar to the BlackScholes forsame delivery date to get the dierence in forward prices,
mula for valuing stock options except that the spot price
but discounted to present value: er(T t) [F (t) F (0)]
of the underlying is replaced by a discounted futures price
. Liquidating the F(0) riskless bonds, each of which is
F.
worth er(T t) , results in a net payo of er(T t) F (t)
Suppose there is constant risk-free interest rate r and the .
futures price F(t) of a particular underlying is log-normal
with constant volatility . Then the Black formula states
the price for a European call option of maturity T on a 3.8.3 See also
futures contract with strike price K and delivery date T'
Financial mathematics
(with T T ) is
BlackScholes
c = erT [F N (d1 ) KN (d2 )]
The corresponding put price is

3.8.4 External links

Discussion

p = erT [KN (d2 ) F N (d1 )]

where

Bond Options, Caps and the Black Model Dr. Milica Cudina, University of Texas at Austin
Online tools

ln(F /K) + ( 2 /2)T

d1 =
T

ln(F /K) ( 2 /2)T

= d1 T ,
T
and N(.) is the cumulative normal distribution function.
d2 =

Caplet And Floorlet Calculator Dr. Shing Hing

Man, Thomson-Reuters Risk Management
'Greeks Calculator using the Black model, Razvan
Pascalau, Univ. of Alabama

Note that T' doesn't appear in the formulae even though

3.8.5 References
it could be greater than T. This is because futures contracts are marked to market and so the payo is realized
Black, Fischer (1976). The pricing of commodity
when the option is exercised. If we consider an option
contracts, Journal of Financial Economics, 3, 167on a forward contract expiring at time T' > T, the payo
179.
doesn't occur until T' . Thus the discount factor erT is

Garman, Mark B. and Steven W. Kohlhagen (1983).

replaced by erT since one must take into account the
time value of money. The dierence in the two cases is
Foreign currency option values, Journal of Internaclear from the derivation below.
tional Money and Finance, 2, 231-237.

84

CHAPTER 3. VALUATION

Miltersen, K., Sandmann, K. et Sondermann, D.,

(1997): Closed Form Solutions for Term Structure
Derivates with Log-Normal Interest Rates, Journal
of Finance, 52(1), 409-430.

3.9 Finite dierence methods for

option pricing

a function of the value at later and adjacent points;

see Stencil (numerical analysis);
2. the value at each point is then found using the technique in question.
The value of the option today, where the underlying
is at its spot price, (or at any time/price combination,) is then found by interpolation.

Finite dierence methods for option pricing are

numerical methods used in mathematical nance for the
3.9.2 Application
valuation of options.[1] Finite dierence methods were
rst applied to option pricing by Eduardo Schwartz in
As above, these methods can solve derivative pricing
1977.[2][3]:180
problems that have, in general, the same level of complexIn general, nite dierence methods are used to price op- ity as those problems solved by tree approaches,[1] but,
tions by approximating the (continuous-time) dierential given their relative complexity, are usually employed only
equation that describes how an option price evolves over when other approaches are inappropriate. At the same
time by a set of (discrete-time) dierence equations. The time, like tree-based methods, this approach is limited
discrete dierence equations may then be solved itera- in terms of the number of underlying variables, and for
tively to calculate a price for the option.[4] The approach problems with multiple dimensions, Monte Carlo metharises since the evolution of the option value can be ods for option pricing are usually preferred. [3]:182 Note
modelled via a partial dierential equation (PDE), as a that, when standard assumptions are applied, the explicit
function of (at least) time and price of underlying; see technique encompasses the binomial- and trinomial tree
for example BlackScholes PDE. Once in this form, a - methods.[6] Tree based methods, then, suitably paramenite dierence model can be derived, and the valuation terized, are a special case of the explicit nite dierence
obtained.[2]
method.[7]
The approach can be used to solve derivative pricing
problems that have, in general, the same level of com3.9.3
plexity as those problems solved by tree approaches.[1]

3.9.1

Method

References

[1] Hull, John C. (2002). Options, Futures and Other Derivatives (5th ed.). Prentice Hall. ISBN 0-13-009056-5.

As above, the PDE is expressed in a discretized form,

using nite dierences, and the evolution in the option
price is then modelled using a lattice with corresponding
dimensions: time runs from 0 to maturity; and price runs
from 0 to a high value, such that the option is deeply
in or out of the money. The option is then valued as
follows:[5]

[2] Schwartz, E. (January 1977). The Valuation of Warrants: Implementing a New Approach. Journal of
Financial Economics 4: 7994. doi:10.1016/0304405X(77)90037-X.

Maturity values are simply the dierence between

the exercise price of the option and the value of the
underlying at each point.

[4] Phil Goddard (N.D.). Option Pricing - Finite Dierence

Methods

Values at the boundary prices are set based on

moneyness or arbitrage bounds on option prices.
Values at other lattice points are calculated
recursively (iteratively), starting at the time step
preceding maturity and ending at time = 0. Here,
using a technique such as CrankNicolson or the
explicit method:
1. the PDE is discretized per the technique chosen,
such that the value at each lattice point is specied as

[3] Boyle, Phelim; Feidhlim Boyle (2001). Derivatives: The

Tools That Changed Finance. Risk Publications. ISBN
189933288X.

[5] Wilmott, P.; Howison, S.; Dewynne, J. (1995). The Mathematics of Financial Derivatives: A Student Introduction.
Cambridge University Press. ISBN 0-521-49789-2.
[6] Brennan, M.; Schwartz, E. (September 1978). Finite
Dierence Methods and Jump Processes Arising in the
Pricing of Contingent Claims: A Synthesis. Journal of
Financial and Quantitative Analysis (University of Washington School of Business Administration) 13 (3): 461
474. doi:10.2307/2330152. JSTOR 2330152.
[7] Rubinstein, M. (2000). On the Relation Between Binomial and Trinomial Option Pricing Models. Journal of
Derivatives 8 (2): 4750. doi:10.3905/jod.2000.319149.

3.10. VARIANCE GAMMA PROCESS

3.9.4

85

External links

Notes
Option Pricing Using Finite Dierence Methods,
Prof. Don M. Chance, Louisiana State University
Finite Dierence Approach to Option Pricing (includes Matlab Code); Numerical Solution of Black
Scholes Equation, Tom Coleman, Cornell University
Option Pricing - Finite Dierence Methods, Dr.
Phil Goddard
Numerically Solving PDEs: Crank-Nicolson Algo- Three sample paths of variance gamma processes (in resp. red,
rithm, Prof. R. Jones, Simon Fraser University
green, black)
Numerical Schemes for Pricing Options, Prof. Yue
Kuen Kwok, Hong Kong University of Science and
Technology

X V G (t; , , ) := (t; 1, ) + W ((t; 1, )) .

Introduction to the Numerical Solution of Partial An alternative way of stating this is that the variance
Dierential Equations in Finance, Claus Munk, gamma process is a Brownian motion subordinated to a
University of Aarhus
Gamma subordinator.
Numerical Methods for the Valuation of Financial Since the VG process is of nite variation it can be written
Derivatives, D.B. Ntwiga, University of the Western as the dierence of two independent gamma processes:[1]
Cape
The Finite Dierence Method, Katia Rocha, X V G (t; , , ) := (t; , 2 ) (t; , 2 )
q
p
q
p
Instituto de Pesquisa Econmica Aplicada
where
Analytical Finance: Finite dierence methods, Jan
Rman, Mlardalen University

2
1
2
2 2

1
p :=
2 +
2 +
+
and
q :=

Online tools
2

2
2

2
Finite Dierence Method, pricing-option.com

3.10 Variance gamma process

In the theory of stochastic processes, a part of the mathematical theory of probability, the variance gamma process (VG), also known as Laplace motion, is a Lvy process determined by a random time change. The process
has nite moments distinguishing it from many Lvy processes. There is no diusion component in the VG process and it is thus a pure jump process. The increments
are independent and follow a Variance-gamma distribution, which is a generalization of the Laplace distribution.

Alternatively it can be approximated by a compound

Poisson process that leads to a representation with explicitly given (independent) jumps and their locations.
This last characterization gives an understanding of the
structure of the sample path with location and sizes of
jumps.[2]
On the early history of the variance-gamma process see
Seneta (2000).[3]

3.10.1 Moments
The mean of a variance gamma process is independent of
and and is given by

There are several representations of the VG process that E[X(t)] = t

relate it to other processes. It can for example be written as a Brownian motion W (t) with drift t subjected The variance is given as
to a random time change which follows a gamma process
(t; 1, ) (equivalently one nds in literature the notation
(t; = 1/, = 1/) ):
V ar[X(t)] = (2 + 2 )t

86

CHAPTER 3. VALUATION

The 3rd central moment is

Simulating VG as Gamma time-changed Brownian

Motion

E[(X(t) E[X(t)])3 ] = (23 2 + 3 2 )t

Input: VG parameters, , and time increments

N
t1 , . . . tN , where i=1 ti = T.

The 4th central moment is

Initialization: Set X(0)=0.

Loop: For i = 1 to N:

E[(X(t)E[X(t)]) ] = (3 +12 +6 )t+(3 +6 2 2 +34 2 )t2

1. Generate independent gamma Gi

(ti /, ) , and normal Zi N (0, 1) variates, independently of past random variates.

3.10.2 Option pricing

2.
Return
X(t
)
=
X(t
)
+
G
+

Gi Zi .
i
i1
i
The VG process can be advantageous to use when pricing
options since it allows for a wider modeling of skewness
and kurtosis than the Brownian motion does. As such Simulating VG as dierence of Gammas
the variance gamma model allows to consistently price
options with dierent strikes and maturities using a sin- This approach[9][10] is based on the dierence of gamma
gle set of parameters. Madan and Seneta present a sym- representation X V G (t; , , ) = (t; p , 2 )
p
metric version of the variance gamma process.[4] Madan, (t; q , 2 ) , where p , q , are dened as above.
q
Carr and Chang [1] extend the model to allow for an asymmetric form and present a formula to price European op Input: VG parameters , , , p , q ] and time inN
tions under the variance gamma process.
crements t1 , . . . tN , where i=1 ti = T.
Hirsa and Madan show how to price American options
Initialization: Set X(0)=0.
under variance gamma.[5] Fiorani presents numerical solutions for European and American barrier options under
Loop: For i = 1 to N:
variance gamma process.[6] He also provides computer
programming code to price vanilla and barrier European
1. Generate independent gamma variates i
and American barrier options under variance gamma pro(ti /, q ), i+ (ti /, p ), indecess.
pendently of past random variates.
Lemmens et al.[7] construct bounds for arithmetic Asian

options for several Lvy models including the variance

2. Return X(ti ) = X(ti1 ) + +
i (t) i (t).
gamma model.

3.10.3

2 2 2

4 3

Simulating a VG path by dierence of gamma bridge

Applications to Credit Risk Model- sampling

ing
The variance gamma process has been successfully applied in the modeling of credit risk in structural models.
The pure jump nature of the process and the possibility
to control skewness and kurtosis of the distribution allow
the model to price correctly the risk of default of securities having a short maturity, something that is generally
not possible with structural models in which the underlying assets follow a Brownian motion. Fiorani, Luciano
and Semeraro[8] model credit default swaps under variance gamma. In an extensive empirical test they show the
overperformance of the pricing under variance gamma,
compared to alternative models presented in literature.

3.10.4

Simulation

Monte Carlo methods for the variance gamma process are

described by Fu (2000).[9] Algorithms are presented by
Korn et al. (2010).[10]

To be continued ...
Variance Gamma as 2-EPT distribution
Under the restriction that 1 is integer the Variance
Gamma distribution can be represented as a 2-EPT Probability Density Function. Under this assumption it is
possible to derive closed form vanilla option prices and
their associated Greeks. For a comprehensive description see.[11]

3.10.5 References
[1] Dilip Madan, Peter Carr, Eric Chang (1998). The Variance Gamma Process and Option Pricing. European FinanceReview 2: 79105.
[2] Samuel Kotz, Tomasz J. Kozubowski, Krzysztof
Podgrski (2001).
The Laplace Distribution and
Generalizations. Birkhuser.

3.11. HEATH-JARROW-MORTON FRAMEWORK

87

[3] Eugene Seneta (2000). The Early Years of the Variance

Gamma Process. In Michael C. Fu, Robert A. Jarrow,
Ju-Yi J. Yen, and Robert J. Elliott. Advances in Mathematical Finance. Boston: Birkhauser. ISBN 978-0-81764544-1.

paper (revised ed.), Cornell University. It has its critics,

however, with Paul Wilmott describing it as "...actually
just a big rug for [mistakes] to be swept under.[2]

[4] Madan, Dilip B.; Seneta, Eugene (1990).

The
Variance Gamma (V.G.) Model for Share Market
Journal of Business 63 (4): 511524.
Returns.
doi:10.1086/296519. JSTOR 2353303.

3.11.1 Framework

[5] Hirsa, Ali; Madan, Dilip B. (2003). Pricing American

Options Under Variance Gamma. Journal of Computational Finance 7 (2): 6380.

The key to these techniques is the recognition that the

drifts of the no-arbitrage evolution of certain variables
can be expressed as functions of their volatilities and the
correlations among themselves. In other words, no drift
estimation is needed.

Models developed according to the HJM framework are

dierent from the so-called short-rate models in the sense
that HJM-type models capture the full dynamics of the
[7] Lemmens, Damiaan; Liang, Ling Zhi; Tempere, Jacques; entire forward rate curve, while the short-rate models
De Schepper, Ann (2010), Pricing bounds for discrete only capture the dynamics of a point on the curve (the
arithmetic Asian options under Lvy models, Physica A: short rate).
[6] Filo Fiorani (2004). Option Pricing Under the Variance
Gamma Process. Unpublished dissertation. p. 380. PDF.

Statistical Mechanics and its Applications 389 (22): 5193

5207, doi:10.1016/j.physa.2010.07.026

However, models developed according to the general

HJM framework are often non-Markovian and can even
[8] Filo Fiorani, Elisa Luciano and Patrizia Semeraro, (2007), have innite dimensions. A number of researchers have
Single and Joint Default in a Structural Model with Purely made great contributions to tackle this problem. They
Discontinuous Assets, Working Paper No. 41, Carlo Al- show that if the volatility structure of the forward rates
berto Notebooks, Collegio Carlo Alberto. URL PDF
satisfy certain conditions, then an HJM model can be ex[9] Michael C. Fu (2000). Variance-Gamma and Monte pressed entirely by a nite state Markovian system, makCarlo. In Michael C. Fu, Robert A. Jarrow, Ju-Yi J. Yen, ing it computationally feasible. Examples include a oneand Robert J. Elliott. Advances in Mathematical Finance. factor, two state model (O. Cheyette, Term Structure
Dynamics and Mortgage Valuation, Journal of Fixed InBoston: Birkhauser. ISBN 978-0-8176-4544-1.
come, 1, 1992; P. Ritchken and L. Sankarasubramanian
[10] Ralf Korn, Elke Korn, and Gerald Kroisandt (2010). in Volatility Structures of Forward Rates and the DyMonte Carlo Methods and Models in Finance and Insur- namics of Term Structure, Mathematical Finance, 5, No.
ance. Boca Raton, Fla.: Chapman and Hall/CRC. ISBN
1, Jan 1995), and later multi-factor versions.
978-1-4200-7618-9. (Section 7.3.3)

[11] Sexton, C. and Hanzon,B.,"State Space Calculations for

two-sided EPT Densities with Financial Modelling Applications, www.2-ept.com

3.11 Heath-Jarrow-Morton framework

3.11.2 Mathematical formulation

The class of models developed by Heath, Jarrow and
Morton (1992) is based on modeling the forward rates,
yet it does not capture all of the complexities of an evolving term structure.

The instantaneous forward rate f (t, T ) , t T is the

The HeathJarrowMorton (HJM) framework is a continuous compounding rate available at time T as seen
general framework to model the evolution of interest rate from time t . It is dened by:
logP (t,T )

curve instantaneous forward rate curve in particular (as f (t, T ) = 1

, (1)
P (t,T ) T P (t, T ) =
T
opposed to simple forward rates). When the volatility
and drift of the instantaneous forward rate are assumed to The basic relation between the rates and the bond prices
be deterministic, this is known as the Gaussian Heath is given by:

JarrowMorton (HJM) model of forward rates.[1]:394 P (t, T ) = e tT f (t,s) ds . (2)

For direct modeling of simple forward rates the Brace
Consequently, the bank account (t) grows according to:
GatarekMusiela model represents an example.
t
f (s,s) ds
(3)
The HJM framework originates from the work of David (t) = e 0
Heath, Robert A. Jarrow, and Andrew Morton in the late since the spot rate at time t is r(t) = f (t, t) .
1980s, especially Bond pricing and the term structure of
interest rates: a new methodology (1987) working paper, The assumption of the HJM model is that the forward
Cornell University, and Bond pricing and the term struc- rates f (t, T ) satisfy for any T :
ture of interest rates: a new methodology (1989) working df (t, T ) = (t, T ) dt + (t, T ) dW (t) (4)

88

CHAPTER 3. VALUATION

where the processes (t, T ) , (t, T ) are continuous and

adapted.
For this assumption to be compatible with the assumption of the existence of martingale measures we need the
following relation to hold:
dP (t,T )
P (t,T )

= [r (t) (t, T ) (t)] dt + (t, T ) dW (t) .

BlackDermanToy model
Chen model
BraceGatarekMusiela model
Cheyette model

(5)

We nd the return on the bond in the HJM model and 3.11.4

compare it (5) to obtain models that do not allow for arNotes
bitrage.
Let

[1] M. Musiela, M. Rutkowski: Martingale Methods in Financial Modelling. 2nd ed. New York : Springer-Verlag,
2004. Print.

X (t) = logP (t, T ) . (6)

Then
X (t) =

T
t

External links and references

[2] Newsweek 2009

f (t, s) ds. (7)

Using Leibnizs rule for dierentiating under the integral

Primary references
sign we have that:
(
)
T
dX = d t f (t, s) ds
= A (t, T ) dt
Heath, D., Jarrow, R. and Morton, A. (1990). Bond
(t, T ) dW (t) , (8)
Pricing and the Term Structure of Interest Rates: A
Discrete Time Approximation. Journal of Financial
where
A (t, T )
=
r (t)
+
T
T
and Quantitative Analysis, 25:419-440.
(t, s) ds and (t, T ) = t (t, s) ds.
t
By It's lemma,
dP (t,T )
P (t,T )

= dX + 12 (dX)2 . (9)

It follows from (5) and (9), we must have that

T
(t, T ) = t (t, s) ds, (10)
)2
(
T
T
(t, T ) (t) = t (t, s) ds 12 t (t, s) ds .
(11)
Rearranging the terms we get that
)2
(
T
T
1
(t,
s)
ds
=

(t,
s)
ds
2
t
t
T
(t) t (t, s) ds. (12)

Heath, D., Jarrow, R. and Morton, A. (1991).

Contingent Claims Valuation with a Random Evolution of Interest Rates. Review of Futures Markets,
9:54-76.
Heath, D., Jarrow, R. and Morton, A. (1992). Bond
Pricing and the Term Structure of Interest Rates: A
New Methodology for Contingent Claims Valuation.
Econometrica, 60(1):77-105. doi:10.2307/2951677
Robert Jarrow (2002). Modelling Fixed Income Securities and Interest Rate Options (2nd ed.). Stanford
Economics and Finance. ISBN 0-8047-4438-6

Dierentiating both sides with respect to T , we have that Articles

(
)
T
(t, T ) = (t, T ) t (t, s) ds (t) . (13)
Non-Bushy Trees For Gaussian HJM And Lognormal Forward Models, Prof Alan Brace, University
Equation (13) is known as the no-arbitrage condition in
of Technology Sydney
the HJM model. Under the martingale probability measure , = 0 and the equation for the forward rates be The Heath-Jarrow-Morton Term Structure Model,
comes:
(
)
Prof. Don Chance E. J. Ourso College of Business,
T
.
df (t, T ) = (t, T ) t (t, s) ds dt + (t, T ) dW
Louisiana State University
(14)
Recombining Trees for One-Dimensional Forward
This equation is used in pricing of bonds and its derivaRate Models, Dariusz Gatarek, Wysza Szkoa Biztives.
nesu National-Louis University, and Jaroslaw Kolakowski

3.11.3

See also

HoLee model
HullWhite model

Implementing No-Arbitrage Term Structure of Interest Rate Models in Discrete Time When Interest
Rates Are Normally Distributed, Dwight M Grant
and Gautam Vora. The Journal of Fixed Income
March 1999, Vol. 8, No. 4: pp. 8598

3.12. HESTON MODEL

HeathJarrowMorton model and its application,
Vladimir I Pozdynyakov, University of Pennsylvania

89
is the vol of vol, or volatility of the volatility; as
the name suggests, this determines the variance of
t.

An Empirical Study of the Convergence Properties

of the Non-recombining HJM Forward Rate Tree in If the parameters obey the following condition (known as
Pricing Interest Rate Derivatives, A.R. Radhakrish- the Feller condition) then the process t is strictly positive
[3]
nan New York University
Modeling Interest Rates with Heath, Jarrow and
Morton. Dr Donald van Deventer, Kamakura Cor2 > 2 .
poration:
With One Factor and Maturity-Dependent
3.12.2
Volatility

Extensions

With One Factor and Rate and MaturityIn order to take into account all the features from the
Dependent Volatility
volatility surface, the Heston model may be a too rigid
With Two Factors and Rate and Maturity- framework. It may be necessary to add degrees of freeDependent Volatility
dom to the original model. A rst straightforward exten With Three Factors and Rate and Maturity- sion is to allow the parameters to be time-dependent. The
Dependent Volatility
model dynamics are then written as:

3.12 Heston model

dSt = St dt +

t St dWtS .

In nance, the Heston model, named after Steven Hes- Here t , the instantaneous variance, is a time-dependent
ton, is a mathematical model describing the evolution of CIR process:
the volatility of an underlying asset.[1] It is a stochastic
volatility model: such a model assumes that the volatility
of the asset is not constant, nor even deterministic, but dt = t (t t ) dt + t t dW
t
follows a random process.

3.12.1

Basic Heston model

and dWtS ,dWt are Wiener processes (i.e., random walks)

with correlation . In order to retain model tractability,
one may require parameters to be piecewise-constant.

The basic Heston model assumes that St, the price of the Another approach is to add a second process of variance,
independent of the rst one.
asset, is determined by a stochastic process:[2]

dSt = St dt +

t St dWtS

dSt = St dt +

t1 St dWtS,1 +

where t , the instantaneous variance, is a CIR process:

dt = ( t ) dt + t dWt

t2 St dWtS,2

dt1 = 1 (1 t1 ) dt + 1

1
t1 dWt

dt2 = 2 (2 t2 ) dt + 2

2
t2 dWt

and dWtS ,dWt are Wiener processes (i.e., random walks)

A signicant extension of Heston model to make both
with correlation , or equivalently, with covariance dt.
volatility and mean stochastic is given by Lin Chen
The parameters in the above equations represent the fol- (1996). In the Chen model the dynamics of the instanlowing:
taneous interest rate are specied by
is the rate of return of the asset.

drt = (t rt ) dt + rt t dWt ,
is the long variance, or long run average price
variance; as t tends to innity, the expected value of

dt = (t t ) dt + t t dWt ,
t tends to .

is the rate at which t reverts to .

dt = (t t ) dt + t t dWt .

90

CHAPTER 3. VALUATION

3.12.3

Risk-neutral measure

See Risk-neutral measure for the complete article

A fundamental concept in derivatives pricing is that of the
Risk-neutral measure; this is explained in further depth in
the above article. For our purposes, it is sucient to note
the following:
1. To price a derivative whose payo is a function of
one or more underlying assets, we evaluate the expected value of its discounted payo under a riskneutral measure.

- the rst in the Stochastic Dierential Equation (SDE)

for the asset and the second in the SDE for the stochastic
volatility. Here, the dimension of the set of equivalent
martingale measures is one; there is no unique risk-free
measure.
This is of course problematic; while any of the risk-free
measures may theoretically be used to price a derivative, it is likely that each of them will give a dierent
price. In theory, however, only one of these risk-free
measures would be compatible with the market prices
of volatility-dependent options (for example, European
calls, or more explicitly, variance swaps). Hence we could
add a volatility-dependent asset; by doing so, we add an
additional constraint, and thus choose a single risk-free
measure which is compatible with the market. This measure may be used for pricing.

2. A risk-neutral measure, also known as an equivalent

martingale measure, is one which is equivalent to the
real-world measure, and which is arbitrage-free: under such a measure, the discounted price of each of 3.12.4 Implementation
the underlying assets is a martingale. See Girsanovs
theorem.
A recent discussion of implementation of the Heston
[4]
3. In the Black-Scholes and Heston frameworks (where model is given in a paper by Kahl and Jckel .
ltrations are generated from a linearly independent Information about how to use the Fourier transform to
set of Wiener processes alone), any equivalent mea- value options is given in a paper by Carr and Madan.[5]
sure can be described in a very loose sense by adding
Extension of the Heston model with stochastic interest
a drift to each of the Wiener processes.
rates is given in the paper by Grzelak and Oosterlee.[6]
4. By selecting certain values for the drifts described Derivation of closed-form option prices for timeabove, we may obtain an equivalent measure which dependent Heston model is presented in the paper by Gofullls the arbitrage-free condition.
bet et al.[7]
Consider a general situation where we have n underlying
assets and a linearly independent set of m Wiener processes. The set of equivalent measures is isomorphic to
Rm , the space of possible drifts. Let us consider the set
of equivalent martingale measures to be isomorphic to a
manifold M embedded in Rm ; initially, consider the situation where we have no assets and M is isomorphic to
Rm .

Derivation of closed-form option prices for double Heston model are presented in papers by Christoersen [8]
and Gauthier. [9]
There exist few known parametrisation of the volatility
surface based on the Heston model (Schonbusher,
SVI and gSVI) as well as their de-arbitraging
methodologies.[10]

Now let us consider each of the underlying assets as pro- 3.12.5 See also
viding a constraint on the set of equivalent measures, as
its expected discount process must be equal to a constant
Stochastic volatility
(namely, its initial value). By adding one asset at a time,
gSVI[11]
we may consider each additional constraint as reducing
the dimension of M by one dimension. Hence we can
Risk-neutral measure (another name for the equivasee that in the general situation described above, the dilent martingale measure)
mension of the set of equivalent martingale measures is
mn.
Girsanovs theorem
In the Black-Scholes model, we have one asset and one
Martingale (probability theory)
Wiener process. The dimension of the set of equiva SABR Volatility Model
lent martingale measures is zero; hence it can be shown
that there is a single value for the drift, and thus a single
risk-neutral measure, under which the discounted asset
3.12.6 References
et St will be a martingale.
In the Heston model, we still have one asset (volatility
is not considered to be directly observable or tradeable
in the market) but we now have two Wiener processes

[1] Heston, Steven L. (1993). A Closed-Form Solution for

Options with Stochastic Volatility with Applications to
Bond and Currency Options. The Review of Financial

3.13. MONTE CARLO METHODS FOR OPTION PRICING

Studies 6 (2): 327343. doi:10.1093/rfs/6.2.327. JSTOR

2962057.
[2] Wilmott, P. (2006), Paul Wilmott on quantitative nance
(2nd ed.), p. 861
[3] Albrecher, H.; Mayer, P.; Schoutens, W.; Tistaert, J. (January 2007), The Little Heston Trap, Wilmott Magazine:
8392, CiteSeerX: 10.1.1.170.9335
[4] Kahl, C.; Jckel, P. (2005). Not-so-complex logarithms
in the Heston model (PDF). Wilmott Magazine. pp. 74
103.
[5] Carr, P.; Madan, D. (1999). Option valuation using the
fast Fourier transform (PDF). Journal of Computational
Finance 2 (4). pp. 6173.
[6] Grzelak, L.A.; Oosterlee, C.W. (2011). On the Heston
Model with Stochastic Interest Rates. SIAM J. Fin. Math.
2. pp. 255286.
[7] Benhamou, E.; Gobet, E.; Miri, M. (2009). Time
Dependent Heston Model.
SSRN Working Paper.
doi:10.2139/ssrn.1367955.
[8] Christoersen, P.; Heston, S.; Jacobs, K. (2009). The
Shape and Term Structure of the Index Option Smirk:
Why Multifactor Stochastic Volatility Models Work so
Well. SSRN Working Paper.
[9] Gauthier, P.; Possamai, D. (2009), Ecient Simulation
of the Double Heston Model, SSRN Working Paper
[10] Babak Mahdavi Damghani (2013). De-arbitraging
with a weak smile. Wilmott.http://www.readcube.com/
articles/10.1002/wilm.10201?locale=en
[11] Mahdavi Damghani, Babak (2013). De-arbitraging With
a Weak Smile: Application to Skew Risk. Wilmott 2013
(1): 4049. doi:10.1002/wilm.10201.

3.13 Monte Carlo methods for option pricing

In mathematical nance, a Monte Carlo option model
uses Monte Carlo methods [Notes 1] to calculate the value
of an option with multiple sources of uncertainty or with
complicated features.[1] The rst application to option
pricing was by Phelim Boyle in 1977 (for European options). In 1996, M. Broadie and P. Glasserman showed
how to price Asian options by Monte Carlo. In 2001 F.
A. Longsta and E. S. Schwartz developed a practical
Monte Carlo method for pricing American-style options.

3.13.1

Methodology

In terms of theory, Monte Carlo valuation relies on risk

neutral valuation.[1] Here the price of the option is its
discounted expected value; see risk neutrality and rational
pricing. The technique applied then, is (1) to generate a

91

large number of possible (but random) price paths for the

underlying (or underlyings) via simulation, and (2) to then
calculate the associated exercise value (i.e. payo) of
the option for each path. (3) These payos are then averaged and (4) discounted to today. This result is the value
of the option.[2]
This approach, although relatively straightforward, allows
for increasing complexity:
An option on equity may be modelled with one
source of uncertainty: the price of the underlying
stock in question.[2] Here the price of the underlying
instrument St is usually modelled such that it follows a geometric Brownian motion with constant
drift and volatility . So: dSt = St dt +
St dWt , where dWt is found via a random sampling from a normal distribution; see further under
BlackScholes. Since the underlying random process is the same, for enough price paths, the value of
a european option here should be the same as under
Black Scholes. More generally though, simulation
is employed for path dependent exotic derivatives,
such as Asian options.
In other cases, the source of uncertainty may be at
a remove. For example, for bond options [3] the
underlying is a bond, but the source of uncertainty
is the annualized interest rate (i.e. the short rate).
Here, for each randomly generated yield curve we
observe a dierent resultant bond price on the options exercise date; this bond price is then the input
for the determination of the options payo. The
same approach is used in valuing swaptions,[4] where
the value of the underlying swap is also a function
of the evolving interest rate. (Whereas these options are more commonly valued using lattice based
models, as above, for path dependent interest rate
derivatives such as CMOs simulation is the primary technique employed.[5] ) For the models used
to simulate the interest-rate see further under Shortrate model; note also that to create realistic interest
rate simulations Multi-factor short-rate models are
sometimes employed.[6]
Monte Carlo Methods allow for a compounding in
the uncertainty.[7] For example, where the underlying is denominated in a foreign currency, an additional source of uncertainty will be the exchange
rate: the underlying price and the exchange rate
must be separately simulated and then combined to
determine the value of the underlying in the local
currency. In all such models, correlation between
the underlying sources of risk is also incorporated;
see Cholesky decomposition #Monte Carlo simulation. Further complications, such as the impact of
commodity prices or ination on the underlying, can
also be introduced. Since simulation can accommodate complex problems of this sort, it is often used in

92

CHAPTER 3. VALUATION

analysing real options [1] where managements deci- make them dicult to value through a straightforward
sion at any point is a function of multiple underlying BlackScholes-style or lattice based computation. The
variables.
technique is thus widely used in valuing path dependent
structures like lookback- and Asian options [9] and in real
[1][7]
Additionally, as above, the modeller
Simulation can similarly be used to value options options analysis.
is
not
limited
as
to
the
probability distribution assumed.[9]
where the payo depends on the value of multiple underlying assets [8] such as a Basket option or Conversely, however, if an analytical technique for valuRainbow option. Here, correlation between asset re- ing the option existsor even a numeric technique, such
turns is likewise incorporated.
as a (modied) pricing tree [9] Monte Carlo methods
will usually be too slow to be competitive. They are, in a
As required, Monte Carlo simulation can be used sense, a method of last resort;[9] see further under Monte
with any type of probability distribution, including Carlo methods in nance. With faster computing capachanging distributions: the modeller is not limited bility this computational constraint is less of a concern.
to normal or lognormal returns;[9] see for example
DatarMathews method for real option valuation.
Additionally, the stochastic process of the underly- 3.13.4 References
ing(s) may be specied so as to exhibit jumps or
mean reversion or both; this feature makes simu- Notes
lation the primary valuation method applicable to
energy derivatives.[10] Further, some models even [1] Although the term 'Monte Carlo method' was coined by
Stanislaw Ulam in the 1940s, some trace such methods to
allow for (randomly) varying statistical (and other)
the 18th century French naturalist Buon, and a question
parameters of the sources of uncertainty. For exhe asked about the results of dropping a needle randomly
ample, in models incorporating stochastic volatility,
on a striped oor or table. See Buons needle.
the volatility of the underlying changes with time;
see Heston model.
Sources

3.13.2

Least Square Monte Carlo

Least Square Monte Carlo is used in valuing American

options. The technique works in a two step procedure.
First, a backward induction process is performed in
which a value is recursively assigned to every state
at every timestep. The value is dened as the least
squares regression against market price of the option
value at that state and time (-step). Option value
for this regression is dened as the value of exercise possibilities (dependent on market price) plus
the value of the timestep value which that exercise
would result in (dened in the previous step of the
process).
Secondly, when all states are valued for every
timestep, the value of the option is calculated by
moving through the timesteps and states by making
an optimal decision on option exercise at every step
on the hand of a price path and the value of the state
that would result in. This second step can be done
with multiple price paths to add a stochastic eect
to the procedure.

[1] Marco Dias: Real Options with Monte Carlo Simulation

[2] Don Chance: Teaching Note 96-03: Monte Carlo Simulation
[3] Peter Carr and Guang Yang: Simulating American Bond
Options in an HJM Framework
[4] Carlos Blanco, Josh Gray and Marc Hazzard: Alternative
Valuation Methods for Swaptions: The Devil is in the Details
[5] Frank J. Fabozzi: Valuation of xed income securities and
derivatives, pg. 138
[6] Donald R. van Deventer (Kamakura Corporation):
Pitfalls in Asset and Liability Management: One Factor
Term Structure Models
[7] Gonzalo Cortazar, Miguel Gravet and Jorge Urzua: The
valuation of multidimensional American real options using the LSM simulation method
[8] global-derivatives.com: Basket Options Simulation
[9] Rich Tanenbaum: Battle of the Pricing Models: Trees vs
Monte Carlo
[10] Les Clewlow, Chris Strickland and Vince Kaminski:
Extending mean-reversion jump diusion

Primary references

3.13.3

Application

As can be seen, Monte Carlo Methods are particularly

useful in the valuation of options with multiple sources
of uncertainty or with complicated features, which would

Boyle, Phelim P. (1977). Options: A Monte

Carlo Approach. Journal of Financial Economics 4
(3): 323338. doi:10.1016/0304-405x(77)900058. Retrieved June 28, 2012.

3.14. FUZZY PAY-OFF METHOD FOR REAL OPTION VALUATION

93

Broadie, M.; Glasserman, P. (1996). Estimating

Security Price Derivatives Using Simulation
(pdf).
Management Science 42: 269285.
doi:10.1287/mnsc.42.2.269.
Retrieved June
28, 2012.

MonteCarlo Simulation
derivatives.com

Longsta, F.A.; Schwartz, E.S. (2001). Valuing

American options by simulation: a simple least
squares approach. Review of Financial Studies
14: 113148. doi:10.1093/rfs/14.1.113. Retrieved
June 28, 2012.

Applications of Monte Carlo Methods in Finance:

Option Pricing, Y. Lai and J. Spanier, Claremont
Graduate University

Books
Bruno Dupire (1998). Monte Carlo:methodologies
and applications for pricing and risk management.
Risk.
Paul Glasserman (2003). Monte Carlo methods in nancial engineering. Springer-Verlag. ISBN 0-38700451-3.

in

Finance,

global-

Monte Carlo Derivative valuation, contd., Timothy

L. Krehbiel, Oklahoma State UniversityStillwater

Option pricing by simulation, Bernt Arne degaard,

Norwegian School of Management
Pricing and Hedging Exotic Options with Monte
Carlo Simulations, Augusto Perilla, Diana Oancea,
Prof. Michael Rockinger, HEC Lausanne
Monte Carlo Method, riskglossary.com

3.14 Fuzzy Pay-O Method for

Real Option Valuation

Peter Jaeckel (2002). Monte Carlo methods in nance. John Wiley and Sons. ISBN 0-471-49741X.

The fuzzy pay-o method for real option valuation

(FPOM or pay-o method) [1] is a new method for
valuing real options, created in 2008. It is based on the
Don L. McLeish (2005). Monte Carlo Simulation &
use of fuzzy logic and fuzzy numbers for the creation of
Finance. ISBN 0-471-67778-7.
the possible pay-o distribution of a project (real option).
Christian P. Robert, George Casella (2004). Monte The structure of the method is similar to the probability
theory based DatarMathews method for real option valCarlo Statistical Methods. ISBN 0-387-21239-6.
uation,[2][3] but the method is not based on probability
theory and uses fuzzy numbers and possibility theory in
3.13.5 External links
framing the real option valuation problem.
Software

3.14.1 Method

Fairmat (freeware) modeling and pricing complex

The Fuzzy pay-o method derives the real option value
options
from a pay-o distribution that is created by using three
MG Soft (freeware) valuation and Greeks of vanilla or four cash-ow scenarios (most often created by an exand exotic options
pert or a group of experts). The pay-o distribution is
created simply by assigning each of the three cash-ow
Comparison of risk analysis Microsoft Excel add-ins
scenarios a corresponding denition with regards to a
fuzzy number (triangular fuzzy number for three scenarOnline tools
ios and a trapezoidal fuzzy number for four scenarios).
This means that the pay-o distribution is created with Monte Carlo simulated stock price time series and out any simulation whatsoever. This makes the procedure
random number generator (allows for choice of dis- easy and transparent. The scenarios used are a minimum
tribution), Steven Whitney
possible scenario (the lowest possible outcome), the maximum possible scenario (the highest possible outcome)
Monte Carlo to price options and compute greeks,
and a best estimate (most likely to happen scenario) that
pricing-option.com
is mapped as a fully possible scenario with a full degree
of membership in the set of possible outcomes, or in the
Discussion papers and documents
case of four scenarios used - two best estimate scenarios
that are the upper and lower limit of the interval that is as Monte Carlo Simulation, Prof. Don M. Chance, signed a full degree of membership in the set of possible
Louisiana State University
outcomes.
Pricing complex options using a simple Monte Carlo The main observations that lie behind the model for deSimulation, Peter Fink (reprint at quantnotes.com) riving the real option value are the following:

94

CHAPTER 3. VALUATION

1. The fuzzy NPV of a project is (equal to) the pay-o and development projects and portfolios.[6] In these analdistribution of a project value that is calculated with yses triangular fuzzy numbers are used. Other uses of
fuzzy numbers.
the method so far are, for example, R&D project valuation IPR valuation, valuation of M&A targets and ex2. The mean value of the positive values of the fuzzy pected synergies,[7] valuation and optimization of M&A
NPV is the possibilistic mean value of the positive strategies, valuation of area development (construction)
fuzzy NPV values.
projects, valuation of large industrial real investments.
3. Real option value, ROV, calculated from the fuzzy
NPV is the possibilistic mean value[4] of the positive fuzzy NPV values multiplied with the positive
area of the fuzzy NPV over the total area of the fuzzy
NPV.
The real option formula can then be written simply as:

ROV =

A(Pos)
E[A+ ]
A(Pos) + A(Neg)
where A(Pos) is the area of the positive part of the fuzzy distribution,
A(Neg) is the area of the negative
part of the fuzzy distribution, and
E[A] is the mean value of the positive part of the distribution. It
can be seen that when the distribution is totally positive, the real options value reduces to the expected
(mean) value, E[A].

As can be seen, the real option value can be derived directly from the fuzzy NPV, without simulation.[5] At the
same time, simulation is not an absolutely necessary step
in the DatarMathews method, so the two methods are
not very dierent in that respect. But what is totally
dierent is that the DatarMathews method is based on
probability theory and as such has a very dierent foundation from the pay-o method that is based on possibility
theory: the way that the two models treat uncertainty is
fundamentally dierent.

3.14.2

Use of the method

The pay-o method for real option valuation is very easy

to use compared to the other real option valuation methods and it can be used with the most commonly used
spreadsheet software without any add-ins. The method is
useful in analyses for decision making regarding investments that have an uncertain future, and especially so if
the underlying data is in the form of cash-ow scenarios. The method is less useful if optimal timing is the objective. The method is exible and accommodates easily
both one-stage investments and multi-stage investments
(compound real options).
The method has been taken into use in some large international industrial companies for the valuation of research

The use of the pay-o method is lately taught within

the larger framework of real options, for example at
the Lappeenranta University of Technology and at the
Tampere University of Technology in Finland.

3.14.3 References
[1] Collan, M., Fullr, R., and Mezei, J., 2009, Fuzzy PayO Method for Real Option Valuation, Journal of Applied
Mathematics and Decision Sciences, vol. 2009
[2] Datar, V. & Mathews, S. 2004. European Real Options:
An Intuitive Algorithm for the Black Scholes Formula.
Journal of Applied Finance, 14(1)
[3] Mathews, S. & Datar, V. 2007. A Practical Method for
Valuing Real Options: The Boeing Approach. Journal of
Applied Corporate Finance, 19(2): 95104.
[4] Fuller, R. & Majlender, P. 2003. On weighted possibilistic mean and variance of fuzzy numbers. Fuzzy Sets and
Systems, 136: 363374.
[5] Collan, M., Fullr, R., and Mezei, J., 2009, Fuzzy PayO Method for Real Option Valuation, Journal of Applied
Mathematics and Decision Sciences, vol. 2009
[6] Heikkil, M., 2009, Selection of R&D Portfolios of Real
Options with Fuzzy Pay-os under Bounded Rationality, IAMSR Research Report, 1/2009, ISBN 978-952-122316-7
[7] Kinnunen, J., 2010, Valuing M&A Synergies as (Fuzzy)
Real Options, 14th Annual International Conference on
Real Options in Rome, Italy, June 1619, 2010

3.14.4 External links

Pay-o Method for ROV Homepage
Powerpoint overview
A Fuzzy Pay-O Method for Real Option Valuation, Journal of Applied Mathematics and Decision
Sciences (Original Journal Publication)
A Fuzzy Pay-O Method for Real Option Valuation,
IEEE BIFE Conference paper
Book on the pay-o method, with application examples

Chapter 4

Volatility and Risk Measurement

4.1 Volatility

starting at the current time and ending at a future

date (normally the expiry date of an option)
historical implied volatility which refers to the
implied volatility observed from historical prices of
the nancial instrument (normally options)
current implied volatility which refers to the implied volatility observed from current prices of the
nancial instrument
future implied volatility which refers to the implied volatility observed from future prices of the
nancial instrument
For a nancial instrument whose price follows a Gaussian
random walk, or Wiener process, the width of the distribution increases as time increases. This is because there
is an increasing probability that the instruments price will
be farther away from the initial price as time increases.
However, rather than increase linearly, the volatility increases with the square-root of time as time increases, because some uctuations are expected to cancel each other
out, so the most likely deviation after twice the time will
not be twice the distance from zero.

the VIX

In nance, volatility is a measure for variation of price of

a nancial instrument over time. Historic volatility is derived from time series of past market prices. An implied
volatility is derived from the market price of a market
traded derivative (in particular an option). The symbol
is used for volatility, and corresponds to standard deviation, which should not be confused with the similarly Since observed price changes do not follow Gaussian disnamed variance, which is instead the square, 2 .
tributions, others such as the Lvy distribution are often
used.[1] These can capture attributes such as "fat tails".
Volatility is a statistical measure of dispersion around the
4.1.1 Volatility terminology
average of any random variable such as market parameters etc.
Volatility as described here refers to the actual current
volatility of a nancial instrument for a specied period
(for example 30 days or 90 days). It is the volatility of 4.1.2 Volatility and liquidity
a nancial instrument based on historical prices over the
specied period with the last observation the most recent Much research has been devoted to modeling and foreprice. This phrase is used particularly when it is wished casting the volatility of nancial returns, and yet few theto distinguish between the actual current volatility of an oretical models explain how volatility comes to exist in
instrument.
the rst place.
Roll (1984) shows that volatility is aected by market microstructure.[2] Glosten and Milgrom (1985) shows that
at least one source of volatility can be explained by the
liquidity provision process. When market makers infer the possibility of adverse selection, they adjust their
actual future volatility which refers to the volatil- trading ranges, which in turn increases the band of price
ity of a nancial instrument over a specied period oscillation.[3]
actual historical volatility which refers to the
volatility of a nancial instrument over a specied
period but with the last observation on a date in the
past

95

96

4.1.3

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

Volatility for investors

and amongst the models are Emanuel Derman and Iraj

Kani's[4] and Bruno Dupire's Local Volatility, Poisson
Investors care about volatility for seven reasons:
Process where volatility jumps to new levels with a predictable frequency, and the increasingly popular Heston
[5]
1. The wider the swings in an investments price, the model of Stochastic Volatility.
harder emotionally it is to not worry;
It is common knowledge that types of assets experience
periods of high and low volatility. That is, during some
2. Price volatility of a trading instrument can dene poperiods, prices go up and down quickly, while during
sition sizing in a portfolio;
other times they barely move at all.[6]
3. When certain cash ows from selling a security are Periods when prices fall quickly (a crash) are often folneeded at a specic future date, higher volatility lowed by prices going down even more, or going up by an
means a greater chance of a shortfall;
unusual amount. Also, a time when prices rise quickly (a
possible bubble) may often be followed by prices going
4. Higher volatility of returns while saving for retireup even more, or going down by an unusual amount.
ment results in a wider distribution of possible nal
The converse behavior, 'doldrums, can last for a long
portfolio values;
time as well.
5. Higher volatility of return when retired gives withdrawals a larger permanent impact on the portfolios Most typically, extreme movements do not appear 'out
of nowhere'; they are presaged by larger movements than
value;
usual. This is termed autoregressive conditional het6. Price volatility presents opportunities to buy assets eroskedasticity. Of course, whether such large movecheaply and sell when overpriced.
ments have the same direction, or the opposite, is more
dicult to say. And an increase in volatility does not al7. Volatility aects pricing of options, being a param- ways presage a further increasethe volatility may simeter of the BlackScholes model
ply go back down again.
In todays markets, it is also possible to trade volatility
directly, through the use of derivative securities such as 4.1.6 Mathematical denition
options and variance swaps. See Volatility arbitrage.
The annualized volatility is the standard deviation of the
instruments yearly logarithmic returns.[7]

4.1.4

Volatility versus direction

The generalized volatility T for time horizon T in years

Volatility does not measure the direction of price is expressed as:
changes, merely their dispersion. This is because when
calculating standard deviation (or variance), all dier
ences are squared, so that negative and positive dier- T = T .
ences are combined into one quantity. Two instruments
with dierent volatilities may have the same expected re- Therefore, if the daily logarithmic returns of a stock have
turn, but the instrument with higher volatility will have a standard deviation of SD and the time period of returns
is P, the annualized volatility is
larger swings in values over a given period of time.
For example, a lower volatility stock may have an expected (average) return of 7%, with annual volatility of
5%. This would indicate returns from approximately negative 3% to positive 17% most of the time (19 times
out of 20, or 95% via a two standard deviation rule). A
higher volatility stock, with the same expected return of
7% but with annual volatility of 20%, would indicate returns from approximately negative 33% to positive 47%
most of the time (19 times out of 20, or 95%). These
estimates assume a normal distribution; in reality stocks
are found to be leptokurtotic.

4.1.5

Volatility over time

SD
= .
P
A common assumption is that P = 1/252 (there are 252
trading days in any given year). Then, if SD = 0.01 the
annualized volatility is

0.01
annual =
= 0.01 252 = 0.1587.
1
252

The monthly volatility (i.e., T = 1/12 of a year) would be

Although the Black Scholes equation assumes predictable

1
= 0.0458.
constant volatility, this is not observed in real markets, monthly = 0.1587 12

4.1. VOLATILITY

97

The formula used above to convert returns or volatility

measures from one time period to another assume a particular underlying model or process. These formulas are
accurate extrapolations of a random walk, or Wiener process, whose steps have nite variance. However, more
generally, for natural stochastic processes, the precise relationship between volatility measures for dierent time
periods is more complicated. Some use the Lvy stability
exponent to extrapolate natural processes:

log(1 + y) = y 21 y 2 + 31 y 3 41 y 4 + ...
Taking only the rst two terms one has:

CAGR AR 12 2
Realistically, most nancial assets have negative skewness and leptokurtosis, so this formula tends to be overoptimistic. Some people use the formula:

T = T 1/ .
If = 2 you get the Wiener process scaling relation, but CAGR AR 21 k 2
some people believe < 2 for nancial activities such as
stocks, indexes and so on. This was discovered by Benot for a rough estimate, where k is an empirical factor (typMandelbrot, who looked at cotton prices and found that ically ve to ten).
they followed a Lvy alpha-stable distribution with =
1.7. (See New Scientist, 19 April 1997.)

4.1.10 Criticisms of volatility forecasting

models

4.1.7

Implied Volatility parametrisation

There exist several known parametrisation of the implied

volatility surface, Schonbucher, SVI and gSVI.[8]

4.1.8

Crude volatility estimation

Using a simplication of the formulae above it is possible to estimate annualized volatility based solely on approximate observations. Suppose you notice that a market price index, which has a current value near 10,000,
has moved about 100 points a day, on average, for many
days. This would constitute a 1% daily movement, up or
down.
To annualize this, you can use the rule of 16, that is,
multiply by 16 to get 16% as the annual volatility. The rationale for this is that 16 is the square root of 256, which is
approximately the number of trading days in a year (252).
This also uses the fact that the standard deviation of the
sum of n independent variables (with equal standard deviations) is n times the standard deviation of the individual
variables.
Of course, the average magnitude of the observations
is merely an approximation of the standard deviation of
the market index. Assuming that the market index daily
changes are normally distributed with mean zero and
standard deviation , the expected value of the magnitude
of the observations is (2/) = 0.798. The net eect is
that this crude approach underestimates the true volatility
by about 20%.

4.1.9

Estimate of compound
growth rate (CAGR)

Consider the Taylor series:

annual

Performance of VIX (left) compared to past volatility (right) as

30-day volatility predictors, for the period of Jan 1990-Sep 2009.
Volatility is measured as the standard deviation of S&P500 oneday returns over a months period. The blue lines indicate linear
regressions, resulting in the correlation coecients r shown. Note
that VIX has virtually the same predictive power as past volatility,
insofar as the shown correlation coecients are nearly identical.

Despite the sophisticated composition of most volatility forecasting models, critics claim that their predictive
power is similar to that of plain-vanilla measures, such
as simple past volatility [9][10] especially out-of-sample,
where dierent data are used to estimate the models and
to test them. [11] Other works have agreed, but claim critics failed to correctly implement the more complicated
models.[12] Some practitioners and portfolio managers
seem to completely ignore or dismiss volatility forecasting models. For example, Nassim Taleb famously titled
one of his Journal of Portfolio Management papers We
Don't Quite Know What We are Talking About When
We Talk About Volatility.[13] In a similar note, Emanuel
Derman expressed his disillusion with the enormous supply of empirical models unsupported by theory.[14] He argues that, while theories are attempts to uncover the hidden principles underpinning the world around us, as Albert Einstein did with his theory of relativity, we should
remember that models are metaphors -- analogies that
describe one thing relative to another.

98

4.1.11

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

Volatility Hedge Funds

[10] Jorion, P. (1995). Predicting Volatility in Foreign Exchange Market. Journal of Finance 50 (2): 507
528. doi:10.1111/j.1540-6261.1995.tb04793.x. JSTOR
2329417.

Well known hedge fund managers with expertise in trading volatility include Paul Britton of Capstone Holdings Group,[15] Andrew Feldstein of Blue Mountain
Capital Management,[16] and Nelson Saiers from Saiers [11] Brooks, Chris; Persand, Gita (2003). Volatility forecasting for risk management. Journal of Forecasting 22 (1):
Capital.[17]
122. doi:10.1002/for.841. ISSN 1099-131X.

4.1.12

See also

Beta (nance)
Derivative (nance)
Financial economics
Implied volatility
IVX

[12] Andersen, Torben G.; Bollerslev, Tim (1998). Answering the Skeptics: Yes, Standard Volatility Models Do Provide Accurate Forecasts. International Economic Review
39 (4): 885905. JSTOR 2527343.
[13] Goldstein, Daniel and Taleb, Nassim, (28 March 2007)
We Don't Quite Know What We are Talking About
When We Talk About Volatility. Journal of Portfolio
Management 33 (4), 2007.
[14] Derman, Emanuel (2011): Models.Behaving.Badly: Why
Confusing Illusion With Reality Can Lead to Disaster, on
Wall Street and in Life, Ed. Free Press.

Risk
Standard deviation
Stochastic volatility
Volatility arbitrage
Volatility smile
Realized variance

4.1.13

References

[15] Devasabai, Kris (1 March 2010). Interview with Paul

Britton Founder CEO of Capstone. Hedge Funds Review.
Retrieved 26 April 2013.
[16] Schaefer, Steve (14 February 2013). Blue Mountains
Andrew Feldstein: Three Ways to Play a More Volatile
Steel Industry. Forbes. Retrieved 26 April 2013.
[17] Creswell, Julie and Louise Story (17 March 2011). Funds
Find Opportunities in Volatility. New York Times. Retrieved 26 April 2013.

[1] Levy Distribution at Wilmonttwiki

[2] Roll, R. (1984): A Simple Implicit Measure of the Effective Bid-Ask Spread in an Ecient Market, Journal
of Finance 39 (4), 1127-1139
[3] Glosten, L. R. and P. R. Milgrom (1985): Bid, Ask and
Transaction Prices in a Specialist Market with Heterogeneously Informed Traders, Journal of Financial Economics 14 (1), 71-100
[4] Derman, E., Iraj Kani (1994). ""Riding on a Smile.
RISK, 7(2) Feb.1994, pp. 139-145, pp. 32-39. (PDF).
Risk. Retrieved 2007-06-01.

4.1.14 External links

Graphical Comparison of Implied and Historical
Volatility, video
An introduction to volatility and how it can be calculated in excel, by Dr A. A. Kotz

[5] http://www.wilmottwiki.com/wiki/index.php?title=
Volatility

Diebold, Francis X.; Hickman, Andrew; Inoue, Atsushi & Schuermannm, Til (1996) Converting 1Day Volatility to h-Day Volatility: Scaling by sqrt(h)
is Worse than You Think

[6] Taking Advantage Of Volatility Spikes With Credit

Spreads.

A short introduction to alternative mathematical

concepts of volatility

[7] Calculating Historical Volatility: Step-by-Step Example

(PDF). 14 July 2011. Retrieved 15 July 2011.
[8] Babak Mahdavi Damghani and Andrew Kos (2013). Dearbitraging with a weak smile. Wilmott.http://www.
readcube.com/articles/10.1002/wilm.10201?locale=en
[9] Cumby, R.; Figlewski, S.; Hasbrouck, J. (1993).
Forecasting Volatility and Correlations with EGARCH
models.
Journal of Derivatives 1 (2): 5163.
doi:10.3905/jod.1993.407877.

Volatility estimation from predicted return density

Example based on Google daily return distribution
using standard density function
Research paper including excerpt from report entitled Identifying Rich and Cheap Volatility Excerpt
from Enhanced Call Overwriting, a report by Ryan
Renicker and Devapriya Mallick at Lehman Brothers (2005).

4.2. VOLATILITY SMILE

4.1.15

99

Further reading

volatility surface is a 3-D plot that plots volatility smile

and term structure of volatility in a consolidated three1. Bartram, Shnke M.; Brown, Gregory W.; Stulz, dimensional surface for all options on a given underlying
Rene M. (August 2012). Why Are U.S. Stocks asset.
More Volatile?". Journal of Finance 67 (4): 1329
1370. doi:10.1111/j.1540-6261.2012.01749.x.

4.2 Volatility smile

4.2.1 Volatility smiles and implied volatility

Implied volatility

In the BlackScholes model, the theoretical value of a

vanilla option is a monotonic increasing function of the
volatility of the underlying asset. This means it is usually
possible to compute a unique implied volatility from a
given market price for an option. This implied volatility is
best regarded as a rescaling of option prices which makes
comparisons between dierent strikes, expirations, and
underlyings easier and more intuitive.

Strike price
a smile

When implied volatility is plotted against strike price, the

resulting graph is typically downward sloping for equity
markets, or valley-shaped for currency markets. For markets where the graph is downward sloping, such as for
equity options, the term "volatility skew" is often used.
For other markets, such as FX options or equity index options, where the typical graph turns up at either end, the
more familiar term "volatility smile" is used. For example, the implied volatility for upside (i.e. high strike)
equity options is typically lower than for at-the-money
equity options. However, the implied volatilities of options on foreign exchange contracts tend to rise in both
the downside and upside directions. In equity markets, a
small tilted smile is often observed near the money as a
kink in the general downward sloping implicit volatility
graph. Sometimes the term smirk is used to describe a
skewed smile.

Volatility smiles are implied volatility patterns that arise

in pricing nancial options. In particular for a given expiration, options whose strike price diers substantially
from the underlying assets price command higher prices
(and thus implied volatilities) than what is suggested by Market practitioners use the term implied-volatility to instandard option pricing models. These options are said to dicate the volatility parameter for ATM (at-the-money)
be either deep in-the-money or out-the-money.
option. Adjustments to this value are undertaken by inGraphing implied volatilities against strike prices for a corporating the values of Risk Reversal and Flys (Skews)
given expiry yields a skewed smile instead of the ex- to determine the actual volatility measure that may be
pected at surface. The pattern diers across vari- used for options with a delta which is not 50.
ous markets. Equity options traded in American markets did not show a volatility smile before the Crash of
1987 but began showing one afterwards.[1] It is believed
that investor reassessments of the probabilities of black
swans have led to higher prices for out-the-money options. This anomaly implies deciencies in the standard
Black-Scholes option pricing model which assumes constant volatility and log-normal distributions of underlying
asset returns. Empirical asset returns distributions, however, tend to exhibit fat-tails (kurtosis) and skew. Modelling the volatility smile is an active area of research in
quantitative nance, and better pricing models such as the
stochastic volatility model partially address this issue.

Callx = ATM + 0.5 RRx + Flyx

Putx = ATM - 0.5 RRx + Flyx
where:
Callx is the implied volatility at which the X%-delta call
is trading in the market
Putx is the implied vol of the X%-delta put
ATM is the At-The-Money Forward vol at which ATM
Calls (and Puts!) are trading in the market
RRx = Callx - Putx
Flyx = 0.5*(Callx + Putx) - ATM

A related concept is that of term structure of volatil- Risk reversals are generally quoted as X% delta risk reity, which describes how (implied) volatility diers for versal and essentially is Long X% delta call, and short X%
related options with dierent maturities. An implied delta put.

100

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

Buttery, on the other hand, is a strategy consisting of: - or expensive options.

Y% delta y which mean Long Y% delta call, Long Y%
delta put, short one ATM call and short one ATM put.
(small hat shape)

4.2.2

Implied volatility and historical

4.2.4 Implied volatility surface
volatility

It is helpful to note that implied volatility is related to

historical volatility, but the two are distinct. Historical
volatility is a direct measure of the movement of the underlyings price (realized volatility) over recent history
(e.g. a trailing 21-day period). Implied volatility, in contrast, is determined by the market price of the derivative
contract itself, and not the underlying. Therefore, dierent derivative contracts on the same underlying have different implied volatilities as a function of their own supply
and demand dynamics. For instance, the IBM call option,
strike at $100 and expiring in 6 months, may have an implied volatility of 18%, while the put option strike at $105
and expiring in 1 month may have an implied volatility of
21%. At the same time, the historical volatility for IBM
for the previous 21 day period might be 17% (all volatilities are expressed in annualized percentage moves).

4.2.3

Term structure of volatility

For options of dierent maturities, we also see characteristic dierences in implied volatility. However, in this
case, the dominant eect is related to the markets implied impact of upcoming events. For instance, it is wellobserved that realized volatility for stock prices rises signicantly on the day that a company reports its earnings.
Correspondingly, we see that implied volatility for options will rise during the period prior to the earnings announcement, and then fall again as soon as the stock price
absorbs the new information. Options that mature earlier exhibit a larger swing in implied volatility (sometimes
called vol of vol) than options with longer maturities.
Other option markets show other behavior. For instance,
options on commodity futures typically show increased
implied volatility just prior to the announcement of harvest forecasts. Options on US Treasury Bill futures show
increased implied volatility just prior to meetings of the
Federal Reserve Board (when changes in short-term interest rates are announced).
The market incorporates many other types of events into
the term structure of volatility. For instance, the impact of upcoming results of a drug trial can cause implied
volatility swings for pharmaceutical stocks. The anticipated resolution date of patent litigation can impact technology stocks, etc.
Volatility term structures list the relationship between implied volatilities and time to expiration. The term structures provide another method for traders to gauge cheap

It is often useful to plot implied volatility as a function

of both strike price and time to maturity.[2] The result is
a three-dimensional curved surface whereby the current
market implied volatility (Z-axis) for all options on the
underlying is plotted against the price or delta (Y-axis)
and time to maturity (X-axis DTM). This denes the
absolute implied volatility surface; changing coordinates so that the price is replaced by delta yields the relative implied volatility surface.
The implied volatility surface simultaneously shows both
volatility smile and term structure of volatility. Option
traders use an implied volatility plot to quickly determine
the shape of the implied volatility surface, and to identify any areas where the slope of the plot (and therefore
relative implied volatilities) seems out of line.
The graph shows an implied volatility surface for all the
put options on a particular underlying stock price. The Zaxis represents implied volatility in percent, and X and Y
axes represent the option delta, and the days to maturity.
Note that to maintain put-call parity, a 20 delta put must
have the same implied volatility as an 80 delta call. For
this surface, we can see that the underlying symbol has
both volatility skew (a tilt along the delta axis), as well as
a volatility term structure indicating an anticipated event
in the near future.

4.3. IMPLIED VOLATILITY

4.2.5

Evolution: Sticky

An implied volatility surface is static: it describes the implied volatilities at a given moment in time. How the surface changes as the spot changes is called the evolution of
the implied volatility surface.
Common heuristics include:
sticky strike (or sticky-by-strike, or stick-tostrike): if spot changes, the implied volatility of an
option with a given absolute strike does not change.
sticky moneyness" (aka, sticky delta"; see
moneyness for why these are equivalent terms): if
spot changes, the implied volatility of an option with
a given moneyness (delta) does not change.

101

4.2.9 External links

Emanuel Derman, The Volatility Smile and Its Implied Tree (RISK, 7-2 Feb.1994, pp. 139-145, pp.
32-39) (PDF)
Mark Rubinstein, Implied Binomial Trees (PDF)
Damiano Brigo, Fabio Mercurio, Francesco Rapisarda and Giulio Sartorelli, Volatility Smile Modeling with Mixture Stochastic Dierential Equations
(PDF)
Visualization of the volatility smile
C. Grunspan, Asymptotics Expansions for the Implied Lognormal Volatility : a Model Free Approach

So if spot moves from $100 to $120, sticky strike would

predict that the implied volatility of a $120 strike option would be whatever it was before the move (though it
has moved from being OTM to ATM), while sticky delta 4.3 Implied volatility
would predict that the implied volatility of the $120 strike
option would be whatever the $100 strike options implied In nancial mathematics, the implied volatility of an
volatility was before the move (as these are both ATM at option contract is that value of the volatility of the underthe time).
lying instrument which, when input in an option pricing
model (such as BlackScholes) will return a theoretical
value equal to the current market price of the option. A
4.2.6 Modeling volatility
non-option nancial instrument that has embedded optionality, such as an interest rate cap, can also have an
Methods of modelling the volatility smile include implied volatility. Implied volatility, a forward-looking
stochastic volatility models and local volatility models. and subjective measure, diers from historical volatility
For a discussion as to the various alternate approaches de- because the latter is calculated from known past returns
veloped here, see Financial economics #Challenges and of a security.
criticism and BlackScholes model#The volatility smile.

4.2.7

See also

Volatility (nance)
Stochastic volatility
SABR volatility model
Vanna Volga method
Heston model

4.3.1 Motivation
An option pricing model, such as BlackScholes, uses a
variety of inputs to derive a theoretical value for an option. Inputs to pricing models vary depending on the type
of option being priced and the pricing model used. However, in general, the value of an option depends on an
estimate of the future realized price volatility, , of the
underlying. Or, mathematically:

Implied binomial tree

Implied trinomial tree
Edgeworth binomial tree
Financial economics#Challenges and criticism

4.2.8

References

[1] John C. Hull, Options, Futures and Other Derivatives, 5th

edition, page 335
[2] Mahdavi Damghani, Babak (2013). De-arbitraging With
a Weak Smile: Application to Skew Risk. Wilmott 2013
(1): 4049. doi:10.1002/wilm.10201.

C = f (, )
where C is the theoretical value of an option, and f is a
pricing model that depends on , along with other inputs.
The function f is monotonically increasing in , meaning
that a higher value for volatility results in a higher theoretical value of the option. Conversely, by the inverse
function theorem, there can be at most one value for
that, when applied as an input to f (, ) , will result in a
particular value for C.
Put in other terms, assume that there is some inverse
function g = f 1 , such that

102

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

which is the case for BlackScholes model, then Newtons method can be more ecient. However, for most
)
C = g(C,
practical pricing models, such as a binomial model, this
is not the case and vega must be derived numerically.
where C is the market price for an option. The value C When forced to solve for vega numerically, one can use
is the volatility implied by the market price C , or the the Christopher and Salkin method or, for more accurate
implied volatility.
calculation of out-of-the-money implied volatilities, one
[2]
In general, it is not possible to give a closed form formula can use the Corrado-Miller model.
for implied volatility in terms of call price. However, in
some cases (large strike, low strike, short expiry, large
expiry) it is possible to give an asymptotic expansion of 4.3.3 Implied volatility as measure of relaimplied volatility in terms of call price.[1]
tive value
Example
A European call option, CXY Z , on 100 shares of nondividend-paying XYZ Corp. The option is struck at $50
and expires in 32 days. The risk-free interest rate is 5%.
XYZ stock is currently trading at $51.25 and the current
market price of CXY Z is $2.00. Using a standard Black
Scholes pricing model, the volatility implied by the market price CXY Z is 18.7%, or:

) = 18.7%
C = g(C,

As stated by Brian Byrne, the implied volatility of an option is a more useful measure of the options relative value
than its price. The reason is that the price of an option depends most directly on the price of its underlying asset. If
an option is held as part of a delta neutral portfolio (that
is, a portfolio that is hedged against small moves in the
underlyings price), then the next most important factor
in determining the value of the option will be its implied
volatility.
Implied volatility is so important that options are often
quoted in terms of volatility rather than price, particularly
between professional traders.

To verify, we apply the implied volatility back into the

Example
pricing model, f and we generate a theoretical value of
$2.0004:
A call option is trading at $1.50 with the underlying trading at $42.05. The implied volatility of the option is determined to be 18.0%. A short time later, the option is
Ctheo = f (C , ) = $2.0004
trading at $2.10 with the underlying at $43.34, yielding
an implied volatility of 17.2%. Even though the options
which conrms our computation of the market implied
price is higher at the second measurement, it is still convolatility.
sidered cheaper based on volatility. The reason is that the
underlying needed to hedge the call option can be sold for
4.3.2 Solving the inverse pricing model a higher price.

function
4.3.4 Implied volatility as a price

In general, a pricing model function, f, does not have a

closed-form solution for its inverse, g. Instead, a root
Another way to look at implied volatility is to think of
nding technique is used to solve the equation:
it as a price, not as a measure of future stock moves.
In this view it simply is a more convenient way to communicate option prices than currency. Prices are dierf (C , ) C = 0
ent in nature from statistical quantities: one can estimate
volatility of future underlying returns using any of a large
While there are many techniques for nding roots, two number of estimation methods; however, the number one
of the most commonly used are Newtons method and gets is not a price. A price requires two counterparties, a
Brents method. Because options prices can move very buyer and a seller. Prices are determined by supply and
quickly, it is often important to use the most ecient demand. Statistical estimates depend on the time-series
method when calculating implied volatilities.
and the mathematical structure of the model used. It is a
Newtons method provides rapid convergence; however, mistake to confuse a price, which implies a transaction,
it requires the rst partial derivative of the options the- with the result of a statistical estimation, which is merely
oretical value with respect to volatility; i.e., C
, which what comes out of a calculation. Implied volatilities are
is also known as vega (see The Greeks). If the pricing prices: they have been derived from actual transactions.
model function yields a closed-form solution for vega, Seen in this light, it should not be surprising that implied

4.4. NET VOLATILITY

103

volatilities might not conform to what a particular statis- 4.3.9 References

tical model would predict.
Beckers, S. (1981), Standard deviations implied
in option prices as predictors of future stock price
variability, Journal of Banking and Finance 5 (3):
4.3.5 Non-constant implied volatility
363381, doi:10.1016/0378-4266(81)90032-7, retrieved 2009-07-07
In general, options based on the same underlying but with
dierent strike values and expiration times will yield different implied volatilities. This is generally viewed as evidence that an underlyings volatility is not constant but
instead depends on factors such as the price level of the
underlying, the underlyings recent price variance, and
the passage of time. There exist few known parametrisation of the volatility surface (Schonbusher, SVI and
gSVI) as well as their de-arbitraging methodologies.[3]
See stochastic volatility and volatility smile for more information.

4.3.6

Volatility instruments

Mayhew, S. (1995), Implied volatility,

Financial Analysts Journal 51 (4):
820,
doi:10.2469/faj.v51.n4.1916
Corrado, C.J.; Su, T. (1997), Implied volatility
skews and stock index skewness and kurtosis implied by S, The Journal of Derivatives (SUMMER
1997), retrieved 2009-07-07
Grunspan, C. (2011), A Note on the Equivalence
between the Normal and the Lognormal Implied
Volatility: A Model Free Approach, preprint
Grunspan, C. (2011), Asymptotics Expansions for
the Implied Lognormal Volatility in a Model Free
Approach, preprint

Volatility instruments are nancial instruments that track

the value of implied volatility of other derivative securities. For instance, the CBOE Volatility Index (VIX) is
calculated from a weighted average of implied volatili- 4.3.10 External links
ties of various options on the S&P 500 Index. There are
also other commonly referenced volatility indices such as Computer implementations
the VXN index (Nasdaq 100 index futures volatility measure), the QQV (QQQ volatility measure), IVX - Implied
Real-time calculator of implied volatilities when
Volatility Index (an expected stock volatility over a futhe underlying follows a Mean-Reverting Geometture period for any of US securities and exchange traded
ric Brownian Motion, by Razvan Pascalau, Univ. of
instruments), as well as options and futures derivatives
Alabama
based directly on these volatility indices themselves.
Implied volatility calculation by Serdar SEN

4.3.7

See also

Forward volatility
gSVI[4]

4.3.8

Notes

[1] Asymptotic Expansions of the Lognormal Implied

Volatility, Grunspan, C. (2011)
[2] Akke, Ronald. Implied Volatility Numerical Methods.
RonAkke.com. Retrieved 9 June 2014.

Test online implied volatility calculation by

Christophe Rougeaux, ESILV
VBA and Excel spreadsheet to calculate implied
volatility with the bisection method

4.4 Net volatility

Net volatility refers to the volatility implied by the price
of an option spread trade involving two or more options.
Essentially, it is the volatility at which the theoretical
value of the spread trade matches the price quoted in the
market, or, in other words, the implied volatility of the
spread.

[3] Mahdavi Damghani, Babak (2013). De-arbitraging With

a Weak Smile: Application to Skew Risk. Wilmott 2013
(1): 4049. doi:10.1002/wilm.10201.

4.4.1 Formula

[4] Mahdavi Damghani, Babak (2013). De-arbitraging With

a Weak Smile: Application to Skew Risk. Wilmott 2013
(1): 4049. doi:10.1002/wilm.10201.

The net volatility for a two-legged spread (with one long

leg, and one short) can be estimated, to a rst order approximation, by the formula:

104

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

4.4.4 See also

N =

L L S S
L S

where

Implied volatility
Volatility arbitrage
Option spread

N is the net volatility for the spread

L and L are the implied volatility and vega
for the long leg

4.5 Value at risk

S and S are the implied volatility and vega

for the short leg

Not to be confused with Valuation risk.

4.4.2

Example

It is now mid-April 2007, and you are considering going

long a Sep07/May07 100 call spread, i.e. buy the Sep 100
call and sell the May 100 call. The Sep 100 call is oered
at a 14.1% implied volatility and the May 100 call is bid
at an 18.3% implied volatility. The vega of the Sep 100
call is 4.3 and the vega of the May 100 call is 2.3. Using
the formula above, the net volatility of the spread is:

VaR redirects here. For the statistical technique

VAR, see Vector autoregression. For the statistic
denoted Var or var, see Variance.

14.1% 4.3 18.3% 2.3

= 9.27%
4.3 2.3

4.4.3

Interpretation

In the example above, going short a May 100 call and long
a Sep 100 call results in a synthetic forward option - i.e.
an option struck at 100 that spans the period from May to
September expirations. To see this, consider that the two
options essentially oset each other from today until the
expiration of the short May option.
Thus, the net volatility calculated above is, in fact, the
implied volatility of this synthetic forward option. While
it may seem counter-intuitive that one can create a synthetic option whose implied volatility is lower than the
implied volatilities of its components, consider that the
rst implied volatility, 18.1%, corresponds to the period
from today to May expiration, while the second implied
volatility, 14.3% corresponds to the period from today to
September expiration. Therefore, the implied volatility
for the period May to September must be less than 14.3%
to compensate for the higher implied volatility during the
period to May.
In practice, one sees this type of situation often when the
short leg is being bid up for a specic reason. For instance, the near option may include an upcoming event,
such as an earnings announcement, that will, in all probability, cause the underlier price to move. After the event
has passed, the market may expect the underlier to be
relatively stable which results in a lower implied volatility
for the subsequent period.

The 5% Value at Risk of a hypothetical prot-and-loss probability density function

In nancial mathematics and nancial risk management,

value at risk (VaR) is a widely used risk measure of
the risk of loss on a specic portfolio of nancial assets.
For a given portfolio, time horizon, and probability p, the
100p% VaR is dened as a threshold loss value, such that
the probability that the loss on the portfolio over the given
time horizon exceeds this value is p. This assumes markto-market pricing, normal markets, and no trading in the
portfolio.[1]
For example, if a portfolio of stocks has a one-day 5%
VaR of $1 million, there is a 0.05 probability that the
portfolio will fall in value by more than $1 million over a
one day period if there is no trading. Informally, a loss of
$1 million or more on this portfolio is expected on 1 day
out of 20 days (because of 5% probability). A loss which
exceeds the VaR threshold is termed a VaR break.[2]
VaR has four main uses in nance: risk management, nancial control, nancial reporting and computing regulatory capital. VaR is sometimes used in nonnancial applications as well.[3]
Important related ideas are economic capital,
backtesting, stress testing, expected shortfall, and
tail conditional expectation.[4]

4.5. VALUE AT RISK

4.5.1

Details

Common parameters for VaR are 1% and 5% probabilities and one day and two week horizons, although other
combinations are in use.[5]
The reason for assuming normal markets and no trading, and to restricting loss to things measured in daily
accounts, is to make the loss observable. In some extreme nancial events it can be impossible to determine
losses, either because market prices are unavailable or
because the loss-bearing institution breaks up. Some
longer-term consequences of disasters, such as lawsuits,
loss of market condence and employee morale and impairment of brand names can take a long time to play
out, and may be hard to allocate among specic prior decisions. VaR marks the boundary between normal days
and extreme events. Institutions can lose far more than
the VaR amount; all that can be said is that they will not
do so very often.[6]
The probability level is about equally often specied as
one minus the probability of a VaR break, so that the VaR
in the example above would be called a one-day 95% VaR
instead of one-day 5% VaR. This generally does not lead
to confusion because the probability of VaR breaks is almost always small, certainly less than 0.5.[1]
Although it virtually always represents a loss, VaR is conventionally reported as a positive number. A negative
VaR would imply the portfolio has a high probability of
making a prot, for example a one-day 5% VaR of negative $1 million implies the portfolio has a 95% chance of
making more than $1 million over the next day.[7]
Another inconsistency is that VaR is sometimes taken to
refer to prot-and-loss at the end of the period, and sometimes as the maximum loss at any point during the period. The original denition was the latter, but in the early
1990s when VaR was aggregated across trading desks and
time zones, end-of-day valuation was the only reliable
number so the former became the de facto denition. As
people began using multiday VaRs in the second half of
the 1990s, they almost always estimated the distribution
at the end of the period only. It is also easier theoretically
to deal with a point-in-time estimate versus a maximum
over an interval. Therefore the end-of-period denition
is the most common both in theory and practice today.[8]

4.5.2

105
To a risk manager, VaR is a system, not a number. The
system is run periodically (usually daily) and the published number is compared to the computed price movement in opening positions over the time horizon. There
is never any subsequent adjustment to the published VaR,
and there is no distinction between VaR breaks caused
by input errors (including Information Technology breakdowns, fraud and rogue trading), computation errors (including failure to produce a VaR on time) and market
movements.[11]
A frequentist claim is made, that the long-term frequency
of VaR breaks will equal the specied probability, within
the limits of sampling error, and that the VaR breaks will
be independent in time and independent of the level of
VaR. This claim is validated by a backtest, a comparison
of published VaRs to actual price movements. In this interpretation, many dierent systems could produce VaRs
with equally good backtests, but wide disagreements on
daily VaR values.[1]
For risk measurement a number is needed, not a system.
A Bayesian probability claim is made, that given the information and beliefs at the time, the subjective probability of a VaR break was the specied level. VaR is adjusted
after the fact to correct errors in inputs and computation,
but not to incorporate information unavailable at the time
of computation.[7] In this context, "backtest" has a dierent meaning. Rather than comparing published VaRs to
actual market movements over the period of time the system has been in operation, VaR is retroactively computed
on scrubbed data over as long a period as data are available and deemed relevant. The same position data and
pricing models are used for computing the VaR as determining the price movements.[2]
Although some of the sources listed here treat only one
kind of VaR as legitimate, most of the recent ones seem to
agree that risk management VaR is superior for making
short-term and tactical decisions today, while risk measurement VaR should be used for understanding the past,
and making medium term and strategic decisions for the
future. When VaR is used for nancial control or nancial
reporting it should incorporate elements of both. For example, if a trading desk is held to a VaR limit, that is both
a risk-management rule for deciding what risks to allow
today, and an input into the risk measurement computation of the desks risk-adjusted return at the end of the
reporting period.[4]

Varieties of VaR

The denition of VaR is nonconstructive; it species a

property VaR must have, but not how to compute VaR.
Moreover, there is wide scope for interpretation in the
denition.[9] This has led to two broad types of VaR, one
used primarily in risk management and the other primarily for risk measurement. The distinction is not sharp,
however, and hybrid versions are typically used in nancial control, nancial reporting and computing regulatory
capital.[10]

VaR in Governance
VaR can also be applied to governance of endowments,
trusts, and pension plans. Essentially trustees adopt portfolio Values-at-Risk metrics for the entire pooled account
and the diversied parts individually managed. Instead of
probability estimates they simply dene maximum levels
of acceptable loss for each. Doing so provides an easy
metric for oversight and adds accountability as managers

106

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

are then directed to manage, but with the additional constraint to avoid losses within a dened risk parameter.
VaR utilized in this manner adds relevance as well as an
easy way to monitor risk measurement control far more
intuitive than Standard Deviation of Return. Use of VaR
in this context, as well as a worthwhile critique on board
governance practices as it relates to investment management oversight in general can be found in Best Practices
in Governance.[12]

we could try to incorporate the economic cost of things

not measured in daily nancial statements, such as loss of
market condence or employee morale, impairment of
brand names or lawsuits.[4]

4.5.3

Rather than assuming a xed portfolio over a xed time

horizon, some risk measures incorporate the eect of expected trading (such as a stop loss order) and consider the
expected holding period of positions. Finally, some risk
measures adjust for the possible eects of abnormal markets, rather than excluding them from the computation.[4]

Mathematical denition

The VaR risk metric summarizes the distribution of possible losses by a quantile, a point with a specied probaGiven a condence level (0, 1) , the VaR of the bility of greater losses. Common alternative metrics are
portfolio at the condence level is given by the smallest standard deviation, mean absolute deviation, expected
number l such that the probability that the loss L exceeds shortfall and downside risk.[1]
l is at most (1 ) .[3] Mathematically, if L is the loss
of a portfolio, then VaR (L) is the level -quantile, i.e.

4.5.5 VaR risk management

VaR (L) = inf{l R : P (L > l) 1

} = inf{l R : FL (l) }. [13]

Supporters of VaR-based risk management claim the rst

and possibly greatest benet of VaR is the improvement
in systems and modeling it forces on an institution. In
The left equality is a denition of VaR. The right equal- 1997, Philippe Jorion wrote:[17]
ity assumes an underlying probability distribution, which
makes it true only for parametric VaR. Risk managers
[T]he greatest benet of VAR lies in the
typically assume that some fraction of the bad events will
imposition of a structured methodology for
have undened losses, either because markets are closed
critically thinking about risk. Institutions that
or illiquid, or because the entity bearing the loss breaks
go through the process of computing their VAR
apart or loses the ability to compute accounts. Therefore,
are forced to confront their exposure to nanthey do not accept results based on the assumption of a
cial risks and to set up a proper risk managewell-dened probability distribution.[6] Nassim Taleb has
ment function. Thus the process of getting to
labeled this assumption, charlatanism.[14] On the other
VAR may be as important as the number itself.
hand, many academics prefer to assume a well-dened
distribution, albeit usually one with fat tails.[1] This point
has probably caused more contention among VaR theo- Publishing a daily number, on-time and with specied
statistical properties holds every part of a trading organirists than any other.[9]
zation to a high objective standard. Robust backup sysValue of Risks can also be written as a distortion tems and default assumptions must be implemented. Porisk
{ measure given by the distortion function g(x) = sitions that are reported, modeled or priced incorrectly
0 if0 x < 1 [15][16]
stand out, as do data feeds that are inaccurate or late
.
and systems that are too-frequently down. Anything that
1 if1 x 1
aects prot and loss that is left out of other reports
will show up either in inated VaR or excessive VaR
breaks. A risk-taking institution that does not compute
4.5.4 Risk measure and risk metric
VaR might escape disaster, but an institution that cannot
The term VaR is used both for a risk measure and a risk compute VaR will not. [18]
metric. This sometimes leads to confusion. Sources ear- The second claimed benet of VaR is that it separates
lier than 1995 usually emphasize the risk measure, later risk into two regimes. Inside the VaR limit, conventional
sources are more likely to emphasize the metric.
statistical methods are reliable. Relatively short-term and
The VaR risk measure denes risk as mark-to-market
loss on a xed portfolio over a xed time horizon, assuming normal markets. There are many alternative risk
measures in nance. Instead of mark-to-market, which
uses market prices to dene loss, loss is often dened as
change in fundamental value. For example, if an institution holds a loan that declines in market price because
interest rates go up, but has no change in cash ows or
credit quality, some systems do not recognize a loss. Or

specic data can be used for analysis. Probability estimates are meaningful, because there are enough data to
test them. In a sense, there is no true risk because you
have a sum of many independent observations with a left
bound on the outcome. A casino doesn't worry about
whether red or black will come up on the next roulette
spin. Risk managers encourage productive risk-taking in
this regime, because there is little true cost. People tend
to worry too much about these risks, because they happen

4.5. VALUE AT RISK

107

frequently, and not enough about what might happen on or resampled VaR).[4][6] Nonparametric methods of VaR
the worst days.[19]
estimation are discussed in Markovich [23] and Novak.[24]
strategies for VaR prediction
Outside the VaR limit, all bets are o. Risk should be an- A comparison of alternative
[25]
is
given
in
Kuester
et
al.
alyzed with stress testing based on long-term and broad
market data.[20] Probability statements are no longer
meaningful.[21] Knowing the distribution of losses beyond the VaR point is both impossible and useless. The
risk manager should concentrate instead on making sure
good plans are in place to limit the loss if possible, and to
survive the loss if not.[1]

A McKinsey report[26] published in May 2012 estimated

that 85% of large banks were using historical simulation.
The other 15% used Monte Carlo methods.

4.5.7 History of VaR

One specic system uses three regimes.[22]

The problem of risk measurement is an old one in
statistics, economics and nance. Financial risk management has been a concern of regulators and nancial executives for a long time as well. Retrospective analysis
has found some VaR-like concepts in this history. But
VaR did not emerge as a distinct concept until the late
1980s. The triggering event was the stock market crash
of 1987. This was the rst major nancial crisis in which
a lot of academically-trained quants were in high enough
positions to worry about rm-wide survival.[1]

1. One to three times VaR are normal occurrences.

You expect periodic VaR breaks. The loss distribution typically has fat tails, and you might get more
than one break in a short period of time. Moreover,
markets may be abnormal and trading may exacerbate losses, and you may take losses not measured
in daily marks such as lawsuits, loss of employee
morale and market condence and impairment of
brand names. So an institution that can't deal with
three times VaR losses as routine events probably The crash was so unlikely given standard statistical modwon't survive long enough to put a VaR system in els, that it called the entire basis of quant nance into
place.
question. A reconsideration of history led some quants
to decide there were recurring crises, about one or two
2. Three to ten times VaR is the range for stress testing.
per decade, that overwhelmed the statistical assumpInstitutions should be condent they have examined
tions embedded in models used for trading, investment
all the foreseeable events that will cause losses in
management and derivative pricing. These aected
this range, and are prepared to survive them. These
many markets at once, including ones that were usuevents are too rare to estimate probabilities reliably,
ally not correlated, and seldom had discernible economic
so risk/return calculations are useless.
cause or warning (although after-the-fact explanations
[21]
Much later, they were named "Black
3. Foreseeable events should not cause losses beyond were plentiful).
Swans"
by
Nassim
Taleb and the concept extended far
ten times VaR. If they do they should be hedged or
[27]
beyond
nance.
insured, or the business plan should be changed to
avoid them, or VaR should be increased. Its hard If these events were included in quantitative analysis they
to run a business if foreseeable losses are orders of dominated results and led to strategies that did not work
magnitude larger than very large everyday losses. day to day. If these events were excluded, the prots
Its hard to plan for these events, because they are out made in between Black Swans could be much smaller
of scale with daily experience. Of course there will than the losses suered in the crisis. Institutions could
be unforeseeable losses more than ten times VaR, fail as a result.[18][21][27]
but its pointless to anticipate them, you can't know
much about them and it results in needless worry- VaR was developed as a systematic way to segregate exing. Better to hope that the discipline of preparing treme events, which are studied qualitatively over longfor all foreseeable three-to-ten times VaR losses will term history and broad market events, from everyday
improve chances for surviving the unforeseen and price movements, which are studied quantitatively using
short-term data in specic markets. It was hoped that
larger losses that inevitably occur.
Black Swans would be preceded by increases in estimated VaR or increased frequency of VaR breaks, in at
A risk manager has two jobs: make people take more least some markets. The extent to which this has proven
risk the 99% of the time it is safe to do so, and survive to be true is controversial.[21]
the other 1% of the time. VaR is the border.[18]
Abnormal markets and trading were excluded from the
VaR estimate in order to make it observable.[19] It is not
always possible to dene loss if, for example, markets are
4.5.6 Computation methods
closed as after 9/11, or severely illiquid, as happened sevVaR can be estimated either parametrically (for example, eral times in 2008.[18] Losses can also be hard to dene if
variance-covariance VaR or delta-gamma VaR) or non- the risk-bearing institution fails or breaks up.[19] A meaparametrically (for examples, historical simulation VaR sure that depends on traders taking certain actions, and

108

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

avoiding other actions, can lead to self reference.[1]

Einhorn compared VaR to an airbag that works all the

This is risk management VaR. It was well established time, except when you have a car accident. He further
in quantitative trading groups at several nancial institu- charged that VaR:
tions, notably Bankers Trust, before 1990, although nei1. Led to excessive risk-taking and leverage at nancial
ther the name nor the denition had been standardized.
institutions
There was no eort to aggregate VaRs across trading
desks.[21]
2. Focused on the manageable risks near the center of
The nancial events of the early 1990s found many rms
the distribution and ignored the tails
in trouble because the same underlying bet had been
made at many places in the rm, in non-obvious ways.
3. Created an incentive to take excessive but remote
Since many trading desks already computed risk manrisks
agement VaR, and it was the only common risk measure that could be both dened for all businesses and ag4. Was potentially catastrophic when its use creates a
gregated without strong assumptions, it was the natural
false sense of security among senior executives and
choice for reporting rmwide risk. J. P. Morgan CEO
watchdogs.
Dennis Weatherstone famously called for a 4:15 report
that combined all rm risk on one page, available within
New York Times reporter Joe Nocera wrote an exten15 minutes of the market close.[9]
sive piece Risk Mismanagement[30] on January 4, 2009
Risk measurement VaR was developed for this purpose. discussing the role VaR played in the Financial crisis of
Development was most extensive at J. P. Morgan, which 2007-2008. After interviewing risk managers (including
published the methodology and gave free access to esti- several of the ones cited above) the article suggests that
mates of the necessary underlying parameters in 1994. VaR was very useful to risk experts, but nevertheless exThis was the rst time VaR had been exposed beyond acerbated the crisis by giving false security to bank exa relatively small group of quants. Two years later, the ecutives and regulators. A powerful tool for professional
methodology was spun o into an independent for-prot risk managers, VaR is portrayed as both easy to misunbusiness now part of RiskMetrics Group.[9]
derstand, and dangerous when misunderstood.
In 1997, the U.S. Securities and Exchange Commission
ruled that public corporations must disclose quantitative
information about their derivatives activity. Major banks
and dealers chose to implement the rule by including VaR
information in the notes to their nancial statements.[1]

Taleb, in 2009, testied in Congress asking for the banning of VaR on two arguments, the rst that tail risks
are non-measurable scientically and the second is that
for anchoring reasons VaR for leading to higher risk
taking.[31]

Worldwide adoption of the Basel II Accord, beginning in

1999 and nearing completion today, gave further impetus
to the use of VaR. VaR is the preferred measure of market
risk, and concepts similar to VaR are used in other parts
of the accord.[1]

A common complaint among academics is that VaR is not

subadditive.[4] That means the VaR of a combined portfolio can be larger than the sum of the VaRs of its components. To a practising risk manager this makes sense. For
example, the average bank branch in the United States
is robbed about once every ten years. A single-branch
bank has about 0.0004% chance of being robbed on a
specic day, so the risk of robbery would not gure into
one-day 1% VaR. It would not even be within an order of
magnitude of that, so it is in the range where the institution should not worry about it, it should insure against it
and take advice from insurers on precautions. The whole
point of insurance is to aggregate risks that are beyond individual VaR limits, and bring them into a large enough
portfolio to get statistical predictability. It does not pay
for a one-branch bank to have a security expert on sta.

4.5.8

Criticism

VaR has been controversial since it moved from trading

desks into the public eye in 1994. A famous 1997 debate
between Nassim Taleb and Philippe Jorion set out some
of the major points of contention. Taleb claimed VaR:[28]
1. Ignored 2,500 years of experience in favor of
untested models built by non-traders

2. Was charlatanism because it claimed to estimate the As institutions get more branches, the risk of a robbery
on a specic day rises to within an order of magnitude
risks of rare events, which is impossible
of VaR. At that point it makes sense for the institution to
run internal stress tests and analyze the risk itself. It will
3. Gave false condence
spend less on insurance and more on in-house expertise.
4. Would be exploited by traders
For a very large banking institution, robberies are a routine daily occurrence. Losses are part of the daily VaR
In 2008 David Einhorn and Aaron Brown debated VaR calculation, and tracked statistically rather than case-byin Global Association of Risk Professionals Review[18][29] case. A sizable in-house security department is in charge

4.5. VALUE AT RISK

109

of prevention and control, the general risk manager just in which MX (z) is the moment-generating function of X
tracks the loss like any other cost of doing business.
at z . In the above equations the variable X denotes the
As portfolios or institutions get larger, specic risks nancial loss, rather than wealth as is typically the case.
change from low-probability/low-predictability/highimpact to statistically predictable losses of low individual
4.5.9 See also
impact. That means they move from the range of far
outside VaR, to be insured, to near outside VaR, to
Capital Adequacy Directive
be analyzed case-by-case, to inside VaR, to be treated
[18]
statistically.
Valuation risk
Even VaR supporters generally agree there are common
Conditional value-at-risk
abuses of VaR:[6][9]
1. Referring to VaR as a worst-case or maximum
tolerable loss. In fact, you expect two or three
losses per year that exceed one-day 1% VaR.

Entropic value at risk

Risk return ratio

2. Making VaR control or VaR reduction the central 4.5.10 References

concern of risk management. It is far more important to worry about what happens when losses ex- [1] Jorion, Philippe (2006). Value at Risk: The New Benchceed VaR.
mark for Managing Financial Risk (3rd ed.). McGrawHill. ISBN 978-0-07-146495-6.

3. Assuming plausible losses will be less than some

multiple, often three, of VaR. The entire point of
VaR is that losses can be extremely large, and sometimes impossible to dene, once you get beyond the
VaR point. To a risk manager, VaR is the level of
losses at which you stop trying to guess what will
happen next, and start preparing for anything.
4. Reporting a VaR that has not passed a backtest.
Regardless of how VaR is computed, it should
have produced the correct number of breaks (within
sampling error) in the past. A common specic violation of this is to report a VaR based on
the unveried assumption that everything follows a
multivariate normal distribution.
VaR, CVaR and EVaR
The VaR is not a coherent risk measure since it violates
the sub-additivity property, which is
If X, Y L, then (X + Y ) (X) + (Y ).
However, it can be bounded by coherent risk measures
like Conditional Value-at-Risk (CVaR) or entropic value
at risk (EVaR). In fact, for X LM + (with LM + the
set of all Borel measurable functions whose momentgenerating function exists for all positive real values) we
have
VaR1 (X) CVaR1 (X) EVaR1 (X),
where
VaR1 (X) := inf {t : Pr(X t) 1 },
tR

1
VaR1 (X)d,
CVaR1 (X) :=
0
EVaR1 (X) := inf {z 1 ln(MX (z)/)},
z>0

[2] Holton, Glyn A. (2014). Value-at-Risk: Theory and Practice second edition, e-book.
[3] McNeil, Alexander; Frey, Rdiger; Embrechts, Paul
(2005). Quantitative Risk Management: Concepts Techniques and Tools. Princeton University Press. ISBN 9780-691-12255-7.
[4] Dowd, Kevin (2005). Measuring Market Risk. John Wiley
& Sons. ISBN 978-0-470-01303-8.
[5] Pearson, Neil (2002). Risk Budgeting: Portfolio Problem
Solving with Value-at-Risk. John Wiley & Sons. ISBN
978-0-471-40556-6.
[6] Aaron Brown (March 2004), The Unbearable Lightness of
Cross-Market Risk, Wilmott Magazine
[7] Crouhy, Michel; Galai, Dan; Mark, Robert (2001). The
Essentials of Risk Management. McGraw-Hill. ISBN 9780-07-142966-5.
[8] Jose A. Lopez (September 1996). Regulatory Evaluation
of Value-at-Risk Models. Wharton Financial Institutions
Center Working Paper 96-51.
[9] Kolman, Joe; Onak, Michael; Jorion, Philippe; Taleb,
Nassim; Derman, Emanuel; Putnam, Blu; Sandor,
Richard; Jonas, Stan; Dembo, Ron; Holt, George; Tanenbaum, Richard; Margrabe, William; Mudge, Dan; Lam,
James; Rozsypal, Jim (April 1998). Roundtable: The
Limits of VaR. Derivatives Strategy.
[10] Aaron Brown (March 1997), The Next Ten VaR Disasters,
Derivatives Strategy
[11] Wilmott, Paul (2007). Paul Wilmott Introduces Quantitative Finance. Wiley. ISBN 978-0-470-31958-1.
[12] Lawrence York (2009), Best Practices in Governance

110

[13] Artzner, Philippe; Delbaen, Freddy; Eber, JeanMarc; Heath, David (1999). Coherent Measures of
Risk (PDF). Mathematical Finance 9 (3): 203228.
doi:10.1111/1467-9965.00068. Retrieved February 3,
2011.
[14] Nassim Taleb (December 1996 January 1997), The
World According to Nassim Taleb, Derivatives Strategy
[15] Julia L. Wirch; Mary R. Hardy. Distortion Risk Measures: Coherence and Stochastic Dominance (PDF). Retrieved March 10, 2012.
[16] Balbs, A.; Garrido, J.; Mayoral, S. (2008). Properties of
Distortion Risk Measures. Methodology and Computing
in Applied Probability 11 (3): 385. doi:10.1007/s11009008-9089-z.
[17] Jorion, Philippe (April 1997). The Jorion-Taleb Debate.
Derivatives Strategy.
[18] Aaron Brown (JuneJuly 2008). Private Prots and Socialized Risk. GARP Risk Review.
[19] Espen Haug (2007). Derivative Models on Models. John
Wiley & Sons. ISBN 978-0-470-01322-9.
[20] Ezra Zask (February 1999), Taking the Stress Out of Stress
Testing, Derivative Strategy
[21] Kolman, Joe; Onak, Michael; Jorion, Philippe; Taleb,
Nassim; Derman, Emanuel; Putnam, Blu; Sandor,
Richard; Jonas, Stan; Dembo, Ron; Holt, George; Tanenbaum, Richard; Margrabe, William; Mudge, Dan; Lam,
James; Rozsypal, Jim (April 1998). Roundtable: The
Limits of Models. Derivatives Strategy.

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

4.5.11 External links

Discussion
Value At Risk, Ben Sopranzetti, Ph.D., CPA
Perfect Storms Beautiful & True Lies In Risk
Management, Satyajit Das
Gloria Mundi All About Value at Risk, Barry
Schachter
Risk Mismanagement, Joe Nocera NYTimes article.
VaR Doesn't Have To Be Hard, Rich Tanenbaum
Tools
Online real-time VaR calculator, Razvan Pascalau,
University of Alabama
Value-at-Risk (VaR), Simon Benninga and Zvi
Wiener. (Mathematica in Education and Research
Vol. 7 No. 4 1998.)
Derivatives Strategy Magazine. Inside D. E. Shaw
Trading and Risk Management 1998

4.6 Greeks

In mathematical nance, the Greeks are the quantities

representing the sensitivity of the price of derivatives such
as options to a change in underlying parameters on which
[23] Markovich, N. (2007), Nonparametric analysis of univari- the value of an instrument or portfolio of nancial instruments is dependent. The name is used because the most
ate heavy-tailed data, Wiley
common of these sensitivities are denoted by Greek let[24] Novak, S.Y. (2011). Extreme value methods with appliters (as are some other nance measures). Collectively
cations to nance. Chapman & Hall/CRC Press. ISBN
these have also been called the risk sensitivities,[1] risk
978-1-4398-3574-6.
measures[2]:742 or hedge parameters.[3]
[22] Aaron Brown (December 2007). On Stressing the Right
Size. GARP Risk Review.

[25] Kuester, Keith; Mittnik, Stefan; Paolella, Marc (2006).

Value-at-Risk Prediction: A Comparison of Alternative
Strategies. Journal of Financial Econometrics 4: 5389.
doi:10.1093/jjnec/nbj002.
[26] McKinsey & Company. McKinsey Working Papers on
Risk, Number 32 (PDF).
[27] Taleb, Nassim Nicholas (2007). The Black Swan: The
Impact of the Highly Improbable. New York: Random
House. ISBN 978-1-4000-6351-2.
[28] Nassim Taleb (April 1997), The Jorion-Taleb Debate,
Derivatives Strategy

4.6.1 Use of the Greeks

The Greeks are vital tools in risk management. Each
Greek measures the sensitivity of the value of a portfolio to a small change in a given underlying parameter, so
that component risks may be treated in isolation, and the
portfolio rebalanced accordingly to achieve a desired exposure; see for example delta hedging.

The Greeks in the BlackScholes model are relatively

easy to calculate, a desirable property of nancial models,
[29] David Einhorn (JuneJuly 2008), Private Prots and So- and are very useful for derivatives traders, especially
those who seek to hedge their portfolios from adverse
cialized Risk, GARP Risk Review
changes in market conditions. For this reason, those
[30] Joe Nocera (January 4, 2009), Risk Mismanagement, The Greeks which are particularly useful for hedging--such
New York Times Magazine
as delta, theta, and vega--are well-dened for measuring
changes in Price, Time and Volatility. Although rho is a
[31] http://gop.science.house.gov/Media/hearings/
oversight09/sept10/taleb.pdf
primary input into the BlackScholes model, the overall

4.6. GREEKS
impact on the value of an option corresponding to changes
in the risk-free interest rate is generally insignicant and
therefore higher-order derivatives involving the risk-free
interest rate are not common.
The most common of the Greeks are the rst order
derivatives: Delta, Vega, Theta and Rho as well as
Gamma, a second-order derivative of the value function. The remaining sensitivities in this list are common
enough that they have common names, but this list is by
no means exhaustive.

4.6.2

Names

The use of Greek letter names is presumably by extension

from the common nance terms alpha and beta. Several
names such as 'vega' and 'zomma' are invented, but sound
similar to Greek letters. The names 'color' and 'charm'
presumably derive from the use of these terms for exotic
properties in quantum mechanics.

4.6.3

First-order Greeks

111
and 25 delta call. 50 Delta put and 50 Delta call are not
quite identical, due to spot and forward diering by the
discount factor, but they are often conated.
Delta is always positive for long calls and negative for long
puts (unless they are zero). The total delta of a complex
portfolio of positions on the same underlying asset can
be calculated by simply taking the sum of the deltas for
each individual position delta of a portfolio is linear
in the constituents. Since the delta of underlying asset
is always 1.0, the trader could delta-hedge his entire position in the underlying by buying or shorting the number of shares indicated by the total delta. For example,
if the delta of a portfolio of options in XYZ (expressed
as shares of the underlying) is +2.75, the trader would
be able to delta-hedge the portfolio by selling short 2.75
shares of the underlying. This portfolio will then retain
its total value regardless of which direction the price of
XYZ moves. (Albeit for only small movements of the
underlying, a short amount of time and not-withstanding
changes in other market conditions such as volatility and
the rate of return for a risk-free investment).
As a proxy for probability Main article: Moneyness

Delta
Delta,[4] , measures the rate of change of the theoretical option value with respect to changes in the underlying
assets price. Delta is the rst derivative of the value V
of the option with respect to the underlying instruments
price S .
Practical use For a vanilla option, delta will be a number between 0.0 and 1.0 for a long call (or a short put) and
0.0 and 1.0 for a long put (or a short call); depending on
price, a call option behaves as if one owns 1 share of the
underlying stock (if deep in the money), or owns nothing
(if far out of the money), or something in between, and
conversely for a put option. The dierence of the delta of
a call and the delta of a put at the same strike is close to
but not in general equal to one, but instead is equal to the
inverse of the discount factor. By putcall parity, long a
call and short a put equals a forward F, which is linear in
the spot S, with factor the inverse of the discount factor,
so the derivative dF/dS is this factor.
These numbers are commonly presented as a percentage
of the total number of shares represented by the option
contract(s). This is convenient because the option will
(instantaneously) behave like the number of shares indicated by the delta. For example, if a portfolio of 100
American call options on XYZ each have a delta of 0.25
(=25%), it will gain or lose value just like 25 shares of
XYZ as the price changes for small price movements.
The sign and percentage are often dropped the sign is
implicit in the option type (negative for put, positive for
call) and the percentage is understood. The most commonly quoted are 25 delta put, 50 delta put/50 delta call,

The (absolute value of) Delta is close to, but not identical
with, the percent moneyness of an option, i.e., the implied probability that the option will expire in-the-money
(if the market moves under Brownian motion in the riskneutral measure).[5] For this reason some option traders
use the absolute value of delta as an approximation for
percent moneyness. For example, if an out-of-the-money
call option has a delta of 0.15, the trader might estimate
that the option has approximately a 15% chance of expiring in-the-money. Similarly, if a put contract has a delta
of 0.25, the trader might expect the option to have a
25% probability of expiring in-the-money. At-the-money
puts and calls have a delta of approximately 0.5 and 0.5
respectively with a slight bias towards higher deltas for
ATM calls,[note 1] i.e. both have approximately a 50%
chance of expiring in-the-money. The correct, exact calculation for the probability of an option nishing at a
particular price of K is its Dual Delta, which is the rst
derivative of option price with respect to strike.
Relationship between call and put delta Given a European call and put option for the same underlying, strike
price and time to maturity, and with no dividend yield,
the sum of the absolute values of the delta of each option
will be 1 more precisely, the delta of the call (positive)
minus the delta of the put (negative) equals 1. This is due
to putcall parity: a long call plus a short put (a call minus
a put) replicates a forward, which has delta equal to 1.
If the value of delta for an option is known, one can calculate the value of the delta of the option of the same strike
price, underlying and maturity but opposite right by subtracting 1 from a known call delta or adding 1 to a known

112

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

put delta.

the option immediately, so a call with strike $50 on a

stock with price $60 would have intrinsic value of $10,
whereas the corresponding put would have zero intrinsic
value. The time value is the value of having the option of
waiting longer before deciding to exercise. Even a deeply
out of the money put will be worth something, as there
is some chance the stock price will fall below the strike
before the expiry date. However, as time approaches maturity, there is less chance of this happening, so the time
value of an option is decreasing with time. Thus if you
are long an option you are short theta: your portfolio will
lose value with the passage of time (all other factors held
constant).

d(call) d(put) = 1, therefore: d(call) = d(put) + 1 and

d(put) = d(call) 1.
For example, if the delta of a call is 0.42 then one can
compute the delta of the corresponding put at the same
strike price by 0.42 1 = 0.58. To derive the delta of a
call from a put, one can similarly take 0.58 and add 1 to
get 0.42.
Vega

Vega[4] measures sensitivity to volatility. Vega is the

derivative of the option value with respect to the volatility
of the underlying asset.
Rho
Vega is not the name of any Greek letter. However,
the glyph used is the Greek letter nu ( ). Presumably
the name vega was adopted because the Greek letter nu
looked like a Latin vee, and vega was derived from vee by
analogy with how beta, eta, and theta are pronounced in
American English. Another possibility is that it is named
after Joseph De La Vega, famous for Confusion of Confusions, a book about stock markets and which discusses
trading operations that were complex, involving both options and forward trades.[6]

Rho,[4] , measures sensitivity to the interest rate: it is

the derivative of the option value with respect to the risk
free interest rate (for the relevant outstanding term).
Except under extreme circumstances, the value of an option is less sensitive to changes in the risk free interest
rate than to changes in other parameters. For this reason,
rho is the least used of the rst-order Greeks.

Rho is typically expressed as the amount of money, per

share of the underlying, that the value of the option will
The symbol kappa, , is sometimes used (by academics) gain or lose as the risk free interest rate rises or falls by
instead of vega (as is tau ( ) or capital Lambda ( 1.0% per annum (100 basis points).
),[7]:315 though these are rare).
Vega is typically expressed as the amount of money per Lambda
underlying share that the options value will gain or lose
as volatility rises or falls by 1%.
Lambda, , omega, , or elasticity[4] is the percentage
Vega can be an important Greek to monitor for an op- change in option value per percentage change in the untion trader, especially in volatile markets, since the value derlying price, a measure of leverage, sometimes called
of some option strategies can be particularly sensitive to gearing.
changes in volatility. The value of an option straddle, for
example, is extremely dependent on changes to volatility.

4.6.4 Second-order Greeks

Theta

Gamma

Theta,[4] , measures the sensitivity of the value of the Gamma,[4] , measures the rate of change in the delta
derivative to the passage of time (see Option time value): with respect to changes in the underlying price. Gamma
the time decay.
is the second derivative of the value function with respect
The mathematical result of the formula for theta (see be- to the underlying price. All long options have positive
low) is expressed in value per year. By convention, it is gamma and all short options have negative gamma. Long
usual to divide the result by the number of days in a year, options have a positive relationship with Gamma because
to arrive at the amount of money per share of the under- as price increases, Gamma increases up as well, causlying that the option loses in one day. Theta is almost ing Delta to approach 1 from 0 (long call option) and 0
always negative for long calls and puts and positive for from 1[8](long put option). The inverse is true for short
short (or written) calls and puts. An exception is a deep options.
in-the-money European put. The total theta for a portfo- Gamma is greatest approximately at-the-money (ATM)
lio of options can be determined by summing the thetas and diminishes the further out you go either in-the-money
(ITM) or out-of-the-money (OTM). Gamma is important
for each individual position.
The value of an option can be analysed into two parts: the because it corrects for the convexity of value.
intrinsic value and the time value. The intrinsic value is When a trader seeks to establish an eective delta-hedge
the amount of money you would gain if you exercised for a portfolio, the trader may also seek to neutralize the

4.6. GREEKS

113
Charm
Charm[4] or delta decay, measures the instantaneous
rate of change of delta over the passage of time. Charm
has also been called DdeltaDtime.[10] Charm can be an
important Greek to measure/monitor when delta-hedging
a position over a weekend. Charm is a second-order
derivative of the option value, once to price and once to
the passage of time. It is also then the derivative of theta
with respect to the underlyings price.

The mathematical result of the formula for charm (see

below) is expressed in delta/year. It is often useful to
Long option Delta, underlying price, and Gamma.[9]
divide this by the number of days per year to arrive at
the delta decay per day. This use is fairly accurate when
the number of days remaining until option expiration is
portfolios gamma, as this will ensure that the hedge will
large. When an option nears expiration, charm itself may
be eective over a wider range of underlying price movechange quickly, rendering full day estimates of delta dements. However, in neutralizing the gamma of a portfocay inaccurate.
lio, alpha (the return in excess of the risk-free rate) is
reduced.
Veta
Veta, or DvegaDtime,[11] measures the rate of change in
the vega with respect to the passage of time. Veta is the
[4]
Vanna, also referred to as DvegaDspot and DdeltaD- second derivative of the value function; once to volatility
vol, [10] is a second order derivative of the option value, and once to time.
once to the underlying spot price and once to volatility. It is common practice to divide the mathematical result of
It is mathematically equivalent to DdeltaDvol, the sensi- veta by 100 times the number of days per year to reduce
tivity of the option delta with respect to change in volatil- the value to the percentage change in vega per one day.
ity; or alternatively, the partial of vega with respect to
the underlying instruments price. Vanna can be a useful
sensitivity to monitor when maintaining a delta- or vega- Vera
hedged portfolio as vanna will help the trader to anticipate
changes to the eectiveness of a delta-hedge as volatil- Vera (sometimes Rhova) measures the rate of change in
ity changes or the eectiveness of a vega-hedge against rho with respect to volatility. Vera is the second derivative of the value function; once to volatility and once to
change in the underlying spot price.
interest rate. Vera can be used to assess the impact of
If the underlying value has continuous second partial volatility change on rho-hedging.

2V
derivatives then, Vanna =
= S = S
Vanna

4.6.5 Third-order Greeks

Vomma

Color
[11]

Vomma, Volga, Vega Convexity,

Vega gamma
or dTau/dVol measures second order sensitivity to
volatility. Vomma is the second derivative of the option
value with respect to the volatility, or, stated another way,
vomma measures the rate of change to vega as volatility
changes. With positive vomma, a position will become
long vega as implied volatility increases and short vega as
it decreases, which can be scalped in a way analogous to
long gamma. And an initially vega-neutral, long-vomma
position can be constructed from ratios of options at different strikes. Vomma is positive for options away from
the money, and initially increases with distance from the
money (but drops o as vega drops o). (Specically,
vomma is positive where the usual d1 and d2 terms are
of the same sign, which is true when d2 < 0 or d1 > 0.)

Color,[note 2] gamma decay or DgammaDtime[10] measures the rate of change of gamma over the passage of
time. Color is a third-order derivative of the option value,
twice to underlying asset price and once to time. Color
can be an important sensitivity to monitor when maintaining a gamma-hedged portfolio as it can help the trader to
anticipate the eectiveness of the hedge as time passes.
The mathematical result of the formula for color (see below) is expressed in gamma/year. It is often useful to
divide this by the number of days per year to arrive at
the change in gamma per day. This use is fairly accurate
when the number of days remaining until option expiration is large. When an option nears expiration, color itself may change quickly, rendering full day estimates of

114

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

gamma change inaccurate.

4.6.7 Formulas
Greeks

for

European

option

See also: BlackScholes model

Speed
Speed[4] measures the rate of change in Gamma with
respect to changes in the underlying price. This is
also sometimes referred to as the gamma of the
gamma[2]:799 or DgammaDspot.[10] Speed is the third
derivative of the value function with respect to the underlying spot price. Speed can be important to monitor when
delta-hedging or gamma-hedging a portfolio.

The Greeks of European options (calls and puts) under

the BlackScholes model are calculated as follows, where
(phi) is the standard normal probability density function and is the standard normal cumulative distribution
function. Note that the gamma and vega formulas are the
same for calls and puts.

Ultima

where

For a given: Stock Price S , Strike Price K , Risk-Free

Rate r , Annual Dividend Yield q , Time to Maturity
= T t , and Volatility ...

Ultima[4] measures the sensitivity of the option vomma

2
with respect to change in volatility. Ultima has also been d1 = ln(S/K) + (r q + /2)

referred to as DvommaDvol.[4] Ultima is a third-order
derivative of the option value to volatility.

ln(S/K) + (r q 2 /2)

d2 =
= d1

x2

e 2
(x) =
2

Zomma

Zomma[4] measures the rate of change of gamma with

x

2
y2
1
y2
respect to changes in volatility. Zomma has also been re- (x) = 1
e
dy = 1
e 2 dy
[10]
2
2 x
ferred to as DgammaDvol. Zomma is the third derivative of the option value, twice to underlying asset price
and once to volatility. Zomma can be a useful sensitivity
to monitor when maintaining a gamma-hedged portfolio 4.6.8 Related measures
as zomma will help the trader to anticipate changes to the
Some related risk measures of nancial derivatives are
eectiveness of the hedge as volatility changes.
listed below.

4.6.6

Greeks for multi-asset options

Bond duration and convexity

Main articles: Bond duration and Bond convexity

If the value of a derivative is dependent on two or more
underlyings, its Greeks are extended to include the crossIn trading of xed income securities (bonds), various
eects between the underlyings.
measures of bond duration are used analogously to the
Correlation delta measures the sensitivity of the deriva- delta of an option. The closest analogue to the delta is
tives value to a change in the correlation between the unDV01, which is the reduction in price (in currency units)
derlyings.
for an increase of one basis point (i.e. 0.01% per annum)
Cross gamma measures the rate of change of delta in one in the yield (the yield is the underlying variable).
underlying to a change in the level of another underlying. Analogous to the lambda is the modied duration, which
[12]

is the percentage change in the market price of the bond(s)

for a unit change in the yield (i.e. it is equivalent to DV01
divided by the market price). Unlike the lambda, which
is an elasticity (a percentage change in output for a percentage change in input), the modied duration is instead
a semi-elasticitya percentage change in output for a unit
Cross volga measures the rate of change of vega in change in input.
one underlying to a change in the volatility of another Bond convexity is a measure of the sensitivity of the duration to changes in interest rates, the second derivative of
underlying.[12]
Cross vanna measures the rate of change of vega in one
underlying due to a change in the level of another underlying. Equivalently, it measures the rate of change of delta
in the second underlying due to a change in the volatility
of the rst underlying.

4.6. GREEKS
the price of the bond with respect to interest rates (duration is the rst derivative). In general, the higher the convexity, the more sensitive the bond price is to the change
in interest rates. Bond convexity is one of the most basic
and widely used forms of convexity in nance.

115

the bias to the call remains (ATM delta > 0.50) due to
the expected value of the lognormal distribution (namely,
the (1/2)2 term). Also, in markets that exhibit contango
forward prices (positive basis), the eect of interest rates
on forward prices will also cause the call delta to increase.
[2] This author has only seen this referred to in the British
spelling Colour, but has written it here in the US spelling
to match the style of the existing article.

Beta
Main article: Beta (nance)

4.6.11 References
The Beta () of a stock or portfolio is a number describing the volatility of an asset in relation to the volatility of
the benchmark that said asset is being compared to. This
benchmark is generally the overall nancial market and
is often estimated via the use of representative indices,
such as the S&P 500.
An asset has a Beta of zero if its returns change independently of changes in the markets returns. A positive
beta means that the assets returns generally follow the
markets returns, in the sense that they both tend to be
above their respective averages together, or both tend to
be below their respective averages together. A negative
beta means that the assets returns generally move opposite the markets returns: one will tend to be above its
average when the other is below its average.
Fugit

[2] Macmillan, Lawrence G. (1993). Options as a Strategic Investment (3rd ed.). New York Institute of Finance. ISBN
978-0-13-636002-5. ISBN 0-13-099661-0
[3] Chriss, Neil (1996). BlackScholes and beyond: option
pricing models. McGraw-Hill Professional. p. 308. ISBN
9780786310258. ISBN 0-7863-1025-1
[4] Haug, Espen Gaardner (2007). The Complete Guide to Option Pricing Formulas. McGraw-Hill Professional. ISBN
9780071389976. ISBN 0-07-138997-0
[5] Suma, John. Options Greeks: Delta Risk and Reward.
Retrieved 7 Jan 2010.
[6] Joseph de la Vega. QFinance. Retrieved 1 July 2013.

Main article: Fugit

The fugit is the expected time to exercise an American
or Bermudan option. It is useful to compute it for hedging purposesfor example, one can represent ows of
an American swaption like the ows of a swap starting at
the fugit multiplied by delta, then use these to compute
sensitivities.

4.6.9

[1] Banks, Erik; Siegel, Paul (2006). The options applications

handbook: hedging and speculating techniques for professional investors. McGraw-Hill Professional. p. 263.
ISBN 9780071453158. ISBN 0-07-145315-6

See also

Alpha (nance)
Beta coecient
Delta neutral

[7] Hull, John C. (1993). Options, Futures, and Other

Derivative Securities (2nd ed.). Prentice-Hall. ISBN
9780136390145. ISBN 0-13-639014-5
[8] Willette, Je (2014-05-28).
Understanding How
Gamma Aect Delta. http://www.traderbrains.com''.
Retrieved 2014-03-07.
[9] Willette, Je (2014-05-28). How Gamma Aects
Delta. http://www.traderbrains.com''. Retrieved 201403-07.
[10] Haug, Espen Gaarder (2003), Know Your Weapon, Part
1 (PDF), Wilmott Magazine (May 2003): 4957
[11] Haug, Espen Gaarder (2003), Know Your Weapon, Part
2, Wilmott Magazine (July 2003): 4357
[12] Fengler, Matthias; Schwendner, Peter. Correlation Risk
Premia for Multi-Asset Equity Options (PDF).

Greek letters used in mathematics

4.6.12 External links

4.6.10

Notes
Discussion

[1] There is a slight bias for a greater probability that a call will
expire in-the-money than a put at the same strike when the
underlying is also exactly at the strike. This bias is due to
the much larger range of prices that the underlying could
be within at expiration for calls (Strike...+inf) than puts
(0...Strike). However, with large strike and underlying
values, this asymmetry can be eectively eliminated. Yet

Why We Have Never Used the Black-ScholesMerton Option Pricing Formula, Nassim Taleb and
Espen Gaarder Haug
Theory

116

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

Delta, Gamma, GammaP, Gamma symmetry, 4.7 Convenience yield

Vanna, Speed, Charm, Saddle Gamma: Vanilla Options - Espen Haug,
A convenience yield is an adjustment to the cost of carry
Volga, Vanna, Speed, Charm, Color: Vanilla Op- in the non-arbitrage pricing formula for forward prices in
tions - Uwe Wystup, Vanilla Options - Uwe Wystup markets with trading constraints.
Let Ft,T be the forward price of an asset with initial price
Step-by-Step Mathematical Derivations of Option St and maturity T . Suppose that r is the continuously
compounded interest rate for one year. Then, the nonGreeks
arbitrage pricing formula should be
Derivation of European Vanilla Call Price

Ft,T = St er(T t)

Derivation of European Vanilla Call Delta

Derivation of European Vanilla Call Speed

However, this relationship does not hold in most commodity markets, partly because of the inability of investors and speculators to short the underlying asset, St .
Instead, there is a correction to the forward pricing formula given by the convenience yield c . Hence

Derivation of European Vanilla Call Vega

Ft,T = St e(rc)(T t)

Derivation of European Vanilla Call Volga

This makes it possible for backwardation to be observable.

Derivation of European Vanilla Call Gamma

Derivation of European Vanilla Call Vanna as

Derivative of Vega with respect to underlying
Derivation of European Vanilla Call Vanna as
Derivative of Delta with respect to volatility

4.7.1 Example

Derivation of European Vanilla Put Price

A trader has observed that the price of 6-month ( T )

gold futures price (F) is $1,300 per troy ounce, whereas
the spot price (S) is $1,371 per troy ounce. The (not compounded) borrowing rate for a 6-month loan ( r ) is 3.5%
per annum, and storage cost for gold is negligible (0%).
Since we know we have the relation:

Derivation of European Vanilla Put Delta

F = S [1 + (r c)T ]

Derivation of European Vanilla Put Gamma

What is the convenience yield implied by the futures

price?

Derivation of European Vanilla Call Theta

Derivation of European Vanilla Call Rho

Derivation of European Vanilla Put Speed

Derivation of European Vanilla Put Vega
Derivation of European Vanilla Put Volga
Derivation of European Vanilla Put Vanna as
Derivative of Vega with respect to underlying
Derivation of European Vanilla Put Vanna as
Derivative of Delta with respect to volatility
Derivation of European Vanilla Put Theta
Derivation of European Vanilla Put Rho
Online tools
Surface Plots of Black-Scholes Greeks, Chris Murray

From the formula above, we isolate the convenience yield

( c ), and we obtain:
(
)
c = r + T1 1 FS
(
)
1
1300
c = 0.035 + 0.5
1 1371
= 0.13857 = 13.9% (per
annum, not compounded)
For information, if we had a continuously compounded
6-month borrowing rate and if we were looking for the
continuously compounded convenience yield, we would
have the formula:
F = S e(rc)T
And the convenience yield would therefore be:
( )
c = r T1 ln FS
(
)
1
ln 1300
c = 0.035 0.5
1371 = 0.14135 = 14.1% (per
annum, continuously compounded)

Online real-time option prices and Greeks calculator

4.7.2
when the underlying is normally distributed, Razvan
Pascalau, Univ. of Alabama

Why should a convenience yield exist?

Excel-based tool to calculate the Greeks - A free ex- Users of a consumption asset may obtain a benet from
cel sheet provided by Pristine
physically holding the asset (as inventory) prior to T (ma-

4.8. MONTE CARLO METHOD

turity) which is not obtained from holding the futures contract. These benets include the ability to prot from
temporary shortages, and the ability to keep a production
process running.
One of the main reasons that it appears is due to availability of stocks and inventories of the commodity in question. Everyone who owns inventory has the choice between consumption today versus investment for the future. A rational investor will choose the outcome that is
best for themselves.

117
tinely better than human intuition or alternative soft
methods.[1]
The modern version of the Monte Carlo method was invented in the late 1940s by Stanislaw Ulam, while he
was working on nuclear weapons projects at the Los
Alamos National Laboratory. Immediately after Ulams
breakthrough, John von Neumann understood its importance and programmed the ENIAC computer to carry out
Monte Carlo calculations.

When inventories are high, this suggests an expected rel- 4.8.1

atively low scarcity of the commodity today versus some
time in the future. Otherwise, the investor would not
perceive that there is any benet of holding onto inventory and therefore sell his stocks. Hence, expected future
prices should be higher than they currently are. Futures
or forward prices Ft,T of the asset should then be higher
than the current spot price, St . From the above formula,
this only tells us that r c > 0 .

Introduction

The interesting line of reasoning comes when inventories are low. When inventories are low, we expect that
scarcity now is greater than in the future. Unlike the previous case, the investor can not buy inventory to make up
for demand today. In a sense, the investor wants to borrow inventory from the future but is unable. Therefore,
we expect future prices to be lower than today and hence
that Ft,T < St . This implies that r c < 0 .
Consequently, the convenience yield is inversely related
to inventory levels.

4.8 Monte Carlo method

Monte Carlo method applied to approximating the value of .

After placing 30000 random points, the estimate for is within
0.07% of the actual value. This happens with an approximate
probability of 20%.

Not to be confused with Monte Carlo algorithm.

Monte Carlo methods vary, but tend to follow a particular
Monte Carlo methods (or Monte Carlo experiments) pattern:
are a broad class of computational algorithms that rely
on repeated random sampling to obtain numerical re1. Dene a domain of possible inputs.
sults. They are often used in physical and mathematical
2. Generate inputs randomly from a probability distriproblems and are most useful when it is dicult or imbution over the domain.
possible to use other mathematical methods. Monte
Carlo methods are mainly used in three distinct problem
3. Perform a deterministic computation on the inputs.
classes: optimization, numerical integration, and generating draws from a probability distribution.
4. Aggregate the results.
In physics-related problems, Monte Carlo methods are
quite useful for simulating systems with many coupled For example, consider a circle inscribed in a unit square.
degrees of freedom, such as uids, disordered materi- Given that the circle and the square have a ratio of areas
als, strongly coupled solids, and cellular structures (see that is /4, the value of can be approximated using a
cellular Potts model). Other examples include modeling Monte Carlo method:[2]
phenomena with signicant uncertainty in inputs such as
the calculation of risk in business and, in math, evalua1. Draw a square on the ground, then inscribe a circle
tion of multidimensional denite integrals with compliwithin it.
cated boundary conditions. In application to space and
2. Uniformly scatter some objects of uniform size
oil exploration problems, Monte Carlobased predictions
(grains of rice or sand) over the square.
of failure, cost overruns and schedule overruns are rou-

118

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

3. Count the number of objects inside the circle and the

total number of objects.
4. The ratio of the two counts is an estimate of the ratio
of the two areas, which is /4. Multiply the result by
4 to estimate .
In this procedure the domain of inputs is the square that
circumscribes our circle. We generate random inputs by
scattering grains over the square then perform a computation on each input (test whether it falls within the circle).
Finally, we aggregate the results to obtain our nal result,
the approximation of .
There are two important points to consider here: Firstly,
if the grains are not uniformly distributed, then our approximation will be poor. Secondly, there should be a
large number of inputs. The approximation is generally
poor if only a few grains are randomly dropped into the
whole square. On average, the approximation improves
as more grains are dropped.

4.8.2

History

time trying to estimate them by

pure combinatorial calculations, I
wondered whether a more practical method than abstract thinking
might not be to lay it out say one
hundred times and simply observe
and count the number of successful plays. This was already possible to envisage with the beginning
of the new era of fast computers,
and I immediately thought of problems of neutron diusion and other
questions of mathematical physics,
and more generally how to change
processes described by certain differential equations into an equivalent form interpretable as a succession of random operations. Later
[in 1946], I described the idea to
John von Neumann, and we began
to plan actual calculations.
Stanislaw Ulam[4]

An early variant of the Monte Carlo method can be seen

in the Buons needle experiment, in which can be estimated by dropping needles on a oor made of parallel
and equidistant strips. In the 1930s, Enrico Fermi rst experimented with the Monte Carlo method while studying
neutron diusion, but did not publish anything on it.[3]

Being secret, the work of von Neumann and Ulam required a code name. A colleague of von Neumann and
Ulam, Nicholas Metropolis, suggested using the name
Monte Carlo, which refers to the Monte Carlo Casino in
Monaco where Ulams uncle would borrow money from
relatives to gamble.[3] Using lists of truly random random numbers was extremely slow, but von Neumann developed a way to calculate pseudorandom numbers, using
the middle-square method. Though this method has been
criticized as crude, von Neumann was aware of this: he
justied it as being faster than any other method at his
disposal, and also noted that when it went awry it did so
obviously, unlike methods that could be subtly incorrect.

In 1946, physicists at Los Alamos Scientic Laboratory

were investigating radiation shielding and the distance
that neutrons would likely travel through various materials. Despite having most of the necessary data, such as
the average distance a neutron would travel in a substance
before it collided with an atomic nucleus, and how much
energy the neutron was likely to give o following a collision, the Los Alamos physicists were unable to solve the
problem using conventional, deterministic mathematical
methods. Stanislaw Ulam had the idea of using random
experiments. He recounts his inspiration as follows:

Monte Carlo methods were central to the simulations required for the Manhattan Project, though severely limited
by the computational tools at the time. In the 1950s they
were used at Los Alamos for early work relating to the
development of the hydrogen bomb, and became popularized in the elds of physics, physical chemistry, and
operations research. The Rand Corporation and the U.S.
Air Force were two of the major organizations responsible for funding and disseminating information on Monte
Carlo methods during this time, and they began to nd a
wide application in many dierent elds.

Before the Monte Carlo method was developed, simulations tested a previously understood deterministic problem and statistical sampling was used to estimate uncertainties in the simulations. Monte Carlo simulations invert this approach, solving deterministic problems using
a probabilistic analog (see Simulated annealing).

The rst thoughts and attempts I

made to practice [the Monte Carlo
Method] were suggested by a question which occurred to me in 1946
as I was convalescing from an illness and playing solitaires. The
question was what are the chances
that a Caneld solitaire laid out
with 52 cards will come out successfully? After spending a lot of

Uses of Monte Carlo methods require large amounts of

random numbers, and it was their use that spurred the
development of pseudorandom number generators, which
were far quicker to use than the tables of random numbers
that had been previously used for statistical sampling.

4.8.3 Denitions
There is no consensus on how Monte Carlo should be dened. For example, Ripley[5] denes most probabilistic

4.8. MONTE CARLO METHOD

119

modeling as stochastic simulation, with Monte Carlo being

reserved for Monte Carlo integration and Monte Carlo
statistical tests. Sawilowsky[6] distinguishes between a
simulation, a Monte Carlo method, and a Monte Carlo
simulation: a simulation is a ctitious representation of
reality, a Monte Carlo method is a technique that can be
used to solve a mathematical or statistical problem, and a
Monte Carlo simulation uses repeated sampling to determine the properties of some phenomenon (or behavior).
Examples:

of the simplest, and most common ones. Weak correlations between successive samples is also often desirable/necessary.

Simulation: Drawing one pseudo-random uniform

variable from the interval [0,1] can be used to simulate the tossing of a coin: If the value is less than or
equal to 0.50 designate the outcome as heads, but if
the value is greater than 0.50 designate the outcome
as tails. This is a simulation, but not a Monte Carlo
simulation.

the (pseudo-random) number generator produces

values that pass tests for randomness

Sawilowsky lists the characteristics of a high quality

Monte Carlo simulation:[6]
the (pseudo-random) number generator has certain
characteristics (e.g., a long period before the sequence repeats)

there are enough samples to ensure accurate results

the proper sampling technique is used

the algorithm used is valid for what is being modeled

Monte Carlo method: Pouring out a box of coins
it simulates the phenomenon in question.
on a table, and then computing the ratio of coins
that land heads versus tails is a Monte Carlo method
of determining the behavior of repeated coin tosses,
Pseudo-random number sampling algorithms are used to
but it is not a simulation.
transform uniformly distributed pseudo-random numbers
Monte Carlo simulation: Drawing a large number into numbers that are distributed according to a given
of pseudo-random uniform variables from the in- probability distribution.
terval [0,1], and assigning values less than or equal
to 0.50 as heads and greater than 0.50 as tails, is a
Monte Carlo simulation of the behavior of repeatedly
tossing a coin.

Low-discrepancy sequences are often used instead of random sampling from a space as they ensure even coverage and normally have a faster order of convergence than
Monte Carlo simulations using random or pseudorandom
sequences. Methods based on their use are called quasi[2]
Kalos and Whitlock point out that such distinctions are Monte Carlo methods.
not always easy to maintain. For example, the emission
of radiation from atoms is a natural stochastic process.
It can be simulated directly, or its average behavior can Monte Carlo simulation versus what if scenarios
be described by stochastic equations that can themselves
be solved using Monte Carlo methods. Indeed, the same There are ways of using probabilities that are denitely
computer code can be viewed simultaneously as a 'natural not Monte Carlo simulations for example, determinsimulation' or as a solution of the equations by natural istic modeling using single-point estimates. Each uncertain variable within a model is assigned a best guess
sampling.
estimate. Scenarios (such as best, worst, or most likely
case) for each input variable are chosen and the results
Monte Carlo and random numbers
recorded.[8]
Monte Carlo simulation methods do not always require
truly random numbers to be useful while for some applications, such as primality testing, unpredictability is
vital.[7] Many of the most useful techniques use deterministic, pseudorandom sequences, making it easy to test
and re-run simulations. The only quality usually necessary to make good simulations is for the pseudo-random
sequence to appear random enough in a certain sense.
What this means depends on the application, but typically they should pass a series of statistical tests. Testing that the numbers are uniformly distributed or follow
another desired distribution when a large enough number of elements of the sequence are considered is one

By contrast, Monte Carlo simulations sample probability

distribution for each variable to produce hundreds or
thousands of possible outcomes. The results are analyzed
to get probabilities of dierent outcomes occurring.[9]
For example, a comparison of a spreadsheet cost construction model run using traditional what if scenarios, and then run again with Monte Carlo simulation and
Triangular probability distributions shows that the Monte
Carlo analysis has a narrower range than the what if
analysis. This is because the what if analysis gives equal
weight to all scenarios (see quantifying uncertainty in corporate nance), while Monte Carlo method hardly samples in the very low probability regions. The samples in
such regions are called rare events.

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CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

4.8.4

Applications

Monte Carlo methods are especially useful for simulating

phenomena with signicant uncertainty in inputs and systems with a large number of coupled degrees of freedom.
Areas of application include:
Physical sciences
See also: Monte Carlo method in statistical physics
Monte Carlo methods are very important in
computational physics, physical chemistry, and related applied elds, and have diverse applications from
complicated quantum chromodynamics calculations
to designing heat shields and aerodynamic forms as
well as in modeling radiation transport for radiation
dosimetry calculations.[10][11][12] In statistical physics
Monte Carlo molecular modeling is an alternative to
computational molecular dynamics, and Monte Carlo
methods are used to compute statistical eld theories
of simple particle and polymer systems.[13] Quantum
Monte Carlo methods solve the many-body problem
for quantum systems. In experimental particle physics,
Monte Carlo methods are used for designing detectors,
understanding their behavior and comparing experimental data to theory. In astrophysics, they are used in such
diverse manners as to model both galaxy evolution[14]
and microwave radiation transmission through a rough
planetary surface.[15] Monte Carlo methods are also used
in the ensemble models that form the basis of modern
weather forecasting.
Engineering
Monte Carlo methods are widely used in engineering for
sensitivity analysis and quantitative probabilistic analysis
in process design. The need arises from the interactive,
co-linear and non-linear behavior of typical process simulations. For example,

In Fluid Dynamics, in particular Rareed Gas Dynamics, where the Boltzmann equation is solved for
nite Knudsen number uid ows using the Direct
Simulation Monte Carlo [18] method in combination
with highly ecient computational algorithms.[19]
In autonomous robotics, Monte Carlo localization
can determine the position of a robot. It is often applied to stochastic lters such as the Kalman lter or
Particle lter that forms the heart of the SLAM (Simultaneous Localization and Mapping) algorithm.
In telecommunications, when planning a wireless
network, design must be proved to work for a wide
variety of scenarios that depend mainly on the number of users, their locations and the services they
want to use. Monte Carlo methods are typically used
to generate these users and their states. The network
performance is then evaluated and, if results are not
satisfactory, the network design goes through an optimization process.
In reliability engineering, one can use Monte Carlo
simulation to generate mean time between failures
and mean time to repair for components.
Computational biology
Monte Carlo methods are used in various elds of computational biology, for example for Bayesian inference
in phylogeny, or for studying biological systems such as
genomes, proteins,[20] or membranes.[21] The systems can
be studied in the coarse-grained or ab initio frameworks
depending on the desired accuracy. Computer simulations allow us to monitor the local environment of a particular molecule to see if some chemical reaction is happening for instance. In cases where it is not feasible to
conduct a physical experiment, thought experiments can
be conducted (for instance: breaking bonds, introducing impurities at specic sites, changing the local/global
structure, or introducing external elds).

In microelectronics engineering, Monte Carlo methods are applied to analyze correlated and uncorre- Computer graphics
lated variations in analog and digital integrated cirPath Tracing, occasionally referred to as Monte Carlo
cuits.
Ray Tracing, renders a 3D scene by randomly tracing
In geostatistics and geometallurgy, Monte Carlo samples of possible light paths. Repeated sampling of any
methods underpin the design of mineral processing given pixel will eventually cause the average of the samowsheets and contribute to quantitative risk analy- ples to converge on the correct solution of the rendering
sis.
equation, making it one of the most physically accurate
3D
graphics rendering methods in existence.
In wind energy yield analysis, the predicted energy
output of a wind farm during its lifetime is calculated giving dierent levels of uncertainty (P90,
Applied statistics
P50, etc.)
impacts of pollution are simulated[16] and diesel In applied statistics, Monte Carlo methods are generally
compared with petrol.[17]
used for two purposes:

4.8. MONTE CARLO METHOD

121

1. To compare competing statistics for small samples

under realistic data conditions. Although Type I error and power properties of statistics can be calculated for data drawn from classical theoretical distributions (e.g., normal curve, Cauchy distribution)
for asymptotic conditions (i. e, innite sample size
and innitesimally small treatment eect), real data
often do not have such distributions.[22]

See also: Computer Go

Monte Carlo methods are also a compromise between approximate randomization and permutation tests. An approximate randomization test is based on a specied subset of all permutations (which entails potentially enormous housekeeping of which permutations have been
considered). The Monte Carlo approach is based on a
specied number of randomly drawn permutations (exchanging a minor loss in precision if a permutation is
drawn twice or more frequentlyfor the eciency of
not having to track which permutations have already been
selected).

Finance and business

Design and visuals

Monte Carlo methods are also ecient in solving coupled integral dierential equations of radiation elds and
energy transport, and thus these methods have been used
2. To provide implementations of hypothesis tests in global illumination computations that produce photothat are more ecient than exact tests such as realistic images of virtual 3D models, with applications
permutation tests (which are often impossible to in video games, architecture, design, computer generated
compute) while being more accurate than critical lms, and cinematic special eects.[30]
values for asymptotic distributions.

Articial intelligence for games

See also: Monte Carlo methods in nance, Quasi-Monte

Carlo methods in nance, Monte Carlo methods for
option pricing, Stochastic modelling (insurance) and
Stochastic asset model
Monte Carlo methods in nance are often used to
evaluate investments in projects at a business unit or corporate level, or to evaluate nancial derivatives. They can
be used to model project schedules, where simulations
aggregate estimates for worst-case, best-case, and most
likely durations for each task to determine outcomes for
the overall project.

Main article: Monte Carlo tree search

Monte Carlo methods have been developed into a technique called Monte-Carlo tree search that is useful for
searching for the best move in a game. Possible moves
are organized in a search tree and a large number of random simulations are used to estimate the long-term potential of each move. A black box simulator represents
the opponents moves.[23]

4.8.5 Use in mathematics

In general, Monte Carlo methods are used in mathematics to solve various problems by generating suitable random numbers (see also Random number generation) and
observing that fraction of the numbers that obeys some
property or properties. The method is useful for obtaining numerical solutions to problems too complicated to
The Monte Carlo Tree Search (MCTS) method has four
solve analytically. The most common application of the
steps:[24]
Monte Carlo method is Monte Carlo integration.
1. Starting at root node of the tree, select optimal child
nodes until a leaf node is reached.
Integration
2. Expand the leaf node and choose one of its children.
3. Play a simulated game starting with that node.
4. Use the results of that simulated game to update the
node and its ancestors.
The net eect, over the course of many simulated games,
is that the value of a node representing a move will go up
or down, hopefully corresponding to whether or not that
node represents a good move.
Monte Carlo Tree Search has been used successfully
to play games such as Go,[25] Tantrix,[26] Battleship,[27]
Havannah,[28] and Arimaa.[29]

Main article: Monte Carlo integration

Deterministic numerical integration algorithms work
well in a small number of dimensions, but encounter
two problems when the functions have many variables.
First, the number of function evaluations needed increases rapidly with the number of dimensions. For example, if 10 evaluations provide adequate accuracy in
one dimension, then 10100 points are needed for 100
dimensionsfar too many to be computed. This is called
the curse of dimensionality. Second, the boundary of a
multidimensional region may be very complicated, so it
may not be feasible to reduce the problem to a series of
nested one-dimensional integrals.[31] 100 dimensions is

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CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

umbrella sampling[32][33] or the VEGAS algorithm.
A similar approach, the quasi-Monte Carlo method, uses
low-discrepancy sequences. These sequences ll the
area better and sample the most important points more
frequently, so quasi-Monte Carlo methods can often converge on the integral more quickly.
Another class of methods for sampling points in a volume
is to simulate random walks over it (Markov chain Monte
Carlo). Such methods include the Metropolis-Hastings
algorithm, Gibbs sampling and the Wang and Landau algorithm.
Simulation and optimization
Main article: Stochastic optimization

Monte-Carlo integration works by comparing random points with

the value of the function

Errors reduce by a factor of 1/

by no means unusual, since in many physical problems,

a dimension is equivalent to a degree of freedom.
Monte Carlo methods provide a way out of this exponential increase in computation time. As long as the function in question is reasonably well-behaved, it can be estimated by randomly selecting points in 100-dimensional
space, and taking some kind of average of the function
values at these points. By the central limit theorem,

this method displays 1/ N convergencei.e., quadrupling the number of sampled points halves the error, regardless of the number of dimensions.[31]
A renement of this method, known as importance sampling in statistics, involves sampling the points randomly,
but more frequently where the integrand is large. To do
this precisely one would have to already know the integral, but one can approximate the integral by an integral of a similar function or use adaptive routines such as
stratied sampling, recursive stratied sampling, adaptive

Another powerful and very popular application for random numbers in numerical simulation is in numerical optimization. The problem is to minimize (or maximize)
functions of some vector that often has a large number of
dimensions. Many problems can be phrased in this way:
for example, a computer chess program could be seen as
trying to nd the set of, say, 10 moves that produces the
best evaluation function at the end. In the traveling salesman problem the goal is to minimize distance traveled.
There are also applications to engineering design, such as
multidisciplinary design optimization. It has been applied
to solve particle dynamics simulation model Quasi-onedimensional models to eciently explore large conguration space.
The traveling salesman problem is what is called a conventional optimization problem. That is, all the facts (distances between each destination point) needed to determine the optimal path to follow are known with certainty
and the goal is to run through the possible travel choices to
come up with the one with the lowest total distance. However, lets assume that instead of wanting to minimize the
total distance traveled to visit each desired destination, we
wanted to minimize the total time needed to reach each
destination. This goes beyond conventional optimization
since travel time is inherently uncertain (trac jams, time
of day, etc.). As a result, to determine our optimal path
we would want to use simulation - optimization to rst
understand the range of potential times it could take to
go from one point to another (represented by a probability distribution in this case rather than a specic distance)
and then optimize our travel decisions to identify the best
path to follow taking that uncertainty into account.
Inverse problems
Probabilistic formulation of inverse problems leads to the
denition of a probability distribution in the model space.
This probability distribution combines prior information
with new information obtained by measuring some ob-

4.8. MONTE CARLO METHOD

123

servable parameters (data). As, in the general case, the 4.8.7 Notes
theory linking data with model parameters is nonlinear,
the posterior probability in the model space may not be [1] Hubbard 2009
easy to describe (it may be multimodal, some moments [2] Kalos & Whitlock 2008
may not be dened, etc.).
[3] Metropolis 1987

When analyzing an inverse problem, obtaining a maximum likelihood model is usually not sucient, as we [4] Eckhardt 1987
normally also wish to have information on the resolution
power of the data. In the general case we may have a [5] Ripley 1987
large number of model parameters, and an inspection of [6] Sawilowsky 2003
the marginal probability densities of interest may be impractical, or even useless. But it is possible to pseudoran- [7] Davenport 1992
domly generate a large collection of models according to [8] Vose 2000, p. 13
the posterior probability distribution and to analyze and
display the models in such a way that information on the [9] Vose 2000, p. 16
relative likelihoods of model properties is conveyed to the [10] GPU-based high-performance computing for radiation
spectator. This can be accomplished by means of an eftherapy. Physics in Medicine and Biology 59: R151
cient Monte Carlo method, even in cases where no exR182. doi:10.1088/0031-9155/59/4/R151.
plicit formula for the a priori distribution is available.
[11] Advances in kilovoltage x-ray beam dosimetry.

The best-known importance sampling method, the

Physics in Medicine and Biology 59: R183R231.
Metropolis algorithm, can be generalized, and this gives
doi:10.1088/0031-9155/59/6/R183.
a method that allows analysis of (possibly highly nonlinear) inverse problems with complex a priori information [12] Fifty years of Monte Carlo simulations for medical
physics. Physics in Medicine and Biology 51: R287
and data with an arbitrary noise distribution.[34][35]
R301. doi:10.1088/0031-9155/51/13/R17.

Petroleum reservoir management

[13] Baeurle 2009

[14] MacGillivray & Dodd 1982

Monte Carlo methods are very popular in hydrocarbon

reservoir management in the context of nonlinear inverse
problems. This includes generating computational models of oil and gas reservoirs for consistency with observed
production data. For the goal of decision making and uncertainty assessment, Monte Carlo methods are used for
generating multiple geological realizations.[36]

[15] Golden 1979

[16] Int Panis et al. 2001
[17] Int Panis et al. 2002
[18] G. A. Bird, Molecular Gas Dynamics, Clarendon, Oxford
(1976)

Auxiliary eld Monte Carlo

[19] Dietrich, S.; Boyd, I. (1996).

A Scalar optimized parallel implementation of the DSMC technique. Journal of Computational Physics 126: 32842.
doi:10.1006/jcph.1996.0141.

Biology Monte Carlo method

[20] Ojeda & et al. 2009,

Comparison of risk analysis Microsoft Excel add-ins

[21] Milik & Skolnick 1993

Direct simulation Monte Carlo

[22] Sawilowsky & Fahoome 2003

Dynamic Monte Carlo method

[23] http://sander.landofsand.com/publications/
Monte-Carlo_Tree_Search_-_A_New_Framework_
for_Game_AI.pdf

4.8.6

See also

Kinetic Monte Carlo

List of software for Monte Carlo molecular modeling
Monte Carlo method for photon transport
Monte Carlo methods for electron transport
Morris method
Quasi-Monte Carlo method
Sobol sequence

[24] Monte Carlo Tree Search - About

[25] Parallel Monte-Carlo Tree Search - Springer
[26] http://www.tantrix.com:4321/Tantrix/TRobot/MCTS%
20Final%20Report.pdf
[27] http://www0.cs.ucl.ac.uk/staff/D.Silver/web/
Publications_files/pomcp.pdf
[28] Improving MonteCarlo Tree Search in Havannah Springer

124

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

[29] http://www.arimaa.com/arimaa/papers/ThomasJakl/
bc-thesis.pdf
[30] Szirmay-Kalos 2008
[31] Press et al. 1996
[32] MEZEI, M (31 December 1986). Adaptive umbrella
sampling: Self-consistent determination of the nonBoltzmann bias. Journal of Computational Physics
68 (1): 237248.
Bibcode:1987JCoPh..68..237M.
doi:10.1016/0021-9991(87)90054-4.
[33] Bartels, Christian; Karplus, Martin (31 December 1997).
Probability Distributions for Complex Systems: Adaptive Umbrella Sampling of the Potential Energy. The
Journal of Physical Chemistry B 102 (5): 865880.
doi:10.1021/jp972280j.
[34] Mosegaard & Tarantola 1995
[35] Tarantola 2005
[36] Shirangi, M. G., History matching production data
and uncertainty assessment with an ecient TSVD parameterization algorithm, Journal of Petroleum Science
and Engineering, http://www.sciencedirect.com/science/
article/pii/S0920410513003227

4.8.8

References

Eckhardt, Roger (1987). Stan Ulam, John von

Neumann, and the Monte Carlo method (PDF).
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Fishman, G. S. (1995). Monte Carlo: Concepts, Algorithms, and Applications. New York: Springer.
ISBN 0-387-94527-X.
C. Forastero and L. Zamora and D. Guirado
and A. Lallena (2010).
A Monte Carlo
tool to simulate breast cancer screening programmes. Phys. In Med. And Biol. 55 (17):
Bibcode:2010PMB....55.5213F.
52135229.
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Golden, Leslie M. (1979). The Eect of Surface Roughness on the Transmission of Microwave
Radiation Through a Planetary Surface. Icarus
38 (3): 451455. Bibcode:1979Icar...38..451G.
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Gould, Harvey; Tobochnik, Jan (1988). An Introduction to Computer Simulation Methods, Part 2, Applications to Physical Systems. Reading: AddisonWesley. ISBN 0-201-16504-X.
Grinstead, Charles; Snell, J. Laurie (1997). Introduction to Probability. American Mathematical Society. pp. 1011.

Anderson, Herbert L. (1986). Metropolis, Monte

Carlo and the MANIAC (PDF). Los Alamos Science 14: 96108.

Hammersley, J. M.; Handscomb, D. C. (1975).

Monte Carlo Methods. London: Methuen. ISBN 0416-52340-4.

Baeurle, Stephan A. (2009). Multiscale modeling

of polymer materials using eld-theoretic methodologies: A survey about recent developments.
Journal of Mathematical Chemistry 46 (2): 363
426. doi:10.1007/s10910-008-9467-3.

Hartmann, A.K. (2009). Practical Guide to Computer Simulations. World Scientic. ISBN 978-981283-415-7.

Berg, Bernd A. (2004). Markov Chain Monte Carlo

Simulations and Their Statistical Analysis (With
Web-Based Fortran Code). Hackensack, NJ: World
Scientic. ISBN 981-238-935-0.

Hubbard, Douglas (2007). How to Measure Anything: Finding the Value of Intangibles in Business.
John Wiley & Sons. p. 46.
Hubbard, Douglas (2009). The Failure of Risk Management: Why Its Broken and How to Fix It. John
Wiley & Sons.

Binder, Kurt (1995). The Monte Carlo Method in

Condensed Matter Physics. New York: Springer.
ISBN 0-387-54369-4.

Kahneman, D.; Tversky, A. (1982). Judgement under Uncertainty: Heuristics and Biases. Cambridge
University Press.

Caisch, R. E. (1998). Monte Carlo and quasiMonte Carlo methods. Acta Numerica 7. Cambridge
University Press. pp. 149.

Kalos, Malvin H.; Whitlock, Paula A. (2008).

Monte Carlo Methods. Wiley-VCH. ISBN 978-3527-40760-6.

Davenport, J. H. Primality testing revisited. Proceeding ISSAC '92 Papers from the international symposium on Symbolic and algebraic computation: 123
129. doi:10.1145/143242.143290. ISBN 0-89791489-9.

Kroese, D. P.; Taimre, T.; Botev, Z.I. (2011).

Handbook of Monte Carlo Methods. New York:
John Wiley & Sons. p. 772. ISBN 0-470-177934.

Doucet, Arnaud; Freitas, Nando de; Gordon, Neil

(2001). Sequential Monte Carlo methods in practice.
New York: Springer. ISBN 0-387-95146-6.

MacGillivray, H. T.; Dodd, R. J. (1982). MonteCarlo simulations of galaxy systems (PDF).

Astrophysics and Space Science (Springer Netherlands) 86 (2).

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MacKeown, P. Kevin (1997). Stochastic Simulation
in Physics. New York: Springer. ISBN 981-308326-3.
Metropolis, N. (1987). The beginning of the
Monte Carlo method (PDF). Los Alamos Science
(1987 Special Issue dedicated to Stanislaw Ulam):
125130.
Metropolis, Nicholas; Rosenbluth, Arianna
W.; Rosenbluth, Marshall N.; Teller, Augusta H.; Teller, Edward (1953).
"Equation
of State Calculations by Fast Computing Machines".
Journal of Chemical Physics 21
Bibcode:1953JChPh..21.1087M.
(6): 1087.
doi:10.1063/1.1699114.
Metropolis, N.; Ulam, S. (1949). The Monte Carlo
Method. Journal of the American Statistical Association (American Statistical Association) 44 (247):
335341. doi:10.2307/2280232. JSTOR 2280232.
PMID 18139350.
M. Milik and J. Skolnick (Jan 1993). Insertion of
peptide chains into lipid membranes: an o-lattice
Monte Carlo dynamics model. Proteins 15 (1): 10
25. doi:10.1002/prot.340150104. PMID 8451235.
Mosegaard, Klaus; Tarantola, Albert (1995).
Monte Carlo sampling of solutions to inverse
problems.
J. Geophys.
Res.
100 (B7):
1243112447. Bibcode:1995JGR...10012431M.
doi:10.1029/94JB03097.
P. Ojeda and M. Garcia and A. Londono and
N.Y. Chen (Feb 2009).
Monte Carlo Simulations of Proteins in Cages: Inuence of
Connement on the Stability of Intermediate
States. Biophys. Jour. (Biophysical Society) 96
(3): 10761082. Bibcode:2009BpJ....96.1076O.
doi:10.1529/biophysj.107.125369.

125
Ripley, B. D. (1987). Stochastic Simulation. Wiley
& Sons.
Robert, C. P.; Casella, G. (2004). Monte Carlo Statistical Methods (2nd ed.). New York: Springer.
ISBN 0-387-21239-6.
Rubinstein, R. Y.; Kroese, D. P. (2007). Simulation
and the Monte Carlo Method (2nd ed.). New York:
John Wiley & Sons. ISBN 978-0-470-17793-8.
Savvides, Savvakis C. (1994). Risk Analysis in Investment Appraisal. Project Appraisal Journal 9
(1). doi:10.2139/ssrn.265905.
Sawilowsky, Shlomo S.; Fahoome, Gail C. (2003).
Statistics via Monte Carlo Simulation with Fortran.
Rochester Hills, MI: JMASM. ISBN 0-9740236-04.
Sawilowsky, Shlomo S. (2003). You think you've
got trivials?" (PDF). Journal of Modern Applied Statistical Methods 2 (1): 218225.
Silver, David; Veness, Joel (2010). Monte-Carlo
Planning in Large POMDPs (PDF). In Laerty,
J.; Williams, C. K. I.; Shawe-Taylor, J.; Zemel, R.
S.; Culotta, A. Advances in Neural Information Processing Systems 23. Neural Information Processing
Systems Foundation.
Szirmay-Kalos, Lszl (2008). Monte Carlo Methods in Global Illumination - Photo-realistic Rendering with Randomization. VDM Verlag Dr. Mueller
e.K. ISBN 978-3-8364-7919-6.
Tarantola, Albert (2005). Inverse Problem Theory.
Philadelphia: Society for Industrial and Applied
Mathematics. ISBN 0-89871-572-5.
Vose, David (2008). Risk Analysis, A Quantitative
Guide (Third ed.). John Wiley & Sons.

Int Panis L; De Nocker L, De Vlieger I, Torfs R

(2001). Trends and uncertainty in air pollution im- 4.8.9 External links
pacts and external costs of Belgian passenger car
Hazewinkel, Michiel, ed. (2001), Monte-Carlo
trac International. Journal of Vehicle Design 27
method, Encyclopedia of Mathematics, Springer,
(14): 183194. doi:10.1504/IJVD.2001.001963.
ISBN 978-1-55608-010-4
Int Panis L, Rabl A, De Nocker L, Torfs R (2002).
Overview and reference list, Mathworld
P. Sturm, ed. Diesel or Petrol ? An environmental
comparison hampered by uncertainty. Mitteilungen
Feynman-Kac models and particle Monte Carlo alInstitut fr Verbrennungskraftmaschinen und Thergorithms
modynamik (Technische Universitt Graz Austria).
Heft 81 Vol 1: 4854.
Introduction to Monte Carlo Methods, Computa Press, William H.; Teukolsky, Saul A.; Vetterling,
William T.; Flannery, Brian P. (1996) [1986]. Numerical Recipes in Fortran 77: The Art of Scientic
Computing. Fortran Numerical Recipes 1 (Second
ed.). Cambridge University Press. ISBN 0-52143064-X.

tional Science Education Project

The Basics of Monte Carlo Simulations, University
of Nebraska-Lincoln
Introduction to Monte Carlo simulation (for
Microsoft Excel), Wayne L. Winston

126

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

Monte Carlo Simulation for MATLAB and 4.9.2 Development

Simulink
The concept of a local volatility was developed when
Monte Carlo Methods Overview and Concept, Bruno Dupire [1] and Emanuel Derman and Iraj Kani[2]
brighton-webs.co.uk
noted that there is a unique diusion process consistent
with the risk neutral densities derived from the market
Monte Carlo techniques applied in physics
prices of European options.
Approximate And Double Check Probability Problems Using Monte Carlo method at Orcik Dot Net Derman and Kani described and implemented a local
volatility function to model instantaneous volatility. They
Monte Carlo simulation using mathematica at Wol- used this function at each node in a binomial options pricfram Mathematica
ing model. The tree successfully produced option valuations consistent with all market prices across strikes and
Eric Grimson; John Guttag. Lecture 20: Monte
expirations.[2] The Derman-Kani model was thus formuCarlo Simulations, Estimating pi. Introduction to
lated with discrete time and stock-price steps. The key
Computer Science and Programming stimating pi.
continuous-time equations used in local volatility modMIT Open Courseware. Retrieved 4 February 2015.
els were developed by Bruno Dupire in 1994. Dupires
equation states

4.9 Local volatility

1
2C
C
C
= 2 (K, T ; S0 )K 2
(r d)K
dC
T
2
K 2
K

A local volatility model, in mathematical nance and

nancial engineering, is one that treats volatility as a function of both the current asset level St and of time t . As There exist few known parametrisation of the volatility
such, a local volatility model is a generalisation of the surface based on the heston model (Schonbusher, SVI[3]and
Black-Scholes model, where the volatility is a constant gSVI) as well as their de-arbitraging methodologies.
(i.e. a trivial function of St and t ).
Derivation

4.9.1

Formulation

In mathematical nance, the asset St that underlies a

nancial derivative, is typically assumed to follow a
stochastic dierential equation of the form

Given the price of the asset St governed by the risk neutral SDE

dSt = (r d)St dt + (t, St )St dWt

The transition probability p(t, St ) conditional to S0 satises the forward Kolmogorov equation (also known as
where rt is the instantaneous risk free rate, giving an aver- FokkerPlanck equation)
age local direction to the dynamics, and Wt is a Wiener
process, representing the inow of randomness into the
1
dynamics. The amplitude of this randomness is measured
pt = [(r d)s p]s + [(s)2 p]ss
by the instant volatility t . In the simplest model i.e.
2
the Black-Scholes model, t is assumed to be constant;
Because of the Martingale pricing theorem, the price of
in reality, the realized volatility of an underlying actually
a call option with maturity T and strike K is
varies with time.
dSt = (rt dt )St dt + t St dWt

When such volatility has a randomness of its ownoften

described by a dierent equation driven by a dierent Wthe model above is called a stochastic volatility
model. And when such volatility is merely a function of
the current asset level St and of time t, we have a local
volatility model. The local volatility model is a useful
simplication of the stochastic volatility model.

C = erT EQ [(ST K)+ ]

(s K) p ds
= erT

K
rT
rT
s p ds K e
=e
K

p ds
K

Local volatility is thus a term used in quantitative - Dierentiating the price of a call option twice with renance to denote the set of diusion coecients, t = spect to K
(St , t) , that are consistent with market prices for all
options on a given underlying. This model is used to cal
culate exotic option valuations which are consistent with
rT
pds
C
=
e
K
observed prices of vanilla options.
K

4.9. LOCAL VOLATILITY

127

and replacing in the formula for the price of a call option be based only on the underlying asset. The general nonand rearranging terms
parametric approach by Dupire is however problematic,
as one needs to arbitrarily pre-interpolate the input implied volatility surface before applying the method. Al
ternative parametric approaches have been proposed, norT
e
s p ds = C K CK
tably the highly tractable mixture dynamical local volatilK
ity models by Damiano Brigo and Fabio Mercurio.[8][9]
Dierentiating the price of a call option with respect to
Since in local volatility models the volatility is a determinK twice
istic function of the random stock price, local volatility
models are not very well used to price cliquet options or
forward start options, whose values depend specically
CKK = erT p
on the random nature of volatility itself.
Dierentiating the price of a call option with respect to T
yields

CT = r C + erT

4.9.4 References
[1] Bruno Dupire (1994).
Pricing with a Smile.
Risk.http://www.risk.net/data/risk/pdf/technical/
2007/risk20_0707_technical_volatility.pdf

(s K)pT ds

using the Forward Kolmogorov equation

CT = r CerT

1
(sK)[(rd)s p]s ds+ erT
2

integrating by parts the rst integral once and the second

intgeral twice

CT = r C +(rd)erT

1
s p ds+ erT (K)2 p
2

using the formulas derived dierentiating the price of a

call option with respect to K

[2] Derman, E., Iraj Kani (1994). ""Riding on a Smile.

RISK, 7(2) Feb.1994, pp. 139-145, pp. 32-39. (PDF).
Risk. Retrieved 2007-06-01.

2
[3](sK)[(s)
Babak Mahdavi
Damghani
and Andrew Kos (2013). Dep]ss
ds
K
arbitraging with a weak smile. Wilmott.http://www.
readcube.com/articles/10.1002/wilm.10201?locale=en

[4] Mahdavi Damghani, Babak (2013). De-arbitraging With

a Weak Smile: Application to Skew Risk. Wilmott 2013
(1): 4049. doi:10.1002/wilm.10201.
[5] Dumas, B., J. Fleming, R. E. Whaley (1998). Implied
volatility functions: Empirical tests. The Journal of Finance 53.
[6] Gatheral, J. (2006). The Volatility Surface: A Practitionerss Guide. Wiley Finance. ISBN 978-0-471-79251-2.

1
CT = r C + (r d)(C K CK ) + 2 K 2 CKK
2
1 2 2
= (r d)K CK d C + K CKK
2

[7] Derman, E. I Kani & J. Z. Zou (1996). The Local

Volatility Surface: Unlocking the Information in Index
Options Prices. Financial Analysts Journal. (July-Aug
1996).

4.9.3

[8] Damiano Brigo and Fabio Mercurio (2001). Displaced

and Mixture Diusions for Analytically-Tractable Smile
Models. Mathematical Finance - Bachelier Congress
2000. Proceedings. Springer Verlag.

Use

Local volatility models are useful in any options market in which the underlyings volatility is predominantly
a function of the level of the underlying, interest-rate
derivatives for example. Time-invariant local volatilities
are supposedly inconsistent with the dynamics of the equity index implied volatility surface,[4][5] but see Crepey,
S (2004). Delta-hedging Vega Risk. Quantitative Finance 4., who claims that such models provide the best
average hedge for equity index options. Local volatility models are nonetheless useful in the formulation of
stochastic volatility models.[6]
Local volatility models have a number of attractive
features.[7] Because the only source of randomness is the
stock price, local volatility models are easy to calibrate.
Also, they lead to complete markets where hedging can

[9] Damiano Brigo and Fabio Mercurio (2002). Lognormalmixture dynamics and calibration to market volatility
smiles (PDF). International Journal of Theoretical and
Applied Finance 5 (4). Retrieved 2011-03-07.

1. Carol Alexander (2004). Normal mixture diusion

with uncertain volatility: Modelling short- and longterm smile eects. Journal of Banking & Finance
28 (12).
1. Babak Mahdavi Damghani and Andrew Kos (2013).
De-Arbitraging with a Weak Smile: Application
to Skew Risk. Wilmott Magazine.http://ssrn.com/
abstract=2428532

128

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

4.10 Stochastic volatility

[ ]
its expectation value is E 2 =

See also Volatility (nance).

This basic model with constant volatility is the starting

point for non-stochastic volatility models such as Black
Scholes model and CoxRossRubinstein model.

n
2
n1

Stochastic volatility models are those in which the

variance of a stochastic process is itself randomly
distributed.[1] They are used in the eld of mathematical
nance to evaluate derivative securities, such as options.
The name derives from the models treatment of the underlying securitys volatility as a random process, governed by state variables such as the price level of the underlying security, the tendency of volatility to revert to
some long-run mean value, and the variance of the volatility process itself, among others.

For a stochastic volatility model, replace the constant

volatility with a function t , that models the variance
of St . This variance function is also modeled as Brownian motion, and the form of t depends on the particular
SV model under study.

Stochastic volatility models are one approach to resolve

a shortcoming of the BlackScholes model. In particular, models based on Black-Scholes assume that the underlying volatility is constant over the life of the derivative, and unaected by the changes in the price level of
the underlying security. However, these models cannot
explain long-observed features of the implied volatility
surface such as volatility smile and skew, which indicate
that implied volatility does tend to vary with respect to
strike price and expiry. By assuming that the volatility of
the underlying price is a stochastic process rather than a
constant, it becomes possible to model derivatives more
accurately.

dt = S,t dt + S,t dBt

4.10.1

Basic model

dSt = St dt +

t St dWt

where S,t and S,t are some functions of and dBt

is another standard gaussian that is correlated with dWt
with constant correlation factor .

Heston model
Main article: Heston model
The popular Heston model is a commonly used SV model,
in which the randomness of the variance process varies as
the square root of variance. In this case, the dierential
equation for variance takes the form:

Starting from a constant volatility approach, assume that

the derivatives underlying asset price follows a standard dt = ( t )dt + t dBt

model for geometric Brownian motion:
where is the mean long-term volatility, is the rate
at which the volatility reverts toward its long-term mean,
is the volatility of the volatility process,and dBt is,
dSt = St dt + St dWt
like dWt , a gaussian with zero mean and dt standard
where is the constant drift (i.e. expected return) of the deviation. However, dWt and dBt are correlated with the
security price St , is the constant volatility, and dWt constant correlation value .
is a standard Wiener process with zero mean and unit rate In other words, the Heston SV model assumes that the
of variance. The explicit solution of this stochastic dif- variance is a random process that
ferential equation is

St = S0 e( 2

1. exhibits a tendency to revert towards a long-term

mean at a rate ,

)t+Wt

The Maximum likelihood estimator to estimate the constant volatility for given stock prices St at dierent
times ti is
(

3. and whose source of randomness is correlated (with

correlation ) with the randomness of the underly1 (ln Stn ln St0 )2 ings price processes.

n
tn t0
2
S
There exist few known parametrisation of the volatility
ln Sttn
0
surface based on the heston model (Schonbusher, SVI and

;
tn t0
gSVI) as well as their de-arbitraging methodologies.[2]

1 (ln Sti ln Sti1 )2

n i=1
ti ti1

S
n
ln St ti

1
i1
=
(ti ti1 )
n i=1
ti ti1

2 =

2. exhibits a volatility proportional to the square root

of its level

4.10. STOCHASTIC VOLATILITY

CEV model
Main article: Constant elasticity of variance model

129
LGARCH, EGARCH, GJR-GARCH, etc. Strictly, however, the conditional volatilities from GARCH models are
not stochastic since at time t the volatility is completely
pre-determined (deterministic) given previous values.[3]

The CEV model describes the relationship between

volatility and price, introducing stochastic volatility:
3/2 model
dSt = St dt + St dWt

The 3/2 model is similar to the Heston model, but assumes that the randomness of the variance process varies
3/2
with t . The form of the variance dierential is:

Conceptually, in some markets volatility rises when prices

rise (e.g. commodities), so > 1 . In other markets,
3
volatility tends to rise as prices fall, modelled with < 1
dt = t ( t ) dt + t2 dBt .
.
Some argue that because the CEV model does not incorporate its own stochastic process for volatility, it is not
truly a stochastic volatility model. Instead, they call it a
local volatility model.

However the meaning of the parameters is dierent from

Heston model. In this model both, mean reverting and
volatility of variance parameters, are stochastic quantities
given by t and t respectively.

SABR volatility model

Chen model

Main article: SABR volatility model

In interest rate modelings, Lin Chen in 1994 developed

the rst stochastic mean and stochastic volatility model,
The SABR model (Stochastic Alpha, Beta, Rho) de- Chen model. Specically, the dynamics of the instantascribes a single forward F (related to any asset e.g. neous interest rate are given by following the stochastic
an index, interest rate, bond, currency or equity) under dierential equations:
stochastic volatility :
drt = (t t ) dt +
dFt = t Ft dWt ,
dt = t dZt ,

rt t , dWt ,

t t dWt ,

dt = (t t ) dt + t t dWt .
dt = (t t ) dt +

The initial values F0 and 0 are the current forward price

and volatility, whereas Wt and Zt are two correlated
Wiener processes (i.e. Brownian motions) with correla- 4.10.2 Calibration
tion coecient 1 < < 1 . The constant parameters
Once a particular SV model is chosen, it must be cal, are such that 0 1, 0 .
ibrated against existing market data. Calibration is the
The main feature of the SABR model is to be able to reprocess of identifying the set of model parameters that
produce the smile eect of the volatility smile.
are most likely given the observed data. One popular technique is to use maximum likelihood estimation
(MLE). For instance, in the Heston model, the set of
GARCH model
model parameters 0 = {, , , } can be estimated
The Generalized Autoregressive Conditional Het- applying an MLE algorithm such as the Powell Directed
eroskedasticity (GARCH) model is another popular Set method to observations of historic underlying secumodel for estimating stochastic volatility. It assumes that rity prices.
the randomness of the variance process varies with the In this case, you start with an estimate for 0 , compute
variance, as opposed to the square root of the variance as the residual errors when applying the historic price data to
in the Heston model. The standard GARCH(1,1) model the resulting model, and then adjust to try to minimize
has the following form for the variance dierential:
these errors. Once the calibration has been performed, it
is standard practice to re-calibrate the model periodically.
dt = ( t ) dt + t dBt
The GARCH model has been extended via numerous
variants, including the NGARCH, TGARCH, IGARCH,

4.10.3 See also

Chen model

130

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

Heston model

4.11 SABR Volatility Model

Local volatility

In mathematical nance, the SABR model is a stochastic

volatility model, which attempts to capture the volatility
smile in derivatives markets. The name stands for
"stochastic alpha, beta, rho", referring to the parameters of the model. The SABR model is widely used by
practitioners in the nancial industry, especially in the
interest rate derivative markets. It was developed by
Patrick Hagan, Deep Kumar, Andrew Lesniewski, and
Diana Woodward.

gSVI[4]
Realized volatility
Risk-neutral measure
SABR volatility model
Volatility
Volatility, uncertainty, complexity and ambiguity
BlackScholes model
Subordinator
Markov switching multifractal

4.10.4

References

4.11.1 Dynamics
The SABR model describes a single forward F , such as
a LIBOR forward rate, a forward swap rate, or a forward
stock price. The volatility of the forward F is described
by a parameter . SABR is a dynamic model in which
both F and are represented by stochastic state variables
whose time evolution is given by the following system of
stochastic dierential equations:

dFt = t Ft dWt ,

[1] Gatheral, J. (2006). The volatility surface: a practitioners

guide. Wiley.

dt = t dZt ,

[2] Babak Mahdavi Damghani (2013). De-arbitraging with

a weak smile. Wilmott.

with the prescribed time zero (currently observed) values

F0 and 0 . Here, Wt and Zt are two correlated Wiener
processes with correlation coecient 1 < < 1 :

[3] Brooks, Chris (2014). Introductory Econometrics for Finance (3rd ed.). Cambridge: Cambridge University Press.
p. 461. ISBN 9781107661455.
[4] Mahdavi Damghani, Babak (2013). De-arbitraging With
a Weak Smile: Application to Skew Risk. Wilmott 2013
(1): 4049. doi:10.1002/wilm.10201.

4.10.5

Additional Sources

Stochastic Volatility and Mean-variance Analysis,

Hyungsok Ahn, Paul Wilmott, (2006).

dWt dZt = dt
The constant parameters , satisfy the conditions 0
1, 0 .
The above dynamics is a stochastic version of the CEV
model with the skewness parameter : in fact, it reduces
to the CEV model if = 0 The parameter is often
referred to as the volvol, and its meaning is that of the
lognormal volatility of the volatility parameter .

4.11.2 Asymptotic solution

A closed-form solution for options with stochastic

We consider a European option (say, a call) on the forvolatility, SL Heston, (1993).
ward F struck at K , which expires T years from now.
Inside Volatility Arbitrage, Alireza Javaheri, (2005). The value of this option is equal to the suitably discounted
expected value of the payo max (FT K, 0) under the
Accelerating the Calibration of Stochastic Volatility probability distribution of the process Ft .
Models, Kilin, Fiodar (2006).

Except for the special cases of = 0 and = 1 , no

closed form expression for this probability distribution is
Lin Chen (1996). Stochastic Mean and Stochastic known. The general case can be solved approximately
Volatility -- A Three-Factor Model of the Term Struc- by means of an asymptotic expansion in the parameter
ture of Interest Rates and Its Application to the Pric- = T 2 . Under typical market conditions, this paing of Interest Rate Derivatives. Blackwell Publish- rameter is small and the approximate solution is actuers. Blackwell Publishers.
ally quite accurate. Also signicantly, this solution has a

4.11. SABR VOLATILITY MODEL

131

rather simple functional form, is very easy to implement

in computer code, and lends itself well to risk managedFt = t |Ft | dWt ,
ment of large portfolios of options in real time.
It is convenient to express the solution in terms of the
implied volatility of the option. Namely, we force the
SABR model price of the option into the form of the
Black model valuation formula. Then the implied volatility, which is the value of the lognormal volatility parameter in Blacks model that forces it to match the SABR
price, is approximately given by:

impl

log (F0 /K)

=
D ()

[
1+

2
22 12 + 1/Fmid
24

dt = t dZt ,
for 0 1/2 and a free boundary condition for
F = 0 . Its exact solution for the zero correlation as
well as an ecient approximation for a general case are
available.[1]

Another SABR model extension for negative rates that

gained popularity in the recent years is the shifted SABR
model, where shifted forward rate is assumed
] to}follow a
(
)2
2
SABR
process
1 0 C (Fmid ) 2 3
0 C (Fmid )
+
+
,

24

where, for clarity, we have set C (F ) = F . The value dFt = t (Ft + s) dWt ,
Fmid denotes a conveniently chosen midpoint
between F0

and K (such as the geometric average F0 K or the arith- dt = t dZt ,

metic average (F0 + K) /2 ). We have also set
for some positive shift s . An obvious drawback of this
approach is the a priori selection of the shift, and the resulting possibility of needing to adjust this shift further
F0
)
(

dx

once the rates go still more negative.

1
1
K
,
=
=
F0
0 K C (x)
0 (1 )

4.11.4 See also

and

Volatility (nance)

C (Fmid )

1 =
=
,
C (Fmid )
Fmid
2 =

Stochastic Volatility
Risk-neutral measure

C (Fmid )
(1 )
=
.
2
C (Fmid )
Fmid

The function D () entering the formula above is given 4.11.5

by
)
(
1 2 + 2 +
.
D () = log
1
Alternatively, one can express the SABR price in terms
of the normal Blacks model. Then the implied normal
volatility can be asymptotically computed by means of
the following expression:

n
impl

F0 K
=
D ()

[
1+

22 12
24

References

[1] Antonov, Alexandre and Konikov, Michael and Spector,

Michael, The Free Boundary SABR: Natural Extension to
Negative Rates (January 28, 2015). Available at SSRN:
http://ssrn.com/abstract=2557046

Managing Smile Risk, P. Hagan et al. The original

paper introducing the SABR model.

Probability Distribution in the SABR Model of

Stochastic Volatility, P. Hagan et al. - Introduced
the normal SABR model, heat kernel expansion, and
asymptotic probability distribution.
] }
(
)2
2
0 C (Fmid )
0 C (Fmid
) SABR
2 3Model,
1 Hedging
under
+
.B. Bartlett Rened
+

4 risk management

24 the SABR model.

under

It is worth noting that the normal SABR implied volatility

is generally somewhat more accurate than the lognormal
implied volatility.

Arbitrage Free SABR, P. Hagan et al. - Rened

treatment of near zero forwards.
Fine Tune Your Smile Correction to Hagan et al.

SABR for the negative rates

A summary of the approaches to the SABR model

for equity derivatives smile

The SABR model can be modied to cover also Negative

interest rate:

Unifying the BGM and SABR models: a short ride

in hyperbolic geometry

4.11.3

132
Asymptotic Approximations to CEV and SABR
Models
Test SABR (with calibration) online
SABR calibration
Advanced Analytics for the SABR Model - Includes
exact formula for zero correlation case
Small-Strike Implied Volatility Expansion in the
SABR Model - Arbitrage-free asymptotic formula
for small strikes and for long-dated options
The Free Boundary SABR: Natural Extension to
Negative Rates - SABR for the negative rates

CHAPTER 4. VOLATILITY AND RISK MEASUREMENT

Chapter 5

Basic Types of Options

5.1 Foreign exchange option

5.1.2 Terms
Call option the right to buy an asset at a xed date
and price.

In nance, a foreign-exchange option (commonly shortened to just FX option or currency option) is a

derivative nancial instrument that gives the right but not
the obligation to exchange money denominated in one
currency into another currency at a pre-agreed exchange
rate on a specied date.[1] See Foreign exchange derivative.

Put option the right to sell an asset a xed date and

price.
Foreign exchange option the right to sell money in
one currency and buy money in another currency at
a xed time and relative price.

The foreign exchange options market is the deepest,

largest and most liquid market for options of any kind.
Most trading is over the counter (OTC) and is lightly
regulated, but a fraction is traded on exchanges like
the International Securities Exchange, Philadelphia Stock
Exchange, or the Chicago Mercantile Exchange for
options on futures contracts. The global market for
exchange-traded currency options was notionally valued
by the Bank for International Settlements at $158.3 trillion in 2005.

5.1.1

Strike price the asset price at which the investor

can exercise an option.
Spot price the price of the asset at the time of the
trade.
Forward price the price of the asset for delivery at
a future time.
Notional the amount of each currency that the option allows the investor to sell or buy.
Ratio of notionals the strike, not the current spot
or forward.

Example

Non-linear payo the payo for a straightforward

FX option is linear in the underlying currency, denominating the payout in a given numraire.

For example a GBPUSD contract could give the owner

the right to sell 1,000,000 and buy $2,000,000 on December 31. In this case the pre-agreed exchange rate, or
strike price, is 2.0000 USD per GBP (or GBP/USD 2.00
as it is typically quoted) and the notional amounts (notionals) are 1,000,000 and $2,000,000.

Numraire the currency in which an asset is valued.

Change of numraire the implied volatility of an
FX option depends on the numraire of the purchaser, again because of the non-linearity of x 7
1/x .

This type of contract is both a call on dollars and a put

on sterling, and is typically called a GBPUSD put, as it is
a put on the exchange rate; although it could equally be
called a USDGBP call.
If the rate is lower than 2.0000 on December 31 (say
at 1.9000), meaning that the dollar is stronger and the
pound is weaker, then the option is exercised, allowing
the owner to sell GBP at 2.0000 and immediately buy
it back in the spot market at 1.9000, making a prot of
(2.0000 GBPUSD 1.9000 GBPUSD)*1,000,000 GBP
= 100,000 USD in the process. If they immediately convert the prot into GBP this amounts to 100,000/1.9000
= 52,631.58 GBP.

The dierence between FX options and traditional options is that in the latter case the trade is to give an amount
of money and receive the right to buy or sell a commodity, stock or other non-money asset. In FX options, the
asset in question is also money, denominated in another
currency.
For example, a call option on oil allows the investor to
buy oil at a given price and date. The investor on the

133

134

CHAPTER 5. BASIC TYPES OF OPTIONS

other side of the trade is in eect selling a put option on 5.1.4

the currency.

Valuation: the GarmanKohlhagen

model

To eliminate residual risk, match the foreign currency notionals, not the local currency notionals, else the foreign As in the BlackScholes model for stock options and the
Black model for certain interest rate options, the value of
currencies received and delivered don't oset.
a European option on an FX rate is typically calculated
In the case of an FX option on a rate, as in the above ex- by assuming that the rate follows a log-normal process.
ample, an option on GBPUSD gives a USD value that
is linear in GBPUSD using USD as the numraire (a In 1983 Garman and Kohlhagen extended the Black
move from 2.0000 to 1.9000 yields a .10 * $2,000,000 Scholes model to cope with the presence of two interest
/ $2.0000 = $100,000 prot), but has a non-linear GBP rates (one for each currency). Suppose that rd is the riskvalue. Conversely, the GBP value is linear in the US- free interest rate to expiry of the domestic currency and
DGBP rate, while the USD value is non-linear. This is rf is the foreign currency risk-free interest rate (where
because inverting a rate has the eect of x 7 1/x , which domestic currency is the currency in which we obtain the
value of the option; the formula also requires that FX
is non-linear.
rates both strike and current spot be quoted in terms
of units of domestic currency per unit of foreign currency). The results are also in the same units and to be
meaningful need to be converted[2] into one of the cur5.1.3 Hedging
rencies.
Corporations primarily use FX options to hedge uncer- Then the domestic currency value of a call option into the
tain future cash ows in a foreign currency. The general foreign currency is
rule is to hedge certain foreign currency cash ows with
forwards, and uncertain foreign cash ows with options.
c = S0 erf T N(d1 ) Kerd T N(d2 )
Suppose a United Kingdom manufacturing rm expects
to be paid US$100,000 for a piece of engineering equip- The value of a put option has value
ment to be delivered in 90 days. If the GBP strengthens
against the US$ over the next 90 days the UK rm loses
money, as it will receive less GBP after converting the
rd T
N(d2 ) S0 erf T N(d1 )
US$100,000 into GBP. However, if the GBP weakens p = Ke
against the US$, then the UK rm receives more GBP.
where :
This uncertainty exposes the rm to FX risk. Assuming that the cash ow is certain, the rm can enter into
a forward contract to deliver the US$100,000 in 90 days
2
time, in exchange for GBP at the current forward rate. d1 = ln(S0 /K) + (rd rf + /2)T
T
This forward contract is free, and, presuming the ex
pected cash arrives, exactly matches the rms exposure,
d2 = d1 T
perfectly hedging their FX risk.
If the cash ow is uncertain, a forward FX contract exposes the rm to FX risk in the opposite direction, in the
case that the expected USD cash is not received, typically
making an option a better choice.
Using options, the UK rm can purchase a GBP call/USD
put option (the right to sell part or all of their expected income for pounds sterling at a predetermined rate), which:

protects the GBP value that the rm expects in 90

days time (presuming the cash is received)

S0 is the current spot rate

K is the strike price
N is the cumulative normal distribution function
rd is domestic risk free simple interest rate
rf is foreign risk free simple interest rate
T is the time to maturity (calculated according
to the appropriate day count convention)
and is the volatility of the FX rate.

costs at most the option premium (unlike a forward, 5.1.5 Risk management
which can have unlimited losses)
A wide range of techniques are in use for calculating
the options risk exposure, or Greeks (as for example the
yields a prot if the expected cash is not received but Vanna-Volga method). Although the option prices proFX rates move in its favor
duced by every model agree (with GarmanKohlhagen),

5.4. CALLABLE BULL/BEAR CONTRACT

135

risk numbers can vary signicantly depending on the as- or commodity and the sale of its related derivative (for
sumptions used for the properties of spot price move- example the purchase of a particular bond and the sale of
ments, volatility surface and interest rate curves.
a related futures contract).
After GarmanKohlhagen, the most common models are
SABR and local volatility, although when agreeing risk
numbers with a counterparty (e.g. for exchanging delta,
or calculating the strike on a 25 delta option) Garman
Kohlhagen is always used.

5.1.6

References

[1] "Foreign Exchange (FX) Terminologies: Forward Deal

and Options Deal" Published by the International Business
Times AU on February 14, 2011.

Basis trading is done when the investor feels that the two
instruments are mispriced relative to one other and that
the mispricing will correct itself so that the gain on one
side of the trade will more than cancel out the loss on the
other side of the trade. In the case of such a trade taking
place on a security and its related futures contract, the
trade will be protable if the purchase price plus the net
cost of carry is less than the futures price.

5.3.1 Basis of futures

Basis can be dened as the dierence between the spot

price of a given cash market asset and the price of its related futures contract.[1] There will be a dierent basis for
each delivery month for each contract. Usually, basis is
5.2 Chooser option
dened as cash price minus futures price, however, the alIn nance, a chooser option is a special type of option ternative denition, future price minus cash, is also used.
contract. It gives the purchaser a xed period of time to A basis trade prots from the closing of an unwarranted
decide whether the derivative will be a European call or gap between the futures contract and the associated cash
market instrument.
put option.
[2] Currency options pricing explained

In more detail, a chooser option has a specied decision

time t1 , where the buyer has to make the decision de- 5.3.2 See also
scribed above. Finally, at the expiration time t2 the option expires. If the buyer has chosen that it should be a
Basis swap
call option, the payout is max(S K, 0) . For the choice
of a put option, the payout is max(K S, 0) . Here K
is the strike price of the option and S is the stock price at 5.3.3 References
expiry.
[1] Hull, Options, Futures and Other Derivatives, 6 Ed,
Prentice Hall

5.2.1

Replication

For stocks without dividend, the chooser option can be 5.4 Callable bull/bear contract
replicated using one call option with strike price K and
expiration time t2 , and one put option with strike price
A callable bull/bear contract, or CBBC in short form,
Ker(t2 t1 ) and expiration time t1 ;.[1]
is a derivative nancial instrument that provides investors
with a leveraged investment in underlying assets, which
can be a single stock, or an index. CBBC is usually is5.2.2 References
sued by third parties, mostly investment banks, but nei[1] Yue-Kuen Kwok, Compound options
ther by stock exchanges nor by asset owners. It was rst
introduced in Europe and Australia in 2001, and it is
now popular in United Kingdom, Germany, Switzerland,
5.2.3 Bibliography
Italy, and Hong Kong.
Yue-Kuen Kwok, Compound options (from Derivatives Week and Encyclopedia of Financial Engineer5.4.1
ing and Risk Management)

Principle

CBBC has two types of contracts, callable bull contract

and callable bear contract, which are always issued in
5.3 Basis
the money. By investing in a callable bull contract, investors are bullish on the prospect of the underlying asBasis trading is a nancial trading strategy which con- set and intend to capture its potential price appreciation.
sists of the purchase of a particular nancial instrument Conversely, investors buying a callable bear contract are

136

CHAPTER 5. BASIC TYPES OF OPTIONS

bearish on the prospect of the underlying asset and try to

make a prot in a falling market.[1]

Generally, one buys a call option on the bond if one believes that interest rates will fall, causing an increase in
bond prices. Likewise, one buys the put option if one believes that the opposite will be the case. One result of
trading in a bond option, is that the price of the underlying
bond is locked in for the term of the contract, thereby
reducing the credit risk associated with uctuations in the
bond price.

CBBC is typically issued at a price that represents the

dierence between the spot price of the underlying asset and the strike price of the CBBCs, plus a small premium (which is usually the funding cost). The strike price
can be equal to or lower (bull)/higher (bear) than the call
price. The call price is also referred to as stop loss,
trigger point, knockout point or barrier by dierent traders.
5.6.1 Valuation
However, CBBC will expire at a predened date or will
Compare: Swaption#Valuation
be called immediately by the issuers when the price of the
underlying asset reaches a call price before expiry.[2]
Bonds, the underlyers in this case, exhibit what is known
as pull-to-par: as the bond reaches its maturity date, all of
5.4.2 See also
the prices involved with the bond become known, thereby
decreasing its volatility. On the other hand, the Black
Option (nance)
Scholes model, which assumes constant volatility, does
not reect this process, and cannot therefore be applied
here; see BlackScholes: Valuing bond options.

5.4.3

References

[1] What are CBBC?

[2] http://www.hkex.com.hk/eng/prod/secprod/cbbc/
Documents/cbbc%20leaflet%20eng.pdf

5.5 Contingent value rights

A Contingent Value Rights (CVR) is a type of option
that can be issued by the buyer of a company to the sellers.
It species an event, which, if triggered, lets the sellers
acquire more shares in the target company.

5.5.1

References

5.5.2

External links

- CVR on Investopedia
- Contingent Value Rights in Acquisitions: Theory
and Empirical Evidence

5.6 Bond option

In nance, a bond option is an option to buy or sell a
bond at a certain price on or before the option expiry date.
These instruments are typically traded OTC.
A European bond option is an option to buy or sell a
bond at a certain date in future for a predetermined
price.
An American bond option is an option to buy or sell
a bond on or before a certain date in future for a
predetermined price.

Addressing this, bond options are usually valued using the

Black model or with a lattice based short rate model such
as Black-Derman-Toy, Ho-Lee or HullWhite. The latter approach is theoretically more correct, , although in
practice the Black Model is more widely used for reasons
of simplicity and speed. For American- and Bermudanstyled options, where exercise is permitted prior to maturity, only the lattice based approach is applicable.
Using the Black model, the spot price in the formula is not simply the market price of the underlying
bond, rather it is the forward bond price. This
forward price is calculated by rst subtracting the
present value of the coupons between the valuation
date (i.e. today) and the exercise date from todays
dirty price, and then forward valuing this amount to
the exercise date. (These calculations are performed
using todays yield curve, as opposed to the bonds
YTM.) The reason that the Black Model may be applied in this way is that the numeraire is then $1 at
the time of delivery (whereas under BlackScholes,
the numeraire is $1 today). This allows us to assume
that (a) the bond price is a random variable at a future date, but also (b) that the risk-free rate between
now and then is constant (since using the forward
measure moves the discounting outside of the expectation term ). Thus the valuation takes place in
a risk-neutral forward world where the expected
future spot rate is the forward rate, and its standard
deviation is the same as in the physical world"; see
Girsanovs theorem. The volatility used, is typically
read-o an Implied volatility surface.
The lattice based model entails a tree of short rates a zeroeth step - consistent with todays yield curve
and short rate (often caplet) volatility, and where
the nal time step of the tree corresponds to the

5.6. BOND OPTION

date of the underlying bonds maturity. Using this
tree (1) the bond is valued at each node by stepping backwards through the tree: at the nal nodes,
bond value is simply face value (or $1), plus coupon
(in cents) if relevant; at each earlier node, it is the
discounted expected value of the up- and downnodes in the later time step, plus coupon payments
during the current time step. Then (2), the option is
valued similar to the approach for equity options: at
nodes in the time-step corresponding to option maturity, value is based on moneyness; at earlier nodes,
it is the discounted expected value of the option at
the up- and down-nodes in the later time step, and,
depending on option style (and other specications
- see below), of the bond value at the node. For
both steps, the discounting is at the short rate for
the tree-node in question. (Note that the Hull-White
tree is usually Trinomial: the logic is as described,
although there are then three nodes in question at
each point.) See Lattice model (nance) #Interest
rate derivatives.

5.6.2

137
at each node in the tree, impacting the bond price and /
or the option price as specied. These bonds are also
sometimes valued using BlackScholes. Here, the bond
is priced as a straight bond (i.e. as if it had no embedded features) and the option is valued using the Black
Scholes formula. The option value is then added to the
straight bond price if the optionality rests with the buyer
of the bond; it is subtracted if the seller of the bond (i.e.
the issuer) may choose to exercise. More sophisticated
approaches view a bond as comprising an equity component and a debt component, each with dierent default
risks, and which must be modeled as a coupled system";
see , .

5.6.3 Relationship with caps and oors

European Put options on zero coupon bonds can be seen
to be equivalent to suitable caplets, i.e. interest rate cap
components, whereas call options can be seen to be equivalent to suitable oorlets, i.e. components of interest rate
oors. See for example Brigo and Mercurio (2001), who
also discuss bond options valuation with dierent models.

Embedded options

The term bond option is also used for option-like fea- 5.6.4 References
tures of some bonds ("embedded options"). These are an
Black, F.; Derman, E. and Toy, W. (January
inherent part of the bond, rather than a separately traded
February 1990). A One-Factor Model of Interproduct. These options are not mutually exclusive, so a
est Rates and Its Application to Treasury Bond Opbond may have several options embedded. Bonds of this
tions (PDF). Financial Analysts Journal: 2432.
type include:
Callable bond: allows the issuer to buy back the
bond at a predetermined price at a certain time in
future. The holder of such a bond has, in eect,
sold a call option to the issuer. Callable bonds cannot be called for the rst few years of their life. This
period is known as the lock out period.
Puttable bond: allows the holder to demand early redemption at a predetermined price at a certain time
in future. The holder of such a bond has, in eect,
purchased a put option on the bond.

Damiano Brigo and Fabio Mercurio (2001). Interest

Rate Models - Theory and Practice with Smile, Ination and Credit (2nd ed. 2006 ed.). Springer Verlag.
ISBN 978-3-540-22149-4.
Aswath Damodaran (2002). Investment Valuation
(2nd ed.). John Wiley. ISBN 0-471-41488-3.,
Chapter 33: Valuing Fixed Income Securities
Frank Fabozzi (1998). Valuation of xed income securities and derivatives (3rd ed.). John Wiley. ISBN
978-1-883249-25-0.

Convertible bond: allows the holder to demand conversion of bonds into the stock of the issuer at a predetermined price at a certain time period in future.

R. Staord Johnson (2010). Bond Evaluation, Selection, and Management (2nd ed.). John Wiley. ISBN
0470478357.

Extendible bond: allows the holder to extend the

bond maturity date by a number of years.

David F. Babbel (1996). Valuation of InterestSensitive Financial Instruments: SOA Monograph MFI96-1 (1st ed.). John Wiley & Sons. ISBN 9781883249151.

Exchangeable bond: allows the holder to demand

conversion of bonds into the stock of a dierent
company, usually a public subsidiary of the issuer,
at a predetermined price at certain time period in 5.6.5 External links
future.
Discussion
Bonds with embedded options can be valued using the
Bond Options, Caps and the Black Model, Milica
lattice-based approach, as above, but additionally allowCudina, University of Texas at Austin
ing that the eect of the embedded option is incorporated

138

CHAPTER 5. BASIC TYPES OF OPTIONS

Valuing Bonds with Embedded Options, Frank J.

Fabozzi

potential buyers. Warrants can also be used in private equity deals. Frequently, these warrants are detachable and
can be sold independently of the bond or stock.

Valuing Convertible Bonds as Derivatives, Goldman

Sachs (authors include Emanuel Derman and Piotr In the case of warrants issued with preferred stocks,
stockholders may need to detach and sell the warrant beKarasinski)
fore they can receive dividend payments. Thus, it is some The Valuation and Calibration of Convertible times benecial to detach and sell a warrant as soon as
Bonds, Sanveer Hariparsad, University of Pretoria
possible so the investor can earn dividends.
Martingales and Measures: Blacks Model, Jacque- Warrants are actively traded in some nancial markets
such as Deutsche Brse and Hong Kong.[1] In Hong Kong
line Henn-Overbeck, University of Basel
Stock Exchange, warrants accounted for 11.7% of the
Binomial Interest Rate Trees and the Valuation of turnover in the rst quarter of 2009, just second to the
Bonds with Embedded Options, Staord Johnson, callable bull/bear contract.[2]
Xavier University
The Problem with Black, Scholes et al., Andrew
5.7.1
Kalotay

Structure and features

Methods of Pricing Convertible Bonds, Ariel Warrants have similar characteristics to that of other eqZadikov, University of Cape Town
uity derivatives, such as options, for instance:
Online tools
Black Bond Option Model, Dr.
thomasho.com

Thomas Ho,

Exercising: A warrant is exercised when the holder

informs the issuer their intention to purchase the
shares underlying the warrant.

Bond Option Pricing using the Black Model Dr. The warrant parameters, such as exercise price, are xed
Shing Hing Man, Thomson-Reuters Risk Manage- shortly after the issue of the bond. With warrants, it is
important to consider the following main characteristics:
ment
Pricing A Bond Using the BDT Model Dr. Shing
Hing Man, Thomson-Reuters Risk Management
'Greeks Calculator using the Black model, Dr. Razvan Pascalau, SUNY Plattsburgh
Pricing Bond Option using G2++ model, pricingoption.com

5.7 Warrant
This article is about nancial instrument.
payment method, see warrant of payment.

For the

In nance, a warrant is a security that entitles the holder

to buy the underlying stock of the issuing company at a
xed price called exercise price until the expiry date.
Warrants and options are similar in that the two contractual nancial instruments allow the holder special rights
to buy securities. Both are discretionary and have expiration dates. The word warrant simply means to endow
with the right, which is only slightly dierent from the
meaning of option.

Premium: A warrants premium represents how

much extra you have to pay for your shares when
buying them through the warrant as compared to
buying them in the regular way.
Gearing (leverage): A warrants gearing is the way
to ascertain how much more exposure you have to
the underlying shares using the warrant as compared
to the exposure you would have if you buy shares
through the market.
Expiration Date: This is the date the warrant expires. If you plan on exercising the warrant you must
do so before the expiration date. The more time
remaining until expiry, the more time for the underlying security to appreciate, which, in turn, will
increase the price of the warrant (unless it depreciates). Therefore, the expiry date is the date on which
the right to exercise ceases to exist.
Restrictions on exercise: Like options, there are different exercise types associated with warrants such
as American style (holder can exercise anytime after expiration) or European style (holder can only
exercise on expiration date).[3]

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 Warrants are longer-dated options and are generally
the yield of the bond and make them more attractive to traded over-the-counter.

5.7. WARRANT

5.7.2

Secondary market

Sometimes the issuer will try to establish a market for the

warrant and to register it with a listed exchange. In this
case, the price can be obtained from a stockbroker. But
often, warrants are privately held or not registered, which
makes their prices less obvious. On the NYSE warrants
can be easily tracked by adding a w after the companys
ticker symbol to check the warrants price. Unregistered
warrant transactions can still be facilitated between accredited parties and in fact several secondary markets
have been formed to provide liquidity for these investments.

139

5.7.4 Traded warrants

Traditional warrant
Naked warrant
Exotic warrant
Barrier warrant

Covered warrant
Hit-warrant
Turbo warrant
Snail warrant

Third party warrants

5.7.3

Comparison with call options

Pricing

Warrants are very similar to call options. For instance,

many warrants confer the same rights as equity options
and warrants often can be traded in secondary markets
like options. However, there also are several key dierences between warrants and equity options:

There are various methods (models) of evaluation available to value warrants theoretically, including the BlackScholes evaluation model. However, it is important to
have some understanding of the various inuences on
warrant prices. The market value of a warrant can be
Warrants are issued by private parties, typically the divided into two components:
corporation on which a warrant is based, rather than
a public options exchange.
Intrinsic value: This is simply the dierence between the exercise (strike) price and the underlying
Warrants issued by the company itself are dilutive.
stock price. Warrants are also referred to as in-theWhen the warrant issued by the company is exermoney or out-of-the-money, depending on where
cised, the company issues new shares of stock, so
the current asset price is in relation to the warrants
the number of outstanding shares increases. When
exercise price. Thus, for instance, for call warrants,
a call option is exercised, the owner of the call opif the stock price is below the strike price, the wartion receives an existing share from an assigned call
rant has no intrinsic value (only time valueto be
writer (except in the case of employee stock options,
explained shortly). If the stock price is above the
where new shares are created and issued by the comstrike, the warrant has intrinsic value and is said to
pany upon exercise). Unlike common stock shares
be in-the-money.
outstanding, warrants do not have voting rights.
Warrants are considered over the counter instruments and thus are usually only traded by nancial
institutions with the capacity to settle and clear these
types of transactions.
A warrants lifetime is measured in years (as long as
15 years), while options are typically measured in
months. Even LEAPS (long-term equity anticipation securities), the longest stock options available,
tend to expire in two or three years. Upon expiration, the warrants are worthless unless the price of
the common stock is greater than the exercise price.
Warrants are not standardized like exchange-listed
options. While investors can write stock options
on the ASX (or CBOE), they are not permitted to
do so with ASX-listed warrants, since only companies can issue warrants and, while each option contract is over 1000 underlying ordinary shares (100
on CBOE), the number of warrants that must be
exercised by the holder to buy the underlying asset
depends on the conversion ratio set out in the oer
documentation for the warrant issue.

Time value: Time value can be considered as the

value of the continuing exposure to the movement
in the underlying security that the warrant provides.
Time value declines as the expiry of the warrant gets
closer. This erosion of time value is called time decay. It is not constant, but increases rapidly towards
expiry. A warrants time value is aected by the following factors:
Time to expiry: The longer the time to expiry,
the greater the time value of the warrant. This
is because the price of the underlying asset has
a greater probability of moving in-the-money
which makes the warrant more valuable.
Volatility: The more volatile the underlying instrument, the higher the price of the warrant
will be (as the warrant is more likely to end up
in-the-money).
Dividends: To include the factor of receiving
dividends depends on if the holder of the warrant is permitted to receive dividends from the
underlying asset.

140

CHAPTER 5. BASIC TYPES OF OPTIONS

Interest rates: An increase in interest rates
will lead to more expensive call warrants and
cheaper put warrants. The level of interest
rates reects the opportunity cost of capital.

5.7.5

Uses

Wedding warrants: are attached to the host debentures and can be exercised only if the host debentures are surrendered
Detachable warrants: the warrant portion of the
security can be detached from the debenture and
traded separately.

Portfolio protection: Put warrants allow the owner

to protect the value of the owners portfolio against
falls in the market or in particular shares.

Naked warrants: are issued without an accompanying bond and, like traditional warrants, are traded on
the stock exchange.

Low cost

Cash or Share Warrants in which the settlement may

be in the form of either cash or physical delivery of
the shares - depending on its status at expiry.

Leverage

5.7.6

Risks

There are certain risks involved in trading warrants

including time decay. Time decay: Time value diminishes as time goes bythe rate of decay increases the
closer to the date of expiration.

5.7.7

Types of warrants

Traditional
Traditional warrants are issued in conjunction with a
Bond (known as a warrant-linked bond) and represent the
right to acquire shares in the entity issuing the bond. In
other words, the writer of a traditional warrant is also the
issuer of the underlying instrument. Warrants are issued
in this way as a sweetener to make the bond issue more
attractive and to reduce the interest rate that must be offered in order to sell the bond issue.

A wide range of warrants and warrant types are available.

The reasons you might invest in one type of warrant may
Example
be dierent from the reasons you might invest in another
type of warrant.
Price paid for bond with warrants P0
Equity warrants: Equity warrants can be call and put
warrants.
Callable warrants: Oer investors the right to
buy shares of a company from that company
at a specic price at a future date prior to expiration.

Coupon payments C
Maturity T
Required rate of return r
Face value of bond F

( T
)
Puttable warrants: Oer investors the right to

C
F

.
sell shares of a company back to that company P0
t
(1 + r)
(1 + r)T
t=1
at a specic price at a future date prior to expiration.
Naked
Covered warrants: A covered warrants is a warrant
that has some underlying backing, for example the
Naked warrants are issued without an accompanying
issuer will purchase the stock beforehand or will use
bond and, like traditional warrants, are traded on the
other instruments to cover the option.
stock exchange. They are typically issued by banks and
Basket warrants: As with a regular equity index, securities rms. These are also called covered warrants
warrants can be classied at, for example, an indus- and are settled for cash, e.g. do not involve the company
try level. Thus, it mirrors the performance of the who issues the shares that underlie the warrant. In most
markets around the world, covered warrants are more
industry.
popular than the traditional warrants described above. Fi Index warrants: Index warrants use an index as the nancially they are also similar to call options, but are typunderlying asset. Your risk is dispersedusing in- ically bought by retail investors, rather than investment
dex call and index put warrantsjust like with reg- funds or banks, who prefer the more keenly priced opular equity indexes. It should be noted that they are tions which tend to trade on a dierent market. Covered
priced using index points. That is, you deal with warrants normally trade alongside equities, which makes
cash, not directly with shares.
them easier for retail investors to buy and sell them.

5.8. OPTION SCREENER

Third-party warrants
Third-party warrant is a derivative issued by the holders
of the underlying instrument. Suppose a company issues
warrants which give the holder the right to convert each
warrant into one share at $500. This warrant is companyissued. Suppose, a mutual fund that holds shares of the
company sells warrants against those shares, also exercisable at $500 per share. These are called third-party warrants. The primary advantage is that the instrument helps
in the price discovery process. In the above case, the mutual fund selling a one-year warrant exercisable at $500
sends a signal to other investors that the stock may trade
at $500-levels in one year. If volumes in such warrants
are high, the price discovery process will be that much
better; for it would mean that many investors believe that
the stock will trade at that level in one year. Third-party
warrants are essentially long-term call options. The seller
of the warrants does a covered call-write. That is, the
seller will hold the stock and sell warrants against them.
If the stock does not cross $500, the buyer will not exercise the warrant. The seller will, therefore, keep the
warrant premium.

5.7.8

Notes

[1]
[2]
[3] Warrants on Wikinvest

5.7.9

References

Incademy
Investopedia
Invest-FAQ

141
Covered warrants from Societe Generale in the UK
Covered warrants from Royal Bank of Scotland in
the UK
Canadian Stock Warrants
Common Stock Warrants

5.8 Option screener

An option screener is a tool that evaluates options based
on criteria and generates a list of potential trading ideas.
Most people who trade options are technical traders. It
essentially means they look for patterns in charts. Also
they use statistical correlations and deviations and give
them Greek names like alpha beta theta gamma.
Few professional money managers use technical analysis
and these tools are typically used by individual traders.
Its counterpart, fundamental analysis, similarly uses some
math to generate ratios, but the inputs and outputs are
much more tangible (e.g. income, revenue, assets).

5.8.1 Overview
Options, particularly exchange-traded options, are highly
volatile securities whose market prices can change
rapidly. In addition, the number of options in a market
can be large. For instance, as of December 2013, there
were over 550,000 individual equity option contracts,
written on nearly 6,100 underlying stocks and exchangetraded funds (ETFs), listed on the various U.S. options
exchanges. Each contract is typically listed on multiple
exchanges, resulting in millions of separate option prices
that all change in real-time.

5.8.2 Screening criterion

Basics of Financial Management, 3rd ed. Frank BaBeing able to isolate option plays that appeal to a specic
con, Tai S. Shin, Suk H. Kim, Ramesh Garg. Copley
trader is a vital component of a useful option screener.
Publishing Company. Action, Mass., 2004.
To do this, the option screener needs to allow the trader
Special Situation Investing: Hedging, Arbitrage, and to dene lters that narrow down the ideal options based
Liquidation, Brian J. Stark, Dow-Jones Publishers. upon what the trader deems important. Typical lters inNew York, NY, 1983. ISBN 0-87094-384-7; ISBN clude, but are not limited to:
978-0-87094-384-3.
option expiration
Warrants on Wikinvest
historic volatility

5.7.10

External links

Chicago Board Options Exchange

Finance glossary by SGCIB
Warrants traded in Hong KongInformation on
warrant products traded in Hong Kong

implied volatility
moneyness
open interest
option price
p/e ratio

142

CHAPTER 5. BASIC TYPES OF OPTIONS

put/call ratio
share price
stock exchange
strike price
intrinsic value
premium
volume

5.8.3

References

5.9 Reverse convertible securities

A reverse convertible security or convertible security
is a short-term note linked to an underlying stock. The
security oers a steady stream of income due to the payment of a high coupon rate. In addition, at maturity the
owner will receive either 100% of the par value or, if the
stock value falls, a predetermined number of shares of the
underlying stock.[1] In the context of structured product,
a reverse convertible can be linked to an equity index or
a basket of indices. In such case, the capital repayment at
maturity is cash settled, either 100% of principal, or less
if the underlying index falls conditional on barrier is hit
in the case of barrier reverse convertibles.

In a low interest rate and high market volatility environment, reverse convertibles are popular as they provide
much enhanced yield for the investors. By receiving enhanced coupons, investors take on the risk of losing part
of the capital. Prior to the turn of the millennium (2000),
reverse convertibles mostly consisted of investors shorting standard ATM put options. Investors would lose capital if at maturity the underlying fell below the initial level.
To increase the protection for investors, barrier reverse
convertibles were introduced whereby investors were instead shorting ATM down-and-in put options. The additional barrier event increased the protection for the investors, as the put option would not come into eect unless the (down) barrier was hit. The barrier protection
feature triggered much increased reverse convertible issuances in UK in the early 2000s as well as in the European retail markets. By the early 2010s, the (barrier)
reverse convertibles were also among the most popular
structured products in US.

While the barrier protection feature was benecial for investors, for the issuers, managing and hedging relatively
long-dated (e.g. 3~5 years) equity barrier risks were a serious challenge. The hedging parameters (Greeks) near
the barrier could be unstable, and they could suddenly
change which would lead to a massive increase in trading
volumes in the process of hedging. In contrast to FX underlyings, equity underlyings for the reverse convertibles
tend to have much less liquidity. The problems would
become more severe as and when the products were introduced to the mass retail market. To solve these practical problems during the product design process, various
technologies [3] were adopted in the barrier reverse convertible pricing models to deal with barrier concentration
5.9.1 Description
risks. Reverse convertibles nowadays account for a large
portion the structured products issued for retail and priFeatures
vate investors. The issuances of other breeds of reverse
These are short-term coupon bearing notes, which are de- convertibles, such as those combining a callable payo, or
signed to provide an enhanced yield while maintaining a knockout clause, have also increased substantially with
certain equity-like risks. Their investment value is de- the ever changing market conditions.
rived from the underlying equity exposure, paid in the
form of xed coupons. Owners receive full principal back
Reference shares
at maturity if the Knock-in Level is not breached (which
is typically 70-80% of the initial reference price). If the
Underlying stocks or basket of equities may include
underlying stock falls in value, the investor will receive
names such as:
shares of stock which will be worth less than his original investment. The underlying stock, index or basket of
Dell
equities is dened as Reference Shares. In most cases,
Wal-Mart
Reverse convertibles are linked to a single stock.
Exxon Mobil
You may also nd inverse reverse convertibles, which are
Cisco
the opposite of a reverse convertible. The owner benets
as long the underlying stock does not go above a predeter Best Buy
mined barrier. If the underlying stock breaches the bar Corning
rier, the owner will receive the principal minus the percentage of the movement against him.
Broad market indices may include names such as:
These are both types of structured products, which are
sophisticated instruments and carry a signicant risk of
loss of capital.[2]

S&P-500 Index
EURO STOXX-50 Index

5.9. REVERSE CONVERTIBLE SECURITIES

143

FTSE-100 Index

Scenario 1 - cash delivery

NIKKEI-225

Scenario 2 - cash delivery

Nasdaq-100 Index

Scenario 3 - physical delivery

How do reverse convertibles work?

5.9.3 Liquidity

They are short-term investments, typically with a one year

maturity. At maturity, the owner receives either 100% of
their original investment or a predetermined number of
shares of the underlying stock, in addition to the stated
coupon payment. The owners earning potential is limited to the securitys stated coupon, because he receives
coupon payments regardless of the performance of the
underlying reference shares. Risk potential is the same
as for the underlying security, less the coupon payment.

These are generally created as a buy and hold investment,

but issuers typically provide liquidity in the secondary
market. The secondary market price may not immediately reect changes in the underlying security. Liquidations prior to maturity may be less than the initial principal amount invested.

Coupon payments are the obligation of the issuer and are

paid on a monthly or quarterly basis. These instruments
are sold by prospectus or oering circular, and prices on
these notes are updated intra day to reect the activity
of the underlying equity. The general rule of thumb is:
The higher the coupon payment, the greater likelihood of
receiving stock at maturity.

They trade at and accrue on a 30/360 or actual/365 basis. End of day pricing is posted on Bloomberg L.P.
and/or the internet. Pricing uctuates intraday. Reverse
Convertibles are registered with the U.S. Securities and
Exchange Commission (SEC).

Trading

Note: Coupon rate is determined by issuer. Sometimes 5.9.4 Ratings

holders do expect zero coupon bond like reverse convertThese are an unsecured debt obligation of the issuer, not
ible bonds.
the reference company, thus they carry the rating of the
issuer. The creditworthiness of the issuer does not aect
or enhance the likely performance of the investment other
5.9.2 Maturity options
than the ability of the issuer to meet its obligations.
Delivery at maturity

5.9.5 Taxes
At maturity, there are two possible outcomes:
For tax purposes Reverse convertible notes are considered to have two components: a debt portion and a put
Cash Delivery: If the stock closes at or above the
option. At maturity, the option component is taxed as a
initial share price upon valuation date, regardless of
short-term capital gain if the investor receives the cash
whether the stock closed below the knock-in level
settlement. In the case of physical delivery, the option
during the holding period, or if the stock closes becomponent will reduce the tax basis of the Reference
low the initial share price, but has never closed beShares delivered to their accounts.
low the knock-in level.
Physical Delivery: If the underlying shares closed
below the knock-in level at any time during the holding period and does not trade back up above the initial share price on valuation date (four days prior to
maturity).

5.9.6 Investor benets

These securities can oer enhanced yield and current income at the cost of higher risk. They also carry downside
protection, typically up to 10-30% on most Reverse Convertible oerings. The bid-ask spread is typically 1%.

Physical delivery

5.9.7 Risk to consider

The initial share price is determined on the trade date.
The nal valuation of the shares is based on the closing
price of the reference shares determined four days prior
to maturity. If the investor is delivered physical shares,
their value will be less than the initial investment.

The price of the reference shares may decline during

the term of the note, which will aect the investor
negatively, while the investor does not have the same
price appreciation potential as the reference shares,

144

CHAPTER 5. BASIC TYPES OF OPTIONS

because at maturity the most the investor will receive
is his original principal amount.

Investors selling notes prior to maturity may receive

a market price which may be higher or lower than
par value, not necessarily reecting any increase or
decrease in the market price of the underlying equity.
Reverse convertibles do not guarantee return of
principal at maturity.
The market price of the Reverse convertibles may
be inuenced by unpredictable market factors.

5.9.8

References

[1] http://online.wsj.com/article/SB124511060085417057.
html
[2] http://www.dailyfinance.com/2009/06/19/
the-reverse-convertible-bond-sparks-a-lively-debate/
[3] Qu, Dong, (2001). Managing Barrier Risks Using Exponential Soft Barriers. Derivatives Week, (15 January)
[4] http://docs.google.com/gview?a=v&q=cache:
wqi0_NYN2AEJ:www.fisbonds.com/fisdocuments/
managedContent/AAMSecurities/RCN%
2520Whitepaper%2520FINAL%2520%28719%
29%2520060107.pdf+Reverse+Convertible+Note&hl=
en&gl=us&sig=AFQjCNFkRjpTERq-cSk7Q2mwR_
SM7HS-Fw

5.9.9

See also

Convertible bond
Convertible security
Exchangeable bond
Structured product

Chapter 6

Options Style
6.1 European option

Friday prior. *Expire the third Friday if the rst of the

month begins on a Saturday.

In nance, the style or family of an option is the class

into which the option falls, usually dened by the dates
on which the option may be exercised. The vast majority
of options are either European or American (style) options. These optionsas well as others where the payo
is calculated similarlyare referred to as "vanilla options". Options where the payo is calculated dierently
are categorized as "exotic options". Exotic options can
pose challenging problems in valuation and hedging.

European options expire the Friday prior to the third Saturday of every month. Therefore they are closed for
trading the Thursday prior to the third Saturday of every
month.
Dierence in value

European options are typically valued using the Black

Scholes or Black model formula. This is a relatively simple Partial Dierential Equation equation with a closedform solution that has become standard in the nancial
6.1.1 American and European options
community. There are no general formulae for American
The key dierence between American and European op- options, but a choice of models to approximate the price
are available (for example Roll-Geske-Whaley, Baronetions relates to when the options can be exercised:
Adesi and Whaley, Bjerksund and Stensland, binomial
options
model by Cox-Ross-Rubinstein, Blacks approx A European option may be exercised only at the
imation
and others; there is no consensus on which is
expiration date of the option, i.e. at a single pre[1]
preferable).
dened point in time.
An American option on the other hand may be ex- An investor holding an American-style option and seeking optimal value will only exercise it before maturity unercised at any time before the expiration date.
der certain circumstances. Owners who wish to realise
the full value of their option will mostly prefer to sell it on,
For both, the payowhen it occursis via:
rather than exercise it immediately, sacricing the time
value.[2]
max{(S K), 0} , for a call option
Where an American and a European option are otherwise
max{(K S), 0} , for a put option
identical (having the same strike price, etc.), the American option will be worth at least as much as the European
(Where K is the Strike price and S is the spot price of the (which it entails). If it is worth more, then the dierence
is a guide to the likelihood of early exercise. In practice,
underlying asset)
one can calculate the BlackScholes price of a European
Option contracts traded on futures exchanges are mainly
option that is equivalent to the American option (except
American-style, whereas those traded over-the-counter
for the exercise dates of course). The dierence between
are mainly European.
the two prices can then be used to calibrate the more comNearly all stock and equity options are American options, plex American option model.
while indexes are generally represented by European opTo account for the Americans higher value there must
tions. Commodity options can be either style.
be some situations in which it is optimal to exercise the
American option before the expiration date. This can
arise in several ways, such as:
Expiration date
Traditional monthly American options expire the third
Saturday of every month. They are closed for trading the
145

An in the money (ITM) call option on a stock is often exercised just before the stock pays a dividend

146

CHAPTER 6. OPTIONS STYLE

that would lower its value by more than the options
remaining time value.

A put option will usually be exercised early if the

underlying asset les for bankruptcy.[3]
A deep ITM currency option (FX option) where the
strike currency has a lower interest rate than the currency to be received will often be exercised early because the time value sacriced is less valuable than
the expected depreciation of the received currency
against the strike.
An American bond option on the dirty price of a
bond (such as some convertible bonds) may be exercised immediately if ITM and a coupon is due.
The underlying has risen/fallen too quickly such that
the divergence between the price and perceived fundamentals is great enough to justify exercising the
option. This would require that future stock prices
can be predicted (to some degree) from past performance, as assumption that violates most versions of
the EMH.
A put option on gold will be exercised early when
deep ITM, because gold tends to hold its value
whereas the currency used as the strike is often expected to lose value through ination if the holder
waits until nal maturity to exercise the option (they
will almost certainly exercise a contract deep ITM,
minimizing its time value).

6.1.2

Non-vanilla exercise rights

There are other, more unusual exercise styles in which

the payo value remains the same as a standard option
(as in the classic American and European options above)
but where early exercise occurs dierently:
A Bermudan option is an option where the buyer
has the right to exercise at a set (always discretely
spaced) number of times. This is intermediate between a European optionwhich allows exercise at
a single time, namely expiryand an American option, which allows exercise at any time (the name is a
pun: Bermuda, a British overseas territory, is somewhat American and somewhat Europeanin terms
of both option style and physical locationbut is
nearer to American in terms of both). For example a typical Bermudian swaption might confer the
opportunity to enter into an interest rate swap. The
option holder might decide to enter into the swap at
the rst exercise date (and so enter into, say, a tenyear swap) or defer and have the opportunity to enter
in six months time (and so enter a nine-year and sixmonth swap); see Swaption: Valuation. Most exotic
interest rate options are of Bermudan style.

A Canary option is an option whose exercise

style lies somewhere between European options and
Bermudian options. (The name refers to the relative geography of the Canary Islands.) Typically,
the holder can exercise the option at quarterly dates,
but not before a set time period (typically one year)
has elapsed. The ability to exercise the option ends
prior to the maturity date of the product. The term
was coined by Keith Kline, who at the time was
an agency xed income trader at the Bank of New
York.
A Verde option is an option whose exercise style
lies somewhere between European options and Canary options. (The name refers to the relative geography of the Cape Verde Islands.) The holder can
exercise the option at incremental dates(typically on
an annual basis, sometimes less frequently), but not
before a set time period has elapsed. The ability to
exercise the option ends prior to the maturity date
of the product. The term was rst coined by John
Young, an agency xed income trader at Hapoalim
Securities in New York.
A capped-style option is not an interest rate cap but
a conventional option with a pre-dened prot cap
written into the contract. A capped-style option is
automatically exercised when the underlying security
closes at a price making the options mark to market
match the specied amount.
A compound option is an option on another option,
and as such presents the holder with two separate
exercise dates and decisions. If the rst exercise date
arrives and the 'inner' options market price is below
the agreed strike the rst option will be exercised
(European style), giving the holder a further option
at nal maturity.
A shout option allows the holder eectively two exercise dates: during the life of the option they can (at
any time) shout to the seller that they are lockingin the current price, and if this gives them a better
deal than the payo at maturity they'll use the underlying price on the shout date rather than the price at
maturity to calculate their nal payo.
A double option gives the purchaser a composite
call-and-put option (an option to either buy or sell)
in a single contract. This has only ever been available
in commodities markets and have never been traded
on exchange.
A swing option gives the purchaser the right to exercise one and only one call or put on any one of a
number of specied exercise dates (this latter aspect
is Bermudian). Penalties are imposed on the buyer

6.1. EUROPEAN OPTION

if the net volume purchased exceeds or falls below
specied upper and lower limits. Allows the buyer
to swing the price of the underlying asset. Primarily used in energy trading.

6.1.3

Exotic options with standard exercise styles

These options can be exercised either European style or

American style; they dier from the plain vanilla option
only in the calculation of their payo value:
A cross option (or composite option) is an option on some underlying asset in one currency with a
strike denominated in another currency. For example a standard call option on IBM, which is denominated in dollars pays $MAX(SK,0) (where S is the
stock price at maturity and K is the strike). A composite stock option might pay JPYMAX(S/QK,0),
where Q is the prevailing FX rate. The pricing of
such options naturally needs to take into account FX
volatility and the correlation between the exchange
rate of the two currencies involved and the underlying stock price.
A quanto option is a cross option in which the exchange rate is xed at the outset of the trade, typically at 1. The payo of an IBM quanto call option
would then be JPYmax(SK,0).
An exchange option is the right to exchange one asset for another (such as a sugar future for a corporate
bond).
A basket option is an option on the weighted average of several underlyings
A rainbow option is a basket option where the
weightings depend on the nal performances of the
components. A common special case is an option
on the worst-performing of several stocks.
A Low Exercise Price Option (LEPO) is a European style call option with a low exercise price of
$0.01.
A Boston option is an American option but with
premium deferred until the option expiration date.

147
A lookback option is a path dependent option
where the option owner has the right to buy (sell) the
underlying instrument at its lowest (highest) price
over some preceding period.
An Asian option (or average option) is an
option where the payo is not determined by
the underlying price at maturity but by the average underlying price over some pre-set period
of time. For example an Asian call option might pay
MAX(DAILY_AVERAGE_OVER_LAST_THREE_MONTHS(S)
K, 0).[4] Asian options were originated in commodity markets to prevent option traders from
attempting to manipulate the price of the underlying security on the exercise date. They were named
'Asian' because their creators were in Tokyo when
they created the rst pricing model[5]
A Russian option is a lookback option that runs for
perpetuity. That is, there is no end to the period into
which the owner can look back.
A game option or Israeli option is an option where
the writer has the opportunity to cancel the option he
has oered, but must pay the payo at that point plus
a penalty fee.
The payo of a cumulative Parisian option is dependent on the total amount of time the underlying
asset value has spent above or below a strike price.
The payo of a standard Parisian option is dependent on the maximum amount of time the underlying asset value has spent consecutively above or
below a strike price.
A barrier option involves a mechanism where if a
'limit price' is crossed by the underlying, the option
either can be exercised or can no longer be exercised.
A double barrier option involves a mechanism
where if either of two 'limit prices is crossed by the
underlying, the option either can be exercised or can
no longer be exercised.

Non-vanilla path dependent exotic

options

A cumulative Parisian barrier option involves a

mechanism where if the total amount of time the
underlying asset value has spent above or below a
'limit price', the option can be exercised or can no
longer be exercised.

The following "exotic options" are still options, but have

payos calculated quite dierently from those above. Although these instruments are far more unusual they can
also vary in exercise style (at least theoretically) between
European and American:

A standard Parisian barrier option involves a

mechanism where if the maximum amount of time
the underlying asset value has spent consecutively
above or below a 'limit price', the option can be exercised or can no longer be exercised.

6.1.4

148

CHAPTER 6. OPTIONS STYLE

A reoption occurs when a contract has expired

without having been exercised. The owner of the
underlying security may then reoption the security.
A binary option (also known as a digital option)
pays a xed amount, or nothing at all, depending on
the price of the underlying instrument at maturity.
A chooser option gives the purchaser a xed period
of time to decide whether the derivative will be a
vanilla call or put.
A forward start option is an option whose strike price
is determined in the future
A cliquet option is a sequence of forward start options

6.1.5

Related

Covered call
Moneyness
Naked put
Option (nance)
Option time value
Put option
Put-call parity

6.1.6

See also

CBOE
Derivative (nance)
Derivatives markets
Financial economics
Financial instruments, Finance
Futures contracts
Option screeners
Monte Carlo methods in nance

6.1.7

Options

Binary option
Bond option
Credit default option
Exotic interest rate option

Foreign exchange option

Interest rate cap and oor
Options on futures
Rainbow option
Real option
Stock option
Swaption
Warrant

6.1.8 References
[1] Global Derivatives, About valuation of American options
[2] see early exercise consideration for a discussion of when
it makes sense to exercise early
[3] http://www.bus.lsu.edu/academics/finance/faculty/
dchance/Essay16.pdf
[4] Rogers, L.C.G.; Shi, Z. (1995), The Value of an Asian
Option (PDF), Journal of Applied Probability 32 (4):
10771088, doi:10.2307/3215221, JSTOR 3215221
[5] Paul Wilmott on Quantitative Finance - Chapter 25 section 25.1

6.1.9 External links

option types data base, global-derivatives.com
Varieties of programming codes on option valuation

6.2 European option

In nance, the style or family of an option is the class
into which the option falls, usually dened by the dates
on which the option may be exercised. The vast majority
of options are either European or American (style) options. These optionsas well as others where the payo
is calculated similarlyare referred to as "vanilla options". Options where the payo is calculated dierently
are categorized as "exotic options". Exotic options can
pose challenging problems in valuation and hedging.

6.2.1 American and European options

The key dierence between American and European options relates to when the options can be exercised:
A European option may be exercised only at the
expiration date of the option, i.e. at a single predened point in time.

6.2. EUROPEAN OPTION

149

An American option on the other hand may be ex- for the exercise dates of course). The dierence between
ercised at any time before the expiration date.
the two prices can then be used to calibrate the more complex American option model.
For both, the payowhen it occursis via:
To account for the Americans higher value there must
be some situations in which it is optimal to exercise the
max{(S K), 0} , for a call option
American option before the expiration date. This can
arise in several ways, such as:
max{(K S), 0} , for a put option
(Where K is the Strike price and S is the spot price of the
underlying asset)
Option contracts traded on futures exchanges are mainly
American-style, whereas those traded over-the-counter
are mainly European.
Nearly all stock and equity options are American options,
while indexes are generally represented by European options. Commodity options can be either style.
Expiration date
Traditional monthly American options expire the third
Saturday of every month. They are closed for trading the
Friday prior. *Expire the third Friday if the rst of the
month begins on a Saturday.
European options expire the Friday prior to the third Saturday of every month. Therefore they are closed for
trading the Thursday prior to the third Saturday of every
month.
Dierence in value
European options are typically valued using the Black
Scholes or Black model formula. This is a relatively simple Partial Dierential Equation equation with a closedform solution that has become standard in the nancial
community. There are no general formulae for American
options, but a choice of models to approximate the price
are available (for example Roll-Geske-Whaley, BaroneAdesi and Whaley, Bjerksund and Stensland, binomial
options model by Cox-Ross-Rubinstein, Blacks approximation and others; there is no consensus on which is
preferable).[1]
An investor holding an American-style option and seeking optimal value will only exercise it before maturity under certain circumstances. Owners who wish to realise
the full value of their option will mostly prefer to sell it on,
rather than exercise it immediately, sacricing the time
value.[2]
Where an American and a European option are otherwise
identical (having the same strike price, etc.), the American option will be worth at least as much as the European
(which it entails). If it is worth more, then the dierence
is a guide to the likelihood of early exercise. In practice,
one can calculate the BlackScholes price of a European
option that is equivalent to the American option (except

An in the money (ITM) call option on a stock is often exercised just before the stock pays a dividend
that would lower its value by more than the options
remaining time value.
A put option will usually be exercised early if the
underlying asset les for bankruptcy.[3]
A deep ITM currency option (FX option) where the
strike currency has a lower interest rate than the currency to be received will often be exercised early because the time value sacriced is less valuable than
the expected depreciation of the received currency
against the strike.
An American bond option on the dirty price of a
bond (such as some convertible bonds) may be exercised immediately if ITM and a coupon is due.
The underlying has risen/fallen too quickly such that
the divergence between the price and perceived fundamentals is great enough to justify exercising the
option. This would require that future stock prices
can be predicted (to some degree) from past performance, as assumption that violates most versions of
the EMH.
A put option on gold will be exercised early when
deep ITM, because gold tends to hold its value
whereas the currency used as the strike is often expected to lose value through ination if the holder
waits until nal maturity to exercise the option (they
will almost certainly exercise a contract deep ITM,
minimizing its time value).

6.2.2 Non-vanilla exercise rights

There are other, more unusual exercise styles in which
the payo value remains the same as a standard option
(as in the classic American and European options above)
but where early exercise occurs dierently:
A Bermudan option is an option where the buyer
has the right to exercise at a set (always discretely
spaced) number of times. This is intermediate between a European optionwhich allows exercise at
a single time, namely expiryand an American option, which allows exercise at any time (the name is a

150

CHAPTER 6. OPTIONS STYLE

pun: Bermuda, a British overseas territory, is somewhat American and somewhat Europeanin terms
of both option style and physical locationbut is
nearer to American in terms of both). For example a typical Bermudian swaption might confer the
opportunity to enter into an interest rate swap. The
option holder might decide to enter into the swap at
the rst exercise date (and so enter into, say, a tenyear swap) or defer and have the opportunity to enter
in six months time (and so enter a nine-year and sixmonth swap); see Swaption: Valuation. Most exotic
interest rate options are of Bermudan style.

A Canary option is an option whose exercise

style lies somewhere between European options and
Bermudian options. (The name refers to the relative geography of the Canary Islands.) Typically,
the holder can exercise the option at quarterly dates,
but not before a set time period (typically one year)
has elapsed. The ability to exercise the option ends
prior to the maturity date of the product. The term
was coined by Keith Kline, who at the time was
an agency xed income trader at the Bank of New
York.
A Verde option is an option whose exercise style
lies somewhere between European options and Canary options. (The name refers to the relative geography of the Cape Verde Islands.) The holder can
exercise the option at incremental dates(typically on
an annual basis, sometimes less frequently), but not
before a set time period has elapsed. The ability to
exercise the option ends prior to the maturity date
of the product. The term was rst coined by John
Young, an agency xed income trader at Hapoalim
Securities in New York.
A capped-style option is not an interest rate cap but
a conventional option with a pre-dened prot cap
written into the contract. A capped-style option is
automatically exercised when the underlying security
closes at a price making the options mark to market
match the specied amount.
A compound option is an option on another option,
and as such presents the holder with two separate
exercise dates and decisions. If the rst exercise date
arrives and the 'inner' options market price is below
the agreed strike the rst option will be exercised
(European style), giving the holder a further option
at nal maturity.
A shout option allows the holder eectively two exercise dates: during the life of the option they can (at
any time) shout to the seller that they are lockingin the current price, and if this gives them a better
deal than the payo at maturity they'll use the underlying price on the shout date rather than the price at
maturity to calculate their nal payo.

A double option gives the purchaser a composite

call-and-put option (an option to either buy or sell)
in a single contract. This has only ever been available
in commodities markets and have never been traded
on exchange.
A swing option gives the purchaser the right to exercise one and only one call or put on any one of a
number of specied exercise dates (this latter aspect
is Bermudian). Penalties are imposed on the buyer
if the net volume purchased exceeds or falls below
specied upper and lower limits. Allows the buyer
to swing the price of the underlying asset. Primarily used in energy trading.

6.2.3 Exotic options with standard exercise styles

These options can be exercised either European style or
American style; they dier from the plain vanilla option
only in the calculation of their payo value:
A cross option (or composite option) is an option on some underlying asset in one currency with a
strike denominated in another currency. For example a standard call option on IBM, which is denominated in dollars pays $MAX(SK,0) (where S is the
stock price at maturity and K is the strike). A composite stock option might pay JPYMAX(S/QK,0),
where Q is the prevailing FX rate. The pricing of
such options naturally needs to take into account FX
volatility and the correlation between the exchange
rate of the two currencies involved and the underlying stock price.
A quanto option is a cross option in which the exchange rate is xed at the outset of the trade, typically at 1. The payo of an IBM quanto call option
would then be JPYmax(SK,0).
An exchange option is the right to exchange one asset for another (such as a sugar future for a corporate
bond).
A basket option is an option on the weighted average of several underlyings
A rainbow option is a basket option where the
weightings depend on the nal performances of the
components. A common special case is an option
on the worst-performing of several stocks.
A Low Exercise Price Option (LEPO) is a European style call option with a low exercise price of
$0.01.
A Boston option is an American option but with
premium deferred until the option expiration date.

6.2. EUROPEAN OPTION

6.2.4

Non-vanilla path dependent exotic

options

The following "exotic options" are still options, but have

payos calculated quite dierently from those above. Although these instruments are far more unusual they can
also vary in exercise style (at least theoretically) between
European and American:
A lookback option is a path dependent option
where the option owner has the right to buy (sell) the
underlying instrument at its lowest (highest) price
over some preceding period.

151
A standard Parisian barrier option involves a
mechanism where if the maximum amount of time
the underlying asset value has spent consecutively
above or below a 'limit price', the option can be exercised or can no longer be exercised.
A reoption occurs when a contract has expired
without having been exercised. The owner of the
underlying security may then reoption the security.
A binary option (also known as a digital option)
pays a xed amount, or nothing at all, depending on
the price of the underlying instrument at maturity.

An Asian option (or average option) is an

option where the payo is not determined by
A chooser option gives the purchaser a xed period
the underlying price at maturity but by the avof time to decide whether the derivative will be a
erage underlying price over some pre-set period
vanilla call or put.
of time. For example an Asian call option might pay
MAX(DAILY_AVERAGE_OVER_LAST_THREE_MONTHS(S)
A forward start option is an option whose strike price
K, 0).[4] Asian options were originated in comis determined in the future
modity markets to prevent option traders from
attempting to manipulate the price of the underly A cliquet option is a sequence of forward start oping security on the exercise date. They were named
tions
'Asian' because their creators were in Tokyo when
[5]
they created the rst pricing model
A Russian option is a lookback option that runs for 6.2.5 Related
perpetuity. That is, there is no end to the period into
which the owner can look back.
Covered call
A game option or Israeli option is an option where
the writer has the opportunity to cancel the option he
has oered, but must pay the payo at that point plus
a penalty fee.
The payo of a cumulative Parisian option is dependent on the total amount of time the underlying
asset value has spent above or below a strike price.

Moneyness
Naked put
Option (nance)
Option time value
Put option

The payo of a standard Parisian option is de Put-call parity

pendent on the maximum amount of time the underlying asset value has spent consecutively above or
below a strike price.
6.2.6 See also
A barrier option involves a mechanism where if a
'limit price' is crossed by the underlying, the option
either can be exercised or can no longer be exercised.

CBOE

A double barrier option involves a mechanism

where if either of two 'limit prices is crossed by the
underlying, the option either can be exercised or can
no longer be exercised.

Derivatives markets

A cumulative Parisian barrier option involves a

mechanism where if the total amount of time the
underlying asset value has spent above or below a
'limit price', the option can be exercised or can no
longer be exercised.

Futures contracts

Derivative (nance)

Financial economics
Financial instruments, Finance

Option screeners
Monte Carlo methods in nance

152

6.2.7

CHAPTER 6. OPTIONS STYLE

Options

Binary option
Bond option
Credit default option
Exotic interest rate option
Foreign exchange option
Interest rate cap and oor
Options on futures

6.3.1 American and European options

The key dierence between American and European options relates to when the options can be exercised:
A European option may be exercised only at the
expiration date of the option, i.e. at a single predened point in time.
An American option on the other hand may be exercised at any time before the expiration date.
For both, the payowhen it occursis via:

Rainbow option

max{(S K), 0} , for a call option

Real option

max{(K S), 0} , for a put option

Stock option
Swaption
Warrant

6.2.8

References

[1] Global Derivatives, About valuation of American options

[2] see early exercise consideration for a discussion of when
it makes sense to exercise early
[3] http://www.bus.lsu.edu/academics/finance/faculty/
dchance/Essay16.pdf
[4] Rogers, L.C.G.; Shi, Z. (1995), The Value of an Asian
Option (PDF), Journal of Applied Probability 32 (4):
10771088, doi:10.2307/3215221, JSTOR 3215221
[5] Paul Wilmott on Quantitative Finance - Chapter 25 section 25.1

6.2.9

(Where K is the Strike price and S is the spot price of the

underlying asset)
Option contracts traded on futures exchanges are mainly
American-style, whereas those traded over-the-counter
are mainly European.
Nearly all stock and equity options are American options,
while indexes are generally represented by European options. Commodity options can be either style.
Expiration date
Traditional monthly American options expire the third
Saturday of every month. They are closed for trading the
Friday prior. *Expire the third Friday if the rst of the
month begins on a Saturday.
European options expire the Friday prior to the third Saturday of every month. Therefore they are closed for
trading the Thursday prior to the third Saturday of every
month.

External links
Dierence in value

option types data base, global-derivatives.com

European options are typically valued using the Black
Varieties of programming codes on option valuation Scholes or Black model formula. This is a relatively simple Partial Dierential Equation equation with a closedform solution that has become standard in the nancial
community. There are no general formulae for American
6.3 European option
options, but a choice of models to approximate the price
In nance, the style or family of an option is the class are available (for example Roll-Geske-Whaley, Baroneinto which the option falls, usually dened by the dates Adesi and Whaley, Bjerksund and Stensland, binomial
on which the option may be exercised. The vast majority options model by Cox-Ross-Rubinstein, Blacks approxof options are either European or American (style) op- imation and[1]others; there is no consensus on which is
tions. These optionsas well as others where the payo preferable).
is calculated similarlyare referred to as "vanilla options". Options where the payo is calculated dierently
are categorized as "exotic options". Exotic options can
pose challenging problems in valuation and hedging.

An investor holding an American-style option and seeking optimal value will only exercise it before maturity under certain circumstances. Owners who wish to realise
the full value of their option will mostly prefer to sell it on,

6.3. EUROPEAN OPTION

153

rather than exercise it immediately, sacricing the time (as in the classic American and European options above)
value.[2]
but where early exercise occurs dierently:
Where an American and a European option are otherwise
identical (having the same strike price, etc.), the American option will be worth at least as much as the European
(which it entails). If it is worth more, then the dierence
is a guide to the likelihood of early exercise. In practice,
one can calculate the BlackScholes price of a European
option that is equivalent to the American option (except
for the exercise dates of course). The dierence between
the two prices can then be used to calibrate the more complex American option model.
To account for the Americans higher value there must
be some situations in which it is optimal to exercise the
American option before the expiration date. This can
arise in several ways, such as:
An in the money (ITM) call option on a stock is often exercised just before the stock pays a dividend
that would lower its value by more than the options
remaining time value.
A put option will usually be exercised early if the
underlying asset les for bankruptcy.[3]
A deep ITM currency option (FX option) where the
strike currency has a lower interest rate than the currency to be received will often be exercised early because the time value sacriced is less valuable than
the expected depreciation of the received currency
against the strike.
An American bond option on the dirty price of a
bond (such as some convertible bonds) may be exercised immediately if ITM and a coupon is due.
The underlying has risen/fallen too quickly such that
the divergence between the price and perceived fundamentals is great enough to justify exercising the
option. This would require that future stock prices
can be predicted (to some degree) from past performance, as assumption that violates most versions of
the EMH.
A put option on gold will be exercised early when
deep ITM, because gold tends to hold its value
whereas the currency used as the strike is often expected to lose value through ination if the holder
waits until nal maturity to exercise the option (they
will almost certainly exercise a contract deep ITM,
minimizing its time value).

6.3.2

Non-vanilla exercise rights

There are other, more unusual exercise styles in which

the payo value remains the same as a standard option

A Bermudan option is an option where the buyer

has the right to exercise at a set (always discretely
spaced) number of times. This is intermediate between a European optionwhich allows exercise at
a single time, namely expiryand an American option, which allows exercise at any time (the name is a
pun: Bermuda, a British overseas territory, is somewhat American and somewhat Europeanin terms
of both option style and physical locationbut is
nearer to American in terms of both). For example a typical Bermudian swaption might confer the
opportunity to enter into an interest rate swap. The
option holder might decide to enter into the swap at
the rst exercise date (and so enter into, say, a tenyear swap) or defer and have the opportunity to enter
in six months time (and so enter a nine-year and sixmonth swap); see Swaption: Valuation. Most exotic
interest rate options are of Bermudan style.
A Canary option is an option whose exercise
style lies somewhere between European options and
Bermudian options. (The name refers to the relative geography of the Canary Islands.) Typically,
the holder can exercise the option at quarterly dates,
but not before a set time period (typically one year)
has elapsed. The ability to exercise the option ends
prior to the maturity date of the product. The term
was coined by Keith Kline, who at the time was
an agency xed income trader at the Bank of New
York.
A Verde option is an option whose exercise style
lies somewhere between European options and Canary options. (The name refers to the relative geography of the Cape Verde Islands.) The holder can
exercise the option at incremental dates(typically on
an annual basis, sometimes less frequently), but not
before a set time period has elapsed. The ability to
exercise the option ends prior to the maturity date
of the product. The term was rst coined by John
Young, an agency xed income trader at Hapoalim
Securities in New York.
A capped-style option is not an interest rate cap but
a conventional option with a pre-dened prot cap
written into the contract. A capped-style option is
automatically exercised when the underlying security
closes at a price making the options mark to market
match the specied amount.
A compound option is an option on another option,
and as such presents the holder with two separate
exercise dates and decisions. If the rst exercise date
arrives and the 'inner' options market price is below

154

CHAPTER 6. OPTIONS STYLE

the agreed strike the rst option will be exercised
(European style), giving the holder a further option
at nal maturity.

A shout option allows the holder eectively two exercise dates: during the life of the option they can (at
any time) shout to the seller that they are lockingin the current price, and if this gives them a better
deal than the payo at maturity they'll use the underlying price on the shout date rather than the price at
maturity to calculate their nal payo.

A basket option is an option on the weighted average of several underlyings

A rainbow option is a basket option where the
weightings depend on the nal performances of the
components. A common special case is an option
on the worst-performing of several stocks.
A Low Exercise Price Option (LEPO) is a European style call option with a low exercise price of
$0.01.

A Boston option is an American option but with

premium deferred until the option expiration date.
A double option gives the purchaser a composite
call-and-put option (an option to either buy or sell)
in a single contract. This has only ever been available
in commodities markets and have never been traded 6.3.4 Non-vanilla path dependent exotic
options
on exchange.
A swing option gives the purchaser the right to exercise one and only one call or put on any one of a
number of specied exercise dates (this latter aspect
is Bermudian). Penalties are imposed on the buyer
if the net volume purchased exceeds or falls below
specied upper and lower limits. Allows the buyer
to swing the price of the underlying asset. Primarily used in energy trading.

6.3.3

Exotic options with standard exercise styles

These options can be exercised either European style or

American style; they dier from the plain vanilla option
only in the calculation of their payo value:
A cross option (or composite option) is an option on some underlying asset in one currency with a
strike denominated in another currency. For example a standard call option on IBM, which is denominated in dollars pays $MAX(SK,0) (where S is the
stock price at maturity and K is the strike). A composite stock option might pay JPYMAX(S/QK,0),
where Q is the prevailing FX rate. The pricing of
such options naturally needs to take into account FX
volatility and the correlation between the exchange
rate of the two currencies involved and the underlying stock price.
A quanto option is a cross option in which the exchange rate is xed at the outset of the trade, typically at 1. The payo of an IBM quanto call option
would then be JPYmax(SK,0).
An exchange option is the right to exchange one asset for another (such as a sugar future for a corporate
bond).

The following "exotic options" are still options, but have

payos calculated quite dierently from those above. Although these instruments are far more unusual they can
also vary in exercise style (at least theoretically) between
European and American:
A lookback option is a path dependent option
where the option owner has the right to buy (sell) the
underlying instrument at its lowest (highest) price
over some preceding period.
An Asian option (or average option) is an
option where the payo is not determined by
the underlying price at maturity but by the average underlying price over some pre-set period
of time. For example an Asian call option might pay
MAX(DAILY_AVERAGE_OVER_LAST_THREE_MONTHS(S)
K, 0).[4] Asian options were originated in commodity markets to prevent option traders from
attempting to manipulate the price of the underlying security on the exercise date. They were named
'Asian' because their creators were in Tokyo when
they created the rst pricing model[5]
A Russian option is a lookback option that runs for
perpetuity. That is, there is no end to the period into
which the owner can look back.
A game option or Israeli option is an option where
the writer has the opportunity to cancel the option he
has oered, but must pay the payo at that point plus
a penalty fee.
The payo of a cumulative Parisian option is dependent on the total amount of time the underlying
asset value has spent above or below a strike price.
The payo of a standard Parisian option is dependent on the maximum amount of time the underlying asset value has spent consecutively above or
below a strike price.

6.3. EUROPEAN OPTION

155

A barrier option involves a mechanism where if a 6.3.6 See also

'limit price' is crossed by the underlying, the option
CBOE
either can be exercised or can no longer be exercised.
A double barrier option involves a mechanism
where if either of two 'limit prices is crossed by the
underlying, the option either can be exercised or can
no longer be exercised.
A cumulative Parisian barrier option involves a
mechanism where if the total amount of time the
underlying asset value has spent above or below a
'limit price', the option can be exercised or can no
longer be exercised.

Derivative (nance)
Derivatives markets
Financial economics
Financial instruments, Finance
Futures contracts
Option screeners
Monte Carlo methods in nance

A standard Parisian barrier option involves a 6.3.7 Options

mechanism where if the maximum amount of time
Binary option
the underlying asset value has spent consecutively
above or below a 'limit price', the option can be ex Bond option
ercised or can no longer be exercised.
Credit default option
A reoption occurs when a contract has expired
without having been exercised. The owner of the
underlying security may then reoption the security.

Exotic interest rate option

Foreign exchange option
Interest rate cap and oor

A binary option (also known as a digital option)

pays a xed amount, or nothing at all, depending on
the price of the underlying instrument at maturity.
A chooser option gives the purchaser a xed period
of time to decide whether the derivative will be a
vanilla call or put.
A forward start option is an option whose strike price
is determined in the future
A cliquet option is a sequence of forward start options

6.3.5

Related

Covered call
Moneyness
Naked put
Option (nance)
Option time value

Options on futures
Rainbow option
Real option
Stock option
Swaption
Warrant

6.3.8 References
[1] Global Derivatives, About valuation of American options
[2] see early exercise consideration for a discussion of when
it makes sense to exercise early
[3] http://www.bus.lsu.edu/academics/finance/faculty/
dchance/Essay16.pdf
[4] Rogers, L.C.G.; Shi, Z. (1995), The Value of an Asian
Option (PDF), Journal of Applied Probability 32 (4):
10771088, doi:10.2307/3215221, JSTOR 3215221
[5] Paul Wilmott on Quantitative Finance - Chapter 25 section 25.1

6.3.9 External links

Put option

option types data base, global-derivatives.com

Put-call parity

Varieties of programming codes on option valuation

156

CHAPTER 6. OPTIONS STYLE

6.4 Asian option

An Asian option (or average value option) is a special
type of option contract. For Asian options the payo
is determined by the average underlying price over some
pre-set period of time. This is dierent from the case of
the usual European option and American option, where
the payo of the option contract depends on the price of
the underlying instrument at exercise; Asian options are
thus one of the basic forms of exotic options.
One advantage of Asian options is that these reduce the
risk of market manipulation of the underlying instrument
at maturity (Kemma & 1990 1077).[1] Another advantage of Asian options involves the relative cost of Asian
options compared to European or American options. Because of the averaging feature, Asian options reduce the
volatility inherent in the option; therefore, Asian options
are typically cheaper than European or American options.
This can be an advantage for corporations that are subject to the Financial Accounting Standards Board (2004
FASB) revised Statement No. 123, which required that
corporations expense employee stock options.[2]

6.4.1

P (T ) = max (S(T ) kA(0, T ), 0) ,

where k is a weighting, usually 1 so often omitted from
descriptions. The equivalent put option payo is given by

P (T ) = max (kA(0, T ) S(T ), 0) .

6.4.3 Types of averaging

The Average A may be obtained in many ways. Conventionally, this means an arithmetic average. In the continuous case, this is obtained by

A(0, T ) =

1
T

S(t)dt.
0

For the case of discrete monitoring (with monitoring at the

times t1 , t2 , . . . , tn ) we have the average given by

Etymology

1
S(ti ).
In the 1980s Mark Standish was with the London-based A(0, T ) = N
i=1
Bankers Trust working on xed income derivatives and
proprietary arbitrage trading. David Spaughton worked
There also exist Asian options with geometric average; in
as systems analyst in the nancial markets with Bankers
the continuous case, this is given by
Trust since 1984 when the Bank of England rst gave licences for banks to do foreign exchange options in the
(
)
London market. In 1987 Standish and Spaughton were in
T
Tokyo on business when they developed the rst com- A(0, T ) = exp 1
ln(S(t))dt .
T 0
mercially used pricing formula for options linked to the
average price of crude oil. They called this exotic option,
the Asian option, because they were in Asia.[3][4][5][6]
N

6.4.4 Pricing of Asian options

6.4.2

Permutations of Asian option

A discussion of the problem of pricing Asian options with

Monte Carlo methods is given in a paper by Kemna and
There are numerous permutations of Asian option; the Vorst.[7]
most basic are listed below:
In the path integral approach to option pricing ,[8] the
Fixed strike (also known as an average rate) Asian call problem for geometric average can be solved via the Efpayout
fective Classical potential [9] of Feynman and Kleinert.[10]

P (T ) = max (A(0, T ) K, 0) ,

Rogers and Shi solve the pricing problem with a PDE approach .[11]

Variance Gamma model can be eciently implemented

where A denotes the average, and K the strike. The equiv- when pricing Asian style options. Then using the Bondesson series representation for generating the variance
alent put option is given by
gamma process shows to increase performance when
pricing this type of option.[12]
P (T ) = max (K A(0, T ), 0) .

Within Lvy models the pricing problem for geometrically Asian options can still be solved.[13] For the arithThe oating strike (or oating rate) Asian call option has metic Asian option in Lvy models one can rely on numerical methods[13] or on analytic bounds .[14]
the payout

6.4. ASIAN OPTION

6.4.5

References

[1] Kemna et al. 1990, p 1077

[2] FASB (2004). Share-based payment (Report) (123). Financial Accounting Standards Board.
[3] William Falloon; David Turner, eds. (1999). The evolution of a market. Managing Energy Price Risk. London:
Risk Books.
[4] Wilmott, Paul (2006). 25. Paul Wilmott on Quantitative
Finance. John Wiley & Sons. p. 427.
[5] Palmer, Brian (July 14, 2010), Why Do We Call Financial Instruments Exotic"? Because some of them are from
Japan., Slate
[6] Glyn A. Holton (2013). Asian Option (Average Option)". Risk Encyclopedia. An Asian option (also called
an average option) is an option whose payo is linked to
the average value of the underlier on a specic set of dates
during the life of the option. "[I]n situations where the
underlier is thinly traded or there is the potential for its
price to be manipulated, an Asian option oers some protection. It is more dicult to manipulate the average value
of an underlier over an extended period of time than it is
to manipulate it just at the expiration of an option.
[7] Kemna, A.G.Z.; Vorst, A.C.F.; Rotterdam, E.U.; Instituut, Econometrisch (1990), A Pricing Method for Options
Based on Average Asset Values
[8] Kleinert, H. (2009), Path Integrals in Quantum Mechanics,
Statistics, Polymer Physics, and Financial Markets
[9] Feynman R.P., Kleinert H. (1986), Eective
classical partition functions, Physical Review A
34:
50805084, Bibcode:1986PhRvA..34.5080F,
doi:10.1103/PhysRevA.34.5080, PMID 9897894
[10] Devreese J.P.A., Lemmens D., Tempere J. (2010),
Path integral approach to Asianoptions in the
Black-Scholes model, Physica A 389: 780788,
arXiv:0906.4456,
Bibcode:2010PhyA..389..780D,
doi:10.1016/j.physa.2009.10.020
[11] Rogers, L.C.G.; Shi, Z. (1995), The value of an Asian
option, Journal of Applied Probability (Applied Probability Trust) 32 (4): 10771088, doi:10.2307/3215221,
JSTOR 3215221
[12] Mattias Sander. Bondessons Representation of the Variance Gamma Model and Monte Carlo Option Pricing.
Lunds Tekniska Hgskola 2008
[13] Fusai, Gianluca.; Meucci, Attilio (2008), Pricing discretely monitored Asian options under Lvy processes,
J. Bank. Finan. 32 (10): 20762088
[14] Lemmens, Damiaan; Liang, Ling Zhi; Tempere, Jacques;
De Schepper, Ann (2010), Pricing bounds for discrete arithmetic Asian options under Lvy models,
Physica A: Statistical Mechanics and its Applications
389 (22): 51935207, Bibcode:2010PhyA..389.5193L,
doi:10.1016/j.physa.2010.07.026

157

Chapter 7

Embedded Options
7.1 Callable bond

embedded.[3]

A callable bond (also called redeemable bond) is a type 7.1.1 Pricing

of bond (debt security) that allows the issuer of the bond
See also Bond option: Embedded options, for
to retain the privilege of redeeming the bond at some
further detail.
point before the bond reaches its date of maturity.[1] In
other words, on the call date(s), the issuer has the right,
but not the obligation, to buy back the bonds from the Price of callable bond = Price of straight bond Price
bond holders at a dened call price. Technically speak- of call option;
ing, the bonds are not really bought and held by the issuer
but are instead cancelled immediately.
Price of a callable bond is always lower than the
The call price will usually exceed the par or issue price. In
price of a straight bond because the call option adds
certain cases, mainly in the high-yield debt market, there
value to an issuer.[4]
can be a substantial call premium.
Yield on a callable bond is higher than the yield on
Thus, the issuer has an option which it pays for by oering
a straight bond.
a higher coupon rate. If interest rates in the market have
gone down by the time of the call date, the issuer will be
able to renance its debt at a cheaper level and so will be
incentivized to call the bonds it originally issued.[2] An- 7.1.2 References
other way to look at this interplay is that, as interest rates
go down, the price of the bonds go up; therefore, it is [1] Callable or Redeemable Bonds
advantageous to buy the bonds back at par value.
[2] Advanced Fixed Income: Callable Bonds

With a callable bond, investors have the benet of a

higher coupon than they would have had with a non- [3] Teaching Note on Convertible Bonds
callable bond. On the other hand, if interest rates fall,
the bonds will likely be called and they can only invest at [4] Callable Bonds
the lower rate. This is comparable to selling (writing) an
option the option writer gets a premium up front, but
has a downside if the option is exercised.
7.1.3 External links

The largest market for callable bonds is that of issues

Bonds 2000
from government sponsored entities. They own a lot of
mortgages and mortgage-backed securities. In the U.S.,
Callable Bond: Denition
mortgages are usually xed rate, and can be prepaid early
without cost, in contrast to the norms in other countries.
If rates go down, many home owners will renance at a
lower rate. As a consequence, the agencies lose assets. 7.2 Puttable bond
By issuing a large number of callable bonds, they have a
natural hedge, as they can then call their own issues and Puttable bond (put bond, putable or retractable bond)
renance at a lower rate.
is a bond with an embedded put option. The holder of
The price behaviour of a callable bond is the opposite of the puttable bond has the right, but not the obligation, to
that of puttable bond. Since call option and put option demand early repayment of the principal. The put option
are not mutually exclusive, a bond may have both options is exercisable on one or more specied dates.[1]
158

7.3. EXCHANGEABLE BOND

7.2.1

Overview

This type of bond protects investors: if interest rates rise

after bond purchase, the future value of coupon payments
will become less valuable. Therefore, investors sell bonds
back to the issuer and may lend proceeds elsewhere at a
higher rate. Bondholders are ready to pay for such protection by accepting a lower yield relative to that of a straight
bond.

159
Introduction to Pricing Approach, Resolution Financial Software
Bonds with Embedded Options and Options on
Bonds

7.3 Exchangeable bond

Of course, if an issuer has a severe liquidity crisis, it may

be incapable of paying for the bonds when the investors
wish. The investors also cannot sell back the bond at any
time, but at specied dates. However, they would still be
ahead of holders of non-puttable bonds, who may have no
more right than 'timely payment of interest and principal'
(which could perhaps be many years to get all their money
back).

Exchangeable bond (or XB) is a type of hybrid security

consisting of a straight bond and an embedded option to
exchange the bond for the stock of a company other than
the issuer (usually a subsidiary or company in which the
issuer owns a stake) at some future date and under prescribed conditions.[1] An exchangeable bond is dierent
from a convertible bond. A convertible bond gives the
holder the option to convert bond into shares of the isThe price behaviour of puttable bonds is the opposite of suer.
that of a callable bond. Since call option and put option
exchangeable bond is similar to that of
are not mutually exclusive, a bond may have both options The pricing of an[2]
convertible
bond,
splitting it in straight debt part and an
[2]
embedded.
embedded option part and valuing the two separately.

7.2.2

Pricing

See also Bond option: Embedded options, for

further detail.
Price of puttable bond = Price of straight bond +
Price of put option

7.3.1 Pricing
See also Bond option: Embedded options, for
further detail.

Price of exchangeable bond = price of straight bond

Price of a puttable bond is always higher than the + price of option to exchange
price of a straight bond because the put option adds
value to an investor;[3][4]
Price of an exchangeable bond is always higher than
the price of a straight bond because the option to
Yield on a puttable bond is lower than the yield on a
exchange adds value to an investor.
straight bond.[5]

7.2.3

References

Yield on an exchangeable bond is lower than the

yield on a straight bond.

[1] Put Bond at Investopedia. Accessed September 27, 2011.

[2] Teaching Note on Convertible Bonds

7.3.2 References

[3] Puttable and Extendible Bonds: Developing Interest Rate

Derivatives for Emerging Markets, IMF, 2003

[1] Successful placement by KfW of exchangeable bonds due

2014, exchangeable into shares of Deutsche Post AG

[4] W. Sean Cleary and Charles P. Jones, Investment Alternatives, Investments: Analysis and Management, John Wiley
& Sons Canada Ltd, 2005

[2] Exchangeable Debt

[5] Putable Bonds

7.2.4

External links

A model to price puttable corporate bonds with default risk, David Wang, Journal of Academy of Business and Economics, International Academy of Business and Economics, 2004

7.3.3 External links

First Exchangeable Bond in Central and Eastern Europe issued by EBRD
Dixons mulls Wanadoo exchangeable bond issue
Allianz: Bonds and Exchangeable Bonds

160

CHAPTER 7. EMBEDDED OPTIONS

7.4 Convertible bond

In nance, a convertible bond or convertible note (or a
convertible debenture if it has a maturity of greater than
10 years) is a type of bond that the holder can convert
into a specied number of shares of common stock in the
issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features. It originated in
the mid-19th century, and was used by early speculators
such as Jacob Little and Daniel Drew to counter market
cornering.[1] Convertible bonds are most often issued by
companies with a low credit rating and high growth potential.
To compensate for having additional value through the
option to convert the bond to stock, a convertible bond
typically has a coupon rate lower than that of similar, nonconvertible debt. The investor receives the potential upside of conversion into equity while protecting downside
with cash ow from the coupon payments and the return
of principal upon maturity. These properties lead naturally to the idea of convertible arbitrage, where a long
position in the convertible bond is balanced by a short
position in the underlying equity.
From the issuers perspective, the key benet of raising money by selling convertible bonds is a reduced cash
interest payment. The advantage for companies of issuing convertible bonds is that, if the bonds are converted to
stocks, companies debt vanishes. However, in exchange
for the benet of reduced interest payments, the value of
shareholders equity is reduced due to the stock dilution
expected when bondholders convert their bonds into new
shares.

7.4.1

Types

The underwriters have been quite innovative and provided various variations of the initial convertible structure. Although no clear classication formally exists in
the nancial market it is possible to segment the convertible universe into the following sub-types:

Mandatory convertibles are a common variation

of the vanilla subtype, especially on the US market. Mandatory convertible would force the holder
to convert into shares at maturityhence the term
Mandatory. Those securities would very often
bear two conversion prices, making their proles
similar to a "risk reversal" option strategy. The rst
conversion price would limit the price where the investor would receive the equivalent of its par value
back in shares, the second would delimit where the
investor will earn more than par. Note that if the
stock price is below the rst conversion price the
investor would suer a capital loss compared to its
original investment (excluding the potential coupon
payments). Mandatory convertibles can be compared to forward selling of equity at a premium.
Reverse convertibles are a less common variation,
mostly issued synthetically. They would be opposite of the vanilla structure: the conversion price
would act as a knock-in short call option: as the
stock price drops below the conversion price the investor would start to be exposed the underlying stock
performance and no longer able to redeem at par its
bond. This negative convexity would be compensated by a usually high regular coupon payment.
Packaged convertibles or sometimes bond + option structures are simply a straight bonds and a
call option/warrant wrapped together. Usually the
investor would be able to then trade both legs separately. Although the initial payo is similar to a
plain vanilla one, the Packaged Convertibles would
then have dierent dynamics and risks associated
with them since at maturity the holder would not receive some cash or shares but some cash and potentially some share. They would for instance miss the
modied duration mitigation eect usual with plain
vanilla convertibles structures.

7.4.2 Additional features

Vanilla convertible bonds are the most plain conAny convertible bond structure, on top of its type, would
vertible structures. They grant the holder the right
bear a certain range of additional features as dened in its
to convert into certain amount of shares determined
issuance prospectus:
according to a conversion price determined in advance. They may oer coupon regular payments
during the life of the security and have a xed ma Conversion price: The nominal price per share at
turity date where the nominal value of the bond is
which conversion takes place, this number is xed
redeemable by the holder. This type is the most
at the issuance but could be adjusted under some
common convertible type and is typically providing
circumstance described in the issuance prospectus
the asymmetric returns prole and positive convex(e.g. Underlying stock split). You could have more
ity often wrongly associated to the entire asset class:
than one conversion price for non-vanilla convertat maturity the holder would indeed either convert
ible issuances.
into shares or request the redemption at par depend Issuance premium: Dierence between the convering on whether or not the stock price is above the
sion price and the stock price at the issuance.
conversion price.

7.4. CONVERTIBLE BOND

Conversion ratio: The number of shares each convertible bond converts into. It may be expressed per
bond or on a per centum (per 100) basis.
Maturity/redemption date: Final payment date of a
loan or other nancial instrument, at which point the
principal (and all remaining interest) is due to be
paid. In some cases, there is no maturity date (i.e.
perpetual), this is often the case with preferred convertibles (e.g. US0605056821).
Final conversion date: Final date at which the holder
can request the conversion into shares. Might be different from the redemption date.
Coupon: Periodic interest payment paid to the convertible bond holder from the issuer. Could be xed
or variable or equal to zero.
Yield: Yield of the convertible bond at the issuance
date, could be dierent from the coupon value if the
bond is oering a premium redemption. In those
cases the yield value would determine the premium
redeption value and intermediary put redemption
value.
Convertibles could bear other more technical features depending on the issuer needs:
Call features: The ability of the issuer (on some
bonds) to call a bond early for redemption. This
should not be mistaken for a call option. A Softcall
would refer to a call feature where the issuer can only
call under certain circumstances, typically based on
the underlying stock price performance (e.g. current stock price is above 130% of the conversion
price for 20 days out of 30 days). A Hardcall feature would not need any specic conditions beyond
a date: that case the issuer would be able to recall a
portion or the totally of the issuance at the Call price
(typically par) after a specic date.
Put features: The ability of the holder of the bond
(the lender) to force the issuer (the borrower) to
repay the loan at a date earlier than the maturity.
These often occur as windows of opportunity, every
three or ve years and allow the holders to exercise
their right to an early repayment.
Contingent conversion (aka CoCo): Restrict the
ability of the convertible bondholders to convert into
equities. Typically, restrictions would be based on
the underlying stock price and/or time (e.g. convertible every quarter if stock price is above 115%
of the conversion price).[2] Reverse convertibles in
that respect could be seen as a variation of a Mandatory bearing a contingent conversion feature based.
More recently some CoCos issuances have been
based on Tier-1 capital ratio for some large bank
issuers.

161
Reset: Conversion price would be reset to a new
value depending on the underlying stock performance. Typically, would be in cases of underperformance (e.g. if stock price after a year is below 50% of the conversion price the new conversion
price would be the current stock price).
Change of control event (aka Ratchet): Conversion
price would be readjusted in case of a take-over on
the underlying company. There are many subtype
of ratchet formula (e.g. Make-whole base, time dependent...), their impact for the bondholder could
be small (e.g. ClubMed, 2013) to signicant (e.g.
Aegis, 2012). Often, this clause would grant as well
the ability for the convertible bondholders to put
i.e. ask for the early repayment of their bonds.

7.4.3 Structure and terminology

Due to their relative complexity, the convertible investors
could refers to the following terms while describing a convertible bonds:
Parity: Immediate value of the convertible if converted, typically obtained as current stock price multiplied by the conversion ratio expressed for a base
of 100. Could be known as Exchange Property.
Bond oor: Value of the xed income element of a
convertible i.e. not considering the ability to convert
into equities.
Premium: Dened as current convertible price minus the parity
Exchangeable bond: Convertible bond where the issuing company and the underlying stock company
are dierent companies (e.g. XS0882243453, GBL
into GDF Suez). This distinction is usually made in
terms of risk i.e. equity and credit risk being correlated: in some case the entities would be legally
distinct, but not consider as an exchangeable as the
ultimate guarantor being the same as the underlying stock company (e.g. typical in the case of the
Sukuk, Islamic convertible bonds, needing a specic
legal setup to be compliant with the Islamic law).
Synthetic: synthetically structured convertible bond
issued by an investment bank to replicate a convertible payo on a specic underlying. Most
reverse convertibles are synthetics. Please note
the Packaged Convertibles (e.g.
Siemens 17
DE000A1G0WA1) are not considered to be synthetics since the issuer would not be an Investment
Bank: they would only act as underwriter. Similarly,
replicated structure using straight bonds and options
would be considered as a package structure.

162

CHAPTER 7. EMBEDDED OPTIONS

7.4.4

Markets and Investor proles

meaning the investor would eectively bear a negative yield to benet from the potential equity underlying upside. Most of the trading is done out
of Tokyo (and Hong-Kong for some international
rms).

The global convertible bond market is a relatively small

with about 400 bn USD (as of Jan 2013, excluding synthetics), as a comparison the straight corporate bond market would be about 14,000 bn USD. Among those 400
bn, about 320 bn USD are Vanilla convertible bonds, Convertible bond investors get split into two broad catethe largest sub-segment of the asset class.
gories: Hedged and Long-only investors.
Convertibles are not spread equally and some slight differences exist between the dierent regional markets:
North America: About 50% of the global convertible market, mostly from the USA (even if Canada
is well represented in the Material sector). This
market is more standardised than the others with
convertible structures being relatively uniform (e.g.
Standard Make-Whole take over features, Contingent Conversion @ 130%). Regarding the trading,
the American convertible market is centralised
around TRACE which helps in terms of price transparency. One other particularity of this market is the
importance of the Mandatory Convertibles and Preferred especially for Financials (about 10-20% of
the issuances in the US regional benchmarks). Most
of the trading operation are based in New-York.
EMEA: European, African and Middle-Eastern issuances are trading usually out of Europe, London
being the biggest node followed by Paris and to a
lesser extend Frankfurt and Geneva. It represents
about 25% of the global market and shows a greater
diversity in terms of structures (e.g. from CoCoCos
to French OCEANE). Because of that lack of standardisation, it is often considered to be more technical and unforgiving than the American market from
a trading perspective. A very tiny amount of the volumes is traded on exchange while the vast majority
is done OTC without a price reporting system (e.g.
like TRACE). Liquidity is signicantly lower than
on the Northern American market. Trading convention are NOT uniform: French Convertibles would
trade dirty in units while the others countries would
trade clean in notional equivalent.

Hedged/Arbitrage/Swap investors:
Proprietary
trading desk or hedged-funds using as core strategy
Convertible Arbitrage which consists in, for its most
basic iteration, as being long the convertible bonds
while being short the underlying stock. Buying the
convertible while selling the stock is often referred
to as being on swap. Hedged investors would
modulate their dierent risks (e.g. Equity, Credit,
Interest-Rate, Volatility, Currency) by putting
in place one or more hedge (e.g. Short Stock,
CDS, Asset Swap, Option, Future). Inherently,
market-makers are hedged investors as they would
have a trading book during the day and/or overnight
held in a hedged fashion to provide the necessary
liquidity to pursue their market making operations.
Long-only/Outright Investors: Convertible investors who will own the bond for their asymmetric
payo proles. They would typically be exposed to
the various risk. Please note that Global convertible
funds would typically hedged their currency risk as
well as interest rate risk in some occasions, however
Volatility, Equity & Credit hedging would typically
be excluded from the scope of their strategy.
The splits between those investors dier across the regions: In 2013, the American region was dominated by
Hedged Investors (about 60%) while EMEA was dominated by Long-Only investors (about 70%). Globally the
split is about balanced between the two categories.

7.4.5 Valuation
See also Bond option: Embedded options, for
further detail.

Asia (ex Japan): This region represents about 17%

of the total market, with an overall structure similar
to the EMEA market albeit with more standardisa- In theory, the market price of a convertible debenture
tion across the issuances. Most of the trading is done should never drop below its intrinsic value. The intrinsic value is simply the number of shares being converted
in Hong-Kong with a minor portion in Singapore.
at par value times the current market price of common
Japan: This region represents about 8% of the total shares.
market as of January 2013 in spite of being in the The 3 main stages of convertible bond behaviour are:
past comparable in size to the Northern American
market. It mostly shrunk because of the low interest
In-the-money convertible bonds
environment making the competitive advantage of
At-the-money convertible bonds
lowering coupon payment less appealing to issuers.
One key specicity of the Japanese market is the of In-the-money: Conversion Price is < Equity Price.
fering price of issuance being generally above 100,

7.4. CONVERTIBLE BOND

At-the-money: Conversion Price is = Equity Price.
Out-the-money: Conversion Price is > Equity Price.
In-the-money CBs are considered as being within
Area of Equity (the right hand side of the diagram)
At-the-money CBs are considered as being within
Area of Equity & Debt (the middle part of the diagram)
Out-the-money CBs are considered as being within
Area of Debt (the left hand side of the diagram)
From a valuation perspective, a convertible bond consists
of two assets: a bond and a warrant. Valuing a convertible
requires an assumption of
1. the underlying stock volatility to value the option
and
2. the credit spread for the xed income portion that
takes into account the rms credit prole and the
ranking of the convertible within the capital structure.

163
These models needed an input of credit spread,
volatility for pricing (historic volatility often
used), and the risk-free rate of return. The
binomial calculation assumes there is a bellshaped probability distribution to future share
prices, and the higher the volatility, the atter
is the bell-shape. Where there are issuer calls
and investor puts, these will aect the expected
residual period of optionality, at dierent share
price levels. The binomial value is a weighted
expected value, (1) taking readings from all the
dierent nodes of a lattice expanding out from
current prices and (2) taking account of varying periods of expected residual optionality at
dierent share price levels.
The three biggest areas of subjectivity are (1)
the rate of volatility used, for volatility is not
constant, and (2) whether or not to incorporate
into the model a cost of stock borrow, for hedge
funds and market-makers. The third important
factor is (3) the dividend status of the equity
delivered, if the bond is called, as the issuer
may time the calling of the bond to minimise
the dividend cost to the issuer.

Using the market price of the convertible, one can deter- 7.4.6 Uses for investors
mine the implied volatility (using the assumed spread) or
Convertible bonds are usually issued oering a
implied spread (using the assumed volatility).
higher yield than obtainable on the shares into which
This volatility/credit dichotomy is the standard practice
the bonds convert.
for valuing convertibles. What makes convertibles so interesting is that, except in the case of exchangeables (see
Convertible bonds are safer than preferred or comabove), one cannot entirely separate the volatility from
mon shares for the investor. They provide asset prothe credit. Higher volatility (a good thing) tends to actection, because the value of the convertible bond
company weaker credit (bad). In the case of exchangewill only fall to the value of the bond oor. At the
ables, the credit quality of the issuer may be decoupled
same time, convertible bonds can provide the possifrom the volatility of the underlying shares. The true
bility of high equity-like returns.
artists of convertibles and exchangeables are the people
who know how to play this balancing act.
Also, convertible bonds are usually less volatile than
A simple method for calculating the value of a convertible
regular shares. Indeed, a convertible bond behaves
involves calculating the present value of future interest
like a call option. Therefore, if C is the call price
and principal payments at the cost of debt and adds the
and S the regular share then
present value of the warrant. However, this method ignores certain market realities including stochastic interest
rates and credit spreads, and does not take into account
popular convertible features such as issuer calls, investor
C
=
C = S.
puts, and conversion rate resets. The most popular modS
els for valuing convertibles with these features are nite
dierence models such as binomial and trinomial trees.
In consequence, since 0 < < 1 we get C < S
, which implies that the variation of C is less than the
Binomial valuations Since 1991-92, most market- variation of S, which can be interpreted as less volatility.
makers in Europe have employed binomial models to evaluate convertibles. Models were available
from INSEAD, Trend Data of Canada, Bloomberg
LP and from home-developed models, amongst others.

The simultaneous purchase of convertible bonds and

the short sale of the same issuers common stock is a
hedge fund strategy known as convertible arbitrage.
The motivation for such a strategy is that the equity

164

CHAPTER 7. EMBEDDED OPTIONS

option embedded in a convertible bond is a source
of cheap volatility, which can be exploited by convertible arbitrageurs.

In limited circumstances, certain convertible bonds

can be sold short, thus depressing the market value
for a stock, and allowing the debt-holder to claim
more stock with which to sell short. This is known
as death spiral nancing.

7.4.7

Redemption options/strategies

Soft putcan be redeemed for cash, stock or notes

or a combination of all three at the companys discretion.
Hard putpayable only in cash
Protective putbuying a put option for the underlying bond security
Subordinated put
Convertible putconvert to share by paying a
charge

7.4.8

Uses for issuers

Lower xed-rate borrowing costs. Convertible

bonds allow issuers to issue debt at a lower cost.
Typically, a convertible bond at issue yields 1% to
3% less than straight bonds.
Locking into low xedrate long-term borrowing. For a nance director watching the trend in
interest rates, there is an attraction in trying to catch
the lowest point in the cycle to fund with xed rate
debt, or swap variable rate bank borrowings for xed
rate convertible borrowing. Even if the xed market
turns, it may still be possible for a company to borrow via a convertible carrying a lower coupon than
ever would have been possible with straight debt
funding.
Higher conversion price than a rights issue strike
price. Similarly, the conversion price a company
xes on a convertible can be higher than the level
that the share price ever reached recently. Compare
the equity dilution on a convertible issued on, say, a
20 or 30pct premium to the higher equity dilution on
a rights issue, when the new shares are oered on,
say, a 15 to 20pct discount to the prevailing share
price.
Voting dilution deferred. With a convertible
bond, dilution of the voting rights of existing shareholders only happens on eventual conversion of the
bond. However convertible preference shares typically carry voting rights when preference dividends

are in arrears. Of course, the bigger voting impact

occurs if the issuer decides to issue an exchangeable
rather than a convertible.
Increasing the total level of debt gearing. Convertibles can be used to increase the total amount
of debt a company has in issue. The market tends
to expect that a company will not increase straight
debt beyond certain limits, without it negatively impacting upon the credit rating and the cost of debt.
Convertibles can provide additional funding when
the straight debt window may not be open. Subordination of convertible debt is often regarded as an
acceptable risk by investors if the conversion rights
are attractive by way of compensation.
Maximising funding permitted under preemption rules. For countries, such as the UK,
where companies are subject to limits on the number of shares that can be oered to non-shareholders
non-pre-emptively, convertibles can raise more
money than via equity issues. Under the UKs 1989
Guidelines issued by the Investor Protection Committees (IPCs) of the Association of British Insurers
(ABI) and the National Association of Pension
Fund Managers (NAPF), the IPCs will advise their
members not to object to non pre-emptive issues
which add no more than 5pct to historic non-diluted
balance sheet equity in the period from AGM to
AGM, and no more than 7.5pct in total over a
period of 3 nancial years. The pre-emption limits
are calculated on the assumption of 100pct probability of conversion, using the gure of undiluted
historic balance sheet share capital (where there is
assumed a 0pct probability of conversion). There
is no attempt to assign probabilities of conversion
in both circumstances, which would result in bigger
convertible issues being permitted. The reason
for his inconsistency may lie in the fact that the
Pre Emption Guidelines were drawn up in 1989,
and binomial evaluations were not commonplace
amongst professional investors until 1991-92.
Premium redemption convertibles such as the
majority of French convertibles and zero-coupon
Liquid Yield Option Notes (LYONs), provide a
xed interest return at issue which is signicantly
(or completely) accounted for by the appreciation
to the redemption price. If, however, the bonds
are converted by investors before the maturity date,
the issuer will have beneted by having issued the
bonds on a low or even zero-coupon. The higher the
premium redemption price, (1) the more the shares
have to travel for conversion to take place before the
maturity date, and (2) the lower the conversion premium has to be at issue to ensure that the conversion
rights are credible.
Takeover paper. Convertibles have a place as the
currency used in takeovers. The bidder can oer

7.4. CONVERTIBLE BOND

165

a higher income on a convertible than the dividend

The price will substantially reect (1) the value of
yield on a bid victims shares, without having to raise
the underlying shares, (2) the discounted gross inthe dividend yield on all the bidders shares. This
come advantage of the convertible over the undereases the process for a bidder with low-yield shares
lying shares, plus (3) some gure for the embedded
acquiring a company with higher-yielding shares.
optionality of the bond. The tax advantage is greatPerversely, the lower the yield on the bidders shares,
est with mandatory convertibles. Eectively a high
the easier it is for the bidder to create a higher contax-paying shareholder can benet from the comversion premium on the convertible, with consepany securitising gross future income on the conquent benets for the mathematics of the takeover.
vertible, income which it can oset against taxable
In the 1980s, UK domestic convertibles accounted
prots.
for about 80pct of the European convertibles market, and over 80pct of these were issued either as
takeover currency or as funding for takeovers. They 7.4.9 2010 U.S. Equity-Linked Underwriting League Table
had several cosmetic attractions.
The pro-forma fully diluted earnings per share
shows none of the extra cost of servicing the
convertible up to the conversion day irrespective of whether the coupon was 10pct or 15pct.
The fully diluted earnings per share is also calculated on a smaller number of shares than if
equity was used as the takeover currency.
In some countries (such as Finland) convertibles of various structures may be treated as equity by the local accounting profession. In such
circumstances, the accounting treatment may
result in less pro-forma debt than if straight
debt was used as takeover currency or to fund
an acquisition. The perception was that gearing
was less with a convertible than if straight debt
was used instead. In the UK the predecessor to
the International Accounting Standards Board
(IASB) put a stop to treating convertible preference shares as equity. Instead it has to be
classied both as (1) preference capital and as
(2) convertible as well.

Source: Bloomberg

7.4.10 See also

Convertible preferred stock
Convertible security
Equity-linked note
Exchangeable bond

7.4.11 References
[1] Jerry W. Markham (2002). A Financial History of the
United States: From Christopher Columbus to the Robber
Barons. M. E. Sharpe. p. 161. ISBN 0-7656-0730-1.
[2] Hirst, Gary (June 21, 2013). Cocos: Contingent Convertible Capital Notes and Insurance Reserves. garyhirst.com. Retrieved April 13, 2014.

7.4.12 External links

Nevertheless, none of the (possibly substantial)
preference dividend cost incurred when servicing a convertible preference share is visible in the pro-forma consolidated pretax prots
statement.
The cosmetic benets in (1) reported proforma diluted earnings per share, (2) debt gearing (for a while) and (3) pro-forma consolidated pre-tax prots (for convertible preference shares) led to UK convertible preference
shares being the largest European class of convertibles in the early 1980s, until the tighter
terms achievable on Euroconvertible bonds resulted in Euroconvertible new issues eclipsing domestic convertibles (including convertible preference shares) from the mid 1980s.
Tax advantages. The market for convertibles is primarily pitched towards the non taxpaying investor.

Convertible Note Term Sheet Generator from Wilson Sonsini Goodrich & Rosati
Pricing Convertible Bonds using Partial Dierential
Equations - by Lucy Li
Pricing Ination-Indexed Convertible Bonds - by
Landskroner and Raviv
Convertible Bond on Wikinvest
Harvard i-lab | Foundations of Financings and Capital Raising for Startups. Explains both plain convertible debt and a simplied form of convertible
debt called SAFE (Simple Agreement for Future
Equity)

Chapter 8

Trading in Derivatives
8.1 Futures exchange
A futures exchange or futures market is a central nancial exchange where people can trade standardized
futures contracts; that is, a contract to buy specic quantities of a commodity or nancial instrument at a specied price with delivery set at a specied time in the future. These types of contracts fall into the category of
derivatives. Such instruments are priced according to
the movement of the underlying asset (stock, physical
commodity, index, etc.). The aforementioned category
is named derivatives because the value of these instruments are derived from another asset class.[1]

8.1.1

Denition

According to The New Palgrave Dictionary of Economics

(Newbery 2008), futures markets provide partial income
risk insurance to producers whose output is risky, but
very eective insurance to commodity stockholders at
remarkably low cost. Speculators absorb some of the
risk but hedging appears to drive most commodity markets. The equilibrium futures price can be either below or
above the (rationally) expected future price (backwardation or contango)...Rollover hedges can extend insurance
from short-horizon contracts over longer periods.[1]

8.1.2

History

In Ancient Mesopotamia, around 1750 BC, the sixth

Babylonian king, Hammurabi, created one of the rst
legal codes: the Code of Hammurabi. Hammurabis
Code allowed sales of goods and assets to be delivered
for an agreed price, at a future date; required contracts
to be in writing and witnessed; and allowed assignment
of contracts. The code facilitated the rst derivatives,
in the form of forward and futures contracts. An active derivatives market existed, with trading carried out
at temples.[2]
One of the earliest written records of futures trading is
in Aristotle's Politics. He tells the story of Thales, a poor
philosopher from Miletus who developed a nancial device, which involves a principle of universal application.

Thales used his skill in forecasting and predicted that the

olive harvest would be exceptionally good the next autumn. Condent in his prediction, he made agreements
with local olive-press owners to deposit his money with
them to guarantee him exclusive use of their olive presses
when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and
no one knew whether the harvest would be plentiful or
pathetic and because the olive-press owners were willing
to hedge against the possibility of a poor yield. When
the harvest-time came, and a sharp increase in demand
for the use of the olive presses outstripped supply (availability of the presses), he sold his future use contracts of
the olive presses at a rate of his choosing, and made a
large quantity of money.[3] It should be noted, however,
that this is a very loose example of futures trading and,
in fact, more closely resembles an option contract, given
that Thales was not obliged to use the olive presses if the
yield was poor.
The rst modern organized futures exchange began in
1710 at the Dojima Rice Exchange in Osaka, Japan.[4]
The London Metal Market and Exchange Company
(London Metal Exchange) was founded in 1877, but the
market traces its origins back to 1571 and the opening
of the Royal Exchange, London. Before the exchange
was created, business was conducted by traders in London coee houses using a makeshift ring drawn in chalk
on the oor.[5] At rst only copper was traded. Lead and
zinc were soon added but only gained ocial trading status in 1920. The exchange was closed during World War
II and did not re-open until 1952.[6] The range of metals
traded was extended to include aluminium (1978), nickel
(1979), tin (1989), aluminium alloy (1992), steel (2008),
and minor metals cobalt and molybdenum (2010). The
exchange ceased trading plastics in 2011. The total value
of the trade is around $US 11.6 trillion annually.[7]
The United States followed in the early 19th century.
Chicago has the largest future exchange in the world, the
Chicago Mercantile Exchange. Chicago is located at the
base of the Great Lakes, close to the farmlands and cattle
country of the Midwest, making it a natural center for
transportation, distribution, and trading of agricultural
produce. Gluts and shortages of these products caused
chaotic uctuations in price, and this led to the develop-

166

8.1. FUTURES EXCHANGE

167

ment of a market enabling grain merchants, processors,

and agriculture companies to trade in to arrive or cash
forward contracts to insulate them from the risk of adverse price change and enable them to hedge. In March
2008 the Chicago Mercantile Exchange announced its acquisition of NYMEX Holdings, Inc., the parent company
of the New York Mercantile Exchange and Commodity Exchange. CMEs acquisition of NYMEX was completed in August 2008.

lion of nominal trade (over 1 million contracts) every single day in "electronic trading" as opposed to open outcry
trading of futures, options and derivatives.

In 1848 the Chicago Board of Trade (CBOT) was

formed. Trading was originally in forward contracts; the
rst contract (on corn) was written on March 13, 1851.
In 1865 standardized futures contracts were introduced.

tivities.

In June 2001 IntercontinentalExchange (ICE) acquired

the International Petroleum Exchange (IPE), now ICE
Futures, which operated Europes leading open-outcry
energy futures exchange. Since 2003 ICE has partnered
with the Chicago Climate Exchange (CCX) to host its
electronic marketplace. In April 2005 the entire ICE
For most exchanges, forward contracts were standard at portfolio of energy futures became fully electronic.
the time. However, most forward contracts were not hon- In 2005, The Africa Mercantile Exchange (AfMX) beored by both the buyer and the seller. For instance, if the came the rst African commodities market to implement
buyer of a corn forward contract made an agreement to an automated system for the dissemination of market data
buy corn, and at the time of delivery the price of corn and information online in real-time through a wide netdiered dramatically from the original contract price, ei- work of computer terminals. As at the end of 2007,
ther the buyer or the seller would back out. Additionally, AfMX had developed a system of secure data storage
the forward contracts market was very illiquid and an ex- providing online services for brokerage rms. The year
change was needed that would bring together a market to 2010, saw the exchange unveil a novel system of elecnd potential buyers and sellers of a commodity instead tronic trading, known as After. After extends the
of making people bear the burden of nding a buyer or potential volume of processing of information and allows
seller.
the Exchange to increase its overall volume of trading ac-

The Chicago Produce Exchange was established in 1874,

renamed the Chicago Butter and Egg Board in 1898 and
then reorganised into the Chicago Mercantile Exchange
(CME) in 1919. Following the end of the postwar international gold standard, in 1972 the CME formed a division called the International Monetary Market (IMM)
to oer futures contracts in foreign currencies: British
pound, Canadian dollar, German mark, Japanese yen,
Mexican peso, and Swiss franc.

In 2006 the New York Stock Exchange teamed up with

the Amsterdam-Brussels-Lisbon-Paris Exchanges Euronext electronic exchange to form the rst transcontinental futures and options exchange. These two developments as well as the sharp growth of internet futures
trading platforms developed by a number of trading companies clearly points to a race to total internet trading of
futures and options in the coming years.
In terms of trading volume, the National Stock Exchange
of India in Mumbai is the largest stock futures trading exchange in the world, followed by JSE Limited in Sandton,
Gauteng, South Africa.[10]

In 1881 a regional market was founded in Minneapolis,

Minnesota, and in 1883 introduced futures for the
rst time. Trading continuously since then, today the 8.1.3 Nature of contracts
Minneapolis Grain Exchange (MGEX) is the only exchange for hard red spring wheat futures and options.[8] For more details on this topic, see Futures contract.
The 1970s saw the development of the nancial futures
contracts, which allowed trading in the future value of
interest rates. These (in particular the 90day Eurodollar
contract introduced in 1981) had an enormous impact on
the development of the interest rate swap market.
Today, the futures markets have far outgrown their agricultural origins. With the addition of the New York
Mercantile Exchange (NYMEX) the trading and hedging
of nancial products using futures dwarfs the traditional
commodity markets, and plays a major role in the global
nancial system, trading over $1.5 trillion per day in
2005.[9]

Exchange-traded contracts are standardized by the exchanges where they trade. The contract details what asset is to be bought or sold, and how, when, where and in
what quantity it is to be delivered. The terms also specify
the currency in which the contract will trade, minimum
tick value, and the last trading day and expiry or delivery
month. Standardized commodity futures contracts may
also contain provisions for adjusting the contracted price
based on deviations from the standard commodity, for
example, a contract might specify delivery of heavier
USDA Number 1 oats at par value but permit delivery
of Number 2 oats for a certain sellers penalty per bushel.

The recent history of these exchanges (Aug 2006) nds

the Chicago Mercantile Exchange trading more than 70% Before the market opens on the rst day of trading a new
of its Futures contracts on its Globex trading platform futures contract, there is a specication but no actual conand this trend is rising daily. It counts for over $45.5 bil- tracts exist. Futures contracts are not issued like other
securities, but are created whenever Open interest in-

168
creases; that is, when one party rst buys (goes long)
a contract from another party (who goes short). Contracts are also destroyed in the opposite manner whenever Open interest decreases because traders resell to reduce their long positions or rebuy to reduce their short
positions.
Speculators on futures price uctuations who do not intend to make or take ultimate delivery must take care to
zero their positions prior to the contracts expiry. After
expiry, each contract will be settled, either by physical delivery (typically for commodity underlyings) or by a cash
settlement (typically for nancial underlyings). The contracts ultimately are not between the original buyer and
the original seller, but between the holders at expiry and
the exchange. Because a contract may pass through many
hands after it is created by its initial purchase and sale,
or even be liquidated, settling parties do not know with
whom they have ultimately traded.

CHAPTER 8. TRADING IN DERIVATIVES

8.1.6 Central counterparty

Derivative contracts are leveraged positions whose value
is volatile. They are usually more volatile than their underlying asset. This can lead to credit risk, in particular
counterparty risk: a situation in which one party to a trade
loses such a large sum of money that it is unable to honor
its settlement obligation. In a safe trading environment,
the parties to a trade need to be assured that the counterparties will honor the trade, no matter how the market has
moved. This requirement can lead to complex arrangements like credit assessments and the setting of trading
limits for each counterparty, thus removing many of the
advantages of a centralised trading facility. To prevent
this, a clearing house interposes itself as a counterparty to
every trade, in order to extend a guarantee that the trade
will be settled as originally intended. This action is called
novation. As a result, trading rms take no risk on the actual counterparty to the trade, but instead the risk falls
on the clearing corporation performing a service called
central counterparty clearing. The clearing corporation is
able to take on this risk by adopting an ecient margining
process.[11]

Compare this with other securities, in which there is a

primary market when an issuer issues the security, and a
secondary market where the security is later traded independently of the issuer. Legally, the security represents
an obligation of the issuer rather than the buyer and seller;
even if the issuer buys back some securities, they still exist. Only if they are legally cancelled can they disappear. 8.1.7

Margin and Mark-to-Market

A margin is collateral that the holder of a nancial instrument has to deposit to cover some or all of the credit
8.1.4 Standardization
risk of their counterparty, in this case the central counterparty clearing houses. Clearing houses charge two types
The contracts traded on futures exchanges are always
of margins: the Initial Margin and the Mark-To-Market
standardized. In principle, the parameters to dene a
margin (also referred to as Variation Margin).
contract are endless (see for instance in futures contract).
To make sure liquidity is high, there is only a limited num- The Initial Margin is the sum of money (or collateral)
to be deposited by a rm to the clearing corporation to
ber of standardized contracts.
cover possible future loss in the positions (the set of positions held is also called the portfolio) held by a rm. Several popular methods are used to compute initial margins.
8.1.5 Clearing and settlement
They include the CME-owned SPAN (a grid simulation
Most large derivatives exchanges operate their own clear- method used by the CME and about 70 other exchanges),
ing houses, allowing them to take revenues from post- STANS (a Monte Carlo simulation based methodology
trade processing as well as trading itself. By netting o used by the OCC), TIMS (earlier used by the OCC, and
the dierent positions traded, a smaller amount of capi- still being used by a few other exchanges).
tal is required as security to cover the trades. Of the big
derivatives venues Chicago Mercantile Exchange, ICE
and Eurex all clear trades themselves. There is sometimes a division of responsibility between provision of
trading facility, and that of clearing and settlement of
those trades. Derivative exchanges like the CBOE and
LIFFE take responsibility for providing the trading environments, settlement of the resulting trades are usually
handled by clearing houses that serve as central counterparties to trades done in the respective exchanges. The
Options Clearing Corporation (OCC) and LCH.Clearnet
(London Clearing House) respectively are the clearing
corporations for CBOE and LIFFE, although LIFFE and
parent NYSE Euronext has long stated its desire to develop its own clearing service.

The Mark-to-Market Margin (MTM margin) on the other

hand is the margin collected to oset losses (if any) that
have already been incurred on the positions held by a rm.
This is computed as the dierence between the cost of
the position held and the current market value of that position. If the resulting amount is a loss, the amount is collected from the rm; else, the amount may be returned to
the rm (the case with most clearing houses) or kept in reserve depending on local practice. In either case, the positions are 'marked-to-market' by setting their new cost to
the market value used in computing this dierence. The
positions held by the clients of the exchange are markedto-market daily and the MTM dierence computation for
the next day would use the new cost gure in its calculation.

8.1. FUTURES EXCHANGE

169

Clients hold a margin account with the exchange, and ev- 8.1.9 See also
ery day the swings in the value of their positions is added
Bond market
to or deducted from their margin account. If the margin
account gets too low, they have to replenish it. In this way
Commodity markets
it is highly unlikely that the client will not be able to fulll
his obligations arising from the contracts. As the clear Currency market
ing house is the counterparty to all their trades, they only
have to have one margin account. This is in contrast with
List of futures exchanges
OTC derivatives, where issues such as margin accounts
have to be negotiated with all counterparties.
List of traded commodities
Paper trading

8.1.8

Regulators

Each exchange is normally regulated by a national governmental (or semi-governmental) regulatory agency:

Prediction market
Stock market
Trader (nance)

In Australia, this role is performed by the Australian

Securities and Investments Commission.
In the Chinese mainland, by the China Securities
Regulatory Commission.
In Hong Kong, by the Securities and Futures Commission.
In India, by the Securities and Exchange Board of
India and Forward Markets Commission (FMC)
In Japan, by the Financial Services Agency.
In Pakistan, by the Securities and Exchange Commission of Pakistan.
In Singapore by the Monetary Authority of Singapore.

8.1.10 References
[1] Newbery, David M. (2008). Steven N. Durlauf; Lawrence
E. Blume, eds. Futures markets, hedging and speculation.
The New Palgrave Dictionary of Economics (2 ed.). Retrieved 22 July 2013.
[2] A History of Derivatives: Ancient Mesopotamia to Trading Places, by Edmund Parker & Professor Georey
Parker You Tube, min 12:59
[3] Aristotle, Politics, trans. Benjamin Jowett, vol. 2, The
Great Books of the Western World, book 1, chap. 11, p.
453.
[4] Private ordering at the worlds rst futures exchange. (Dojima Rice Exchange in Osaka, Japan) - Michigan Law Review | Encyclopedia.com
[5] BBC Radio 4 Today, broadcast 25 October 2011.

In the UK, futures exchanges are regulated by the

Financial Services Authority.

[6] The exchange was closed during World War II and did not
re-open until 1952 http://blog.steinerelectric.com/2014/
04/what-is-the-london-metals-exchange/

In the USA, by the Commodity Futures Trading

Commission.

[7] LME achieves another year of record volume. London

Metal Exchange. 5 January 2009. Retrieved 29 July 2009.

In Malaysia,
Malaysia.

by the Securities Commission

In Spain, by the Comisin Nacional del Mercado de

Valores (CNMV).
In Brazil, by the Comisso de Valores Mobilirios
(CVM).
In South Africa, by the Financial Services Board
(South Africa).
In Mauritius, by the Financial Services Commission
(FSC)

[8] MGEX via U.S. Futures Exchange (2007). Minneapolis

Grain Exchange. and Minter, Adam (August 2006).
Gimme Grain!". The Rake. and Buyers & Processors. North Dakota Wheat Commission. 2007. Retrieved 2007-03-29.
[9] Notional volume in interest rate derivatives for 2005
was nearly $1.5 trillion, 85% of which came from
260 institutions trading more than $1 billion each
http://www.investopedia.com/articles/optioninvestor/07/
derivatives_retail.asp
[10] http://www.tribuneindia.com/2007/20071129/biz.htm#2
[11] http://chicagofed.org/webpages/publications/
understanding_derivatives/index.cfm

170

8.1.11

CHAPTER 8. TRADING IN DERIVATIVES

Further reading

Millman, Gregory J. (2008). Futures and Options

Markets. In David R. Henderson (ed.). Concise
Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty. ISBN 9780865976658. OCLC 237794267.
Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank of Chicago, Financial
Markets Group
Futures Contract Specications and Tick Values at
ExcelTradingModels.com

8.2 Margin
For the 2011 lm, see Margin Call (lm).

their own money. Whereas today, the Federal Reserve's

margin requirement (under Regulation T) limits debt to
50 percent. During the 1920s leverage rates of up to 90
percent debt were not uncommon.[1] When the stock market started to contract, many individuals received margin
calls. They had to deliver more money to their brokers
or their shares would be sold. Since many individuals
did not have the equity to cover their margin positions,
their shares were sold, causing further market declines
and further margin calls. This was one of the major contributing factors which led to the Stock Market Crash
of 1929, which in turn contributed to the Great Depression.[1] However, as reported in Peter Rappoport and Eugene N. Whites 1994 paper published in The American
Economic Review, "Was the Crash of 1929 Expected",[2]
all sources indicate that beginning in either late 1928 or
early 1929, margin requirements began to rise to historic new levels. The typical peak rates on brokers loans
were 4050 percent. Brokerage houses followed suit and
demanded higher margin from investors.

In nance, a margin is collateral that the holder of a

nancial instrument has to deposit to cover some or all
of the credit risk of their counterparty (most often their
broker or an exchange). This risk can arise if the holder 8.2.2 Types of margin requirements
has done any of the following:
The current liquidating margin is the value of a se Borrowed cash from the counterparty to buy nan- curitys position if the position were liquidated now. In
other words, if the holder has a short position, this is
cial instruments,
the money needed to buy back; if they are long, it is the
Sold nancial instruments short, or
money they can raise by selling it.
Entered into a derivative contract.
The collateral can be in the form of cash or securities,
and it is deposited in a margin account. On United
States futures exchanges, margins were formerly called
performance bonds. Most of the exchanges today use
SPAN (Standard Portfolio Analysis of Risk) methodology, which was developed by the Chicago Mercantile
Exchange in 1988, for calculating margins for options and
futures.

The variation margin or mark to market is not collateral, but a daily payment of prots and losses. Futures are
marked-to-market every day, so the current price is compared to the previous days price. The prot or loss on the
day of a position is then paid to or debited from the holder
by the futures exchange. This is possible, because the exchange is the central counterparty to all contracts, and the
number of long contracts equals the number of short contracts. Certain other exchange traded derivatives, such as
options on futures contracts, are marked-to-market in the
same way.

The seller of an option has the obligation to deliver the

underlying of the option if it is exercised. To ensure they
can fulll this obligation, they have to deposit collateral.
Margin buying refers to the buying of securities with cash This premium margin is equal to the premium that they
borrowed from a broker, using other securities as collat- would need to pay to buy back the option and close out
eral. This has the eect of magnifying any prot or loss their position.
made on the securities. The securities serve as collateral
for the loan. The net valuethe dierence between the Additional margin is intended to cover a potential fall
value of the securities and the loanis initially equal to in the value of the position on the following trading day.
the amount of ones own cash used. This dierence has This is calculated as the potential loss in a worst-case sceto stay above a minimum margin requirement, the pur- nario.
pose of which is to protect the broker against a fall in the SMA and portfolio margins oer alternative rules for U.S.
value of the securities to the point that the investor can and NYSE regulatory margin requirements.
no longer cover the loan.
Enhanced leverage is a strategy oered by some brokers

8.2.1

Margin buying

In the 1920s, margin requirements were loose. In other that provides 4:1 or 6:1+ leverage. This requires mainwords, brokers required investors to put in very little of taining two sets of accounts, long and short.

8.2. MARGIN
Example 1 An investor sells a call option, where the
buyer has the right to buy 100 shares in Universal
Widgets S.A. at 90. He receives an option premium of 14. The value of the option is 14, so
this is the premium margin. The exchange has calculated, using historical prices, that the option value
will not exceed 17 the next day, with 99% certainty. Therefore, the additional margin requirement is set at 3, and the investor has to post at least
14 + 3 = 17 in his margin account as collateral.
Example 2 Futures contracts on sweet crude oil closed
the day at $65. The exchange sets the additional
margin requirement at $2, which the holder of a long
position pays as collateral in her margin account. A
day later, the futures close at $66. The exchange
now pays the prot of $1 in the mark-to-market to
the holder. The margin account still holds only the
$2.

171
Margin balance
Margin balance is the total balance in a margin account.
If the balance is negative, then the amount is owed to the
brokerage rm. If the balance is positive, then the money
is available to the account holder to reinvest, or is left
in the account to earn interest. In terms of futures and
cleared derivatives, Margin balance would refer to the
total value of collateral pledged to the CCP and or FCM.

8.2.4 Margin call

For the lm, see Margin Call (lm).
When the margin posted in the margin account is below
the minimum margin requirement, the broker or exchange issues a margin call. The investors now either
have to increase the margin that they have deposited or
close out their position. They can do this by selling the
securities, options or futures if they are long and by buying them back if they are short. But if they do none of
these, then the broker can sell their securities to meet the
margin call. If a margin call occurs unexpectedly, it can
cause a domino eect of selling which will lead to other
margin calls and so forth, eectively crashing an asset
class or group of asset classes. The Bunker Hunt Day
crash of the silver market on Silver Thursday, March 27,
1980 is one such example.

Example 3 An investor is long 50 shares in Universal

Widgets Ltd, trading at 120 pence (1.20) each.
The broker sets an additional margin requirement
of 20 pence per share, so 10 for the total position.
The current liquidating margin is currently 60 in
favour of the investor. The minimum margin requirement is now -60 + 10 = -50. In other words,
the investor can run a decit of 50 in his margin account and still full his margin obligations. This is
the same as saying he can borrow up to 50 from the This situation most frequently happens as a result of an
broker.
adverse change in the market value of the leveraged asset or contract. It could also happen when the margin
requirement is raised, either due to increased volatility
8.2.3 Initial and maintenance margin re- or due to legislation. In extreme cases, certain securities
quirements
may cease to qualify for margin trading; in such a case,
the brokerage will require the trader to either fully fund
The initial margin requirement is the amount required their position, or to liquidate it.[3]
to be collateralized in order to open a position. Thereafter, the amount required to be kept in collateral until
the position is closed is the maintenance requirement. 8.2.5 Price of stock for margin calls
The maintenance requirement is the minimum amount to
be collateralized in order to keep an open position and The minimum margin requirement, sometimes called
is generally lower than the initial requirement. This al- the maintenance margin requirement, is the ratio set
lows the price to move against the margin without forc- for:
ing a margin call immediately after the initial transaction. When the total value of collateral after haircuts dips
(Stock Equity Leveraged Dollars) to Stock Equity
below the maintenance margin requirement, the position
Stock Equity being the stock price multiplied by the
holder must pledge additional collateral to bring their tonumber of stocks bought, and leveraged dollars betal balance after haircuts back up to or above the initial
ing the amount borrowed in the margin account.
margin requirement. On instruments determined to be
especially risky, however, the regulators, the exchange, or
E.g., An investor bought 1,000 shares of ABC comthe broker may set the maintenance requirement higher
pany each priced at $50. If the initial margin rethan normal or equal to the initial requirement to requirement were 60%:
duce their exposure to the risk accepted by the trader.
For speculative futures and derivatives clearing accounts,
Stock Equity: $50 1,000 = $50,000
FCMs may charge a premium or margin multiplier to ex Leveraged Dollars or amount borrowed: ($50
change requirements. This is typically 10%25% added
1,000) (100% 60%) = $20,000
on.

172

CHAPTER 8. TRADING IN DERIVATIVES

So the maintenance margin requirement uses the vari- 8.2.8 Return on margin
ables above to form a ratio that investors have to abide
Return on margin (ROM) is often used to judge perby in order to keep the account active.
formance because it represents the net gain or net loss
Assume the maintenance margin requirement is 25%.
compared to the exchanges perceived risk as reected in
That means the customer has to maintain Net Value equal
required margin. ROM may be calculated (realized reto 25% of the total stock equity. That means they have
turn) / (initial margin). The annualized ROM is equal to
to maintain net equity of $50,000 0.25 = $12,500. So
at what price would the investor be getting a margin call?
(ROM + 1)(1/trade duration in years) - 1
For stock price P the stock equity will be (in this example) 1,000P.
For example if a trader earns 10% on margin in two
(Current Market Value Amount Borrowed) / Cur- months, that would be about 77% annualized
rent Market Value = 25%
(1,000P - 20,000) / 1000P = 0.25
(1,000P - 20,000) = 250P
750P = $20,000

Annualized ROM = (ROM +1)1/(2/12) - 1

that is, Annualized ROM = 1.16 - 1 = 77%

Sometimes, return on margin will also take into account

peripheral charges such as brokerage fees and interest
paid on the sum borrowed. The margin interest rate is
So if the stock price drops from $50 to $26.66, investors
usually based on the brokers call.
will be called to add additional funds to the account to
make up for the loss in stock equity.
P = $20,000/750 = $26.66 / share

Alternatively, one can calculate P using P

= 8.2.9 See also
(1requirement margin initial)
P0 (1requirement margin maintenance) where P0 is the ini Collateral management
tial price of the stock. Lets use the same example to
demonstrate this:
Credit default swap
(10.6)
P = $50 (10.25)
= $26.66.
Leverage (nance)

8.2.6

Reduced margins

LIBOR

Portfolio margin
Margin requirements are reduced for positions that oset each other. For instance spread traders who have o Repurchase agreement
setting futures contracts do not have to deposit collateral
Special memorandum account
both for their short position and their long position. The
exchange calculates the loss in a worst-case scenario of
Short selling
the total position. Similarly an investor who creates a
collar has reduced risk since any loss on the call is oset by a gain in the stock, and a large loss in the stock is
8.2.10 References
oset by a gain on the put; in general, covered calls have
less strict requirements than naked call writing.
[1] Cundi, Kirby R. (January 2007). Monetary-Policy Dis-

8.2.7

Margin-equity ratio

asters of the Twentieth Century. The Freeman Online.

Retrieved 10 Feb 2009.
[2] Rappoport, Peter; White, Eugene N. (March 1994). Was

the Crash of 1929 Expected. The American Economic

The margin-equity ratio is a term used by speculators,
Review (United States: American Economic Association)
representing the amount of their trading capital that is be84 (1): 271281. JSTOR 2117982.
ing held as margin at any particular time. Traders would
rarely (and unadvisedly) hold 100% of their capital as
[3]
margin. The probability of losing their entire capital at
some point would be high. By contrast, if the marginequity ratio is so low as to make the traders capital equal
to the value of the futures contract itself, then they would 8.3 Spread trade
not prot from the inherent leverage implicit in futures
trading. A conservative trader might hold a margin- In nance, a spread trade (also known as relative value
equity ratio of 15%, while a more aggressive trader might trade) is the simultaneous purchase of one security and
sale of a related security, called legs, as a unit. Spread
hold 4%.

8.3. SPREAD TRADE

trades are usually executed with options or futures contracts as the legs, but other securities are sometimes used.
They are executed to yield an overall net position whose
value, called the spread, depends on the dierence between the prices of the legs. Common spreads are priced
and traded as a unit on futures exchanges rather than as
individual legs, thus ensuring simultaneous execution and
eliminating the execution risk of one leg executing but the
other failing.
Spread trades are executed to attempt to prot from the
widening or narrowing of the spread, rather than from
movement in the prices of the legs directly.[1] Spreads
are either bought or sold depending on whether the
trade will prot from the widening or narrowing of the
spread.[2]

8.3.1

173
Intercommodity spreads
Intercommodity spreads are formed from two distinct but
related commodities, reecting the economic relationship
between them.
Common examples are:
The crack spread between crude oil and one of its
byproducts, reecting the premium inherent in rening oil into gasoline or heating oil
The spark spread between natural gas and electricity,
for gas-red power stations
The crush spread between soybeans and one of its
byproducts, reecting the premium inherent in processing soybeans into soy meal and soy oil

Margin

The volatility of the spread is typically much lower than

the volatility of the individual legs, since a change in the
market fundamentals of a commodity will tend to aect
both legs similarly. The margin requirement for a futures
spread trade is therefore usually less than the sum of the
margin requirements for the two individual futures contracts, and sometimes even less than the requirement for
one contract.

Option spreads
Option spreads are formed with dierent option contracts
on the same underlying stock or commodity. There are
many dierent types of named option spreads, each pricing a dierent abstract aspect of the price of the underlying, leading to complex arbitrage attempts.

8.3.3 See also

8.3.2

Types of spread trades

Bucket shop (stock market)

Calendar spreads

Contract for dierence

Calendar spreads are executed with legs diering only

in delivery date. They price the market expectation of
supply and demand at one point in time relative to another point.[3]

Forex
Financial betting

Spread betting
A common use of the calendar spread is to roll over
an expiring position into the future. When a futures contract expires, its seller is nominally obliged to physically
deliver some quantity of the underlying commodity to the 8.3.4 References
purchaser. In practice, this is almost never done; it is far
more convenient for both buyers and sellers to settle the [1] Spread Order, retrieved 17 September 2009
trade nancially rather than arrange for physical delivery.
This is most commonly done by entering into an oset- [2] Intro to Spread Trading - The Common Spreads
ting position in the market. For example, someone who
has sold a futures contract can eectively cancel the po- [3] http://chicagofed.org/digital_assets/publications/
sition out by purchasing an identical futures contract, and
understanding_derivatives/understanding_derivatives_
chapter_1_derivatives_overview.pdf
vice versa.
The contract expiry date is xed at purchase. If a trader
wishes to hold a position in the commodity beyond the
expiration date, the contract can be rolled over via 8.3.5 External links
a spread trade, neutralizing the soon to expire position
How to Calculate Spread Trading Contract Legs at
while simultaneously opening a new position that expires
ExcelTradingModels.com
later.

174

CHAPTER 8. TRADING IN DERIVATIVES

8.4 Bid-oer spread

If the USD/JPY currency pair is currently trading at

101.89/101.92, that is another way of saying that the bid
for the USD/JPY is 101.89 and the oer is 101.92. This
means that currently, holders of USD can sell 1 USD for
101.89 JPY and investors who wish to buy dollars can do
so at a cost of 101.92 JPY per 1 USD.

The bidoer spread (also known as bidask or buysell

spread (in the case of a market maker), and their equivalents using slashes in place of the dashes) for securities
(such as stocks, futures contracts, options, or currency
pairs) is the dierence between the prices quoted (either
by a single market maker or in a limit order book) for an
8.4.4 See also
immediate sale (bid) and an immediate purchase (oer).
The size of the bid-oer spread in a security is one mea Bidask matrix
sure of the liquidity of the market and of the size of the
transaction cost.[1] If the spread is 0 then it is a frictionless
High-frequency trading
asset.
Market maker

8.4.1

Liquidity

Mid price

Scalping (trading)
The trader initiating the transaction is said to demand
Spot price
liquidity, and the other party (counterparty) to the transaction supplies liquidity. Liquidity demanders place
market orders and liquidity suppliers place limit orders.
For a round trip (a purchase and sale together) the liquid- 8.4.5 References
ity demander pays the spread and the liquidity supplier
earns the spread. All limit orders outstanding at a given [1] Spreads denition
time (i.e., limit orders that have not been executed) are [2] Demsetz, H. 1968. The Cost of Transacting. Quartogether called the Limit Order Book. In some markets
terly Journal of Economics 82: 3353 http://web.cenet.
such as NASDAQ, dealers supply liquidity. However,
org.cn/upfile/100078.pdf doi:10.2307/1882244 JSTOR
on most exchanges, such as the Australian Securities Ex1882244
change, there are no designated liquidity suppliers, and
liquidity is supplied by other traders. On these exchanges,
and even on NASDAQ, institutions and individuals can 8.4.6 Further reading
supply liquidity by placing limit orders.
1. Bartram, Shnke M.; Fehle, Frank R.; Shrider,
The bidoer spread is an accepted measure of liquidity
David (May 2008). Does Adverse Selection Aect
costs in exchange traded securities and commodities. On
Bid-Ask Spreads for Options?". Journal of Futures
any standardized exchange, two elements comprise alMarkets 28 (5): 417437. doi:10.1002/fut.20316.
most all of the transaction costbrokerage fees and bidoer spreads. Under competitive conditions, the bid-oer
spread measures the cost of making transactions without
delay. The dierence in price paid by an urgent buyer 8.5 Over-the-counter
and received by an urgent seller is the liquidity cost. Since
brokerage commissions do not vary with the time taken Over-the-counter (OTC) or o-exchange trading is
to complete a transaction, dierences in bid-oer spread done directly between two parties, without any superviindicate dierences in the liquidity cost.[2]
sion of an exchange. It is contrasted with exchange trading, which occurs via exchanges. A stock exchange has
the benet of facilitating liquidity, mitigates all credit risk
8.4.2 Percent spread
concerning the default of one party in the transaction,
provides transparency, and maintains the current market
bid
price. In an OTC trade, the price is not necessarily pub
100%
.
Percent spread is oer
oer
lished for the public.

8.4.3

Example: Currency spread

If the current bid price for the EUR/USD currency pair is

1.5760 and the current oer price is 1.5763, this means
that currently you can sell the EUR/USD at 1.5760 and
buy at 1.5763. The dierence between those prices (3
pips) is the spread.

OTC trading, as well as exchange trading, occurs with

commodities, nancial instruments (including stocks),
and derivatives of such. Products traded on the exchange
must be well standardized. This means that exchanged
deliverables match a narrow range of quantity, quality,
and identity which is dened by the exchange and identical to all transactions of that product. This is necessary
for there to be transparency in trading. The OTC market

8.5. OVER-THE-COUNTER

175

does not have this limitation. They may agree on an unusual quantity, for example.[1] In OTC market contracts
are bilateral (i.e. contract between only two parties), each
party could have credit risk concerns with respect to the
other party. OTC derivative market is signicant in some
asset classes: interest rate, foreign exchange, stocks, and
commodities.[2]

agree on how a particular trade or agreement is to be settled in the future. It is usually from an investment bank
to its clients directly. Forwards and swaps are prime examples of such contracts. It is mostly done online or by
telephone. For derivatives, these agreements are usually
governed by an International Swaps and Derivatives Association agreement. This segment of the OTC market
In 2008 approximately 16 percent of all U.S. stock trades is occasionally referred to as the "Fourth Market. Critics have labelled the OTC market as the dark market
were o-exchange trading"; by April 2014 that number
[1]
[1]
increased to about forty percent. Although the notional because prices are often unpublished and unregulated.
amount outstanding of OTC derivatives in late 2012 had Over-the-counter derivatives are especially important for
declined 3.3% over the previous year, the volume of hedging risk in that they can be used to create a perfect
cleared transactions at the end of 2012 totalled US$346.4 hedge. With exchange traded contracts, standardization
trillion.[3] The Bank for International Settlements statis- does not allow for as much exibility to hedge risk betics on OTC derivatives markets showed that notional cause the contract is a one-size-ts-all instrument. With
amounts outstanding totalled $693 trillion at the end of OTC derivatives, though, a rm can tailor the contract
June 2013... [T]he gross market value of OTC derivatives specications to best suit its risk exposure. [6]
that is, the cost of replacing all outstanding contracts at
current market prices declined between end-2012 and
end-June 2013, from $25 trillion to $20 trillion.[4]
8.5.3 Counterparty risk

8.5.1

OTC-traded stocks

In the United States, over-the-counter trading in stock is

carried out by market makers using inter-dealer quotation
services such as OTC Link (a service oered by OTC
Markets Group) and the OTC Bulletin Board (OTCBB,
operated by FINRA). The OTCBB licenses the services
of OTC Link for their OTCBB securities. Although
exchange-listed stocks can be traded OTC on the third
market, it is rarely the case. Usually OTC stocks are not
listed nor traded on exchanges, and vice versa. Stocks
quoted on the OTCBB must comply with certain limited
U.S. Securities and Exchange Commission (SEC) reporting requirements. The SEC imposes more stringent nancial and reporting requirements on other OTC stocks,
specically the OTCQX stocks (traded through the OTC
Market Group Inc). Other OTC stocks have no reporting requirements, for example Pink Sheets securities and
gray market stocks.
Some companies, with Wal-Mart as one of the largest,[5]
began trading as OTC stocks and eventually upgraded to
a listing on fully regulated market. By 1969 Wal-Mart
Stores Inc. was incorporated. In 1972, with stores in
ve states, including Arkansas, Kansas, Louisiana, Oklahoma and Missouri, Wal-Mart began trading as over-thecounter (OTC) stocks. By 1972 Walmart had earned over
US$1 billion in sales the fastest company to ever accomplish this. In 1972 Wal-Mart was listed on the New
York Stock Exchange (NYSE) under the ticker symbol
WMT.[5]

OTC derivatives can lead to signicant risks. Especially counterparty risk has gained particular emphasis
due to the credit crisis in 2007. Counterparty risk is
the risk that a counterparty in a derivatives transaction
will default prior to expiration of the trade and will not
make the current and future payments required by the
contract.[7] There are many ways to limit counterparty
risk. One of them focuses on controlling credit exposure with diversication, netting, collateralisation and
hedging.[8]
In their market review published in 2010 the International
Swaps and Derivatives Association [Notes 1] examined OTC
Derivative Bilateral Collateralization Practice as one way
of mitigating risk.[9]

8.5.4 Importance of OTC derivatives in

modern banking
OTC derivatives are signicant part of the world of
global nance. The OTC derivatives markets are large.
They grew exponentially from 1980 through 2000. The
expansion has been driven by interest rate products,
foreign exchange instruments and credit default swaps.
The notional outstanding of OTC derivatives markets
rose throughout the period and totalled approximately
US$601 trillion at December 31, 2010.[9]

In their 2000 paper by Schinasi et al. published by the

International Monetary Fund in 2001, the authors observed that the increase in OTC derivatives transactions
would have been impossible without the dramatic advances in information and computer technologies that
occurred from 1980 to 2000.[10] During that time, major
8.5.2 OTC contracts
internationally active nancial institutions signicantly
An over-the-counter is a bilateral contract in which two increased the share of their earnings from derivatives acparties (or their brokers or bankers as intermediaries) tivities. These institutions manage portfolios of deriva-

176

CHAPTER 8. TRADING IN DERIVATIVES

tives involving tens of thousand of positions and aggre- [9] International Swaps and Derivatives Association (ISDA)
2010.
gate global turnover over $1 trillion. At that time prior
to the nancial crisis of 2008, the OTC market was an
informal network of bilateral counterparty relationships [10] Schinasi et al. 2001, pp. 57.
and dynamic, time-varying credit exposures whose size
[11] Mathieson & Schinasi 2000, p. 3.
and distribution tied to important asset markets. International nancial institutions increasingly nurtured the ability to prot from OTC derivatives activities and nancial
8.5.8 References
markets participants benetted from them. In 2000 the
authors acknowledged that the growth in OTC transac Monetary and Economic Department (November
tions in many ways made possible, the modernization of
2013), Statistical release OTC derivatives statistics
commercial and investment banking and the globalization
at end June 2013 (PDF), Bank for International Setof nance.[10] However, in September, an IMF team led
tlements (BIS), retrieved 12 April 2014
by Mathieson and Schinasi cautioned that episodes of
turbulence in the late 1990s revealed the risks posed to
WMT Overview, Better Trades, 2012, retrieved
market stability originated in features of OTC derivatives
12 April 2014
instruments and markets.[11]
Market Review of OTC Derivative Bilateral ColThe NYMEX has created a clearing mechanism for a
lateralization Practices (PDF), International Swaps
slate of commonly traded OTC energy derivatives which
and Derivatives Association (ISDA), 1 March 2010,
allows counterparties of many bilateral OTC transactions
retrieved
12 April 2014
to mutually agree to transfer the trade to ClearPort, the
exchanges clearing house, thus eliminating credit and
performance risk of the initial OTC transaction counterparts.

8.5.5

See also

Collateral management
Delta One
London Platinum and Palladium Market

8.5.6

Notes

[1] ISDA 2012 Market Analysis drew on information

sources including LCH.Clearnets SwapClear, TriOptima,
the DTCC Trade Information Warehouse, Markit, ICE,
CME, ISDAs 2012 Margin Survey and other clearinghouses and trade vendors.

8.5.7

Citations

[1] McCrank 2014.

[2] Gregory 2011, p. 7.

OTC Derivatives Market Analysis, Year-End

2010, ISDA (PDF), 26 May 2011
OTC Derivatives Market Analysis, Year-End
2012, ISDA (PDF), June 2013
Gregory, Jon (7 September 2011), Counterparty
Credit Risk: The new challenge for global nancial markets, John Wiley & Sons, ISBN 978-0-47068576-1
Mathieson, Donald J.; Schinasi, Garry J. (September 2000), International Capital Markets: Developments, Prospects, and Key Policy Issues (PDF),
World Economic and Financial Surveys
McCrank, John (6 April 2014), Dark markets may
be more harmful than high-frequency trading, New
York: Reuters, retrieved 12 April 2014
Schinasi, Garry J.; Craig, R. Sean; Drees, Burkhard;
Kramer, Charles (9 January 2001), Modern Banking
and OTC Derivatives Markets: The Transformation
of Global Finance and its Implications for Systemic
Risk, International Monetary Fund, ISBN 1-55775999-5, retrieved 12 April 2014

[3] ISDA 2013.

[4] Bank for International Settlements (BIS) 2013.
[5] Better Trades 2012.
[6] http://chicagofed.org/digital_assets/publications/
understanding_derivatives/understanding_derivatives_
chapter_3_over_the_counter_derivatives.pdf
[7] Gregory 2011, p. 17.
[8] Gregory 2011, p. 25.

8.5.9 External links

European Union proposals on derivatives regulation
- 2008 onwards
Understanding Derivatives: Markets and Infrastructure Chapter 3, Over-the-Counter Derivatives By
Richard Heckinger, Ivana Runi, and Kirstin Wells
(Federal Reserve Bank of Chicago)

8.6. NORMAL BACKWARDATION

177
silver lease rates are in backwardation. Negative lease
rates for silver may indicate bullion banks require a risk
premium for selling silver futures into the market.

8.6.1 Occurrence
This is the case of a convenience yield that is greater than
the risk free rate and the carrying costs.

The graph depicts how the price of a single forward contract will
behave through time in relation to the expected future price at any
point time. A contract in backwardation will increase in value
until it equals the spot price of the underlying at maturity. Note
that this graph does not show the forward curve (which plots
against maturities on the horizontal).

8.6 Normal backwardation

It is argued that backwardation is abnormal, and suggests

supply insuciencies in the corresponding (physical) spot
market. However, many commodities markets are frequently in backwardation, especially when the seasonal
aspect is taken into consideration, e.g., perishable and/or
soft commodities.
In Treatise on Money (1930, chapter 29), economist
John Maynard Keynes argued that in commodity markets,
backwardation is not an abnormal market situation, but
rather arises naturally as normal backwardation from
the fact that producers of commodities are more prone
to hedge their price risk than consumers. The academic
dispute on the subject continues to this day.[5]

Normal backwardation, also sometimes called back8.6.2 Examples

wardation, is the market condition wherein the price of a
forward or futures contract is trading below the expected
Notable examples of backwardation include:
spot price at contract maturity.[1] The resulting futures or
forward curve would typically be downward sloping (i.e.
Copper circa 1990, apparently arising from market
inverted), since contracts for further dates would typ[2]
manipulation by Yasuo Hamanaka of Sumitomo
ically trade at even lower prices. In practice, the exCorporation in what has come to be called the
pected future spot price is unknown, and the term back"Sumitomo copper aair".
wardation may be used to refer to positive basis, which
occurs when the current spot price exceeds the price of
A more recent example of market backwardation
the future.[3]:22
In 2013, the wholesale commercial gas market enThe opposite market condition to normal backwardation
tered backwardation during the month of March.
is known as contango. Similarly, in practice the term may
The 2-year contract prices fell below the price of
be used to refer to negative basis where the current spot
1-year contracts. [6]
price is below the future price.[3]
A backwardation starts when the dierence between the
forward price and the spot price is less than the cost of 8.6.3 Origin of term: London Stock Excarry, or when there can be no delivery arbitrage because
change
the asset is not currently available for purchase.
Futures contract price includes compensation for the risk Like contango, the term originated in mid-19th century
transferred from the asset holder. This makes actual price England, originating from backward.
on expiry to be lower than futures contract price. Backwardation very seldom arises in money commodities like
gold or silver. In the early 1980s, there was a one-day
backwardation in silver while some metal was physically
moved from COMEX to CBOT warehouses. Gold has
historically been positive with exception for momentary
backwardations (hours) since gold futures started trading
on the Winnipeg Commodity Exchange in 1972.[4]
The term is sometimes applied to forward prices other
than those of futures contracts, when analogous price patterns arise. For example, if it costs more to lease silver
for 30 days than for 60 days, it might be said that the

In that era on the London Stock Exchange, backwardation

was a fee paid by a seller wishing to defer delivering stock
they had sold. This fee was paid either to the buyer, or to
a third party who lent stock to the seller.
The purpose was normally speculative, allowing short
selling. Settlement days were on a xed schedule (such
as fortnightly) and a short seller did not have to deliver
stock until the following settlement day, and on that day
could carry over their position to the next by paying
a backwardation fee. This practice was common before
1930, but came to be used less and less, particularly since
options were reintroduced in 1958.

178

CHAPTER 8. TRADING IN DERIVATIVES

The fee here did not indicate a near-term shortage of

stock the way backwardation means today, it was more
like a lease rate, the cost of borrowing a stock or commodity for a period of time.
In more recent years, a backwardation in equities quoted
on the London Stock Exchange has come to signify
the unusual occurrence of an individual equities quote
whereby the bid appears to be higher than the oer. This
(of course) cannot occur for electronically traded stocks
via SETS or SETS MM but only for quote-driven stocks
(SEAQ)

8.6.4

Normal backwardation vs. backwardation

The term backwardation, when used without the qualier normal, can be somewhat ambiguous. Although
sometimes used as a synonym for normal backwardation
(where a futures contract price is lower than the expected
spot price at contract maturity), it may also refer to the
situation where a futures contract price is merely lower
than the current spot price.

8.6.5

References

[1] Contango Vs. Normal Backwardation, Investopedia

[2] The curves in question plot market prices for various contracts at dierent maturitiescf. yield curve
[3] Gorton G, Rouwenhorst KG. Facts and Fantasies about
Commodity Futures. NBER.
[4] Antal E. Fekete (2 December 2008). RED ALERT:
GOLD BACKWARDATION!!!(page 3)" (PDF). Retrieved 20 December 2008.
[5] Zvi Bodie & Victor Rosansky, Risk and Return in Commodity Futures, FINANCIAL ANALYSTS' JOURNAL
(May/June 1980)
[6] http://www.apolloenergy.co.uk/
wholesale-gas-market-an-important-update/

Encyclopdia Britannica, eleventh edition (1911),

articles Backwardation, Contango and Stock Exchange, and fteenth edition (1974), articles Contango and Backwardation and Stock Market.
Modern Market Manipulation, Mike Riess, 2003,
paper at the International Precious Metals Institute
27th Annual Conference
LME launches and investigation in primary aluminium trading, London Metal Exchange advice to
members 15 January 1999, reproduced at aluNET
International
New Orleans Temporary Suspension of Warrants,
London Metal Exchange press release 6 September
2005.

investopedia Website, Articles on Contango and

Backwardation and Stock Market.

Chapter 9

Credit Derivatives
9.1 Credit risk
Credit risk refers to the risk that a borrower will
default on any type of debt by failing to make required
payments.[1] The risk is primarily that of the lender and
includes lost principal and interest, disruption to cash
ows, and increased collection costs. The loss may
be complete or partial and can arise in a number of
circumstances.[2] For example:
A consumer may fail to make a payment due on a
mortgage loan, credit card, line of credit, or other
loan
A company is unable to repay asset-secured xed or
oating charge debt
A business or consumer does not pay a trade invoice
when due

Credit default risk The risk of loss arising from

a debtor being unlikely to pay its loan obligations in
full or the debtor is more than 90 days past due on
any material credit obligation; default risk may impact all credit-sensitive transactions, including loans,
securities and derivatives.
Concentration risk The risk associated with any
single exposure or group of exposures with the potential to produce large enough losses to threaten
a banks core operations. It may arise in the form
of single name concentration or industry concentration.
Country risk The risk of loss arising from a
sovereign state freezing foreign currency payments
(transfer/conversion risk) or when it defaults on
its obligations (sovereign risk); this type of risk is
prominently associated with the countrys macroeconomic performance and its political stability.

A business does not pay an employees earned wages

when due
9.1.2

Assessing credit risk

A business or government bond issuer does not make Main articles: Credit analysis and Consumer credit risk
a payment on a coupon or principal payment when
due
Signicant resources and sophisticated programs are used
An insolvent insurance company does not pay a pol- to analyze and manage risk.[4] Some companies run a
icy obligation
credit risk department whose job is to assess the nancial health of their customers, and extend credit (or not)
An insolvent bank won't return funds to a depositor accordingly. They may use in house programs to advise
A government grants bankruptcy protection to an on avoiding, reducing and transferring risk. They also
use third party provided intelligence. Companies like
insolvent consumer or business
Standard & Poors, Moodys, Fitch Ratings, DBRS, Dun
and Bradstreet, Bureau van Dijk and Rapid Ratings InTo reduce the lenders credit risk, the lender may perform
ternational provide such information for a fee.
a credit check on the prospective borrower, may require
the borrower to take out appropriate insurance, such as Most lenders employ their own models (credit scorecards)
mortgage insurance or seek security or guarantees of third to rank potential and existing customers according to risk,
[5]
parties. In general, the higher the risk, the higher will be and then apply appropriate strategies. With products
the interest rate that the debtor will be asked to pay on the such as unsecured personal loans or mortgages, lenders
charge a higher price for higher risk customers and vice
debt.
versa.[6][7] With revolving products such as credit cards
and overdrafts, risk is controlled through the setting of
credit limits. Some products also require collateral, usu9.1.1 Types of credit risk
ally an asset that is pledged to secure the repayment of
Credit risk can be classied as follows:[3]
the loan.
179

180
Credit scoring models also form part of the framework
used by banks or lending institutions to grant credit to
clients. For corporate and commercial borrowers, these
models generally have qualitative and quantitative sections outlining various aspects of the risk including, but
not limited to, operating experience, management expertise, asset quality, and leverage and liquidity ratios, respectively. Once this information has been fully reviewed
by credit ocers and credit committees, the lender provides the funds subject to the terms and conditions presented within the contract (as outlined above).
Sovereign risk
Sovereign risk is the risk of a government being unwilling
or unable to meet its loan obligations, or reneging on loans
it guarantees. Many countries have faced sovereign risk
in the late-2000s global recession. The existence of such
risk means that creditors should take a two-stage decision
process when deciding to lend to a rm based in a foreign
country. Firstly one should consider the sovereign risk
quality of the country and then consider the rms credit
quality.[8]
Five macroeconomic variables that aect the probability
of sovereign debt rescheduling are:[9]
Debt service ratio
Import ratio
Investment ratio
Variance of export revenue
Domestic money supply growth
The probability of rescheduling is an increasing function of debt service ratio, import ratio, variance of
export revenue and domestic money supply growth.[9]
The likelihood of rescheduling is a decreasing function of investment ratio due to future economic productivity gains. Debt rescheduling likelihood can increase if the investment ratio rises as the foreign country could become less dependent on its external creditors
and so be less concerned about receiving credit from these
countries/investors.[10]
Counterparty risk
A counterparty risk, also known as a default risk, is
a risk that a counterparty will not pay as obligated
on a bond, credit derivative, trade credit insurance or
payment protection insurance contract, or other trade or
transaction.[11] Financial institutions may hedge or take
out credit insurance. Osetting counterparty risk is not
always possible, e.g. because of temporary liquidity issues or longer term systemic reasons.[12]

CHAPTER 9. CREDIT DERIVATIVES

Counterparty risk increases due to positively correlated
risk factors. Accounting for correlation between portfolio
risk factors and counterparty default in risk management
methodology is not trivial.[13]

9.1.3 Mitigating credit risk

Lenders mitigate credit risk using several methods:
Risk-based pricing: Lenders generally charge a
higher interest rate to borrowers who are more likely
to default, a practice called risk-based pricing.
Lenders consider factors relating to the loan such as
loan purpose, credit rating, and loan-to-value ratio
and estimates the eect on yield (credit spread).
Covenants:[14] Lenders may write stipulations on
the borrower, called covenants, into loan agreements:
Periodically report its nancial condition
Refrain from paying dividends, repurchasing
shares, borrowing further, or other specic,
voluntary actions that negatively aect the
companys nancial position
Repay the loan in full, at the lenders request,
in certain events such as changes in the borrowers debt-to-equity ratio or interest coverage ratio
Credit insurance and credit derivatives: Lenders
and bond holders may hedge their credit risk by
purchasing credit insurance or credit derivatives.
These contracts transfer the risk from the lender to
the seller (insurer) in exchange for payment. The
most common credit derivative is the credit default
swap.
Tightening: Lenders can reduce credit risk by reducing the amount of credit extended, either in total
or to certain borrowers. For example, a distributor
selling its products to a troubled retailer may attempt
to lessen credit risk by reducing payment terms from
net 30 to net 15.
Diversication:[15] Lenders to a small number of
borrowers (or kinds of borrower) face a high degree
of unsystematic credit risk, called concentration
risk. Lenders reduce this risk by diversifying the
borrower pool.
Deposit insurance: Many governments establish
deposit insurance to guarantee bank deposits in
the event of insolvency and encourage consumers to
hold their savings in the banking system instead of
in cash.

9.1. CREDIT RISK

9.1.4

Credit risk related acronyms

ACPM Active credit portfolio management

CCR Counterparty Credit Risk
CVA Credit valuation adjustment
EAD Exposure at default
EL Expected loss

181

[2] Risk Glossary: Credit Risk

[3] Credit Risk Classication
[4] BIS Paper:Sound credit risk assessment and valuation for
loans
[5] Huang and Scott:Credit Risk Scorecard Design, Validation and User Acceptance

LGD Loss given default

[6] Investopedia: Risk-based mortgage pricing

PD Probability of default

[7] Edelman: Risk based pricing for personal loans

KMV quantitative credit analysis[16]

[8] Cary L. Cooper, Derek F. Channon (1998). The Concise Blackwell Encyclopedia of Management. ISBN 9780-631-20911-9.

VAR Value at Risk

PFE Potential future exposure

9.1.5

See also

Credit (nance)
Default (nance)

9.1.6

Further reading

Bluhm, Christian, Ludger Overbeck, and Christoph

Wagner (2002). An Introduction to Credit Risk Modeling. Chapman & Hall/CRC. ISBN 978-1-58488326-5.
Damiano Brigo and Massimo Masetti (2006). Risk
Neutral Pricing of Counterparty Risk, in: Pykhtin,
M. (Editor), Counterparty Credit Risk Modeling: Risk
Management, Pricing and Regulation. Risk Books.
ISBN 1-904339-76-X.
de Servigny, Arnaud and Olivier Renault (2004).
The Standard & Poors Guide to Measuring and
Managing Credit Risk. McGraw-Hill. ISBN 9780-07-141755-6.
Darrell Due and Kenneth J. Singleton (2003).
Credit Risk: Pricing, Measurement, and Management. Princeton University Press. ISBN 978-0-69109046-7.
Principles for the management of credit risk from
the Bank for International Settlements

9.1.7

References

[1] Principles for the Management of Credit Risk - nal document. Basel Committee on Banking Supervision. BIS.
September 2000. Retrieved 13 December 2013. Credit
risk is most simply dened as the potential that a bank
borrower or counterparty will fail to meet its obligations
in accordance with agreed terms.

[9] Frenkel, Karmann and Scholtens (2004). Sovereign Risk

and Financial Crises. Springer. ISBN 978-3-540-222484.
[10] Cornett, Marcia Millon and Saunders, Anthony (2006).
Financial Institutions Management: A Risk Management
Approach, 5th Edition. McGraw-Hill. ISBN 978-0-07304667-9.
[11] Investopedia. Counterparty risk. Retrieved 2008-10-06
[12] Tom Henderson. Counterparty Risk and the Subprime Fiasco. 2008-01-02. Retrieved 2008-10-06
[13] Brigo, Damiano and Andrea Pallavicini (2007). Counterparty Risk under Correlation between Default and Interest
Rates. In: Miller, J., Edelman, D., and Appleby, J. (Editors), Numerical Methods for Finance. Chapman Hall.
ISBN 1-58488-925-X.Related SSRN Research Paper
[14] Debt covenants
[15] MBA Mondays:Risk Diversication
[16] Duan, Jin-Chuan; Gauthier, Genevive; Simonato, JeanGuy. On the equivalence of the KMV and maximum
likelihood methods for structural credit risk models.
CiteSeerX: 10.1.1.154.6371.

9.1.8 External links

Bank Management and Control, Springer - Management for Professionals, 2014
Credit Risk Calculators - QuantCalc
A Guide to Modeling Counterparty Credit Risk SSRN Research Paper, July 2007
Defaultrisk.com - research and white papers on
credit risk modelling

182

CHAPTER 9. CREDIT DERIVATIVES

9.2 Credit derivative

The main market participants are banks, hedge

funds, insurance companies, pension funds, and other
[6]
In nance, a credit derivative refers to any one of vari- corporates.
ous instruments and techniques designed to separate and
then transfer the credit risk"[1] or the risk of an event of
default of a corporate or sovereign borrower, transferring 9.2.2 Types
it to an entity other than the lender[2][3] or debtholder.
Credit derivatives are fundamentally divided into two catAn unfunded credit derivative is one where credit proegories: funded credit derivatives and unfunded credit
tection is bought and sold between bilateral counterparderivatives.
ties without the protection seller having to put up money
upfront or at any given time during the life of the deal An unfunded credit derivative is a bilateral contract beunless an event of default occurs. Usually these contracts tween two counterparties, where each party is responsiare traded pursuant to an International Swaps and Deriva- ble for making its payments under the contract (i.e., paytives Association (ISDA) master agreement. Most credit ments of premiums and any cash or physical settlement
derivatives of this sort are credit default swaps. If the amount) itself without recourse to other assets.
credit derivative is entered into by a nancial institution A funded credit derivative involves the protection seller
or a special purpose vehicle (SPV) and payments under (the party that assumes the credit risk) making an initial
the credit derivative are funded using securitization tech- payment that is used to settle any potential credit events.
niques, such that a debt obligation is issued by the nan- (The protection buyer, however, still may be exposed to
cial institution or SPV to support these obligations, this is the credit risk of the protection seller itself. This is known
known as a funded credit derivative.
as counterparty risk.)
This synthetic securitization process has become in- Unfunded credit derivative products include the following
creasingly popular over the last decade, with the sim- products:
ple versions of these structures being known as synthetic collateralized debt obligations (CDOs); credit Credit default swap (CDS)
linked notes; single tranche CDOs, to name a few. In
funded credit derivatives, transactions are often rated by
Total return swap
rating agencies, which allows investors to take dierent
[4]
slices of credit risk according to their risk appetite.
Constant maturity credit default swap (CMCDS)

9.2.1

History and participants

The market in credit derivatives started from nothing in

1993 after having been pioneered by J.P. Morgan's Peter Hancock.[5] By 1996 there was around $40 billion of
outstanding transactions, half of which involved the debt
of developing countries.[1]
Credit default products are the most commonly traded
credit derivative product[6] and include unfunded products such as credit default swaps and funded products such
as collateralized debt obligations (see further discussion
below).

First to Default Credit Default Swap

Portfolio Credit Default Swap
Secured Loan Credit Default Swap
Credit Default Swap on Asset Backed Securities
Credit default swaption
Recovery lock transaction
Credit Spread Option

On May 15, 2007, in a speech concerning credit deriva CDS index products
tives and liquidity risk, Geithner stated: Financial innovation has improved the capacity to measure and manage
Funded credit derivative products include the following
risk. [7]
products:
The ISDA[8] reported in April 2007 that total notional
amount on outstanding credit derivatives was $35.1 tril Credit-linked note (CLN)
lion with a gross market value of $948 billion (ISDAs
Website). As reported in The Times on September 15,
Synthetic collateralized debt obligation (CDO)
2008, the Worldwide credit derivatives market is valued
[9]
at $62 trillion.
Constant Proportion Debt Obligation (CPDO)
Although the credit derivatives market is a global one,
Synthetic constant proportion portfolio insurance
London has a market share of about 40%, with the rest
(Synthetic CPPI)
of Europe having about 10%.[6]

9.2. CREDIT DERIVATIVE

Key unfunded credit derivative products
Credit default swap

Main article: Credit default swap

The credit default swap or CDS has become the cornerstone product of the credit derivatives market. This product represents over thirty percent of the credit derivatives
market.[6]
The product has many variations, including where there is
a basket or portfolio of reference entities, although fundamentally, the principles remain the same. A powerful recent variation has been gathering market share of
late: credit default swaps which relate to asset-backed
securities.[10]
Total return swap

Main article: Total return swap

Key funded credit derivative products

183
For example, a bank may sell some of its exposure to
a particular emerging country by issuing a bond linked
to that countrys default or convertibility risk. From the
banks point of view, this achieves the purpose of reducing its exposure to that risk, as it will not need to reimburse all or part of the note if a credit event occurs. However, from the point of view of investors, the risk prole is
dierent from that of the bonds issued by the country. If
the bank runs into diculty, their investments will suer
even if the country is still performing well.
The credit rating is improved by using a proportion of
government bonds, which means the CLN investor receives an enhanced coupon.
Through the use of a credit default swap, the bank receives some recompense if the reference credit defaults.
There are several dierent types of securitized product,
which have a credit dimension.
Credit-linked notes (CLN): Credit-linked note is a
generic name related to any bond whose value is
linked to the performance of a reference asset, or
assets. This link may be through the use of a credit
derivative, but does not have to be.
Collateralized debt obligation (CDO): Generic term
for a bond issued against a mixed pool of assets There also exists CDO-squared (CDO^2) where the
underlying assets are CDO tranches.
Collateralized bond obligations (CBO): Bond issued
against a pool of bond assets or other securities. It
is referred to in a generic sense as a CDO

In this example coupons from the banks portfolio of loans are

passed to the SPV which uses the cash ow to service the credit
linked notes.

Credit linked notes A credit linked note is a note

whose cash ow depends upon an event, which may be
a default, change in credit spread, or rating change. The
denition of the relevant credit events must be negotiated
by the parties to the note.

Collateralized loan obligations (CLO): Bond issued

against a pool of bank loan. It is referred to in a
generic sense as a CDO
CDO refers either to the pool of assets used to support
the CLNs or the CLNs themselves.
Collateralized debt obligations
collateralized debt obligation

Main article:

A CLN in eect combines a credit-default swap with a

regular note (with coupon, maturity, redemption). Given Not all collateralized debt obligations (CDOs) are credit
its note-like features, a CLN is an on-balance-sheet asset, derivatives. For example a CDO made up of loans
in contrast to a CDS.
is merely a securitizing of loans that is then tranched
Typically, an investment fund manager will purchase such based on its credit rating. This particular securitization
a note to hedge against possible down grades, or loan de- is known as a collateralized loan obligation (CLO) and
the investor receives the cash ow that accompanies the
faults.
paying of the debtor to the creditor. Essentially, a CDO
Numerous dierent types of credit linked notes (CLNs) is held up by a pool of assets that generate cash. A CDO
have been structured and placed in the past few years. only becomes a derivative when it is used in conjunction
Here we are going to provide an overview rather than a with credit default swaps (CDS), in which case it becomes
detailed account of these instruments.
a Synthetic CDO. The main dierence between CDOs
The most basic CLN consists of a bond, issued by a well- and derivatives is that a derivative is essentially a bilateral
rated borrower, packaged with a credit default swap on a agreement in which the payout occurs during a specic
event which is tied to the underlying asset.
less creditworthy risk.

184

CHAPTER 9. CREDIT DERIVATIVES

Other more complicated CDOs have been developed

where each underlying credit risk is itself a CDO tranche.
These CDOs are commonly known as CDOs-squared.

9.2.3

Pricing

Pricing of credit derivative is not an easy process.[3] This

is because:
The complexity in monitoring the market price of
the underlying credit obligation.
Understanding the creditworthiness of a debtor is
often a cumbersome task as it is not easily quantiable.
The incidence of default is not a frequent phenomenon and makes it dicult for the investors to
nd the empirical data of a solvent company with
respect to default.

[4] Bruyere, Richard; Cont, Rama (2006). Credit Derivatives

and Structured Credit: A guide for investors. Wiley. ISBN
978-0470018798.
[5] AIG: Americas Improved Giant. The Economist (London). February 2, 2013. Retrieved March 30, 2015.
[6] British Banker Association Credit Derivatives Report
(PDF). 2006.
[7] Remarks at the Federal Reserve Bank of Atlantas 2007
Financial Markets ConferenceCredit Derivatives, Sea
Island, Georgia
[8] ISDA. April 2007.
[9] Hosking, Patrick; Costello, Miles; Leroux, Marcus
(September 16, 2008). Dow dives as Federal Reserve
lines up 75bn emergency loan for AIG. The Times (London). Retrieved April 30, 2010.
[10] Parker, Edmund; Piracci, Jamila (April 19, 2007).
Documenting credit default swaps on asset backed securities. Mayer Brown. Archived from the original on May
21, 2011.

Even though one can take help of dierent ratings

published by ranking agencies but often these ratings
will be dierent.
9.2.7

9.2.4

Risks

Risks involving credit derivatives are a concern among

regulators of nancial markets. The US Federal Reserve
issued several statements in the Fall of 2005 about these
risks, and highlighted the growing backlog of conrmations for credit derivatives trades. These backlogs pose
risks to the market (both in theory and in all likelihood),
and they exacerbate other risks in the nancial system.[3]
One challenge in regulating these and other derivatives
is that the people who know most about them also typically have a vested incentive in encouraging their growth
and lack of regulation. Incentive may be indirect, e.g.,
academics have not only consulting incentives, but also
incentives in keeping open doors for research.

9.2.5

See also

Credit default swap

Credit-linked note

External links

Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank, Financial Markets
Group
A Credit Derivatives Risk Primer - Simplied explanation for lay persons.
The Lehman Brothers Guide to Exotic Credit
Derivatives
The J.P. Morgan Guide to Credit Derivatives
History of Credit Derivatives, Financial-edu.com
A Beginners Guide to Credit Derivatives - Noel
Vaillant, Nomura International
Documenting credit default swaps on asset backed
securities, Edmund Parker and Jamila Piracci,
Mayer Brown, Euromoney Handbooks.

9.3 Credit default swap

A credit default swap (CDS) is a nancial swap agreement that the seller of the CDS will compensate the buyer
(usually the creditor of the reference loan) in the event of
[1] The Economist Passing on the risks 2 November 1996
a loan default (by the debtor) or other credit event. This is
to say that the seller of the CDS insures the buyer against
[2] Das, Satyajit (2005). Credit Derivatives: CDOs and Strucsome reference loan defaulting. The buyer of the CDS
tured Credit Products, 3rd Edition. Wiley. ISBN 978-0makes a series of payments (the CDS fee or spread)
470-82159-6.
to the seller and, in exchange, receives a payo if the loan
[3] Michael Simkovic, Secret Liens and the Financial Crisis defaults. It was invented by Blythe Masters from JP Morof 2008, American Bankruptcy Law Journal 2009
gan in 1994.

9.2.6

Notes and references

9.3. CREDIT DEFAULT SWAP

185
credit default swaps database.[11]
CDS data can be used by nancial professionals, regulators, and the media to monitor how the market views
credit risk of any entity on which a CDS is available,
which can be compared to that provided by the Credit
Rating Agencies. U.S. Courts may soon be following
suit.[1]

If the reference bond performs without default, the protection

buyer pays quarterly payments to the seller until maturity

Most CDSs are documented using standard forms drafted

by the International Swaps and Derivatives Association
(ISDA), although there are many variants.[7] In addition
to the basic, single-name swaps, there are basket default
swaps (BDSs), index CDSs, funded CDSs (also called
credit-linked notes), as well as loan-only credit default
swaps (LCDS). In addition to corporations and governments, the reference entity can include a special purpose
vehicle issuing asset-backed securities.[12]
Some claim that derivatives such as CDS are potentially
dangerous in that they combine priority in bankruptcy
with a lack of transparency.[8] A CDS can be unsecured
(without collateral) and be at higher risk for a default.

9.3.1 Description

Protection buyer

t1 t2 t3 t4 t5 t6 ... tn
...

If the reference bond defaults, the protection seller pays par value
of the bond to the buyer, and the buyer transfers ownership of the
bond to the seller

t0

Protection seller

tn

Buyer purchased a CDS at time t0 and makes regular

premium payments at times t1 , t2 , t3 , and t4 . If the
In the event of default the buyer of the CDS receives com- associated credit instrument suers no credit event, then
pensation (usually the face value of the loan), and the the buyer continues paying premiums at t5 , t6 and so on
seller of the CDS takes possession of the defaulted loan.[1] until the end of the contract at time t .
However, anyone can purchase a CDS, even buyers who Protection buyer
do not hold the loan instrument and who have no direct
t1 t2 t3 t4 t5
insurable interest in the loan (these are called naked
CDSs). If there are more CDS contracts outstanding than
bonds in existence, a protocol exists to hold a credit event
auction; the payment received is usually substantially less
t0
tn
than the face value of the loan.[2]
Credit default swaps have existed since 1994, and increased in use after 2003. By the end of 2007, the
outstanding CDS amount was $62.2 trillion,[3] falling to
$26.3 trillion by mid-year 2010[4] and reportedly $25.5[5]
trillion in early 2012. CDSs are not traded on an exchange and there is no required reporting of transactions
to a government agency.[6] During the 2007-2010 nancial crisis the lack of transparency in this large market became a concern to regulators as it could pose a systemic
risk.[7][8][9][10] In March 2010, the [DTCC] Trade Information Warehouse (see Sources of Market Data) announced it would give regulators greater access to its

Protection seller

However, if the associated credit instrument suered a

credit event at t5 , then the seller pays the buyer for the
loss, and the buyer would cease paying premiums to the
seller.
A CDS is linked to a reference entity or reference
obligor, usually a corporation or government. The reference entity is not a party to the contract. The buyer
makes regular premium payments to the seller, the premium amounts constituting the spread charged by the
seller to insure against a credit event. If the reference

186
entity defaults, the protection seller pays the buyer the
par value of the bond in exchange for physical delivery
of the bond, although settlement may also be by cash or
auction.[7][13]
A default is often referred to as a credit event and includes such events as failure to pay, restructuring and
bankruptcy, or even a drop in the borrowers credit rating.[7] CDS contracts on sovereign obligations also usually include as credit events repudiation, moratorium and
acceleration.[6] Most CDSs are in the $10$20 million
range[14] with maturities between one and 10 years. Five
years is the most typical maturity.[12]

CHAPTER 9. CREDIT DERIVATIVES

AAA-Bank pays the investor the dierence between
the par value and the market price of a specied debt
obligation (even if Risky Corp defaults there is usually some recovery, i.e., not all the investors money
is lost), which is known as cash settlement.

The spread of a CDS is the annual amount the protection buyer must pay the protection seller over the length
of the contract, expressed as a percentage of the notional
amount. For example, if the CDS spread of Risky Corp
is 50 basis points, or 0.5% (1 basis point = 0.01%), then
an investor buying $10 million worth of protection from
AAA-Bank must pay the bank $50,000. Payments are
An investor or speculator may buy protection to hedge usually made on a quarterly basis, in arrears. These paythe risk of default on a bond or other debt instrument, re- ments continue until either the CDS contract expires or
gardless of whether such investor or speculator holds an Risky Corp defaults.
interest in or bears any risk of loss relating to such bond
or debt instrument. In this way, a CDS is similar to credit All things being equal, at any given time, if the maturity
insurance, although CDS are not subject to regulations of two credit default swaps is the same, then the CDS
governing traditional insurance. Also, investors can buy associated with a company with a higher CDS spread is
and sell protection without owning debt of the reference considered more likely to default by the market, since a
entity. These naked credit default swaps allow traders higher fee is being charged to protect against this happento speculate on the creditworthiness of reference entities. ing. However, factors such as liquidity and estimated loss
CDSs can be used to create synthetic long and short po- given default can aect the comparison. Credit spread
sitions in the reference entity.[9] Naked CDS constitute rates and credit ratings of the underlying or reference
most of the market in CDS.[15][16] In addition, CDSs can obligations are considered among money managers to be
the best indicators of the likelihood of sellers of CDSs
also be used in capital structure arbitrage.
having to perform under these contracts.[7]
A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payo Dierences from insurance
if an underlying nancial instrument defaults or experiences a similar credit event.[7][13][17] The CDS may refer CDS contracts have obvious similarities with insurance,
to a specied loan or bond obligation of a reference en- because the buyer pays a premium and, in return, receives
a sum of money if an adverse event occurs.
tity, usually a corporation or government.[14]
However there are also many dierences, the most important being that an insurance contract provides an indemnity against the losses actually suered by the policy
holder on an asset in which it holds an insurable interest. By contrast a CDS provides an equal payout to all
holders, calculated using an agreed, market-wide method.
The holder does not need to own the underlying security
and does not even have to suer a loss from the deIf the investor actually owns Risky Corps debt (i.e., is
fault event.[18][19][20][21] The CDS can therefore be used
owed money by Risky Corp), a CDS can act as a hedge.
to speculate on debt objects.
But investors can also buy CDS contracts referencing
Risky Corp debt without actually owning any Risky Corp The other dierences include:
debt. This may be done for speculative purposes, to
bet against the solvency of Risky Corp in a gamble to
the seller might in principle not be a regulated entity
make money, or to hedge investments in other compa(though in practice most are banks);
nies whose fortunes are expected to be similar to those of
the seller is not required to maintain reserves to
Risky Corp (see Uses).
cover the protection sold (this was a principal cause
If the reference entity (i.e., Risky Corp) defaults, one of
of AIGs nancial distress in 2008; it had insutwo kinds of settlement can occur:
cient reserves to meet the run of expected payouts
caused by the collapse of the housing bubble);
As an example, imagine that an investor buys a CDS from
AAA-Bank, where the reference entity is Risky Corp.
The investorthe buyer of protectionwill make regular payments to AAA-Bankthe seller of protection.
If Risky Corp defaults on its debt, the investor receives
a one-time payment from AAA-Bank, and the CDS contract is terminated.

the investor delivers a defaulted asset to Bank for

payment of the par value, which is known as physical
settlement;

insurance requires the buyer to disclose all known

risks, while CDSs do not (the CDS seller can in
many cases still determine potential risk, as the debt

9.3. CREDIT DEFAULT SWAP

187

instrument being insured is a market commodity

available for inspection, but in the case of certain
instruments like CDOs made up of slices of debt
packages, it can be dicult to tell exactly what is
being insured);

to a CDS contract must post collateral (which is common), there can be margin calls requiring the posting of
additional collateral. The required collateral is agreed on
by the parties when the CDS is rst issued. This margin
amount may vary over the life of the CDS contract, if the
market price of the CDS contract changes, or the credit
insurers manage risk primarily by setting loss re- rating of one of the parties changes. Many CDS contracts
serves based on the Law of large numbers and even require payment of an upfront fee (composed of reactuarial analysis. Dealers in CDSs manage risk pri- set to par and an initial coupon.).[23]
marily by means of hedging with other CDS deals
Another kind of risk for the seller of credit default swaps
and in the underlying bond markets;
is jump risk or jump-to-default risk.[7] A seller of a
CDS contracts are generally subject to mark-to- CDS could be collecting monthly premiums with little
market accounting, introducing income statement expectation that the reference entity may default. A deand balance sheet volatility while insurance con- fault creates a sudden obligation on the protection selltracts are not;
ers to pay millions, if not billions, of dollars to protection buyers.[24] This risk is not present in other over-the Hedge accounting may not be available under US
counter derivatives.[7][24]
Generally Accepted Accounting Principles (GAAP)
unless the requirements of FAS 133 are met. In
practice this rarely happens.
Sources of market data
to cancel the insurance contract the buyer can typiData about the credit default swaps market is available
cally stop paying premiums, while for CDS the confrom three main sources. Data on an annual and semitract needs to be unwound.
annual basis is available from the International Swaps
and Derivatives Association (ISDA) since 2001[25] and
from the Bank for International Settlements (BIS) since
Risk
2004.[26] The Depository Trust & Clearing Corporation
When entering into a CDS, both the buyer and seller of (DTCC), through its global repository Trade Information Warehouse (TIW), provides weekly data but pubcredit protection take on counterparty risk:[7][12][22]
licly available information goes back only one year.[27]
The buyer takes the risk that the seller may default. The numbers provided by each source do not always
If AAA-Bank and Risky Corp. default simultane- match because each provider uses dierent sampling
[7]
ously ("double default"), the buyer loses its protec- methods.
tion against default by the reference entity. If AAA- According to DTCC, the Trade Information Warehouse
Bank defaults but Risky Corp. does not, the buyer maintains the only global electronic database for virtumight need to replace the defaulted CDS at a higher ally all CDS contracts outstanding in the marketplace.[28]
cost.
The Oce of the Comptroller of the Currency publishes
The seller takes the risk that the buyer may default quarterly credit derivative data about insured U.S comon the contract, depriving the seller of the expected mercial banks and trust companies.[29]
revenue stream. More important, a seller normally
limits its risk by buying osetting protection from
another party that is, it hedges its exposure. If 9.3.2 Uses
the original buyer drops out, the seller squares its
position by either unwinding the hedge transaction Credit default swaps can be used by investors for
or by selling a new CDS to a third party. Depending speculation, hedging and arbitrage.
on market conditions, that may be at a lower price
than the original CDS and may therefore involve a
Speculation
loss to the seller.
Credit default swaps allow investors to speculate on
changes in CDS spreads of single names or of market
indices such as the North American CDX index or the
European iTraxx index. An investor might believe that
an entitys CDS spreads are too high or too low, relative
to the entitys bond yields, and attempt to prot from that
view by entering into a trade, known as a basis trade, that
As is true with other forms of over-the-counter derivative, combines a CDS with a cash bond and an interest rate
CDS might involve liquidity risk. If one or both parties swap.
In the future, in the event that regulatory reforms require that CDS be traded and settled via a central
exchange/clearing house, such as ICE TCC, there will
no longer be 'counterparty risk', as the risk of the counterparty will be held with the central exchange/clearing
house.

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CHAPTER 9. CREDIT DERIVATIVES

Finally, an investor might speculate on an entitys credit

quality, since generally CDS spreads increase as creditworthiness declines, and decline as credit-worthiness increases. The investor might therefore buy CDS protection on a company to speculate that it is about to default.
Alternatively, the investor might sell protection if it thinks
that the companys creditworthiness might improve. The
investor selling the CDS is viewed as being long on
the CDS and the credit, as if the investor owned the
bond.[9][12] In contrast, the investor who bought protection is short on the CDS and the underlying credit.[9][12]
Credit default swaps opened up important new avenues
to speculators. Investors could go long on a bond without
any upfront cost of buying a bond; all the investor need do
was promise to pay in the event of default.[30] Shorting a
bond faced dicult practical problems, such that shorting
was often not feasible; CDS made shorting credit possible
and popular.[12][30] Because the speculator in either case
does not own the bond, its position is said to be a synthetic
long or short position.[9]

In another scenario, after one year the market now

considers Risky much less likely to default, so its
CDS spread has tightened from 500 to 250 basis
points. Again, the hedge fund may choose to sell $10
million worth of protection for 1 year to AAA-Bank
at this lower spread. Therefore over the two years
the hedge fund pays the bank 2 * 5% * $10 million
= $1 million, but receives 1 * 2.5% * $10 million =
$250,000, giving a total loss of $750,000. This loss
is smaller than the $1 million loss that would have
occurred if the second transaction had not been entered into.
Transactions such as these do not even have to be entered
into over the long-term. If Risky Corps CDS spread had
widened by just a couple of basis points over the course
of one day, the hedge fund could have entered into an
osetting contract immediately and made a small prot
over the life of the two CDS contracts.

Credit default swaps are also used to structure synthetic

collateralized debt obligations (CDOs). Instead of owning bonds or loans, a synthetic CDO gets credit exposure
to a portfolio of xed income assets without owning those
assets through the use of CDS.[10] CDOs are viewed as
complex and opaque nancial instruments. An example of a synthetic CDO is Abacus 2007-AC1, which is
the subject of the civil suit for fraud brought by the SEC
If Risky Corp does indeed default after, say, one
against Goldman Sachs in April 2010.[31] Abacus is a synyear, then the hedge fund will have paid $500,000 to
thetic CDO consisting of credit default swaps referencing
AAA-Bank, but then receives $10 million (assuma variety of mortgage-backed securities.
ing zero recovery rate, and that AAA-Bank has the
liquidity to cover the loss), thereby making a prot.
AAA-Bank, and its investors, will incur a $9.5 milNaked credit default swaps In the examples above,
lion loss minus recovery unless the bank has somethe hedge fund did not own any debt of Risky Corp. A
how oset the position before the default.
CDS in which the buyer does not own the underlying debt
is referred to as a naked credit default swap, estimated to
However, if Risky Corp does not default, then the be up to 80% of the credit default swap market.[15][16]
CDS contract runs for two years, and the hedge There is currently a debate in the United States and Eufund ends up paying $1 million, without any return, rope about whether speculative uses of credit default
thereby making a loss. AAA-Bank, by selling pro- swaps should be banned. Legislation is under considertection, has made $1 million without any upfront in- ation by Congress as part of nancial reform.[16]
vestment.
Critics assert that naked CDSs should be banned, comparing them to buying re insurance on your neighbors
Note that there is a third possibility in the above scenario; house, which creates a huge incentive for arson. Analothe hedge fund could decide to liquidate its position after gizing to the concept of insurable interest, critics say
a certain period of time in an attempt to realise its gains you should not be able to buy a CDSinsurance against
or losses. For example:
defaultwhen you do not own the bond.[32][33][34] Short
selling is also viewed as gambling and the CDS market
[16][35]
Another concern is the size of the CDS
After 1 year, the market now considers Risky Corp as a casino.
market.
Because
naked
credit default swaps are synthetic,
more likely to default, so its CDS spread has widened
there
is
no
limit
to
how
many can be sold. The gross
from 500 to 1500 basis points. The hedge fund may
amount
of
CDSs
far
exceeds
all real corporate bonds
choose to sell $10 million worth of protection for 1
[6][33]
As
a result, the risk of default
and
loans
outstanding.
year to AAA-Bank at this higher rate. Therefore,
is
magnied
leading
to
concerns
about systemic risk.[33]
over the two years the hedge fund pays the bank 2 *
For example, a hedge fund believes that Risky Corp will
soon default on its debt. Therefore, it buys $10 million
worth of CDS protection for two years from AAA-Bank,
with Risky Corp as the reference entity, at a spread of
500 basis points (=5%) per annum.

5% * $10 million = $1 million, but receives 1 * 15% Financier George Soros called for an outright ban on
* $10 million = $1.5 million, giving a total prot of naked credit default swaps, viewing them as toxic and
allowing speculators to bet against and bear raid com$500,000.

9.3. CREDIT DEFAULT SWAP

189

panies or countries.[36] His concerns were echoed by several European politicians who, during the Greek Financial Crisis, accused naked CDS buyers of making the crisis worse.[37][38]

swap, the bank can lay o default risk while still keeping
the loan in its portfolio.[10] The downside to this hedge is
that without default risk, a bank may have no motivation
to actively monitor the loan and the counterparty has no
[10]
Despite these concerns, Secretary of Treasury relationship to the borrower.
Geithner[16][37] and Commodity Futures Trading Another kind of hedge is against concentration risk. A
Commission Chairman Gensler[39] are not in favor of banks risk management team may advise that the bank
an outright ban on naked credit default swaps. They is overly concentrated with a particular borrower or inprefer greater transparency and better capitalization dustry. The bank can lay o some of this risk by buying
requirements.[16][24] These ocials think that naked a CDS. Because the borrowerthe reference entityis
CDSs have a place in the market.
not a party to a credit default swap, entering into a CDS
without
Proponents of naked credit default swaps say that short allows the bank to achieve its diversity objectives [7]
impacting
its
loan
portfolio
or
customer
relations.
Simselling in various forms, whether credit default swaps, opilarly,
a
bank
selling
a
CDS
can
diversify
its
portfolio
by
tions or futures, has the benecial eect of increasing liqgaining
exposure
to
an
industry
in
which
the
selling
bank
[32]
uidity in the marketplace. That benets hedging activi[12][14][43]
ties. Without speculators buying and selling naked CDSs, has no customer base.
A bank buying protection can also use a CDS to free regulatory capital. By ooading a particular credit risk, a
bank is not required to hold as much capital in reserve
against the risk of default (traditionally 8% of the total
loan under Basel I). This frees resources the bank can use
to make other loans to the same key customer or to other
[7][44]
Despite assertions that speculators are making the Greek borrowers.
crisis worse, Germanys market regulator BaFin found no Hedging risk is not limited to banks as lenders. Holdproof supporting the claim.[38] Some suggest that without ers of corporate bonds, such as banks, pension funds or
credit default swaps, Greeces borrowing costs would be insurance companies, may buy a CDS as a hedge for simihigher.[38] As of November 2011, the Greek bonds have lar reasons. Pension fund example: A pension fund owns
ve-year bonds issued by Risky Corp with par value of
a bond yield of 28%.[41]
A bill in the U.S. Congress proposed giving a public au- $10 million. To manage the risk of losing money if Risky
thority the power to limit the use of CDSs other than for Corp defaults on its debt, the pension fund buys a CDS
from Derivative Bank in a notional amount of $10 milhedging purposes, but the bill did not become law.[42]
lion. The CDS trades at 200 basis points (200 basis points
= 2.00 percent). In return for this credit protection, the
pension fund pays 2% of $10 million ($200,000) per anHedging
num in quarterly installments of $50,000 to Derivative
Bank.
Credit default swaps are often used to manage the risk of
default that arises from holding debt. A bank, for exam If Risky Corporation does not default on its bond
ple, may hedge its risk that a borrower may default on a
payments, the pension fund makes quarterly payloan by entering into a CDS contract as the buyer of proments to Derivative Bank for 5 years and receives its
tection. If the loan goes into default, the proceeds from
$10 million back after ve years from Risky Corp.
the CDS contract cancel out the losses on the underlying
Though the protection payments totaling $1 million
debt.[14]
reduce investment returns for the pension fund, its
There are other ways to eliminate or reduce the risk of
risk of loss due to Risky Corp defaulting on the bond
default. The bank could sell (that is, assign) the loan
is eliminated.
outright or bring in other banks as participants. How If Risky Corporation defaults on its debt three years
ever, these options may not meet the banks needs. Coninto the CDS contract, the pension fund would stop
sent of the corporate borrower is often required. The
paying the quarterly premium, and Derivative Bank
bank may not want to incur the time and cost to nd loan
would ensure that the pension fund is refunded for its
participants.[10]
loss of $10 million minus recovery (either by physiIf both the borrower and lender are well-known and the
cal or cash settlement see Settlement below). The
market (or even worse, the news media) learns that the
pension fund still loses the $600,000 it has paid over
bank is selling the loan, then the sale may be viewed
three years, but without the CDS contract it would
as signaling a lack of trust in the borrower, which could
have lost the entire $10 million minus recovery.
severely damage the banker-client relationship. In addition, the bank simply may not want to sell or share the In addition to nancial institutions, large suppliers can use
potential prots from the loan. By buying a credit default a credit default swap on a public bond issue or a basket of
banks wanting to hedge might not nd a ready seller of
protection.[16][32] Speculators also create a more competitive marketplace, keeping prices down for hedgers. A
robust market in credit default swaps can also serve as
a barometer to regulators and investors about the credit
health of a company or country.[32][40]

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CHAPTER 9. CREDIT DERIVATIVES

similar risks as a proxy for its own credit risk exposure on The dierence between CDS spreads and asset swap
receivables.[16][32][44][45]
spreads is called the basis and should theoretically be
Although credit default swaps have been highly criticized close to zero. Basis trades can aim to exploit any diffor their role in the recent nancial crisis, most observers ferences to make risk-free prot.
conclude that using credit default swaps as a hedging device has a useful purpose.[32]
9.3.3
Arbitrage

History

Conception

Forms of credit default swaps had been in existence from

at least the early 1990s,[47] with early trades carried out by
Bankers Trust in 1991.[48] J.P. Morgan & Co. is widely
credited with creating the modern credit default swap
in 1994.[49][50][51] In that instance, J.P. Morgan had extended a $4.8 billion credit line to Exxon, which faced
the threat of $5 billion in punitive damages for the Exxon
Valdez oil spill. A team of J.P. Morgan bankers led by
Blythe Masters then sold the credit risk from the credit
line to the European Bank of Reconstruction and DevelTechniques reliant on this are known as capital structure opment in order to cut the reserves that J.P. Morgan was
arbitrage because they exploit market ineciencies be- required to hold against Exxons default, thus improving
tween dierent parts of the same companys capital struc- its own balance sheet.[52]
ture; i.e., mis-pricings between a companys debt and equity. An arbitrageur attempts to exploit the spread be- In 1997, JPMorgan developed a proprietary product
tween a companys CDS and its equity in certain situa- called BISTRO (Broad Index Securitized Trust Oering)
that used CDS to clean up a banks balance sheet.[49][51]
tions.
The advantage of BISTRO was that it used securitization
For example, if a company has announced some bad news to split up the credit risk into little pieces that smaller inand its share price has dropped by 25%, but its CDS vestors found more digestible, since most investors lacked
spread has remained unchanged, then an investor might EBRDs capability to accept $4.8 billion in credit risk all
expect the CDS spread to increase relative to the share at once. BISTRO was the rst example of what later beprice. Therefore a basic strategy would be to go long on came known as synthetic collateralized debt obligations
the CDS spread (by buying CDS protection) while simul- (CDOs).
taneously hedging oneself by buying the underlying stock.
This technique would benet in the event of the CDS Mindful of the concentration of default risk as one of the
found CDSs
spread widening relative to the equity price, but would causes of the S&L crisis, regulators initially[48]
ability
to
disperse
default
risk
attractive.
In 2000,
lose money if the companys CDS spread tightened relacredit
default
swaps
became
largely
exempt
from
regulative to its equity.
tion by both the U.S. Securities and Exchange CommisAn interesting situation in which the inverse correlation sion (SEC) and the Commodity Futures Trading Combetween a companys stock price and CDS spread breaks mission (CFTC). The Commodity Futures Modernizadown is during a Leveraged buyout (LBO). Frequently tion Act of 2000, which was also responsible for the
this leads to the companys CDS spread widening due Enron loophole,[6] specically stated that CDSs are neito the extra debt that will soon be put on the companys ther futures nor securities and so are outside the remit of
books, but also an increase in its share price, since buyers the SEC and CFTC.[48]
of a company usually end up paying a premium.
Capital Structure Arbitrage is an example of an arbitrage
strategy that uses CDS transactions.[46] This technique relies on the fact that a companys stock price and its CDS
spread should exhibit negative correlation; i.e., if the outlook for a company improves then its share price should
go up and its CDS spread should tighten, since it is less
likely to default on its debt. However if its outlook worsens then its CDS spread should widen and its stock price
should fall.

Another common arbitrage strategy aims to exploit the

Market growth
fact that the swap-adjusted spread of a CDS should trade
closely with that of the underlying cash bond issued by
At rst, banks were the dominant players in the market,
the reference entity. Misalignments in spreads may occur
as CDS were primarily used to hedge risk in connection
due to technical reasons such as:
with its lending activities. Banks also saw an opportunity to free up regulatory capital. By March 1998, the
Specic settlement dierences
global market for CDS was estimated at about $300 billion, with JP Morgan alone accounting for about $50 bil Shortages in a particular underlying instrument
lion of this.[48]
The cost of funding a position
The high market share enjoyed by the banks was soon
Existence of buyers constrained from buying exotic eroded as more and more asset managers and hedge
derivatives.
funds saw trading opportunities in credit default swaps.

9.3. CREDIT DEFAULT SWAP

191

By 2002, investors as speculators, rather than banks

as hedgers, dominated the market.[7][12][44][47] National
banks in the USA used credit default swaps as early as
1996.[43] In that year, the Oce of the Comptroller of
the Currency measured the size of the market as tens of
billions of dollars.[53] Six years later, by year-end 2002,
the outstanding amount was over $2 trillion.[3]
Although speculators fueled the exponential growth,
other factors also played a part. An extended market could not emerge until 1999, when ISDA standardized the documentation for credit default swaps.[54][55][56]
Also, the 1997 Asian Financial Crisis spurred a market
for CDS in emerging market sovereign debt.[56] In addition, in 2004, index trading began on a large scale and
grew rapidly.[12]
The market size for Credit Default Swaps more than doubled in size each year from $3.7 trillion in 2003.[3] By
the end of 2007, the CDS market had a notional value
of $62.2 trillion.[3] But notional amount fell during 2008
as a result of dealer portfolio compression eorts (replacing osetting redundant contracts), and by the end of
2008 notional amount outstanding had fallen 38 percent
to $38.6 trillion.[57]

Proportion of CDSs nominals (lower left) held by United States

banks compared to all derivatives, in 2008Q2. The black disc
represents the 2008 public debt.

around 0.2% of investment grade companies default in

any one year),[61] in most CDS contracts the only payments are the premium payments from buyer to seller.
Thus, although the above gures for outstanding notionals are very large, in the absence of default the net cash
ows are only a small fraction of this total: for a 100 bp
= 1% spread, the annual cash ows are only 1% of the
notional amount.

Explosive growth was not without operational headaches.

On September 15, 2005, the New York Fed summoned
14 banks to its oces. Billions of dollars of CDS
were traded daily but the record keeping was more than
two weeks behind.[58] This created severe risk management issues, as counterparties were in legal and nancial limbo.[12][59] U.K. authorities expressed the same
Regulatory concerns over CDS The market for Credit
concerns.[60]
Default Swaps attracted considerable concern from regulators after a number of large scale incidents in 2008,
starting with the collapse of Bear Stearns.[62]
Market as of 2008

In the days and weeks leading up to Bears collapse, the

banks CDS spread widened dramatically, indicating a
surge of buyers taking out protection on the bank. It has
been suggested that this widening was responsible for the
perception that Bear Stearns was vulnerable, and therefore restricted its access to wholesale capital, which eventually led to its forced sale to JP Morgan in March. An
alternative view is that this surge in CDS protection buyers was a symptom rather than a cause of Bears collapse;
i.e., investors saw that Bear was in trouble, and sought to
hedge any naked exposure to the bank, or speculate on its
collapse.
In September, the bankruptcy of Lehman Brothers
caused a total close to $400 billion to become payable
to the buyers of CDS protection referenced against the
insolvent bank. However the net amount that changed
hands was around $7.2 billion.[63] (The given citation
Composition of the United States 15.5 trillion US dollar CDS does not support either of the two purported facts stated
market at the end of 2008 Q2. Green tints show Prime asset in previous two sentences.). This dierence is due to
CDSs, reddish tints show sub-prime asset CDSs. Numbers fol- the process of 'netting'. Market participants co-operated
lowed by Y indicate years until maturity.
so that CDS sellers were allowed to deduct from their
payouts the inbound funds due to them from their hedgSince default is a relatively rare occurrence (historically ing positions. Dealers generally attempt to remain risk-

192

CHAPTER 9. CREDIT DERIVATIVES

neutral, so that their losses and gains after big events o- for the dealers to limit the expansion of the products that
set each other.
are centrally cleared, and to create barriers to electronic
markets
Also in September American International Group (AIG) trading and smaller dealers making competitive
[70]
in
cleared
products
(Litan
2010:8).
[64]
required
a $85 billion federal loan because it had
been excessively selling CDS protection without hedging
against the possibility that the reference entities might decline in value, which exposed the insurance giant to potential losses over $100 billion. The CDS on Lehman
were settled smoothly, as was largely the case for the
other 11 credit events occurring in 2008 that triggered
payouts.[62] And while it is arguable that other incidents
would have been as bad or worse if less ecient instruments than CDS had been used for speculation and insurance purposes, the closing months of 2008 saw regulators
working hard to reduce the risk involved in CDS transactions.

In 2009 the U.S. Securities and Exchange Commission

granted an exemption for IntercontinentalExchange to
begin guaranteeing credit-default swaps. The SEC exemption represented the last regulatory approval needed
by Atlanta-based Intercontinental.[71] A derivatives analyst at Morgan Stanley, one of the backers for IntercontinentalExchanges subsidiary, ICE Trust in New
York, launched in 2008, claimed that the clearinghouse,
and changes to the contracts to standardize them, will
probably boost activity.[71] IntercontinentalExchanges
subsidiary, ICE Trusts larger competitor, CME Group
Inc., hasnt received an SEC exemption, and agency
In 2008 there was no centralized exchange or clearing spokesman John Nester said he didnt know when a decihouse for CDS transactions; they were all done over the sion would be made.
counter (OTC). This led to recent calls for the market to
open up in terms of transparency and regulation.[65]
Market as of 2009
In November 2008 the Depository Trust & Clearing Corporation (DTCC), which runs a warehouse for CDS trade The early months of 2009 saw several fundamental
conrmations accounting for around 90% of the total changes to the way CDSs operate, resulting from conmarket,[66] announced that it will release market data cerns over the instruments safety after the events of the
on the outstanding notional of CDS trades on a weekly previous year. According to Deutsche Bank managing
basis.[67] The data can be accessed on the DTCCs web- director Athanassios Diplas the industry pushed through
site here:[68]
10 years worth of changes in just a few months. By late
By 2010, Intercontinental Exchange, through its sub- 2008 processes had been introduced allowing CDSs that
sidiaries, ICE Trust in New York, launched in 2008, and oset each other to be cancelled. Along with terminaICE Clear Europe Limited in London, UK, launched tion of contracts that have recently paid out such as those
in July 2009, clearing entities for credit default swaps based on Lehmans, this had by March reduced the face
[72]
(CDS) had cleared more than $10 trillion in credit default value of the market down to an estimated $30 trillion.
swaps (CDS) (Terhune Bloomberg Business Week 2010- The Bank for International Settlements estimates that
07-29).[69] [notes 1] Bloombergs Terhune (2010) explained outstanding derivatives total $708 trillion.[73] U.S. and
how investors seeking high-margin returns use Credit De- European regulators are developing separate plans to stafault Swaps (CDS) to bet against nancial instruments bilize the derivatives market. Additionally there are some
owned by other companies and countries. Interconti- globally agreed standards falling into place in March
nentals clearing houses guarantee every transaction be- 2009, administered by International Swaps and Derivatween buyer and seller providing a much-needed safety tives Association (ISDA). Two of the key changes are:
net reducing the impact of a default by spreading the risk.
ICE collects on every trade.(Terhune Bloomberg Busi- 1. The introduction of central clearing houses, one for
ness Week 2010-07-29).[69] Brookings senior research the US and one for Europe. A clearing house acts as
fellow, Robert E. Litan, cautioned however, valuable the central counterparty to both sides of a CDS transpricing data will not be fully reported, leaving ICEs in- action, thereby reducing the counterparty risk that both
stitutional partners with a huge informational advantage buyer and seller face.
over other traders. He calls ICE Trust a derivatives deal- 2. The international standardization of CDS contracts, to
ers club in which members make money at the expense prevent legal disputes in ambiguous cases where what the
of nonmembers (Terhune citing Litan in Bloomberg Busi- payout should be is unclear.
ness Week 2010-07-29).[69] (Litan Derivatives Dealers
Speaking before the changes went live, Sivan MahadeClub 2010). [70] Actually, Litan conceded that some
van, a derivatives analyst at Morgan Stanley,[71] one of the
limited progress toward central clearing of CDS has been
backers for IntercontinentalExchanges subsidiary, ICE
made in recent months, with CDS contracts between
Trust in New York, launched in 2008, claimed that
dealers now being cleared centrally primarily through one
clearinghouse (ICE Trust) in which the dealers have a sig- In the U.S., central clearing operations began in March
nicant nancial interest (Litan 2010:6). [70] However, 2009, operated by InterContinental Exchange (ICE). A
as long as ICE Trust has a monopoly in clearing, watch key competitor also interested in entering the CDS clearing sector is CME Group.

9.3. CREDIT DEFAULT SWAP

In Europe, CDS Index clearing was launched by IntercontinentalExchanges European subsidiary ICE Clear Europe on July 31, 2009. It launched Single Name clearing
in Dec 2009. By the end of 2009, it had cleared CDS contracts worth EUR 885 billion reducing the open interest
down to EUR 75 billion[74]
By the end of 2009, banks had reclaimed much of their
market share; hedge funds had largely retreated from the
market after the crises. According to an estimate by the
Banque de France, by late 2009 the bank JP Morgan alone
now had about 30% of the global CDS market.[48][74]

193
J.P. Morgan losses
In April 2012, hedge fund insiders became aware that
the market in credit default swaps was possibly being affected by the activities of Bruno Iksil, a trader for J.P.
Morgan Chase & Co., referred to as the London whale
in reference to the huge positions he was taking. Heavy
opposing bets to his positions are known to have been
made by traders, including another branch of J.P. Morgan, who purchased the derivatives oered by J.P. Morgan in such high volume.[76][77] Major losses, $2 billion,
were reported by the rm in May 2012 in relationship to
these trades. The disclosure, which resulted in headlines
in the media, did not disclose the exact nature of the trading involved, which remains in progress. The item traded,
possibly related to CDX IG 9, an index based on the default risk of major U.S. corporations,[78][79] has been described as a derivative of a derivative.[80][81]

Government approvals relating to ICE and its competitor CME The SECs approval for ICE Futures request to be exempted from rules that would prevent it
clearing CDSs was the third government action granted to
Intercontinental in one week. On March 3, its proposed
acquisition of Clearing Corp., a Chicago clearinghouse
owned by eight of the largest dealers in the credit-default
swap market, was approved by the Federal Trade Com- 9.3.4 Terms of a typical CDS contract
mission and the Justice Department. On March 5, 2009,
the Federal Reserve Board, which oversees the clearing- A CDS contract is typically documented under a conrmation referencing the credit derivatives denitions as
house, granted a request for ICE to begin clearing.
published by the International Swaps and Derivatives AsClearing Corp. shareholders including JPMorgan Chase sociation.[82] The conrmation typically species a refer& Co., Goldman Sachs Group Inc. and UBS AG, re- ence entity, a corporation or sovereign that generally, alceived $39 million in cash from Intercontinental in the though not always, has debt outstanding, and a reference
acquisition, as well as the Clearing Corp.s cash on hand obligation, usually an unsubordinated corporate bond or
and a 50-50 prot-sharing agreement with Intercontinen- government bond. The period over which default protectal on the revenue generated from processing the swaps. tion extends is dened by the contract eective date and
scheduled termination date.
SEC spokesperson John Nestor stated
The conrmation also species a calculation agent who
is responsible for making determinations as to successors
and substitute reference obligations (for example necessary if the original reference obligation was a loan that
is repaid before the expiry of the contract), and for performing various calculation and administrative functions
in connection with the transaction. By market convention, in contracts between CDS dealers and end-users, the
dealer is generally the calculation agent, and in contracts
Clearing house member requirements Members of between CDS dealers, the protection seller is generally
the calculation agent.
the Intercontinental clearinghouse ICE Trust (now ICE
Clear Credit) in March 2009 would have to have a net It is not the responsibility of the calculation agent to deterworth of at least $5 billion and a credit rating of A or mine whether or not a credit event has occurred but rather
better to clear their credit-default swap trades. Intercon- a matter of fact that, pursuant to the terms of typical continental said in the statement today that all market partic- tracts, must be supported by publicly available informaipants such as hedge funds, banks or other institutions are tion delivered along with a credit event notice. Typical
open to become members of the clearinghouse as long as CDS contracts do not provide an internal mechanism for
challenging the occurrence or non-occurrence of a credit
they meet these requirements.
A clearinghouse acts as the buyer to every seller and seller event and rather leave the matter to the courts if necesto every buyer, reducing the risk of counterparty default- sary, though actual instances of specic events being dising on a transaction. In the over-the-counter market, puted are relatively rare.
Other proposals to clear credit-default swaps have been
made by NYSE Euronext, Eurex AG and LCH.Clearnet
Ltd. Only the NYSE eort is available now for clearing
after starting on Dec. 22. As of Jan. 30, no swaps had
been cleared by the NYSEs London- based derivatives
exchange, according to NYSE Chief Executive Ocer
Duncan Niederauer.[75]

where credit- default swaps are currently traded, participants are exposed to each other in case of a default. A
clearinghouse also provides one location for regulators to
view traders positions and prices.

CDS conrmations also specify the credit events that will

give rise to payment obligations by the protection seller
and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the

194

CHAPTER 9. CREDIT DERIVATIVES

reference entity and failure to pay with respect to its

direct or guaranteed bond or loan debt. CDS written
on North American investment grade corporate reference entities, European corporate reference entities and
sovereigns generally also include restructuring as a credit
event, whereas trades referencing North American highyield corporate reference entities typically do not.
Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations
that a protection buyer may deliver upon a credit event.
Trading conventions for deliverable obligation characteristics vary for dierent markets and CDS contract types.
Typical limitations include that deliverable debt be a bond
or loan, that it have a maximum maturity of 30 years, that
it not be subordinated, that it not be subject to transfer restrictions (other than Rule 144A), that it be of a standard
currency and that it not be subject to some contingency
before becoming due.
The premium payments are generally quarterly, with maturity dates (and likewise premium payment dates) falling
on March 20, June 20, September 20, and December 20.
Due to the proximity to the IMM dates, which fall on the
third Wednesday of these months, these CDS maturity
dates are also referred to as IMM dates.

9.3.5

Credit default swap and sovereign

debt crisis

Main article: Causes of the European sovereign-debt crisis

The European sovereign debt crisis resulted from a combination of complex factors, including the globalisation
of nance; easy credit conditions during the 20022008
period that encouraged high-risk lending and borrowing
practices; the 20072012 global nancial crisis; international trade imbalances; real-estate bubbles that have
since burst; the 20082012 global recession; scal policy choices related to government revenues and expenses;
and approaches used by nations to bail out troubled banking industries and private bondholders, assuming private
debt burdens or socialising losses. The Credit default
swap market also reveals the beginning of the sovereign
crisis.

Sovereign credit default swap prices of selected European countries (2010-2011). The left axis is basis points, or 100ths of a
percent; a level of 1,000 means it costs $1 million per year to
protect $10 million of debt for ve years.

Monetary Fund negotiators are trying to avoid these triggers as they may jeopardize the stability of major European banks who have been protection writers. (An alternative would be to create new credit default swaps (CDS)
which clearly would pay in the event of any Greek restructuring. The market could then price the spread between these and old (potentially more ambiguous) credit
default swaps (CDS).) This practice is far more typical in
jurisdictions that do not provide protective status to insolvent debtors similar to that provided by Chapter 11 of
Since December 1, 2011 the European Parliament has the United States Bankruptcy Code. In particular, conbanned naked Credit default swap (CDS) on the debt for cerns arising out of Conseco's restructuring in 2000 led
to the credit events removal from North American high
sovereign nations.[83]
yield trades.[84]
The denition of restructuring is quite technical but is
essentially intended to respond to circumstances where
a reference entity, as a result of the deterioration of its
credit, negotiates changes in the terms in its debt with its 9.3.6 Settlement
creditors as an alternative to formal insolvency proceedings (i.e., the debt is restructured). During the current Physical or cash
2012 negotiations regarding the restructuring of Greek
sovereign debt, one important issue is whether the re- As described in an earlier section, if a credit event occurs
structuring will trigger Credit default swap (CDS) pay- then CDS contracts can either be physically settled or cash
ments. European Central Bank and the International settled.[7]

9.3. CREDIT DEFAULT SWAP

Physical settlement: The protection seller pays the
buyer par value, and in return takes delivery of a
debt obligation of the reference entity. For example, a hedge fund has bought $5 million worth of
protection from a bank on the senior debt of a company. In the event of a default, the bank pays the
hedge fund $5 million cash, and the hedge fund must
deliver $5 million face value of senior debt of the
company (typically bonds or loans, which are typically worth very little given that the company is in
default).

195

settlement of all CDS contracts and all physical settlement requests as well as matched limit oers resulting
from the auction are actually settled. According to the
International Swaps and Derivatives Association (ISDA),
who organised them, auctions have recently proved an effective way of settling the very large volume of outstanding CDS contracts written on companies such as Lehman
Brothers and Washington Mutual.[87] Commentator Felix
Salmon, however, has questioned in advance ISDAs ability to structure an auction, as dened to date, to set compensation associated with a 2012 bond swap in Greek
government debt.[88] For its part, ISDA in the leadup to
Cash settlement: The protection seller pays the a 50% or greater haircut for Greek bondholders, issued
buyer the dierence between par value and the mar- an opinion that the bond swap would not constitute a deket price of a debt obligation of the reference entity. fault event.[89]
For example, a hedge fund has bought $5 million
worth of protection from a bank on the senior debt Below is a list of the auctions that have been held since
[90]
of a company. This company has now defaulted, 2005.
and its senior bonds are now trading at 25 (i.e., 25
cents on the dollar) since the market believes that se9.3.7 Pricing and valuation
nior bondholders will receive 25% of the money they
are owed once the company is wound up. ThereThere are two competing theories usually advanced for
fore, the bank must pay the hedge fund $5 million *
the pricing of credit default swaps. The rst, referred
(100%25%) = $3.75 million.
to herein as the 'probability model', takes the present
value of a series of cashows weighted by their probaThe development and growth of the CDS market has bility of non-default. This method suggests that credit
meant that on many companies there is now a much larger default swaps should trade at a considerably lower spread
outstanding notional of CDS contracts than the outstand- than corporate bonds.
ing notional value of its debt obligations. (This is because
many parties made CDS contracts for speculative pur- The second model, proposed by Darrell Due, but also
poses, without actually owning any debt that they wanted by John Hull and Alan White, uses a no-arbitrage apto insure against default.) For example, at the time it led proach.
for bankruptcy on September 14, 2008, Lehman Brothers had approximately $155 billion of outstanding debt[85] Probability model
but around $400 billion notional value of CDS contracts
had been written that referenced this debt.[86] Clearly not Under the probability model, a credit default swap is
all of these contracts could be physically settled, since priced using a model that takes four inputs; this is simthere was not enough outstanding Lehman Brothers debt ilar to the rNPV (risk-adjusted NPV) model used in drug
to fulll all of the contracts, demonstrating the necessity development:
for cash settled CDS trades. The trade conrmation produced when a CDS is traded states whether the contract
the issue premium,
is to be physically or cash settled.
the recovery rate (percentage of notional repaid in
event of default),
Auctions
the credit curve for the reference entity and
When a credit event occurs on a major company on which
the "LIBOR curve.
a lot of CDS contracts are written, an auction (also known
as a credit-xing event) may be held to facilitate settlement of a large number of contracts at once, at a xed If default events never occurred the price of a CDS would
cash settlement price. During the auction process par- simply be the sum of the discounted premium payments.
ticipating dealers (e.g., the big investment banks) submit So CDS pricing models have to take into account the posprices at which they would buy and sell the reference en- sibility of a default occurring some time between the eftitys debt obligations, as well as net requests for physical fective date and maturity date of the CDS contract. For
settlement against par. A second stage Dutch auction is the purpose of explanation we can imagine the case of a
held following the publication of the initial midpoint of one-year CDS with eective date t0 with four quarterly
the dealer markets and what is the net open interest to premium payments occurring at times t1 , t2 , t3 , and t4
deliver or be delivered actual bonds or loans. The nal . If the nominal for the CDS is N and the issue premium
clearing point of this auction sets the nal price for cash is c then the size of the quarterly premium payments is

196

CHAPTER 9. CREDIT DERIVATIVES

N c/4 . If we assume for simplicity that defaults can only The probabilities p1 , p2 , p3 , p4 can be calculated usoccur on one of the payment dates then there are ve ways ing the credit spread curve. The probability of no default
the contract could end:
occurring over a time period from t to t + t decays exponentially with a time-constant determined by the credit
either it does not have any default at all, so the four spread, or mathematically p = exp(s(t)t/(1 R))
premium payments are made and the contract sur- where s(t) is the credit spread zero curve at time t . The
riskier the reference entity the greater the spread and the
vives until the maturity date, or
more rapidly the survival probability decays with time.
a default occurs on the rst, second, third or fourth To get the total present value of the credit default swap we
payment date.
multiply the probability of each outcome by its present
value to give
To price the CDS we now need to assign probabilities
to the ve possible outcomes, then calculate the present
value of the payo for each outcome. The present value No-arbitrage model
of the CDS is then simply the present value of the ve
payos multiplied by their probability of occurring.
In the 'no-arbitrage' model proposed by both Due, and
This is illustrated in the following tree diagram where at Hull-White, it is assumed that there is no risk free areach payment date either the contract has a default event, bitrage. Due uses the LIBOR as the risk free rate,
in which case it ends with a payment of N (1 R) shown whereas Hull and White use US Treasuries as the risk free
in red, where R is the recovery rate, or it survives with- rate. Both analyses make simplifying assumptions (such
out a default being triggered, in which case a premium as the assumption that there is zero cost of unwinding the
payment of N c/4 is made, shown in blue. At either side xed leg of the swap on default), which may invalidate the
of the diagram are the cashows up to that point in time no-arbitrage assumption. However the Due approach
with premium payments in blue and default payments in is frequently used by the market to determine theoretical
red. If the contract is terminated the square is shown with prices.
solid shading.
Under the Due construct, the price of a credit default
swap can also be derived by calculating the asset swap
N(1-R)
spread of a bond. If a bond has a spread of 100, and
the swap spread is 70 basis points, then a CDS contract
1-p1
p1
should trade at 30. However there are sometimes technical reasons why this will not be the case, and this may
or may not present an arbitrage opportunity for the canny
investor. The dierence between the theoretical model
N(1-R)
and the actual price of a credit default swap is known as
the basis.
Nc/4
1-p2

p2

9.3.8 Criticisms
Nc/4

N(1-R)
1-p3

N(1-R)
Nc/4 Nc/4

Critics of the huge credit default swap market have

Nc/4 Nc/4
claimed that it has been allowed to become too large
p3
without proper regulation and that, because all contracts
are privately negotiated, the market has no transparency.
Furthermore, there have been claims that CDSs exacerbated the 2008 global nancial crisis by hastening
the demise of companies such
as Lehman Brothers and
Nc/4 Nc/4 Nc/4
AIG.[49]
1-p4

p4

In the case of Lehman Brothers, it is claimed that the

widening of the banks CDS spread reduced condence
in the bank and ultimately gave it further problems that
it was not able to overcome. However, proponents of the
Nc/4
Nc/4
Nc/4
CDS market argue that thisNc/4
confuses
cause
and eect;
Nc/4 Nc/4 Nc/4
CDS spreads simply reected the reality that the comThe probability of surviving over the interval ti1 to ti pany was in serious trouble. Furthermore, they claim that
without a default payment is pi and the probability of the CDS market allowed investors who had counterparty
a default being triggered is 1 pi . The calculation of risk with Lehman Brothers to reduce their exposure in the
present value, given discount factor of 1 to 4 is then
case of their default.

9.3. CREDIT DEFAULT SWAP

Credit default swaps have also faced criticism that they
contributed to a breakdown in negotiations during the
2009 General Motors Chapter 11 reorganization, because
certain bondholders might benet from the credit event of
a GM bankruptcy due to their holding of CDSs. Critics
speculate that these creditors had an incentive to push for
the company to enter bankruptcy protection.[91] Due to
a lack of transparency, there was no way to identify the
protection buyers and protection writers.[92]
It was also feared at the time of Lehmans bankruptcy
that the $400 billion notional of CDS protection which
had been written on the bank could lead to a net payout
of $366 billion from protection sellers to buyers (given
the cash-settlement auction settled at a nal price of
8.625%) and that these large payouts could lead to further bankruptcies of rms without enough cash to settle
their contracts.[93] However, industry estimates after the
auction suggest that net cashows were only in the region
of $7 billion.[93] because many parties held osetting positions. Furthermore, CDS deals are marked-to-market
frequently. This would have led to margin calls from buyers to sellers as Lehmans CDS spread widened, reducing
the net cashows on the days after the auction.[87]
Senior bankers have argued that not only has the CDS
market functioned remarkably well during the nancial
crisis; that CDS contracts have been acting to distribute
risk just as was intended; and that it is not CDSs themselves that need further regulation but the parties who
trade them.[94]

197
ers debt, which amounted to somewhere between $150
to $360 billion.[96]
Despite Buetts criticism on derivatives, in October
2008 Berkshire Hathaway revealed to regulators that
it has entered into at least $4.85 billion in derivative
transactions.[97] Buett stated in his 2008 letter to shareholders that Berkshire Hathaway has no counterparty risk
in its derivative dealings because Berkshire require counterparties to make payments when contracts are inititated,
so that Berkshire always holds the money.[98] Berkshire
Hathaway was a large owner of Moodys stock during the
period that it was one of two primary rating agencies for
subprime CDOs, a form of mortgage security derivative
dependent on the use of credit default swaps.
The monoline insurance companies got involved with
writing credit default swaps on mortgage-backed CDOs.
Some media reports have claimed this was a contributing
factor to the downfall of some of the monolines.[99][100]
In 2009 one of the monolines, MBIA, sued Merrill
Lynch, claiming that Merill had misrepresented some of
its CDOs to MBIA in order to persuade MBIA to write
CDS protection for those CDOs.[101][102][103]
Systemic risk

During the 2008 nancial crisis, counterparties became

subject to a risk of default, amplied with the involvement
of Lehman Brothers and AIG in a very large number of
CDS transactions. This is an example of systemic risk,
Some general criticism of nancial derivatives is also
risk which threatens an entire market, and a number of
relevant to credit derivatives. Warren Buett famously
commentators have argued that size and deregulation of
described derivatives bought speculatively as nancial
the CDS market have increased this risk.
weapons of mass destruction. In Berkshire Hathaway's
annual report to shareholders in 2002, he said, Un- For example, imagine if a hypothetical mutual fund had
less derivatives contracts are collateralized or guaranteed, bought some Washington Mutual corporate bonds in
their ultimate value also depends on the creditworthi- 2005 and decided to hedge their exposure by buying CDS
ness of the counterparties to them. In the meantime, protection from Lehman Brothers. After Lehmans dethough, before a contract is settled, the counterparties fault, this protection was no longer active, and Washingrecord prots and lossesoften huge in amountin their ton Mutuals sudden default only days later would have led
current earnings statements without so much as a penny to a massive loss on the bonds, a loss that should have been
changing hands. The range of derivatives contracts is lim- insured by the CDS. There was also fear that Lehman
ited only by the imagination of man (or sometimes, so it Brothers and AIGs inability to pay out on CDS contracts
would lead to the unraveling of complex interlinked chain
seems, madmen).[95]
of CDS transactions between nancial institutions.[104] So
To hedge the counterparty risk of entering a CDS transacfar this does not appear to have happened, although some
tion, one practice is to buy CDS protection on ones councommentators have noted that because the total CDS exterparty. The positions are marked-to-market daily and
posure of a bank is not public knowledge, the fear that
collateral pass from buyer to seller or vice versa to proone could face large losses or possibly even default themtect both parties against counterparty default, but money
selves was a contributing factor to the massive decrease
does not always change hands due to the oset of gains
in lending liquidity during September/October 2008.[105]
and losses by those who had both bought and sold protection. Depository Trust & Clearing Corporation, the Chains of CDS transactions can arise from a practice
[106]
Here, company B may buy a CDS
clearinghouse for the majority of trades in the US over- known as netting.
the-counter market, stated in October 2008 that once o- from company A with a certain annual premium, say 2%.
setting trades were considered, only an estimated $6 bil- If the condition of the reference company worsens, the
lion would change hands on October 21, during the set- risk premium rises, so company B can sell a CDS to comtlement of the CDS contracts issued on Lehman Broth- pany C with a premium of say, 5%, and pocket the 3%
dierence. However, if the reference company defaults,

198
company B might not have the assets on hand to make
good on the contract. It depends on its contract with company A to provide a large payout, which it then passes
along to company C.

CHAPTER 9. CREDIT DERIVATIVES

The thrust of this criticism is that Naked CDS are indistinguishable from gambling wagers, and thus give rise in
all instances to ordinary income, including to hedge fund
managers on their so-called carried interests,[114] and that
the IRS exceeded its authority with the proposed regulations. This is evidenced by the fact that Congress conrmed that certain derivatives, including CDS, do constitute gambling when, in 2000, to allay industry fears
that they were illegal gambling,[115] it exempted them
from any State or local law that prohibits or regulates
gaming.[116] While this decriminalized Naked CDS, it
did not grant them relief under the federal gambling tax
provisions.

The problem lies if one of the companies in the chain

fails, creating a "domino eect" of losses. For example,
if company A fails, company B will default on its CDS
contract to company C, possibly resulting in bankruptcy,
and company C will potentially experience a large loss
due to the failure to receive compensation for the bad debt
it held from the reference company. Even worse, because
CDS contracts are private, company C will not know that
its fate is tied to company A; it is only doing business with
company B.
The accounting treatment of CDS used for hedging may
As described above, the establishment of a central ex- not parallel the economic eects and instead, increase
change or clearing house for CDS trades would help to volatility. For example, GAAP generally require that
solve the domino eect problem, since it would mean CDS be reported on a mark to market basis. In contrast,
that all trades faced a central counterparty guaranteed by assets that are held for investment, such as a commercial
loan or bonds, are reported at cost, unless a probable and
a consortium of dealers.
signicant loss is expected. Thus, hedging a commerSee also: Category:Systemic risk
cial loan using a CDS can induce considerable volatility
into the income statement and balance sheet as the CDS
changes value over its life due to market conditions and
due to the tendency for shorter dated CDS to sell at lower
prices than longer dated CDS. One can try to account for
9.3.9 Tax and accounting issues
the CDS as a hedge under FASB 133[117] but in practice
that can prove very dicult unless the risky asset owned
The U.S federal income tax treatment of CDS is uncertain by the bank or corporation is exactly the same as the Ref(Nirenberg and Kopp 1997:1, Peaslee & Nirenberg 2008- erence Obligation used for the particular CDS that was
07-21:129 and Brandes 2008).[107][108][109] [notes 2] Com- bought.
mentators have suggested that, depending on how they
are drafted, they are either notional principal contracts or
options for tax purposes,(Peaslee & Nirenberg 2008-0721:129).[108] but this is not certain. There is a risk of having CDS recharacterized as dierent types of nancial 9.3.10 LCDS
instruments because they resemble put options and credit
guarantees. In particular, the degree of risk depends on A new type of default swap is the loan only credit dethe type of settlement (physical/cash and binary/FMV) fault swap (LCDS). This is conceptually very similar to a
and trigger (default only/any credit event) (Nirenberg & standard CDS, but unlike vanilla CDS, the underlying
Kopp 1997:8).[107] And, as noted below, the appropriate protection is sold on syndicated secured loans of the Reftreatment for Naked CDS may be entirely dierent.
erence Entity rather than the broader category of Bond
If a CDS is a notional principal contract, pre-default pe- or Loan. Also, as of May 22, 2007, for the most widely
riodic and nonperiodic payments on the swap are de- traded LCDS form, which governs North American sinductible and included in ordinary income.[110] If a pay- gle name and index trades, the default settlement method
ment is a termination payment, or a payment received on for LCDS shifted to auction settlement rather than physia sale of the swap to a third party, however, its tax treat- cal settlement. The auction method is essentially the same
ment is an open question.[110] In 2004, the Internal Rev- that has been used in the various ISDA cash settlement
enue Service announced that it was studying the charac- auction protocols, but does not require parties to take any
terization of CDS in response to taxpayer confusion.[111] additional steps following a credit event (i.e., adherence
As the outcome of its study, the IRS issued proposed reg- to a protocol) to elect cash settlement. On October 23,
rst ever LCDS auction was held for Movie
ulations in 2011 specically classifying CDS as notional 2007, the
[118]
Gallery.
principal contracts, and thereby qualifying such termination and sale payments for favorable capital gains tax
treatment.[112] These proposed regulationswhich are
yet to be nalizedhave already been subject to criticism
at a public hearing held by the IRS in January 2012,[113]
as well as in the academic press,[114] insofar as that classication would apply to Naked CDS.

Because LCDS trades are linked to secured obligations

with much higher recovery values than the unsecured
bond obligations that are typically assumed the cheapest to deliver in respect of vanilla CDS, LCDS spreads
are generally much tighter than CDS trades on the same
name.

9.3. CREDIT DEFAULT SWAP

9.3.11

See also

Bucket shop (stock market)

Constant maturity credit default swap
Credit default option
Credit default swap index
CUSIP Linked MIP Code, reference entity code
Inside Job (2010 lm), an Oscar-winning documentary lm about the nancial crisis of 20072010 by
Charles H. Ferguson
Recovery swap
Toxic security
IntercontinentalExchange

9.3.12

Notes

[1] Intercontinental Exchanges closest rival as credit default

swaps (CDS) clearing houses, CME Group (CME) cleared
$192 million in comparison to ICEs $10 trillion (Terhune
Bloomberg Business Week 2010-07-29).
[2] The link is to an earlier version of this paper.

9.3.13

References

[1] Simkovic, Michael, Leveraged Buyout Bankruptcies, the

Problem of Hindsight Bias, and the Credit Default Swap
Solution, Columbia Business Law Review (Vol. 2011, No.
1, pp. 118), 2011.
[2] Pollack, Lisa (January 5, 2012). Credit event auctions:
Why do they exist?". FT Alphaville. Retrieved January 5,
2012.
[3] Chart; ISDA Market Survey; Notional amounts outstanding at year-end, all surveyed contracts, 1987present (PDF). International Swaps and Derivatives Association (ISDA). Retrieved April 8, 2010.
[4] ISDA 2010 MID-YEAR MARKET SURVEY. Latest
available a/o 2012-03-01.
[5] ISDA: CDS Marketplace :: Market Statistics. Isdacdsmarketplace.com. December 31, 2010. Retrieved March
12, 2012.
[6] Ki, John; Jennifer Elliott; Elias Kazarian; Jodi Scarlata;
Carolyne Spackman (November 2009). Credit Derivatives: Systemic Risks and Policy Options (PDF). International Monetary Fund: IMF Working Paper (WP/09/254).
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[7] Weistroer, Christian; Deutsche Bank Research (December 21, 2009). Credit default swaps: Heading towards
a more stable system (PDF). Deutsche Bank Research:
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199

[8] Simkovic, Michael, Secret Liens and the Financial Crisis

of 2008.
[9] Sirri, Erik, Director, Division of Trading and Markets
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2, 2010.
[10] Partnoy, Frank; David A. Skeel, Jr. (2007). The Promise
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[11] Media Statement: DTCC Policy for Releasing CDS Data
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in: |date= (help)
[13] International Swaps and Derivatives Association, Inc.
(ISDA). 24. Product description: Credit default swaps.
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represents participants in the privately negotiated derivatives industry
[14] Federal Reserve Bank of Atlanta (April 14, 2008). Did
You Know? A Primer on Credit Default Swaps. Financial update 21 (2). Retrieved March 31, 2010.
[15] Kopecki, Dawn; Shannon D. Harrington (July 24, 2009).
Banning Naked Default Swaps May Raise Corporate
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[17] CFA Institute. (2008). Derivatives and Alternative Investments. pg G-11. Boston: Pearson Custom Publishing.
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[18] Cox, Christopher, Chairman, U.S. Securities and Exchange Commission. Testimony Concerning Turmoil in
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[19] Garbowski, Mark (October 24, 2008). United States:
Credit Default Swaps: A Brief Insurance Primer. Retrieved November 3, 2008. like insurance insofar as the
buyer collects when an underlying security defaults ... unlike insurance, however, in that the buyer need not have
an insurable interest in the underlying security
[20] Morgenson, Gretchen (August 10, 2008). Credit default swap market under scrutiny. Retrieved November
3, 2008. If a default occurs, the party providing the credit
protection the seller must make the buyer whole on
the amount of insurance bought.

200

[21] Frielink, Karel (August 10, 2008). Are credit default

swaps insurance products?". Retrieved November 3,
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under a CDS, there is some risk of breach of insurance
regulations for the manager.... There is no Netherlands
Antilles case law or literature available which makes clear
whether a CDS constitutes the conducting of insurance
business under Netherlands Antilles law. However, if certain requirements are met, credit derivatives do not qualify
as an agreement of (non-life) insurance because such an
arrangement would in those circumstances not contain all
the elements necessary to qualify it as such.
[22] http://chicagofed.org/webpages/publications/
understanding_derivatives/index.cfm
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[24] Gensler, Gary, Chairman Commodity Futures Trading Commission (March 9, 2010). Keynote Address
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[25] Surveys & Market Statistics. International Swaps
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[26] Regular OTC Derivatives Market Statistics. Bank for
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[28] The Trade Information Warehouse (Warehouse) is the
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[29] Publications: OCCs Quarterly Report on Bank Derivatives Activities. Oce of the Comptroller of the Currency. Retrieved April 20, 2010.
[30] Lucas, Douglas; Laurie S. Goodman; Frank J. Fabozzi
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swaps. Financial Times. Retrieved April 24, 2010.

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|date= (help)
[45] Miller, Ken (Spring 2009). Using Letters Of Credit,
Credit Default Swaps And Other Forms of Credit Enhancements in Net Lease Transactions (PDF). Virginia
Law & Business Review 4 (1): 6978, 80. Retrieved April
15, 2010. the use of an exotic credit default swap (called
a Net Lease CDS), which eectively hedges tenant credit
risk but at a substantially higher price than a vanilla swap.
[46] Chatiras, Manolis, and Barsendu Mukherjee. Capital
Structure Arbitrage: Investigation using Stocks and High
Yield Bonds. Amherst, MA: Center for International Securities and Derivatives Markets, Isenberg School of Management, University of Massachusetts, Amherst, 2004.
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[47] Smithson, Charles; David Mengle (Fall 2006). The
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of Applied Corporate Finance (Morgan Stanley) 18 (4):
5460. Retrieved April 8, 2010.
[48] Tett, Gillian (2009). Fools Gold: How Unrestrained
Greed Corrupted a Dream, Shattered Global Markets and
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[49] Philips, Matthew (September 27, 2008). The Monster

That Ate Wall Street. Newsweek. Retrieved April 7,
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[66] Bowers, Simon (November 5, 2008). Banks hit back at

derivatives criticism. The Guardian (London). Retrieved
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[50] Lanchester, John (June 1, 2009). Outsmarted. New

Yorker. Retrieved April 7, 2010.

[67] Harrington, Shannon D. (November 5, 2008). CreditDefault Swaps on Italy, Spain Are Most Traded (Update1)". Bloomberg. Retrieved August 27, 2010.

[51] Tett, Gillian. The Dream Machine: Invention of Credit

Derivatives. Financial Times. March 24, 2006. Retrieved March 17, 2009.
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[53] Simon, Ellen (October 20, 2008). Meltdown 101: What
are credit default swaps?". USA Today. Retrieved April
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[54] Remarks by Chairman Alan Greenspan Risk Transfer
and Financial Stability To the Federal Reserve Bank of
Chicagos Forty-rst Annual Conference on Bank Structure, Chicago, Illinois (via satellite) May 5, 2005. Federal Reserve Board. May 5, 2005. Retrieved April 8,
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[55] McDermott, Robert (December/January 1997). The
Long Awaited Arrival of Credit Derivatives. Derivatives
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values in: |date= (help)
[56] Ranciere, Romain G. (April 2002). Credit Derivatives in
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[68] DTCC " DTCC Deriv/SERV Trade Information Warehouse Reports. Dtcc.com. Retrieved August 27, 2010.
[69] Chad Terhune (July 29, 2010). ICEs Jerey Sprecher:
The Sultan of Swaps. Bloomberg Business Week. Retrieved February 15, 2013.
[70] Robert E. Litan (April 7, 2010). The Derivatives Dealers Club and Derivatives Markets Reform: A Guide for
Policy Makers, Citizens and Other Interested Parties
(PDF). Brookings Institute.
[71] IntercontinentalExchange gets SEC exemption: The
exchange will begin clearing credit-default swaps next
week. Bloomberg News. March 7, 2009.
[72] Van Duyn, Aline. Worries Remain Even After CDS
Clean-Up. The Financial Times. Retrieved March 12,
2009.
[73] Monetary and Economic Department. OTC derivatives
market activity in the rst half of 2011 (PDF). Bank for
International Settlements. Retrieved Dec 15, 2011.
[74] Report Center - Data. ICE. Retrieved March 12, 2012.

[57] ISDA Market Survey, Year-End 2008. Isda.org. Retrieved August 27, 2010.

[75] Leising, Matthew; Harrington, Shannon D (March 6,

2009). Intercontinental to Clear Credit Swaps Next
Week. Bloomberg. Retrieved March 12, 2009.

[58] Atlas, Riva D. (September 16, 2005). Trying to Put

Some Reins on Derivatives. New York Times. Retrieved
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[76] Zuckerman, Gregory; Burne, Katy (April 6, 2012).

"'London Whale' Rattles Debt Market. The Wall Street
Journal.

[59] Weithers, Tim (Fourth Quarter 2007). Credit Derivatives, Macro Risks, and Systemic Risks (PDF). Economic
Review (FRB Atlanta) 92 (4): 4369. Retrieved April 9,
2010. Check date values in: |date= (help)

[77] Azam Ahmed (May 15, 2012). As One JPMorgan Trader Sold Risky Contracts, Another One Bought
Them. The New York Times. Retrieved May 16, 2012.

[60] The level of outstanding credit-derivative trade conrmations presents operational and legal risks for rms (PDF).
Financial Risk Outlook 2006. The Financial Services Authority. Retrieved April 8, 2010.
[61] Default Rates. Efalken.com. Retrieved August 27,
2010.
[62] Colin Barr (March 16, 2009). The truth about credit default swaps. CNN / Fortune. Retrieved March 27, 2009.
[63] Bad news on Lehman CDS. Ft.com. October 11, 2008.
Retrieved August 27, 2010.
[64] http://www.reuters.com/article/2008/09/18/
us-derivatives-credit-idUSN1837154020080918
[65] Testimony Concerning Turmoil in U.S. Credit Markets: Recent Actions Regarding Government Sponsored
Entities, Investment Banks and Other Financial Institutions (Christopher Cox, September 23, 2008)". Sec.gov.
September 23, 2008. Retrieved August 27, 2010.

[78] Katy Burne (April 10, 2012). Making Waves Against

'Whale'". The Wall Street Journal. Retrieved May 16,
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[79] Farah Khalique (May 11, 2012). Chart of the Day: London Whale trading. Financial News. Retrieved May 16,
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[80] Crony Capitalism: After Lobbying Against New Financial Regulations, JPMorgan Loses $2B in Risky Bet.
Democracy Now!. May 15, 2012. Retrieved May 16,
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[81] Jessica Silver-Greenberg; Peter Eavis (May 10, 2012).
JPMorgan Discloses $2 Billion in Trading Losses. The
New York Times. Retrieved May 16, 2012.
[82] 2003 Credit Derivatives Denitions. Isda.org. Retrieved August 27, 2010.
[83] Euro-Parliament bans naked Credit Default Swaps.
EUbusiness. Nov 16, 2011. Retrieved Nov 26, 2011.

202

CHAPTER 9. CREDIT DERIVATIVES

[84] Financewise.com

[104] Investing Daily (September 16, 2008). AIG, the Global

Financial System and Investor Anxiety. Kciinvest[85] Settlement Auction for Lehman CDS: Surprises
ing.com. Retrieved August 27, 2010.
Ahead?". Seeking Alpha. October 10, 2008. Retrieved
August 27, 2010.
[105] Sam Fleming, Daily Mail16 October 2008, 12:00am Data
(October 16, 2008). Banks caught in jaws of CDS men[86] In depth: Fed to hold CDS clearance talks. Ft.com. Reace. This is Money. Retrieved August 27, 2010.
trieved August 27, 2010.
[87] Isda Ceo Notes Success Of Lehman Settlement, Addresses Cds Misperceptions. Isda.org. October 21,
2008. Retrieved August 27, 2010.

[106] Unregulated Credit Default Swaps Led to Weakness. All

things Considered, National Public Radio. Oct 31, 2008.

[107] Nirenberg, David Z.; Steven L. Kopp. Credit Derivatives: Tax Treatment of Total Return Swaps, Default
[88] Salmon, Felix (March 1, 2012). How Greeces Default
Swaps, and Credit-Linked Notes. Journal of Taxation
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date=August 1997.
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[89] Watts, William L., No Greek CDS payout on swap, panel [108] Peaslee, James M.; David Z. Nirenberg (November 26,
2007). Federal Income Taxation of Securitization Transsays, MarketWatch, March 1, 2012. Retrieved 2012-03actions: Cumulative. Supplement No. 7. p. 83. Re01.
trieved July 28, 2008.
[90] Markit. Tradeable Credit Fixings. Retrieved 2008-10-28.
[109] Ari J. Brandes (July 21, 2008). A Better Way to Under[91] Gannett and the Side Eects of Default Swaps. The New
stand Credit Default Swaps. Tax Notes.
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[110] Id.
[92] Protecting GM from Credit Default Swap Holders.
Firedoglake. May 14, 2009. Retrieved July 14, 2009.
[111] Peaslee & Nirenberg, 89.
[93] "/ Financials Lehman CDS pay-outs higher than ex[112] I.R.S. REG-111283-11, IRB 2011-42 (Oct. 17, 2011).
pected. Ft.com. October 10, 2008. Retrieved August
27, 2010.
[113] Diane Freda, I.R.S. Proposed Rules Mistakenly Classify
Section 1256 Contracts, I.R.S. Witnesses Say, DAILY
[94] Daily Brief. October 28, 2008. Retrieved November 6,
TAX REP. (BNA) No. 12 at G-4 (Jan. 20, 2012).
2008.
[95] Buett, Warren (February 21, 2003). Berkshire Hath- [114] James Blakey, Tax Naked Credit Default Swaps for What
They Are: Legalized Gambling, 8 U. Mass. L. Rev. 136
away Inc. Annual Report 2002 (PDF). Berkshire Hath(2013).
away. Retrieved September 21, 2008.
[96] Olsen, Kim Asger, Pay-up time for Lehman swaps, [115] See Hearing to Review the Role of Credit Derivatives in
the U.S. Economy, Before H. Comm. on Agriculture, at 4
atimes.com, October 22, 2008.
(Nov. 20, 2008) (statement of Eric Dinallo, Superinten[97] Holm, Erik (November 21, 2008). Berkshire Asked by
dent of New York State Ins. Dept.) (declaring that [w]ith
SEC in June for Derivative Data (Update1)". Bloomberg.
the proliferation of various kinds of derivatives in the late
Retrieved August 27, 2010.
20th Century came legal uncertainty as to whether certain
derivatives, including credit default swaps, violated state
[98] Buett, Warren. Berkshire Hathaway Inc. Annual Rebucket shop and gambling laws. [The Commodity Futures
port 2008 (PDF). Berkshire Hathaway. Retrieved DeModernization Act of 2000] created a safe harbor by . . .
cember 21, 2009.
preempting state and local gaming and bucket shop laws .
. .) available at http://www.dfs.ny.gov/about/speeches_
[99] Ambac, MBIA Lust for CDO Returns Undercut AAA
ins/sp0811201.pdf.
Success (Update2) , Christine Richard, bloomberg, jan
22, 2008. Retrieved 2010 4 29.
[116] Commodity Futures Modernization Act of 2000, H.R.
5660, 106th Cong. 117(e)(2).
[100] Credit Default Swaps: Monolines faces litigious and costly
endgame, Aug 2008, Louise Bowman, euromoney.com.
[117] FASB 133. Fasb.org. June 15, 1999. Retrieved August
Retrieved 2010 4 29.
27, 2010.
[101] Supreme Court of New York County (April 2009).
MBIA Insurance Co.
v Merrill Lynch (PDF). [118] Final Results of the Movie Gallery Auction, October 23,
2007. (archived 2009)
mbia.com. Retrieved 2010-04-23.
[102] MBIA Sues Merrill Lynch , Wall Street Journal, Serena
Ng, 2009 May 1. Retrieved 2010 4 23.
[103] UPDATE 1-Judge dismisses most of MBIAs suit vs Merrill Apr 9, 2010, Reuters, Edith Honan, ed. Gerald E.
McCormick

9.3.14 External links

Interactive data visualizations of 680 Credit Default
Swaps (Sovereign, Corporate, Financial) and indices

9.3. CREDIT DEFAULT SWAP

203

Barroso considers ban on speculation with ban- News

ning purely speculative naked sales on credit default
swaps of sovereign debt
Zweig, Phillip L. (July 1997), BusinessWeek New
ways to dice up debt - Suddenly, credit derivatives Systemic Counterparty Confusion: Credit Default
deals that spread credit risk--are surging
Swaps Demystied. Derivative Dribble. October
23, 2008.
Goodman, Peter (Oct 2008) New York Times The
spectacular boom and calamitous bust in derivatives
CBS '60 minutes video on CDS
trading
2003 ISDA Credit Derivatives Template.
Pulliam, Susan and Ng, Serena (January 18, 2008),
International Swaps and Derivatives AssociaWall Street Journal: "Default Fears Unnerve Martion
kets"
Understanding Derivatives: Markets and Infrastuc Das, Satayjit (February 5, 2008), Financial Times:
ture Federal Reserve Bank of Chicago, Financial
"CDS market may create added risks"
Markets Group
BIS - Regular Publications. Bank for International
Settlements.
A Beginners Guide to Credit Derivatives - Nomura
International Probability.net
A billion-dollar game for bond managers.
Financial Times.
Due, Darrell. Credit Swap Valuation. Stanford
Graduate School of Business.
CiteSeerX:
10.1.1.139.4044.
John C. Hull and Alan White. Valuing Credit
Default Swaps I: No Counterparty Default Risk.
University of Toronto.
Hull, J. C. and A. White, Valuing Credit Default Swaps II: Modeling Default Correlations.
Smartquant.com
Elton et al., Explaining the rate spread on corporate
bonds
Warren Buett on Derivatives - Excerpts from the
Berkshire Hathaway annual report for 2002. ntools.com
The Real Reason for the Global Financial Crisis.
Financial Sense Archive
Demystifying the Credit Crunch. Private Equity
Council.
The AIG Bailout William Sjostrom, Jr.
Standard CDS Pricing Model Source Code - ISDA
and Markit. CDSModel.com
List of CDS premiums of various countries in
English translation from German
Calculators for Credit Default Swap. QuantCalc,
Online Financial Math Calculator
Calculators for Credit Default Swap with hazard
rate. QuantCalc, Online Financial Math Calculator

Morgenson, Gretchen (February 17, 2008), New

York Times: "Arcane Market is Next to Face Big
Credit Test"
March 17, 2008 Credit Default Swaps: The Next
Crisis?, Time
Schwartz, Nelson D. and Creswell, Julie (March 23,
2008), New York Times: "Who Created This Monster?"
Evans, David (May 20, 2008), Bloomberg: "Hedge
Funds in Swaps Face Peril With Rising Junk Bond
Defaults"
van Duyn, Aline (May 28, 2008), Financial Times:
"Moodys issues warning on CDS risks"
Morgenson, Gretchen (June 1, 2008), New York
Times: "First Comes the Swap. Then Its the
Knives."
Kelleher, James B. (September 18, 2008), Reuters:
"Buetts 'time bomb' goes o on Wall Street."
Morgenson, Gretchen (September 27, 2008), New
York Times: "Behind Insurers Crisis, Blind Eye to a
Web of Risk"
Varchaver, Nicholas and Benner, Katie (Sep 2008),
Fortune Magazine: "The $55 Trillion Question" - on
CDS spotlight during nancial crisis.
Dizard, John (October 23, 2006). A billion dollar game. Financial Times. Retrieved October 19,
2008.
October 19, 2008, Portfolio.com: "Why the CDS
Market Didn't Fail" Analyzes the CDS markets performance in the Lehman Bros. bankruptcy.
Boumlouka, Makrem (April 8, 2009), Wall Street
Letter: "Credit Default Swap Market: Big Bang?
".

204

CHAPTER 9. CREDIT DERIVATIVES

9.4 Credit linked note

A credit linked note (CLN) is a form of funded credit
derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a
specic credit risk to credit investors. The issuer is not
obligated to repay the debt if a specied event occurs.
This eliminates a third-party insurance provider.
It is issued by a special purpose company or trust, designed to oer investors par value at maturity unless the
referenced entity defaults. In the case of default, the investors receive a recovery rate.
The trust will also have entered into a default swap with
a dealer. In case of default, the trust will pay the dealer
par minus the recovery rate, in exchange for an annual fee
which is passed on to the investors in the form of a higher
yield on their note.
The purpose of the arrangement is to pass the risk of
specic default onto investors willing to bear that risk
in return for the higher yield it makes available. The
CLNs themselves are typically backed by very highly
rated collateral, such as U.S. Treasury securities.
The Italian dairy products giant, Parmalat, notoriously
dressed up its books by creating a credit-linked note for
itself, betting on its own credit worthiness.

a direct investment in the sovereign debt may not be legal

due to domicile restrictions of the country. One instance
would be the local government requiring the purchaser
of debt to have a business oce in the country. Another
instance would be tax restrictions or taris in countries
with NDF currencies. A fund in USD would have diculty repatriating the currency if local restrictions or taxes
made it undesirable. When this occurs, the sell side global
bank purchases the debt and structures it into a derivative note then issued to the client or clients. The client
then owns the issued security which derives its total return
from the underlying instrument. A CDS, credit default
swap, is embedded in the instrument. It can be thought
of as a fully funded total return swap where the underlying asset total return is exchanged for a funding fee as
well as the cost of the issued CLN. From a market risk
perspective owning a CLN is almost identical to owning
the local debt.
However downstream, in the back oce, diculties can
arise from failure to appropriately control the risks associated from the lack of data and compatibility of accounting platforms. The issue stems from the bespoke nature
of the CLN in that it is priced in USD but the underlying asset is denominated in another currency. Secondly,
the sell side may price the CLN based on the issued asset in USD. This in turn does not appropriately reect the
Yield to Maturity of the underlying asset as it approaches
par value at maturity. Thirdly, the underlying asset may
be ination linked, or have periodic paydowns that compound the rst and third issues mentioned before.

In Hong Kong and Singapore, credit-linked notes have

been marketed as "minibonds" and sold to individual investors. After Lehman Brothers, the major issuer of minibond in Hong Kong and Singapore, led for
bankruptcy in September 2008, many retail investors of
minibonds claim that banks and brokers mis-sold mini9.4.3
bonds as low-risk products. Many banks accepted minibonds as collateral for loans and credit facilities.[1]

Notes

[1] HK Hong Kong Gov't seeks to help Lehman minibond investors, International Business Times, 22 September 2008

9.4.1

Explanation

A bank lends money to a company, XYZ, and at the time

of loan issues credit-linked notes bought by investors.
The interest rate on the notes is determined by the credit
risk of the company XYZ. The funds the bank raises by
issuing notes to investors are invested in bonds with low
probability of default. If company XYZ is solvent, the
bank is obligated to pay the notes in full. If company
XYZ goes bankrupt, the note-holders/investors become
the creditor of the company XYZ and receive the company XYZ loan. The bank in turn gets compensated by
the returns on less-risky bond investments funded by issuing credit linked notes.

9.4.2

Emerging Market CLN

The emerging market credit linked note, also sometimes

called a clean, are traded by buy side clients to gain access to local debt markets for several reasons. First is that

Under this structure, the coupon or price of the note is

linked to the performance of a reference asset. It offers borrowers a hedge against credit risk, and gives investors a higher yield on the note for accepting exposure
to a specied credit event.

9.4.4 See also

Credit
Credit derivative
Credit derivative risks
Credit risk
Equity-linked note (ELN)

9.5. COLLATERALIZED DEBT OBLIGATION

205

9.5 Collateralized debt obligation

lion in 2000 to around $500 billion in 2006.[14] From

2004 through 2007, $1.4 trillion worth of CDOs were
[15]
A collateralized debt obligation (CDO) is a type of issued.
structured asset-backed security (ABS).[1] Originally de- Early CDOs were diversied, and might include everyveloped for the corporate debt markets, over time CDOs thing from aircraft lease-equipment debt, manufactured
evolved to encompass the mortgage and mortgage-backed housing loans, to student loans and credit card debt. The
security (MBS) markets.[2]
diversication of borrowers in these multisector CDOs
Like other private label securities backed by assets, a was a selling point, as it meant that if there was a downCDO can be thought of as a promise to pay investors in turn in one industry like aircraft manufacturing and their
like manufactured housa prescribed sequence, based on the cash ow the CDO loans defaulted, other industries
[16]
ing
might
be
unaected.
Another
selling point was that
collects from the pool of bonds or other assets it owns.
CDOs
oered
returns
that
were
sometimes
2-3 percentThe CDO is sliced into tranches, which catch the
age
points
higher
than
corporate
bonds
with
the same
cash ow of interest and principal payments in sequence
[16][17]
credit
rating.
[3]
based on seniority. If some loans default and the cash
collected by the CDO is insucient to pay all of its investors, those in the lowest, most junior tranches suffer losses rst. The last to lose payment from default are Explanations for growth
the safest, most senior tranches. Consequently coupon
payments (and interest rates) vary by tranche with the
Advantages of securitization -- Depository banks
safest/most senior tranches paying the lowest rates and
had incentive to "securitize" loans they originated
the lowest tranches paying the highest rates to compenoften in the form of CDO securitiesbecause this
sate for higher default risk. As an example, a CDO might
removes the loans from their books. The transfer
issue the following tranches in order of safeness: Senior
of these loans (along with related risk) to securityAAA (sometimes known as super senior); Junior AAA;
buying investors banks in return for cash replenishes
AA; A; BBB; Residual.[4]
the banks capital. This enabled them to remain
in compliance with capital requirement laws while
Separate special purpose entitiesrather than the parlending again and generating additional origination
ent investment bankissue the CDOs and pay interest
fees.
to investors. As CDOs developed, some sponsors repackaged tranches into yet another iteration, known as CDOsquared or CDOs of CDOs.[4]
Global demand for xed income investments - From 2000 to 2007 worldwide xed income in[5]
In the early 2000s, CDOs were generally diversied,
vestment (i.e. investments in bonds and other
but by 20062007when the CDO market grew to
conservative securities) roughly doubled in size to
$100s of billionsthis changed. CDO collateral be$70 trillion, yet the supply of relatively safe, incame dominated not by loans, but by lower level (BBB or
come generating investments had not grown as fast,
A) tranches recycled from other asset-backed securities,
which bid up bond prices and drove down inter[6]
whose assets were usually non-prime mortgages. These
est rates.[18][19] Investment banks on Wall Street anCDOs have been called the engine that powered the
swered this demand with nancial innovation such as
mortgage supply chain for nonprime mortgages,[7] and
the mortgage-backed security (MBS) and collaterare credited with giving lenders greater incentive to make
alized debt obligation (CDO), which were assigned
[8]
non-prime loans leading up to the 2007-9 subprime
safe ratings by the credit rating agencies.[19]
mortgage crisis.

9.5.1

Market history

Beginnings
The rst CDO was issued in 1987 by bankers at nowdefunct Drexel Burnham Lambert Inc. for the also
now-defunct Imperial Savings Association.[9] During the
1990s the collateral of CDOs was generally corporate
and emerging market bonds and bank loans.[10] After
1998 multi-sector CDOs were developed by Prudential
Securities,[11] but CDOs remained fairly obscure until after 2000.[12] In 2002 and 2003 CDOs had a setback when
rating agencies were forced to downgrade hundreds of
the securities,[13] but sales of CDOs grewfrom $69 bil-

Low interest rates -- Fears of deation, the bursting of the dot-com bubble, a U.S. recession, and
the U.S. trade decit kept interest rates low globally from 2000 to 2004-5, according to Economist
Mark Zandi.[20] The low yield of the safe US Treasury bonds created demand by global investors for
subprime mortgage-backed CDOs with their relatively high-yields but credit ratings as high as the
Treasuries. This search for yield by global investors
caused many to purchase CDOs, though they lived to
regret trusting the credit rating agencies ratings.[21]
Pricing models -- Gaussian copula models, introduced in 2001 by David X. Li, allowed for the rapid
pricing of CDOs.[22][23]

206

CHAPTER 9. CREDIT DERIVATIVES

The volume of CDOs issued globally crashed during the subprime

crisis but has recovered slightly. (source: SIFMA, Statistics, Structured Finance[24]

Subprime mortgage boom

Main article: Subprime mortgage crisis
See also: Subprime lending and Bear Stearns subprime
mortgage hedge fund crisis
Source: Final Report of the National Commission on the Causes
of the Financial and Economic Crisis in the United States, p.128,
gure 8.1

IMF Diagram of CDO and RMBS

Around 2005, as the CDO market continued to grow,

subprime mortgages began to replace the diversied consumer loans as collateral. By 2004, mortgage-backed securities accounted for more than half of the collateral in
CDOs.[7][25][26][27][28][29] According to the Financial Crisis Inquiry Report, the CDO became the engine that powered the mortgage supply chain,[7] promoting an increase
in demand for mortgage-backed securities without which
lenders would have had less reason to push so hard to
make non-prime loans.[8] CDOs not only bought crucial
tranches of subprime mortgage-backed securities, they
provided cash for the initial funding of the securities.[7]
Between 2003 and 2007, Wall Street issued almost $700
billion in CDOs that included mortgage-backed securities
as collateral.[7] Despite this loss of diversication, CDO
tranches were given the same proportion of high ratings
by rating agencies[30] on the grounds that mortgages were
diversied by region and so uncorrelated[31] though
those ratings were lowered after mortgage holders began
to default.[32][33]
The rise of ratings arbitragei.e. pooling low-rated
tranches to make CDOshelped push sales of CDOs to
about $500 billion in 2006,[14] with a global CDO market of over USD $1.5 trillion.[34] CDO was the fastestgrowing sector of the structured nance market between
2003 and 2006; the number of CDO tranches issued in
2006 (9,278) was almost twice the number of tranches
issued in 2005 (4,706).[35]
CDOs, like mortgage-backed securities, were nanced
with debt, enhancing their prots but also enhancing
losses if the market reversed course.[36]

Securitization markets were impaired during the crisis.

Explanations for growth Subprime mortgages had

been nanced by mortgage-backed securities (MBS).
Like CDOs, MBSs were structured into tranches,

9.5. COLLATERALIZED DEBT OBLIGATION

but issuers of the securities had diculty selling the
more lower level/lower-rated mezzanine tranchesthe
tranches rated somewhere from AA to BB.
[B]ecause most traditional mortgage investors are risk-averse, either because of the
restrictions of their investment charters or business practices, they are interested in buying the
higher-rated segments of the loan stack; as a result, those slices are easiest to sell. The more
challenging task is nding buyers for the riskier
pieces of at the bottom of the pile. The way
mortgage securities are structured, if you cannot nd buyers for the lower-rated slices, the
rest of the pool cannot be sold.[37][38]
To deal with the problem investment bankers recycled
the mezzanine tranches, selling them to underwriters
making more structured securitiesCDOs. Though the
pool that made up the CDO collateral might be overwhelmingly mezzanine tranches, most of the tranches
(70[39] to 80%[40][41] ) of the CDO were rated not BBB,
A-, etc., but triple A. The minority of the tranches that
were mezzanine were often bought up by other CDOs,
concentrating the lower rated tranches still further. (see
chart on The Theory of How the Financial System Created AA-rated Assets out of Subprime Mortgages)
As one journalist (Gretchen Morgenson) put it, CDOs
became the perfect dumping ground for the low-rated
slices Wall Street couldn't sell on its own.[37]
Other factors explaining the popularity of CDOs include:
Growing demand for xed income investments that
started earlier in the decade continued.[18][19] A
global savings glut[42] leading to large capital
inows from abroad helped nance the housing
boom, keeping down US mortgage rates, even after
the Federal Reserve Bank had raised interest rates
to cool o the economy.[43]
Supply generated by hefty fees the CDO industry
earned. According to one hedge fund manager who
became a big investor in CDOs, as much as 40 to
50 percent of the cash ow generated by the assets
in a CDO went to pay the bankers, the CDO manager, the rating agencies, and others who took out
fees. [13] Rating agencies in particularwhose high
ratings of the CDO tranches were crucial to the industry and who were paid by CDO issuersearned
extraordinary prots. Moodys Investors Service,
one of the two biggest rating agencies, could earn
as much as $250,000 to rate a mortgage pool with
$350 million in assets, versus the $50,000 in fees
generated when rating a municipal bond of a similar size. In 2006, revenues from Moodys structured nance division accounted for fully 44%"
of all Moodys sales.[44][45] Moodys operating margins were consistently over 50%, making it one of

207
the most protable companies in existencemore
protable in terms of margins than Exxon Mobil or
Microsoft.[46] Between the time Moodys was spun
o as a public company and February 2007, its stock
rose 340%.[46][47]
Trust in rating agencies. CDO managers didn't always have to disclose what the securities contained
because the contents of the CDO were subject to
change. But this lack of transparency did not affect demand for the securities. Investors weren't so
much buying a security. They were buying a tripleA rating, according to business journalists Bethany
McLean and Joe Nocera.[13]
Financial innovations, such as credit default swaps
and synthetic CDO. Credit default swaps provided
insurance to investors against the possibility of
losses in the value of tranches from default in exchange for premium-like payments, making CDOs
appear to be virtually risk-free to investors.[48]
Synthetic CDOs were cheaper and easier to create than original cash CDOs. Synthetics referenced cash CDOs, replacing interest payments
from MBS tranches with premium-like payments
from credit default swaps. Rather than providing funding for housing, synthetic CDO-buying investors were in eect providing insurance against
mortgage default.[49] If the CDO did not perform per
contractual requirements, one counterparty (typically a large investment bank or hedge fund) had
to pay another.[50] As underwriting standards deteriorated and the housing market became saturated, subprime mortgages became less abundant.
Synthetic CDOs began to ll in for the original cash CDOs. Because more than onein fact
numeroussynthetics could be made to reference
the same original, the amount of money that moved
among market participants increased dramatically.
Crash
In the summer of 2006, the Case-Shiller index of house
prices peaked.[52] In California home prices had more
than doubled since 2000[53] and median house prices in
Los Angeles had risen to ten times the median annual income. To entice the low and moderate income to sign
up for mortgages, down payments, income documentation were often dispensed with and interest and principal
payments were often deferred upon request.[54] Journalist
Michael Lewis gave as an example of unsustainable practices underwriting practices a loan in Bakerseld, California, where a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he
needed to buy a house of $724,000.[54]
As two-year "teaser mortgage rates common with that
made home purchases like this expired, and mortgage
payments skyrocketed. Renancing to lower mortgage

208

CHAPTER 9. CREDIT DERIVATIVES

tions of triple A tranches of Alt-A or subprime mortgagebacked securities suered the same fate. (see Impaired
Securities chart)
Collateralized debt obligations (CDOs) also made up
over half ($542 billion) of the nearly trillion dollars in
losses suered by nancial institutions from 2007 to early
2009.[32]
Criticism

More than half of the highest-rated (Aaa) CDOs were impaired

(losing principal or downgraded to junk status), compared to a
small fraction of similarly rated Subprime and Alt-A mortgagebacked securities. (source: Financial Crisis Inquiry Report [51] )

Prior to the crisis, a few academics, analysts and investors such as Warren Buett (who famously disparaged CDOs and other derivatives as nancial weapons of
mass destruction, carrying dangers that, while now latent,
are potentially lethal[70] ), and the IMF's former chief
economist Raghuram Rajan[71] warned that rather than
reducing risk through diversication, CDOs and other
derivatives spread risk and uncertainty about the value of
the underlying assets more widely.
During and after the crisis, criticism of the CDO market was more vocal. According to the radio documentary Giant Pool of Money, it was the strong demand
for MBS and CDO, that drove down home lending standards. Mortgages were needed for collateral and by approximately 2003, the supply of mortgages originated at
traditional lending standards had been exhausted.[19]

payment was no longer available since it depended on rising home prices.[55] Mezzanine tranches started to lose
value in 2007, by mid year AA tranches were worth only
70 cents on the dollar. By October triple-A tranches
had started to fall.[56] Regional diversication notwithstanding, the mortgage backed securities turned out to be
The head of banking supervision and regulation at the
highly correlated.[10]
Federal Reserve, Patrick Parkinson, termed the whole
Big CDO arrangers like Citigroup, Merrill Lynch and
concept of ABS CDOs, an abomination.[10]
UBS experienced some of the biggest losses, as did In December 2007, journalists Carrick Mollenkamp and
nancial guaranteers such as AIG, Ambac, MBIA.[10]
Serena Ng wrote of a CDO called Norma created by MerAn early indicator of the crisis came in July 2007 when
rill Lynch at the behest of Illinois hedge fund, Magnerating agencies made unprecedented mass downgrades
tar. It was a tailor-made bet on subprime mortgages that
of mortgage-related securities[57] (by the end of 2008
went too far. Janet Tavakoli, a Chicago consultant who
91% of CDO securities were downgraded[58] ), and two
specializes in CDOs said Norma is a tangled hairball of
highly leveraged Bear Stearns hedge funds holding MBSs
risk. When it came to market in March 2007, any savvy
and CDOs collapsed. Investors were informed by Bear
investor would have thrown this...in the trash bin.[72][73]
Stearns that they would get little if any of their money
According to journalists Bethany McLean and Joe Noback.[59][60]
cera, no securities became more pervasive -- or [did]
In October and November the CEOs of Merrill Lynch
more damage than collateralized debt obligations to creand Citigroup resigned after reporting multi-billion dollar
ate the Great Recession.[12]
[61][62][63]
As the global marlosses and CDO downgrades.
ket for CDOs dried up[64][65] the new issue pipeline for Gretchen Morgenson described the securities as a sort of
CDOs slowed signicantly,[66] and what CDO issuance secret refuse heap for toxic mortgages [that] created even
there was usually in the form of collateralized loan obliga- more demand for bad loans from wanton lenders.
tions backed by middle-market or leveraged bank loans,
rather than home mortgage ABS.[67] The CDO collapse
CDOs prolonged the mania, vastly amplihurt mortgage credit available to homeowners since the
fying the losses that investors would suer
bigger MBS market depended on CDO purchases of mezand ballooning the amounts of taxpayer money
zanine tranches.[68][69]
that would be required to rescue companies
like Citigroup and the American International
While non-prime mortgage defaults aected all securiGroup. ...[74]
ties backed by mortgages, CDOs were especially hard hit.
More than half -- $300 billion worthof tranches issued
in 2005, 2006, and 2007 rated most safetriple A -- by In the rst quarter of 2008 alone, credit rating agenrating agencies, were either downgraded to junk status or cies announced 4,485 downgrades of CDOs.[67] At least
lost principal by 2009.[51] In comparison, only small frac- some analysts complained the agencies over-relied on

9.5. COLLATERALIZED DEBT OBLIGATION

209

computer models with imprecise inputs, failed to account

adequately for large risks (like a nationwide collapse of
housing values), and assumed the risk of the low rated
tranches that made up CDOs would be diluted when in
fact the mortgage risks were highly correlated, and when
one mortgage defaulted, many did, aected by the same
nancial events.[32][75]

to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional
lending standards.[21]

They were strongly criticized by economist Joseph

Stiglitz, among others. Stiglitz considered the agencies
one of the key culprits, of the crisis who performed
that alchemy that converted the securities from F-rated
to A-rated. The banks could not have done what they
did without the complicity of the ratings agencies.[76][77]
According to Morgenson the agencies had pretended to
transform dross into gold. [44]

Concept

As usual, the ratings agencies were chronically behind on developments in the nancial
markets and they could barely keep up with the
new instruments springing from the brains of
Wall Streets rocket scientists. Fitch, Moodys,
and S&P paid their analysts far less than the
big brokerage rms did and, not surprisingly
wound up employing people who were often
looking to befriend, accommodate, and impress the Wall Street clients in hopes of getting
hired by them for a multiple increase in pay.
... Their [the rating agencies] failure to recognize that mortgage underwriting standards had
decayed or to account for the possibility that
real estate prices could decline completely undermined the ratings agencies models and undercut their ability to estimate losses that these
securities might generate. [78]
Michael Lewis also pronounced the transformation of
BBB tranches into 80% triple A CDOs as dishonest,
articial and the result of fat fees paid to rating agencies by Goldman Sachs and other Wall Street rms.[79]
Synthetic CDOs were criticized in particular, because of
the diculties to judge (and price) the risk inherent in
that kind of securities correctly. That adverse eect roots
in the pooling and tranching activities on every level of
the derivation.[3]

9.5.2 Concept, structures, varieties

CDOs vary in structure and underlying assets, but the

basic principle is the same. A CDO is a type of assetbacked security. To create a CDO, a corporate entity is
constructed to hold assets as collateral backing packages
of cash ows which are sold to investors.[83] A sequence
in constructing a CDO is:
A special purpose entity (SPE) is designed/constructed to acquire a portfolio of
underlying assets. Common underlying assets
held may include mortgage-backed securities,
commercial real estate bonds and corporate loans.
The SPE issues bonds to investors in exchange for
cash, which are used to purchase the portfolio of underlying assets. Like other ABS private label securities, the bonds are not uniform but issued in layers
called tranches, each with dierent risk characteristics. Senior tranches are paid from the cash ows
from the underlying assets before the junior tranches
and equity tranches. Losses are rst borne by the equity tranches, next by the junior tranches, and nally
by the senior tranches.[84]
A common analogy compares the cash ow from the
CDOs portfolio of securities (say mortgage payments
from mortgage-backed bonds) to water owing into cups
of the investors where senior tranches were lled rst and
overowing cash owed to junior tranches, then equity
tranches. If a large portion of the mortgages enter default, there is insucient cash ow to ll all these cups
and equity tranche investors face the losses rst.
The risk and return for a CDO investor depends both
on how the tranches are dened, and on the underlying
assets. In particular, the investment depends on the assumptions and methods used to dene the risk and return
of the tranches.[85] CDOs, like all asset-backed securities, enable the originators of the underlying assets to pass
credit risk to another institution or to individual investors.
Thus investors must understand how the risk for CDOs is
calculated.

Others pointed out the risk of undoing the connection between borrowers and lendersremoving the lenders incentive to only pick borrowers who were creditworthy
inherent in all securitization.[80][81][82] According to
economist Mark Zandi: As shaky mortgages were combined, diluting any problems into a larger pool, the The issuer of the CDO, typically an investment bank,
incentive for responsibility was undermined.[21]
earns a commission at the time of issue and earns manageZandi and others also criticized lack of regulation. Fi- ment fees during the life of the CDO. The ability to earn
nance companies weren't subject to the same regulatory substantial fees from originating CDOs, coupled with the
oversight as banks. Taxpayers weren't on the hook if absence of any residual liability, skews the incentives of
they went belly up [pre-crisis], only their shareholders and originators in favor of loan volume rather than loan qualother creditors were. Finance companies thus had little ity.

210
In some cases, the assets held by one CDO consisted entirely of equity layer tranches issued by other CDOs. This
explains why some CDOs became entirely worthless, as
the equity layer tranches were paid last in the sequence
and there wasn't sucient cash ow from the underlying
subprime mortgages (many of which defaulted) to trickle
down to the equity layers.
Structures
CDO is a broad term that can refer to several dierent
types of products. They can be categorized in several
ways. The primary classications are as follows:
Source of fundscash ow vs. market value
Cash ow CDOs pay interest and principal to tranche
holders using the cash ows produced by the CDOs
assets. Cash ow CDOs focus primarily on managing the credit quality of the underlying portfolio.
Market value CDOs attempt to enhance investor returns through the more frequent trading and profitable sale of collateral assets. The CDO asset manager seeks to realize capital gains on the assets in
the CDOs portfolio. There is greater focus on
the changes in market value of the CDOs assets.
Market value CDOs are longer-established, but less
common than cash ow CDOs.
Motivationarbitrage vs. balance sheet
Arbitrage transactions (cash ow and market value)
attempt to capture for equity investors the spread
between the relatively high yielding assets and the
lower yielding liabilities represented by the rated
bonds. The majority, 86%, of CDOs are arbitragemotivated.[86]
Balance sheet transactions, by contrast, are primarily motivated by the issuing institutions desire to
remove loans and other assets from their balance
sheets, to reduce their regulatory capital requirements and improve their return on risk capital. A
bank may wish to ooad the credit risk to reduce
its balance sheets credit risk.
Fundingcash vs. synthetic
Cash CDOs involve a portfolio of cash assets, such
as loans, corporate bonds, asset-backed securities or
mortgage-backed securities. Ownership of the assets is transferred to the legal entity (known as a
special purpose vehicle) issuing the CDOs tranches.
The risk of loss on the assets is divided among
tranches in reverse order of seniority. Cash CDO
issuance exceeded $400 billion in 2006.

CHAPTER 9. CREDIT DERIVATIVES

Synthetic CDOs do not own cash assets like bonds
or loans. Instead, synthetic CDOs gain credit exposure to a portfolio of xed income assets without
owning those assets through the use of credit default
swaps, a derivatives instrument. (Under such a swap,
the credit protection seller, the CDO, receives periodic cash payments, called premiums, in exchange
for agreeing to assume the risk of loss on a specic
asset in the event that asset experiences a default or
other credit event.) Like a cash CDO, the risk of
loss on the CDOs portfolio is divided into tranches.
Losses will rst aect the equity tranche, next the
junior tranches, and nally the senior tranche. Each
tranche receives a periodic payment (the swap premium), with the junior tranches oering higher premiums.
A synthetic CDO tranche may be either
funded or unfunded. Under the swap agreements, the CDO could have to pay up to a
certain amount of money in the event of a
credit event on the reference obligations in the
CDOs reference portfolio. Some of this credit
exposure is funded at the time of investment
by the investors in funded tranches. Typically,
the junior tranches that face the greatest risk
of experiencing a loss have to fund at closing. Until a credit event occurs, the proceeds
provided by the funded tranches are often invested in high-quality, liquid assets or placed
in a GIC (Guaranteed Investment Contract)
account that oers a return that is a few basis
points below LIBOR. The return from these
investments plus the premium from the swap
counterparty provide the cash ow stream to
pay interest to the funded tranches. When a
credit event occurs and a payout to the swap
counterparty is required, the required payment
is made from the GIC or reserve account that
holds the liquid investments. In contrast, senior tranches are usually unfunded as the risk
of loss is much lower. Unlike a cash CDO,
investors in a senior tranche receive periodic
payments but do not place any capital in the
CDO when entering into the investment. Instead, the investors retain continuing funding
exposure and may have to make a payment
to the CDO in the event the portfolios losses
reach the senior tranche. Funded synthetic issuance exceeded $80 billion in 2006. From
an issuance perspective, synthetic CDOs take
less time to create. Cash assets do not have
to be purchased and managed, and the CDOs
tranches can be precisely structured.
Hybrid CDOs have a portfolio including both cash
assetslike a cash CDOsand swaps that give the
CDO credit exposure ot additional assetslike a
synthetic CDO. A portion of the proceeds from the

9.5. COLLATERALIZED DEBT OBLIGATION

211

funded tranches is invested in cash assets and the Types

remainder is held in reserve to cover payments that
may be required under the credit default swaps. The A) Based on the underlying asset:
CDO receives payments from three sources: the return from the cash assets, the GIC or reserve account
Collateralized loan obligations (CLOs):
investments, and the CDO premiums.
backed primarily by leveraged bank loans.

Single-tranche CDOs The exibility of credit default

swaps is used to construct Single Tranche CDOs
(bespoke CDOs) where the entire CDO is structured
specically for a single or small group of investors,
and the remaining tranches are never sold but held
by the dealer based on valuations from internal models. Residual risk is delta-hedged by the dealer.

CDOs

Collateralized bond obligations (CBOs): CDOs

backed primarily by leveraged xed income securities.
Collateralized synthetic obligations (CSOs): CDOs
backed primarily by credit derivatives.
Structured nance CDOs (SFCDOs): CDOs
backed primarily by structured products (such
as asset-backed securities and mortgage-backed
securities).[90]

Structured Operating Companies Unlike

CDOs,
which are terminating structures that typically B) Other types of CDOs by assets/collateral include:
wind-down or renance at the end of their nancing term, Structured Operating Companies are
Commercial Real Estate CDOs (CRE CDOs):
permanently capitalized variants of CDOs, with
backed primarily by commercial real estate assets
an active management team and infrastructure.
Collateralized bond obligations (CBOs): CDOs
They often issue term notes, commercial paper,
backed primarily by corporate bonds
and/or auction rate securities, depending upon
the structural and portfolio characteristics of the
Collateralized Insurance Obligations (CIOs):
company. Credit Derivative Products Companies
backed by insurance or, more usually, reinsurance
(CDPC) and Structured Investment Vehicles (SIV)
contracts
are examples, with CDPC taking risk synthetically
and SIV with predominantly 'cash' exposure.
CDO-Squared: CDOs backed primarily by the
tranches issued by other CDOs.[90]

Taxation

CDO^n: Generic term for CDO3 (CDO cubed)

and higher, where the CDO is backed by other
CDOs/CDO2 /CDO3 . These are particularly dicult vehicles to model because of the possible repetition of exposures in the underlying CDO.

The issuer of a CDOusually a special purpose entity

is typically is a corporation established outside the United
States to avoid being subject to U.S. federal income taxation on its global income. These corporations must re- Types of collateral
strict their activities to avoid U.S. tax; corporations that
are deemed to engage in trade or business in the U.S. The collateral for cash CDOs include:
will be subject to federal taxation.[87] Foreign corporations that only invest in and hold portfolios of U.S. stock
Structured nance securities (mortgage-backed
and debt securities are not. Investing, unlike trading or
securities, home equity asset-backed securities,
dealing, is not considered to be a trade or business, recommercial mortgage-backed securities)
gardless of its volume or frequency.[88]
Leveraged loans
In addition, a safe harbor protects CDO issuers that do
trade actively in securities, even though trading in securi Corporate bonds
ties technically is a business, provided the issuers activi Real estate investment trust (REIT) debt
ties do not cause it to be viewed as a dealer in securities
[89]
or engaged in a banking, lending or similar businesses.
Commercial real estate mortgage debt (including
CDOs are generally taxable as debt instruments except
whole loans, B notes, and Mezzanine debt)
for the most junior class of CDOs which are treated as
Emerging-market sovereign debt
equity and are subject to special rules (such as PFIC and
CFC reporting). The PFIC and CFC reporting is very
Project nance debt
complex and requires a specialized accountant to perform
Trust Preferred securities
these calculations and tax reporting.

212
Transaction participants

CHAPTER 9. CREDIT DERIVATIVES

will be included in the CDOs transaction documents and
other les.

Participants in a CDO transaction include investors, the

underwriter, the asset manager, the trustee and collateral
administrator, accountants and attorneys. Beginning in
1999, the Gramm-Leach-Bliley Act allowed banks to also
participate.

The nal step is to price the CDO (i.e., set the coupons for
each debt tranche) and place the tranches with investors.
The priority in placement is nding investors for the risky
equity tranche and junior debt tranches (A, BBB, etc.) of
the CDO. It is common for the asset manager to retain a
piece of the equity tranche. In addition, the underwriter
Investors Investorsbuyers
of
CDOinclude was generally expected to provide some type of secondary
insurance companies, mutual fund companies, unit market liquidity for the CDO, especially its more senior
trusts, investment trusts, commercial banks, investment tranches.
banks, pension fund managers, private banking organi- According to Thomson Financial, the top underwritzations, other CDOs and structured investment vehicles. ers before September 2008 were Bear Stearns, Merrill
Investors have dierent motivations for purchasing CDO Lynch, Wachovia, Citigroup, Deutsche Bank, and Bank
securities depending on which tranche they select. At of America Securities.[91] CDOs are more protable for
the more senior levels of debt, investors are able to underwriters than conventional bond underwriting beobtain better yields than those that are available on more cause of the complexity involved. The underwriter is paid
traditional securities (e.g., corporate bonds) of a similar a fee when the CDO is issued.
rating. In some cases, investors utilize leverage and
hope to prot from the excess of the spread oered by
the senior tranche and their cost of borrowing. This is The asset manager The asset manager plays a key role
true because senior tranches pay a spread above LIBOR in each CDO transaction, even after the CDO is issued.
despite their AAA-ratings. Investors also benet from An experienced manager is critical in both the constructhe diversication of the CDO portfolio, the expertise tion and maintenance of the CDOs portfolio. The manof the asset manager, and the credit support built into ager can maintain the credit quality of a CDOs portfolio
the transaction. Investors include banks and insurance through trades as well as maximize recovery rates when
companies as well as investment funds.
defaults on the underlying assets occur.
Junior tranche investors achieve a leveraged, non- In theory, the asset manager should add value in the manrecourse investment in the underlying diversied collat- ner outlined below, although in practice, this did not oceral portfolio. Mezzanine notes and equity notes oer cur during the credit bubble of the mid-2000s (decade).
yields that are not available in most other xed income In addition, it is now understood that the structural aw
securities. Investors include hedge funds, banks, and in all asset-backed securities (originators prot from loan
wealthy individuals.
volume not loan quality) make the roles of subsequent
participants peripheral to the quality of the investment.
Underwriter The underwriter of a CDO is typically an
investment bank, and acts as the structurer and arranger.
Working with the asset management rm that selects the
CDOs portfolio, the underwriter structures debt and equity tranches. This includes selecting the debt-to-equity
ratio, sizing each tranche, establishing coverage and collateral quality tests, and working with the credit rating
agencies to gain the desired ratings for each debt tranche.

The asset managers role begins in the months before a

CDO is issued, a bank usually provides nancing to the
manager to purchase some of the collateral assets for the
forthcoming CDO. This process is called warehousing.
Even by the issuance date, the asset manager often will
not have completed the construction of the CDOs portfolio. A ramp-up period following issuance during which
the remaining assets are purchased can extend for several
months after the CDO is issued. For this reason, some
senior CDO notes are structured as delayed drawdown
notes, allowing the asset manager to draw down cash from
investors as collateral purchases are made. When a transaction is fully ramped, its initial portfolio of credits has
been selected by the asset manager.

The key economic consideration for an underwriter that

is considering bringing a new deal to market is whether
the transaction can oer a sucient return to the equity
noteholders. Such a determination requires estimating
the after-default return oered by the portfolio of debt securities and comparing it to the cost of funding the CDOs
rated notes. The excess spread must be large enough to However, the asset managers role continues even after
oer the potential of attractive IRRs to the equityholders. the ramp-up period ends, albeit in a less active role. DurOther underwriter responsibilities include working with ing the CDOs reinvestment period, which usually exa law rm and creating the special purpose legal vehicle tends several years past the issuance date of the CDO, the
(typically a trust incorporated in the Cayman Islands) that asset manager is authorized to reinvest principal proceeds
will purchase the assets and issue the CDOs tranches. In by purchasing additional debt securities. Within the conaddition, the underwriter will work with the asset man- nes of the trading restrictions specied in the CDOs
ager to determine the post-closing trading restrictions that transaction documents, the asset manager can also make

9.5. COLLATERALIZED DEBT OBLIGATION

213

trades to maintain the credit quality of the CDOs portfolio. The manager also has a role in the redemption of a
CDOs notes by auction call.

US Bank (note: US Bank recently also acquired the

corporate trust unit of Wachovia in 2008 and Bank
of America in September 2011)

There are approximately 300 asset managers in the marketplace. CDO Asset Managers, as with other Asset
Managers, can be more or less active depending on the
personality and prospectus of the CDO. Asset Managers
make money by virtue of the senior fee (which is paid
before any of the CDO investors are paid) and subordinated fee as well as any equity investment the manager has
in the CDO, making CDOs a lucrative business for asset
managers. These fees, together with underwriting fees,
administrationapprox 1.5 - 2% -- by virtue of capital
structure are provided by the equity investment, by virtue
of reduced cashow.

Wells Fargo

See also: List of CDO Managers

The trustee and collateral administrator The trustee

holds title to the assets of the CDO for the benet of the
noteholders (i.e., the investors). In the CDO market,
the trustee also typically serves as collateral administrator. In this role, the collateral administrator produces and
distributes noteholder reports, performs various compliance tests regarding the composition and liquidity of the
asset portfolios in addition to constructing and executing
the priority of payment waterfall models.[92] In contrast
to the asset manager, there are relatively few trustees in
the marketplace. The following institutions oer trustee
services in the CDO marketplace:

Wilmington Trust: Wilmington shut down their

business in early 2009.
Accountants The underwriter typically will hire an accounting rm to perform due diligence on the CDOs
portfolio of debt securities. This entails verifying certain attributes, such as credit rating and coupon/spread,
of each collateral security. Source documents or public
sources will typically be used to tie-out the collateral pool
information. In addition, the accountants typically calculate certain collateral tests and determine whether the
portfolio is in compliance with such tests.
The rm may also perform a cash ow tie-out in which the
transactions waterfall is modeled per the priority of payments set forth in the transaction documents. The yield
and weighted average life of the bonds or equity notes
being issued is then calculated based on the modeling assumptions provided by the underwriter. On each payment
date, an accounting rm may work with the trustee to verify the distributions that are scheduled to be made to the
noteholders.

Attorneys Attorneys ensure compliance with applicable securities law and negotiate and draft the transaction
documents. Attorneys will also draft an oering document or prospectus the purpose of which is to satisfy
ATC Capital Markets
statutory requirements to disclose certain information to
investors. This will be circulated to investors. It is com Bank of New York Mellon (note: the Bank of New
mon for multiple counsels to be involved in a single deal
York Mellon recently also acquired the corporate
because of the number of parties to a single CDO from
trust unit of JP Morgan which is the market share
asset management rms to underwriters.
leader),
BNP Paribas Securities Services (note: currently
9.5.3
serves the European market only)

See also

Citibank

Asset-backed security

Deutsche Bank

Collateralized mortgage obligation (also known by

initials CMO)

Equity Trust
Intertrust Group (note: until mid-2009 was known
as Fortis Intertrust)
HSBC
LaSalle Bank (Recently acquired by Bank of America Purchased by US Bank late 2010)

Collateralized fund obligation

Inside Job (2010 lm), a 2010 Oscar-winning documentary lm about the nancial crisis of 20072010
by Charles H. Ferguson
List of CDO managers
Credit default swap

Sanne Trust

Single-tranche CDO

State Street Corporation

Synthetic CDO

214

9.5.4

CHAPTER 9. CREDIT DERIVATIVES

References

[1] An asset-backed security is sometimes used as an umbrella term for a type of security backed by a pool
of assetsincluding collateralized debt obligations and
mortgage-backed securities (Example: The capital market in which asset-backed securities are issued and traded
is composed of three main categories: ABS, MBS and
CDOs. (italics added) (source: Vink, Dennis. ABS,
MBS and CDO compared: an empirical analysis (PDF).
August 2007. Munich Personal RePEc Archive. Retrieved 13 July 2013.)
and sometimes for a particular type of that security
one backed by consumer loans (example: As a rule
of thumb, securitization issues backed by mortgages are
called MBS, and securitization issues backed by debt obligations are called CDO, [and] Securitization issues backed
by consumer-backed productscar loans, consumer loans
and credit cards, among othersare called ABS ... (italics
added, source Vink, Dennis. ABS, MBS and CDO compared: an empirical analysis (PDF). August 2007. Munich Personal RePEc Archive. Retrieved 13 July 2013.,
see also What are Asset-Backed Securities?". SIFMA.
Retrieved 13 July 2013. Asset-backed securities, called
ABS, are bonds or notes backed by nancial assets. Typically these assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans,
manufactured-housing contracts and home-equity loans.)
[2] Lemke, Lins and Picard, Mortgage-Backed Securities,
5:15 (Thomson West, 2014).
[3] Koehler, Christian. The Relationship between the Complexity of Financial Derivatives and Systemic Risk.
Working Paper: 17.
[4] Lemke, Lins and Smith, Regulation of Investment Companies (Matthew Bender, 2014 ed.).
[5] McLean, Bethany and Joe Nocera, All the Devils Are Here,
the Hidden History of the Financial Crisis, Portfolio, Penguin, 2010, p.120
[6] Final Report of the National Commission on the Causes of
the Financial and Economic Crisis in the United States, aka
The Financial Crisis Inquiry Report, p.127
[7] The Financial Crisis Inquiry Report, 2011, p.130
[8] The Financial Crisis Inquiry Report, 2011, p.133
[9] Cresci, Gregory. Merrill, Citigroup Record CDO Fees
Earned in Top Growth Market. August 30, 2005.
Bloomberg. Retrieved 11 July 2013.
[10] The Financial Crisis Inquiry Report, 2011, p.129
[11] The Financial Crisis Inquiry Report, 2011, p.129-30
[12] McLean and Nocera, All the Devils Are Here, 2010 p.120
[13] McLean and Nocera, All the Devils Are Here, 2010 p.121
[14] McLean and Nocera, All the Devils Are Here, 2010 p.123
[15] Morgenson, Gretchen; Joshua Rosner (2011). Reckless
Endangerment : How Outsized ambition, Greed and Corruption Led to Economic Armageddon. New York: Times
Books, Henry Holt and Company. p. 283.

[16] Morgenson and Rosner Reckless Endangerment, 2010

pp.279-280
[17] McLean and Nocera, All the Devils Are Here, 2010 p.189
[18] Public Radio International. April 5, 2009. This American Life": Giant Pool of Money wins Peabody
[19] The Giant Pool of Money. This American Life. Episode
355. transcript. May 9, 2008. NPR. CPM.
[20] of Moodys Analytics
[21] Zandi, Mark (2009). Financial Shock. FT Press. ISBN
978-0-13-701663-1.
[22] Hsu, Steve (2005-09-12).
Information Processing: Gaussian copula and credit derivatives. Infoproc.blogspot.com. Retrieved 2013-01-03.
[23] How a Formula Ignited Market That Burned Some Big Investors| Mark Whitehouse| Wall Street Journal| September
12, 2005
[24] SIFMA, Statistics, Structured Finance, Global CDO Issuance and Outstanding (xls) - quarterly data from 2000 to
Q2 2013 (issuance), 1990 - Q1 2013 (outstanding)". Securities Industry and Financial Markets Association. Retrieved 2013-07-10.
[25] One study based on a sample of 735 CDO deals originated
between 1999 and 2007, found the percentage of CDO
assets made up of lower level tranches from non-prime
mortgage-backed securities (nonprime means subprime
and other less-than-prime mortgages, mainly Alt-A mortgages) grew from 5% to 36%. (source: Anna Katherine
Barnett-Hart The Story of the CDO Market Meltdown:
An Empirical Analysis-March 2009)
[26] Other sources give an even higher proportion. In the fall
of 2005 Gene Park, an executive at AIG Financial Products division found, The percentage of subprime securities in the CDOs wasn't 10 percent -- it was 85 percent!"
(source: McLean and Nocera, All the Devils Are Here,
2010 (p.201)
[27] An email by Park to his superior is also quoted in the Financial Crisis Inquiry Report p.201: The CDO of the
ABS market ... is currently at a state where deals are almost totally reliant on subprime/nonprime mortgage residential mortgage collateral.
[28] Still another source (The Big Short, Michael Lewis, p.71)
says:
The `consumer loans` piles that Wall Street rms, led by
Goldman Sachs, asked AIG FP to insure went from being 2% subprime mortgages to being 95% subprime mortgages. In a matter of months, AIG-FP, in eect, bought
$50 billion in triple-B-rated subprime mortgage bonds by
insuring them against default. And yet no one said anything about it ...
[29] In 2007, 47% of CDOs were backed by structured products, such as mortgages; 45% of CDOs were backed by
loans, and only less than 10% of CDOs were backed by
xed income securities. (source: Securitization rankings
of bookrunners, issuers, etc.

9.5. COLLATERALIZED DEBT OBLIGATION

[30] Moodys and S&P to bestow[ed] triple-A ratings on

roughly 80% of every CDO. (source: The Big Short,
Michael Lewis, p.207-8)
[31] The Big Short, Michael Lewis, pp. 2078
[32] Anna Katherine Barnett-Hart The Story of the CDO Market Meltdown: An Empirical Analysis-March 2009-Cited
by Michael Lewis in The Big Short
[33] SEC Broadens CDO Probes. June 15th, 2011. Global
Economic Intersection. Retrieved 8 February 2014. [Includes] graph and table from Pro Publica [that] show the
size and institutional reach of the Magnetar CDOs [versus
the whole CDO market].
[34] Collateralized Debt Obligations Market (Press release).
Celent. 2005-10-31. Retrieved 2009-02-23.
[35] Benmelech, Efraim; Jennifer Dlugosz (2009). The
Credit Rating Crisis (PDF). NBER Macroeconomics Annual 2009, (in Volume 24). National Bureau of Economic
Research, NBER Macroeconomics Annual.
[36] The Financial Crisis Inquiry Report, 2011, p.134, section="Leverage is inherent in CDOs
[37] Morgenson and Rosner Reckless Endangerment, 2010
p.278

215

[44] Morgenson and Rosner Reckless Endangerment, 2010

p.280
[45] see also: Bloomberg-Flawed Credit Ratings Reap Prots
as Regulators Fail Investors-April 2009
[46] McLean and Nocera, All the Devils Are Here, p.124
[47] PBS-Credit and Credibility-December 2008
[48] The Financial Crisis Inquiry Report, 2011, p.132
[49] Unlike the traditional cash CDO, synthetic CDOs contained no actual tranches of mortgage-backed securities
... in the place of real mortgage assets, these CDOs contained credit default swaps and did not nance a single
home purchase. (source: The Financial Crisis Inquiry Report, 2011, p.142)
[50] The Magnetar Trade: How One Hedge Fund Helped Keep
the Bubble Going (Single Page)-April 2010
[51] Final Report of the National Commission on the Causes
of the Financial and Economic Crisis in the United States,
p.229, gure 11.4
[52] The Big Short, Michael Lewis, p.95
[53] The Financial Crisis Inquiry Report, 2011, p.87, gure 6.2
[54] Michael Lewis, The Big Short, p.94-7

[38] see also Financial Crisis Inquiry Report, p.127

[39] 70%. Firms bought mortgage-backed bonds with the
very highest yields they could nd and reassembled them
into new CDOs. The original bonds ... could be lowerrated securities that once reassembled into a new CDO
would wind up with as much as 70% of the tranches rated
triple-A. Ratings arbitrage, Wall Street called this practice. A more accurate term would have been ratings laundering. (source: McLean and Nocera, All the Devils Are
Here, 2010 p.122)
[40] 80%. Approximately 80% of these CDO tranches would
be rated triple A despite the fact that they generally comprised the lower-rated tranches of mortgage-backed securities. (source: The Financial Crisis Inquiry Report, 2011,
p.127
[41] 80%. In a CDO you gathered a 100 dierent mortgage bondsusually the riskiest lower oors of the original tower ...... They bear a lower credit rating triple B.
... if you could somehow get them rerated as triple A,
thereby lowering their perceived risk, however dishonestly
and articially. This is what Goldman Sachs had cleverly
done. is was absurd. The 100 buildings occupied the same
oodplain; in the event of ood, the ground oors of all
of them were equally exposed. But never mind: the rating agencies, who were paid fat fees by Goldman Sachs
and other Wall Street rms for each deal they rated, pronounced 80% of the new tower of debt triple-A. (source:
Michael Lewis, The Big Short : Inside the Doomsday Machine WW Norton and Co, 2010, p.73)

[55] Lewis, Michael, The Big Short

[56] CDOh no! (see Subprime performance chart)". The
Economist. 8 November 2007.
[57] By the rst quarter of 2008, rating agencies announced
4,485 downgrades of CDOs. source: Aubin, Dena (200804-09). CDO deals resurface but down 90 pct in Q1report. Reuters.
[58] The Financial Crisis Inquiry Report, 2011, p.148
[59] Bear Stearns Tells Fund Investors 'No Value Left' (Update3)". Bloomberg. 2007-07-18.
[60] Many CDOs are marked to market and thus experienced
substantial write-downs as their market value collapsed
during the subprime crisis, with banks writing down the
value of their CDO holdings mainly in the 2007-2008 period.
[61] Eavis, Peter (2007-10-24). Merrills $3.4 billion balance
sheet bomb. CNN. Retrieved 2010-04-30.
[62] Herds head trampled. The Economist. 2007-10-30.
[63] Citigroup chief executive resigns. BBC News. 2007-1105. Retrieved 2010-04-30.
[64] Merrill sells assets seized from hedge funds. CNN. June
20, 2007. Retrieved May 24, 2010.
[65] Timeline: Sub-prime losses. BBC. May 19, 2008. Retrieved May 24, 2010.

[42] The Financial Crisis Inquiry Report, 2011, p.103

[43] The Financial Crisis Inquiry Report, 2011, p.104

[66] http://www.sifma.org/research/pdf/SIFMA_
CDOIssuanceData2008.pdf

216

[67] Aubin, Dena (2008-04-09). CDO deals resurface but

down 90 pct in Q1-report. Reuters.

CHAPTER 9. CREDIT DERIVATIVES

[68] nearly USD 1 trillion in mortgage bonds in 2006 alone

[87] Peaslee, James M. & David Z. Nirenberg. Federal Income

Taxation of Securitization Transactions and Related Topics. Frank J. Fabozzi Associates (2011, with periodic supplements, www.securitizationtax.com): 1018.

[69] McLean, Bethany (2007-03-19). The dangers of investing in subprime debt. Fortune.

[88] Peaslee & Nirenberg. Federal Income Taxation of Securitization Transactions, 1023.

[70] Warren Buet on Derivatives (PDF). Following are

edited excerpts from the Berkshire Hathaway annual report
for 2002. ntools.com.

[89] Peaslee & Nirenberg. Federal Income Taxation of Securitization Transactions, 1026.

[71] Raghu Rajan analyses subprime crisis| Mostly Economics|

(from a speech given on December 17, 2007)
[72] Wall Street Wizardry Amplied Risk, Wall Street Journal,
December 27, 2007

[90] Paddy Hirsch (October 3, 2008). Crisis explainer: Uncorking CDOs. American Public Media.
[91] Dealbook. Citi and Merrill Top Underwriting League
Tables. January 2, 2008,. New York Times. Retrieved
16 July 2013.

[73] Ng, Serena, and Mollenkamp, Carrick. "A Fund Behind Astronomical Losses, (Magnetar) Wall Street Journal, January 14, 2008.

[92] Two notable exceptions to this are Virtus Partners and

Wilmington Trust Conduit Services, a subsidiary of
Wilmington Trust, which oer collateral administration
services, but are not trustee banks.

[74] Morgenson, Gretchen; Joshua Rosner (2011). Reckless

Endangerment : How Outsized ambition, Greed and Corruption Led to Economic Armageddon. New York: Times
Books, Henry Holt and Company. p. 278.

9.5.5 External links

[75] The Financial Crisis Inquiry Report, 2011, p.118-121

[76] Bloomberg-Smith-Bringing Down Ratings Let Loose
Subprime Scourge
[77] Bloomberg-Smith-Race to Bottom at Rating Agencies Secured Subprime Boom, Bust
[78] Morgenson and Rosner, Reckless Endangerment, 2010
p.280-1
[79] Lewis, Michael (2010). The Big Short : Inside the Doomsday Machine. W.W. Norton & Company. p. 73. ISBN
978-0-393-07223-5.
[80] All the Devils Are Here, MacLean and Nocera, p.19
[81] Mortgage lending using securitization is sometimes referred to as the originate-to-distribute approach, in contrast to the traditional originate-to-hold approach. (The
Financial Crisis Inquiry Report, 2011, p.89)

How a CDO is like a bottle of Champagne. From

Marketplace
Global Pool of Money and CDOs (NPR radio)
The Story of the CDO Market Meltdown: An
Empirical Analysis-Anna Katherine Barnett-HartMarch 2009-Cited by Michael Lewis in The Big
Short
CDO Diagram-Bionic Turtle
CDO and RMBS Diagram-FCIC and IMF
Whats a CDO? Interactive Graphic - December
2007
Investment Landll
Mezzanine Debt
Portfolio.com explains what CDOs are in an easyto-understand multimedia graphic

[82] Koehler, Christian. The Relationship between the Complexity of Financial Derivatives and Systemic Risk.
Working Paper: 42.

The Making of a Mortgage CDO multimedia

graphic from The Wall Street Journal

[83] Koehler, Christian. The Relationship between the Complexity of Financial Derivatives and Systemic Risk.
Working Paper: 1213.

JPRI Occasional Paper No. 37, October 2007 Risk

vs Uncertainty: The Cause of the Current Financial
Crisis By Marshall Auerback

[84] Koehler, Christian. The Relationship between the Complexity of Financial Derivatives and Systemic Risk.
Working Paper: 13.
[85] Koehler, Christian. The Relationship between the Complexity of Financial Derivatives and Systemic Risk.
Working Paper: 19.
[86] http://archives1.sifma.org/assets/files/SIFMA_
CDOIssuanceData2007q1.pdf

Collateralized debt obligations: whos to blame

when the market blows up? - Summer, 2007
How credit cards become asset-backed bonds. From
Marketplace
Vink, Dennis and Thibeault, Andr (2008). ABS,
MBS and CDO Compared: An Empirical Analysis [[Journal of Structured Finance|The Journal of
Structured Finance]

9.6. COLLATERALIZED LOAN OBLIGATION

217

A tsunami of hope or terror?", Alan Kohler, Nov businesses to repay. Normally a leveraged loan would
19, 2008.
have a xed interest rate, but potentially only a certain
lender would feel that the risk of loss is worth the interest
Collateralized Debt Obligations at Wikinvest
that is charged. By pooling multiple loans and dividing
them into tranches, in eect multiple loans are created,
with relatively safe ones being paid lower interest rates
9.6 Collateralized loan obligation (designed to appeal to conservative investors), and higher
risk ones appealing to higher risk investors (by oering a
higher interest rate). The whole point is to lower the cost
Collateralized loan obligations (CLOs) are a form
of money to businesses by increasing the supply of lenders
of securitization where payments from multiple mid(attracting both conservative and risk taking lenders).
dle sized and large business loans are pooled together
and passed on to dierent classes of owners in various CLOs were created because the same tranching structranches. A CLO is a type of collateralized debt obliga- ture was invented and proven to work for home mortgages
in the early 1980s. Very early on, pools of residential
tion.
home mortgages were turned into dierent tranches of
bonds to appeal to various forms of investors. Corporations with good credit ratings were already able to borrow
9.6.1 Leveraging
cheaply with bonds, but those that couldn't had to borrow
Each class of owner may receive larger yields in exchange from banks at higher costs. The CLO created a means by
for being the rst in line to risk losing money if the busi- which companies with weaker credit ratings could borrow
nesses fail to repay the loans that a CLO has purchased. from institutions other than banks, lowering the overall
The actual loans used are multi-million dollar loans to pri- cost of money to them.
vately owned enterprises. Known as syndicated loans and
originated by a lead bank with the intention of the majority of the loans being immediately syndicated, or sold, 9.6.3 Demand
to the collateralized loan obligation owners. The lead
bank retains a minority amount of the loan while main- As a result of the subprime mortgage crisis, the demand
taining agent responsibilities representing the interests for lending money either in the form of mortgage bonds
to a halt, with negligible issuance
of the syndicate of CLOs as well as servicing the loan or CLOs almost ground
[1]
in
2008
and
2009.
payments to the syndicate. The loans are usually termed
high risk, high yield, or leveraged, that is, loans to The market for U.S. collateralized loan obligations was
companies which owe an above average amount of money truly reborn in 2012, however, hitting $55.2 billion, with
for their size and kind of business, usually because a new new-issue CLO volume quadrupling from the previous
business owner has borrowed funds against the business year, according to data from Royal Bank of Scotland anto purchase it (known as a "leveraged buyout"), because alysts. Big names such as Barclays, RBS and Nomura
the business has borrowed funds to buy another business, launched their rst deals since before the credit crisis; and
or because the enterprise borrowed funds to pay a divi- smaller names such as Onex, Valcour, Kramer Van Kirk,
dend to equity owners.
and Och Zi ventured for the rst ever time into the CLO
market, reecting the rebounding of market condence
in CLOs as an investment vehicle.[2] CLO issuance has
9.6.2 Rationale
soared since then, culminating in full-year 2013 CLO issuance in the U.S. of $81.9 billion, the most since the
The reason behind the creation of CLOs was to increase pre-Lehman era of 2006-07, as a combination of rising
the supply of willing business lenders, so as to lower the interest rates and below-trend default rates drew signiprice (interest costs) of loans to businesses and to allow cant amounts of capital to the leveraged loan asset class.
banks more often to immediately sell loans to external [3]
investor/lenders so as to facilitate the lending of money
The US CLO market picked up even more steam in 2014,
to business clients and earn fees with little to no risk to
with $124.1 billion in issuance, easily surpassing the prior
themselves. CLOs accomplish this through a 'tranche'
record of $97 billion in 2006. [4]
structure. Instead of a regular lending situation where a
lender can earn a xed interest rate but be at risk for a
loss if the business does not repay the loan, CLOs com- 9.6.4 See also
bine multiple loans but don't transmit the loan payments
equally to the CLO owners. Instead, the owners are di Collateralized debt obligation, securitization vehicle
vided into dierent classes, called tranches, with each
for various debt instruments
class entitled to more of the interest payments than the
Collateralized fund obligation, securitization vehicle
next, but with them being ahead in line in absorbing any
for private equity and hedge fund assets
losses amongst the loan group due to the failure of the

218

CHAPTER 9. CREDIT DERIVATIVES

Collateralized mortgage obligation, securitization in one go, it borrows in tranches and which have diervehicle for residential mortgages
ent risks associated with them. As an example consider
the following transaction:
Class D notes are not rated and they are called equity or
the rst loss piece. As soon as there are defaults within
the portfolio, the principals of the Class D notes are reCLOs/Institutional Investors. Leveraged Loan Primer |
duced with the corresponding amount. If there are a total
LCD.
of $12,000,000 of losses in the portfolio during the life
http://www.creditflux.com/Newsletter/2012-08-02/
of the deal, Class D noteholders receive only $18,000,000
Citi-leads-charge-as-CLO-volumes-surge-past-last-yearrsquos-tally/
back, having lost $12,000,000 of their capital. Class A,
B, and C noteholders receive all of their money back.
Miller, Steve (2014-01-02). 2013 CLO Issuance Hits
However, if there are $42,000,000 of losses in the portfo$81.9B; Most Since 2007. Forbes.
lio during the life of the transaction then the entire capital
Husband, Sarah. U.S. CLO market prints record of the Class D noteholders is gone and the Class C noteholders receive only $58,000,000.
$123.6B of new issuance in 2014.

9.6.5
[1]
[2]
[3]
[4]

References

Collateralized Loan Obligations: A Powerful New What drives full capital-structure deals?
Portfolio Management Tool for Banks
The investor who has most at risk is the equity investor.
In the above example this is the investor of the Class D
notes. The equity piece is the most dicult part of the
9.7 Single-tranche CDO
capital structure to place. Therefore the equity investor
has the most say in shaping up a full capital structure deal.
Single-tranche CDO or Bespoke CDO is an extension
Typically the sponsor of the CDO will take a portion of
of full capital structure synthetic CDO deals, which are a
the equity notes with the condition of not selling them unform of collateralized debt obligation. These are bespoke
til maturity to demonstrate that they are comfortable with
transactions where the bank and the investor work closely
the portfolio and expect the deal to perform well. This is
to achieve a specic target.
an important selling point for the investors of mezzanine
In a bespoke portfolio transaction, the investor chooses and senior notes.
or agrees to the list of reference entities, the rating of the
tranche, maturity of the transaction, coupon type (xed
or oating), subordination level, type of collateral assets Structure of full-capital-structure deals
used etc. Typically the objective is to create a debt instrument where the return is signicantly higher than com- In synthetic transactions, credit risk of the Reference
parably rated bonds. In a nutshell, a single-tranche CDO Portfolio is transferred to the SPV via credit default
is a CDO where the arranging bank does not simultane- swaps. For each name in the portfolio the SPV enters
ously place the entirety of the capital structure. These into a credit default swap where the SPV sells credit proCDOs are also called arbitrage CDOs because the arrang- tection to the bank in return for a periodically paid preing bank seeks to pay a lower return than the return avail- mium. The cash raised from the sale of the various classes
of notes, i.e.; Class A, B, C and D in the above example,
able from hedging the single-tranche exposure.
is placed in collateral securities. Typically these are AAA
rated notes issued by supranationals, governments, governmental organizations, or covered bonds (Pfandbrief).
9.7.1 Full-capital-structure CDOs
These are low-risk instruments with a return slightly beIn a full capital structure transaction, the total nominal low the interbank market yield. If there is a default in the
of the notes issued equals to the total nominal of the un- portfolio, the credit default swap for that entity is trigderlying portfolio. Therefore, the full capital structure gered and the bank demands the loss suered for that entransaction requires all of the tranches being placed with tity from the SPV. For example if the bank has entered
into a credit default swap for $10,000,000 on Company
investors.
A and this company is bankrupt the bank will demand
$10,000,000 less the recovery amount from the SPV.
Full-capital-structure deal example
The recovery amount is the secondary market price of
$10,000,000 of bonds of Company A after bankruptcy.
Consider a US$1,000,000,000 portfolio consisting of Typically recovery amount is assumed to be 40% but this
100 entities. Furthermore, consider an SPV which has number changes depending on the credit cycle, industry
no assets or liabilities to start with. In order to pur- type, and depending on the company in question. Hence,
chase this $1,000,000,000 portfolio it has to borrow if recovery amount is $4,000,000 (working on 40% re$1,000,000,000. Instead of borrowing $1,000,000,000 covery assumption), the bank receives $6,000,000 from

9.8. TOTAL RETURN SWAP

the SPV. In order to pay this money, the SPV has to liquidate some collateral securities to pay the bank. Having
lost some assets, the SPV has to reduce some liabilities as
well and it does so by reducing the notional of the equity
notes. Hence, after the rst default in the portfolio, the
equity notes, i.e.; Class D notes in the above example are
reduced to $24,000,000 from $30,000,000.
A typical single-tranche CDO is a note issued by a bank
or an SPV where in addition to the credit risk of the issuing entity, the investors take credit risk on a portfolio of
entities. In return for taking this additional credit risk on
the portfolio, the investors achieve a higher return than
the market interest rate for the corresponding maturity.
A typical Single Tranche CDO will have the following
terms depending on whether it is issued by the bank or by
the SPV:

219

Rotman School of Management, University of Toronto,

CiteSeerX: 10.1.1.139.2245

9.8 Total return swap

Interest payment (LIBOR rate plus spread)
Loss in value of the reference asset

Bank A
(Protection Buyer)

Increase in value of the reference asset

Bank B
(Protection Seller)

Interest rate payments (from ref asset)

Interest payment

Reference asset

Diagram explaining Total return swap

9.7.2

Bespoke portfolio

Total return swap, or TRS (especially in Europe), or

total rate of return swap, or TRORS, or Cash Settled
According to researchers at Joseph L. Rotman School of Equity Swap is a nancial contract that transfers both the
credit risk and market risk of an underlying asset.
Management, the [1]
Tranches of nonstandard portfolios are
regularly traded. These are referred to as
bespokes. Bespoke portfolios dier in the
names that are included in the portfolio,
the average CDS spread for the names in
the portfolio, and in the dispersion of the
CDS spreads. The approach to estimating
tranche spreads for a bespoke depends on its
characteristics.
Hull and White 2008

9.8.1 Contract denition

A swap agreement in which one party makes payments
based on a set rate, either xed or variable, while the other
party makes payments based on the return of an underlying asset, which includes both the income it generates
and any capital gains. In total return swaps, the underlying asset, referred to as the reference asset, is usually an
equity index, loans, or bonds. This is owned by the party
receiving the set rate payment.

Total return swaps allow the party receiving the total return to gain exposure and benet from a reference asset
without actually having to own it. These swaps are popHow does it work?
ular with hedge funds because they get the benet of a
In the above example, the investor is making a large exposure with a minimal cash outlay. [1]
$10,000,000 investment. He will receive 6 month Li- Less common, but related, are the partial return swap and
bor + 1.00% as long as the cumulative losses in the Ref- the partial return reverse swap agreements, which usuerence Portfolio remain below 5%. If for example at ally involve 50% of the return, or some other specied
the end of the transaction the losses in the portfolio re- amount. Reverse swaps involve the sale of the asset with
main below $50,000,000 (5% of $1,000,000,000) the in- the seller then buying the returns, usually on equities.
vestor will receive $10,000,000 back. If however, the
losses in the portfolio amount to $52,000,000, which corresponds to 5.2% of pool notional, the investor will lose 9.8.2 Advantage of using Total Return
20% ($2,000,000) of his capital, i.e. he will receive only
Swaps
$8,000,000 back. The coupon he receives will be on the
reduced notional from the moment the portfolio suers a The TRORS allows one party (bank B) to derive the ecoloss that aects the investor.
nomic benet of owning an asset without putting that as-

9.7.3

References

[1] Hull, John; White, Alan (June 2008), An Improved Implied Copula Method and its Application to the Valuation
of Bespoke CDO Tranches, Toronto, Canada: Joseph L.

set on its balance sheet, and allows the other (bank A,

which does retain that asset on its balance sheet) to buy
protection against loss in its value.[2]
TRORS can be categorised as a type of credit derivative, although the product combines both market risk and
credit risk, and so is not a pure credit derivative.

220

9.8.3

CHAPTER 9. CREDIT DERIVATIVES

Users

Hedge funds use Total Return Swaps to obtain leverage

on the Reference Assets: they can receive the return of
the asset, typically from a bank (which has a funding cost
advantage), without having to put out the cash to buy the
Asset. They usually post a smaller amount of collateral
upfront, thus obtaining leverage.
Hedge funds (such as The Childrens Investment Fund
(TCI)) have attempted to use Total Return Swaps to sidestep public disclosure requirements enacted under the
Williams Act. As discussed in CSX Corp. v. The Childrens Investment Fund Management, TCI argued that it
was not the benecial owner of the shares referenced by
its Total Return Swaps and therefore the swaps did not
require TCI to publicly disclose that it had acquired a
stake of more than 5% in CSX. The United States District
Court rejected this argument and enjoined TCI from further violations of Section 13(d) Securities Exchange Act
and the SEC-Rule promulgated thereunder.[3]
Total Return Swaps are also very common in many
structured nance transactions such as collateralized debt
obligations (CDOs). CDO Issuers often enter TRS agreements as protection seller in order to leverage the returns
for the structures debt investors. By selling protection,
the CDO gains exposure to the underlying asset(s) without having to put up capital to purchase the assets outright. The CDO gains the interest receivable on the reference asset(s) over the period while the counterparty mitigates their market risk.

9.8.4

References

[1] , Investopedia.
[2] Dufey, Gunter; Rehm, Florian (2000).
An Introduction to Credit Derivatives (Teaching Note)".
hdl:2027.42/35581.
[3] 562 F.Supp.2d 511 (S.D.N.Y. 2008), see also

9.8.5

External links

Total Return Swap article on Financial-edu.com

https://www.youtube.com/watch?v=G_
42YuJOu4A

9.8.6

See also

Repurchase agreement
Credit derivative

9.9 Constant maturity credit default swap

A constant maturity credit default swap (CMCDS) is
a type of credit derivative product, similar to a standard
credit default swap (CDS). Addressing CMCDS typically
requires prior understanding of credit default swaps. In a
CMCDS the protection buyer makes periodic payments
to the protection seller (these payments constitute the premium leg), and in return receives a payo (protection
or default leg) if an underlying nancial instrument defaults. Dierently from a standard CDS, the premium
leg of a CMCDS does not pay a xed and pre-agreed
amount but a oating spread, using a traded CDS as a reference index. More precisely, given a pre-assigned timeto-maturity, at any payment instant of the premium leg
the rate that is oered is indexed at a traded CDS spread
on the same reference credit existing in that moment for
the pre-assigned time-to-maturity (hence the name constant maturity CDS). The default or protection leg is
mostly the same as the leg of a standard CDS. Often CMCDS are expressed in terms of participation rate. The
participation rate may be dened as the ratio between the
present value of the premium leg of a standard CDS with
the same nal maturity and the present value of the premium leg of the constant maturity CDS. CMCDS may
be combined with CDS on the same entity to take only
spread risk and not default risk on an entity. Indeed, as
the default leg is the same, buying a CDS and selling a
CMCDS or vice versa will oset the default legs and leave
only the dierence in the premium legs, that are driven
by spread risk. Valuation of CMCDS has been explored
by Damiano Brigo (2004) and Anlong Li (2006)

9.9.1 References
Damiano Brigo, Constant Maturity CDS valuation
with market models (2006). Risk Magazine, June
issue. Related 2004 SSRN paper
Anlong Li, Valuation of Swaps and Options on
Constant Maturity CDS Spreads, Barclays Capital
Research, available at SSRN (2006)

9.10 Collateralized mortgage obligation

A collateralized mortgage obligation (CMO) is a type
of complex debt security that repackages and directs the
payments of principal and interest from a collateral pool
to dierent types and maturities of securities, thereby
meeting investor needs.[1] CMOs were rst created in
1983 by the investment banks Salomon Brothers and First
Boston for the U.S. mortgage liquidity provider Freddie

9.10. COLLATERALIZED MORTGAGE OBLIGATION

Mac. (The Salomon Brothers team was led by Gordon Taylor. The First Boston team was led by Dexter
Senft[2] ).
Legally, a CMO is a debt security issued by an abstraction - a special purpose entity - and is not a debt
owed by the institution creating and operating the entity. The entity is the legal owner of a set of mortgages, called a pool. Investors in a CMO buy bonds issued by the entity, and they receive payments from the
income generated by the mortgages according to a dened set of rules. With regard to terminology, the mortgages themselves are termed collateral, 'classes refers to
groups of mortgages issued to borrowers of roughly similar credit worthiness, tranches are specied fractions or
slices, metaphorically speaking, of a pool of mortgages
and the income they produce that are combined into an
individual security, while the structure is the set of rules
that dictates how the income received from the collateral
will be distributed. The legal entity, collateral, and structure are collectively referred to as the deal. Unlike traditional mortgage pass-through securities, CMOs feature
dierent payment streams and risks, depending on investor preferences.[1] For tax purposes, CMOs are generally structured as Real Estate Mortgage Investment Conduits, which avoid the potential for double-taxation.[3]
Investors in CMOs include banks, hedge funds, insurance
companies, pension funds, mutual funds, government
agencies, and most recently central banks. This article
focuses primarily on CMO bonds as traded in the United
States of America.

221
risk.
A 30 year time frame is a long time for an investors
money to be locked away. Only a small percentage of investors would be interested in locking away
their money for this long. Even if the average home
owner renanced their loan every 10 years, meaning
that the average bond would only last 10 years, there
is a risk that the borrowers would not renance, such
as during an extending high interest rate period, this
is known as extension risk. In addition, the longer
time frame of a bond, the more the price moves up
and down with the changes of interest rates, causing
a greater potential penalty or bonus for an investor
selling his bonds early. This is known as interest rate
risk.
Most normal bonds can be thought of as interest
only loans, where the borrower borrows a xed
amount and then pays interest only before returning the principal at the end of a period. On a normal mortgage, interest and principal are paid each
month, causing the amount of interest earned to decrease. This is undesirable to many investors because they are forced to reinvest the principal. This
is known as reinvestment risk.
On loans not guaranteed by the quasi-governmental
agencies Fannie Mae or Freddie Mac, certain investors may not agree with the risk reward tradeo
of the interest rate earned versus the potential loss of
principal due to the borrower not paying. The latter
event is known as default risk.

The term collateralized mortgage obligation technically

refers to a security issued by specic type of legal entity
dealing in residential mortgages, but investors also frequently refer to deals put together using other types of Salomon Brothers and First Boston created the CMO
entities such as real estate mortgage investment conduits concept to address these issues. A CMO is essentially
as CMOs.
a way to create many dierent kinds of bonds from the
same mortgage loan so as to please many dierent kinds
of investors. For example:

9.10.1

Purpose

The most basic way a mortgage loan can be transformed

into a bond suitable for purchase by an investor would
simply be to split it. For example, a $300,000 30 year
mortgage with an interest rate of 6.5% could be split into
300 1000 dollar bonds. These bonds would have a 30 year
amortization, and an interest rate of 6.00% for example
(with the remaining .50% going to the servicing company
to send out the monthly bills and perform servicing work).
However, this format of bond has various problems for
various investors
Even though the mortgage is 30 years, the borrower
could theoretically pay o the loan earlier than 30
years, and will usually do so when rates have gone
down, forcing the investor to have to reinvest his
money at lower interest rates, something he may
have not planned for. This is known as prepayment

A group of mortgages could create 4 dierent

classes of bonds. The rst group would receive any
prepayments before the second group would, and so
on. Thus the rst group of bonds would be expected
to pay o sooner, but would also have a lower interest rate. Thus a 30 year mortgage is transformed
into bonds of various lengths suitable for various investors with various goals.
A group of mortgages could create 4 dierent
classes of bonds. Any losses would go against the
rst group, before going against the second group,
etc. The rst group would have the highest interest
rate, while the second would have slightly less, etc.
Thus an investor could choose the bond that is right
for the risk they want to take (i.e. a conservative
bond for an insurance company, a speculative bond
for a hedge fund).

222
A group of mortgages could be split into principalonly and interest-only bonds. The principal-only
bonds would sell at a discount, and would thus be
zero coupon bonds (e.g., bonds that you buy for
$800 each and which mature at $1,000, without
paying any cash interest). These bonds would satisfy investors who are worried that mortgage prepayments would force them to re-invest their money
at the exact moment interest rates are lower; countering this, principal only investors in such a scenario would also be getting their money earlier rather
than later, which equates to a higher return on their
zero-coupon investment. The interest-only bonds
would include only the interest payments of the underlying pool of loans. These kinds of bonds would
dramatically change in value based on interest rate
movements, e.g., prepayments mean less interest
payments, but higher interest rates and lower prepayments means these bonds pay more, and for a
longer time. These characteristics allow investors
to choose between interest-only (IO) or principalonly (PO) bonds to better manage their sensitivity
to interest rates, and can be used to manage and oset the interest rate-related price changes in other
investments.[4]

CHAPTER 9. CREDIT DERIVATIVES

Credit tranching
The most common form of credit protection is called
credit tranching. In the simplest case, credit tranching
means that any credit losses will be absorbed by the most
junior class of bondholders until the principal value of
their investment reaches zero. If this occurs, the next
class of bonds absorb credit losses, and so forth, until nally the senior bonds begin to experience losses. More
frequently, a deal is embedded with certain triggers related to quantities of delinquencies or defaults in the loans
backing the mortgage pool. If a balance of delinquent
loans reaches a certain threshold, interest and principal
that would be used to pay junior bondholders is instead
directed to pay o the principal balance of senior bondholders, shortening the life of the senior bonds.
Overcollateralization
In CMOs backed by loans of lower credit quality, such
as subprime mortgage loans, the issuer will sell a quantity
of bonds whose principal value is less than the value of
the underlying pool of mortgages. Because of the excess
collateral, investors in the CMO will not experience losses
until defaults on the underlying loans reach a certain level.

If the overcollateralization turns into undercollateralization (the assumptions of the default rate were inadeWhenever a group of mortgages is split into dierent quate), then the CMO defaults. CMOs have contributed
classes of bonds, the risk does not disappear. Rather, it is to the subprime mortgage crisis.
reallocated among the dierent classes. Some classes receive less risk of a particular type; other classes more risk
of that type. How much the risk is reduced or increased Excess spread
for each class depends on how the classes are structured.
Another way to enhance credit protection is to issue
bonds that pay a lower interest rate than the underlying
mortgages. For example, if the weighted average interest
rate of the mortgage pool is 7%, the CMO issuer could
choose to issue bonds that pay a 5% coupon. The addi9.10.2 Credit protection
tional interest, referred to as excess spread, is placed
into a spread account until some or all of the bonds in
CMOs are most often backed by mortgage loans, which the deal mature. If some of the mortgage loans go delinare originated by thrifts (savings and loans), mortgage quent or default, funds from the excess spread account can
companies, and the consumer lending units of large com- be used to pay the bondholders. Excess spread is a very
mercial banks. Loans meeting certain size and credit eective mechanism for protecting bondholders from decriteria can be insured against losses resulting from bor- faults that occur late in the life of the deal because by that
rower delinquencies and defaults by any of the Gov- time the funds in the excess spread account will be suernment Sponsored Enterprises (GSEs) (Freddie Mac, cient to cover almost any losses.
Fannie Mae, or Ginnie Mae). GSE guaranteed loans can
serve as collateral for Agency CMOs, which are subject
to interest rate risk but not credit risk. Loans not meeting 9.10.3 Prepayment tranching
these criteria are referred to as Non-Conforming, and
can serve as collateral for private label mortgage bonds, The principal (and associated coupon) stream for CMO
which are also called whole loan CMOs. Whole loan collateral can be structured to allocate prepayment risk.
CMOs are subject to both credit risk and interest rate Investors in CMOs wish to be protected from prepayment
risk. Issuers of whole loan CMOs generally structure risk as well as credit risk. Prepayment risk is the risk that
their deals to reduce the credit risk of all certain classes the term of the security will vary according to diering
of bonds (Senior Bonds) by utilizing various forms of rates of repayment of principal by borrowers (repayments
from renancings, sales, curtailments, or foreclosures).
credit protection in the structure of the deal.

9.10. COLLATERALIZED MORTGAGE OBLIGATION

If principal is prepaid faster than expected (for example, if mortgage rates fall and borrowers renance), then
the overall term of the mortgage collateral will shorten,
and the principal returned at par will cause a loss for premium priced collateral. This prepayment risk cannot be
removed, but can be reallocated between CMO tranches
so that some tranches have some protection against this
risk, whereas other tranches will absorb more of this risk.
To facilitate this allocation of prepayment risk, CMOs
are structured such that prepayments are allocated between bonds using a xed set of rules. The most common
schemes for prepayment tranching are described below.
Sequential tranching (or by time)

223
few of the mortgages prepaid, but could get very little money if many mortgages prepaid.
Z bonds
This type of tranche supports other tranches by not receiving an interest payment. The interest payment that
would have accrued to the Z tranche is used to pay o
the principal of other bonds, and the principal of the Z
tranche increases. The Z tranche starts receiving interest
and principal payments only after the other tranches in
the CMO have been fully paid. This type of tranche is
often used to customize sequential tranches, or VADM
tranches.

All of the available principal payments go to the rst seSchedule bonds (also called PAC or TAC bonds)
quential tranche, until its balance is decremented to zero,
then to the second, and so on. There are several reasons
This type of tranching has a bond (often called a PAC
that this type of tranching would be done:
or TAC bond) which has even less uncertainty than a sequential bond by receiving prepayments according to a
The tranches could be expected to mature at very dened schedule. The schedule is maintained by using
dierent times and therefore would have dierent support bonds (also called companion bonds) that absorb
yields that correspond to dierent points on the yield the excess prepayments.
curve.
The underlying mortgages could have a great deal
of uncertainty as to when the principal will actually
be received since home owners have the option to
make their scheduled payments or to pay their loan
o early at any time. The sequential tranches each
have much less uncertainty.
Parallel tranching
This simply means tranches that pay down pro rata. The
coupons on the tranches would be set so that in aggregate
the tranches pay the same amount of interest as the underlying mortgages. The tranches could be either xed rate
or oating rate. If they have oating coupons, they would
have a formula that make their total interest equal to the
collateral interest. For example, with collateral that pays
a coupon of 8%, you could have two tranches that each
have half of the principal, one being a oater that pays
LIBOR with a cap of 16%, the other being an inverse
oater that pays a coupon of 16% minus LIBOR.
A special case of parallel tranching is known as the
IO/PO split. IO and PO refer to Interest Only and
Principal Only. In this case, one tranche would have
a coupon of zero (meaning that it would get no interest at all) and the other would get all of the interest. These bonds could be used to speculate on
prepayments. A principal only bond would be sold
at a deep discount (a much lower price than the underlying mortgage) and would rise in price rapidly
if many of the underlying mortgages were prepaid.
The interest only bond would be very protable if

Planned Amortization Class (PAC) bonds have a

principal payment rate determined by two dierent
prepayment rates, which together form a band (also
called a collar). Early in the life of the CMO, the
prepayment at the lower PSA will yield a lower prepayment. Later in the life, the principal in the higher
PSA will have declined enough that it will yield a
lower prepayment. The PAC tranche will receive
whichever rate is lower, so it will change prepayment
at one PSA for the rst part of its life, then switch
to the other rate. The ability to stay on this schedule
is maintained by a support bond, which absorbs excess prepayments, and will receive less prepayments
to prevent extension of average life. However, the
PAC is only protected from extension to the amount
that prepayments are made on the underlying MBSs.
When the principal of that bond is exhausted, the
CMO is referred to as a busted PAC, or busted
collar.
Target Amortization Class (TAC) bonds are similar
to PAC bonds, but they do not provide protection
against extension of average life. The schedule of
principal payments is created by using just a single
PSA.
Very accurately dened maturity (VADM) bonds
Very accurately dened maturity (VADM) bonds are similar to PAC bonds in that they protect against both extension and contraction risk, but their payments are supported in a dierent way. Instead of a support bond, they
are supported by accretion of a Z bond. Because of this,

224

CHAPTER 9. CREDIT DERIVATIVES

a VADM tranche will receive the scheduled prepayments rate tranche. An IO pays a coupon only based on a noeven if no prepayments are made on the underlying.
tional principal, it receives no principal payments from
amortization or prepayments. Notional principal does not
have any cash ows but shadows the principal changes
Non-accelerating senior (NAS)
of the original tranche, and it is this principal o which
the coupon is calculated. For example a $100mm PAC
NAS bonds are designed to protect investors from volatil- tranche o 6% collateral with a 6% coupon ('6 o 6' or
ity and negative convexity resulting from prepayments. '6-squared') can be cut into a $100mm PAC tranche with
NAS tranches of bonds are fully protected from prepay- a 5% coupon (and hence a lower dollar price) called a '5
ments for a specied period, after which time prepay- o 6', and a PAC IO tranche with a notional principal of
ments are allocated to the tranche using a specied step $16.666667mm and paying a 6% coupon. Note the redown formula. For example, an NAS bond might be pro- sulting notional principle of the IO is less than the original
tected from prepayments for ve years, and then would principal. Using the example, the IO is created by taking
receive 10% of the prepayments for the rst month, then 1% of coupon o the 6% original coupon gives an IO of
20%, and so on. Recently, issuers have added features to 1% coupon o $100mm notional principal, but this is by
accelerate the proportion of prepayments owing to the convention 'normalized' to a 6% coupon (as the collatNAS class of bond in order to create shorter bonds and eral was originally 6% coupon) by reducing the notional
reduce extension risk. NAS tranches are usually found principal to $16.666667mm ($100mm / 6).
in deals that also contain short sequentials, Z-bonds, and
credit subordination. A NAS tranche receives principal
payments according to a schedule which shows for a given PO/premium xed rate pair
month the share of pro rata principal that must be distributed to the NAS tranche.
Similarly if a xed rate CMO tranche coupon is desired
NASquential

to be increased, then principal can be removed to form

a Principal Only (PO) class and a premium xed rate
tranche. A PO pays no coupon, but receives principal
payments from amortization and prepayments. For example a $100mm sequential (SEQ) tranche o 6% collateral with a 6% coupon ('6 o 6') can be cut into an
$92.307692mm SEQ tranche with a 6.5% coupon (and
hence a higher dollar price) called a '6.5 o 6', and a SEQ
PO tranche with a principal of $7.692308mm and paying
a no coupon. The principal of the premium SEQ is calculated as (6 / 6.5) * $100mm, the principal of the PO is
calculated as balance from $100mm.

NASquentials were introduced in mid-2005 and represented an innovative structural twist, combining the
standard NAS (Non-Accelerated Senior) and Sequential structures. Similar to a sequential structure, the
NASquentials are tranched sequentially, however, each
tranche has a NAS-like hard lockout date associated with
it. Unlike with a NAS, no shifting interest mechanism
is employed after the initial lockout date. The resulting
bonds oer superior stability versus regular sequentials,
and yield pickup versus PACs. The support-like cashows falling out on the other side of NASquentials are
IO/PO pair
sometimes referred to as RUSquentials (Relatively Unstable Sequentials).
The simplest coupon tranching is to allocate the coupon
stream to an IO, and the principal stream to a PO. This
is generally only done on the whole collateral without any
9.10.4 Coupon tranching
prepayment tranching, and generates strip IOs and strip
The coupon stream from the mortgage collateral can POs. In particular FNMA and FHLMC both have extenalso be restructured (analogous to the way the princi- sive strip IO/PO programs (aka Trusts IO/PO or SMBS)
pal stream is structured). This coupon stream alloca- which generate very large, liquid strip IO/PO deals at regtion is performed after prepayment tranching is com- ular intervals.

plete. If the coupon tranching is done on the collateral without any prepayment tranching, then the resulting
Floater/inverse pair
tranches are called 'strips. The benet is that the resulting CMO tranches can be targeted to very dierent sets
of investors. In general, coupon tranching will produce a The construction of CMO Floaters is the most eective
means of getting additional market liquidity for CMOs.
pair (or set) of complementary CMO tranches.
CMO oaters have a coupon that moves in line with a
given index (usually 1 month LIBOR) plus a spread, and
is thus seen as a relatively safe investment even though
IO/discount xed rate pair
the term of the security may change. One feature of
A xed rate CMO tranche can be further restructured into CMO oaters that is somewhat unusual is that they have
an Interest Only (IO) tranche and a discount coupon xed a coupon cap, usually set well out of the money (e.g. 8%

9.10. COLLATERALIZED MORTGAGE OBLIGATION

when LIBOR is 5%) In creating a CMO oater, a CMO
Inverse is generated. The CMO inverse is a more complicated instrument to hedge and analyse, and is usually
sold to sophisticated investors.
The construction of a oater/inverse can be seen in two
stages. The rst stage is to synthetically raise the eective coupon to the target oater cap, in the same way as
done for the PO/Premium xed rate pair. As an example using $100mm 6% collateral, targeting an 8% cap,
we generate $25mm of PO and $75mm of '8 o 6'. The
next stage is to cut up the premium coupon into a oater
and inverse coupon, where the oater is a linear function
of the index, with unit slope and a given oset or spread.
In the example, the 8% coupon of the '8 o 6' is cut into
a oater coupon of:

225
Once an underlying debt is paid o, that debts future
stream of interest is terminated. Therefore, IO securities
are highly sensitive to prepayments and/or interest rates
and bear more risk. (These securities usually have a negative eective duration.) IOs have investor demand due
to their negative duration acting as a hedge against conventional securities in a portfolio, their generally positive
carry (net cashow), and their implicit leverage (low dollar price versus potential price action).
Principal only (PO)

A principal only (PO) strip may be carved from collateral

securities to receive just the principal portion of a payment. A PO typically has more eective duration than
its collateral. (One may think of this in two ways: 1. The
1 * LIBOR + 0.40%
increased eective duration must balance the matching
(indicating a 0.40%, or 40bps, spread in this example)
IOs negative eective duration to equal the collaterals
The inverse formula is simply the dierence of the orig- eective duration, or 2. Bonds with lower coupons usuinal premium xed rate coupon less the oater formula. ally have higher eective durations and a PO has no [zero]
coupon.) POs have investor demand as hedges against IO
In the example:
type streams (e.g. mortgage servicing).
8% - (1 * LIBOR + 0.40%) = 7.60% - 1 * LIBOR
The oater coupon is allocated to the premium xed rate
tranche principal, in the example the $75mm '8 o 6', 9.10.6 See also
giving the oater tranche of '$75mm 8% cap + 40bps LI Asset-backed security
BOR SEQ oater'. The oater will pay LIBOR + 0.40%
each month on an original balance of $75mm, subject to
Collateralized debt obligation (CDO)
a coupon cap of 8%.
Collateralized fund obligation (CFO)
The inverse coupon is to be allocated to the PO principal, but has been generated of the notional principal of
the premium xed rate tranche (in the example the PO
principal is $25mm but the inverse coupon is notionalized o $75mm). Therefore the inverse coupon is 'renotionalized' to the smaller principal amount, in the example this is done by multiplying the coupon by ($75mm
/$25mm) = 3. Therefore the resulting coupon is:

GNMA
Mortgage-backed security
Real estate mortgage investment conduit

9.10.7 References

3 * (7.60% - 1 * LIBOR) = 22.8% - 3 * LIBOR

In the example the inverse generated is a '$25mm 3 times
levered 7.6 strike LIBOR SEQ inverse'.

[1] Lemke, Lins and Picard, Mortgage-Backed Securities,

Chapter 4 (Thomson West, 2013 ed.).
[2] FIAS: Dexter Senft

Other structures

[3] Lemke, Lins and Picard, Mortgage-Backed Securities,

4:20 (Thomson West, 2013 ed.).

Other structures include Inverse IOs, TTIBs, Digital

TTIBs/Superoaters, and 'mountain' bonds. A special
class of IO/POs generated in non-agency deals are WAC
IOs and WAC POs, which are used to build a xed pass
through rate on a deal.

[4] The Various Types of CMOs

9.10.5

Attributes of IOs and POs

Interest only (IO)

An interest only (IO) strip may be carved from collateral
securities to receive just the interest portion of a payment.

Chapter 10

Interest Rate Derivatives

10.1 Interest rate risk

7. Analyzing Duration, Convexity, DV01 and Key

Rate Duration.

Interest rate risk is the risk that arises for bond owners
from uctuating interest rates. How much interest rate
risk a bond has depends on how sensitive its price is to
interest rate changes in the market. The sensitivity de10.1.2 Interest rate risk at banks
pends on two things, the bonds time to maturity, and the
[1]
coupon rate of the bond.
The assessment of interest rate risk is a very large topic
at banks, thrifts, saving and loans, credit unions, and
10.1.1 Calculating interest rate risk
other nance companies, and among their regulators.
The widely deployed CAMELS rating system assesses
Interest rate risk analysis is almost always based on sim- a nancial institutions: (C)apital adequacy, (A)ssets,
ulating movements in one or more yield curves using the (M)anagement Capability, (E)arnings, (L)iquidity, and
Heath-Jarrow-Morton framework to ensure that the yield (S)ensitivity to market risk. A large portion of the
curve movements are both consistent with current market (S)ensitivity in CAMELS is interest rate risk. Much of
yield curves and such that no riskless arbitrage is possible. what is known about assessing interest rate risk has been
The Heath-Jarrow-Morton framework was developed in developed by the interaction of nancial institutions with
the early 1991 by David Heath of Cornell University, An- their regulators since the 1990s. Interest rate risk is undrew Morton of Lehman Brothers, and Robert A. Jarrow questionably the largest part of the (S)ensitivity analysis
of Kamakura Corporation and Cornell University.
in the CAMELS system for most banking institutions.
There are a number of standard calculations for measur- When a bank receives a bad CAMELS rating equity holding the impact of changing interest rates on a portfolio ers, bond holders and creditors are at risk of loss, senior
consisting of various assets and liabilities. The most com- managers can lose their jobs and the rms are put on the
FDIC problem bank list.
mon techniques include:
See the (S)ensitivity section of the CAMELS rating sys1. Marking to market, calculating the net market value tem for a substantial list of links to documents and exof the assets and liabilities, sometimes called the aminer manuals, issued by nancial regulators, that cover
many issues in the analysis of interest rate risk.
market value of portfolio equity
2. Stress testing this market value by shifting the yield In addition to being subject to the CAMELS system, the
largest banks are often subject to prescribed stress testing.
curve in a specic way.
The assessment of interest rate risk is typically informed
3. Calculating the value at risk of the portfolio
by some type of stress testing. See: Stress test (nancial),
List of bank stress tests, List of systemically important
4. Calculating the multiperiod cash ow or nancial acbanks.
crual income and expense for N periods forward in
a deterministic set of future yield curves
5. Doing step 4 with random yield curve movements
and measuring the probability distribution of cash
10.1.3
ows and nancial accrual income over time.
6. Measuring the mismatch of the interest sensitivity
gap of assets and liabilities, by classifying each asset
and liability by the timing of interest rate reset or
maturity, whichever comes rst.
226

References

[1] Ross, Westereld, Jordan (2010). Fundamentals of Corporate Finance. New York: McGraw Hill / Irwin. ISBN
978-007-108855-8.

10.2. INTEREST RATE DERIVATIVE

10.2 Interest rate derivative

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 cashow needs
or specic views on the interest rate movements (such as
volatility movements or simple directional movements)
and are therefore usually traded OTC; see nancial engineering.

227
Range accrual swaps/notes/bonds
In-arrears swap
Constant maturity swap (CMS) or constant treasury
swap (CTS) derivatives (swaps, caps, oors)
Interest rate swap based upon two oating interest
rates

The interest rate derivatives market is the largest derivaExotic derivatives

tives market in the world. The Bank for International Settlements estimates that the notional amount outstanding
Building o these structures are the "exotic" interest rate
in June 2012 [1] were US$494 trillion for OTC interest
derivatives (least liquid, traded over the counter), such as:
rate contracts, and US$342 trillion for OTC interest rate
swaps. According to the International Swaps and Deriva Power reverse dual currency note (PRDC or Turbo)
tives Association, 80% of the worlds top 500 companies
as of April 2003 used interest rate derivatives to control
Target redemption note (TARN)
their cashows. This compares with 75% for foreign exchange options, 25% for commodity options and 10% for
CMS steepener
stock options.
Snowball
Modeling of interest rate derivatives is usually done on a
Inverse oater
time-dependent multi-dimensional Lattice (tree) built
for the underlying risk drivers, usually domestic or for Strips of Collateralized mortgage obligation
eign short rates and foreign exchange market rates, and
incorporating delivery- and day count conventions; see
Ratchet caps and oors
Short-rate model. Specialised simulation models are also
Bermudan swaptions
often used.
Cross currency swaptions

10.2.1

Types

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 (xed-for-oating)
Interest rate cap or interest rate oor
Interest rate swaption
Bond option
Forward rate agreement
Interest rate future
Money market instruments

Most of the exotic interest rate derivatives are structured

as swaps or notes, and can be classied as having two payment legs: a funding leg and an exotic coupon leg.
A funding leg usually consists of series of xed
coupons or oating coupons (LIBOR) plus xed
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 so-called Bermudan
exercise feature. There may also be some rangeaccrual and knock-out features inherent in the exotic
coupon denition.

Cross currency swap (see Forex swap)

10.2.2 Example of interest rate derivatives

Interest rate cap

Quasi-vanilla
An interest rate cap is designed to hedge a companys
The next intermediate level is a quasi-vanilla class of maximum exposure to upward interest rate movements.
(fairly liquid) derivatives, examples of which are:
It establishes a maximum total dollar interest amount the

228

CHAPTER 10. INTEREST RATE DERIVATIVES

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 benet of the
cap over the life of the contract.
Range accrual note

Damiano Brigo, Fabio Mercurio (2001). Interest

Rate Models - Theory and Practice with Smile, Ination and Credit (2nd ed. 2006 ed.). Springer Verlag.
ISBN 978-3-540-22149-4.
John C. Hull (2005) Options, Futures and Other
Derivatives, Sixth Edition. Prentice Hall. ISBN 013-149908-4
John F. Marhsall (2000). Dictionary of Financial
Engineering. Wiley. ISBN 0-471-24291-8

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
10.2.6 External links
instead. This note pays interest only if the oating interest
rate (i.e.London Interbank Oered Rate) stays within a
Basic Fixed Income Derivative Hedging - Article on
pre-determined band. This note eectively contains an
Financial-edu.com.
embedded option which, in this case, the buyer of the
note has sold to the issuer. This option adds to the yield
Interest Rate Modeling by L. Andersen and V. Piterof the note. In this way, if volatility remains low, the bond
barg
yields more than a standard bond.
Bermudan swaption
Suppose a xed-coupon callable bond was brought to the
market by a company. The issuer however, entered into
an interest rate swap to convert the xed coupon payments
to oating 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, eectively
canceling the swap leaving no more interest rate exposure
for the issuer.

10.2.3

See also

Mathematical nance
Financial modeling

10.2.4

References

[1] Bank for International Settlements Semiannual OTC

derivatives statistics at end-June 2012. Retrieved 5 July
2013.

10.3 Forward rate agreement

In nance, a forward rate agreement (FRA) is a
forward contract, an over-the-counter contract between
parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will
determine the rates to be used along with the termination
date and notional value.[1] On this type of agreement, it
is only the dierential that is paid on the notional amount
of the contract. It is paid on the eective date. The reference rate is xed one or two days before the eective
date, dependent on the market convention for the particular currency. FRAs are over-the counter derivatives.
FRAs are very similar to swaps except that in a FRA a
payment is only made once at maturity. Instruments such
as interest rate swap could be viewed as a chain of FRAs.
Many banks and large corporations will use FRAs to
hedge future interest or exchange rate exposure. The
buyer hedges against the risk of rising interest rates, while
the seller hedges against the risk of falling interest rates.
Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional
changes in interest rates. The development swaps in the
1980s provided organisations with an alternative to FRAs
for hedging and speculating.

In other words, a forward rate agreement (FRA) is a

tailor-made, over-the-counter nancial futures contract
on short-term deposits. A FRA transaction is a contract
between two parties to exchange payments on a deposit,
10.2.5 Further reading
called the Notional amount, to be determined on the basis
of a short-term interest rate, referred to as the Reference
Leif B.G. Andersen, Vladimir V. Piterbarg (2010). rate, over a predetermined time period at a future date.
Interest Rate Modeling in Three Volumes (1st ed. FRA transactions are entered as a hedge against interest
2010 ed.). Atlantic Financial Press. ISBN 978-0- rate changes. The buyer of the contract locks in the in9844221-0-4.
terest rate in an eort to protect against an interest rate

10.4. INTEREST RATE FUTURE

229

increase, while the seller protects against a possible inter- 10.3.4 See also
est rate decline. At maturity, no funds exchange hands;
Forward rate
rather, the dierence between the contracted interest rate
and the market rate is exchanged. The buyer of the con Derivative (nance)
tract is paid if the reference rate is above the contracted
rate, and the buyer pays to the seller if the reference rate
List of nance topics
is below the contracted rate. A company that seeks to
Forward Rate Agreements on Wikinvest
hedge against a possible increase in interest rates would
purchase FRAs, whereas a company that seeks an interest hedge against a possible decline of the rates would sell
10.4 Interest rate future
FRAs.

10.3.1

Payo formula

Short Sterling redirects here. For the World War II

bomber, see Short Stirling.

The netted payment made at the eective date is as folAn interest rate future is a nancial derivative (a futures
lows
contract) with an interest-bearing instrument as the unPayment
=
Notional
Amount

(
)
derlying asset.[1] It is a particular type of interest rate
(Reference RateFixed Rate)
derivative.
(1+Reference Rate)
Examples include Treasury-bill futures, Treasury-bond
The Fixed Rate is the rate at which the contract is futures and Eurodollar futures.
agreed.
The global market for exchange-traded interest rate fu The Reference Rate is typically Euribor or LIBOR. tures is notionally valued by the Bank for International
Settlements at $5,794,200 million in 2005.
is the day count fraction, i.e. the portion of a year
over which the rates are calculated, using the day
count convention used in the money markets in the 10.4.1 Uses
underlying currency. For EUR and USD this is generally the number of days divided by 360, for GBP Interest rate futures are used to hedge against the risk that
interest rates will move in an adverse direction, causing a
it is the number of days divided by 365 days.
cost to the company.
The Fixed Rate and Reference Rate are rates that
For example, borrowers face the risk of interest rates risshould accrue over a period starting on the eective
ing. Futures use the inverse relationship between interest
date, and then paid at the end of the period (termirates and bond prices to hedge against the risk of rising
nation date). However, as the payment is already
interest rates. A borrower will enter to sell a future today.
known at the beginning of the period, it is also paid
Then if interest rates rise in the future, the value of the
at the beginning. This is why the discount factor is
future will fall (as it is linked to the underlying asset, bond
used in the denominator.
prices), and hence a prot can be made when closing out
of the future (i.e. buying the future).

10.3.2

FRAs Notation

FRA Descriptive Notation and Interpretation

How to interpret a quote for FRA?
[US$ 3x9 - 3.25/3.50%p.a ] - means deposit interest starting 3 months from now for 6 month is 3.25% and borrowing interest rate starting 3 months from now for 6 month
is 3.50% (see also bidoer spread). Entering a payer
FRA means paying the xed rate (3.50% p.a.) and receiving a oating 6-month rate, while entering a receiver
FRA means paying the same oating rate and receiving
a xed rate (3.25% p.a.).

10.3.3

References

[1] http://www.investopedia.com/terms/f/fra.asp

Treasury futures are contracts sold on the Globex market

for March, June, September and December contracts. As
pressure to raise interest rates rises, futures contracts will
reect that speculation as a decline in price. Price and
yield will always be in an inversely correlated relationship.
It is important to note that interest rate futures are not directly correlated with the market interest rates. When one
enters into an interest rate futures contract (like a bond
future), the trader has ability to eventually take delivery
of the underlying asset. In the case of notes and bonds
this means the trader could potentially take delivery of a
bunch of bonds if the contract is not cash settled. The
bonds which the seller can deliver vary depending on the
futures contract. The seller can choose to deliver a variety of bonds to the buyer that t the denitions laid out in
the contract. The futures contract price takes this into account, therefore prices have less to do with current market

230

CHAPTER 10. INTEREST RATE DERIVATIVES

interest rates, and more to do with what existing bonds in

the market are cheapest to deliver to the buyer.[2]

10.4.2

STIRS

A short-term interest rate (STIR) future is a futures

contract that derives its value from the interest rate at
maturation. Common short-term interest rate futures
are Eurodollar, Euribor, Euroyen, Short Sterling and Euroswiss, which are calculated on LIBOR at settlement,
with the exception of Euribor which is based on Euribor.
This value is calculated as 100 minus the interest rate.
Exchange-traded Strategies
A great deal of the trading on these contracts is exchange
traded multi-leg strategies, essentially bets upon the future shape of the yield curve and/or basis. Both Lie and
CME allow direct exchange trading in calendar spreads
(the order book for spreads is separate from that of the
underlying futures), which are quoted in terms of implied prices (price dierences between futures of dierent expiries). Exchange-traded futures spreads greatly reduce execution risk and slippage, allowing traders to place
guaranteed limit orders for entire spreads, otherwise impossible when entering into spreads via two separate futures orders.

10.4.3

See also

Forward contract

10.4.4

10.5 Interest rate option

An Interest rate option is a specic nancial derivative
contract whose value is based on interest rates. Its value
is tied to an underlying interest rate, such as the yield on
10 year treasury notes.
Similar to equity options, there are two types of contracts:
calls and puts. A call gives the bearer the right, but not
the obligation, to benet o a rise in interest rates. A put
gives the bearer the right, but not the obligation, to prot
from a decrease in interest rates.
The exchange of these interest rate derivatives are monitored and facilitated by a central exchange such as those
operated by CME Group.

10.5.1 See also

Derivative (nance)

10.6 Interest rate swap

An interest rate swap (IRS) is a popular and highly
liquid nancial derivative instrument in which two parties agree to exchange interest rate cash ows, based
on a specied notional amount from a xed rate to a
oating rate (or vice versa) or from one oating rate to
another.[1] Interest rate swaps are used for both hedging
and speculating.

10.6.1 Structure

External links

The Fundamentals of Trading U.S. Treasury Bond

and Note Futures by CME Group
Answers.com description of interest rate futures
contracts
Euronext description of short sterling contracts
Quandl: Rates Futures - free, historical data
Interest Rate Futures Contract Specications and
Tick Values at ExcelTradingModels.com
Party A is currently paying oating rate, but wants to pay xed

10.4.5

References

[1] The future regulation of derivatives markets: is the EU

on the right track? (Introduction)". Parliament. 23 March
2010. Retrieved 18 June 2013.
[2] Willette, Je (1 October 2013). Bond Futures: What Do
The Quote Prices Really Mean?". www.RadBrains.com.
Retrieved 2013-10-08.

rate. Party B is currently paying xed rate, but wants to pay oating rate. By entering into an interest rate swap, the net result is
that each party can swap their existing obligation for their desired
obligation.

In an interest rate swap, each counterparty agrees to pay

either a xed or oating rate denominated in a particular
currency to the other counterparty. The xed or oating
rate is multiplied by a notional principal amount (say, $1
million) and an accrual factor given by the appropriate

10.6. INTEREST RATE SWAP

day count convention. When both legs are in the same
currency, this notional amount is typically not exchanged
between counterparties, but is used only for calculating
the size of cashows to be exchanged. When the legs are
in dierent currencies, the respective notional amounts
are typically exchanged at the start and the end of the
swap.
The most common interest rate swap involves counterparty A paying a xed rate (the swap rate) to counterparty
B while receiving a oating rate indexed to a reference
rate like LIBOR, EURIBOR, or MIBOR. By market
convention, the counterparty paying the xed rate is the
payer (while receiving the oating rate), and the counterparty receiving the xed rate is the receiver (while
paying the oating rate).
A pays xed rate to B (A receives oating rate)
B pays oating rate to A (B receives xed rate)
Currently, A borrows from Market @ LIBOR +1.5%. B
borrows from Market @ 8.5%.

231
number of varieties and can be structured to meet the
specic needs of the counterparties. For example, the
legs of the swap could be in same or dierent currencies;
the notional of the swap could be amortized over time;
reset dates (or xing dates) of the oating rate could be
irregular.
The interbank market, however, only has a few standardized types which are listed below. Each currency has
its own standard market conventions regarding the frequency of payments, the day count conventions and the
end-of-month rule.[3]
Fixed-for-oating rate swap, same currency
For example, if a company has a $10 million xed rate
loan at 5.3% paid monthly and a oating rate investment
of JPY 1.2 billion that returns JPY 1M Libor +50bps every month, and wants to lock in the prot in USD as they
expect the JPY 1M Libor to go down or USDJPY to go up
(JPY depreciate against USD), then they may enter into a
xed-for-oating swap in dierent currencies where the
company pays oating JPY 1M Libor+50bps and receives
5.6% xed rate, locking in 30bps prot against the interest rate and the FX exposure.

Consider the following swap in which Party A agrees

to pay Party B periodic xed interest rate payments of
8.65% in exchange for periodic variable interest rate payments of LIBOR + 70 bps (0.70%) in the same currency. Note that there is no exchange of the principal
amounts and that the interest rates are on a notional
(i.e., imaginary) principal amount. Also note that interest Floating-for-xed rate swap, same currency
payments are settled in net; that is, Party A pays (LIBOR
+ 1.50%)+8.65% - (LIBOR+0.70%) = 9.45% net. The Fixed-for-oating rate swap, dierent currencies
xed rate (8.65% in this example) is referred to as the
Floating-for-xed rate swap, dierent currencies
swap rate.[2]

At the point of initiation of the swap, the swap is priced so

that it has a net present value of zero. If one party wants Fixed-for-xed rate swap, same currency
to pay 50 bps above the par swap rate, the other party has
to pay approximately 50bps over LIBOR to compensate Floating-for-oating rate swap, same currency
for this.
Party P pays/receives oating interest in currency A indexed to X to receive/pay oating rate in currency A indexed to Y on a notional N for a tenure of T years. For
10.6.2 Types
example, you pay JPY 1M LIBOR monthly to receive
JPY 1M TIBOR monthly on a notional JPY 1 billion for
three years or you pay EUR 3M EURIBOR quarterly to
receive EUR 6M EURIBOR semi-annually. The second
example, where the indexes are the same type but with
dierent tenors, are the most liquid and most commonly
traded same currency oating-for-oating swaps.
Floating-for-oating rate swaps are used to hedge against
or speculate on the spread between the two indexes. For
example, if a company has a oating rate loan at JPY 1M
LIBOR and the company has an investment that returns
Normally the parties do not swap payments directly, but rather JPY 1M TIBOR + 30bps and currently the JPY 1M TIeach sets up a separate swap with a nancial intermediary such BOR = JPY 1M LIBOR + 10bps. At the moment, this
as a bank. In return for matching the two parties together, the company has a net prot of 40bps. If the company thinks
bank takes a spread from the swap payments (in this case 0.30% JPY 1M TIBOR is going to come down (relative to the
compared to the above example)
LIBOR) or JPY 1M LIBOR is going to increase in the
future (relative to the TIBOR) and wants to insulate from
As OTC instruments, interest rate swaps can come in a this risk, they can enter into a oat-oat swap in same

232

CHAPTER 10. INTEREST RATE DERIVATIVES

currency where they pay, say, JPY TIBOR + 30bps and

rity of the debt, then when the company converts the
receive JPY LIBOR + 35bps. With this, they have efJPY to USD to pay back its matured debt, it receives
fectively locked in a 35bit/s prot instead of running with
less USD and suers a loss.
a current 40bps gain and index risk. The 5bps dier USDJPY interest rate risk: If JPY rates come
ence (w.r.t. the current rate dierence) comes from the
down, the return on the investment in Japan may also
swap cost which includes the market expectations of the
go down, introducing interest rate risk.
future rate dierence between these two indices and the
bid-oer spread, which is the swap commission for the
dealer.
The FX risk can be hedged with long-dated FX forward
Floating-for-oating rate swaps are also seen where both contracts, but this introduces yet another risk where the
sides reference the same index, but on dierent payment implied rate from the FX spot and the FX forward is a
dates, or use dierent business day conventions. This xed but the JPY investment returns a oating rate. Alcan be vital for asset-liability management. An example though there are several alternatives to hedge both expowould be swapping 3M LIBOR being paid with prior non- sures eectively without introducing new risks, the easibusiness day convention, quarterly on JAJO (i.e., Jan, est and most cost-eective alternative is to use a oatingApr, Jul, Oct) 30, into FMAN (i.e., Feb, May, Aug, Nov) for-oating swap in dierent currencies.
28 modied following.
Other variations
Fixed-for-xed rate swap, dierent currencies
Party P pays/receives xed interest in currency A to receive/pay xed rate in currency B for a term of T years.
For example, you pay JPY 1.6% on a JPY notional of
1.2 billion and receive USD 5.36% on the USD equivalent notional of $10 million at an initial exchange rate of
USDJPY 120.

A number of other far less common variations are possible. Mostly tweaks are made to ensure that a bond is
hedged perfectly, so that all the interest payments received are exactly oset, which can lead to swaps where
the principal is paid on one or more legs, rather than just
interest (for example to hedge a coupon strip), or where
the balance of the swap is automatically adjusted to match
that of a prepaying bond like residential mortgage-backed
securities.

Floating-for-oating rate swap, dierent currencies

Party P pays/receives oating interest in currency A indexed to X to receive/pay oating rate in currency B indexed to Y on a notional N at an initial exchange rate of
FX for a tenure of T years. The notional is usually exchanged at the start and at the end of the swap. This is
the most liquid type of swap with dierent currencies.
For example, you pay oating USD 3M LIBOR on the
USD notional 10 million quarterly to receive JPY 3M TIBOR quarterly on a JPY notional 1.2 billion (at an initial
exchange rate of USDJPY 120) for 4 years; at the start
you receive the notional in USD and pay the notional in
JPY and at the end you pay back the same USD notional
(10 million) and receive back the same JPY notional (1.2
billion).
For example, consider a U.S. company operating in Japan
that needs JPY 10 billion to fund its Japanese growth. The
easiest way to do this is to issue debt in Japan, but this
may be expensive if the company is new in the Japanese
market and lacking a good reputation among the Japanese
investors. Additionally, the company may not have the
appropriate debt issuance program in Japan or may lack
a sophisticated treasury operation in Japan. The company
could issue USD debt and convert to JPY on the FX market. This option solves the rst problem, but it introduces
two new risks:

Brazilian Swap

10.6.3 Uses
Interest rate swaps are used to hedge against or speculate
on changes in interest rates.
Speculation
Interest rate swaps are also used speculatively by hedge
funds or other investors who expect a change in interest rates or the relationships between them. Traditionally, xed income investors who expected rates to fall
would purchase cash bonds, whose value increased as
rates fell. Today, investors with a similar view could enter a oating-for-xed interest rate swap; as rates fall, investors would pay a lower oating rate in exchange for the
same xed rate.
Interest rate swaps are also popular for the arbitrage
opportunities they provide.
Varying levels of
creditworthiness means that there is often a positive quality spread dierential that allows both parties to
benet from an interest rate swap.

The interest rate swap market in USD is closely linked to

the Eurodollar futures market which trades among others
FX risk: If this USDJPY spot goes up at the matu- at the Chicago Mercantile Exchange.

10.6. INTEREST RATE SWAP

233
period and P D (ti ) is the discount factor for the payment
time ti .

British local authorities

In June 1988 the Audit Commission was tipped o by
someone working on the swaps desk of Goldman Sachs
that the London Borough of Hammersmith and Fulham
had a massive exposure to interest rate swaps. When the
commission contacted the council, the chief executive
told them not to worry as everybody knows that interest
rates are going to fall"; the treasurer thought the interest
rate swaps were a nice little earner. The Commissions
Controller, Howard Davies, realised that the council had
put all of its positions on interest rates going down and
ordered an investigation.

The value of the oating leg is given by the present value

of the oating coupon payments determined at the agreed
dates of each payment. However, at the start of the swap,
only the actual payment rates of the xed leg are known in
the future, whereas the forward rates are unknown. The
forward rate for each oating payment date is calculated
using the forward curves. The forward rate for the period
[tj1 , tj ] with accrual factor i is given by

)
(
1 P I (tj1 )
Fj =
1
By January 1989 the Commission obtained legal opinj
P I (tj )
ions from two Queens Counsel. Although they did not
agree, the commission preferred the opinion which made where I is the market index, such as USD LIBOR, and
I
it ultra vires for councils to engage in interest rate swaps. P (tj ) is the discount factor associated to the relevant
Moreover, interest rates had increased from 8% to 15%. forward curve. The value of the oating leg is given by
The auditor and the commission then went to court and the following:
had the contracts declared illegal (appeals all the way up
to the House of Lords failed in Hazell v Hammersmith
m

and Fulham LBC); the ve banks involved lost millions of P V

(Fj j P D (tj ))
oat = N
pounds. Many other local authorities had been engaging
j=1
in interest rate swaps in the 1980s.[4] This resulted in several cases in which the banks generally lost their claims where m is the number of oating payments, i is the acfor compound interest on debts to councils, nalised in crual factor according to the oating leg day count conWestdeutsche Landesbank Girozentrale v Islington Lon- vention.
don Borough Council.[5]
In the event that
PD = PI ,

10.6.4

Valuation and pricing

Further information: Rational_pricing Swaps

The valuation of vanilla swaps was often done using the
so-called textbook formulas using a unique curve in each
currency. Some early literature described some incoherence introduced by that approach and multiple banks
were using dierent techniques to reduce them. It became even more apparent with the 20072012 global
nancial crisis that the approach was not appropriate.
The now-standard pricing framework is the multi-curves
framework.

this formula simplies to

P Voat = N (1 P D (tm ))
on the reset dates, since the summation in P Voat telescopes to the rst and last terms only. On reset dates, the
value of an o-the-run swap (old issue) is given by
P Vxed P Voat = N (Beq 1)
where Beq is the value of hypothetical bond that mimics
the xed leg of the swap with a unit principal payable at
expiry. On none reset dates the swap value becomes
P Vxed P Voat = N (Beq P D (tr ))

where tr is the nearest reset date. The xed rate oered in

The present value of a plain vanilla (i.e., xed rate for the swap is the rate which values the xed rates payments
oating rate) swap can be computed by determining the at the same PV as the variable rate payments using todays
present value (PV) of the xed leg and the oating leg.
forward rates, i.e.:
The value of the xed leg is given by the present value of
the xed coupon payments known at the start of the swap,
i.e.

P Vxed = N C

n (

)
i P D (ti )

C=

P Voat

i=1 (N i P

[6]
D (t
i ))

Therefore, at the time the contract is entered into, there

is no advantage to either party, i.e.,

i=1

P Vxed = P Voat
where C is the swap rate, n is the number of xed payments, N is the notional amount, i is the accrual factor Thus, the swap requires no upfront payment from either
according to the day count convention for the xed rate party.

234

CHAPTER 10. INTEREST RATE DERIVATIVES

During the life of the swap the same valuation technique

default risk in exchange for a xed percentage of
is used, but since, over time, both the discounting factors
the transaction (the bid-ask spread). In an intermeand the forward rates change, the PV of the swap will
diated swap, the two parties are not typically even
aware of the identity of the second party to the transdeviate from its initial value. Therefore, the swap will
be an asset to one party and a liability to the other. The
action, making a quantication of the other partys
way these changes in value are reported is the subject of
credit risk not only irrelevant, but impossible.
IAS 39 for jurisdictions following IFRS, and FAS 133 for
U.S. GAAP. Swaps are marked to market by debt security
10.6.6 Market size
traders to visualize their inventory at a certain time.
On its December 2014 statistics release, the Bank for International Settlements reported that interest rate swaps
were the largest component of the global OTC derivative
Interest rate swaps expose users to interest rate risk and market representing 80% of it, with the notional amount
credit risk.
outstanding in OTC interest rate swaps of $630 trillion,
and the gross market value of $21 trillion.[8]
Market risk: A typical swap consists of two legs
Interest rate swaps can be traded as an index through the
one xed, the other oating. The risks of these
FTSE MTIRS Index.
two component will naturally dier. Newcomers to
market nance may think that the risky component
is the oating leg, since the underlying interest rate 10.6.7 See also
oats, and hence, is unknown. This rst impression
is wrong. The risky component is in fact the xed
Swap rate
leg and it is very easy to see why this is so.[7]
Interest rate cap and oor
(Comment: the above comment is not entirely accurate.
Equity swap
Normally people will assume a hypothetical notional exchange at the end. After this hypothetical assumption, the
Total return swap
swap can be understood as a oating rate bond vs a xed
Ination derivative
rate bond. The risks on the oating bond side are small
compared to the risks from the x rate bond side. How Eurodollar
ever, without this hypothetical notional exchange at the
end, purely the oating cash ow from the coupon pay Constant maturity swap
ments will have higher risks than the cash ow from the
FTSE MTIRS Index
xed coupon payments. Both understanding have their
merit and fully understand these two views are important
to see the risks, particularly for oating oating swaps)

10.6.5

Risks

The discussion of pricing interest rate swaps illustrated

an important point. Regardless of what happens to future Libor rates, the value of a rolling deposit or oating
rate note (FRN) always equals the notional amount N at
the reset dates. Between the reset dates this value may
be dierent from N, but the discrepancy cannot be very
large since the will be 3 or 6 months. Interest rate uctuations have minimal eect on the values of xed instruments with short maturities; in other words, the value
of the oating leg changes very little during the life of a
swap.
On the other hand the xed leg of a swap is equivalent to
a coupon bond and uctuations of the swap rate may have
major eects on the value of the future xed payments.
Credit risk on the swap comes into play if the swap
is in the money or not. If one of the parties is in
the money, then that party faces credit risk of possible default by another party. However, when the
swap is negotiated through an intermediary nancial institution, usually the intermediary assumes the

10.6.8 References

[1] Interest Rate Swap. Glossary. ISDA.

[2] "Interest Rate Swap" by Fiona Maclachlan, The Wolfram
Demonstrations Project.
[3] "Interest Rate Instruments and Market Conventions
Guide" Quantitative Research, OpenGamma, 2012.
[4] Duncan Campbell-Smith, Follow the Money: The Audit Commission, Public Money, and the Management of
Public Services 1983-2008, Allen Lane, 2008, chapter 6
passim.
[5] [1996] UKHL 12, [1996] AC 669
[6] Understanding interest rate swap math & pricing (PDF).
California Debt and Investment Advisory Commission.
January 2007. Retrieved 2007-09-27.
[7] http://chicagofed.org/webpages/publications/
understanding_derivatives/index.cfm
[8] OTC derivatives statistics at end-December 2014
(PDF). Bank for International Settlements.

10.7. INTEREST RATE CAP AND FLOOR

Pricing and Hedging Swaps, Miron P. & Swannell
P., Euromoney books 1991

235

10.7 Interest rate cap and oor

An interest rate cap is a derivative in which the buyer

Early literature on the incoherence of the one curve pric- receives payments at the end of each period in which the
interest rate exceeds the agreed strike price. An example
ing approach.
of a cap would be an agreement to receive a payment for
Interest rate parity, money market basis swaps and each month the LIBOR rate exceeds 2.5%.
cross-currency basis swaps, Tuckman B. and Por- Similarly an interest rate oor is a derivative contract
rio P., Fixed income liquid markets research, in which the buyer receives payments at the end of each
Lehman Brothers, 2003.
period in which the interest rate is below the agreed strike
price.
Cross currency swap valuation, Boenkost W. and
Schmidt W., Working Paper 2, HfB - Business Caps and oors can be used to hedge against interest rate
School of Finance & Management, 2004. SSRN uctuations. For example a borrower who is paying the
LIBOR rate on a loan can protect himself against a rise in
preprint.
rates by buying a cap at 2.5%. If the interest rate exceeds
The Irony in the Derivatives Discounting, Henrard 2.5% in a given period the payment received from the
M., Wilmott Magazine, pp. 9298, July 2007. derivative can be used to help make the interest payment
SSRN preprint.
for that period, thus the interest payments are eectively
capped at 2.5% from the borrowers point of view.
Multi-curves framework:

10.7.1 Interest rate cap

A multi-quality model of interest rates, Kijima M.,

Tanaka K., and Wong T., Quantitative Finance, An interest rate cap is a derivative in which the buyer
pages 133-145, 2009.
receives payments at the end of each period in which the
Two Curves, One Price: Pricing & Hedging Interest interest rate exceeds the agreed strike price. An example
Rate Derivatives Decoupling Forwarding and Dis- of a cap would be an agreement to receive a payment for
counting Yield Curves, Bianchetti M., Risk Maga- each month the LIBOR rate exceeds 2.5%.
zine, August 2010. SSRN preprint.

The interest rate cap can be analyzed as a series of

European call options or caplets which exist for each pe The Irony in the Derivatives Discounting Part II: The riod the cap agreement is in existence.
Crisis, Henrard M., Wilmott Journal, Vol. 2, pp.
In mathematical terms, a caplet payo on a rate L struck
301316, 2010. SSRN preprint.
at K is

10.6.9

External links

N max(L K, 0)
Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank of Chicago, Financial where N is the notional value exchanged and is the
Markets Group
day count fraction corresponding to the period to which
L applies. For example suppose you own a caplet on the
Bank for International Settlements - Semiannual six month USD LIBOR rate with an expiry of 1 February
OTC derivatives statistics
2007 struck at 2.5% with a notional of 1 million dollars.
Then if the USD LIBOR rate sets at 3% on 1 February
Glossary - Interest rate swap glossary
you receive
Investopedia - Spreadlock - An interest rate swap fu- $1M 0.5 max(0.03 0.025, 0) = $2500
ture (not an option)
Customarily the payment is made at the end of the rate
Basic Fixed Income Derivative Hedging - Article on period, in this case on 1 August.
Financial-edu.com.
Hussman Funds - Freight Trains and Steep Curves
Interest Rate Swap Calculator

10.7.2 Interest rate oor

An interest rate oor is a series of European put options

or oorlets on a specied reference rate, usually LIBOR.
Historical LIBOR Swaps data
The buyer of the oor receives money if on the matu All about money rates in the world: Real estate in- rity of any of the oorlets, the reference rate is below the
terest rates, WorldwideInterestRates.com
agreed strike price of the oor.

236

CHAPTER 10. INTEREST RATE DERIVATIVES

10.7.3

Valuation of interest rate caps

Black model

The purchase of the cap protects against rising rates

while the sale of the oor generates premium income.

A collar creates a band within which the buyers efThe simplest and most common valuation of interest rate
fective interest rate uctuates
caplets is via the Black model. Under this model we assume that the underlying rate is distributed log-normally
with volatility . Under this model, a caplet on a LIBOR And Reverse Collars?
expiring at t and paying at T has present value
buying an interest rate oor and simultaneously selling
an interest rate cap.
V = P (0, T ) (F N (d1 ) KN (d2 )) ,
where
P(0,T) is todays discount factor for T
F is the forward price of
( the rate. For
) LIBOR
(0,t)
rates this is equal to 1 PP(0,T

1
)
K is the strike
N is the standard normal CDF.
d1 =

ln(F /K)+0.5 2 t

and

d2 = d1 t
Notice that there is a one-to-one mapping between the
volatility and the present value of the option. Because all
the other terms arising in the equation are indisputable,
there is no ambiguity in quoting the price of a caplet simply by quoting its volatility. This is what happens in the
market. The volatility is known as the Black vol or
implied vol.
As a bond put
It can be shown that a cap on a LIBOR from t to T is
equivalent to a multiple of a t-expiry put on a T-maturity
bond. Thus if we have an interest rate model in which
we are able to value bond puts, we can value interest rate
caps. Similarly a oor is equivalent to a certain bond call.
Several popular short rate models, such as the Hull-White
model have this degree of tractability. Thus we can value
caps and oors in those models..
What about Collars?
Interest rate collar

The objective is to protect the bank from falling interest rates.

The buyer selects the index rate and matches the maturity and notional principal amounts for the oor
and cap.
Buyers can construct zero cost reverse collars when
it is possible to nd oor and cap rates with the same
premiums that provide an acceptable band.
The size of cap and oor premiums are determined
by a wide range of factors
The relationship between the strike rate and the prevailing 3-month LIBOR
premiums are highest for in the money options and lower for at the money and out of
the money options
Premiums increase with maturity.
The option seller must be compensated more
for committing to a xed-rate for a longer period of time.
Prevailing economic conditions, the shape of the
yield curve, and the volatility of interest rates.
upsloping yield curvecaps will be more expensive than oors.
the steeper is the slope of the yield curve,
ceteris paribus, the greater are the cap premiums.
oor premiums reveal the opposite relationship.

the simultaneous purchase of an interest rate cap and

sale of an interest rate oor on the same index for the
Valuation of CMS Caps
same maturity and notional principal amount.
Caps based on an underlying rateLIBOR (like a Constant
Maturity Swap Rate) cannot be valued using simple tech The objective of the buyer of a collar is to protect niques described above. The methodology for valuation
against rising interest rates (while agreeing to give of CMS Caps and Floors can be referenced in more adup some of the benet from lower interest rates).
vanced papers.
The cap rate is set above the oor rate.

10.7. INTEREST RATE CAP AND FLOOR

10.7.4

Implied Volatilities

An important consideration is cap and oor volatilities. Caps consist of caplets with volatilities dependent on the corresponding forward LIBOR rate. But
caps can also be represented by a at volatility, so
the net of the caplets still comes out to be the same.
(15%,20%,....,12%) (16.5%,16.5%,....,16.5%)
So one cap can be priced at one vol.
Another important relationship is that if the xed
swap rate is equal to the strike of the caps and oors,
then we have the following put-call parity: CapFloor = Swap.
Caps and oors have the same implied vol too for a
given strike.
Imagine a cap with 20% vol and oor with
30% vol. Long cap, short oor gives a swap
with no vol. Now, interchange the vols. Cap
price goes up, oor price goes down. But the
net price of the swap is unchanged. So, if a
cap has x vol, oor is forced to have x vol else
you have arbitrage.

237
Understanding the composition of the interest rate
The researcher [2] decided that to assess the appropriateness of an interest rate cap as a policy instrument, (or
whether other approaches would be more likely to achieve
the desired outcomes of government), it was vital to consider what exactly makes up the interest rate and how
banks and MFIs are able to justify rates that might be
considered excessive.[1]
He found broadly there were four components to the interest rate: Cost of funds
The overheads
Non performing loans
Prot[1]
Cost of funds The cost of funds is the amount that the
nancial institution must pay to borrow the funds that it
then lends out. For a commercial bank or deposit taking
micronance institutions this is usually the interest that it
gives on deposits. For other institutions it could be the
cost of wholesale funds, or a subsidised rate for credit
provided by government or donors. Other MFIs might
have very cheap funds from charitable contributions.[1]

A Cap at strike 0% equals the price of a oating leg

(just as a call at strike 0 is equivalent to holding a
The overheads The overheads reect three broad catstock) regardless of volatility cap.
egories of cost.

10.7.5

Interest rate caps and their impact

on nancial inclusion

Outreach costs - the expansion of a network or development of new products and services must also
be funded by the interest rate margin

Research was conducted after Zambia reopened an old

Processing costs - is the cost of credit processing and
debate on a lending rate ceiling for banks and other loan assessment, which is an increasing function of
nancial institutions. The issue originally came to the
the degree of information asymmetry
fore during the nancial liberalisations of the 1990s and
again as micronance increased in prominence with the
General overheads- general administration and overaward of the Nobel Peace Prize to Muhammad Yunus
heads associated with running a network of oces
and Grameen Bank in 2006. It was over the appropriand branches[1]
ateness of regulatory intervention to limit the charging of
rates that are deemed, by policymakers, to be excessively The overheads, and in particular the processing costs can
high.[1]
drive the price dierential between larger loans from
[1]
banks and smaller loans from MFIs. Overheads can vary
A 2013 research paper asked
signicantly between lenders and measuring overheads
as a ratio of loans made is an indicator of institutional
Where are interest rate caps currently used, and eciency.[1]
where have they been used historically?
What have been the impacts of interest rate caps, Non performing loans Lenders must absorb the cost
particularly on expanding access to nancial ser- of bad debts and write them o in the rate that they
vices?
charge. This allowance for non-performing loans means
lenders with eective credit screening processes should
What are the alternatives to interest rate caps in re- be able to bring down rates in future periods, while reckducing spreads in nancial markets? [1]
less lenders will be penalised.[1]

238

CHAPTER 10. INTEREST RATE DERIVATIVES

Prot Lenders will include a prot margin that again

varies considerably between institutions. Banks and
commercial MFIs with shareholders to satisfy are under
greater pressure to make prots than NGO or not-forprot MFIs.[1]

The researcher claims that traditional micronance

group lending methodology helps manage adverse selection risk by using social capital and risk understanding within a community to price risk. However, interest rate controls are most often found at the lower end
of the market where nancial institutions (usually MFIs)
use the information asymmetry to justify high lending
The rationale behind interest rate caps
rates. In a non-competitive market (as is likely to exist
in a remote African village), the lender likely holds the
Interest rate caps are used by governments for political monopoly power to make excessive prot without comand economic reasons, most commonly to provide sup- petition evening them out.[1]
port to a specic industry or area of the economy. Government may have identied what it considers being a The nancial markets will segment so large commercial
market failure in an industry, or is attempting to force banks service larger clients with larger loans at lower ina greater focus of nancial resources on that sector than terest rates and micronance institutions charge higher
rates of interest on a larger volume of low value loans. In
the market would determine.[1]
between, smaller commercial banks can nd a niche serving medium to large enterprises. Inevitably the missing
Loans to the agricultural sector to boost agricultural middle, individuals and businesses will be unable to acproductivity as in Bangladesh.
cess credit from either banks or MFIs.[1]
Loans to credit constrained SMEs as in Zambia.[1]
The researcher found it is also often argued that interest
rate ceilings can be justied on the basis that nancial institutions are making excessive prots by charging exorbitant interest rates to clients. This is the usury argument
[3]
and is essentially one of market failure where government intervention is required to protect vulnerable clients
from predatory lending practices. The argument, predicated on an assumption that demand for credit at higher
rates is price inelastic, postulates nancial institutions are
able to exploit information asymmetry, and in some cases
short run monopoly market power, to the detriment of
client welfare. Aggressive collection practices for nonpayment of loans have exacerbated the image of certain
lenders.[1]
The researcher says that economic theory suggests market imperfections will result from information asymmetry
and the inability of lenders to dierentiate between safe
and risky borrowers.[4] When making a credit decision, a
bank or a micronance institution cannot fully identify a
clients potential for repayment.[1]

The researcher found it intuitive that basic interest rate

caps are most likely to bite at the lower end of the market,
with interest rates charged by micronance institutions
generally higher than those by banks [5] and this is driven
by a higher cost of funds and higher relative overheads.
Transaction costs make larger loans relatively more cost
eective for the nancial institution.[1]
If it costs a commercial bank $100 to make a credit decision on a $10,000 loan then it will factor this 1% into
the price of the loan (the interest rate). The cost of loan
assessment does not fall in proportion with the loan size
and so if a loan of $1,000 still costs $30 to assess, the cost
which must be factored in rises to 3%. This cost pushes
the higher rates of lending on smaller loans. The higher
prices are usually paid because the marginal product of
capital is higher for people with little or no access to it.[1]
In implementing a cap, government is aiming to incentivise lenders to push out the supply curve and increase
access to credit while bringing down lending rates, assuming the cap is set below the market equilibrium. If
above then lenders will continue to lend as before.[1]

The researcher thinks such thinking ignores the actions

of the banks and MFIs operating under asymmetric information. The imposition of a maximum price of loans
Adverse selection - clients that are demonstrably magnies the problem of adverse selection as the conlower risk are likely to have already received some sumer surplus that it creates is a larger pool willing bor[1]
form of credit. Those that remain will either be rowers of unidentiable creditworthiness.
higher risk, or lower risk but unable to prove it. Un- Faced with this problem, he proposes lenders have three
able to dierentiate, the bank will charge an aggre- options:[1]
gated rate which will be more attractive to the higher
risk client. This leads to a raised probability of de- - Increased lending, meaning lending to more bad clients
and pushing up NPLs - Increased investment in processfault ex ante.[1]
ing systems to better identify good clients, increasing
overheads - Increased investment in outreach to clients,
Moral hazard - clients borrowing at a higher rate identied as having good repayment potential, increasing
might be required to take more risk (hence higher overheads [1]
potential return) to cover their borrowing costs leading to a higher probability of default afterwards.[1]

Two fundamental issues arise:[1]

10.7. INTEREST RATE CAP AND FLOOR

All options increase costs and force the supply curve back
to the left, detrimental to nancial outreach as the quantity of credit falls. Unless nancial service providers can
absorb the cost increases while maintaining a prot, they
may ration credit to those that they can readily support at
the prescribed interest rate, refuse credit to other clients
and the market moves.[1]

239
small business, RRx2.2)+20% per annum Developmental credit agreements for low income housing
(unsecured)(RRx2.2)+20% per annum, Short-term
transactions, 5% per month, Other credit agreements(RRx2.2)+10% per annum, Incidental credit
agreements 2% per month.[1]

The researcher asks if the story of interest rate caps lead10.7.7

ing to credit rationing is borne out in reality?[1]

The impact of interest caps

Supply side

10.7.6

The use of interest rate caps

Though conceptually simple, there is much variation in

the methodologies used by governments to implement
limits on lending rates. While some countries use a
vanilla interest rate cap written into all regulations for
licensed nancial institutions, others have attempted a
more exible approach.[1]
The most simple interest rate control puts an upper limit
on any loans from formal institutions. This might simply say that no nancial institution may issue a loan at a
rate greater than, say, 40% interest per annum, or 3% per
month.[1]

Financial outreach The researcher identied the major argument used against the capping of interest rates
as them distorting the market and preventing nancial
institutions from oering loan products to those at the
markets lower end with no alternative credit access. This
counters the nancial outreach agenda prevalent in many
poor countries today. He claims the debate boils down
to the prioritisation of cost of credit over access to
credit.[1] He identies a randomised experiment in Sri
Lanka [7] which found the average real return to capital
for microenterprises to be 5.7% per month, well above
the typical interest rate of between 2-3% that was provided by MFIs. Similarly, the same authors found in
Mexico[8] that returns to capital were an estimated 2033% per month, up to ve times higher than market interest rates.[1]

Rather than set a rigid interest rate limit, governments in

many countries nd it preferable to discriminate between
dierent types of loan and set individual caps based on the
client and type of loan. The logic for such a variable cap is His paper states that MFIs have historically been able to
that it can bite at various levels of the market, minimising expand outreach rapidly by funding network expansion
consumer surplus.[1]
with prots from existing borrowers, meaning existing
As a more exible measure, the interest cap is often clients are subsidising outreach to new areas. Capping inlinked to the base rate set by the central bank in setting terest rates can hinder this as MFIs may remain protable
monetary policy meaning the cap reacts in line with mar- in existing markets but cut investment in new markets and
ket conditions rising with monetary tightening and falling at extremes, government action on interest rates can cause
existing networks to retract. In Nicaragua,[9] the governwith easing.[1]
ments Micronance Association Law in 2001 limited mi This is the model used in Zambia,[6] where banks are
croloan interest to the average of rates set by the banking
able to lend at nine percentage points over the policy rate
[1] system and attempted to legislate for widespread debt forand micronance lending is priced as a multiple of this.
giveness. In response to perceived persecution by govern Elsewhere, governments have linked the lending rate to ment, a number of MFIs and commercial banks withdrew
the deposit rate and regulated the spread that banks and from certain areas hindering the outreach of the nancial
deposit taking MFIs can charge between borrowing and sector.[1]
lending rates. As some banks look to get around lendThe researcher articulates that there is also evidence to
ing caps by increasing arrangement fees and other costs
suggest capping lending rates for licensed MFIs incento the borrower, governments have often tried to limit
tives, NGO-MFIs, and other nance sources for the poor
the total price of the loan. Other governments have atto stay outside of the regulatory system. In Bolivia, the
tempted to set dierent caps for dierent forms of lendimposition of a lending cap led to a notable fall in the li[1]
ing instrument.
censing of new entities, .[9] Keeping lenders out of the
system should be unattractive to governments as it in In South Africa, the National Credit Act (2005) creases the potential for predatory lending and lack of
identied eight sub-categories of loan, each with consumer protection.[1]
their own prescribed maximum interest rate.
Mortgages(RRx2.2)+5% per annum, Credit facilities(RRx2.2)+10% per annum, Unsecured credit
transactions (RRx2.2)+20% per annum, Developmental credit agreements for the development of a

Price rises The paper states there is evidence from developed markets that the imposition of price caps could in
fact increase the level of interest rates.[1] The researcher
came across a study of payday loans in Colorado,[10] the

240

CHAPTER 10. INTEREST RATE DERIVATIVES

imposition of a price ceiling initially saw reduced interest

rates but over a longer period rates steadily rose towards
the interest rate cap. This was explained by implicit collusion, by which the price cap set a focal point so that
lenders knew that the extent of price rises would be limited and hence collusive behaviour had a limited natural
outcome.[1]

Are interest rates too high?

The researcher showed that Karlan and Zinman[11] carried out a randomised control trial in South Africa to
test the received wisdom that the poor are relatively nonsensitive to interest rates. They found around lenders
standard rates, elasticities of demand rose sharply meaning that even small increases in interest rates lead to a
signicant fall in the credit demand. If the poor are indeed this responsive to changes in the interest rate, then
it suggests that the practice of unethical monetary loans
would not be commercially sustainable and hence there is
little need for government to cap interest rates.[1]

generated millions of dollars in prot for its shareholders.

Compartamos had been accused of immoral money lending (usury), charging clients annualised rates in excess of
85%. The CGAP study found that the most protable ten
percent of MFIs globally were making returns on equity
in excess of 35%.[1]

The paper shows a detailed 2009 study by CGAP [14]

looked in detail at the four elements of loan pricing for
MFIs and attempted to measure whether the poor were
indeed being exploited by excessively high interest rates.
Their data is interesting for international comparison, but
tell us relatively little about eciency of individual companies and markets. However they do provide some interesting and positive conclusions, for example, the ratio of
Demand side
operating expenses to total loan portfolio declined from
Elasticity of demand The paper asserts that inherent 15.6% in 2003 to 12.7% in 2006, a trend likely to have
in any argument for an upper limit on interest rates is been driven by the twin factors of competition and learn[1][14]
an assumption that demand for credit is price inelastic. ing by doing.
If the inverse were true, and that market demand was The researcher mentions protability as there is some evhighly sensitive to small rises in lending rates then there idence of MFIs generating very high prots from microwould be minimal reason for government or regulators to nance clients. The most famous case was the IPO of
intervene.[1]
Compartamos, a Mexican micronance organisation that

Borrower trends The publication explains that the

chain behind implementing an interest cap runs that the
cap will have an eect on the wider economy through
its impact on consumer and business activities and says
the key question to be addressed by any cap is whether
it bites and therefore impacts borrower behaviour at the
margin.[1]

He proposes that while the international comparison is

interesting, it also has practical implications. It provides
policymakers with a conceptual framework with which to
assess the appropriateness of intervention in credit markets. The question that policymakers must answer if they
are to justify interfering in the market and capping interest rates is whether excessive prots or bloated overheads
are pushing interest rates to a higher rate than their natural level. This is a subjective regulatory question, and the
aim of a policy framework should be to ensure sucient
contestability to keep prots in check before the need for
intervention arises.[1]

It gives the case study of South Africa where the National

10.7.8 Alternative methods of reducing inCredit Act was introduced in 2005 to protect consumers
terest rate spreads
and to guard against reckless lending practices by nancial institutions. It was a variable cap that discriminated
between eight types of lending instrument to ensure the He states that from an economic perspective, input based
solutions like interest rate caps or subsidies distort the
cap bit at dierent levels.
market and hence it would better to let the market determine the interest rate, and to support certain desirable
Credit constraints and productivity The researcher sectors through other means (such as output based aid.
that
observed that an interest cap exacerbates the problem of Indeed there are a number of other methods available
[1]
can
contribute
to
a
reduction
in
interest
rates.
adverse selection as it restricts lenders ability to price
discriminate and means that some enterprises that might
have received more expensive credit for riskier business
ventures will not receive funding. There has been some
attempt to link this constraint in the availability of credit
to output. In Bangladesh,[12] rms with access to credit
were found to be more ecient than rms with a credit
constraint. The World Bank [13] found credit constraints
may reduce prot margins buy up to 13.6% per year.[1]

In the short term, soft pressure can be an eective tool

as banks and MFIs need licenses to operate, they are
often receptive to inuence from the central bank or regulatory authority. However to truly bring down interest
rates sustainably, governments need to build a business
and regulatory environment and support structures that
encourage the supply of nancial services at lower cost
and hence push the supply curve to the right.[1]

10.7. INTEREST RATE CAP AND FLOOR

241

Market structure

vocacy can lead to the development of demand-led products and services. The FinMark Trust is an example of
The paper shows that the paradigm of classical eco- donor funds supporting the development of research and
nomics runs that competition between nancial institu- analysis as a tool for inuencing policy.[1]
tions should force them to compete on the price of loans
that they provide and hence bring down interest rates.
Competitive forces can certainly play a role in forces Demand side support
lenders to either improve eciency in order to bring
down overheads, or to cut prot margins. In a survey of The researcher states that Government can help to push
MFI managers in Latin America and the Caribbean,[9] down interest rates by promoting transparency and nancompetition was cited as the largest factor determining cial consumer protection. Investment in nancial literthe interest rate that they charged. The macro evidence acy can strengthen the voice of the borrower and protect
supports this view Latin countries with the most com- against possible exploitation. Forcing regulated nancial
petitive micronance industries, such as Bolivia and Peru, institutions to be transparent in their lending practices
means that consumers are protected from hidden costs.
generally have the lowest interest rates.[1]
Government can publish and advertise lending rates of
The corollary of this, and the orthodox view, would seem
competing banks to increase competition. Any demand
to be that governments should license more nancial inside work is likely to have a long lead time to impact but
stitutions to promote competition and drive down rates.
it is vital that even if the supply curve does shift to the
However it is not certain that more players means greater
right that the demand curve follows it.[1]
competition. Due to the nature of the nancial sector,
with high xed costs and capital requirements, smaller
players might be forced to levy higher rates in order to
remain protable. Weak businesses that are ineciently 10.7.9 Conclusion
run will not necessarily add value to an industry and government support can often be misdirected to supporting The researcher concludes that there are situations when an
bad businesses. Governments should be willing to adapt interest rate cap may be a good policy decision for govand base policy on a thorough analysis of the market ernments. Where insucient credit is being provided to
structure, with the promotion of competition, and the re- a particular industry that is of strategic importance to the
moval of unnecessary barriers to entry such as excessive economy, interest rate caps can be a short-term solution.
While often used for political rather than economic purred tape, as a goal.[1]
poses, they can help to kick start a sector or incubate it
from market forces for a period of time until it is commercially sustainable without government support. They
Market information
can also promote fairness as long as a cap is set at a
The evidence the researcher suggests that learning by do- high enough level to allow for protable lending for efing is a key factor in building up eciency and hence cient nancial institutions to SMEs, it can protect conlowering overheads and hence interest rates. Institutions sumers from usury without signicantly impacting outwith a decent track record are better able to control costs reach. Additionally, nancial outreach is not an end in itand more ecient at evaluating loans while a larger loan self and greater economic and social impact might result
book will generate economies of scale. More established from cheaper credit in certain sectors rather than greater
businesses should also be able to renegotiate and source outreach. Where lenders are known to be very protable
cheaper funds, again bringing down costs. In China, the then it might be possible to force them to lend at lower
government supports the nancial sector by setting a ceil- rates in the knowledge that the costs can be absorbed
ing on deposits and a oor on lending rates meaning that into their prot margins. Caps on interest rates also probanks are able to sustain a minimum level of margin. Fol- tect against usurious lending practices and can be used to
lowing an international sample of MFIs, there is clear guard against the exploitation of vulnerable members of
evidence from the Micronance Information Exchange society.[1]
[15]
(MIX) that operating expenses fell as a proportion of However, he does say that although there are undoubtgross loan portfolio as businesses matured.[1]
edly market failures in credit markets, and government
The implication of this is that governments would be better o addressing the cost structures of nancial institutions to allow them to remain commercially sustainable in
the longer term. For example, government investment in
credit reference bureaus and collateral agencies decreases
the costs of loan appraisal for banks and MFIs. Supporting product innovation, for example through the use of a
nancial sector challenge fund, can bring down the cost
of outreach and government support for research and ad-

does have a role in managing these market failures (and

indeed supporting certain sectors), interest rate caps are
ultimately an inecient way of reaching the goal of lower
long-term interest rates. This is because they address the
symptom, not the cause of nancial market failures. In
order to bring down rates sustainably, it is likely that governments will need to act more systemically, addressing
issues in market information and market structure and on
the demand side and ultimately supporting a deeper level

242

CHAPTER 10. INTEREST RATE DERIVATIVES

10.7.12 References

of nancial sector reform.[1]

10.7.10

Damiano Brigo, Fabio Mercurio (2001). Interest

Rate Models - Theory and Practice with Smile, Ination and Credit (2nd ed. 2006 ed.). Springer Verlag.
ISBN 978-3-540-22149-4.

Compare

Interest rate swap

10.7.11

Notes

[1] Miller, H., Interest rate caps and their impact on nancial inclusion, ECONOMIC AND PRIVATE SECTOR PROFESSIONAL EVIDENCE AND APPLIED
KNOWLEDGE SERVICES, http://partnerplatform.org/
?0sf32f0p

David F. Babbel (1996). Valuation of InterestSensitive Financial Instruments: SOA Monograph MFI96-1 (1st ed.). John Wiley & Sons. ISBN 9781883249151.
Frank Fabozzi (1998). Valuation of xed income securities and derivatives (3rd ed.). John Wiley. ISBN
978-1-883249-25-0.

[2] Howard Miller, Nathan Associates, February 2013

[3] Oce of Fair Trading (OFT), Price Controls: Evidence
and arguments surrounding price control and interest rate
caps for high-cost credit (May 2010)
[4] Stiglitz, Joseph & Weiss, Andrew, Credit Rationing in
Markets with Imperfect Information (June 1981)
[5] Kneiding, Cristoph and Rosenberg, Richard, Variations in
Microcredit Interest Rates (July 2008) CGAP Brief
[6] Bank of Zambia press release, available
http://www.boz.zm/publishing/Speeches/Press%
20Release%20on%20Interest%20Rates.pdf

here

[7] De Mel, Suresh, McKenzie, David John and Woodru,

Christopher M., Returns to Capital in Microenterprises:
Evidence from a Field Experiment (May 1, 2007). World
Bank Policy Research Working Paper No. 4230
[8] McKenzie, David John and Woodru, Christopher M.,
Experimental Evidence on Returns to Capital and Access
to Finance in Mexico (March 2008)
[9] Campion, Anita, Ekka, Rashmi Kiran and Wenner, Mark,
Interest Rates and Implications for Micronance in Latin
America and the Caribbean, IADB (March 2012)
[10] DeYoung, Robert and Phillips, Ronnie J., Payday Loan
Pricing (2009)
[11] Karlan, Dean S. and Zinman, Jonathan, Credit Elasticities
in Less-Developed Economies: Implications for Micronance (December 2006)
[12] Baqui Khalily, M.A. and Khaleque, M.A., Access to
Credit and Productivity of Enterprises in Bangladesh: Is
There Causality? (2012)
[13] Khandker, Shahidur R., Samad, Hussain A. and Ali,
Rubaba, Does Access to Finance Matter in Microenterprise Growth? Evidence from Bangladesh (January 2013)
World Bank Policy Research Working Paper no. 6333
[14] Rosenberg, Richard, Gonzalez, Adrian and Narian,
Sushma, The New Moneylenders: Are the Poor Being
Exploited by High Microcredit Interest Rates? (February
2009)
[15] http://www.themix.org/publications/
microbanking-bulletin/2011/05/
microfinance-efficiency

10.7.13 External links

Basic Fixed Income Derivative Hedging - Article on
Financial-edu.com.
Convexity Conundrums by Patrick Hagan
Martingales and Measures: Blacks Model Dr.
Jacqueline Henn-Overbeck, University of Basel
Bond Options, Caps and the Black Model Dr. Milica Cudina, University of Texas at Austin
Online Caplet And Floorlet Calculator Dr. Shing
Hing Man, Thomson Reuters Risk Management
Introduction to Caps, Floors, Collars and Swaptions

10.8 Interest rate basis

In nance, a day count convention determines how
interest accrues over time for a variety of investments,
including bonds, notes, loans, mortgages, medium-term
notes, swaps, and forward rate agreements (FRAs). This
determines the number of days between two coupon payments; thus, calculating the amount transferred on payment dates and also the accrued interest for dates between
payments.[1] The day count is also used to quantify periods of time when discounting a cash-ow to its present
value. When a security such as a bond is sold between interest payment dates, the seller is eligible to some fraction
of the coupon amount.
The day count convention is used in many other formulas
in nancial mathematics as well.

10.8.1 Development
The need for day count conventions is a direct consequence of interest-earning investments. Dierent conventions were developed to address often conicting requirements, including ease of calculation, constancy of

10.8. INTEREST RATE BASIS

243

time period (day, month, or year) and the needs of the Freq The coupon payment frequency. 1 = annual, 2 =
Accounting department. This development occurred long
semi-annual, 4 = quarterly, 12 = monthly, etc.
before the advent of computers.
Principal Par value of the investment.
There is no central authority dening day count conventions, so there is no standard terminology, how- For all conventions, the Interest is calculated as:
ever the International Swaps and Derivatives Association
(ISDA) and the International Capital Market Association (ICMA) have done work gathering and document- Interest = Principal CouponRate Factor
ing conventions. Certain terms, such as 30/360, Actual/Actual, and money market basis must be under10.8.3 30/360 methods
stood in the context of the particular market.
The conventions have evolved, and this is particularly true All conventions of this class calculate the Factor as:
since the mid-1990s. Part of it has simply been providing
for additional cases[2] or clarication.[3]
360 (Y2 Y1 ) + 30 (M2 M1 ) + (D2 D1 )
There has also been a move towards convergence in the Factor =
360
marketplace, which has resulted in the number of convenThey
calculate
the
CouponFactor
as:
tions in use being reduced. Much of this has been driven
by the introduction of the euro.[4][5]
360 (Y3 Y1 ) + 30 (M3 M1 ) + (D3 D1 )
360
This is the same as the Factor calculation, with Date2 replaced by Date3. In the case that it is a regular coupon
period, this is equivalent to:
CouponFactor =

10.8.2

Denitions

Interest Amount of interest accrued on an investment.

CouponFactor The Factor to be used when determining

the amount of interest paid by the issuer on coupon
payment dates. The periods may be regular or irreg- CouponFactor = 1
Freq
ular.
CouponRate The interest rate on the security or loan- The conventions are distinguished by the manner in which
type agreement, e.g., 5.25%. In the formulas this they adjust Date1 and/or Date2 for the end of the month.
Each convention has a set of rules directing the adjustwould be expressed as 0.0525.
ments.
Date1 (Y1.M1.D1) Starting date for the accrual. It is
Treating a month as 30 days and a year as 360 days was
usually the coupon payment date preceding Date2.
devised for its ease of calculation by hand compared with
Date2 (Y2.M2.D2) Date through which interest is being manually calculating the actual days between two dates.
accrued. You could word this as the to date, with Also, because 360 is highly factorable, payment frequenDate1 as the from date. For a bond trade, it is the cies of semi-annual and quarterly and monthly will be
180, 90, and 30 days of a 360 day year, meaning the paysettlement date of the trade.
ment amount will not change between payment periods.
Date3 (Y3.M3.D3) The coupon payment date following
Date2. This would be the maturity date if there are
30/360 Bond Basis
no more interim payments to be made.
Days(StartDate, EndDate) Function returning the This convention is exactly as 30U/360 below, except for
number of days between StartDate and EndDate the rst two rules. Note that the order of calculations is
on a Julian basis (i.e., all days are counted). For important:
instance, Days(15 October 2007, 15 November
2007) returns 31.
D1 = MIN (D1, 30).
EOM Indicates that the investment always pays interest
If D1 = 30 Then D2 = MIN (D2,30)
on the last day of the month. If the investment is
not EOM, it will always pay on the same day of the Other names:
month (e.g., the 10th).
30A/360.
Factor Figure representing the amount of the CouponRate to apply in calculating Interest. It is often ex- Sources:
pressed as days in the accrual period / days in the
ISDA 2006 Section 4.16(f), though the rst two
year. If Date2 is a coupon payment date, Factor is
rules are not included.[6]
zero.

244
30/360 US

CHAPTER 10. INTEREST RATE DERIVATIVES

Eurobond basis (ISDA 2006)

Special German
Date adjustment rules (more than one may take eect;
apply them in order, and if a date is changed in one rule
Sources:
the changed value is used in the following rules):
If the investment is EOM and (Date1 is the last day
of February) and (Date2 is the last day of February),
then change D2 to 30.

ICMA Rule 251.1(ii), 251.2.[7]

ISDA 2006 Section 4.16(g).[6]

If the investment is EOM and (Date1 is the last day

30E/360 ISDA
of February), then change D1 to 30.
If D2 is 31 and D1 is 30 or 31, then change D2 to
30.
If D1 is 31, then change D1 to 30.

Date adjustment rules:

If D1 is the last day of the month, then change D1
to 30.

This convention is used for US corporate bonds and many

If D2 is the last day of the month (unless Date2 is
US agency issues. It is most commonly referred to as
the maturity date and M2 is February), then change
30/360, but the term 30/360 may also refer to any
D2 to 30.
of the other conventions of this class, depending on the
context.
Other names:
Other names:
30E/360 ISDA
30U/360 - 30U/360 is not strictly the same as
Eurobond basis (ISDA 2000)
30/360, it is used for the Euribor (Euro denominated Libor) curve and Euro denominated swaps,
German
with the distinction that under 30/360, each day in
a 31 day month accrues 30/31 of interest, whereas
Sources:
in 30U/360 payment occurs on the 30th and the
31st is considered to be part of the next month. ISDA 2006 Section 4.16(h).[6]
Bloomberg
Bond basis
30/360

10.8.4 Actual methods

The conventions of this class calculate the number of days

between two dates (e.g., between Date1 and Date2) as
the Julian dierence. This is the function Days(StartDate,
ISDA 2006 Section 4.16(f), though the rst two EndDate).
rules are not included.[6]
The conventions are distinguished primarily by the
amount of the CouponRate they assign to each day of the
(Mayle 1993)
accrual period.

Sources:

30E/360
Date adjustment rules:

Actual/Actual ICMA
Formulas:

If D1 is 31, then change D1 to 30.

If D2 is 31, then change D2 to 30.
Other names:

Factor =

Days(Date1, Date2)
Freq Days(Date1, Date3)

For regular coupon periods:

30/360 ICMA
30S/360

CouponFactor =

1
Freq

10.8. INTEREST RATE BASIS

245

For irregular coupon periods, the period has to be divided days in the periods. The formula applies to both regular
into one or more quasi-coupon periods (also called no- and irregular coupon periods.
tional periods) that match the normal frequency of pay- Other names are:
ment dates. The interest in each such period (or partial period) is then computed, and then the amounts are
Actual/Actual
summed over the number of quasi-coupon periods. For
[4]
details, see (Mayle 1993) or the ISDA paper.
Act/Act
This method ensures that all coupon payments are always
Actual/365
for the same amount.
Act/365
It also ensures that all days in a coupon period are valued
equally. However, the coupon periods themselves may be
of dierent lengths; in the case of semi-annual payment Sources:
on a 365 day year, one period can be 182 days and the
ISDA 2006 Section 4.16(b).[6]
other 183 days. In that case, all the days in one period
will be valued 1/182nd of the payment amount and all
the days in the other period will be valued 1/183rd of the
Actual/365 Fixed
payment amount.
This is the convention used for US Treasury bonds and Formulas:
notes, among other securities.
Other names:
Factor =
Actual/Actual
Act/Act ICMA
ISMA-99
Act/Act ISMA
Sources:
ICMA Rule 251.1(iii).[7]
ISDA 2006 Section 4.16(c).[6]

Days(Date1, Date2)
365

Each month is treated normally and the year is assumed

to be 365 days. For example, in a period from February
1, 2005 to April 1, 2005, the Factor is considered to be
59 days divided by 365.
The CouponFactor uses the same formula, replacing
Date2 by Date3. In general, coupon payments will vary
from period to period, due to the diering number of
days in the periods. The formula applies to both regular
and irregular coupon periods.
Other names:

(Mayle 1993)

Act/365 Fixed

Actual/Actual comparison, EMU and Market Conventions: Recent Developments.[4]

A/365 Fixed

Actual/Actual ISDA

A/365F
English
Sources:

Formulas:

ISDA 2006 Section 4.16(d).[6]

Factor =

Days not in leap year Days in leap year

+
365
366

(Mayle 1993)

This convention accounts for days in the period based on

Actual/360
the portion in a leap year and the portion in a non-leap
year.
Formulas:
The days in the numerators are calculated on a Julian day
dierence basis. In this convention the rst day of the
Days(Date1, Date2)
period is included and the last day is excluded.
Factor =
360
The CouponFactor uses the same formula, replacing
Date2 by Date3. In general, coupon payments will vary This convention is used in money markets for short-term
from period to period, due to the diering number of lending of currencies, including the US dollar and Euro,

246

CHAPTER 10. INTEREST RATE DERIVATIVES

and is applied in ESCB monetary policy operations. It is

the convention used with Repurchase agreements. Each
month is treated normally and the year is assumed to be
360 days. For example, in a period from February 1,
2005 to April 1, 2005, the Factor is 59 days divided by
360 days.

If February 29 is in the range from Date1 (exclusive) to Date3 (inclusive), then DiY = 366,
else DiY = 365.
If Freq <> 1:

If Date3 is in a leap year, then DiY = 366, else

DiY = 365.
The CouponFactor uses the same formula, replacing
Date2 by Date3. In general, coupon payments will vary
from period to period, due to the diering number of The CouponFactor uses the same formula, replacing
days in the periods. The formula applies to both regular Date2 by Date3. In general, coupon payments will vary
and irregular coupon periods.
from period to period, due to the diering number of
days in the periods. The formula applies to both regular
Other names:
and irregular coupon periods.
Act/360

Other names:

A/360

ISMA-Year

French
Sources:
Sources:
ICMA Rule 251.1(i) (not sterling).

[7]

ISDA 2006 Section 4.16(e).[6]

ICMA Rule 251.1(i) (Euro-sterling oating-rate

notes).[7]
Actual/Actual AFB

(Mayle 1993)
Formulas:
Actual/364
Factor =

Formulas:

Factor =

Days(Date1, Date2)
364

Each month is treated normally and the year is assumed

to be 364 days. For example, in a period from February
1, 2005 to April 1, 2005, the Factor is considered to be
59 days divided by 364.
The CouponFactor uses the same formula, replacing
Date2 by Date3. In general, coupon payments will vary
from period to period, due to the diering number of
days in the periods. The formula applies to both regular
and irregular coupon periods.
Actual/365L
Formulas:

Factor =

Days(Date1, Date2)
DiY

Days(Date1, Date2)
DiY

This convention requires a set of rules in order to determine the days in the year (DiY).
The basic rule is that if February 29 is in the range from
Date1 (inclusive) to Date2 (exclusive), then DiY = 366,
else DiY = 365.
If the period from Date1 to Date2 is more than one year,
the calculation is split into two parts:
the number of complete years, counted back from
the last day of the period
the remaining initial stub, calculated using the basic
rule.
As an example, a period from 1994-02-10 to 1997-06-30
is split as follows:
1994-06-30 to 1997-06-30 = 3 (whole years calculated backwards from the end)
1994-02-10 to 1994-06-30 = 140/365

This convention requires a set of rules in order to deterResulting in a total value of 3 + 140/365.
mine the days in the year (DiY).
If Freq = 1 (annual coupons):

This convention was originally written in French and

during translation the term Priode d'Application was

10.8. INTEREST RATE BASIS

247

converted to Calculation Period. As ISDA assigns a

very specic meaning to Calculation Period (Date1 to
Date3) confusion can ensue. Reading the original French,
the period referred to is Date1 to Date2, not Date1 to
Date3.[8]

year as 360 days was originally devised for its ease of calculation by hand compared with the actual days between
two dates. Because 360 is highly factorable, payment frequencies of semi-annual and quarterly and monthly will
be 180, 90, and 30 days of a 360 day year, meaning the
The original French version of the convention contained payment amount will not change between payment perino specic rules for counting back the years. A later ods.
ISDA paper [4] added an additional rule: When counting The Actual/360 method calls for the borrower for the acbackwards for this purpose, if the last day of the relevant tual number of days in a month. This eectively means
period is 28 February, the full year should be counted that the borrower is paying interest for 5 or 6 additional
back to the previous 28 February unless 29 February ex- days a year as compared to the 30/360 day count convenists, in which case, 29 February should be used. No tion. Spreads and rates on Actual/360 transactions are
source can be found explaining the appearance or ratio- typically lower, e.g., 9 basis points. Since monthly loan
nale of the extra rule. The table below compares the later payments are the same for both methods and since the
ISDA count back rule to a simple count back rule (which investor is being paid for an additional 5 or 6 days of inwould have been implied by the original French) for one terest with the Actual/360 year base, the loans principal
of the few cases where they dier. The simple rule illus- is reduced at a slightly lower rate. This leaves the loan
trated here is based on subtraction of n years from Date2, balance 1-2% higher than a 30/360 10-year loan with the
where subtracting whole years from a date goes back to same payment.
the same day-of-month, except if starting on 29 February and going back to a non-leap year then 28 February
Business date convention
results.
Sources:

Date rolling (business date) conventions are a common

practice to adjust non-business days into business days.

Denitions Communes plusieurs Additifs Techniques, by the Association Francaise des Banques
10.8.6
in September 1994.[8]

Footnotes

FBF Master Agreement for Financial Transactions,

Supplement to the Derivatives Annex, Edition 2004,
section 7i.[9]

[1] Investopedia denition. investopedia.com.

Actual/Actual comparison, EMU and Market Conventions: Recent Developments.[4]

[3] the ISDA 2006 vs. ISDA 2000 denitions, for instance.

1/1
This is used for ination instruments and divides the overall 4 year period distributing the additional day across all
4 years i.e. giving 365.25 days to each year.

[4] EMU and Market Conventions: Recent Developments

(PDF). 1998. Retrieved 2014-09-18.
[5] Practical Issues Arising from the Introduction of the Euro
- Issue 7 (PDF). 12 March 1998. Retrieved 2014-09-18.
[6] ISDA Denitions, Section 4.16 (PDF). 2006. Retrieved
2014-09-18.
[7] ICMA Rule Book, Rule 251 (PDF). Retrieved 201409-18.

Sources:
ISDA 2006 Section 4.16(a).[6]
FBF Master Agreement for Financial Transactions,
Supplement to the Derivatives Annex, Edition 2004,
section 7a.[9]

10.8.5

[2] see the treatment of 30/360 in (Mayle 1993).

Discussion

Comparison of 30/360 and Actual/360

The 30/360 methods assume every month has 30 days and
each year has 360 days. The 30/360 calculation is listed
on standard loan constant charts and is now typically used
by a calculator or computer in determining mortgage payments. This method of treating a month as 30 days and a

[8] Bulletin Ociel d la Banque de France, Dnitions communes a plusieurs additifs techniques (PDF). January
1999. Retrieved 2014-09-18. |chapter= ignored (help)
[9] FBF Master Agreement for Financial Transactions, Supplement to the Derivatives Annex, Edition 2004 (PDF).
2004. Retrieved 2014-09-18.

10.8.7 References
Mayle, Jan (1993), Standard Securities Calculation Methods: Fixed Income Securities Formulas
for Price, Yield and Accrued Interest 1 (3rd ed.),
Securities Industry and Financial Markets Association, ISBN 1-882936-01-9. The standard reference

248

CHAPTER 10. INTEREST RATE DERIVATIVES

for conventions applicable to US securities. For the
30/360 US convention, this edition adds the rst two
rules to those given in earlier editions.

Online Day Count Calculator. Online Day Count

Calculator for Common Conventions

ICMA Rule Book, Rule 251 (PDF), retrieved 2007- 10.8.9

07-31. ICMA's denition of certain day count conventions.
10.9
ISDA Denitions, Section 4.16 (PDF), 2006. ISDAs
denition of certain day count conventions. Note
that these denitions dier in some cases from the
ISDAs Annex to the 2000 Denitions.

Related information

Basis swap

A basis swap is an interest rate swap which involves the

exchange of two oating rate nancial instruments. A basis swap functions as a oating-oating interest rate swap
under which the oating rate payments are referenced to
dierent bases.

EMU and Market Conventions: Recent Developments

(PDF), 1998, retrieved 2007-07-31. ISDAs discussion of market convergence, including an extensive 10.9.1 Usage of basis swaps for hedging
discussion of irregular coupon periods.
Basis risk occurs for positions that have at least one paying
FBF Master Agreement for Financial Transactions, and one receiving stream of cash ows that are driven by
Supplement to the Derivatives Annex, Edition 2004 dierent factors and the correlation between those factors
(PDF), 2004, retrieved 2014-09-13. Denition of is less than one. Entering into a Basis Swap may oset
the eect of gains or losses resulting from changes in the
various day counts in section 7.
basis, thus reducing basis risk.

10.8.8

Further reading

Financial Interest Calculator. Online calculation of

interest with dierent day count conventions, created by eTradeTech.com.

1. against exposure to currency uctuations (for example, 1 mo USD LIBOR for 1 mo GBP LIBOR)
2. against one index in the favor of another (for example, 1 mo USD T-bill for 1 mo USD LIBOR)

Bond Calculator. Online calculation of interest and

rate indicators with dierent day count conventions,
created by SIX Swiss Exchange.

3. dierent points on a yield curve (for example, 1 mo

USD LIBOR for 6 mo USD LIBOR)

Pricing of Game Options (in a market with stochastic interest rates) - Section Chapter II: A Little Bit of
Finance, Section 1: Brief introduction to Financial
Securities, from pages 26 to 33, formally mention
day count conventions.

10.9.2 Basis swaps in energy commodities

In energy markets, a basis swap is a swap on the price
dierential for a product and a major index product (e.g.
Brent Crude or Henry Hub gas).

Practical Issues Arising from the Introduction of the

Euro - Issue 7 (March 1998) - Chapter 4: Finan10.9.3 See also
cial Markets and Exchanges: discusses European
nations day-count conventions and changes required
Interest rate swap
to unify the day-count conventions for the EU mem Basis trading
ber states.
jFin pure Java open source implementation of nancial date arithmetic.
comparison of nancial day count convention used
in Excel and OOXML
Interest Rate Instruments and Market Conventions
Guide. A reference guide containing conventions
and market standards for the most common nancial instruments.
Day Count Conventions, 2007, retrieved 2007-0731. Web page on the history and context of day
count conventions, including a cross-reference.

10.10 Range accrual

In nance, a range accrual is a type of derivative product
very popular among structured-note investors. It is estimated that more than US$160 billion of Range Accrual
indexed on interest rates only have been sold to investors
between 2004 and 2007.[1] It is one of the most popular
non-vanilla nancial derivatives. In essence the investor
in a range accrual is betting that the reference index usually interest rates or currency exchange rates - will stay
within a predened range.

10.10. RANGE ACCRUAL

10.10.1

Payo description

A general expression for the payo of a range accrual is:

i=1

1index(i)Range

1
N

index(i) is the value of the index at the ith observation date

N is the total number of observations within a period
P is the payout when the index is in the range
If the observation frequency is daily, the payo could be
more easily written as

n
N

where
n is the number of days a specied index is within a
given range

249
5.00% 130/181 = 3.5912% (there are 181
days in total between January 1, 2009 and July
1, 2009).
The coupon paid on July 1, 2009 would be:
US$100m 3.5912% 0.5 = $1,795,600 (assuming 0.5 for the day-count fraction between
January 1, 2009 and July 1, 2009)
Second coupon - Between July 1, 2009 and January
1, 2010, if USD 3m Libor xes between 1.00% and
6.00% for 155 days, then the rate applied for the
second semester will be:
5.00% 155/184= 4.2120%.
The coupon paid on January 1, 2010 would be:
US$100m 4.2120% 0.5 = $2,106,000 (assuming 0.5 for the day-count fraction between
July 1, 2009 and January 1, 2010).
For the 8 following coupons, the same methodology
applies. The highest rate investor will get is 5.00%
and the lowest 0.00%.

N is the total number of days of the observation pe- Dierent types of range accruals
riod
P is the payout for any given day where the index is The payout (P in our notation), for each day the index is
in the range, could be either a x or variable rate.
in the range
The index could be an interest rate (e.g. USD 3 months
Libor), or a FX rate (e.g. EUR/USD) or a commodity
(e.g. oil price) or any other observable nancial index.
The observation period can be dierent from daily (e.g.
weekly, monthly,etc.), though a daily observation is the
most encountered.

10.10.2 Valuation and risks

A range accrual can be seen as a strip of binary options,

with a decreasing lag between xing date and payment
date. For this reason, it is important the valuation model
is well calibrated to the volatility term structure of the
The receiver of the range accrual coupons is selling binary underlying, at least at the strikes implied by the range.
options. The value of these options is used to enhance the
If furthermore the range accrual is callable, then the valcoupon paid.
uation model also needs to take into account the dynamic
between the swaption and the underlying.
Example
Accrual swaps that monitor permanence of interest rates
into a range and pay a related interest rate times the perLets take an example of a 5 years range accrual note
manence factor also depend on correlation across dierlinked to USD 3 months Libor, with range set as [1.00%;
ent adjacent forward rates. For the details see for exam6.00%] and a conditional coupon of 5.00%. Lets assume
ple Brigo and Mercurio (2001).
the note to start on January 1, 2009 and the rst coupon
payment to happen on July 1, 2009.
An investor who buys USD 100m of this note will have 10.10.3
the following cash ows:
First coupon Between January 1 and July 1,
2009, if USD 3m Libor xes between

Market

(To be completed)

10.10.4 References
1.00% and 6.00% for 130 days, then the rate applied for
the rst semester will be:

[1] Mtn-I Publication 2007

250

CHAPTER 10. INTEREST RATE DERIVATIVES

Damiano Brigo, Fabio Mercurio (2001). Interest

Rate Models Theory and Practice with Smile, Ination and Credit (2nd ed. 2006 ed.). Springer Verlag. ISBN 978-3-540-22149-4.

10.11 Overnight indexed swap

LIBOR is risky in the sense that the lending bank loans

cash to the borrowing bank, and the OIS is stable in
the sense that both counterparties only swap the oating
rate of interest for the xed rate of interest. The spread
between the two is, therefore, a measure of how likely
borrowing banks will default. This reects counterparty
credit risk premiums in contrast to liquidity risk premiums.[3] However, given the mismatch in the tenor of the
funding, it also reects worries about liquidity risk as well.

An overnight indexed swap (OIS) is an interest rate

swap where the periodic oating payment is generally
based on a return calculated from a daily compound in- 10.11.2 Historical levels
terest investment. The reference for a daily compounded
rate is an overnight rate (or overnight index rate) and the In the United States, the LIBOROIS spread generally
exact averaging formula depends on the type of such rate. maintains around 10 bps. This changed abruptly, as the
spread jumped to a rate of around 50 bps in early August
The index rate is typically the rate for overnight unse- 2007 as the nancial markets began to price in a higher
cured lending between banks, for example the Federal risk environment. Within months, the Bank of England
funds rate for US dollars, Eonia for Euros or Sonia for was forced to rescue Northern Rock from failure. The
sterling. The xed rate of OIS is typically an interest spread continued to maintain historically high levels as
rate considered less risky than the corresponding inter- the crisis continued to unfold.[3]
bank rate (LIBOR) because there is limited counterparty
As markets improved, the spread fell and as of Octorisk.[1][2]
ber 2009, stood at 10 bps once again, only to rise again
The LIBOROIS spread is the dierence between as struggles of the PIIGS countries threatened European
LIBOR and the (OIS) rates. The spread between the banks. As of December 2011, the spread again stands at
two rates is considered to be a measure of health of the 40+ bps level.
banking system.[3] It is an important measure of risk and
liquidity in the money market,[4] considered by many,
including former US Federal Reserve chairman Alan 10.11.3 See also
Greenspan, to be a strong indicator for the relative stress
TED spread
in the money markets.[5] A higher spread (high Libor) is
typically interpreted as indication of a decreased willingness to lend by major banks, while a lower spread indicates higher liquidity in the market. As such, the spread 10.11.4 References
can be viewed as indication of banks perception of the [1] CSFB Zurich note on OIS
creditworthiness of other nancial institutions and the
[2] Overnight Index Swaps (OIS), thisMatter.com
general availability of funds for lending purposes.[6]
The LIBOROIS spread has historically hovered around
10 basis points (bps). However, in the midst of the
nancial crisis of 20072010, the spread spiked to an alltime high of 364 basis points in October 2008, indicating
a severe credit crunch. Since that time the spread has declined erratically but substantially, dropping below 100
basis points in mid-January 2009 and returning to 1015
basis points by September 2009.[7]

[3] Sengupta, Rajdeep and Yu Man Tam. (2008) The

LIBOROIS Spread as a Summary Indicator. Economic
Synopses, Number 25, 2008. Federal Reserve Bank of
St. Louis

10.11.1

[6] Capo McCormick, Liz (January 24, 2008). InterestRate Derivatives Signal Banks Still Reluctant to Lend.
Bloomberg.com.

Risk barometer

[4] Zeng, Min (September 20, 2008). Money Flows Back to

Commercial Paper. The Wall Street Journal.
[5] Brown, Matthew; Finch, Gavin (January 12, 2009).
Libor for Dollars Slides Most Since Dec. 17 on Cash
Injections. Bloomberg.com.

Three-month LIBOR is generally a oating rate of nancing, which uctuates depending on how risky a lending [7] 3 MO LIBOR OIS SPREAD. Bloomberg.com. January 12, 2009.
bank feels about a borrowing bank. The OIS is a swap
derived from the overnight rate, which is generally xed
by the local central bank. The OIS allows LIBOR-based
10.11.5 External links
banks to borrow at a xed rate of interest over the same
period. In the United States, the spread is based on the
Dollar LiborOIS Spread at 2-Year High Amid EuLIBOR Eurodollar rate and the Federal Reserves Fed
rope Bank Concern
Funds rate.[3]

Chapter 11

Currency Derivatives
11.1 Foreign exchange market
Forex redirects here. For the football club, see FC
Forex Braov. For the U.S. FBI sting operation, see
Dominic Brooklier Bompensiero murder.

change transactions (the Bretton Woods system of monetary management established the rules for commercial
and nancial relations among the worlds major industrial states after World War II), when countries gradually switched to oating exchange rates from the previous exchange rate regime, which remained xed as per
the Bretton Woods system.

The foreign exchange market (forex, FX, or currency The foreign exchange market is unique because of the
market) is a global decentralized market for the trading following characteristics:
of currencies. In terms of volume of trading, it is by
far the largest market in the world.[1] The main partic its huge trading volume representing the largest asset
ipants in this market are the larger international banks.
class in the world leading to high liquidity;
Financial centres around the world function as anchors of
its geographical dispersion;
trading between a wide range of multiple types of buyers and sellers around the clock, with the exception of
its continuous operation: 24 hours a day except
weekends. The foreign exchange market determines the
weekends, i.e., trading from 22:00 GMT on Sunday
relative values of dierent currencies.[2]
(Sydney) until 22:00 GMT Friday (New York);
The foreign exchange market works through nancial in the variety of factors that aect exchange rates;
stitutions, and it operates on several levels. Behind the
the low margins of relative prot compared with
scenes banks turn to a smaller number of nancial rms
other markets of xed income; and
known as dealers, who are actively involved in large
quantities of foreign exchange trading. Most foreign ex the use of leverage to enhance prot and loss marchange dealers are banks, so this behind-the-scenes margins and with respect to account size.
ket is sometimes called the interbank market, although
a few insurance companies and other kinds of nancial As such, it has been referred to as the market closest to the
rms are involved. Trades between foreign exchange
ideal of perfect competition, notwithstanding currency
dealers can be very large, involving hundreds of millions intervention by central banks.
of dollars. Because of the sovereignty issue when involv[4]
ing two currencies, forex has little (if any) supervisory According to the Bank for International Settlements,
the preliminary global results from the 2013 Triennial
entity regulating its actions.
Central Bank Survey of Foreign Exchange and OTC
The foreign exchange market assists international trade Derivatives Markets Activity show that trading in foreign
and investments by enabling currency conversion. For exchange markets averaged $5.3 trillion per day in April
example, it permits a business in the United States to im- 2013. This is up from $4.0 trillion in April 2010 and $3.3
port goods from the European Union member states, es- trillion in April 2007. Foreign exchange swaps were the
pecially Eurozone members, and pay Euros, even though most actively traded instruments in April 2013, at $2.2
its income is in United States dollars. It also supports trillion per day, followed by spot trading at $2.0 trillion.
direct speculation and evaluation relative to the value of According to the Bank for International Settlements,[5] as
currencies, and the carry trade, speculation based on the of April 2010, average daily turnover in global foreign exinterest rate dierential between two currencies.[3]
change markets is estimated at $3.98 trillion, a growth of
In a typical foreign exchange transaction, a party pur- approximately 20% over the $3.21 trillion daily volume
chases some quantity of one currency by paying with as of April 2007. Some rms specializing on foreign exsome quantity of another currency. The modern foreign change market had put the average daily turnover in exexchange market began forming during the 1970s after cess of US$4 trillion.[6] The $3.98 trillion break-down is
three decades of government restrictions on foreign ex- as follows:
251

252

CHAPTER 11. CURRENCY DERIVATIVES

$1.490 trillion in spot transactions

$475 billion in outright forwards
$1.765 trillion in foreign exchange swaps
$43 billion currency swaps
$207 billion in options and other products

11.1.1

History

Ancient
Currency trading and exchange rst occurred in ancient
times.[7] Money-changing people, people helping others
to change money and also taking a commission or charging a fee were living in the times of the Talmudic writings (Biblical times). These people (sometimes called
kollybists) used city-stalls, at feast times the temples
Court of the Gentiles instead.[8] Money-changers were
also in more recent ancient times silver-smiths and/or
gold-smiths.[9]
During the 4th century, the Byzantine government kept a
monopoly on the exchange of currency.[10]
Papyri PCZ I 59021 (c.259/8 BC), shows the occurrences
of exchange of coinage within Ancient Egypt. [11]
Currency and exchange was also a vital and crucial element of trade during the ancient world so that people could buy and sell items like food, pottery and raw
materials.[12] If a Greek coin held more gold than an
Egyptian coin due to its size or content, then a merchant
could barter fewer Greek gold coins for more Egyptian
ones, or for more material goods. This is why, at some
point in their history, most world currencies in circulation
today had a value xed to a specic quantity of a recognized standard like silver and gold.

within U.S.A.[21] During 1880, J.M. do Esprito Santo de

Silva (Banco Esprito Santo) applied for and was given
permission to begin to engage in a foreign exchange trading business.[22][23]
The year 1880 is considered by at least one source to be
the beginning of modern foreign exchange, signicant for
the fact of the beginning of the gold standard during the
year.[24]
Prior to the rst world war, there was a much more limited
control of international trade. Motivated by the outset
of war, countries abandoned the gold standard monetary
system.[25]
Modern to post-modern
From 1899 to 1913, holdings of countries foreign exchange increased at an annual rate of 10.8%, while holdings of gold increased at an annual rate of 6.3% between
1903 and 1913.[26]
At the time of the closing of the year 1913, nearly half
of the worlds foreign exchange was conducted using the
Pound sterling.[27] The number of foreign banks operating within the boundaries of London increased in the
years from 1860 to 1913 from 3 to 71. In 1902 there
were altogether two London foreign exchange brokers.[28]
During the earliest years of the 20th century, trade was
most active in Paris, New York and Berlin, while Britain
remained largely uninvolved in trade until 1914. Between
1919 and 1922, the employment of foreign exchange brokers within London increased to 17, in 1924 there were
40 rms operating for the purposes of exchange.[29] During the 1920s the occurrence of trade in London resembled more the modern manifestation, by 1928 forex trade
was integral to the nancial functioning of the city. Continental exchange controls, plus other factors, in Europe
and Latin America, hampered any attempt at wholesale
prosperity from trade for those of 1930s London.[30]

Medieval and later

During the 1920s, the Kleinwort family were known to be

the leaders of the foreign exchange market; while Japheth,
During the 15th century, the Medici family were required
Montagu & Co., and Seligman still warrant recognition as
to open banks at foreign locations in order to exchange
signicant FX traders.[31]
[13][14]
currencies to act on behalf of textile merchants.
To
facilitate trade the bank created the nostro (from Italian
translated ours) account book which contained two After WWII After WWII, the Bretton Woods Accord
columned entries showing amounts of foreign and local was signed allowing currencies to uctuate within a range
currencies, information pertaining to the keeping of an of 1% to the currencies par.[32] In Japan the law was
account with a foreign bank.[15][16][17][18] During the 17th changed during 1954 by the Foreign Exchange Bank Law,
(or 18th ) century, Amsterdam maintained an active forex so, the Bank of Tokyo was to become, because of this, the
market.[19] In 1704, foreign exchange took place between centre of foreign exchange by September of that year.
agents acting in the interests of the Kingdom of England Between 1954 and 1959 Japanese law was made to aland the County of Holland.[20]
low the inclusion of many more Occidental currencies in
Japanese forex.[33]
U.S. President Richard Nixon is credited with ending the
Bretton Woods Accord and xed rates of exchange, evenAlex. Brown & Sons traded foreign currencies exchange tually bringing about a free-oating currency system. Afsometime about 1850 and was a leading participant in this ter the ceasing of the enactment of the Bretton Woods
Early modern

11.1. FOREIGN EXCHANGE MARKET

Accord during 1971,[34] the Smithsonian Agreement allowed trading to range to 2%. During 196162, the
amount of foreign operations by the U.S. Federal Reserve
was relatively low.[35][36] Those involved in controlling
exchange rates found the boundaries of the Agreement
were not realistic and so ceased this in March 1973, when
sometime afterward none of the major currencies were
maintained with a capacity for conversion to gold, organisations relied instead on reserves of currency.[37][38] During 1970 to 1973 the amount of trades occurring in the
market increased three-fold.[39][40][41] At some time (according to Gandolfo during FebruaryMarch 1973) some
of the markets were split, so a two tier currency market
was subsequently introduced, with dual currency rates.
This was abolished during March 1974.[42][43][44]

253
February 1985 particularly.[58] The greatest proportion
of all trades world-wide during 1987 were within the
United Kingdom, slightly over one quarter, with the
U.S. of America the nation with the second most places
involved in trading.[59]
During 1991 the republic of Iran changed international
agreements with some countries from oil-barter to foreign
exchange.[60]

11.1.2 Market size and liquidity

Reuters introduced during June 1973 computer monitors, replacing the telephones and telex used previously
for trading quotes.[45]
Markets close Due to the ultimate ineectiveness of
the Bretton Woods Accord and the European Joint Float
the forex markets were forced to close sometime during
1972 and March 1973.[46][47] The very largest of all purchases of dollars in the history of 1976 was when the West
German government achieved an almost 3 billion dollar
acquisition (a gure given as 2.75 billion in total by The
Statesman: Volume 18 1974), this event indicated the impossibility of the balancing of exchange stabilities by the
measures of control used at the time and the monetary
system and the foreign exchange markets in West Germany and other countries within Europe closed for two
weeks (during February and, or, March 1973. Giersch,
Paqu, & Schmieding state closed after purchase of 7.5
million Dmarks Brawley states "... Exchange markets
had to be closed. When they re-opened ... March 1 " that
is a large purchase occurred after the close).[48][49][50][51]
After 1973 The year 1973 marks the point to which
nation-state, banking trade and controlled foreign exchange ended and complete oating, relatively free conditions of a market characteristic of the situation in contemporary times began (according to one source),[52] although another states the rst time a currency pair were
given as an option for U.S.A. traders to purchase was during 1982, with additional currencies available by the next
year.[53][54]
On 1 January 1981, as part of changes beginning during 1978, the Peoples Bank of China allowed certain
domestic enterprises to participate in foreign exchange
trading.[55][56] Sometime during 1981, the South Korean
government ended forex controls and allowed free trade
to occur for the rst time. During 1988 the countries
government accepted the IMF quota for international
trade.[57]

Main foreign exchange market turnover, 19882007, measured

in billions of USD.

The foreign exchange market is the most liquid nancial

market in the world. Traders include large banks, central banks, institutional investors, currency speculators,
corporations, governments, other nancial institutions,
and retail investors. The average daily turnover in the
global foreign exchange and related markets is continuously growing. According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was US$3.98
trillion in April 2010 (vs $1.7 trillion in 1998).[5] Of this
$3.98 trillion, $1.5 trillion was spot transactions and $2.5
trillion was traded in outright forwards, swaps and other
derivatives.
In April 2010, trading in the United Kingdom accounted
for 36.7% of the total, making it by far the most important centre for foreign exchange trading. Trading in the
United States accounted for 17.9% and Japan accounted
for 6.2%.[61]
In April 2013, for the rst time, Singapore surpassed
Japan in average daily foreign-exchange trading volume
with $383 billion per day. So the rank became: the
United Kingdom (41%), the United States (19%), Singapore (5.7)%, Japan (5.6%) and Hong Kong (4.1%).[62]

Turnover of exchange-traded foreign exchange futures

and options have grown rapidly in recent years, reaching
$166 billion in April 2010 (double the turnover recorded
Intervention by European banks especially the in April 2007). Exchange-traded currency derivatives
Bundesbank inuenced the forex market, on 27 represent 4% of OTC foreign exchange turnover. Foreign

254

CHAPTER 11. CURRENCY DERIVATIVES

exchange futures contracts were introduced in 1972 at the of access. This is due to volume. If a trader can guaranChicago Mercantile Exchange and are actively traded rel- tee large numbers of transactions for large amounts, they
ative to most other futures contracts.
can demand a smaller dierence between the bid and ask
Most developed countries permit the trading of deriva- price, which is referred to as a better spread. The levels of
tive products (like futures and options on futures) on access that make up the foreign exchange market are detheir exchanges. All these developed countries already termined by the size of the line (the amount of money
interbank marhave fully convertible capital accounts. Some govern- with which they are trading). The top-tier[61]
From there,
ket
accounts
for
39%
of
all
transactions.
ments of emerging markets do not allow foreign exchange
smaller banks, followed by large multi-national corporaderivative products on their exchanges because they have
capital controls. The use of derivatives is growing in tions (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the
many emerging economies.[63] Countries such as South
Korea, South Africa, and India have established currency retail market makers. According to Galati and Melvin,
Pension funds, insurance companies, mutual funds, and
futures exchanges, despite having some capital controls.
other institutional investors have played an increasingly
Foreign exchange trading increased by 20% between important role in nancial markets in general, and in FX
April 2007 and April 2010 and has more than doubled markets in particular, since the early 2000s. (2004) In
since 2004.[64] The increase in turnover is due to a num- addition, he notes, Hedge funds have grown markedly
ber of factors: the growing importance of foreign ex- over the 20012004 period in terms of both number and
change as an asset class, the increased trading activity overall size.[66] Central banks also participate in the forof high-frequency traders, and the emergence of retail eign exchange market to align currencies to their ecoinvestors as an important market segment. The growth nomic needs.
of electronic execution and the diverse selection of execution venues has lowered transaction costs, increased
market liquidity, and attracted greater participation from Commercial companies
many customer types. In particular, electronic trading via
online portals has made it easier for retail traders to trade An important part of the foreign exchange market comes
in the foreign exchange market. By 2010, retail trading from the nancial activities of companies seeking foreign
is estimated to account for up to 10% of spot turnover, or exchange to pay for goods or services. Commercial com$150 billion per day (see below: Retail foreign exchange panies often trade fairly small amounts compared to those
traders).
of banks or speculators, and their trades often have little
Foreign exchange is an over-the-counter market where short-term impact on market rates. Nevertheless, trade
brokers/dealers negotiate directly with one another, so ows are an important factor in the long-term direction
there is no central exchange or clearing house. The of a currencys exchange rate. Some multinational corpobiggest geographic trading center is the United Kingdom, rations (MNCs) can have an unpredictable impact when
primarily London, which according to TheCityUK esti- very large positions are covered due to exposures that are
mates has increased its share of global turnover in tradi- not widely known by other market participants.
tional transactions from 34.6% in April 2007 to 36.7% in
April 2010. Due to Londons dominance in the market,
a particular currencys quoted price is usually the London
market price. For instance, when the International Monetary Fund calculates the value of its special drawing rights
every day, they use the London market prices at noon that
day.

11.1.3

Market participants

See also: Forex scandal

Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the interbank
market, which is made up of the largest commercial
banks and securities dealers. Within the interbank market, spreads, which are the dierence between the bid and
ask prices, are razor sharp and not known to players outside the inner circle. The dierence between the bid and
ask prices widens (for example from 0 to 1 pip to 12 pips
for currencies such as the EUR) as you go down the levels

Central banks
National central banks play an important role in the foreign exchange markets. They try to control the money
supply, ination, and/or interest rates and often have ofcial or unocial target rates for their currencies. They
can use their often substantial foreign exchange reserves
to stabilize the market. Nevertheless, the eectiveness
of central bank stabilizing speculation is doubtful because central banks do not go bankrupt if they make large
losses, like other traders would, and there is no convincing evidence that they do make a prot trading.
Foreign exchange xing
Foreign exchange xing is the daily monetary exchange
rate xed by the national bank of each country. The idea
is that central banks use the xing time and exchange rate
to evaluate behavior of their currency. Fixing exchange
rates reects the real value of equilibrium in the market.

11.1. FOREIGN EXCHANGE MARKET

255

Banks, dealers and traders use xing rates as a trend in- Forex CTA instead of a CTA). Those NFA members that
dicator.
would traditionally be subject to minimum net capital reThe mere expectation or rumor of a central bank foreign quirements, FCMs and IBs, are subject to greater miniexchange intervention might be enough to stabilize a cur- mum net capital requirements if they deal in Forex. A
rency, but aggressive intervention might be used several number of the foreign exchange brokers operate from
times each year in countries with a dirty oat currency the UK under Financial Services Authority regulations
regime. Central banks do not always achieve their ob- where foreign exchange trading using margin is part of
jectives. The combined resources of the market can eas- the wider over-the-counter derivatives trading industry
that includes Contract for dierences and nancial spread
ily overwhelm any central bank.[67] Several scenarios of
this nature were seen in the 199293 European Exchange betting.
Rate Mechanism collapse, and in more recent times in There are two main types of retail FX brokers oering
Asia.
the opportunity for speculative currency trading: brokers
and dealers or market makers. Brokers serve as an agent
of the customer in the broader FX market, by seeking the
Hedge funds as speculators
best price in the market for a retail order and dealing on
behalf of the retail customer. They charge a commission
About 70% to 90% of the foreign exchange transactions
or mark-up in addition to the price obtained in the marconducted are speculative. This means the person or inket. Dealers or market makers, by contrast, typically act
stitution that bought or sold the currency has no plan to
as principal in the transaction versus the retail customer,
actually take delivery of the currency in the end; rather,
and quote a price they are willing to deal at.
they were solely speculating on the movement of that particular currency. Since 1996, hedge funds have gained a
reputation for aggressive currency speculation. They con- Non-bank foreign exchange companies
trol billions of dollars of equity and may borrow billions
more, and thus may overwhelm intervention by central Non-bank foreign exchange companies oer currency exbanks to support almost any currency, if the economic change and international payments to private individufundamentals are in the hedge funds favor.
als and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but rather currency exchange with
Investment management rms
payments (i.e., there is usually a physical delivery of currency to a bank account).
Investment management rms (who typically manage
large accounts on behalf of customers such as pension It is estimated that in the UK, 14% of currency
funds and endowments) use the foreign exchange market transfers/payments are made via Foreign Exchange
to facilitate transactions in foreign securities. For exam- Companies.[70] These companies selling point is usually
ple, an investment manager bearing an international eq- that they will oer better exchange rates or cheaper payuity portfolio needs to purchase and sell several pairs of ments than the customers bank.[71] These companies difforeign currencies to pay for foreign securities purchases. fer from Money Transfer/Remittance Companies in that
they generally oer higher-value services.
Some investment management rms also have more speculative specialist currency overlay operations, which manage clients currency exposures with the aim of generating Money transfer/remittance companies and bureaux
prots as well as limiting risk. While the number of this de change
type of specialist rms is quite small, many have a large
value of assets under management and, hence, can gen- Money transfer companies/remittance companies pererate large trades.
form high-volume low-value transfers generally by economic migrants back to their home country. In 2007,
the Aite Group estimated that there were $369 billion
Retail foreign exchange traders
of remittances (an increase of 8% on the previous year).
Individual retail speculative traders constitute a growing The four largest markets (India, China, Mexico and the
segment of this market with the advent of retail foreign Philippines) receive $95 billion. The largest and best
exchange trading, both in size and importance. Currently, known provider is Western Union with 345,000 agents
they participate indirectly through brokers or banks. Re- globally followed by UAE Exchange.
tail brokers, while largely controlled and regulated in the
USA by the Commodity Futures Trading Commission
and National Futures Association, have in the past been
subjected to periodic foreign exchange fraud.[68][69] To
deal with the issue, in 2010 the NFA required its members that deal in the Forex markets to register as such (I.e.,

Bureaux de change or currency transfer companies provide low value foreign exchange services for travelers.
These are typically located at airports and stations or at
tourist locations and allow physical notes to be exchanged
from one currency to another. They access the foreign exchange markets via banks or non bank foreign exchange

256

CHAPTER 11. CURRENCY DERIVATIVES

companies.

11.1.4

Trading characteristics

There is no unied or centrally cleared market for the

majority of trades, and there is very little cross-border
regulation. Due to the over-the-counter (OTC) nature
of currency markets, there are rather a number of interconnected marketplaces, where dierent currencies
instruments are traded. This implies that there is not
a single exchange rate but rather a number of dierent
rates (prices), depending on what bank or market maker
is trading, and where it is. In practice the rates are quite
close due to arbitrage. Due to Londons dominance in the
market, a particular currencys quoted price is usually the
London market price. Major trading exchanges include
Electronic Broking Services (EBS) and Thomson Reuters
Dealing, while major banks also oer trading systems.
A joint venture of the Chicago Mercantile Exchange and
Reuters, called Fxmarketspace opened in 2007 and aspired but failed to the role of a central market clearing
mechanism.

USD is the counter currency (e.g. GBPUSD, AUDUSD,

NZDUSD, EURUSD).
The factors aecting XXX will aect both XXXYYY
and XXXZZZ. This causes positive currency correlation
between XXXYYY and XXXZZZ.
On the spot market, according to the 2013 Triennial Survey, the most heavily traded bilateral currency pairs were:
EURUSD: 24.1%
USDJPY: 18.3%
GBPUSD (also called cable): 8.8%
and the US currency was involved in 87.0% of transactions, followed by the euro (33.4%), the yen (23.0%),
and sterling (11.8%) (see table). Volume percentages for
all individual currencies should add up to 200%, as each
transaction involves two currencies.
Trading in the euro has grown considerably since the currencys creation in January 1999, and how long the foreign exchange market will remain dollar-centered is open
to debate. Until recently, trading the euro versus a nonEuropean currency ZZZ would have usually involved two
trades: EURUSD and USDZZZ. The exception to this is
EURJPY, which is an established traded currency pair in
the interbank spot market.

The main trading centers are London and New York City,
though Tokyo, Hong Kong and Singapore are all important centers as well. Banks throughout the world participate. Currency trading happens continuously throughout
the day; as the Asian trading session ends, the European
session begins, followed by the North American session
and then back to the Asian session, excluding weekends. 11.1.5
Fluctuations in exchange rates are usually caused by actual monetary ows as well as by expectations of changes
in monetary ows caused by changes in gross domestic
product (GDP) growth, ination (purchasing power parity theory), interest rates (interest rate parity, Domestic
Fisher eect, International Fisher eect), budget and
trade decits or surpluses, large cross-border M&A deals
and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people
have access to the same news at the same time. However,
the large banks have an important advantage; they can see
their customers order ow.
Currencies are traded against one another in pairs. Each
currency pair thus constitutes an individual trading product and is traditionally noted XXXYYY or XXX/YYY,
where XXX and YYY are the ISO 4217 international
three-letter code of the currencies involved. The rst currency (XXX) is the base currency that is quoted relative to
the second currency (YYY), called the counter currency
(or quote currency). For instance, the quotation EURUSD
(EUR/USD) 1.5465 is the price of the Euro expressed in
US dollars, meaning 1 euro = 1.5465 dollars. The market convention is to quote most exchange rates against
the USD with the US dollar as the base currency (e.g.
USDJPY, USDCAD, USDCHF). The exceptions are the
British pound (GBP), Australian dollar (AUD), the New
Zealand dollar (NZD) and the euro (EUR) where the

Determinants of exchange rates

Main article: Exchange rate

The following theories explain the uctuations in exchange rates in a oating exchange rate regime (In a xed
exchange rate regime, rates are decided by its government):
1. International parity conditions: Relative purchasing
power parity, interest rate parity, Domestic Fisher
eect, International Fisher eect. Though to some
extent the above theories provide logical explanation for the uctuations in exchange rates, yet these
theories falter as they are based on challengeable assumptions [e.g., free ow of goods, services and capital] which seldom hold true in the real world.
2. Balance of payments model: This model, however,
focuses largely on tradable goods and services, ignoring the increasing role of global capital ows. It
failed to provide any explanation for continuous appreciation of dollar during the 1980s and most part
of the 1990s in face of soaring US current account
decit.
3. Asset market model: views currencies as an important asset class for constructing investment portfolios. Assets prices are inuenced mostly by peoples

11.1. FOREIGN EXCHANGE MARKET

257

willingness to hold the existing quantities of assets,

which in turn depends on their expectations on the
future worth of these assets. The asset market model
of exchange rate determination states that the exchange rate between two currencies represents the
price that just balances the relative supplies of, and
demand for, assets denominated in those currencies.

Ination levels and trends: Typically a currency

will lose value if there is a high level of ination in the country or if ination levels are perceived to be rising. This is because ination erodes
purchasing power, thus demand, for that particular currency. However, a currency may sometimes
strengthen when ination rises because of expectations that the central bank will raise short-term interest rates to combat rising ination.

None of the models developed so far succeed to explain

exchange rates and volatility in the longer time frames.
For shorter time frames (less than a few days), algorithms
can be devised to predict prices. It is understood from
the above models that many macroeconomic factors aect
the exchange rates and in the end currency prices are a
result of dual forces of demand and supply. The worlds
currency markets can be viewed as a huge melting pot: in
a large and ever-changing mix of current events, supply
and demand factors are constantly shifting, and the price
of one currency in relation to another shifts accordingly.
No other market encompasses (and distills) as much of
what is going on in the world at any given time as foreign
exchange.[74]

Economic growth and health: Reports such as GDP,

employment levels, retail sales, capacity utilization
and others, detail the levels of a countrys economic
growth and health. Generally, the more healthy and
robust a countrys economy, the better its currency
will perform, and the more demand for it there will
be.
Productivity of an economy: Increasing productivity
in an economy should positively inuence the value
of its currency. Its eects are more prominent if the
increase is in the traded sector.[75]

Political conditions
Supply and demand for any given currency, and thus its
value, are not inuenced by any single element, but rather Internal, regional, and international political conditions
by several. These elements generally fall into three cate- and events can have a profound eect on currency margories: economic factors, political conditions and market kets.
psychology.
All exchange rates are susceptible to political instability
and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a naEconomic factors
tions economy. For example, destabilization of coalition
These include: (a) economic policy, disseminated by gov- governments in Pakistan and Thailand can negatively afernment agencies and central banks, (b) economic condi- fect the value of their currencies. Similarly, in a country
tions, generally revealed through economic reports, and experiencing nancial diculties, the rise of a political
faction that is perceived to be scally responsible can have
other economic indicators.
the opposite eect. Also, events in one country in a region may spur positive/negative interest in a neighboring
Economic policy comprises government scal pol- country and, in the process, aect its currency.
icy (budget/spending practices) and monetary policy (the means by which a governments central bank
inuences the supply and cost of money, which is Market psychology
reected by the level of interest rates).
Market psychology and trader perceptions inuence the
Government budget decits or surpluses: The mar- foreign exchange market in a variety of ways:
ket usually reacts negatively to widening government
budget decits, and positively to narrowing budget
Flights to quality: Unsettling international events
decits. The impact is reected in the value of a
can lead to a "ight-to-quality", a type of capital
countrys currency.
ight whereby investors move their assets to a perceived "safe haven". There will be a greater de Balance of trade levels and trends: The trade ow
mand, thus a higher price, for currencies perceived
between countries illustrates the demand for goods
as stronger over their relatively weaker counterparts.
and services, which in turn indicates demand for a
The US dollar, Swiss franc and gold have been tracountrys currency to conduct trade. Surpluses and
ditional safe havens during times of political or ecodecits in trade of goods and services reect the
nomic uncertainty.[76]
competitiveness of a nations economy. For exam Long-term trends: Currency markets often move in
ple, trade decits may have a negative impact on a
nations currency.
visible long-term trends. Although currencies do not

258

CHAPTER 11. CURRENCY DERIVATIVES

have an annual growing season like physical commodities, business cycles do make themselves felt.
Cycle analysis looks at longer-term price trends that
may rise from economic or political trends.[77]

One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money
does not actually change hands until some agreed upon
future date. A buyer and seller agree on an exchange rate
for any date in the future, and the transaction occurs on
that date, regardless of what the market rates are then.
The duration of the trade can be one day, a few days,
months or years. Usually the date is decided by both parties. Then the forward contract is negotiated and agreed
upon by both parties.

Buy the rumor, sell the fact": This market truism

can apply to many currency situations. It is the tendency for the price of a currency to reect the impact
of a particular action before it occurs and, when the
anticipated event comes to pass, react in exactly the
opposite direction. This may also be referred to as
a market being oversold or overbought.[78] To
buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when Swap
investors focus too much on the relevance of outside
events to currency prices.
Main article: Foreign exchange swap
Economic numbers: While economic numbers can
certainly reect economic policy, some reports and
numbers take on a talisman-like eect: the number
itself becomes important to market psychology and
may have an immediate impact on short-term market moves. What to watch can change over time.
In recent years, for example, money supply, employment, trade balance gures and ination numbers
have all taken turns in the spotlight.

The most common type of forward transaction is the foreign exchange swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse
the transaction at a later date. These are not standardized
contracts and are not traded through an exchange. A deposit is often required in order to hold the position open
until the transaction is completed.

Technical trading considerations: As in other markets, the accumulated price movements in a cur- Futures
rency pair such as EUR/USD can form apparent
patterns that traders may attempt to use. Many Main article: Currency future
traders study price charts in order to identify such
patterns.[79]
Futures are standardized forward contracts and are usually traded on an exchange created for this purpose. The
average contract length is roughly 3 months. Futures con11.1.6 Financial instruments
tracts are usually inclusive of any interest amounts.
Spot
Main article: Foreign exchange spot

Currency futures contracts are contracts specifying a

standard volume of a particular currency to be exchanged
on a specic settlement date. Thus the currency futures
contracts are similar to forward contracts in terms of their
obligation, but dier from forward contracts in the way
they are traded. They are commonly used by MNCs to
hedge their currency positions. In addition they are traded
by speculators who hope to capitalize on their expectations of exchange rate movements.

A spot transaction is a two-day delivery transaction (except in the case of trades between the US dollar, Canadian
dollar, Turkish lira, euro and Russian ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a direct exchange between two currencies, has the
shortest time frame, involves cash rather than a contract,
and interest is not included in the agreed-upon transac- Option
tion. Spot trading is one of the most common types of
Forex Trading. Often, a forex broker will charge a small Main article: Foreign exchange option
fee to the client to roll-over the expiring transaction into
a new identical transaction for a continuum of the trade.
A foreign exchange option (commonly shortened to just
This roll-over fee is known as the Swap fee.
FX option) is a derivative where the owner has the right
but not the obligation to exchange money denominated
in one currency into another currency at a pre-agreed exForward
change rate on a specied date. The FX options market
See also: Forward contract
is the deepest, largest and most liquid market for options
of any kind in the world.

11.1. FOREIGN EXCHANGE MARKET

11.1.7

259

Speculation

Controversy about currency speculators and their eect

on currency devaluations and national economies recurs
regularly. Nevertheless, economists including Milton
Friedman have argued that speculators ultimately are a
stabilizing inuence on the market and perform the important function of providing a market for hedgers and
transferring risk from those people who don't wish to bear
it, to those who do.[80] Other economists, such as Joseph
Stiglitz, consider this argument to be based more on pol- Fig.1 Chart showing MSCI World Index of Equities fell while the
itics and a free market philosophy than on economics.[81] US dollar Index rose.
Large hedge funds and other well capitalized position
traders are the main professional speculators. According
to some economists, individual traders could act as "noise
traders" and have a more destabilizing role than larger
and better informed actors.[82] Also to be considered is
the rise in foreign exchange autotrading; algorithmic, or
automated, trading has increased from 2% in 2004 up to
45% in 2010.[83]

assets due to uncertainty.[86]

In the context of the foreign exchange market, traders liquidate their positions in various currencies to take up positions in safe-haven currencies, such as the US dollar.[87]
Sometimes, the choice of a safe haven currency is more of
a choice based on prevailing sentiments rather than one of
economic statistics. An example would be the Financial
Currency speculation is considered a highly suspect ac- Crisis of 2008. The value of equities across the world fell
tivity in many countries. While investment in traditional while the US dollar strengthened (see Fig.1). This hapnancial instruments like bonds or stocks often is consid- pened despite the strong focus of the crisis in the USA.[88]
ered to contribute positively to economic growth by providing capital, currency speculation does not; according
to this view, it is simply gambling that often interferes 11.1.9 Carry trade
with economic policy. For example, in 1992, currency
speculation forced the Central Bank of Sweden to raise Main article: Carry trade
interest rates for a few days to 500% per annum, and later
to devalue the krona.[84] Mahathir Mohamad, one of the Currency carry trade refers to the act of borrowing one
former Prime Ministers of Malaysia, is one well-known currency that has a low interest rate in order to purchase
proponent of this view. He blamed the devaluation of another with a higher interest rate. A large dierence in
the Malaysian ringgit in 1997 on George Soros and other rates can be highly protable for the trader, especially if
speculators.
high leverage is used. However, with all levered investGregory Millman reports on an opposing view, compar- ments this is a double edged sword, and large exchange
ing speculators to vigilantes who simply help enforce rate price uctuations can suddenly swing trades into huge
international agreements and anticipate the eects of ba- losses.
sic economic laws in order to prot.[85]
In this view, countries may develop unsustainable
nancial bubbles or otherwise mishandle their national
economies, and foreign exchange speculators made the
inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic
mishandling, followed by an eventual, larger, collapse.
Mahathir Mohamad and other critics of speculation are
viewed as trying to deect the blame from themselves for
having caused the unsustainable economic conditions.

11.1.8

Risk aversion

See also: Safe-haven currency

Risk aversion is a kind of trading behavior exhibited by
the foreign exchange market when a potentially adverse
event happens which may aect market conditions. This
behavior is caused when risk averse traders liquidate their
positions in risky assets and shift the funds to less risky

11.1.10 Forex signals

Main article: Forex signal
Forex trade alerts, often referred to as forex signals, are
trade strategies provided by either experienced traders or
market analysts. These signals which are often charged
a premium fee for can then be copied or replicated by a
trader to his own live account. Forex signal products are
packaged as either alerts delivered to a users inbox or
SMS, or can be installed to a traders trading platforms.
Algorithmic trading, whereby foreign exchange users can
programme (or buy ready made software) to place trades
on their behalf, according to pre-determined rules has become very popular in recent years. This means that users
can set their 'Algos to trade on their behalf, thus reducing the need to sit and monitor the markets continuously,
plus it can remove the element of human emotion around

260

CHAPTER 11. CURRENCY DERIVATIVES

executing a trade.

[18] Oxford dictionaries online nostro account

11.1.11

See also

[19] S Homer, Richard E Sylla A History of Interest Rates John

Wiley & Sons, 29 August 2005 Retrieved 14 July 2012
ISBN 0471732834

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choice.com.au.

Overseas money transfers.

[72] Worlds Most Traded Currencies By Value 2012. investopedia.com. Retrieved 10 June 2013.
[73] The total sum is 200% because each currency trade always
involves a currency pair.
[74] The Microstructure Approach to Exchange Rates,
Richard Lyons, MIT Press (pdf chapter 1)

11.1.13 External links

Frankel, Jerey A. (2008). Foreign Exchange.
In David R. Henderson (ed.). Concise Encyclopedia of Economics (2nd ed.). Indianapolis: Library
of Economics and Liberty. ISBN 978-0865976658.
OCLC 237794267.
A users guide to the Triennial Central Bank Survey
of foreign exchange market activity, Bank for International Settlements
London Foreign Exchange Committee with links
(on right) to committees in NY, Tokyo, Canada,
Australia, HK, Singapore
United States Federal Reserve daily update of exchange rates

[75] To What Extent Does Productivity Drive the Dollar?".

ssrn.com.

Bank of Canada historical (10-year) currency converter and data download

[76] Safe Haven Currency. Financial Glossary (Reuters).

Retrieved 22 April 2013.

OECD Exchange rate statistics (monthly averages)

[77] John J. Murphy, Technical Analysis of the Financial Markets (New York Institute of Finance, 1999), pp. 343375.

National Futures Association (2010). Trading in

the Retail O-Exchange Foreign Currency Market.
Chicago, Illinois.

[78] Overbought. Investopedia. Retrieved 22 April 2013.

[79] Sam Y. Cross, All About the Foreign Exchange Market
in the United States, Federal Reserve Bank of New York
(1998), chapter 11, pp. 113115.

11.2 Exchange rate

[80] Michael A. S. Guth, "Protable Destabilizing Speculation, Chapter 1 in Michael A. S. Guth, Speculative behavior and the operation of competitive markets under uncertainty, Avebury Ashgate Publishing, Aldorshot, England (1994), ISBN 1-85628-985-0.
[81] What I Learned at the World Economic Crisis Joseph
Stiglitz, The New Republic, 17 April 2000, reprinted at
GlobalPolicy.org
[82] Summers LH and Summers VP (1989) 'When nancial
markets work too well: a Cautious case for a securities
transaction tax' Journal of nancial services
[83] Anatomy of the Forex Market. Pepperstone. Retrieved
22 April 2013.
[84] Redburn, Tom (17 September 1992). But Don't Rush
Out to Buy Kronor: Swedens 500% Gamble. The New
York Times. Retrieved 18 April 2015.

USD and EUR

In nance, an exchange rate (also known as a foreignexchange rate, forex rate, FX rate or Agio) between
two currencies is the rate at which one currency will be
[86] Risk Averse. Investopedia. Retrieved 25 February exchanged for another. It is also regarded as the value
2010.
of one countrys currency in terms of another currency.[1]
[87] Moon, Angela (5 February 2010). Global markets US For example, an interbank exchange rate of 119 Japanese
stocks rebound, dollar gains on risk aversion. Reuters. yen (JPY, ) to the United States dollar (US$) means that
119 will be exchanged for each US$1 or that US$1 will
Retrieved 27 February 2010.
be exchanged for each 119.
[85] Gregory J. Millman, Around the World on a Trillion Dollars a Day, Bantam Press, New York, 1995.

[88] Stewart, Heather (9 April 2008). IMF says US crisis

is 'largest nancial shock since Great Depression'". The
Guardian (London). Retrieved 27 February 2010.

Exchange rates are determined in the foreign exchange

market,[2] which is open to a wide range of dierent types

11.2. EXCHANGE RATE

263

of buyers and sellers where currency trading is continuous: 24 hours a day except weekends, i.e. trading from
20:15 GMT on Sunday until 22:00 GMT Friday. The
spot exchange rate refers to the current exchange rate.
The forward exchange rate refers to an exchange rate that
is quoted and traded today but for delivery and payment
on a specic future date.
In the retail currency exchange market, a dierent buying rate and selling rate will be quoted by money dealers.
Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign
currency, and the selling rate is the rate at which they will
sell the currency. The quoted rates will incorporate an allowance for a dealers margin (or prot) in trading, or else
the margin may be recovered in the form of a commission
or in some other way. Dierent rates may also be quoted
for cash (usually notes only), a documentary form (such
as travelers cheques) or electronically (such as a credit
card purchase). The higher rate on documentary transac- Exchange rates display in Thailand
tions has been justied to compensate for the additional
time and cost of clearing the document, while the cash
is available for resale immediately. Some dealers on the
There is a market convention that determines which is
other hand prefer documentary transactions because of
the xed currency and which is the variable currency. In
the security concerns with cash.
most parts of the world, the order is: EUR GBP AUD
NZD USD others. Accordingly, a conversion from
EUR to AUD, EUR is the xed currency, AUD is the
11.2.1 Retail exchange market
variable currency and the exchange rate indicates how
many Australian dollars would be paid or received for 1
Currency for international travel and cross-border pay- Euro. Cyprus and Malta which were quoted as the base
ments is predominantly purchased from banks, foreign to the USD and others were recently removed from this
exchange brokerages and various forms of Bureau de list when they joined the Eurozone.
change. These retail outlets source currency o the interIn some areas of Europe and in the non-professional marbank markets which are valued by the Bank for Internaket in the UK, EUR and GBP are reversed so that GBP
tional Settlements at $5.3 trillion-dollar-per-day . The
is quoted as the base currency to the euro. In order to
purchase price is conducted at the spot contract rate. The
determine which is the base currency where both currenprocess of selling currency on to retail clients will involve
cies are not listed (i.e. both are other), market conventhe charge of commission to cover processing costs while
tion is to use the base currency which gives an exchange
also deriving prot. Additional gains are realised by the
rate greater than 1.000. This avoids rounding issues and
quotation of an exchange rate that diers to the original
exchange rates being quoted to more than four decimal
spot rate.[3] This dierence is referred to as the bid-ask
places. There are some exceptions to this rule, for examspread. In determining their own bid and ask price the
ple, the Japanese often quote their currency as the base
retail provider is therefore the Market maker of the reto other currencies.
tail currency market which conrms this market as being
Quotes using a countrys home currency as the price curdetermined on discretion.
rency (for example, EUR 0.9009 = USD 1.00 in the Eurozone) are known as direct quotation or price quotation
(from that countrys perspective)[4] and are used by most
11.2.2 Quotations
countries.
Main article: Currency pair

Quotes using a countrys home currency as the unit currency (for example, USD 1.11 = EUR 1.00 in the EuroA currency pair is the quotation of the relative value of a zone) are known as indirect quotation or quantity quotacurrency unit against the unit of another currency in the tion and are used in British newspapers and are also comforeign exchange market. The quotation EUR/USD 1.11 mon in Australia, New Zealand and the Eurozone.
means that 1 Euro is able to buy 1.11 US dollar. In other Using direct quotation, if the home currency is strengthwords, this is the price of a unit of Euro in US dollar. ening (that is, appreciating, or becoming more valuable)
Here, EUR is called the Fixed currency, while USD is then the exchange rate number decreases. Conversely, if
the foreign currency is strengthening, the exchange rate
called the Variable currency.

264

CHAPTER 11. CURRENCY DERIVATIVES

number increases and the home currency is depreciating. within a narrow range. As a result, currencies become
Market convention from the early 1980s to 2006 was that over-valued or under-valued, leading to excessive trade
most currency pairs were quoted to four decimal places decits or surpluses.
for spot transactions and up to six decimal places for forward outrights or swaps. (The fourth decimal place is
usually referred to as a "pip"). An exception to this was
exchange rates with a value of less than 1.000 which were
usually quoted to ve or six decimal places. Although
there is not any xed rule, exchange rates with a value
greater than around 20 were usually quoted to three decimal places and currencies with a value greater than 80
were quoted to two decimal places. Currencies over 5000
were usually quoted with no decimal places (for example,
the former Turkish Lira). e.g. (GBPOMR : 0.765432 - :
1.4436 - EURJPY : 165.29). In other words, quotes are
given with ve digits. Where rates are below 1, quotes
frequently include ve decimal places.[5]

11.2.4 Fluctuations in exchange rates

A market-based exchange rate will change whenever the
values of either of the two component currencies change.
A currency will tend to become more valuable whenever
demand for it is greater than the available supply. It will
become less valuable whenever demand is less than available supply (this does not mean people no longer want
money, it just means they prefer holding their wealth in
some other form, possibly another currency).[7]
Increased demand for a currency can be due to either an
increased transaction demand for money or an increased
speculative demand for money. The transaction demand
is highly correlated to a countrys level of business activity, gross domestic product (GDP), and employment
levels. The more people that are unemployed, the less
the public as a whole will spend on goods and services.
Central banks typically have little diculty adjusting the
available money supply to accommodate changes in the
demand for money due to business transactions.

In 2005, Barclays Capital broke with convention by offering spot exchange rates with ve or six decimal places
on their electronic dealing platform.[6] The contraction of
spreads (the dierence between the bid and ask rates) arguably necessitated ner pricing and gave the banks the
ability to try and win transaction on multibank trading
platforms where all banks may otherwise have been quoting the same price. A number of other banks have now
Speculative demand is much harder for central banks to
followed this system.
accommodate, which they inuence by adjusting interest
rates. A speculator may buy a currency if the return (that
is the interest rate) is high enough. In general, the higher
11.2.3 Exchange rate regime
a countrys interest rates, the greater will be the demand
for that currency. It has been argued that such speculaMain article: Exchange rate regime
tion can undermine real economic growth, in particular
since large currency speculators may deliberately create
Each country, through varying mechanisms, manages the
downward pressure on a currency by shorting in order to
value of its currency. As part of this function, it deterforce that central bank to buy their own currency to keep
mines the exchange rate regime that will apply to its curit stable. (When that happens, the speculator can buy the
rency. For example, the currency may be free-oating,
currency back after it depreciates, close out their position,
pegged or xed, or a hybrid.
and thereby take a prot.)
If a currency is free-oating, its exchange rate is allowed
For carrier companies shipping goods from one nation to
to vary against that of other currencies and is determined
another, exchange rates can often impact them severely.
by the market forces of supply and demand. Exchange
Therefore, most carriers have a CAF charge to account
rates for such currencies are likely to change almost confor these uctuations.[8][9]
stantly as quoted on nancial markets, mainly by banks,
around the world.
A movable or adjustable peg system is a system of xed
exchange rates, but with a provision for the revaluation
(usually devaluation) of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB)
was pegged to the United States dollar at RMB 8.2768 to
$1. China was not the only country to do this; from the
end of World War II until 1967, Western European countries all maintained xed exchange rates with the US dollar based on the Bretton Woods system. But that system
had to be abandoned in favor of oating, market-based
regimes due to market pressures and speculations in the
1970s.

11.2.5 Purchasing power of currency

The real exchange rate (RER) is the purchasing power
of a currency relative to another at current exchange rates
and prices. It is the ratio of the number of units of a given
countrys currency necessary to buy a market basket of
goods in the other country, after acquiring the other countrys currency in the foreign exchange market, to the number of units of the given countrys currency that would be
necessary to buy that market basket directly in the given
country . There are dierent kind of measurement for
RER.[10]

Still, some governments strive to keep their currency Thus the real exchange rate is the exchange rate times

11.2. EXCHANGE RATE

the relative prices of a market basket of goods in the two
countries. For example, the purchasing power of the US
dollar relative to that of the euro is the dollar price of a
euro (dollars per euro) times the euro price of one unit
of the market basket (euros/goods unit) divided by the
dollar price of the market basket (dollars per goods unit),
and hence is dimensionless. This is the exchange rate (expressed as dollars per euro) times the relative price of the
two currencies in terms of their ability to purchase units
of the market basket (euros per goods unit divided by dollars per goods unit). If all goods were freely tradable, and
foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold
for the exchange rate and GDP deators (price levels) of
the two countries, and the real exchange rate would always equal 1.

265

11.2.7 Uncovered interest rate parity

See also: Interest rate parity Uncovered interest rate
parity

Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of one currency against another
currency might be neutralized by a change in the interest rate dierential. If US interest rates increase while
Japanese interest rates remain unchanged then the US
dollar should depreciate against the Japanese yen by an
amount that prevents arbitrage (in reality the opposite,
appreciation, quite frequently happens in the short-term,
as explained below). The future exchange rate is reected
into the forward exchange rate stated today. In our example, the forward exchange rate of the dollar is said to be
The rate of change of this real exchange rate over time at a discount because it buys fewer Japanese yen in the
equals the rate of appreciation of the euro (the positive or forward rate than it does in the spot rate. The yen is said
negative percentage rate of change of the dollars-per-euro to be at a premium.
exchange rate) plus the ination rate of the euro minus the
UIRP showed no proof of working after the 1990s. Conination rate of the dollar.
trary to the theory, currencies with high interest rates
characteristically appreciated rather than depreciated on
the reward of the containment of ination and a higheryielding currency.

11.2.6

Bilateral vs. eective exchange rate

11.2.8 Balance of payments model
The balance of payments model holds that foreign exchange rates are at an equilibrium level if they produce
a stable current account balance. A nation with a trade
decit will experience a reduction in its foreign exchange
reserves, which ultimately lowers (depreciates) the value
of its currency. A cheaper (undervalued) currency renders the nations goods (exports) more aordable in the
global market while making imports more expensive. After an intermediate period, imports will be forced down
and exports to rise, thus stabilizing the trade balance and
bring the currency towards equilibrium.

Like purchasing power parity, the balance of payments

model focuses largely on trade-able goods and services,
ignoring the increasing role of global capital ows. In
Example of GNP-weighted nominal exchange rate history of a
basket of 6 important currencies (US Dollar, Euro, Japanese Yen, other words, money is not only chasing goods and services, but to a larger extent, nancial assets such as stocks
Chinese Renminbi, Swiss Franks, Pound Sterling
and bonds. Their ows go into the capital account item of
the balance of payments, thus balancing the decit in the
Bilateral exchange rate involves a currency pair, while an current account. The increase in capital ows has given
eective exchange rate is a weighted average of a basket rise to the asset market model eectively.
of foreign currencies, and it can be viewed as an overall measure of the countrys external competitiveness. A
nominal eective exchange rate (NEER) is weighted with 11.2.9 Asset market model
the inverse of the asymptotic trade weights. A real eective exchange rate (REER) adjusts NEER by appropriate See also: Capital asset pricing model and Net Capital
foreign price level and deates by the home country price Outow
level.[10] Compared to NEER, a GDP weighted eective The increasing volume of trading of nancial assets
exchange rate might be more appropriate considering the (stocks and bonds) has required a rethink of its impact
global investment phenomenon.
on exchange rates. Economic variables such as economic

266

CHAPTER 11. CURRENCY DERIVATIVES

11.2.11 See also

Bureau de change
Current account
Currency strength
Dynamic currency conversion
Eective exchange rate
Euro calculator
Foreign exchange market
World banknotes

Foreign exchange fraud

Functional currency

growth, ination and productivity are no longer the only

drivers of currency movements. The proportion of foreign exchange transactions stemming from cross bordertrading of nancial assets has dwarfed the extent of currency transactions generated from trading in goods and
services.[11]

Tables of historical exchange rates to the USD

Telegraphic transfer
USD Index
Black Wednesday

The asset market approach views currencies as asset

11.2.12 References
prices traded in an ecient nancial market. Consequently, currencies are increasingly demonstrating [1] O'Sullivan, Arthur; Steven M. Sherin (2003).
a strong correlation with other markets, particularly
Economics: Principles in action. Upper Saddle River,
equities.
New Jersey 07458: Pearson Prentice Hall. p. 458. ISBN
0-13-063085-3.
Like the stock exchange, money can be made (or lost)
on trading by investors and speculators in the foreign ex- [2] The Economist Guide to the Financial Markets (pdf)
change market. Currencies can be traded at spot and
foreign exchange options markets. The spot market [3] Peters, Will. Find the Best British Pound to Euro Exchange Rate. Pound Sterling Live. Retrieved 21 March
represents current exchange rates, whereas options are
2015.
derivatives of exchange rates.
[4] Understanding foreign exchange: exchange rates
[5] Mouhamed Abdulla, Ph.D. Understanding Pip Movement in FOREX Trading (PDF). Report, Mar. 2014.

11.2.10

Manipulation of exchange rates

A country may gain an advantage in international trade if

it controls the market for its currency to keep its value low,
typically by the national central bank engaging in open
market operations. The Peoples Republic of China has
been acting this way over a long period of time.[12]

[6] http://www.finextra.com/fullstory.asp?id=13480
[7] Exchange Rate uctuation
[8] Currency Adjustment Factor - CAF. Academic Dictionaries and Encyclopedias.
[9] Currency Adjustment Factor. Global Forwarding.
[10] Erlat, Guzin and Arslaner, Ferhat. Measuring Annual

Other nations, including Iceland, Japan, Brazil, and so on

Real Exchange Rate Series for Turkey. Yapi Kredi Ecoalso devalue their currencies in the hopes of reducing the
nomic Review, Volume 2, Issue 8, December 1997, pp. 35cost of exports and thus bolstering their economies. A
61.
lower exchange rate lowers the price of a countrys goods
for consumers in other countries, but raises the price of [11] The Microstructure Approach to Exchange Rates,
Richard Lyons, MIT Press (pdf chapter 1)
imported goods and services, for consumers in the low
value currency country.[13]
[12] China denies currency undervalued article on BBC

News on Sunday, 14 March 2010

In general, a country that exports goods and services will
prefer a lower value on their currencies, while a country [13] More Countries Adopt Chinas Tactics on Currency arthat imports goods and services will prefer a higher value
ticle by David E. Sanger and Michael Wines in The New
York Times October 3, 2010, accessed October 4, 2010
on their currencies.

11.3. CURRENCY RISK

11.3 Currency risk

267
future cash ows, and ultimately the rms value. Economic exposure can aect the present value of future cash
ows. Any transaction that exposes the rm to foreign exchange risk also exposes the rm economically, but economic exposure can be caused by other business activities and investments which may not be mere international
transactions, such as future cash ows from xed assets.
A shift in exchange rates that inuences the demand for
a good in some country would also be an economic exposure for a rm that sells that good. Economic Exposures cannot be hedged as well due to limited data, and it
is costly and time consuming. Economic Exposures can
be managed by, product dierention, pricing, branding,
outsourcing, etc.

Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a nancial risk that
exists when a nancial transaction is denominated in a
currency other than that of the base currency of the company. Foreign exchange risk also exists when the foreign
subsidiary of a rm maintains nancial statements in a
currency other than the reporting currency of the consolidated entity. The risk is that there may be an adverse movement in the exchange rate of the denomination currency in relation to the base currency before the
date when the transaction is completed.[1][2] Investors and
businesses exporting or importing goods and services or
making foreign investments have an exchange rate risk
which can have severe nancial consequences; but steps
Translation exposure
can be taken to manage (i.e., reduce) the risk.[3][4]

11.3.1

Types of exposure

Transaction exposure
A rm has transaction exposure whenever it has contractual cash ows (receivables and payables) whose values are subject to unanticipated changes in exchange
rates due to a contract being denominated in a foreign
currency. To realize the domestic value of its foreigndenominated cash ows, the rm must exchange foreign
currency for domestic currency. As rms negotiate contracts with set prices and delivery dates in the face of
a volatile foreign exchange market with exchange rates
constantly uctuating, the rms face a risk of changes in
the exchange rate between the foreign and domestic currency. It refers to the risk associated with the change in
the exchange rate between the time an enterprise initiates
a transaction and settles it.
Applying public accounting rules causes rms with transactional exposures to be impacted by a process known as
remeasurement. The current value of contractual cash
ows are remeasured at each balance sheet date. If the
value of the currency of payment or receivable changes
in relation to the rms base or reporting currency from
one balance sheet date to the next, the expected value of
these cash ows will change. U.S. accounting rules[5] for
this process are specied in ASC 830, originally known
as FAS 52. Under ASC 830, changes in the value of these
contractual cash ows due to currency valuation changes
will impact current income.

A rms translation exposure is the extent to which its

nancial reporting is aected by exchange rate movements. As all rms generally must prepare consolidated
nancial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities or the nancial statements of
foreign subsidiary|subsidiaries from foreign to domestic currency. While translation exposure may not affect a rms cash ows, it could have a signicant impact on a rms reported earnings and therefore its stock
price.Translation exposure is distinguished from transaction risk as a result of income and losses from various
types of risk having dierent accounting treatments.
Contingent exposure
A rm has contingent exposure when bidding for foreign
projects or negotiating other contracts or foreign direct investments. Such an exposure arises from the potential for
a rm to suddenly face a transactional or economic foreign exchange risk, contingent on the outcome of some
contract or negotiation. For example, a rm could be
waiting for a project bid to be accepted by a foreign business or government that if accepted would result in an
immediate receivable. While waiting, the rm faces a
contingent exposure from the uncertainty as to whether
or not that receivable will happen. If the bid is accepted
and a receivable is paid the rm then faces a transaction
exposure, so a rm may prefer to manage contingent exposures.

11.3.2 Measurement
Economic exposure
A rm has economic exposure (also known as forecast
risk) to the degree that its market value is inuenced by
unexpected exchange rate uctuations. Such exchange
rate adjustments can severely aect the rms market
share position with regards to its competitors, the rms

If foreign exchange markets are ecient such that

purchasing power parity, interest rate parity, and the
international Fisher eect hold true, a rm or investor
needn't protect against foreign exchange risk due to an indierence toward international investment decisions. A
deviation from one or more of the three international par-

268

CHAPTER 11. CURRENCY DERIVATIVES

ity conditions generally needs to occur for an exposure to Translation exposure is largely dependent on the accountforeign exchange risk.[6]
ing standards of the home country and the translation
Financial risk is most commonly measured in terms of methods required by those standards. For example, the
the variance or standard deviation of a variable such as United States Federal Accounting Standards Board specpercentage returns or rates of change. In foreign ex- ies when and where to use certain methods such as
change, a relevant factor would be the rate of change of the temporal method and current rate method. Firms
the spot exchange rate between currencies. Variance rep- can manage translation exposure by performing a balance
resents exchange rate risk by the spread of exchange rates, sheet hedge. Since translation exposure arises from discrepancies between net assets and net liabilities on a balwhereas standard deviation represents exchange rate risk
by the amount exchange rates deviate, on average, from ance sheet solely from exchange rate dierences. Following this logic, a rm could acquire an appropriate amount
the mean exchange rate in a probability distribution. A
higher standard deviation would signal a greater currency of exposed assets or liabilities to balance any outstanding
discrepancy. Foreign exchange derivatives may also be
risk. Economists have criticized the accuracy of stan[7]
dard deviation as a risk indicator for its uniform treatment used to hedge against translation exposure.
of deviations, be they positive or negative, and for automatically squaring deviation values. Alternatives such as
11.3.4 History
average absolute deviation and semivariance have been
[4]
advanced for measuring nancial risk.
Many businesses were unconcerned with and did not
manage foreign exchange risk under the Bretton Woods
system of international monetary order. It wasn't until
Value at Risk
the switch to oating exchange rates following the collapse of the Bretton Woods system that rms became exPractitioners have advanced and regulators have accepted
posed to an increasing risk from exchange rate uctuaa nancial risk management technique called value at
tions and began trading an increasing volume of nancial
risk (VaR), which examines the tail end of a distribuderivatives in an eort to hedge their exposure.[8][9] The
tion of returns for changes in exchange rates to highlight
currency crises of the 1990s and early 2000s, such as the
the outcomes with the worst returns. Banks in Europe
Mexican peso crisis, Asian currency crisis, 1998 Russian
have been authorized by the Bank for International Setnancial crisis, and the Argentine peso crisis, led to subtlements to employ VaR models of their own design in esstantial losses from foreign exchange and led rms to pay
tablishing capital requirements for given levels of market
closer attention to their foreign exchange risk.[10]
risk. Using the VaR model helps risk managers determine
the amount that could be lost on an investment portfolio
over a certain period of time with a given probability of 11.3.5 References
changes in exchange rates.[4]

11.3.3

Management

See also: Foreign exchange hedge

Firms with exposure to foreign exchange risk may use a
number of foreign exchange hedging strategies to reduce
the exchange rate risk. Transaction exposure can be reduced either with the use of the money markets, foreign
exchange derivatives such as forward contracts, futures
contracts, options, and swaps, or with operational techniques such as currency invoicing, leading and lagging of
receipts and payments, and exposure netting.[7]
Firms may adopt alternative strategies to nancial hedging for managing their economic or operating exposure,
by carefully selecting production sites with a mind for
lowering costs, using a policy of exible sourcing in its
supply chain management, diversifying its export market
across a greater number of countries, or by implementing
strong research and development activities and dierentiating its products in pursuit of greater inelasticity and
less foreign exchange risk exposure.[7]

[1] Levi, Maurice D. (2005). International Finance, 4th

Edition. New York, NY: Routledge. ISBN 978-0-41530900-4.
[2] Moett, Michael H.; Stonehill, Arthur I.; Eiteman, David
K. (2009). Fundamentals of Multinational Finance, 3rd
Edition. Boston, MA: Addison-Wesley. ISBN 978-0-32154164-2.
[3] Homaifar, Ghassem A. (2004). Managing Global Financial and Foreign Exchange Risk. Hoboken, NJ: John Wiley
& Sons. ISBN 978-0-47-128115-3.
[4] Moosa, Imad A. (2003). International Financial Operations: Arbitrage, Hedging, Speculation, Financing and Investment. New York, NY: Palgrave Macmillan. ISBN 0333-99859-6.
[5] FASB.
[6] Wang, Peijie (2005). The Economics of Foreign Exchange
and Global Finance. Berlin, Germany: Springer. ISBN
978-3-54-021237-9.
[7] Eun, Cheol S.; Resnick, Bruce G. (2011). International
Financial Management, 6th Edition. New York, NY:
McGraw-Hill/Irwin. ISBN 978-0-07-803465-7.

11.4. REAL EXCHANGE RATE PUZZLES

[8] Dunn, Robert M., Jr.; Mutti, John H. (2004). International Economics, 6th Edition. New York, NY: Routledge.
ISBN 978-0-41-531154-0.
[9] Pilbeam, Keith (2006). International Finance, 3rd Edition. New York, NY: Palgrave Macmillan. ISBN 978-140-394837-3.
[10] Reszat, Beate (2003). The Japanese Foreign Exchange
Market. New Fetter Lane, London: Routledge. ISBN 0203-22254-7.

11.3.6

Further reading

269
9. Bartram, Shnke M. (2002). The Interest Rate Exposure of Nonnancial Corporations. European Finance Review (now Review of Finance) 6 (1): 101
125. doi:10.1023/a:1015024825914.

11.4 Real exchange rate puzzles

The real exchange-rate puzzles is a common term for
two much-discussed anomalies of real exchange rates:
that real exchange rates are more volatile and show more
persistence than what most models can account for. These
two anomalies are sometimes referred to as the purchasing power parity puzzles.

1. Bartram, Shnke M.; Burns, Natasha; Helwege,

Jean (September 2013). Foreign Currency Expo- Dornbusch's (1976)[1] exchange rate overshooting hysure and Hedging: Evidence from Foreign Acquisi- pothesis argued that exchange rate volatility is essentially
tions. Quarterly Journal of Finance. forthcoming. driven by monetary shocks interacting with sticky prices.
This model can account for real exchange rate volatility,
2. Bartram, Shnke M.; Bodnar, Gordon M. (June but does not say anything about the volatility of relative to
2012). Crossing the Lines: The Relation be- output or the persistence of the real exchange rate movetween Exchange Rate Exposure and Stock Returns ments.
in Emerging and Developed Markets. Journal of
[2]
International Money and Finance 31 (4): 766792. Chari, Kehoe and McGrattan (2002) showed how a
model with two countries and where prices were only aldoi:10.1016/j.jimonn.2012.01.011.
lowed to change once-a-year had the potential to simulta3. Bartram, Shnke M.; Brown, Gregory W.; Minton, neously account for the volatility of U.S. output and real
Bernadette (February 2010). Resolving the Expo- exchange rates.
sure Puzzle: The Many Facets of Exchange Rate These two anomalies are related to, but should not be
Exposure. Journal of Financial Economics 95 (2): confused with, the Backus-Smith consumption-real ex148173. doi:10.1016/j.jneco.2009.09.002.
change rate anomaly, which is the observation that in
most economic models the correlation between the real
4. Bartram, Shnke M. (August 2008).
What exchange rate and relative consumption is high and posiLies Beneath:
Foreign Exchange Rate Ex- tive, whereas in the data it ranges from small and positive
posure, Hedging and Cash Flows.
Journal to negative.
of Banking and Finance 32 (8): 15081521.
Another real-exchange-rate anomaly was documented by
doi:10.1016/j.jbankn.2007.07.013.
Mussa (1986).[3] In this paper Mussa documented that
5. Bartram,
Shnke M. (December 2007). industrial countries which moved from xed to oating
Corporate Cash Flow and Stock Price Expo- exchange rate regimes experienced dramatic rises in
sures to Foreign Exchange Rate Risk. Jour- nominal-exchange-rate volatility. Since the volatility innal of Corporate Finance 13 (5): 981994. creases much more than what can be accounted for by
doi:10.1016/j.jcorpn.2007.05.002.
changes in the domestic price levels, it means that the
real-exchange-rate volatility increases. This is sometimes
6. Bartram, Shnke M.; Bodnar, Gordon M. (Septem- referred to as the Mussa puzzle.
ber 2007). The Foreign Exchange Exposure
Puzzle. Managerial Finance, 33 (9): 642666. Obstfeld and Rogo (2000) identied the purchasing
power and exchange rate disconnect puzzle as one of the
doi:10.1108/03074350710776226.
six major puzzles in international economics.[4] These
7. Bartram, Shnke M.; Karolyi, G. Andrew (Octo- were the consumption correlation puzzle, home bias in
ber 2006). The Impact of the Introduction of the trade puzzle, the equity home bias puzzle, the FeldsteinEuro on Foreign Exchange Rate Risk Exposures. Horioka savings-investment correlations puzzle, and the
Journal of Empirical Finance 13 (4-5): 519549. exchange rate regime puzzle. The sixth puzzle is described as why exchange rates are so volatile and apdoi:10.1016/j.jempn.2006.01.002.
parently disconnected from fundamentals. Here Obst8. Bartram, Shnke M. (June 2004). Linear and Non- feld and Rogo (2000) quotes the Meese and Rogo
linear Foreign Exchange Rate Exposures of Ger- (1983) exchange rate forecasting puzzle and the Baxter
man Nonnancial Corporations. Journal of In- and Stockman (1989) neutrality of exchange rate regime
ternational Money and Finance 23 (4): 673699. puzzle. These two puzzles are closely to the Mussa puzzle
doi:10.1016/s0261-5606(04)00018-x.
as well as the other real exchange rate puzzles.

270

11.4.1

CHAPTER 11. CURRENCY DERIVATIVES

See also

Economic puzzle
Forward premium anomaly
Equity premium puzzle

11.4.2

References

[1] Rudiger Dornbusch (1976), Expectations and Exchange

Rate Dynamics, Journal of Political Economy 84 (6):
11611176, doi:10.1086/260506.
[2] Chari, V.V.; Kehoe, Patrick J.; McGrattan, Ellen (2002),
Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?", Review of Economic Studies
69 (3): 533563, doi:10.1111/1467-937X.00216
[3] Mussa, Michael (1986), Nominal Exchange Rate
Regimes and the Behavior of Real Exchange Rates:
Evidence and Implications, Carnegie-Rochester Conference Series on Public Policy 25 (1): 117214,
doi:10.1016/0167-2231(86)90039-4
[4] Obstfeld, Maurice; Rogo, Kenneth (2000), The Six
Major Puzzles in International Macroeconomics: Is There
a Common Cause?", in Bernanke, Ben; Rogo, Kenneth,
NBER Macroeconomics Annual 2000 15, The MIT Press,
pp. 339390, ISBN 0-262-02503-5

Coudert, Virginie and Valrie Mignon. The Forward Premium Puzzle and the Sovereign Default
Risk, Journal of International Money and Finance,
2012. http://www.cepii.fr/anglaisgraph/workpap/pdf/
2011/wp2011-17.pdf

11.5 Interest rate parity

Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will
be indierent to interest rates available on bank deposits
in two countries.[1] The fact that this condition does not
always hold allows for potential opportunities to earn riskless prots from covered interest arbitrage. Two assumptions central to interest rate parity are capital mobility
and perfect substitutability of domestic and foreign assets.
Given foreign exchange market equilibrium, the interest
rate parity condition implies that the expected return on
domestic assets will equal the exchange rate-adjusted expected return on foreign currency assets. Investors then
cannot earn arbitrage prots by borrowing in a country
with a lower interest rate, exchanging for foreign currency, and investing in a foreign country with a higher
interest rate, due to gains or losses from exchanging back
to their domestic currency at maturity.[2] Interest rate parity takes on two distinctive forms: uncovered interest rate
parity refers to the parity condition in which exposure to
foreign exchange risk (unanticipated changes in exchange

rates) is uninhibited, whereas covered interest rate parity

refers to the condition in which a forward contract has
been used to cover (eliminate exposure to) exchange rate
risk. Each form of the parity condition demonstrates a
unique relationship with implications for the forecasting
of future exchange rates: the forward exchange rate and
the future spot exchange rate.[1]
Economists have found empirical evidence that covered
interest rate parity generally holds, though not with precision due to the eects of various risks, costs, taxation,
and ultimate dierences in liquidity. When both covered and uncovered interest rate parity hold, they expose
a relationship suggesting that the forward rate is an unbiased predictor of the future spot rate. This relationship
can be employed to test whether uncovered interest rate
parity holds, for which economists have found mixed results. When uncovered interest rate parity and purchasing
power parity hold together, they illuminate a relationship
named real interest rate parity, which suggests that expected real interest rates represent expected adjustments
in the real exchange rate. This relationship generally
holds strongly over longer terms and among emerging
market countries.

11.5.1 Assumptions
Interest rate parity rests on certain assumptions, the rst
being that capital is mobile - investors can readily exchange domestic assets for foreign assets. The second
assumption is that assets have perfect substitutability, following from their similarities in riskiness and liquidity.
Given capital mobility and perfect substitutability, investors would be expected to hold those assets oering
greater returns, be they domestic or foreign assets. However, both domestic and foreign assets are held by investors. Therefore, it must be true that no dierence can
exist between the returns on domestic assets and the returns on foreign assets.[2] That is not to say that domestic investors and foreign investors will earn equivalent returns, but that a single investor on any given side would
expect to earn equivalent returns from either investment
decision.[3]

11.5.2 Uncovered interest rate parity

When the no-arbitrage condition is satised without the
use of a forward contract to hedge against exposure to
exchange rate risk, interest rate parity is said to be uncovered. Risk-neutral investors will be indierent among the
available interest rates in two countries because the exchange rate between those countries is expected to adjust
such that the dollar return on dollar deposits is equal to
the dollar return on euro deposits, thereby eliminating the
potential for uncovered interest arbitrage prots. Uncovered interest rate parity helps explain the determination
of the spot exchange rate. The following equation repre-

11.5. INTEREST RATE PARITY

271

i$ = ic +

Et (St+k )
St

where

Et (St+k )
A visual representation of uncovered interest rate parity holding
in the foreign exchange market, such that the returns from investing domestically are equal to the returns from investing abroad.

sents uncovered interest rate parity.[1]

(1 + i$ ) =

Et (St+k )
(1 + ic )
St

Et (St+k )/St
A more universal way of stating the approximation is the
home interest rate equals the foreign interest rate plus the
expected rate of depreciation of the home currency.[1]

11.5.3 Covered interest rate parity

where
Et (St+k ) is the expected future spot exchange
rate at time t + k
k is the number of periods into the future from
time t
St is the current spot exchange rate at time t
i$ is the interest rate in one country (for example, the United States)
ic is the interest rate in another country or currency area (for example, the Eurozone)
The dollar return on dollar deposits, 1+i$ , is shown to be
equal to the dollar return on euro deposits, Et (SStt+k ) (1 +
ic ) .
Approximation
Uncovered interest rate parity asserts that an investor with
dollar deposits will earn the interest rate available on dollar deposits, while an investor holding euro deposits will
earn the interest rate available in the eurozone, but also a
potential gain or loss on euros depending on the rate of
appreciation or depreciation of the euro against the dollar. Economists have extrapolated a useful approximation
of uncovered interest rate parity that follows intuitively
from these assumptions. If uncovered interest rate parity
holds, such that an investor is indierent between dollar
versus euro deposits, then any excess return on euro deposits must be oset by some expected loss from depreciation of the euro against the dollar. Conversely, some
shortfall in return on euro deposits must be oset by some
expected gain from appreciation of the euro against the
dollar. The following equation represents the uncovered
interest rate parity approximation.[1]

A visual representation of covered interest rate parity holding in

the foreign exchange market, such that the returns from investing
domestically are equal to the returns from investing abroad.

When the no-arbitrage condition is satised with the use

of a forward contract to hedge against exposure to exchange rate risk, interest rate parity is said to be covered.
Investors will still be indierent among the available interest rates in two countries because the forward exchange
rate sustains equilibrium such that the dollar return on
dollar deposits is equal to the dollar return on foreign deposit, thereby eliminating the potential for covered interest arbitrage prots. Furthermore, covered interest rate
parity helps explain the determination of the forward exchange rate. The following equation represents covered
interest rate parity.[1][4]

(1 + i$ ) =

Ft
(1 + ic )
St

where
Ft is the forward exchange rate at time t
The dollar return on dollar deposits, 1 + i$ , is shown to
be equal to the dollar return on euro deposits, FStt (1 + ic )
.

272

CHAPTER 11. CURRENCY DERIVATIVES

11.5.4

Empirical evidence

Covered interest rate parity (CIRP) is found to hold when

there is open capital mobility and limited capital controls, and this nding is conrmed for all currencies freely
traded in the present-day. One such example is when
the United Kingdom and Germany abolished capital controls between 1979 and 1981. Maurice Obstfeld and Alan
Taylor calculated hypothetical prots as implied by the
expression of a potential inequality in the CIRP equation (meaning a dierence in returns on domestic versus foreign assets) during the 1960s and 1970s, which
would have constituted arbitrage opportunities if not for
the prevalence of capital controls. However, given nancial liberalization and resulting capital mobility, arbitrage temporarily became possible until equilibrium was
restored. Since the abolition of capital controls in the
United Kingdom and Germany, potential arbitrage profits have been near zero. Factoring in transaction costs
arising from fees and other regulations, arbitrage opportunities are eeting or nonexistent when such costs exceed deviations from parity.[1][5] While CIRP generally
holds, it does not hold with precision due to the presence of transaction costs, political risks, tax implications
for interest earnings versus gains from foreign exchange,
and dierences in the liquidity of domestic versus foreign
assets.[5][6][7] Researchers found evidence that signicant
deviations from CIRP during the onset of the global nancial crisis in 2007 and 2008 were driven by concerns
over risk posed by counter parties to banks and nancial
institutions in Europe and the US in the foreign exchange
swap market. The European Central Bank's eorts to
provide US dollar liquidity in the foreign exchange swap
market, along with similar eorts by the Federal Reserve,
had a moderating impact on CIRP deviations between the
dollar and the euro. Such a scenario was found to be reminiscent of deviations from CIRP during the 1990s driven
by struggling Japanese banks which looked toward foreign exchange swap markets to try and acquire dollars to
bolster their creditworthiness.[8]

Ft = Et (St+k )
This equation represents the unbiasedness hypothesis,
which states that the forward exchange rate is an unbiased
predictor of the future spot exchange rate.[9][10] Given
strong evidence that CIRP holds, the forward rate unbiasedness hypothesis can serve as a test to determine
whether UIRP holds (in order for the forward rate and
spot rate to be equal, both CIRP and UIRP conditions
must hold). Evidence for the validity and accuracy of
the unbiasedness hypothesis, particularly evidence for
cointegration between the forward rate and future spot
rate, is mixed as researchers have published numerous papers demonstrating both empirical support and empirical
failure of the hypothesis.[9]

UIRP is found to have some empirical support in tests

for correlation between expected rates of currency depreciation and the forward premium or discount.[1] Evidence suggests that whether UIRP holds depends on the
currency examined, and deviations from UIRP have been
found to be less substantial when examining longer time
horizons.[11] Some studies of monetary policy have offered explanations for why UIRP fails empirically. Researchers demonstrated that if a central bank manages
interest rate spreads in strong response to the previous
periods spreads, that interest rate spreads had negative
coecients in regression tests of UIRP. Another study
which set up a model wherein the central banks monetary policy responds to exogenous shocks, that the central
banks smoothing of interest rates can explain empirical
failures of UIRP.[12] A study of central bank interventions on the US dollar and Deutsche mark found only limited evidence of any substantial eect on deviations from
UIRP.[13] UIRP has been found to hold over very small
spans of time (covering only a number of hours) with a
high frequency of bilateral exchange rate data.[14] Tests
of UIRP for economies experiencing institutional regime
changes, using monthly exchange rate data for the US
dollar versus the Deutsche mark and the Spanish peseta
When both covered and uncovered interest rate parity versus the British pound, have found some evidence that
(UIRP) hold, such a condition sheds light on a notewor- UIRP held when US and German regime changes were
thy relationship between the forward and expected future volatile, and held between Spain and the United Kingspot exchange rates, as demonstrated below.
dom particularly after Spain joined the European Union
in 1986 and began liberalizing capital mobility.[15]
U IRP : (1 + i$ ) =

Et (St+k )
(1 + ic )
St

Ft
(1 + ic )
St
Dividing the equation for UIRP by the equation for CIRP
yields the following equation:
CIRP : (1 + i$ ) =

1=

Et (St+k )
Ft

which can be rewritten as:

11.5.5 Real interest rate parity

When both UIRP (particularly in its approximation form)
and purchasing power parity (PPP) hold, the two parity conditions together reveal a relationship among expected real interest rates, wherein changes in expected
real interest rates reect expected changes in the real exchange rate. This condition is known as real interest rate
parity (RIRP) and is related to the international Fisher
eect.[16][17][18][19][20] The following equations demonstrate how to derive the RIRP equation.

11.5. INTEREST RATE PARITY

U IRP : Et (St+k ) = Et (St+k ) St = i$ ic

P P P : Et (St+k ) = Et (p$ t+k ) Et (pc t+k )
where

p
If the above conditions hold, then they can be combined
and rearranged as the following:

RIRP : i$ Et (p$ t+k ) = ic Et (pc t+k )

273

[5] Levi, Maurice D. (2005). International Finance, 4th Edition. New York, NY: Routledge. ISBN 978-0-41530900-4.
[6] Dunn, Robert M., Jr.; Mutti, John H. (2004). International Economics, 6th Edition. New York, NY: Routledge.
ISBN 978-0-415-31154-0.
[7] Frenkel, Jacob A.; Levich, Richard M. (1981). Covered
interest arbitrage in the 1970s. Economics Letters
8 (3). doi:10.1016/0165-1765(81)90077-X. Retrieved
2011-07-15.
[8] Baba, Naohiko; Packer, Frank (2009). Interpreting
deviations from covered interest parity during
Jourthe nancial market turmoil of 2007-08.
nal of Banking & Finance 33 (11): 19531962.
doi:10.1016/j.jbankn.2009.05.007. Retrieved 201107-21.

RIRP rests on several assumptions, including ecient

markets, no country risk premia, and zero change in the [9] Delcoure, Natalya; Barkoulas, John; Baum, Christopher
F.; Chakraborty, Atreya (2003). The Forward Rate
expected real exchange rate. The parity condition sugUnbiasedness Hypothesis Reexamined: Evidence from
gests that real interest rates will equalize between couna New Test. Global Finance Journal 14 (1): 8393.
tries and that capital mobility will result in capital ows
doi:10.1016/S1044-0283(03)00006-1. Retrieved 2011that eliminate opportunities for arbitrage. There exists
06-21.
strong evidence that RIRP holds tightly among emerging
markets in Asia and also Japan. The half-life period of [10] Ho, Tsung-Wu (2003). A re-examination of the unbiasedness forward rate hypothesis using dynamic SUR
deviations from RIRP have been examined by researchers
model. The Quarterly Review of Economics and Finance
and found to be roughly six or seven months, but between
43 (3): 542559. doi:10.1016/S1062-9769(02)00171-0.
two and three months for certain countries. Such variaRetrieved 2011-06-23.
tion in the half-lives of deviations may be reective of
dierences in the degree of nancial integration among [11] Bekaert, Geert; Wei, Min; Xing, Yuhang (2007).
Uncovered interest rate parity and the term structure.
the country groups analyzed.[21] RIRP does not hold over
Journal of International Money and Finance 26 (6):
short time horizons, but empirical evidence has demon10381069. doi:10.1016/j.jimonn.2007.05.004. Restrated that it generally holds well across long time horitrieved 2011-07-21.
[22]
zons of ve to ten years.

11.5.6

See also

Carry trade
Covered interest arbitrage
Foreign exchange derivative
Uncovered interest arbitrage

11.5.7

References

[1] Feenstra, Robert C.; Taylor, Alan M. (2008). International Macroeconomics. New York, NY: Worth Publishers. ISBN 978-1-4292-0691-4.
[2] Mishkin, Frederic S. (2006). Economics of Money, Banking, and Financial Markets, 8th edition. Boston, MA:
Addison-Wesley. ISBN 978-0-321-28726-7.
[3] Madura, Je (2007). International Financial Management: Abridged 8th Edition. Mason, OH: Thomson SouthWestern. ISBN 0-324-36563-2.
[4] Waki, Natsuko (2007-02-21). No end in sight for yen
carry craze. Reuters. Retrieved 2012-07-09.

[12] Anker, Peter (1999). Uncovered interest parity, monetary policy and time-varying risk premia. Journal
of International Money and Finance 18 (6): 835851.
doi:10.1016/S0261-5606(99)00036-4. Retrieved 201107-21.
[13] Baillie, Richard T.; Osterberg, William P. (2000).
Deviations from daily uncovered interest rate parity and
the role of intervention. Journal of International Financial Markets, Institutions and Money 10 (4): 363379.
doi:10.1016/S1042-4431(00)00029-9. Retrieved 201107-21.
[14] Chaboud, Alain P.; Wright, Jonathan H. (2005).
Uncovered interest parity: it works, but not for long.
Journal of International Economics 66 (2): 349362.
doi:10.1016/j.jinteco.2004.07.004. Retrieved 2011-0721.
[15] Beyaert, Arielle; Garca-Solanes, Jos; Prez-Castejn,
Juan J. (2007). Uncovered interest parity with switching regimes. Economic Modelling 24 (2): 189202.
doi:10.1016/j.econmod.2006.06.010. Retrieved 201107-21.
[16] Cuthbertson, Keith; Nitzsche, Dirk (2005). Quantitative Financial Economics: Stocks, Bonds and Foreign Exchange, 2nd Edition. Chichester, UK: John Wiley & Sons.
ISBN 978-0-47-009171-5.

274

[17] Juselius, Katarina (2006). The Cointegrated VAR Model:

Methodology and Applications. Oxford, UK: Oxford University Press. ISBN 978-0-19-928566-2.

CHAPTER 11. CURRENCY DERIVATIVES

11.7.1 Structure

A foreign exchange swap has two legsa spot transaction and a forward transactionthat are executed simul[18] Eun, Cheol S.; Resnick, Bruce G. (2011). International
taneously for the same quantity, and therefore oset each
Financial Management, 6th Edition. New York, NY:
other. Forward foreign exchange transactions occur if
McGraw-Hill/Irwin. ISBN 978-0-07-803465-7.
both companies have a currency the other needs. It pre[3]
[19] Moosa, Imad A. (2003). International Financial Opera- vents negative foreign exchange risk for either party.
tions: Arbitrage, Hedging, Speculation, Financing and In- Foreign exchange spot transactions are similar to forward
vestment. New York, NY: Palgrave Macmillan. ISBN 0- foreign exchange transactions in terms of how they are
agreed upon; however, they are planned for a specic date
333-99859-6.
in the very near future, usually within the same week.
[20] Bordo, Michael D.; National Bureau of Economic Research (2000-03-31). The Globalization of International
Financial Markets: What Can History Teach Us? (PDF).
International Financial Markets: The Challenge of Globalization. College Station, TX: Texas A&M University.

It is also common to trade forward-forward, where both

transactions are for (dierent) forward dates.

11.7.2 Uses
[21] Baharumshah, Ahmad Zubaidi; Haw, Chan Tze; Fountas, Stilianos (2005). A panel study on real interest rate parity in East Asian countries: Pre- and postliberalization era. Global Finance Journal 16 (1): 6985.
doi:10.1016/j.gfj.2005.05.005. Retrieved 2011-07-21.
[22] Chinn, Menzie D. (2007). Interest Parity Conditions.
In Reinert, Kenneth A.; Rajan, Ramkishen S.; Glass, Amy
Jocelyn et al. Princeton Encyclopedia of the World Economy. Princeton, NJ: Princeton University Press. ISBN
978-0-69-112812-2.

11.6 Foreign exchange derivative

A foreign exchange derivative is a nancial derivative
whose payo depends on the foreign exchange rate(s) of
two (or more) currencies. These instruments are commonly used for currency speculation and arbitrage or for
hedging foreign exchange risk. Specic foreign exchange
derivatives, and related concepts include:

The most common use of foreign exchange swaps is for

institutions to fund their foreign exchange balances.
Once a foreign exchange transaction settles, the holder is
left with a positive (or long) position in one currency,
and a negative (or short) position in another. In order to
collect or pay any overnight interest due on these foreign
balances, at the end of every day institutions will close out
any foreign balances and re-institute them for the following day. To do this they typically use tom-next swaps,
buying (or selling) a foreign amount settling tomorrow,
and then doing the opposite, selling (or buying) it back
settling the day after.
The interest collected or paid every night is referred to as
the cost of carry. As currency traders know roughly how
much holding a currency position will make or cost on a
daily basis, specic trades are put on based on this; these
are referred to as carry trades.
Companies may also use them to avoid foreign exchange
risk.
Example:

11.7 Forex swap

Not to be confused with Currency swap.
In nance, a foreign exchange swap, forex swap, or
FX swap is a simultaneous purchase and sale of identical
amounts of one currency for another with two dierent
value dates (normally spot to forward).[1] see Foreign exchange derivative. Foreign Exchange Swap allows sums
of a certain currency to be used to fund charges designated in another currency without acquiring foreign exchange risk. It permits companies that have funds in different currencies to manage them eciently.[2] swap contract: swap contract is an agreement between two parties to exchange a cash ow in one currency against a
cash ow in another currency according to predetermined
terms and conditions.

A British Company may be long EUR from

sales in Europe but operate primarily in Britain
using GBP. However, they know that they
need to pay their manufacturers in Europe in
1 months time.
They could of course SPOT Sell their EUR and
buy GBP to cover their expenses in Britain, and
then in one month SPOT Buy EUR and sell
GBP to pay their business partners in Europe.
However, this exposes them to FX risk. If
Britain has nancial trouble and the EURGBP
exchange rate goes against them, they may
have to spend a lot more GBP to get the same
amount of EUR.

11.8. EFFECTIVE EXCHANGE RATE

Therefore they create a 1M Swap, where they
Sell EUR and Buy GBP on SPOT and simultaneously Buy EUR and Sell GBP on a 1 Month
(1M) forward. This signicantly reduces their
risk as they know that they will be able to purchase EUR reliably, while still being able to use
the money for their domestic transactions in the
meantime.

11.7.3

275

11.7.6 References
[1] Reuters Glossary, FX Swap
[2] Foreign Exchange Swap Transaction
[3] Forward Currency Contract

11.8 Eective Exchange Rate

Pricing
120

Main article: Interest rate parity

110
100

The relationship between spot and forward is known as

the interest rate parity, which states that
(
F =S

1 + rd T
1 + rf T

90
80
70

where

60
50
40
1970

F = forward rate
S = spot rate

1980

1990

2000

2010

2020

The trade-weighted index for the Australian dollar, quarterly

since 1970.

r = simple interest rate of the term currency

The trade-weighted eective exchange rate index, a

common form of the eective exchange rate index, is
r = simple interest rate of the base currency
a multilateral exchange rate index. It is compiled as a
T = tenor (calculated according to the appropriate weighted average of exchange rates of home versus forday count convention)
eign currencies, with the weight for each foreign country
equal to its share in trade. Depending on the purpose
The forward points or swap points are quoted as the dif- for which it is used, it can be export-weighted, importference between forward and spot, F - S, and is expressed weighted, or total-external trade weighted.
as the following:
The trade-weighted eective exchange rate index is an
economic indicator for comparing the exchange rate of a
(
)
country against those of their major trading partners. By
1 + rd T
S(rd rf )T
F S = S
1 =
S (rd rdesign,
f ) T, movements in the currencies of those trading part1 + rf T
1 + rf T
ners with a greater share in an economys exports and imif rf T is small. Thus, the value of the swap points is ports will have a greater eect on the eective exchange
roughly proportional to the interest rate dierential.
rate. In a multilateral, highly globalized, world, the eective exchange rate index is much more useful than a bilateral exchange rate, such as that between the Australian
11.7.4 Related instruments
dollar and the United States dollar, for assessing changes
A foreign exchange swap should not be confused with a in the competitiveness due to exchange rate movements.
currency swap, which is a rarer long-term transaction gov- Generally, the weighting method is geometric weighting
erned by dierent rules.
rather than arithmetic weighting. Refer to weighted geometric mean.

11.7.5

See also

Cross currency swap

Foreign exchange market
Forward exchange rate
Interest rate parity
Overnight indexed swap

The use of trade weights in a globalized economy is potentially misleading, because the amount of value added
content in exports destined for a country may deviate signicantly from the gross value of exports shipped to that
country. See the entry under eective exchange rate index for an alternative approach to compiling an eective
exchange rate index.
The interpretation of the eective exchange rate is that if
the index rises, other things being equal, the purchasing

276

CHAPTER 11. CURRENCY DERIVATIVES

power of that currency also rises (the currency strengthened against those of the countrys or areas trading partners). This will reduce the cost of imports but will undermine the competitiveness of exports. Here other things
refer, in particular, to the relative ination rates of the
economy as compared to the ination rates of its trading
partners. To fully account for the eects of relative ination rates, the real eective exchange rate index is compiled as the product of the eective exchange rate index
and the relative price index between the home economy
and the trading partners.

11.8.1

External links

Data from Bank for International Settlements:

eective exchange rate indices
Monthly data from U.S. Federal Reserve: Monthly
Rates
Eective exchange rates of the euro from the
European Central Bank: data, methodology

Chapter 12

Option Strategies
12.1 Covered call

12.1.1 Examples
Trader A (A) has 500 shares of XYZ stock, valued at
$10,000. A sells (writes) 5 call option contracts, bought
by Investor B (B) (in the US, 1 option contract covers
100 shares) for $1500. This premium of $1500 covers
a certain amount of decrease in the price of XYZ stock
(i.e. only after the stock value has declined by more than
$1500 would the owner of the stock, A, lose money overall). Losses cannot be prevented, but merely reduced in a
covered call position. If the stock price drops, it will not
make sense for the option buyer (B) to exercise the option at the higher strike price since the stock can now be
purchased cheaper at the market price, and A, the seller
(writer), will keep the money paid on the premium of the
option. Thus, As loss is reduced from a maximum of
$10000 to [$10000 - (premium)], or $8500.

This protection has its potential disadvantage if the

price of the stock increases. If B exercises the option
to buy, and the stock price has increased such that As
shares of XYZ are now worth more than $10,000 in the
market, A (the option writer) will be forced to sell the
A covered call is a nancial market transaction in which stock below market price at expiration, or must buy back
the seller of call options owns the corresponding amount the calls at a price higher than A sold them for.
of the underlying instrument, such as shares of a stock
or other securities. If a trader buys the underlying instru- If, before expiration, the spot price does not reach the
ment at the same time the trader sells the call, the strategy strike price, the investor might repeat the same process
is often called a "buy-write" strategy. In equilibrium, the again if he believes that stock will either fall or be neutral.
strategy has the same payos as writing a put option.
A call option can be sold even if the option writer (A)
Payos and prots from buying stock and writing a call.

The long position in the underlying instrument is said to does not initially own the underlying stock, but is buying
provide the cover as the shares can be delivered to the the stock at the same time. This is called a buy write. If
XYZ trades at $33 and $35 calls are priced at $1, then A
buyer of the call if the buyer decides to exercise.
can purchase 100 shares of XYZ for $3300 and write/sell
Writing (i.e. selling) a call generates income in the form one (100-share) call option for $100, for a net cost of only
of the premium paid by the option buyer. And if the stock $3200. The $100 premium received for the call will cover
price remains stable or increases, then the writer will be a $1 decline in stock price. The break-even point of the
able to keep this income as a prot, even though the prot transaction is $32/share. Upside potential is limited to
may have been higher if no call were written. The risk $300, but this amounts to a return of almost 10%. (If the
of stock ownership is not eliminated. If the stock price stock price rises to $35 or more, the call option holder
declines, then the net position will likely lose money.[1]
will exercise the option and As prot will be $3532 =
Since in equilibrium the payos on the covered call po- $3) If the stock price at expiry is below $35 but above
sition is the same as a short put position, the price (or $32, the call option will be allowed to expire, but A (the
premium) should be the same as the premium of the short seller/writer) can still prot by selling the shares. Only if
put or naked put.
the price is below $32/share will A experience a loss.
277

278

CHAPTER 12. OPTION STRATEGIES

Payoff

Profit

Pr
o

Premium

fit

A call option can also be sold even if the option writer

(A) doesn't own the stock at all. This is called a naked
call. It is more dangerous, as the option writer can later
be forced to buy the stock at the then-current market
price, then sell it immediately to the option owner at the
low strike price (if the naked option is ever exercised).

Share Price at Maturity

Strike
Price

Short Put

Payos from a short put position, equivalent to that of a covered

call

to expiry, and 85-101 would be an 85 dollar strike price

with 101 days to expiry. [3]
Taking a look at one slice (left) of the above data, namely
what is the portfolio value if the stock price is $85 at expiry. This plot shows the Strike Price - Days to expiry vs
the portfolios value at expiry. It is worth taking a couple of minutes to digest what this plot is really presenting.
Stepping through the data, the bottom axis shows various
call options which an investor could write (AKA sell or
short). Each of the options indicates the number of days
to expiry. The plot does not show the portfolio value of
each of the options on the same day, instead the plot is
showing the portfolio value at expiry. However, for some
of the options expiry is 710 days away, and for other options expiry is only 10 days away. The implication of this
is that for some of the positions you will have to wait a
long time to realize the prot. Finally this chart makes
the other assumption that the stock price is $85 at expiry.
This is the case of being called for all the options. What
this boundary condition presents is the maximum prot
that this portfolio could have. [4]

To summarize:

12.1.2 Marketing
Concrete example

This strategy is sometimes marketed as being safe or

conservative and even hedging risk as it provides premium income, but its aws have been well known at least
since 1975 when Fischer Black published Fact and Fantasy in the Use of Options. According to Reilly and
Brown,:[5] to be protable, the covered call strategy requires that the investor guess correctly that share values
will remain in a reasonably narrow band around their
present levels.
Two recent developments may have increased interest in
covered call strategies: (1) in 2002 the Chicago Board
Options Exchange introduced a benchmark index for covered call strategies, the CBOE S&P 500 BuyWrite Index
(ticker BXM), and (2) in 2004 the Ibbotson Associates
consulting rm published a case study on buy-write strategies.[6]

3D plot of a portfolios value vs the option written, and the stocks

price at expiry. This picture is only an at expiry valuation, because options are always worth more than their expiry value, a
portfolios mark-to-market value would always be less for a covered position.
[2]

This type of option is best used when the investor would

like to generate income o a long position while the
market is moving sideways. It allows an investor/writer
to continue a buy-and-hold strategy to make money o
a stock which is currently inactive in gains. The investor/writer must correctly guess that the stock won't
make any gains within the time frame of the option; this
is best done by writing an out-of-the-money option. A
covered call doesn't have as much potential for reward as
other types of options, thus the risk is also low.

Presenting a concrete example of a buy-write expiry

payout, one will be able to see and understand what is
the expiry value of a portfolio as a function of the option they wrote, and the stock price at expiry. See the
3D mesh plot and discussion. The Figure on the right
shows a 3-Dimensional plot of expiry value versus stock
price for FCX on expiry Saturday versus the option pur- 12.1.3 See also
chased. Please take a few moments to study the chart
making careful note of the Y-axis which represents the
Married put
option purchased in the format of (Strike Price) - (Days
Option screener
to Expiry), e.g. 70-10 would be 70 dollars and 10 days

12.1. COVERED CALL

12.1.4

References

[1] Warner, Adam (2009). Chapter 12: Buy-Write--You

Bet. Options Volatility Trading: Strategies for Proting from Market Swings (1 edition ed.). Amazon.com:
McGraw-Hill. pp. 188, 177193. ISBN 978-0-07162965-2. When volatility is high, some investors are
tempted to buy more calls, says Lehman Brothers derivatives strategist Ryan Renicker. But volatility is also highest
when the market is pricing in its worst fears...overwriting
strategies that are dynamically rebalanced ahead of large
market rallies or downturns can naturally enhance the returns generated, say Renicker and Lehmans Devapriya
Mallick.
[2] Entering a Buy-Write Strategy
[3] QuantPrinciples Buy-Write Strategy
[4] Buy-Write Strategy boundary condition for the MAXIMUM payout
[5] Reilly and Brown. Investment Analysis and Portfolio
Management. South-Western College Pub. p. 995
[6] Buy Writing Makes Comeback as Way to Hedge Risk,
Pensions & Investments, (May 16, 2005)

12.1.5

External links

Chicago Board Options Exchange

Covered Call Worksheet.
Benchmark Indexes for Buy-write Strategies.

12.1.6

Bibliography

Brill, Maria. Options for Generating Income. Financial Advisor. (July 2006) pp. 8586.
Calio, Vince. Covered Calls Become Another Alpha Source. Pensions & Investments. (May 1,
2006).
Covered Call Strategy Could Have Helped, Study
Shows Pensions & Investments, Sept. 20, 2004, p.
38.
Crawford, Gregory. Buy Writing Makes Comeback as Way to Hedge Risk. Pensions & Investments. May 16, 2005.
Demby, Elayne Robertson. Maintaining Speed - In a Sideways or Falling Market, Writing Covered Call Options Is One Way To Give Your
Clients Some Traction. Bloomberg Wealth Manager, February 2005.
Feldman, Barry, and Dhruv Roy, Passive OptionsBased Investment Strategies: The Case of the
CBOE S&P 500 BuyWrite Index." The Journal of
Investing . (Summer 2005).

279
Frankel, Doris. Buy-writes Catch on in Sideways
U.S. Stock Market. Reuters. (Jun 17, 2005).
Fulton, Benjamin T., and Matthew T. Moran. BuyWrite Benchmark Indexes and the First OptionsBased ETFs Institutional InvestorA Guide to
ETFs and Indexing Innovations (Fall 2008), pp.
101110.
Szado, Edward, and Thomas Schneeweis.
QQ_Active_Collar_Paper_website_v3
Loosening Your Collar: Alternative Implementations of
QQQ Collars." CISDM, Isenberg School of Management, University of Massachusetts, Amherst.
(Original Version: August 2009. Current Update:
September 2009).
Kapadia, Nikunj, and Edward Szado. The Risk and
Return Characteristics of the Buy-Write Strategy on
the Russell 2000 Index." The Journal of Alternative
Investments. (Spring 2007). pp. 3956.
Renicker, Ryan, Devapriya Mallick. Enhanced
Call Overwriting." Lehman Brothers Equity Derivatives Strategy. (Nov 17, 2005).
Tan, Kopin. Better Covered Calls. Covered-Call
Writing Yields Higher Returns in Down Markets."
Barrons: The Striking Price. (Nov 28, 2005).
Tan, Kopin. More Bang, Less Buck. Selling Call
Options." Barrons, SmartMoney. (Dec. 2, 2005).
Piazza, Linda. Options 101: Fashion Revival" OptionInvestor.com, Option Investor, Inc. (Oct. 3,
2009).
Hill, Joanne, Venkatesh Balasubramanian, Krag
(Buzz) Gregory, and Ingrid Tierens. Finding Alpha via Covered Index Writing." Financial Analysts
Journal. (Sept.-Oct. 2006). pp. 29-46.
Lauricella, Tom. "'Buy Write' Funds May Well Be
The Right Strategy. Wall Street Journal. (Sep 8,
2008). pg. R1.
Moran, Matthew. Risk-adjusted Performance for
Derivatives-based Indexes - Tools to Help Stabilize
Returns. The Journal of Indexes. (Fourth Quarter,
2002) pp. 34 40.
Schneeweis, Thomas, and Richard Spurgin. The
Benets of Index Option-Based Strategies for Institutional Portfolios The Journal of Alternative Investments, Spring 2001, pp. 44 52.
Tan, Kopin. Covered Calls Grow in Popularity as
Stock Indexes Remain Sluggish. Wall Street Journal, April 12, 2002.
Tergesen, Anne. Taking Cover with Covered
Calls. Business Week, May 21, 2001, p. 132.

280

CHAPTER 12. OPTION STRATEGIES

Tracy, Tennille. "'Buy-Write' Is Looking Attrac- 12.2.1 References

tive. Wall Street Journal. (Dec 1, 2008). pg. C6.
Mark D. Wolnger, The Rookies Guide to Options The Beginners Handbook of Trading Equity
Whaley, Robert. Risk and Return of the CBOE
Options W&A Publishing, Cedar Falls, 2008.
BuyWrite Monthly Index." The Journal of Derivatives (Winter 2002) pp. 35 42.
[1] Investopedia Sta (17 September 2009). Introduction to
Put Writing. Investopedia. Retrieved 21 February 2012.

12.2 Naked put

12.2.2 External links
Chicago Board Options Exchange
Australian Stock Exchange

Investopedia, Options tutorial

it
of
Pr

Premium

Payoff

Profit

12.3 Straddle
Share Price at Maturity

Strike
Price

Short Put

Payos and prots from writing a short put

This article is about the nancial investment strategy.

For other meanings, see Straddle (disambiguation).
In nance, a straddle refers to two transactions that share
the same security, with positions that oset one another.
One holds long risk, the other short. As a result, it involves the purchase or sale of particular option derivatives
that allow the holder to prot based on how much the
price of the underlying security moves, regardless of the
direction of price movement. The purchase of particular
option derivatives is known as a long straddle, while the
sale of the option derivatives is known as a short straddle.

A naked put (also called an uncovered put) is a put option where the option writer (i.e., the seller) does not have
sucient liquidity (cash) to cover the contracts in case of
assignment. No amount of underlying stock will satisfy
assignment, because the seller/writer is forced to accept
the underlying (from option buyer) in exchange for cash,
even if the cash must come by way of a margin call by
the sellers broker. If the option buyer doesn't exercise
on or before expiration, the seller keeps the option pre12.3.1
mium. Due to the risks involved, put writing is rarely
used alone. Investors typically use puts in combination
with other options contracts.[1]

Long straddle

If the market price of the underlying stock is below the

strike price of the option on the day the option expires,
the option buyer can exercise the put option and force the
seller to buy the underlying stock at the strike price. That
allows the exerciser to prot from the dierence between
the market price of the stock and the options strike price.
But if the market price is at or above the strike price when
expiration day arrives, the option expires worthless and
the put writer prots by keeping the premium collected
when the put option was sold.
During the options lifetime, if the stock price moves
lower, then the option premium may increase (depending
on how far the stock falls and how much time passes), and
it becomes more costly to close (repurchase the put sold
earlier) the position - resulting in a loss. The maximum
loss scenario for the put seller occurs if the stock price
drops to zero. In that case, the loss is equal to the strike
price minus the premium received. Loss is not unlimited,
as in the case of a naked call.

An option payo diagram for a long straddle position

A long straddle involves going long, i.e., purchasing, both

a call option and a put option on some stock, interest rate,
index or other underlying. The two options are bought at
the same strike price and expire at the same time. The
owner of a long straddle makes a prot if the underlying

12.3. STRADDLE

281

price moves a long way from the strike price, either above
or below. Thus, an investor may take a long straddle position if he thinks the market is highly volatile, but does
not know in which direction it is going to move. This position is a limited risk, since the most a purchaser may
lose is the cost of both options. At the same time, there
is unlimited prot potential.[1]
For example, company XYZ is set to release its quarterly
nancial results in two weeks. A trader believes that the
release of these results will cause a large movement in
the price of XYZs stock, but does not know whether the
price will go up or down. He can enter into a long straddle, where he gets a prot no matter which way the price
of XYZ stock moves, if the price changes enough either
way. If the price goes up enough, he uses the call option and ignores the put option. If the price goes down,
he uses the put option and ignores the call option. If the
price does not change enough, he loses money, up to the
total amount paid for the two options. The risk is limited
by the total premium paid for the options, as opposed to
the short straddle where the risk is virtually unlimited.

An option payo diagram for a short straddle position

This strategy is called nondirectional because the short

straddle prots when the underlying security changes little in price before the expiration of the straddle. The short
straddle can also be classied as a credit spread because
If the stock is suciently volatile and option duration the sale of the short straddle results in a credit of the preis long, the trader could prot from both options. This miums of the put and call.
would require the stock to move both below the put op- A risk for holder of a short straddle position is unlimited
tions strike price and above the call options strike price due to the sale of the call and the put options which exat dierent times before the option expiration date.
pose the investor to unlimited losses (on the call) or losses
limited to the strike price (on the put), whereas maximum
prot is limited to the premium gained by the initial sale
12.3.2 Short straddle
of the options.

12.3.3 Tax straddle

A tax straddle is straddling applied specically to taxes,
typically used in futures and options to create a tax
shelter.[2]
For example, an investor with a capital gain manipulates
investments to create an articial loss from an unrelated
transaction to oset their gain in a current year, and postpone the gain till the following tax year. One position accumulates an unrealized gain, the other a loss. Then the
position with the loss is closed prior to the completion
of the tax year, countering the gain. When the new year
An option payo diagram for a short straddle position
for tax begins, a replacement position is created to oset the risk from the retained position. Through repeated
A short straddle is a non-directional options trading strat- straddling, gains can be postponed indenitely over many
egy that involves simultaneously selling a put and a call of years.[3]
the same underlying security, strike price and expiration
date. The prot is limited to the premium received from
the sale of put and call. The risk is virtually unlimited as 12.3.4 References
large moves of the underlying securitys price either up
or down will cause losses proportional to the magnitude [1] Barrie, Scott (2001). The Complete Idiots Guide to Opof the price move. A maximum prot upon expiration is
tions and Futures. Alpha Books. pp. 120121. ISBN
achieved if the underlying security trades exactly at the
0-02-864138-8.
strike price of the straddle. In that case both puts and
calls comprising the straddle expire worthless allowing [2] Passthrough Entity Straddle Tax Shelter. IRS.gov. Retrieved Jan 9, 2015.
straddle owner to keep full credit received as their prot.

282

CHAPTER 12. OPTION STRATEGIES

[3] Brabec, Barbara (Nov 26, 2014). How to Maximize Schedule C Deductions & Cut Self-Employment Taxes to the
BONE -. Barbara Brabec Productions. p. 107. ISBN
978-0985633318.

12.3.5

Further reading

Publication 17 Your Federal Income Tax

Form 1040 series of forms and instructions
Social Securitys booklet Medicare Premiums:
Rules for Higher-Income Beneciaries and the calProt from a long buttery spread position. The spread is created
culation of the Social Security MAGI.
McMillan, Lawrence G. (2002). Options as a Strategic Investment (4th ed. ed.). New York : New York
Institute of Finance. ISBN 978-0-7352-0197-2.
McMillan, Lawrence G. (2012). Options as a Strategic Investment (5th ed. ed.). Prentice Hall Press.
ISBN 978-0-7352-0465-2.

by buying a call with a relatively low strike (x1 ), buying a call with
a relatively high strike (x3 ), and shorting two calls with a strike
in between (x2 ).

Short 2 calls with a strike price of X

Long 1 call with a strike price of (X + a)

Specic

where X = the spot price (i.e. current market price of

underlying) and a > 0.

12.4 Buttery

Using putcall parity a long buttery can also be created

as follows:
Long 1 put with a strike price of (X + a)
Short 2 puts with a strike price of X
Long 1 put with a strike price of (X a)

Payoff

Premium

Profit

where X = the spot price and a > 0.

Profit

All the options have the same expiration date.

Share Price at Maturity

Long Butterfly

Payo chart from buying a buttery spread.

At expiration the value (but not the prot) of the buttery

will be:
zero if the price of the underlying is below (X a)
or above (X + a)

In nance, a buttery is a limited risk, non-directional

positive if the price of the underlying is between (X
options strategy that is designed to have a large probability
- a) and (X + a)
of earning a limited prot when the future volatility of the
underlying asset is expected to be lower than the implied
The maximum value occurs at X (see diagram).
volatility.

12.4.1

Long buttery

12.4.2 Short buttery

A long buttery position will make prot if the future A short buttery position will make prot if the future
volatility is lower than the implied volatility.
volatility is higher than the implied volatility.
A long buttery options strategy consists of the following A short buttery options strategy consists of the same opoptions:
tions as a long buttery. However now the middle strike
Long 1 call with a strike price of (X a)

option position is a long position and the upper and lower

strike option positions are short.

12.5. COLLAR

12.4.3

Margin Requirements

12.4.4

Buttery Variations

283

Most commonly, the two strikes are roughly equal distances from the current price. For example, an investor
Margin requirements for all options positions, including would insure against loss more than 20% in return for
a buttery, are governed by what is known as Regulation giving up gain more than 20%. In this case the cost of
T. However brokers are permitted to apply more stringent the two options should be roughly equal. In case the premargin requirements than the regulations.
miums are exactly equal, this may be called a zero-cost
collar; the return is the same as if no collar was applied,
provided that the ending price is between the two strikes.
On expiry the value (but not the prot) of the collar will
1. The double option position in the middle is called be:
the body, while the two other positions are called
X if the price of the underlying is below X
the wings.
2. The option strategy where the middle options (the
body) have dierent strike prices is known as a
Condor.

the value of the underlying if the underlying is between X and (X+a), inclusive
X+a if the underlying is above X+a.

3. In case the distance between middle strike price and

strikes above and below is unequal, such position is
Example
referred to as broken wings buttery.
Consider an investor who owns one hundred shares of a
stock with a current share price of $5. An investor could
12.4.5 References
construct a collar by buying one put with a strike price
McMillan, Lawrence G. (2002). Options as a Strate- of $3 and selling one call with a strike price of $7. The
gic Investment (4th ed. ed.). New York : New York collar would ensure that the gain on the portfolio will be
no higher than $2 and the loss will be no worse than $2
Institute of Finance. ISBN 0-7352-0197-8.
(before deducting the net cost of the put option, i.e. the
Credit By Brokers And Dealers (Regulation T), cost of the put option less what is received for selling the
FINRA, 1986
call option).

12.5 Collar
In nance, a collar is an option strategy that limits
the range of possible positive or negative returns on an
underlying to a specic range.

12.5.1

Equity Collar

Structure
A collar is created by:[1]
Long the underlying
long a put option at strike price X (called the oor)
Short a call option at strike price (X+a) (called the
cap)
These latter two are a short Risk reversal position. So:
Underlying - Risk reversal = Collar
The premium income from selling the call reduces the
cost of purchasing the put. The amount saved depends
on the strike price of the two options.

There are three possible scenarios when the options expire:

If the stock price is above the $7 strike price on the
call he wrote, the person who bought the call from
the investor will exercise the purchased call; the investor eectively sells the shares at the $7 strike
price. This would lock in a $2 prot for the investor. He only makes a $2 prot (minus fees), no
matter how high the share price goes. For example
if the stock price goes up to $11, the buyer of the call
will exercise the option and the investor will sell the
shares that he bought at $5 for $11, for a $6 prot,
but must then pay out $11$7=$4, making his prot
only $2 ($6-$4). The premium paid for the put must
then be subtracted from this $2 prot to calculate the
total return on this investment.
If the stock price drops below the $3 strike price on
the put then the investor may exercise the put and
the person who sold it is forced to buy the investors
100 shares at $3. The investor loses $2 on the stock
but can lose only $2 (plus fees) no matter how low
the price of the stock goes. For example if the stock
price falls to $1 then the investor exercises the put
and has a $2 gain. The value of the investors stock
has fallen by $5$1 = $4. The call expires worthless
(since the buyer does not exercise it) and the total
net loss is $2$4= -$2. The premium received for

284

CHAPTER 12. OPTION STRATEGIES

the call must then be added to reduce this $2 loss to
calculate the total return on this investment.

3. Falling interest rates - she will benet from a fall in

interest rates up to a limit of 5% as per the oor
agreement. If it falls further, A will make payments
to C under the Floor agreement while saving the
same amount on the original obligation. Hence A
cannot benet from a fall of more than 1%.

If the stock price is between the two strike prices on

the expiry date, both options expire unexercised and
the investor is left with the 100 shares whose value
is that stock price (x100), plus the cash gained from
selling the call option, minus the price paid to buy
the put option, minus fees.
12.5.3

Why do this?

One source of risk is counterparty risk. If the stock price

expires below the $3 oor then the counterparty may default on the put contract, thus creating the potential for
losses up to the full value of the stock (plus fees).

In times of high volatility, or in bear markets, it can be

useful to limit the downside risk to a portfolio. One obvious way to do this is to sell the stock. In the above example, if an investor just sold the stock, the investor would
get $5. This may be ne, but it poses additional questions. Does the investor have an acceptable investment
12.5.2 Interest Rate Collar
available to put the money from the sale into? What are
the transaction costs associated with liquidating the portStructure
folio? Would the investor rather just hold on to the stock?
In an interest rate collar, the investor seeks to limit ex- What are the tax consequences?
posure to changing interest rates and at the same time If it makes more sense to hold on to the stock (or other
lower its net premium obligations. Hence, the investor underlying asset), the investor can limit that downside risk
goes long on the cap (oor) that will save it money for that lies below the strike price on the put in exchange for
a strike of X +(-) S1 but at the same time shorts a oor giving up the upside above the strike price on the call.
(cap) for a strike of X +(-) S2 so that the premium of Another advantage is that the cost of setting up a collar is
one at least partially osets the premium of the other. (usually) free or nearly free.The price received for selling
Here S1 is the maximum tolerable unfavorable change in the call is used to buy the putone pays for the other.
payable interest rate and S2 is the maximum benet of a
Finally, using a collar strategy takes the return from the
favorable move in interest rates.[2]
probable to the denite. That is, when an investor owns
a stock (or another underlying asset) and has an expected
return, that expected return is only the mean of the disExample
tribution of possible returns, weighted by their probabilConsider an investor A who has an obligation to pay oat- ity. The investor may get a higher or lower return. When
ing 6 month LIBOR annually on a notional N and which an investor who owns a stock (or other underlying asset)
(when invested) earns 6%. A rise in LIBOR above 6% uses a collar strategy, the investor knows that the return
will hurt the investor while a drop will benet her. Thus it can be no higher than the return dened by strike price
is desirable for her to purchase an interest rate cap which on the call, and no lower than the return that results from
will pay her back if the LIBOR rises above her level of the strike price of the put.
comfort. Figuring that she is comfortable paying up to
7%, she enters into an Interest Rate Cap with counterparty B wherein B will pay her the dierence between Symmetric Collar
6 mo LIBOR and 7% when the LIBOR exceeds 7% for
a premium of 0.08*N. To oset this premium, she sells A symmetric collar is one where the initial value of each
an Interest Rate Floor to counterparty C wherein she will leg is equal. The product has therefore no cost to enter.
pay them the dierence between 6 mo LIBOR and 5%
when the LIBOR falls below 5%. For this she receives
12.5.4 References
0.075*N premium, thus osetting what she paid for the
Cap.[3]
Hull, John (2005). Fundamentals of Futures and
Now she can face 3 scenarios:
1. Rising interest rates - she will pay a maximum of 7%
on her original obligation. Anything over and above
that will be oset by the payments she will receive
from party B under the Cap agreement. Hence A is
not exposed to interest rate rises of more than 1%.
2. Stationary interest rates - as long as the LIBOR stays
around 6%, A is not aected.

Options Markets, 5th ed. Upper Saddle River, NJ:

Prentice Hall. ISBN 0-13-144565-0.
[1] Statement 133 Implementation Issue No. E18. Retrieved July 8, 2011.
[2] HM Revenues and Customs. CFM13350 - Understanding corporate nance: derivative contracts: interest rate
collars: Using interest rate collars. Retrieved July 8,
2011.

12.6. IRON CONDOR

[3] Interest Rate Collars. Investopedia. Retrieved July 8,

2011.

285
both sides of the position by rst re-purchasing the written options and then selling the purchased options.

Szado, Edward, and Thomas Schneeweis.

Loosening Your Collar: Alternative Implementations of QQQ Collars. Isenberg School 12.6.1
of Management, CISDM. University of Massachusetts, Amherst. (Original Version: August
2009. Current Update: September 2009).

Long iron condor

12.6 Iron condor

The iron condor is an option trading strategy utilizing
two vertical spreads a put spread and a call spread with
the same expiration and four dierent strikes. A long iron
condor is essentially selling both sides of the underlying
instrument by simultaneously shorting the same number
of calls and puts, then covering each position with the Prot/loss graph for a long iron condor at expiration.
purchase of further out of the money call(s) and put(s)
respectively. The converse produces a short iron condor.
The position is so named because of the shape of the The simultaneous selling of OTM (Out of The Money)
prot/loss graph, which loosely resembles a large-bodied put and call spreads. The dierence between the put conbird, such as a condor. In keeping with this analogy, tract strikes will generally be the same as the distance betraders often refer to the inner options collectively as the tween the call contract strikes.
body and the outer options as the wings. The word Because the premium earned on the sales of the written
iron in the name of this position indicates that, like an contracts is greater than the premium paid on the puriron buttery, this position is constructed using both calls chased contracts, a long iron condor is typically a net
and puts, by combining a bull put spread with a bear credit transaction. This net credit represents the maxicall spread. The combination of these two credit spreads mum prot potential for an iron condor.
makes the long iron condor (and the long iron buttery) a
credit spread, despite the fact that it is long. This distin- The potential loss of a long iron condor is the dierence
guishes the position from a plain Condor position (and the between the strikes on either the call spread or the put
plain Buttery), which would be constructed with all calls spread (whichever is greater if it is not balanced) multior all puts, by combining either a bull call spread with a plied by the contract size (typically 100 or 1000 shares of
bear call spread or a bull put spread with a bear put spread. the underlying instrument), less the net credit received.
Because the long, plain Condor (and Buttery) combine A trader who buys an iron condor speculates that the spot
a debit spread with a credit spread, that overall position is price of the underlying instrument will be between the
instead entered at a net debit (though usually small).[1]
short strikes when the options expire where the position
is the most protable. Thus, the iron condor is an options
One of the practical advantages of an iron condor over a
single vertical spread (a put spread or call spread), is that strategy considered when the trader has a neutral outlook
for the market.
the initial and maintenance margin requirements[2] for the
iron condor are often the same as the margin requirements The long iron condor is an eective strategy for capturing
for a single vertical spread, yet the iron condor oers the any perceived excessive volatility risk premium,[3] which
prot potential of two net credit premiums instead of only is the dierence between the realized volatility of the unone. This can signicantly improve the potential rate of derlying and the volatility implied by options prices.
return on capital risked when the trader doesn't expect the Buying iron condors are popular with traders who seek
underlying instruments spot price to change signicantly. regular income from their trading capital. An iron conAnother practical advantage of the iron condor is that
if the spot price of the underlying is between the inner
strikes towards the end of the option contract, the trader
can avoid additional transaction charges by simply letting
some or all of the options contracts expire. If the trader
is uncomfortable, however, with the proximity of the underlyings spot price to one of the inner strikes and/or is
concerned about pin risk, then the trader can close one or

dor buyer will attempt to construct the trade so that the

short strikes are close enough that the position will earn
a desirable net credit, but wide enough apart so that it is
likely that the spot price of the underlying will remain
between the short strikes for the duration of the options
contract. The trader would typically play iron condors every month (if possible) thus generating monthly income
with the strategy.

286

CHAPTER 12. OPTION STRATEGIES

Related strategies

To sell or go short an iron condor, the trader will buy

(long) options contracts for the inner strikes using an outAn option trader who considers a long iron condor is one of-the-money put and out-of-the-money call options. The
who expects the price of the underlying instrument to trader will then also sell or write (short) the options conchange very little for a signicant duration of time. This tracts for the outer strikes.
trader might also consider one or more of the following Because the premium earned on the sales of the written
strategies.
contracts is less than the premium paid for the purchased
A short strangle is eectively a long iron condor, but
without the wings. It is constructed by writing an
out-of-the-money put and an out-of-the money call.
A short strangle with the same short strikes as an iron
condor is generally more protable, but unlike a long
iron condor, the short strangle oers no protection to
limit losses should the underlying instruments spot
price change dramatically.
A long iron buttery is very similar to a long iron
condor, except that the inner, short strikes are at the
same strike. The iron buttery requires the underlying instruments spot price to remain virtually unchanged over the life of the contract in order to retain the full net credit, but the trade is potentially
more protable (larger net credit) than an Iron Condor.
A short straddle is eectively a long iron buttery
without the wings and is constructed simply by writing an at-the-money call and an at-the-money put.
Similar to a short strangle, the short straddle oers
no protection to limit losses and similar to a long iron
buttery, the straddle requires the underlying instruments spot price to remain virtually unchanged over
the life of the contract in order to retain the full net
credit.
A bull put spread is simply the lower side of a long
iron condor and has virtually identical initial and
maintenance margin requirements.
A bear call spread is simply the upper side of a long
iron condor and has virtually identical initial and
maintenance margin requirements.

12.6.2

Short iron condor

contracts, a short iron condor is typically a net debit transaction. This debit represents the maximum potential loss
for the short iron condor.
The potential prot for a short iron condor is the dierence between the strikes on either the call spread or the
put spread (whichever is greater if it is not balanced) multiplied by the size of each contract (typically 100 or 1000
shares of the underlying instrument) less the net debit
paid.
A trader who sells an iron condor speculates that the spot
price of the underlying instrument will not be between the
short strikes when the options expire. If the spot price of
the underlying is less than the outer put strike, or greater
than the outer call strike at expiration, then the short iron
condor trader will realise the maximum prot potential.
Related strategies
An option trader who considers a short iron condor strategy is one who expects the price of the underlying to
change greatly, but isn't certain of the direction of the
change. This trader might also consider one or more of
the following strategies.
A strangle is eectively a short iron condor, but
without the wings. It is constructed by purchasing
an out-ot-the-money put and an out-of-the money
call. The strangle is a more expensive trade (higher
net debit to be paid due to the absence of the outer
strikes that typically reduce the net debit), but the
Strangle does not restrict prot potential in the case
of a dramatic change in the spot price of the underlying instrument.
A short iron buttery is very similar to a short iron
condor, except that the inner, long strikes are at the
same strike. The resulting position requires the underlyings spot price to change less before there is
a prot, but the trade is typically more expensive
(larger net debit) than a short iron condor.
A straddle is eectively a short iron buttery without the wings and is constructed simply by purchasing an at-the-money call and an at-the-money put.
Similar to the strangle, the straddle oers a greater
prot potential at the expense of a greater net debit.

Prot/loss graph for a short iron condor at expiration.

A bear put spread is simply the lower side of a short

iron condor and has virtually identical initial and
maintenance margin requirements.

12.7. STRANGLE

287

A bull call spread is simply the upper side of a short long strangle makes a prot if the underlying price moves
iron condor and has virtually identical initial and far enough away from the current price, either above or
maintenance margin requirements.
below. Thus, an investor may take a long strangle position if he thinks the underlying security is highly volatile,
but does not know which direction it is going to move.
12.6.3 References
This position is a limited risk, since the most a purchaser
may lose is the cost of both options. At the same time,
[1] Cohen, Guy. (2005). The Bible of Options Strate- there is unlimited prot potential.[1]
gies. New Jersey : Pearson Education, Inc. ISBN 0-13171066-4.

[2] Chicago Board Options Exchange - Margin Manual

12.7.2 Short strangle

[3]

Pr
of

it

12.7 Strangle

Long strangle

Share Price at Maturity

Strike
Prices

Short Strangle

payo of short strangle

The short strangle involves shorting (selling) both a call

option and a put option of the same underlying security.
Like a short straddle, the options expire at the same time,
but unlike a straddle, the options have dierent strike
prices. The premium can be chosen by the short party,
with the hope that this will cover any potential volatility.
The short party of the strangle makes a prot if the underlying price stays within the boundaries of the strike price
of which they would be exercised, either above or below. Thus, an investor may take a short strangle position
if he thinks the underlying security is not at all volatile.
This position has limited prot and unlimited risk. A long
iron condor is similar, but due to the wings it has limited
downside.

fit
Pr
o

Pa
y

of

12.7.1

Premium

Profit

0
In nance, a strangle is an investment strategy involving
the purchase or sale of particular option derivatives that
allows the holder to prot based on how much the price
of the underlying security moves, with relatively minimal
exposure to the direction of price movement. A purchase
of particular options is known as a long strangle, while
a sale of the same options is known as a short strangle.
As an options position strangle is a variation of a more
generic straddle position. Strangles key dierence from
a straddle is in giving investor choice of balancing cost of
opening a strangle versus a probability of prot. For example, given the same underlying security, strangle positions can be constructed with low cost and low probability
of prot. Low cost is relative and comparable to a cost of
straddle on the same underlying. Strangles can be used
with equity options, index options or options on futures.

Payoff

12.7.3 References
Premium

Profit

[1] Barrie, Scott (2001). The Complete Idiots Guide to Options and Futures. Alpha Books. pp. 120121. ISBN
0-02-864138-8.

Share Price at Maturity

Strike
Prices

Long Strangle

Payos of buying a strangle spread.

The long strangle involves going long (buying) both a

call option and a put option of the same underlying security. Like a straddle, the options expire at the same time,
but unlike a straddle, the options have dierent strike
prices. A strangle can be less expensive than a straddle
if the strike prices are out-of-the-money. The owner of a

12.7.4 External links

Chapter 13

Options Spread
13.1 Options spread

Credit and debit spreads

If the premiums of the options sold is higher than the

For the American football oensive scheme, see Spread
premiums of the options purchased, then a net credit is
oense.
received when entering the spread. If the opposite is true,
then a debit is taken. Spreads that are entered on a debit
Options spreads are the basic building blocks of many are known as debit spreads while those entered on a credit
options trading strategies. A spread position is entered by are known as credit spreads.
buying and selling equal number of options of the same
class on the same underlying security but with dierent
Ratio spreads and backspreads
strike prices or expiration dates.
The three main classes of spreads are the horizontal
spread, the vertical spread and the diagonal spread. They
are grouped by the relationships between the strike price
and expiration dates of the options involved.

There are also spreads in which unequal number of options are simultaneously purchased and written. When
more options are written than purchased, it is a ratio
spread. When more options are purchased than written,
Vertical spreads, or money spreads, are spreads involving it is a backspread.
options of the same underlying security, same expiration
month, but at dierent strike prices.
Spread combinations
Horizontal, calendar spreads, or time spreads are created
using options of the same underlying security, same strike Many options strategies are built around spreads and combinations of spreads. For example, a bull put spread is
prices but with dierent expiration dates.
basically a bull spread that is also a credit spread while
Diagonal spreads are constructed using options of the
the iron buttery can be broken down into a combination
same underlying security but dierent strike prices and
of a bull put spread and a bear call spread.
expiration dates. They are called diagonal spreads because they are a combination of vertical and horizontal
spreads.
Box spread

13.1.1

A box spread consists of a bull call spread and a bear put

spread. The calls and puts have the same expiration date.
The resulting portfolio is delta neutral. For example, a
40-50 January 2010 box consists of:

Call and put spreads

Any spread that is constructed using calls can be referred

to as a call spread, while a put spread is constructed using
put options.

Long a January 2010 40-strike call

Short a January 2010 50-strike call
Long a January 2010 50-strike put
Short a January 2010 40-strike put

Bull and bear spreads

If a spread is designed to prot from a rise in the price of
the underlying security, it is a bull spread. A bear spread
is a spread where favorable outcome is obtained when the
price of the underlying security goes down.

A box spread position has a constant payo at exercise

equal to the dierence in strike values. Thus, the 4050 box example above is worth 10 at exercise. For this
reason, a box is sometimes considered a pure interest

288

13.3. BOX SPREAD

289

rate play because buying one basically constitutes lending some money to the counterparty until exercise.
Net volatility
For the main article, see net volatility
The net volatility of an option spread trade is the volatility
level such that the theoretical value of the spread trade is
equal to the spreads market price. In practice, it can be
considered the implied volatility of the option spread.

13.1.2

References

Payos from a bull call spread

McMillan, Lawrence G. (2002). Options as a Strategic Investment (4th ed. ed.). New York : New York
Institute of Finance. ISBN 0-7352-0197-8.

13.1.3

External links

Option Strategies - An illustrated introduction to option spreads.

Options spread at DMOZ

13.2 Bull spread

A bull spread can be constructed using two call options.

In options trading, a bull spread is a bullish, vertical

spread options strategy that is designed to prot from a lower striking out-of-the-money put options on the same
underlying security with the same expiration date. The
moderate rise in the price of the underlying security.
options trader employing this strategy hopes that the price
Because of put-call parity, a bull spread can be conof the underlying security goes up far enough such that the
structed using either put options or call options. If conwritten put options expire worthless.
structed using calls, it is a bull call spread. If constructed
If the bull put spread is done so that both the sold and
using puts, it is a bull put spread.
bought put expire on the same day, it is a vertical credit
put spread.

13.2.1

Bull call spread

Break even point=upper strike price- Net premium paid

A bull call spread is constructed by buying a call option

with a low strike price (K), and selling another call option
13.2.3
with a higher strike price.

References

Often the call with the lower exercise price will be at-the McMillan, Lawrence G. (2002). Options as a Stratemoney while the call with the higher exercise price is outgic Investment (4th ed. ed.). New York : New York
of-the-money. Both calls must have the same underlying
Institute of Finance. ISBN 0-7352-0197-8.
security and expiration month. If the bull call spread is
done so that both the sold and bought calls expire on the
The bull put spread is explained as selling ITM put and
same day, it is a vertical debit call spread.
buying OTM put, while in the example both puts are ITM.
Break even point= Lower strike price+ Net premium paid

13.2.2

Bull put spread

13.3 Box spread

A bull put spread is constructed by selling higher striking In options trading, a box spread is a combination of poin-the-money put options and buying the same number of sitions that has a certain (i.e. riskless) payo, considered

290

CHAPTER 13. OPTIONS SPREAD

A present value of zero for B leads to a parity relation.
Two well-known parity relations are: Spot futures parity. The current price of a stock
equals the current price of a futures contract discounted by the time remaining until settlement:
S = F erT

Prot diagram of a box spread. It is a combination of positions

with a riskless payo.

to be simply delta neutral interest rate position. For example, a bull spread constructed from calls (e.g. long a
50 call, short a 60 call) combined with a bear spread constructed from puts (e.g. long a 60 put, short a 50 put), has
a constant payo of the dierence in exercise prices (e.g.
10). Under the no-arbitrage assumption the net premium
paid out to acquire this position should be equal to the
present value of the payo.

Put call parity. A long European call c together with

a short European put p at the same strike price K
is equivalent to borrowing KerT and buying the
stock at price S. In other words, we can combine
options with cash to construct a synthetic stock:
c p = S KerT
Note that directly exploiting deviations from either of
these two parity relations involves purchasing or selling
the underlying stock.

13.3.2 The Box Spread

They are often called alligator spreads because the

commissions eat up all your prot due to the large number Now consider the put/call parity equation at two dierent
of trades required for most box spreads.
strike prices K1 and K2 . The stock price S will disappear
if
we subtract one equation from the other, thus enabling
The box-spread usually combines two pairs of options;
one
to exploit a violation of put/call parity without the
and its name derives from the fact that the prices for these
need
to invest in the underlying stock. The subtraction
options form a rectangular box in two columns of a quodone
one
way corresponds to a long-box spread; done the
tation.
other way it yields a short box-spread. The pay-o for
Note that box spreads also form a strategy in futures trad- the long box-spread will be the dierence between the
ing - see below.
two strike prices; and the prot will be the amount by
which the discounted payo exceeds the net premium.
For parity, the prot should be zero. Otherwise, there is
13.3.1 Background
a certain prot to be had by creating either a long boxspread if the prot is positive or a short box-spread if the
An arbitrage operation may be represented as a sequence prot is negative. [Normally, the discounted payo would
which begins with zero balance in an account, initiates dier little from the net premium, and any nominal prot
transactions at time t = 0, and unwinds transactions at would be consumed by transaction costs.]
time t = T so that all that remains at the end is a balance
whose value B will be known for certain at the beginning The long box-spread comprises four options, on the same
of the sequence. If there were no transaction costs then a underlying asset with the same terminal date. They can
non-zero value for B would allow an arbitrageur to prot be paired in two ways as shown in the following table (asby following the sequence either as it stands if the present sume strike-prices K1 < K2 ):value of B is positive, or with all transactions reversed Reading the table horizontally and vertically we obtain
if the present value of B is negative. However, market two views of a long box-spread.
forces tend to close any arbitrage windows which might
open; hence the present value of B is usually insuciently
A long box-spread can be viewed as a long synthetic
dierent from zero for transaction costs to be covered.
stock at a price K1 plus a short synthetic stock at a
This is considered typically to be a Market Maker/ Floor
higher price K2 .
trader strategy only, due to extreme commission costs of
the multiple-leg spread. If the box is for example 20 dol A long box-spread can be viewed as a long bull calllars as per lower example getting short the box anything
spread at one pair of strike prices, K1 and K2 , plus a
under 20 is prot and long anything over, has hedged all
long bear put-spread at the same pair of strike prices.
risk .

13.3. BOX SPREAD

We can obtain a third view of the long box-option by reading the table diagonally. In order to interpret the diagonals we need to introduce the straddle, which is a combination of a long call and a long put both at a strike price
equal to the current stock price (at-the-money). This
combination is direction neutral, its terminal payo being
dependent not on the direction of movement of the stock
price but only on the magnitude of the movement. The
band between the break-even points can be extended by
separating the strike prices of the two options symmetrically with respect to the current stock price:-

291
0.01%). [Ratio spreads took more than 15%, and about a
dozen other instruments took the remaining 30%.This is
considered typically to be a Market Maker/Floor trader
strategy only, due to extreme commission costs of the
multiple leg spread. If the box is for example 20 dollars as per lower example getting short the box anything
under 20 is prot and long anything over, has hedged all
risk.]

13.3.5 The box spread in futures

If both options are in-the-money the combination is A box spread in futures contracts is a spread from two
consecutive buttery spreads, summing to +1 3 +3 1
called a long gut.
in consecutive, or at least equally spaced, contracts. Of If both options out-of-the-money the combination is ten presumed not to move much (as in theory they are
called a long strangle.
practically non directional) and therefore trade in a range.
Returning to the long box-spread, we see that the leading
diagonal is a long gut combination, and the other diagonal
is a short strangle combination. Hence a long box-spread
may be created as a coupling of a long gut with a short
strangle.
The short box-spread can be treated similarly.

13.3.3

An Example

As an example, consider a three-month option on a stock

whose current price is $100. If the interest rate is 8% pa
and the volatility is 30% pa then the prices for the options
might be:

The initial investment for a long box-spread would be

$19.30. The following table displays the payos of the
4 options for the three ranges of values for the terminal
stock price ST :

For linear commodities instruments (i.e., futures, forwards, swaps), box spread is used to refer to a four-leg
position consisting of long a two-leg spread in one time
period, and short the same two-leg spread in another time
period. For instance, buying the Cal 13-12, SP-NP box
spread, would be buying power at CAISO hub SP versus
selling power at CAISO hub NP for 2013, while also doing the opposite (so, selling at SP and buying at NP) for
2012. (Customarily, a leg that is purchased is mentioned
before a leg that is sold. And commonly, the more expensive leg is also mentioned rst (to avoid using a negative
spread price). Therefore, the way that the CAISO box
spread is referred to suggests that SP is trading over NP,
and SP-minus-NP is wider in 2013 than in 2012.) Another pair of contracts that commonly trade box spreads
is WTI and Brent crude oil. One motivation for trading
a box would be to roll an existing two-leg spread position
to another (typically later) time period. E.g., to roll ones
existing 2012 SP-NP spread position out to 2013 (i.e.,
close 2012 and replace with 2013). Another motivation
would be to trade the box position itself, taking a view
that there will be a trend for a two-leg spread (widening
or narrowing) over time.

The terminal payo has a value of $ 20 independent of the 13.3.6 References

terminal value of the share price. The discounted value
Ben-Zion Uri., Danan Shmuel and Yagil Joseph,
of the payo is $ 19.60. Hence there is a nominal prot
Box Spread Strategies and Arbitrage Opportuniof 30 cents to be had by investing in the long box-spread.
ties, The Journal of Derivatives, Spring 2005, 4762.

13.3.4

Prevalence

To what extent are the various instruments introduced

above traded on exchanges? Chaput and Ederington, surveyed Chicago Mercantile Exchange's market for options
on Eurodollar futures. For the year 1999-2000 they found
that some 25% of the trading volume was in outright options, 25% in straddles and vertical spreads (call-spreads
and put-spreads), and about 5% in strangles. Guts constituted only about 0.1%, and box-spreads even less (about

Bharadwaj, Anu and James B. Wiggins, Box spread

and put-call parity tests for the S&P 500 index
LEAPS market, Journal of Derivatives, 8(4) (2001):
62-71. The box-spread reveals an arbitrage prot insucient to cover transaction costs.
Billingsley, R.S. and Don M. Chance, Options market eciency and the box spread strategy, Financial
Review, 20 (1987): 287-301.

292

CHAPTER 13. OPTIONS SPREAD

Chance, Don M, An Introduction to Derivatives, 5th

edition, Thomson, 2001.
Chaput, J. Scott and Louis H. Ederington, Option
spread and combination trading, , 2002.
Hemler, Michael L.and Thomas W. Miller, Jr. Box
spread arbitrage prots following the 1987 market
crash: real or illusory?, Journal of Financial and
Quantitative Analysis, 32(1)(1997): 71-90. Postmarket simulations with box-spreads on the S&P An example prot and loss graph for a Put Backspread options
500 Index show that market ineency increased af- strategy placed at a net credit. The solid black line shows the
combined value of the position at expiration. The dashed blue
ter the 1987 crash.
Hull, John C., Fundamentals of Futures and Options
Markets, 4th edition, Prentice-Hall, 2002.

line shows the combined value of the position some time before
expiration and when there exists signicant implied volatility in
the options.

Ronn, Edud and Aimee Gerbarg Ronn, The Box

spread arbitrage conditions: theory, tests, and investment strategies, Review of Financial Studies,
2(1) (1989): 91-108. The box-spread is used to test
for arbitrage opportunities on Chicago Board Options Exchange data.

at-the-money puts. This strategy is generally considered

very bearish but it can also serve as a neutral/bullish play
under the right conditions.

13.4 Backspread

The maximum prot for this strategy is achieved when

the price of the underlying security moves to zero before
expiration of the options. Given these declarations:
Kl = price strike lower
Ku = price strike upper

The backspread is the converse strategy to the ratio

Cn = share per credit net
spread and is also known as reverse ratio spread. Using
N = contract options per shares of number
calls, a bullish strategy known as the call backspread can
be constructed and with puts, a strategy known as the put The maximum prot per put backspread combination can
backspread can be constructed.
be expressed as:
Prot Maximum = [Ku 2 (Ku Kl ) + Cn ] N

13.4.1

Call backspread

The call backspread (reverse call ratio spread) is a

bullish strategy in options trading whereby the options
trader writes a number of call options and buys more call
options of the same underlying stock and expiration date
but at a higher strike price. It is an unlimited prot, limited risk strategy that is used when the trader thinks that
the price of the underlying stock will rise sharply in the
near future.

The maximum upside prot is achieved if the price of the

underlying is at or above the upper strike price at expiration and can be expressed simply as:
(upside) Prot Maximum = Cn
The maximum loss for this strategy is taken when the
price of the underlying security moves to exactly the
lower strike at expiration. The loss taken per put backspread combination can be expressed as:
Loss Maximum = (Cn + Kl Ku ) N

A 2:1 call backspread can be created by selling a number of calls at a lower strike price and buying twice the
number of calls at a higher strike.
As a very bearish strategy

13.4.2

Put backspread

The put backspread is a strategy in options trading

whereby the options trader writes a number of put options at a higher strike price (often at-the-money) and
buys a greater number (often twice as many) of put options at a lower strike price (often out-of-the-money) of
the same underlying stock and expiration date. Typically
the strikes are selected such that the cost of the long puts
is largely oset by the premium earned in writing the

The maximum prot from this strategy is realised if the

underlying moves to zero before the options expire. The
maximum loss for this strategy is realised when, at expiration, the underlying has moved moderately bearishly to
the price of the lower strike price. This strategy might
be used when the trader believes that there will be a very
sharp, downward move and would like to enter the position without paying a lot of premium, as the written puts
will oset the cost of the purchased puts.

13.5. CALENDAR SPREAD

As a neutral/bullish strategy

293
For equity markets (as described above), the call backspread does not generally oer these helpful dynamics
because the generally associated changes in volatility as
price moves in the equity markets may exacerbate losses
on a bearish move and reduce prots on a bullish move
in the underlying.

The strategy can often be placed for a net credit when

the net premium earned for the written puts minus the
premium paid for the long puts is positive. In this case,
this strategy can be considered a neutral or bullish play,
since the net credit may be kept if the underlying remains
at or greater than the upper strike price when the options
In commodity futures markets With options on
expire.
commodity futures (and possibly inverse ETFs), this relationship may be reversed as the observed correlation
between price movement and implied volatility is positive meaning that as prices rise, so does volatility. In this
case, the call backspread trader might benet from these
eects and the put backspread trader might not.

13.4.3 See also

Options spread
An illustration of the put backspread, placed for a net credit,
showing the overall prot/loss of the position at expiry (solid
black line) and sometime before expiry with dierent levels of
implied volatility (dashed blue lines, darker = higher volatility).

13.4.4 References
McMillan, Lawrence G. (2002). Options as a Strategic Investment (4th ed. ed.). New York : New York
Institute of Finance. ISBN 0-7352-0197-8.

The dynamics of The Greeks This position has a complex prole in that the Greeks Vega and Theta aect
Hull, John C. (2006). Options, Futures and Other
the protability of the position dierently, depending on
Derivatives (6th ed. ed.). Pearson Prentice Hall. p.
whether the underlying spot price is above or below the
381. ISBN 0-13-149908-4.
upper strike. When the underlyings price is at or above
the upper strike, the position is short vega (the value of
the position decreases as volatility increases) and long
theta (the value of the position increases as time passes). 13.5 Calendar spread
When the underlying is below the upper strike price, it is
long vega (the value of the position increases as volatilIn nance, a calendar spread (also called a time spread
ity increases) and short theta (the value of the position
or horizontal spread) is a spread trade involving the sidecreases as time passes).
multaneous purchase of futures or options expiring at particular date and the sale of the same instrument expiring
In equity markets In equity options markets (includ- another date. The legs of the spread vary only in expiraing equity indexes and derivative equities such as ETFs, tion date; they are based on the same underlying market
but possibly excluding inverse ETFs), it has been ob- and strike price.
served that there exists an inverse correlation between the The usual case involves the purchase of futures or options
price of the underlying and the implied volatility of its expiring in a more distant month and the sale of futures
options. The implied volatility will often increase as the or options in a more nearby month.[1]
price of the underlying decreases and vice versa. This
correlation manifests itself in a benecial way to traders
in a put backspread position.
13.5.1 Uses
Since this position is long vega when the underlyings
price falls below the upper strike price, this position may
oer some degree of protection to the equity options
trader who did not desire a bearish move. As volatility
increases so does the current value of the position which
may allow the trader time to exit with reduced losses or
even a small prot in some conditions. Since this position is short vega when the underlying is above the upper
strike price, this dynamic is again helpful to the equity
options trader.

The calendar spread can be used to attempt to take advantage of a dierence in the implied volatilities between two
dierent months options. The trader will ordinarily implement this strategy when the options he is buying have
a distinctly lower implied volatility than the options he is
writing (selling).
In the typical version of this strategy, a rise in the overall
implied volatility of a markets options during the trade
will tend very strongly to be to the traders advantage, and

294

CHAPTER 13. OPTIONS SPREAD

a decline in implied volatility will tend strongly to work 13.6.1 Purpose

to the traders disadvantage.
If the trader instead buys a nearby months options in Ideally, this strategy should be used when either A) the
some underlying market and sells that same underlying implied volatility of the options expiring in a particular
markets further-out options of the same striking price, month has recently moved sharply higher and is now bethis is known as a reverse calendar spread. This strategy ginning to decline, or B) the trader believes for whatwill tend strongly to benet from a decline in the overall ever reason that the underlying market of the option(s)
will move steadily in his favor during the life of the opimplied volatility of that markets options over time.
tion. The trader will use call options in this strategy
if he believes the underlying market will move steadily
higher, and put options if he believes the market will
13.5.2 Futures Pricing
move steadily lower.
Futures calendar spreads or switches represent simultaneous purchase and sales in dierent delivery months, and
are quoted as the dierence in prices. If gold for August
delivery is bid $1601.20 asking $1601.30, and gold for
October delivery is bid $1603.20 asking $1603.30, then
the calendar spread would be bid -$2.00 asking -$1.90 for
August-October.

In the case of call options, the trader will buy some number of options having striking price X and write (sell) a
larger number of options having striking price Y, where
Y is greater than X. In the case of put options, the trader
will buy some number of options having striking price A,
but write (sell) a larger number of options having striking
price B, where B is less than A.

The straight ratio-spread describes this strategy if the

Calendar spreads or switches are most often used in the
trader buys and writes (sells) options having the same exfutures markets to 'roll over' a position for delivery from
piration. If, instead, the trader executes this strategy by
one month into another month.
buying options having expiration in one month but writing
(selling) options having expiration in a dierent month,
this is known as a ratio-diagonal trade.

13.5.3

References

[1] Fontanills, George (2005). The Options Course: High

Prot & Low Stress Trading Methods. Hoboken, New Jersey USA: John Wiley & Sons, Inc. p. 284. ISBN 0-47166851-6.

McMillan, Lawrence G. (2002). Options as a Strategic Investment (4th ed. ed.). New York : New York
Institute of Finance. ISBN 0-7352-0197-8.

As with all option spreads, the trader in a ratio-spread will

strongly prefer to buy options having a distinctly lower
implied volatility than the options he is writing (selling).

13.6.2 See also

Options spread

13.6.3 References
13.5.4

External links

Google Gadget for Daily Top Calendar Spreads

McMillan, Lawrence G. (2002). Options as a Strategic Investment (4th ed. ed.). New York : New York
Institute of Finance. ISBN 0-7352-0197-8.

13.6 Ratio spread

13.7 Vertical spread

A Ratio spread is a complex, multileg options position

that is a variation of a vertical spread. Like a vertical,
the ratio spread involves buying and selling options on
the same underlying security with dierent strike prices
and the same expiration date. Unlike a vertical spread,
a number of option contracts sold is not equal to a number of contracts bought. An unequal number of options
contracts gives this spread certain unique properties compared to a regular vertical spread. A typical ratio spread
would be where twice as much option contracts are sold,
thus forming a 1:2 ratio.

In options trading, a vertical spread is an options strategy involving buying and selling of multiple options of
the same underlying security, same expiration date, but
at dierent strike prices. They can be created with either
all calls or all puts. The term originates from the trading
sheets that were used in the open outcry pits on which option prices were listed out by expiry date & strike price,
thus looking down the sheet (vertical) the trader would
see all options of the same maturity. Vertical spreads
approximate binary options, and can be produced using
vanilla options.

13.8. CREDIT SPREAD

13.7.1

Bull vertical spread

295
can go and the time frame in which the decline will happen in order to select the optimum trading strategy.

Bull call spread and bull put spread are bullish vertical Moderately bearish' options traders usually set a target
spreads constructed using calls and puts respectively.
price for the expected decline and utilize bear spreads to
reduce cost. While maximum prot is capped for these
strategies, they usually cost less to employ. The bear call
13.7.2 Bear vertical spread
spread and the bear put spread are common examples of
moderately bearish strategies.
Bear call spread and bear put spread are bearish vertical
spreads constructed using calls and puts respectively.

13.8.3 Breakeven
13.7.3

References

To nd the credit spread breakeven points for call spreads,

the net premium is added to the lower strike price. For put
McMillan, Lawrence G. (2002). Options as a Strate- spreads, the net premium is subtracted from the higher
gic Investment (4th ed. ed.). New York : New York strike price to breakeven.
Institute of Finance. ISBN 0-7352-0197-8.
Most brokers will let you engage in these dened risk /
dened reward trades.

13.8 Credit Spread

13.8.4 Maximum potential
In nance, a credit spread, or net credit spread, involves a purchase of one option and a sale of another option in the same class and expiration but dierent strike
prices. Investors receive a net credit for entering the position, and want the spreads to narrow or expire for prot.
In contrast, an investor would have to pay to enter a debit
spread. In this context, to narrow means that the option sold by the trader is in the money at expiration, but
by an amount that is less than the net premium received;
in which event the trade is protable but by less than the
maximum that would be realized if both options of the
spread were to expire worthless.

13.8.1

Bullish strategies

The maximum gain and loss potential are the same for
call and put spreads. Note that net credit = dierence in
premiums.
Maximum gain
Maximum gain = net credit, realized when both options
expire.
Maximum loss
Maximum loss = dierence in strike prices - net credit.

Bullish options strategies are employed when the options

13.8.5 Analysis
trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price
Credit spreads are negative vega since, if the price of
can go and the time frame in which the rally will occur in
the underlying doesn't change, the trader will tend to
order to select the optimum trading strategy.
make money as volatility goes down.
Moderately bullish options traders usually set a target
price for the bull run and utilize bull spreads to reduce
Credit spreads are also positive theta in that, broadly
cost. (It does not reduce risk because the options can
speaking if the price of the underlying doesn't move
still expire worthless.) While maximum prot is capped
past the short strike, the trader will tend to make
for these strategies, they usually cost less to employ for a
money just by the passage of time.
given nominal amount of exposure. The bull call spread
and the bull put spread are common examples of moderately bullish strategies.
13.8.6 Examples
For example - One uses a credit spread as a conservative
strategy designed to earn modest income for the trader
while also having losses strictly limited. It involves siBearish options strategies are employed when the options multaneously buying and selling (writing) options on the
trader expects the underlying stock price to move down- same security/index in the same month, but at dierent
wards. It is necessary to assess how low the stock price strike prices. (This is also a vertical spread)

13.8.2

Bearish strategies

296

CHAPTER 13. OPTIONS SPREAD

If the trader is BEARISH (expects prices to fall), you use in price and perhaps due for a rebound) as candidates for
a bearish call spread. Its named this way because you're bullish put spreads. Additionally, writing (selling) credit
buying and selling a call and taking a bearish position.
spreads with higher current IV (implied volatility) 50%
and higher, will increase the prospects for a protable
Look at the following example.
trade.
Trader Joe expects XYZ to fall from its current price of
NOTICE IN BOTH cases the losses and gains are strictly
$35 a share.
limited. This is a nice strategy for earning a modest
Write 10 January 36 calls at 1.10 $1100
amount of income from a portfolio that can be used to
Buy 10 January 37 calls at .75 ($ 750)
supplement your wages, dividends, or social security payments as long as you're aware of the limits.
net credit $350
Consider the following scenarios:
The stock falls or remains BELOW $36 by expiration. In 13.8.7 See also
this case all the options expire worthless and the trader
Credit (nance)
keeps the net credit of $350 minus commissions (probably about $20 on this transaction) netting approx $330
Credit risk
prot.
Debit spread
If the stock rises above $37 by expiration, you must unwind the position by buying the 36 calls BACK, and sell Yield curve spread
ing the 37 calls you bought; this dierence will be $1, the
Option-adjusted spread
dierence in strike prices. For all ten calls this costs you
$1000; when you subtract the $350 credit, this gives you
Credit spread (bond)
a MAXIMUM Loss of $650.
If the nal price was between 36 and 37 your losses would
be less or your gains would be less. The breakeven stock 13.8.8 References
price would be $36.35: the lower strike price plus the
McMillan, Lawrence G. (2002). Options as a Stratecredit for the money you received up front.
gic Investment (4th ed. ed.). New York : New York
Traders often using charting software and technical analInstitute of Finance. ISBN 0-7352-0197-8.
ysis to nd stocks that are OVERBOUGHT (have run up
in price and are likely to sell o a bit, or stagnate) as candidates for bearish call spreads.
If the trader is BULLISH, you set up a bullish credit
spread using puts. Look at the following example.

13.9 Debit spread

In nance, a debit spread, AKA net debit spread, reTrader Joe expects XYZ to rally sharply from its current sults when an investor simultaneously buys an option with
price of $20 a share.
a higher premium and sells an option with a lower premium. The investor is said to be a net buyer and expects
Write 10 January 19 puts at $0.75 $750
the premiums of the two options (the options spread) to
Buy 10 January 18 puts at $.40 ($400)
widen.
net credit $350
Consider the following scenarios:

13.9.1 Bullish & Bearish Debit Spreads

If the stock price stays the same or rises sharply, both puts
expire worthless and you keep your $350, minus commis- Investors want debit spreads to widen for prot.
sions of about $20 or so.
A bullish debit spread can be constructed using calls. See
If the stock price instead, falls to below 18 say, to $15, bull call spread.
you must unwind the position by buying back the $19 puts
at $4 and selling back the 18 puts at $3 for a $1 dier- A bearish debit spread can be constructed using puts. See
ence, costing you $1000. Minus the $350 credit, your bear put spread.
maximum loss is $650.

A bull-bear phase spread can be constructed using near

A nal stock price between $18 and $19 would provide month call & put.
you with a smaller loss or smaller gain; the breakeven
stock price is $18.65, which is the higher strike price mi13.9.2 Breakeven Point
nus the credit.
Traders often scan price charts and use technical analysis
to nd stocks that are OVERSOLD (have fallen sharply

Breakeven for call spreads = lower strike + net premium

13.9. DEBIT SPREAD

Breakeven for put spreads = higher strike - net premium

13.9.3

Maximum Potential

The maximum gain and loss potential are the same for call
and put debit spreads. Note that net debit = dierence in
premiums.
Maximum Gain
Maximum gain = dierence in strike prices - net debit,
realized when both options are in-the-money.
Maximum Loss
Maximum loss = net debit, realized when both options
expire worthless.

13.9.4

See also

Credit spread (option)

13.9.5

References

McMillan, Lawrence G. (2002). Options as a Strategic Investment (4th ed. ed.). New York : New York
Institute of Finance. ISBN 0-7352-0197-8.

297

Chapter 14

Combinations, Exotic Options, Other

Derivatives, etc.
14.1 Exotic option

14.1.2 Development

In nance, an exotic option is an option which has features making it more complex than commonly traded
vanilla options. Like the more general exotic derivatives they may have several triggers relating to determination of payo. An exotic option may also include nonstandard underlying instrument, developed for a particular client or for a particular market. Exotic options are
more complex than options that trade on an exchange,
and are generally traded over the counter (OTC).

14.1.1

Exotic options are often created by nancial engineers

and rely on complex models to price them.

14.1.3 Features
A straight call or put option, either American or
European, would be considered non-exotic or vanilla option. An exotic option could have one or more of the
following features:
The payo at maturity depends not just on the value
of the underlying instrument at maturity, but at its
value at several times during the contracts life (it
could be an Asian option depending on some average, a lookback option depending on the maximum
or minimum, a barrier option which ceases to exist if a certain level is reached or not reached by the
underlying, a digital option, peroni options, range
options, spread options, etc.)

Etymology

The term exotic option was popularized by Mark Rubinstein's 1990 working paper (published 1992, with Eric
Reiner) Exotic Options, with the term based either on
exotic wagers in horse racing, or due to the use of international terms such as Asian option, suggesting the
exotic Orient.[1][2]

It could depend on more than one index such as in

basket options, outperformance options, Himalaya
options, peroni options, or other mountain range options

Journalist Brian Palmer used the successful $1 bet on

the superfecta in the 2010 Kentucky Derby that paid
a whopping $101,284.60 as an example of the controversial high-risk, high-payout exotic bets that were observed by track-watchers since the 1970s in his article
about why we use the term exotic for certain types of nancial instrument. Palmer compared these horse racing
bets to the controversial emerging exotic nancial instruments that concerned then-chairman of the Federal Reserve Paul Volcker in 1980. He argued that just as the
exotic wagers survived the media controversy so will the
exotic options[1]
In 1987, Bankers Trust Mark Standish and David
Spaughton, were in Tokyo on business when they developed the rst commercially used pricing formula for
options linked to the average price of crude oil. They
called this exotic option, the Asian option, because they
were in Asia.[3]

The manner of settlement may vary depending on

the moneyness of the option at expiry, such as a cash
or share option.
There could be callability and putability rights.
It could involve foreign exchange rates in various
ways, such as a quanto or composite option.
Even products traded actively in the market can have
the characteristics of exotic options, such as convertible
bonds, whose valuation can depend on the price and
volatility of the underlying equity, the credit rating, the
level and volatility of interest rates, and the correlations
between these factors.

298

14.2. BARRIER OPTION

14.1.4

Barriers

Barriers in exotic option are determined by the underlying price and ability of the stock to be active or inactive
during the trade period, for instance up-and out option
has a high chance of being inactive should the underlying
price go beyond the marked barrier. Down-and-in-option
is very likely to be active should the underlying prices of
the stock go below the marked barrier. Up-and-in option is very likely to be active should the underlying price
go beyond the marked barrier.[4] One-touch double barrier binary options are path-dependent options in which
the existence and payment of the options depend on the
movement of the underlying price through their option
life. [5]

14.1.5

Examples

Barrier
Cash or Share
Cliquet
Compound option
Constant proportion portfolio insurance
Digital/Binary option

299

14.1.7 Further reading

Haug, Espen Gaarder (2007). The Complete Guide
to Option Pricing Formulas. New York: McGrawHill. ISBN 0-07-147734-9.
Banks, Erik; Paul Siegel (2007). The Options Applications Handbook: Hedging and Speculating Techniques for Professional Investors. New York: Wiley.
ISBN 0-07-145315-6.
Kuznetsov, Alex (2006). The Complete Guide to
Capital Markets for Quantitative Professionals. New
York: McGraw-Hill. ISBN 0-07-146829-3.
Kyprianou, Andreas E.; Wim Schoutens; Paul
Wilmott (2005). Exotic Option Pricing and Advanced Levy Models. Hoboken, NJ: John Wiley &
Sons. ISBN 0-470-01684-1.
Rebonato, Riccardo (1998). Interest-rate Option
Models: Understanding, Analysing and Using Models for Exotic Interest-rate Options. New York:
McGraw-Hill. ISBN 0-471-97958-9.

14.1.8 External links

Lookback

A paper on exotic options

Rainbow option

Overview of exotic options

Timer call
Unit Contingent Options
Variance swap
Bermudan options

14.1.6

References

[1] Brian Palmer (14 July 2010). Why Do We Call Financial

Instruments Exotic"? Because some of them are from
Japan. Slate. Retrieved 9 September 2013. The article
quotes then-chairman of the Federal Reserve Paul Volcker
in 1908 when he argued, This is hardly the time to search
out for new exotic lending areas or to nance speculative
or purely nancial activities that have little to do with the
performance of the American economy.
[2] Rubinstein, Mark; Reiner, Eric (1995). Exotic Options.
Working Paper, University of California at Berkeley.
[3] William Falloon; David Turner, eds. (1999). The evolution of a market. Managing Energy Price Risk. London:
Risk Books.

14.2 Barrier option

In nance, a barrier option is an exotic derivative typically an option on the underlying asset whose price reaching the pre-set barrier level either springs the option into
existence or extinguishes an already existing option.
Where the option springs into existence on the price
of the underlying asset breaching a barrier, it may
be known as an up and in, knock-in, or down
and in option.
Where the option is extinguished on the price of
the underlying asset breaching a barrier, it may be
known as an up and out, knock-out, or down
and out option.

Barrier options are always cheaper than a similar option

without barrier. Thus, barrier options were created to
provide the insurance value of an option without charging
[4] Exotic And Double Digital Options. BOB. May 18, as much premium. For example, if you believe that IBM
2013. Retrieved 11 July 2013.
will go up this year, but are willing to bet that it won't
[5] Double Barrier And Exotic Options. BinaryToday. go above $200, then you can buy the barrier and pay less
March 9, 2015. Retrieved April 15, 2015.
premium than the vanilla option.

300

14.2.1

CHAPTER 14. COMBINATIONS, EXOTIC OPTIONS, OTHER DERIVATIVES, ETC.

Types

Barrier options are path-dependent exotics that are similar in some ways to ordinary options. You can call or
put in American, Bermudan, or European exercise style.
But they become activated (or extinguished) only if the
underlying reaches a predetermined level (the barrier).
In options start their lives worthless and only become
active in the event that a predetermined knock-in barrier
price is breached. Out options start their lives active and
become null and void in the event that a certain knock-out
barrier price is breached.

that trade have to be? Would it have to be on an exchange

or could it be between private parties? When barrier
options were rst introduced to options markets, many
banks had legal trouble resulting from a mismatched understanding with their counterparties regarding exactly
what constituted a barrier event.

14.2.3 Variations

Barrier options are sometimes accompanied by a rebate,

which is a payo to the option holder in case of a barrier
event. Rebates can either be paid at the time of the event
If the option expires inactive, then it may be worthless, or at expiration.
or there may be a cash rebate paid out as a fraction of the
premium.
A discrete barrier is one for which the barrier event is
considered at discrete times, rather than the normal
The four main types of barrier options are:
continuous barrier case.
Up-and-out: spot price starts below the barrier level
and has to move up for the option to be knocked out.
Down-and-out: spot price starts above the barrier
level and has to move down for the option to become
null and void.
Up-and-in: spot price starts below the barrier level
and has to move up for the option to become activated.

A Parisian option is a barrier option where the barrier condition applies only once the price of the underlying instrument has spent at least a given period
of time on the wrong side of the barrier.
A turbo warrant is a barrier option namely a knock
out call that is initially in the money and with the
barrier at the same level as the strike.

Down-and-in: spot price starts above the barrier Barrier options can have either American, Bermudan or
level and has to move down for the option to become European exercise style.
activated.
For example, a European call option may be written on an
underlying with spot price of $100 and a knockout barrier
of $120. This option behaves in every way like a vanilla
European call, except if the spot price ever moves above
$120, the option knocks out and the contract is null and
void. Note that the option does not reactivate if the spot
price falls below $120 again. Once it is out, its out for
good. Also note that once its in, its in for good.
In-out parity is the barrier options answer to put-call parity. If we combine one in option and one out barrier
option with the same strikes and expirations, we get the
price of a vanilla option: C = Cin + Cout . A simple arbitrage argumentsimultaneously holding the in
and the out option guarantees that exactly one of the
two will pay o identically to a standard European option while the other will be worthless. The argument only
works for European options without rebate.

14.2.2

Barrier events

A barrier event occurs when the underlying crosses the

barrier level. While it seems straightforward to dene a
barrier event as underlying trades at or above a given
level, in reality its not so simple. What if the underlying
only trades at the level for a single trade? How big would

14.2.4 Valuation
The valuation of barrier options can be tricky, because
unlike other simpler options they are path-dependent
that is, the value of the option at any time depends not
just on the underlying at that point, but also on the path
taken by the underlying (since, if it has crossed the barrier, a barrier event has occurred). Although the classical
BlackScholes approach does not directly apply, several
more complex methods can be used:
The simplest way to value barrier options is to use a
static replicating portfolio of vanilla options (which
can be valued with BlackScholes), chosen so as to
mimic the value of the barrier at expiry and at selected discrete points in time along the barrier. This
approach was pioneered by Peter Carr and gives
closed form prices and replication strategies for all
types of barrier options, but usually only by assuming that the Black-Scholes model is correct. This
method is therefore inappropriate when there is a
volatility smile. For a more general but similar approach that uses numerical methods, see Derman,
E., D. Ergener & I. Kani. Static Options Replication. The Journal of Derivatives, 2(4) (Summer
1995), pp. 78-95.

14.4. SWAPTION
Another approach is to study the law of the maximum (or minimum) of the underlying. This approach gives explicit (closed form) prices to barrier
options.

301
Put on Put (PoP)
Put on Call (PoC

14.3.2 Compound Option Parity

Yet another method is the partial dierential equation (PDE) approach. The PDE satised by an out
barrier options is the same one satised by a vanilla 14.3.3 References
option under Black and Scholes assumptions, with
[1] Glossary of Option Terms: Caput Option
extra boundary conditions demanding that the option become worthless when the underlying touches [2] Split-Fee Option
the barrier.
[3] Compound Option

When an exact formula is dicult to obtain, barrier

options can be priced with the Monte Carlo option 14.3.4 External links
model. However, computing the Greeks (sensitivities) using this approach is numerically unstable.
Compound Options
A faster approach is to use Finite dierence methods for option pricing to diuse the PDE backwards
from the boundary condition (which is the terminal
payo at expiry, plus the condition that the value
along the barrier is always 0 at any time). Both
explicit nite-dierencing methods and the Crank
Nicolson scheme have their advantages.

Evaluation of compound options using perturbation

approximation
COMPOUND OPTION Calculator

14.4 Swaption

A swaption is an option granting its owner the right but

not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the
Online Calculators for Barrier Option - QuantCalc, term swaption typically refers to options on interest rate
Online Financial Math Calculator
swaps.

14.2.5

External links

An Overview of Barrier Options (PDF), Kevin There are two types of swaption contracts:
Cheng, global-derivatives.com
A payer swaption gives the owner of the swaption
the right to enter into a swap where they pay the xed
leg and receive the oating leg.

14.3 Compound option

A receiver swaption gives the owner of the swaption the right to enter into a swap in which they will
A compound option or split-fee option is an option on
receive the xed leg, and pay the oating leg.
an option.[1][2] The exercise payo of a compound option
involves the value of another option. A compound option
then has two expiration dates and two strike prices. Usu- In addition, a straddle refers to a combination of a really, compounded options are used for currency or xed ceiver and a payer option on the same underlying swap.
income markets where insecurity exists regarding the op- The buyer and seller of the swaption agree on:
tions risk protection. Another common business application that compound options are used for is to hedge bids
the premium (price) of the swaption
for business projects that may or may not be accepted.
length of the option period (which usually ends two
business days prior to the start date of the underlying
swap),
14.3.1 Variants
Compound options provide their owners with the right to
buy or sell another option. These options create positions
with greater leverage than do traditional options. There
are four basic types of compound options:[3]
Call on Call (CoC)
Call on Put (CoP) or caput option

the terms of the underlying swap, including:

notional amount (with amortization amounts, if any)
the xed rate (which equals the strike of the swaption)
the frequency of observation for the oating leg of
the swap (for example, 3 month Libor paid quarterly)

302

CHAPTER 14. COMBINATIONS, EXOTIC OPTIONS, OTHER DERIVATIVES, ETC.

14.4.1

The swaption market

The participants in the swaption market are predominantly large corporations, banks, nancial institutions and
hedge funds. End users such as corporations and banks
typically use swaptions to manage interest rate risk arising from their core business or from their nancing arrangements. For example, a corporation wanting protection from rising interest rates might buy a payer swaption. A bank that holds a mortgage portfolio might buy
a receiver swaption to protect against lower interest rates
that might lead to early prepayment of the mortgages. A
hedge fund believing that interest rates will not rise by
more than a certain amount might sell a payer swaption,
aiming to make money by collecting the premium. Major investment and commercial banks such as JP Morgan
Chase, Bank of America Securities and Citigroup make
markets in swaptions in the major currencies, and these
banks trade amongst themselves in the swaption interbank market. The market making banks typically manage
large portfolios of swaptions that they have written with
various counterparties. A signicant investment in technology and human capital is required to properly monitor
the resulting exposure. Swaption markets exist in most
of the major currencies in the world, the largest markets
being in U.S. dollars, euro, sterling and Japanese yen.
The swaption market is over-the-counter (OTC), i.e., not
traded on any exchange. Legally, a swaption is a contract granting a party the right to enter an agreement with
another counterparty to exchange the required payments.
The counterparties are exposed to each others failure to
make scheduled payments on the underlying swap, although this exposure is typically mitigated through the
use of collateral agreements whereby variation margin is
posted to cover the anticipated future exposure

14.4.2

Swaption styles

There are three main categories of Swaption, although

exotic desks may be willing to create customised types,
analogous to exotic options, in some cases. The standard
varieties are
Bermudan swaption, in which the owner is allowed
to enter the swap on multiple specied dates.
European swaption, in which the owner is allowed
to enter the swap only on the expiration date. These
are the standard in the marketplace.[1]
American swaption, in which the owner is allowed
to enter the swap on any day that falls within a range
of two dates.

14.4.3

Valuation

Compare: Bond option#Valuation

The valuation of swaptions is complicated in that the

at-the-money level is the forward swap rate, being the
forward rate that would apply between the maturity of
the option - time m - and the tenor of the underlying swap
such that the swap, at time m, would have an "NPV" of
zero; see swap valuation. Moneyness, therefore, is determined based on whether the strike rate is higher, lower,
or at the same level as the forward swap rate.
Addressing this, quantitative analysts value swaptions by
constructing complex lattice-based term structure and
short rate models that describe the movement of interest
rates over time.[2][3] However, a standard practice, particularly amongst traders, to whom speed of calculation is
more important, is to value European swaptions using the
Black model. For American- and Bermudan- styled options, where exercise is permitted prior to maturity, only
the lattice based approach is applicable.
To use the lattice based approach, the analyst constructs a tree of short rates - a zeroeth step consistent with todays yield curve and short rate
(caplet) volatility, and where the nal time step of
the tree corresponds to the date of the underlying
swaps maturity. Models commonly used here are
HoLee, Black-Derman-Toy and Hull-White. Using this tree, (1) the swap is valued at each node
by stepping backwards through the tree, where at
each node, its value is the discounted expected value
of the up- and down-nodes in the later time step,
added to which is the discounted value of payments
made during the time step in question, and noting
that oating payments are based on the short rate at
each tree-node. Then (2), the option is valued similar to the approach for equity options: at nodes in the
time-step corresponding to option maturity, value is
based on moneyness; at earlier nodes, it is the discounted expected value of the option at the up- and
down-nodes in the later time step, and, depending on
option style, of the swap value at the node. For both
steps, the discounting is at the short rate at the treenode in question. (Note that the Hull-White Model
returns a Trinomial Tree: the same logic is applied,
although there are then three nodes in question at
each point.) See Lattice model (nance) #Interest
rate derivatives.
In valuing European swaptions using the Black
model, the underlier is treated as a forward contract
on a swap. Here, as mentioned, the forward price
is the forward swap rate. The volatility is typically
read-o a two dimensional grid of at-the-money
volatilities as observed from prices in the Interbank
swaption market. On this grid, one axis is the time to
expiration and the other is the length of the underlying swap. Adjustments may then be made for moneyness; see Implied volatility surface under Volatility smile.

14.5. BOND PLUS OPTION

14.4.4

See also

Hedge (nance)

14.4.5

Notes

[1] J. Hobbs: Swaption strategies for pension plans, Blackrock, 2010

[2] Frank J. Fabozzi, CFA (15 January 1998). Valuation of
Fixed Income Securities and Derivatives. John Wiley &
Sons. pp. . ISBN 978-1-883249-25-0.
[3] Option valuation (PDF). Fall 2000. Retrieved May
2014.

14.4.6

References

Damiano Brigo, Fabio Mercurio (2001). Interest

Rate Models - Theory and Practice with Smile, Ination and Credit (2nd ed. 2006 ed.). Springer Verlag.
ISBN 978-3-540-22149-4.

303

14.5 Bond plus option

In nance, a Bond+Option is a capital guarantee product that provides an investor with a xed, predetermined
participation to an option. Buying the zero-coupon bond
ensures the guarantee of the capital, and the remaining
proceeds are used to buy an option.
As an example, we can consider a bond+call on 5 years,
with Nokia as an underlying. Say it is a USD currency
option, and that 5 year rates are 4.7%. That gives you
a zero-coupon bond price of ZCB(U SD, 5y, 4.7%) =
e50.047 0.7906 .
Say we are counting in units of $100. We then have to buy
$79.06 worth of bond to guarantee the 100 to be repaid
at maturity, and we have $20.94 to spend on an option.
Now the option price is unlikely to be exactly equal to
20.94 in this case, and it really depends on the underlying.
Say we are using the BlackScholes price for the call, and
that we strike the option at the money, the volatility is the
dening part here. A call on an underlying with implied
volatility of 25% will give you a BlackScholes price of
$15.7 while with a volatility of 45%, you'd have to pay
$21.76.

David F. Babbel (1996). Valuation of InterestSensitive Financial Instruments: SOA Monograph MFI96-1 (1st ed.). John Wiley & Sons. ISBN 978Hence the participation would be the proportion you can
1883249151.
get with the money you have.
Frank Fabozzi (1998). Valuation of xed income securities and derivatives (3rd ed.). John Wiley. ISBN
In the 25% vol case you get a 133% participation
978-1-883249-25-0.
In the 45% vol case, 96%.

14.4.7

External links

Theory
Longsta, Francis A., Pedro Santa-Clara, and Eduardo S. Schwartz. The Relative Valuation of Caps
and Swaptions: Theory and Empirical Evidence.

The alternative is to simply buy the bond, which would

return $126.49.

14.6 Cliquet

Blanco, Carlos, Josh Gray and Marc Hazzard. A cliquet option or ratchet option is an exotic option
Alternative Valuation Methods for Swaptions: The consisting of a series of consecutive forward start opDevil is in the Details.
tions.[1] The rst is active immediately. The second be Basic Fixed Income Derivative Hedging. Financial- comes active when the rst expires, etc. Each option is
struck at-the-money when it becomes active.[2]
edu.com.
Martingales and Measures: Blacks Model Dr. A cliquet is, therefore, a series of at-the-money options
but where the total premium is determined in advance. A
Jacqueline Henn-Overbeck, University of Basel
cliquet can be thought of as a series of pre-purchased at Black-Scholes and binomial valuation of swaptions the-money options. The payout on each option can either
(Advanced Fixed Income Analytics 4:5), Prof. D. be paid at the nal maturity, or at the end of each reset
Backus and Prof. S. Zin, New York University Stern period.
School of Business
Tools
Pricing a European Swaption By BDT Model, Dr.
Shing Hing Man, Thomson-Reuters' Risk Management
Black-Swaption XLS Spreadsheet, thomasho.com

14.6.1 Example
A three-year cliquet with reset dates each year would
have three payos. The rst would payo at the end
of the rst year and has the same payo as a normal
ATM option.

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CHAPTER 14. COMBINATIONS, EXOTIC OPTIONS, OTHER DERIVATIVES, ETC.

The second years payo has the same payo as a

two-year option, but with the strike price equal to
the stock price at the end of the rst year.
The third years payo has the same payo as a
three-year option, but with the strike price equal to
the stock price at the end of the second year.

14.6.2

14.7.2 Pricing
Usually, an equity-linked note can be thought of as a combination of a zero-coupon bond and an equity option with
appropriate prices. Indeed, the issuer of the note usually
covers the equity payout liability by purchasing an identical option. In some equity-linked notes, the payout structure is more complicated, resembling that of an exotic
option.

References

[1] Cliquet/Ratchet Options

[2] Riskglossary.com

14.7.3 See also

Convertible bond
Credit linked note

14.6.3

External links

Cliquet at Investopedia.com
Valuation of Cliquet Options by M.Shparber &
Sh.Reshe at www.global-derivatives.com

Exchangeable bond
Structured product

14.7.4 External links

Equity-Linked Notes: An Introduction

14.7 ELN

Are Structured Products Suitable for Retail Investors?

Equity-Linked Note (ELN) on Amex.com

Equity-linked note (ELN) is a debt instrument, usually

a bond, that diers from a standard xed-income security in that the nal payout is based on the return of the
underlying equity, which can be a single stock, basket of
stocks, or an equity index. Equity-linked notes are a type
of structured products.
Most equity-linked notes are not actively traded on the
secondary market and are designed to be kept to maturity.
However, the issuer or arranger of the notes may oer
to buy back the notes. Unlike the maturity payout, the
buy-back price before maturity may be below the amount
invested in rst place.

14.7.1

Payout

Equity Linked Note Structures article on Financialedu.com

14.8 Commodore option

A Commodore option is an exotic option consisting of
a number of digital barrier options that pay a coupon if a
pre-determined level of the Underlying or Basket of Underlyings is reached. Sometimes the digital barrier increases with the number of years since the trade began.
All of the options are active from the start of the trade.

14.8.1 Example

A typical ELN is principal-protected, i.e. the investor is A three year Commodore Option with annual barriers
guaranteed to receive 100% of the original amount in- would have three potential payos. The rst would pay
vested at maturity but receives no interest.
at the end of the rst year and would be dependent on
Usually, the nal payout is the amount invested, plus the the pre-determined barrier being reached or exceeded.
gain in the underlying stock or index times a note-specic For example, if the Underlying or Basket of Underlyings
participation rate, which can be more or less than 100%. reached or exceeded 102% of its initial level at the end of
For example, if the underlying equity gains 50% during year one, a coupon of 6% would be paid. At the end of
the investment period and the participation rate is 80%, year two, if the Underlying reached or exceeded 104% of
the investor receives 1.40 dollars for each dollar invested. its initial level, another 6% coupon would be paid. The
If the equity remains unchanged or declines, the investor coupon in the nal year would be 6% if the Underlying
still receives one dollar per dollar invested (as long as the reached or exceeded 106%. The coupon should exceed
issuer does not default). Generally, the participation rate the performance level of the Underlying, otherwise the
is better in longer maturity notes, since the total amount investor would achieve the same result by investing diof interest given up by the investor is higher.
rectly in the Underlying.

14.9. DELTA NEUTRAL

The name comes from the original Commodore option
that was linked to the performance of a leading UK Stock
Index. The coupons were 6% per annum and the barriers were 102% on the initial level of the index at the
end of year 1 increasing by 2% per annum for years 2, 3
and 4. The investor received 3 times the performance
the Stock Index, and this structure quickly gained the
nickname Commodore after the Commodore song
Once, Twice, Three Times a Lady

305
security, will be zero; see Hedge (nance). Since delta
measures the exposure of a derivative to changes in the
value of the underlying, a portfolio that is delta neutral
is eectively hedged. That is, its overall value will not
change for small changes in the price of its underlying
instrument.

14.9.3 Creating the position

Delta hedging - i.e. establishing the required hedge may be accomplished by buying or selling an amount of
14.9 Delta neutral
the underlier that corresponds to the delta of the portfolio.
By adjusting the amount bought or sold on new positions,
In nance, delta neutral describes a portfolio of related the portfolio delta can be made to sum to zero, and the
nancial securities, in which the portfolio value remains portfolio is then delta neutral. See Rational pricing #Delta
unchanged when small changes occur in the value of hedging.
the underlying security. Such a portfolio typically contains options and their corresponding underlying securi- Options market makers, or others, may form a delta neuties such that positive and negative delta components o- tral portfolio using related options instead of the underlyset, resulting in the portfolios value being relatively in- ing. The portfolios delta (assuming the same underlier)
sensitive to changes in the value of the underlying secu- is then the sum of all the individual options deltas. This
method can also be used when the underlier is dicult
rity.
to trade, for instance when an underlying stock is hard to
A related term, delta hedging is the process of setting or borrow and therefore cannot be sold short.
keeping the delta of a portfolio as close to zero as possible. In practice, maintaining a zero delta is very com- One example of delta neutral strategy is buying a deep
plex because there are risks associated with re-hedging in the money call and buying a deep in the money put
on large movements in the underlying stocks price, and option. Deep in the money call will have delta of 1 and
research indicates portfolios tend to have lower cash ows deep in the money put will have delta of 1. Hence their
deltas will cancel each other to some extent of stock price
if re-hedged too frequently.[1]
movement.

14.9.1

Nomenclature

14.9.4 Theory

The sensitivity of an options value to a change in the

The existence of a delta neutral portfolio was shown as
underlying stocks price.
part of the original proof of the BlackScholes model, the
V0 The initial value of the option.
rst comprehensive model to produce correct prices for
some classes of options. See Black-Scholes: Derivation.
V The current value of the option.
S0 The initial value of the underlying stock.

14.9.2

From the Taylor expansion of the value of an option, we

get the change in the value of an option, C(s) , for a
change in the value of the underlier ( ) :

Mathematical interpretation

Main article: Greeks (nance)

Delta measures the sensitivity of the value of an option to
changes in the price of the underlying stock assuming all
other variables remain unchanged.[2]

C(s + ) = C(s) + C (s) + 1/2 2 C (s) + ...

where C (s) = (delta) and
C (s) = (gamma); see Greeks
(nance).

Mathematically, delta is represented as partial derivative For any small change in the underlier, we can ignore the
V
S of the options fair value with respect to the price of second-order term and use the quantity to determine
the underlying security.
how much of the underlier to buy or sell to create a hedged
Delta is clearly a function of S, however Delta is also a portfolio. However, when the change in the value of the
function of strike price and time to expiry. [3]
underlier is not small, the second-order term, , cannot
Therefore, if a position is delta neutral (or, instanta- be ignored: see Convexity (nance).
neously delta-hedged) its instantaneous change in value, In practice, maintaining a delta neutral portfolio requires
for an innitesimal change in the value of the underlying continuous recalculation of the positions Greeks and re-

306

CHAPTER 14. COMBINATIONS, EXOTIC OPTIONS, OTHER DERIVATIVES, ETC.

balancing of the underliers position. Typically, this re- 14.10.3

balancing is performed daily or weekly.

References

[1] What Does Rainbow Option Mean?". investopedia.com.

Retrieved 2014-02-12.

14.9.5

References

[1] De Weert F. ISBN 0-470-02970-6 pp. 74-81

[2] http://www.quantprinciple.com/invest/index.php/docs/
quant_strategies/delta_neutral_hedging_strategies/
[3] http://www.quantprinciple.com/invest/index.php/docs/
quant_strategies/delta_neutral_hedging_strategies/

[2] Supported Equity Derivatives. mathworks.com. Retrieved 2014-02-12.

[3] Rainbow options

14.10.4 External links

PRICING RAINBOW OPTIONS

14.9.6

External links

Rainbow Options at Global-derivatives.com

Delta Hedging, investopedia.com

Rainbow options Mark Rubinstein

Theory & Application for Delta Hedging

Rainbow option calculator

Delta Neutral Hedging Strategies

14.10 Basket Options (Rainbow)

14.11 Low Exercise Price Option

A Low Exercise Price Option (LEPO) is an Australian

Stock
Exchange traded option with a low exercise price
Rainbow option is a derivative exposed to two or more
[1]
that
was
specically designed to be traded on margin. It
sources of uncertainty, as opposed to a simple option
is
a
European
style call option with a low exercise price
that is exposed to one source of uncertainty, such as the
of
$0.01
and
a
contract size of 100 shares to be delivered
price of underlying asset.
on exercise.
The premium is close to the whole share price, and
a trader only posts margin, not the full price. Both
Rainbow options are usually calls or puts on the best or the buyer and the seller are margined, all positions are
worst of n underlying assets, or options which pay the marked-to-market daily. LEPOs work like a futures conbest or worst of n assets.[2] The number of assets under- tract.
lying the option is called the number of colours of the
rainbow.[3] The options are often considered a correla14.11.1 History
tion trade since the value of the option is sensitive to the
correlation between the various basket components.
The Australian Stock Exchange started listing LEPO exRainbow options are used, for example, to value natural change traded options in 1995 to allow traders to trade
resources deposits. Such assets are exposed to two underlying shares on margin.
uncertaintiesprice and quantity.

14.10.1

Overview

Some simple options can be transformed into more complex instruments if the underlying risk model that the option reected does not match a future reality. In particular, derivatives in the currency and mortgage markets
have been subject to liquidity risk that was not reected
in the pricing of the option when sold.

14.10.2

Pricing and valuation

Rainbow options are usually priced using an appropriate

industry-standard model (such as BlackScholes) for each
individual basket component, and a matrix of correlation
coecients applied to the underlying stochastic drivers
for the various models. While degenerate cases have simpler solutions, the general case must be approached with
Monte Carlo methods.

14.11.2 Dierences from standard options

Several important dierences distinguish LEPOs from
standard exchange-traded options, and these dierences
have important implications for the pricing of LEPO.
The buyer of a LEPO does not pay the full amount
of the premium upfront.
Both buyer and seller of LEPOs involve ongoing
margin payments.
The buyer of a LEPO does not receive dividends or
obtain voting rights on the underlying shares until
the shares are transferred after exercise.
LEPOs are only available as call options.

14.12. FORWARD START OPTION

307

LEPOs have a very low exercise price and a high 14.11.4 References
premium close to the initial value of the underlying
1. Stephen A. Easton, Sean M. Pinder The Pricing of
shares.
Low Exercise Price Options http://www.agsm.edu.
LEPOs have only one exercise price per expiry
au/eajm/9812/pdf/easton.pdf
month.
2. Low Exercise Price Options Explanatory Booklet, ASX http://www.asx.com.au/products/pdf/
LEPOs may be over either shares or an index.
UnderstandingLEPOs.pdf

14.11.3

Pricing of Low Exercise Price Options

14.12

Forward start option

The current value of a contract is equal to the current

In nance, a forward start option is an option that starts
price of the underlying share compounded by the riskat a specied future date with an expiration date set furfree interest rate, less the accumulated value of any divither in the future.[1] A forward start option starts at a specdends, less the exercise price of $0.01.
ied date in the future; however, the premium is paid in
advance, and the time of expiration is established at the
r(n/365)
r(ny)/365
time the forward start option is purchased.[2] Since the asL0,1 = S0 e
De
X
set price at the start of this option is not known a priori,
where:
it is common to specify that the strike price will be set in
the future so that the option is initially at the money or
L0,1 = price of LEPO contract entered into at time a certain percentage in the money or out of the money.
0 for delivery at time 1;
This contract can be used to give an investor exposure to
forward volatility. Executive stock options can be viewed
S0 = price of underlying share at time 0;
as a type of forward start option. This is because a com r = risk-free rate of return;
pany commits to granting at-the-money options to employees in the future.[3]
n = number of days until contract maturity;
D = value of share dividends;
y = number of days until dividend is paid.
X = exercise price (equals $0.01);

A series of consecutive forward start options creates a

cliquet option.[2]

14.12.1 Valuation

To prove that above formula is correct, we'll calculate

In a BlackScholes model, the value of the forward-start
price using BlackScholes formula. The BlackScholes
option is proportional to the asset price. Therefore the
formula after modications to recognize that the prevalue of the forward-start option is a multiple of the curmium is paid at the expiry of the contract:
rent asset price, with that multiple depending on forward
volatility.
L0,1 = [S0 N (d1 ) Xern/365 N (d2 )]ern/365

14.12.2 References

where:
N(d) is cumulative probability distribution function for a
standard normal distribution.

[1] Musiela-Rutkowski: Martingale Methods in Financial

Modelling, 2nd Edition, page 197
[2] Riskglossary.com

ln(S0 /X) + (r + /2)(n/365)

n/365

d2 = d1 n/365

d1 =

[3] Spirn, Daniel. (March 31, 2008). Options, Futures,

Derivatives. School of Mathematics, University of
Minnesota. Retrieved from http://www.math.umn.edu/
~{}spirn/5076/Lecture16.pdf

For a LEPO an underlying price S0 is very big compare

to exercise price X. Because of that N (d1 ) is very close htpootp://w
to 1, with insignicant dierence. Thus LEPO price per
BlackScholes formula (without dividend) is

14.13 Binary option

L0,1 = S0 ern/365 X
and it matches our previous formula.

In nance, a binary option is a type of option in which

the payo can take only two possible outcomes, either

308

CHAPTER 14. COMBINATIONS, EXOTIC OPTIONS, OTHER DERIVATIVES, ETC.

some xed monetary amount (or a precise predened

quantity or units of some asset) or nothing at all (in contrast to ordinary nancial options that typically have a
continuous spectrum of payo). The two main types of
binary options are the cash-or-nothing binary option and
the asset-or-nothing binary option. The cash-or-nothing
binary option pays some xed amount of cash if the option expires in-the-money while the asset-or-nothing pays
the value of the underlying security. They are also called
all-or-nothing options, digital options (more common
in forex/interest rate markets), and xed return options
(FROs) (on the American Stock Exchange).[1]
For example, a purchase is made of a binary cash-ornothing call option on XYZ Corps stock struck at $100
with a binary payo of $1,000. Then, if at the future
maturity date, often referred to as an expiry date, the
stock is trading at above $100, $1,000 is received. If the
stock is trading below $100, no money is received. And
if the stock is trading at $100, the money is returned to
the purchaser.
The value of a digital option can be expressed in terms
of the probability of exceeding a certain value, that is,
the cumulative distribution function, which in the BlackScholes equation is the Gaussian. Due to the diculty
for market-makers to hedge binary options that are near
the strike price around expiry, these are much less liquid
than vanilla options. Dealers often replicate them using
vertical spreads, which provides a rough, inexact hedge.

Authority conrmed that in their view binary options fell

under the scope of the Markets in Financial Instruments
Directive (MiFID) 2004/39/EC. With this announcement
Malta became the second EU jurisdiction to regulate binary options as a nancial instrument, providers will now
have to gain a category 3 Investment Services licence and
conform to MiFIDs minimum capital requirements.[6]
Prior to this announcement it had been possible for rms
to operate from the jurisdiction provided the rm had a
valid Lottery and Gaming Authority licence.
In 2013, CySEC prevailed over the disreputable binary options brokers and communicated intensively with
traders in order to prevent the risks of using unregulated nancial services. On September 19, 2013, Cyprus
Securities and Exchange Commission (CySEC) sent out
a press release warning investors against binary options
broker TraderXP, CySEC stated that TraderXP is not and
has never been licensed by CySEC.[7] On October 18,
2013, CySEC released an investor warning about binary
options broker NRGbinary and its parent company NRG
Capital (CY) Ltd., stating that NRGbinary is not and has
never been licensed by CySEC.[8]

The Cypriot regulator also temporarily suspended the

license of the Cedar Finance on December 19, 2013.
The decision was taken by Cyprus Securities and Exchange Commission(CySEC) because the potential violations referenced appear to seriously endanger the interests of the companys customers and the proper functionThough binary options sometimes trade on regulated ex- ing of capital markets, as described in the ocial issued
changes, they are generally unregulated, trading on the press release.
internet, and prone to fraud.[1] The U.S. Securities and CySEC also issued a warning against binary option broExchange Commission (SEC) and Commodity Futures ker PlanetOption at the end of the year and another warnTrading Commission (CFTC) have issued a joint warn- ing against binary option broker LBinary on January 10,
ing to American investors regarding unregulated binary 2014, pointing out that it is not regulated by the Commission and the Commission has not received any notication
options.[2]
by any of its counterparts in other European countries to
the eect of this rm being a regulated provider.

14.13.1

Regulation and compliance

As far as penalties are concerned, the Cyprus regulator

imposed a penalty of 15,000 against ZoomTrader. OpOn non-regulated platforms, client money is not neces- tionBravo and ChargeXP were also nancially penalized.
sarily kept in a trust account, as required by government CySEC also indicated that it has voted to reject the Shortnancial regulation, and transactions are not monitored Option license application.[9]
by third parties in order to ensure fair play.[3]
The U.S. Commodity Futures Trading Commission
On May 3, 2012, the Cyprus Securities and Exchange
Commission (CySEC) announced a policy change regarding the classication of binary options as nancial instruments. The eect is that binary options platforms operating in Cyprus, where many of the platforms are based,
will have to be CySEC regulated within six months of
the date of the announcement. CySEC was the rst EU
MiFID-member regulator to treat binary options as nancial instruments.[4]
In March 2013, Maltas Financial Services Authority announced that binary options regulation would be
transferred away from Maltas Lottery and Gaming
Authority.[5] On 18 June 2013, Maltas Financial Services

(CFTC) oversees the regulation of futures, options, and

swaps trading in the United States. On June 6, 2013, the
CFTC and the U.S. Securities and Exchange Commission
jointly issued an Investor Alert to warn about fraudulent
promotional schemes involving binary options and binary
options trading platforms. At the same time they charged
Banc De Binary Ltd., a Cyprus-based company, with illegally selling binary options to U.S. investors.[10][11]
In the UK, the Department for Culture, Media and Sport
have written to the Gambling Commission suggesting binary options are to be reclassied from xed odds bets
to nancial instruments.[12] This would mean regulation
falls under the remit of the Financial Conduct Authority.

14.13. BINARY OPTION

309

This would be a signicant step in the regulation of bi- 14.13.4 Example of a binary options trade
nary options as FCA regulation would carry much more
weight both with European members and UK consumers. A trader who thinks that the EUR/USD price will close at
or above 1.2500 at 3:00 p.m. can buy a call option on that
outcome. A trader who thinks that the EUR/USD price
will close at or below 1.2500 at 3:00 p.m. can buy a put
option or sell a call option contract.
14.13.2 Criticism
These platforms may be considered by some as gaming
platforms rather than investment platforms because of
their negative cumulative payout (they have an edge over
the investor) and because they require little or no knowledge of the stock market to trade. According to Gordon
Pape, writing in Forbes, this sort of thing can quickly become addictive...no one, no matter how knowledgeable,
can consistently predict what a stock or commodity will
do within a short time frame.[13]

At 2:00 p.m. the EUR/USD price is 1.2490. The trader

believes this will increase, so he buys 10 call options for
EUR/USD at or above 1.2500 at 3:00 p.m. at a cost of
$40 each.
The risk involved in this trade is known. The traders
gross prot/loss follows the all or nothing principle. He
can lose all the money he invested, which in this case is
$40 x 10 = $400, or make a gross prot of $100 x 10
= $1,000. If the EUR/USD price will close at or above
1.2500 at 3:00 p.m. the traders net prot will be the payo at expiry minus the cost of the option: $1,000 $400
= $600.

The trader can also choose to liquidate (buy or sell in

order to close) his position prior to expiration, at which
point the option value is not guaranteed to be $100. The
In 2007, the Options Clearing Corporation proposed a
larger the gap between the spot price and the strike price,
[14]
rule change to allow binary options, and the Securities
the value of the option decreases, as the option is less
and Exchange Commission approved listing cash-orlikely to expire in the money.
[15]
nothing binary options in 2008.
In May 2008, the
American Stock Exchange (Amex) launched exchange- In this example, at 3:00 p.m. the spot has risen to 1.2505.
traded European cash-or-nothing binary options, and the The option has expired in the money and the gross payo
Chicago Board Options Exchange (CBOE) followed in is $1,000. The traders net prot is $600.
June 2008. The standardization of binary options allows
them to be exchange-traded with continuous quotations.

14.13.3

Exchange-traded binary options

Amex oers binary options on some ETFs and a few

highly liquid equities such as Citigroup and Google.
Amex calls binary options Fixed Return Options
(FROs); calls are named Finish High and puts are
named Finish Low. To reduce the threat of market
manipulation of single stocks, Amex FROs use a settlement index dened as a volume-weighted average of
trades on the expiration day. Amex and Donato A. Montanaro submitted a patent application for exchange-listed
binary options using a volume-weighted settlement index
in 2005.[16]
CBOE oers binary options on the S&P 500 (SPX) and
the CBOE Volatility Index (VIX).[17] The tickers for
these are BSZ[18] and BVZ, respectively.[19] CBOE only
oers calls, as binary put options are trivial to create synthetically from binary call options. BSZ strikes are at 5point intervals and BVZ strikes are at 1-point intervals.
The actual underlying to BSZ and BVZ are based on the
opening prices of index basket members.

14.13.5 BlackScholes valuation

In the BlackScholes model, the price of the option can
be found by the formulas below.[21] In fact, the Black
Scholes formula for the price of a vanilla call option (or
put option) can be interpreted by decomposing a call option into an asset-or-nothing call option minus a cash-ornothing call option, and similarly for a put the binary
options are easier to analyze, and correspond to the two
terms in the BlackScholes formula.
In these, S is the initial stock price, K denotes the strike
price, T is the time to maturity, q is the dividend rate, r
is the risk-free interest rate and is the volatility. denotes the cumulative distribution function of the normal
distribution,

1
(x) =
2

Both Amex and CBOE listed options have values between

$0 and $1, with a multiplier of 100, and tick size of $0.01, and,
and are cash settled.[17]

e 2 z dz.
1

In 2009, Nadex, a U.S.-based binary options provider

S

launched binary options on a range of forex, commodiln K

+ (r q + 2 /2)T

d
=
, d2 = d1 T .
[20]
1
ties and stock indices markets.
T

310

CHAPTER 14. COMBINATIONS, EXOTIC OPTIONS, OTHER DERIVATIVES, ETC.

Cash-or-nothing call

In case of a digital put (this is a put FOR/call DOM) paying out one unit of the domestic currency we get as present
This pays out one unit of cash if the spot is above the value,
strike at maturity. Its value now is given by,
P = erDOM T (d2 )
C = erT (d2 ).
Cash-or-nothing put

While in case of a digital call (this is a call FOR/put

DOM) paying out one unit of the foreign currency we get
as present value,

This pays out one unit of cash if the spot is below the
C = SerF OR T (d1 )
strike at maturity. Its value now is given by,

P = erT (d2 ).
Asset-or-nothing call

and in case of a digital put (this is a put FOR/call DOM)

paying out one unit of the foreign currency we get as
present value,
P = SerF OR T (d1 )

This pays out one unit of asset if the spot is above the
Skew
strike at maturity. Its value now is given by,
In the standard BlackScholes model, one can interpret
the premium of the binary option in the risk-neutral world
C = Se
(d1 ).
as the expected value = probability of being in-the-money
* unit, discounted to the present value. The Black
Scholes model relies on symmetry of distribution and igAsset-or-nothing put
nores the skewness of the distribution of the asset. MarThis pays out one unit of asset if the spot is below the ket makers adjust for such skewness by, instead of using a single standard deviation for the underlying asset
strike at maturity. Its value now is given by,
across all strikes, incorporating a variable one (K)
where volatility depends on strike price, thus incorporating the volatility skew into account. The skew matters
qT
P = Se
(d1 ).
because it aects the binary considerably more than the
regular options.
Foreign exchange
A binary call option is, at long expirations, similar to a
tight call spread using two vanilla options. One can model
Further information: Foreign exchange derivative
the value of a binary cash-or-nothing option, C, at strike
K, as an innitessimally tight spread, where Cv is a vanilla
European
call:[22][23]
If we denote by S the FOR/DOM exchange rate (i.e., 1
unit of foreign currency is worth S units of domestic currency) we can observe that paying out 1 unit of the doC (K ) Cv (K)
mestic currency if the spot at maturity is above or below C = lim v
0

the strike is exactly like a cash-or nothing call and put respectively. Similarly, paying out 1 unit of the foreign cur- Thus, the value of a binary call is the negative of the
rency if the spot at maturity is above or below the strike is derivative of the price of a vanilla call with respect to
exactly like an asset-or nothing call and put respectively. strike price:
Hence if we now take rF OR , the foreign interest rate,
rDOM , the domestic interest rate, and the rest as above,
dCv
we get the following results.
C=
dK
In case of a digital call (this is a call FOR/put DOM) paying out one unit of the domestic currency we get as present When one takes volatility skew into account, is a function of K :
value,
qT

C = erDOM T (d2 )

C=

Cv
Cv
dCv (K, (K))
=

dK
K
K

14.14. CHOOSER OPTION

311

The rst term is equal to the premium of the binary option [10] SEC Warns Investors About Binary Options and Charges
Cyprus-Based Company with Selling Them Illegally in
ignoring skew:
U.S.. Retrieved 23 May 2014.
[11] Binary Options and Fraud. Retrieved 23 May 2014.

Cv
(S(d1 ) KerT (d2 ))
=
= erT (d2 ) = Cnoskew
[12] Binary Options brokers to be regulated by the FCA. ReK
K
trieved 14 May 2015.

Cv

is the Vega of the vanilla call; K

is sometimes
called the skew slope or just skew. Skew is typically [13] Pape, Gordon (27 July 2010). Dont Gamble On Binary Options. Forbes.com. Archived from the original
negative, so the value of a binary call is higher when takon 2013-06-21. Retrieved 15 April 2011.
ing skew into account.

C = Cnoskew V egav Skew

14.13.6

Relationship to vanilla options

Greeks

[14] Securities and Exchange Commission, Release No. 3456471; File No. SR-OCC-2007-08, September 19, 2007.
Self-Regulatory Organizations; The Options Clearing
Corporation; Notice of Filing of a Proposed Rule Change
Relating to Binary Options.
[15] Frankel, Doris (9 June 2008). CBOE to list binary options on S&P 500, VIX. Reuters.

Since a binary call is a mathematical derivative of a vanilla [16] System and methods for trading binary options on an exchange, World Intellectual Property Organization ling.
call with respect to strike, the price of a binary call has
Wipo.int. Retrieved on 2013-01-12.
the same shape as the delta of a vanilla call, and the delta
of a binary call has the same shape as the gamma of a [17] BINARY OPTIONS ON SPXSM AND VIX.
vanilla call.
cboe.com

14.13.7

See also

Options strategies
Options spread
Options arbitrage
Synthetic position

14.13.8

References

[1] Binary Option Denition Investopedia. Retrieved 201306-30.

[2] Investor Alert Binary Options and Fraud (PDF). Securities Exchange Commission. Retrieved 20 November
2013.
[3] warning against unauthorised websites oering binary
options trading. AMF. Retrieved 14 January 2012.
[4] regarding the supervision of Binary Options (PDF). CySEC. 3 May 2012. Retrieved 4 June 2012.
[5] Gaming or Trading? That is the Question MFSA To
Regulate Binary Options as a Financial Product
[6] Malta The Next Cyprus? MFSA Announces Regulatory
Framework For Binary Options. Finance Magnates. July
18, 2013.
[7] Warning (PDF). Retrieved 27 March 2014.
[8] Warning (PDF). Retrieved 27 March 2014.
[9] The projects of the CySEC regulator in terms of binary
options in 2014. Retrieved 27 March 2014.

[18] SPX Binary Contract Specications. Cboe.com (201204-16). Retrieved on 2013-01-12.

[19] VIX Binary Contract Specications. Cboe.com (201204-16). Retrieved on 2013-01-12.
[20] Nadex 2009 Press Release. Retrieved September 20th,
2011. (PDF) . Retrieved on 2013-01-12.
[21] Hull, John C. (2005). Options, Futures and Other Derivatives. Prentice Hall. ISBN 0-13-149908-4.
[22] Breeden, D. T., & Litzenberger, R. H. (1978). Prices of
state-contingent claims implicit in option prices. Journal
of business, 621-651.
[23] Gatheral, J. (2006). The volatility surface: a practitioners
guide (Vol. 357). John Wiley & Sons.

14.13.9 External links

CFTC investor alert

14.14 Chooser option

In nance, a chooser option is a special type of option
contract. It gives the purchaser a xed period of time to
decide whether the derivative will be a European call or
put option.
In more detail, a chooser option has a specied decision
time t1 , where the buyer has to make the decision described above. Finally, at the expiration time t2 the option expires. If the buyer has chosen that it should be a
call option, the payout is max(S K, 0) . For the choice

312

CHAPTER 14. COMBINATIONS, EXOTIC OPTIONS, OTHER DERIVATIVES, ETC.

of a put option, the payout is max(K S, 0) . Here K the life of the option, and ST is the underlying assets
is the strike price of the option and S is the stock price at price at maturity T .
expiry.

14.15.2 Lookback option with xed strike

14.14.1

Replication

For stocks without dividend, the chooser option can be

replicated using one call option with strike price K and
expiration time t2 , and one put option with strike price
Ker(t2 t1 ) and expiration time t1 ;.[1]

14.14.2

References

[1] Yue-Kuen Kwok, Compound options

14.14.3

Bibliography

As for the standard European options, the options strike

price is xed. The dierence is that the option is not exercised at the price at maturity: the payo is the maximum
dierence between the optimal underlying asset price and
the strike. For the call option, the holder chooses to exercise at the point when the underlying asset price is at
its highest level. For the put option, the holder chooses to
exercise at the underlying assets lowest price. The payo functions for the lookback call and the lookback put,
respectively, are given by:

LCf ix = max(Smax K, 0), and LPf ix = max(KSmin , 0),

Yue-Kuen Kwok, Compound options (from Derivawhere Smax is the assets maximum price during the life
tives Week and Encyclopedia of Financial Engineerof the option, Smin is the assets minimum price during
ing and Risk Management)
the life of the option, and K is the strike price.

14.15 Lookback option

14.15.3 Arbitrage-free price of lookback

options with oating strike

Lookback options, in the terminology of nance, are a

type of exotic option with path dependency, among many
other kind of options. The payo depends on the optimal
(maximum or minimum) underlying assets price occurring over the life of the option. The option allows the
holder to look back over time to determine the payo.
There exist two kinds of lookback options: with oating
strike and with xed strike.

14.15.1

Using the BlackScholes model, and its notations, we

can price the European lookback options with oating
strike. The pricing method is much more complicated
than for the standard European options, and can be found
in Musiela.[1] Assume that there exists a continuouslycompounded risk-free interest rate r > 0 and a constant
stocks volatility > 0 . Assume that the time to maturity is T > 0 , and that we will price the option at time
t < T , although the life of the option started at time
Lookback option with oating zero. Dene = T t . Finally, set that

strike

As the name introduces it, the options strike price is oating and determined at maturity. The oating strike is the
optimal value of the underlying assets price during the
option life. The payo is the maximum dierence between the market assets price at maturity and the oating
strike. For the call, the strike price is xed at the assets
lowest price during the options life, and, for the put, it is
xed at the assets highest price. Note that these options
are not really options, as they will be always exercised
by their holder. In fact, the option is never out-of-themoney, which makes it more expensive than a standard
option. The payo functions for the lookback call and
the lookback put, respectively, are given by:

M = max Su , m = min Su and St = S.

0ut

0ut

Then, the price of the lookback call option with oating

strike is given by:

LCt = S(a1 (S, m))mer (a2 (S, m))

S 2
((a1 (S, m))er
2r

where

a1 (S, H) =

ln(S/H) + (r + 21 2 )

ln(S/H) + (r 21 2 )
a
(S,
H)
=
2
LCf loat = max(ST Smin , 0) = ST Smin , and LPf loat = max(Smax ST , 0)
= Smax ST ,= a1 (S, H)

where Smax is the assets maximum price during the life

ln(S/H) (r 12 2 )
2r

, with H > 0, S
= a1 (S, H)
of the option, Smin is the assets minimum price during a3 (S, H) =

14.17. CPPI

313

and where is the standardnormal cumulative

distribu- 14.16.2 Atlas Options
x2
a
tion function, (a) = 12 e 2 dx .
Atlas was a Titan who supported the Earth on his back.
Similarly, the price of the lookback put option with oatThe Atlas option is a call on the mean (or average) of a
ing strike is given by:
basket of stocks, with some of the best and worst performers removed. (Quessette 2002). Given n stocks
2S1 , S2 , ..., Sn in a basket, dene:
2r
S
LPt = S(a1 (S, M ))+M er (a2 (S, M ))+
((a1 (S, M ))er (M /S) 2 (a3 (S, M ))).
2r

14.15.4

t
R(1)
= min {

References

[1] Musiela, Mark; Rutkowski, Marek (November 25, 2004).

Martingale Methods in Financial Modelling. Springer.
ISBN 978-3-540-20966-9.

S1t S2t
Snt
,
,
...,
},
S10 S20
S1n

t
R(n)
= max {

S1t S2t
Snt
,
,
...,
},
S10 S20
Sn0

t
where R(i)
is the i-th smallest return, so that:

14.16 Mountain range

Mountain ranges are exotic options originally marketed
by Socit Gnrale in 1998. The options combine the
characteristics of basket options and range options by basing the value of the option on several underlying assets,
and by setting a time frame for the option.

t
t
t
t
R(2)
R(i)
R(n)
.
R(1)

The Atlas removes a xed number ( n1 ) of stocks from

the minimum ordering of the basket and a xed number (
n2 ) of stocks from the maximum ordering of the basket.
In a basket of n stocks, notice that ( n1 + n2 < n ), to
The mountain range options are further subdivided into leave at least one stock in the basket on which to compute
further types, depending on the specic terms of the op- the option payo. With a strike price K , the payo for
the Atlas option is:
tions. Examples include:
Altiplano - in which a vanilla option is combined
with a compensatory coupon payment if the underlying security never reaches its strike price during a
given period.

nn
2

T
R(j)

j=1+n1

n (n1 + n2 )

K)+ .

Annapurna - in which the option holder is rewarded

if all securities in the basket never fall below a cer- 14.16.3 Himalayan Options
tain price during the relevant time period
A Himalayan option with notional N , and maturity T
Atlas - in which the best and worst-performing secu- starts with a basket of m equities. The terms of the
rities are removed from the basket prior to execution contract will specify m payo times: t0 = 0 < t1 <
of the option
t2 < < tm = T . At payo time ti , i = 1 :
m , the percentage returns since inception of all equi Everest - a long-term option in which the option
ties currently in the basket are computed, and the eqholder gets a payo based on the worst-performing
uity with the largest return is noted; denote this equity
securities in the basket
by Ski , 1 k(
then makes the
i m . The derivative
)
Himalayan - based on the performance of the best payo: N max Ski ,ti Ski ,t0 , 0 , and Ski is removed
Ski ,t0
asset in the portfolio
from the basket. The procedure is repeated until maturity, at which time the nal payo occurs and the basket
Most mountain ranges cannot be priced using closed is emptied.
form formulae, and are instead valued through the use
of Monte Carlo simulation methods.

14.16.1

14.17 CPPI

Everest Options

Although Mount Everest is the highest point on earth, the

Everest option payo is on the worst performer in a basket of 10-25 stocks, with 10-15 year maturity. (Richard
Quessette 2002). Given n stocks, S1 , S2 , ..., Sn in a basST
ket, the payo for an Everest option is: mini=1...n ( Si0 ).
i

Constant proportion portfolio insurance (CPPI) is a

trading strategy that allows an investor to maintain an exposure to the upside potential of a risky asset while provide a capital guarantee against downside risk. The outcome of the CPPI strategy is somewhat similar to that
of buying a call option, but does not use option contracts.

314

CHAPTER 14. COMBINATIONS, EXOTIC OPTIONS, OTHER DERIVATIVES, ETC.

Thus CPPI is sometimes referred to as a convex strategy, periodic rebalancing of the portfolio to attempt to mainas opposed to a concave strategy like constant mix.
tain this.
CPPI products on a variety of risky assets have been
sold by nancial institutions, including equity indices and 14.17.2 Dynamic trading strategy
credit default swap indices. Constant proportion portfolio insurance (CPPI) was rst studied by Perold (1986)[1]
Rules
for xed-income instruments and by Black and Jones
(1987),[2] Black and Rouhani (1989),[3] and Black and
If the gap remains between an upper and a lower trigPerold for equity instruments.[4]
ger band (resp. releverage and deleverage triggers), the
In order to guarantee the capital invested, the seller of strategy does not trade. It eectively reduces transaction
portfolio insurance maintains a position in a treasury costs, but the drawback is that whenever a trade event to
bonds or liquid monetary instruments, together with a reallocate the weights to the theoretical values happen,
leveraged position in a risky asset, usually a market in- the prices have either shifted quite a bit high or low, redex. While in the case of a bond+call, the client would sulting in the CPPI eectively buying (due to leverage)
only get the remaining proceeds (or initial cushion) in- high and selling low.
vested in an option, bought once and for all, the CPPI
provides leverage through a multiplier. This multiplier is
Risks
set to 100 divided by the crash size (as a percentage) that
is being insured against.
As dynamic trading strategies assume that capital markets
For example, say an investor has a $100 portfolio, a oor trade in a continuous fashion, gap risk is the main concern
of $90 (price of the bond to guarantee his $100 at ma- of CPPI writer, since a sudden drop in the risky underlyturity) and a multiplier of 5 (ensuring protection against ing trading instrument(s) could reduce the overall CPPI
a drop of at most 20% before rebalancing the portfolio). net asset value below the value of the bond oor needed to
Then on day one, the writer will allocate (5 * ($100 guarantee the capital at maturity. In the models initially
$90)) = $50 to the risky asset and the remaining $50 to introduced by Black and Jones[2] Black & Rouhani,[3] this
the riskless asset (the bond). The exposure will be revised risk does not materialize: to measure it one needs to take
as the portfolio value changes, i.e., when the risky asset into account sudden moves (jumps) in prices.[5] Such sudperforms and with leverage multiplies by 5 the perfor- den price moves may make it impossible to shift the pomance (or vice versa). Same with the bond. These rules sition from the risky assets to the bond, leading the strucare predened and agreed once and for all during the life ture to a state where it is impossible to guarantee principal
of the product.
at maturity. With this feature being ensured by contract
with the buyer, the writer has to put up money of his own
to cover for the dierence (the issuer has eectively writ14.17.1 Some denitions
ten a put option on the structure NAV). Banks generally
charge a small protection or gap fee to cover this risk,
Bond oor
usually as a function of the notional leveraged exposure.
The bond oor is the value below which the value of the
CPPI portfolio should never fall in order to be able to 14.17.3 Practical CPPI
ensure the payment of all future due cash ows (including
notional guarantee at maturity).
In some CPPI structured products, the multipliers are
constant. Say for a 3 asset CPPI, we have a ratio of
Multiplier
x:y:100%-x-y as the third asset is the safe and riskless
equivalent asset like cash or bonds. At the end of each
Unlike a regular bond + call strategy which only allocates period, the exposure is rebalanced. Say we have a note
the remaining dollar amount on top of the bond value (say of $1 million, and the initial allocations are 100k, 200k,
the bond to pay 100 is worth 80, the remaining cash value and 700k. After period one, the market value changes to
is 20), the CPPI leverages the cash amount. The multi- 120k:80k:600k. We now rebalance to increase exposure
plier is usually 4 or 5, meaning you do not invest 80 in on the outperforming asset and reduce exposure to the
the bond and 20 in the equity, rather m*(100-bond) in worst-performing asset. Asset A is the best performer,
so its rebalanced to be left at 120k, B is the worst perthe equity and the remainder in the zero coupon bond.
former, to its rebalanced to 60k, and C is the remaining,
800k-120k-60k=620k. We are now back to the original
Gap
xed weights of 120:60:620 or ratio-wise 2:1:remaining.
A measure of the proportion of the equity part compared
to the cushion, or (CPPI-bond oor)/equity. Theoreti14.17.4
cally, this should equal 1/multiplier and the investor uses

References

14.19. EQUITY DERIVATIVE

315

Articles

Usually, the nal payout is the amount invested, plus the

gain in the underlying stock or index times a note-specic
[1] Andr F. Perold (August 1986). Constant Proportion participation rate, which can be more or less than 100%.
Portfolio Insurance, Harvard Business School.
For example, if the underlying equity gains 50% during
[2] Fischer Black; Robert W. Jones (Fall 1987). Simplify- the investment period and the participation rate is 80%,
ing Portfolio Insurance. The Journal of Portfolio Man- the investor receives 1.40 dollars for each dollar invested.
If the equity remains unchanged or declines, the investor
agement 14 (1): 4851. doi:10.3905/jpm.1987.409131.
still receives one dollar per dollar invested (as long as the
[3] Fischer Black and Ramine Rouhani (1989). Constant issuer does not default). Generally, the participation rate
Proportion Portfolio Insurance and the Synthetic Put Op- is better in longer maturity notes, since the total amount
tion: A Comparison, Institutional Investor focus on In- of interest given up by the investor is higher.
vestment Management.

[4] Fischer Black and Andr F. Perold (1992), Theory of

Constant Proportion Portfolio Insurance, Journal of Economic Dynamics and Control, 16(3-4): 403-426.
[5] Rama Cont and Peter Tankov (July 2009), Constant
Proportion Portfolio Insurance in Presence of Jumps in
Asset Prices, Mathematical Finance 19(3): 379401.
doi:10.1111/j.1467-9965.2009.00377.x

http://www.tstm.eu/index.php?option=com_
content&view=article&id=1&Itemid=7

14.18.2 Pricing
Usually, an equity-linked note can be thought of as a combination of a zero-coupon bond and an equity option with
appropriate prices. Indeed, the issuer of the note usually
covers the equity payout liability by purchasing an identical option. In some equity-linked notes, the payout structure is more complicated, resembling that of an exotic
option.

http://homepages.nyu.edu/~{}yr366/CPPI.doc Summary of the pricing and basic principles of

14.18.3
CPPI on HF
http://www.productinnovations.co.uk/knowledge/
CPPI.pdf - Overview of retail examples and
mechanics of CPPI

14.17.5

See also

Portfolio insurance

14.18 ELN
Equity-linked note (ELN) is a debt instrument, usually
a bond, that diers from a standard xed-income security in that the nal payout is based on the return of the
underlying equity, which can be a single stock, basket of
stocks, or an equity index. Equity-linked notes are a type
of structured products.
Most equity-linked notes are not actively traded on the
secondary market and are designed to be kept to maturity.
However, the issuer or arranger of the notes may oer
to buy back the notes. Unlike the maturity payout, the
buy-back price before maturity may be below the amount
invested in rst place.

See also

Convertible bond
Credit linked note
Exchangeable bond
Structured product

14.18.4 External links

Equity-Linked Notes: An Introduction
Are Structured Products Suitable for Retail Investors?
Equity-Linked Note (ELN) on Amex.com
Equity Linked Note Structures article on Financialedu.com

14.19 Equity derivative

In nance, 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
A typical ELN is principal-protected, i.e. the investor is far the most common equity derivatives, however there
guaranteed to receive 100% of the original amount in- are many other types of equity derivatives that are actively
traded.
vested at maturity but receives no interest.

14.18.1

Payout

316

14.19.1

CHAPTER 14. COMBINATIONS, EXOTIC OPTIONS, OTHER DERIVATIVES, ETC.

Equity options

other G12 country indices. Indices for OTC products are

broadly similar, but oer more exibility.

Main article: Option (nance)

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).

14.19.2

Warrants

Main article: Warrant (nance)

In nance, a warrant is a security that entitles the holder
to buy stock of the company that issued it at a specied
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.

14.19.3

Convertible bonds

Main article: Convertible bond

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), as the basket
denition is not standardized in the way that an equity
index is.
These are used normally for correlation trading.

Single-stock futures
Single-stock futures are exchange-traded futures contracts based on an individual underlying security rather
than a stock index. Their performance is similar to that
of the underlying equity itself, although as futures contracts they are usually traded with greater leverage. Another dierence is that holders of long positions in single
stock futures typically do not receive dividends and holders of short positions do not pay dividends. Single-stock
futures may be cash-settled or physically settled by the
transfer of the underlying stocks at expiration, although
in the United States only physical settlement is used to
avoid speculation in the market.......

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- Equity index swaps
and equity-like features. It can be used by investors to
obtain the upside of equity-like returns while protecting
An equity index swap is an agreement between two parties
the downside with regular bond-like coupons.
to swap two sets of cash ows on predetermined dates for
an agreed number of years. The cash ows will be an
equity index value swapped, for instance, with LIBOR.
14.19.4 Equity futures, options and swaps Swaps can be considered a relatively straightforward way
of gaining exposure to a required asset class. They can
Investors can gain exposure to the equity markets using also be relatively cost ecient......
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
Equity swap
the price of the underlying stock or stocks.
Main article: Equity swap
Stock market index futures
Main article: Stock market index future
Stock markets 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 well-established indices such as S&P 500, FTSE 100, DAX, CAC 40 and

An equity swap, like an equity index swap, is an agreement between two parties to swap two sets of cash ows.
In this case the cash ows will be the price of an underlying stock value swapped, for instance, with LIBOR. A
typical example of this type of derivative is the Contract
for dierence (CFD) where one party gains exposure to a
share price without buying or selling the underlying share
making it relatively cost ecient as well as making it relatively easy to transact.

14.21. INFLATION DERIVATIVES

14.19.5

Exchange-traded derivatives

Other examples of equity derivative securities include

exchange-traded funds and Intellidexes.

14.19.6

317

14.20.4 External links

Fund-linked Derivatives
Nomura wins Silver Award for Best Hedge-Fund
Linked Certicate

References

[1] Investopedia.comEquity derivatives

14.20 Fund derivative

14.21 Ination derivatives

In nance, ination derivative (or ination-indexed
derivatives) refers to an over-the-counter and exchangetraded derivative that is used to transfer ination risk from
one counterparty to another. See Exotic derivatives.

A fund derivative is a nancial structured product related to a fund, normally using the underlying fund to determine the payo. This may be a private equity fund,
mutual fund or hedge fund. Purchasers obtain exposure
to the underlying fund (or funds) whilst improving their
risk prole over a direct investment.

Typically, real rate swaps also come under this

bracket, such as asset swaps of ination-indexed bonds
(government-issued ination-indexed bonds, such as the
Treasury Ination Protected Securities, UK inationlinked gilt-edged securities (ILGs), French OATeis, Italian BTPeis, German Bundeis and Japanese JGBis are
prominent examples). Ination swaps are the linear form
of these derivatives. They can take a similar form to
14.20.1 Example
xed versus oating interest rate swaps (which are the
derivative form for xed rate bonds), but use a real rate
For example the purchaser may be attracted by a funds coupon versus oating, but also pay a redemption pickup
star manager, performance history or strategy, whilst im- at maturity (i.e., the derivative form of ination-indexed
proving their counter-party risk and getting leverage, cur- bonds).
rency hedging or a capital guarantee via the derivative.
Ination swaps are typically priced on a zero-coupon basis
(ZC) (like ZCIIS for example), with payment exchanged
at the end of the term. One party pays the compounded
14.20.2 Features
xed rate and the other the actual ination rate for the
term. Ination swaps can also be paid on a year-on-year
The structured product may be investible by retail clients
basis (YOY) (like YYIIS for example) where the yearor institutional investors that would not otherwise buy
on-year rate of change of the price index is paid, typically
the fund, because of its provision of safeguard features
yearly as in the case of most European YOY swaps, but
such as capital guarantees or the appointment of indealso monthly for many swapped notes in the US market.
pendent administrators to calculate the underlying funds
Even though the coupons are paid monthly, the ination
value and additional oversight mechanisms.
rate used is still the year-on-year rate.

14.20.3

Types

Typical fund derivatives might be a call option on a fund,

a CPPI on a fund, or a leveraged note on a fund. More
complicated structures might include auto-call features
guaranteeing that if the derivative reached a certain value
that value was locked in, on top of an initial minimum
value guarantee at issuance. Maturities might range from
three to ten years, or more rarely multiple decades. The
big players in this eld are investment banks such as
Barclays Investment Bank, BNP Paribas,TPG, Citigroup,
Credit Suisse, Deutsche Bank, Goldman Sachs, Morgan
Stanley, Socit Gnrale, UBS Investment Bank.

Options on ination including interest rate caps, interest

rate oors and straddles can also be traded. These are
typically priced against YOY swaps, whilst the swaption
is priced on the ZC curve.

Asset swaps also exist where the coupon payment of the

linker (ination bond) as well as the redemption pickup
at maturity is exchanged for interest rate payments expressed as a premium or discount to LIBOR for the relevant bond coupon period, all dates are co-terminus. The
redemption pickup is the above par redemption value in
the case of par/par asset swaps, or the redemption above
the proceeds notional in the case of the proceeds asset
swap. The proceeds notional equals the dirty nominal
price of the bond at the time of purchase and is used as
Fund derivatives have had explosive growth over the past the xed notional on the LIBOR leg.
10 years but are still a major growth area. New structures Real rate swaps are the nominal interest swap rate less the
are constantly being developed to suit market and client corresponding ination swap. As for modelling, the trend
opportunities.
has been either to provide :

318

CHAPTER 14. COMBINATIONS, EXOTIC OPTIONS, OTHER DERIVATIVES, ETC.

a model describing at the same time, nominal rates,

real rates and ination and representing the ination
as the exchange rate between nominal and real rates.
The rst type of model along these lines has been the
one of Jarrow and Yildirim.

[2] http://www.derivsource.com/articles/
pricing-partners-extends-significantly-its-inflation-module-market-standard
E2%80%9Cbbk%E2%80%9D-model, Pricing Partners
Extends Signicantly its Ination Module with the
Market Standard BBK Model, June 2009
[3] http://www.fabiomercurio.it/stochinf.pdf, Pricing Ina-

a market model that represent the ination like a

tion Indexed options with stochastic volatility, Fabio Merreal asset and uses similar ideas as the one of BGM
curio, Nicola Moreni, August 2005
to represent the ination returns. The rst type of
model along these lines has been the one of Blegrade, Benhamou, Koehler[1] that is commercially
14.22 PRDC
available in Pricing Partners modelling suite.[2] Another more advanced version has been the one of
A dual-currency note (DC) pays coupons in the investors
Fabio Mercurio and Nicola Moreni[3]
domestic currency with the notional in the issuers domestic currency. A reverse dual-currency note (RDC) is a
note which pays a foreign interest rate in the investors do14.21.1 External links
mestic currency. A power reverse dual-currency note
ISDA Ination Derivatives Denitions
(PRDC) is a structured product where an investor is seeking a better return and a borrower a lower rate by tak Hughston; Ination Derivatives
ing advantage of the interest rate dierential between two
economies. The power component of the name denotes
Jarrow & Yildirim; Pricing Treasury Ination Prohigher initial coupons and the fact that coupons rise as
tected Securities and Related Derivatives using an
the foreign exchange rate depreciates. The power feature
HJM Model Journal of Financial and Quantitative
comes with a higher risk for the investor, which characAnalysis, Vol. 38, No. 2, June 2003
terizes the product as leveraged carry trade. Cash ows
Huang & Cairns; Valuation and Hedging of LPI may have a digital cap feature where the rate gets locked
once it reaches a certain threshold. Other add-on features
Liabilities
include barriers such as knockouts and cancel provision
for the issuer. PRDCs are part of the wider Structured
Hoare Capital Markets LLP
Notes Market.[1]
Savvysoft prices ination derivatives
Print

14.22.1 Market

Brice Benaben; Ination-Linked Products: A The majority of investors are Japanese with 9 billion USD
Guide for Asset and Liability Managers Risk worth of notes issued in 2003 and the issued notional
increasing every year thereafter up until 2008 when it
Books, 2005. ISBN 1-904339-60-3.
sharply declined. Major participants in the market in Deacon, Mark, Andrew Derry, and Dariush Mir- clude issuers (usually Supranationals) of the notes under
fendereski; Ination-Indexed Securities: Bonds, their Euro Medium Term Note program. Also heavily inSwaps, and Other Derivatives (2nd edition, 2004) volved are PRDC swap hedgers - the major ones include
JPMorgan Chase, Nomura Securities Co., UBS InvestWiley Finance. ISBN 0-470-86812-0.
ment Bank, Deutsche Bank, Goldman Sachs, Citigroup,
Brigo, Damiano and Fabio Mercurio; Interest Rate Barclays Investment Bank, Credit Suisse, Bank of AmerModels -- Theory and Practice, with Smile, Ina- ica Merrill Lynch and Royal Bank of Scotland.
tion, and Credit (2nd edition, 2006) Springer Finance. ISBN 3-540-22149-2.

14.22.2 Payo and cashows

Canty, Paul and Markus Heider; Ination Markets:

A Comprehensive and Cohesive Guide (2012) Risk
The investor pays a coupon times a xed rate in currency
Books. ISBN 9781906348755.
c1 and receives a coupon times a xed rate in currency
c2 times current FX rate divided by the FX rate at the
inception of the deal. However, the cash ows are always
References
guaranteed to be positive for the investor. The investor,
therefore, has the option to receive cash ows making the
[1] http://papers.ssrn.com/sol3/papers.cfm?abstract_id=
576081, A Market Model for Ination by Nabyl Belgrade, payo similar to a Bermudan style FX option. The swap
Eric Benhamou, Etienne Koehler, January 2004
house is, thus, selling a series of Currency options with a

14.22. PRDC

319

oating rate as a premium; the rate is usually subtracted SABR Volatility Models, or models which allow mixing
with a spread.
of the two.
Nowadays, most dealers use a variant of the industrystandard LIBOR market model to price the PRDCs.
Inputs
Correlation constants between each factor. Those
correlation parameters are usually estimated historically or calibrated to market prices
FX volatility calibrated to FX Options and user inputs
IRS volatilities of each currency calibrated based on
IRS Swaptions and yield curves
Yield curve of money market rate1 and rate2 based
on deposit rates, futures prices and swap rates
Basis swap spread curves
Spot FX rate

14.22.4 Computation
Plain vanilla PRDCs can be broken down into a string of
vanilla options.
n
t=1

Xt
M AX(N FF X
r1t r2t (N 1), 0)
0

where

N = notional

For Callable PRDCs - which are not replicable - the

present value and the risks are now computed using quasiMonte Carlo simulations and can take several hours. The
same can be said of the TARN PRDCs and Chooser
PRDCs (which are also callable).

14.22.5 Hedging

A plain vanilla PRDC is exposed to the movements in

interest rates, FX, volatility (on both interest rates and
0 = deal the of start the at time
fx), correlation and basis. Those risks are hedged with
r1 = 0. time at xed are t every for rates of set A currency1.
of t at
rate
xedin each currency to reduce interest rate
interest
rate
swaps
risk,
interest
rate
r2 = 0. time at xed are t every for rates of set A currency2. of t at rate xedswaptions in each currency to reduce
interest rate volatility exposures, FX Options to reduce
F X = currency2 and currency1 between rate exchange FX volatility exposures and Basis swaps to reduce basis
risk. Correlation exposure can be partially hedged with
correlation swaps.
t = ow cash a of time

14.22.3

Model

The pricing of PRDCs used to be done using 3-factor

grid/lattice or Monte Carlo models where one factor represents the short rate in currency1; the second factor the
short rate in currency2; and the third factor the movement
in the FX rate between currency1 and currency2.
Model choice for the interest rate factors varies - for speed
reasons, popular choices are Hull-White model, BlackKarasinski model, and extended Cheyette Model.
FX model choice also varies among houses - popular
choices are Dupire-type local volatility models, stochastic

While such hedges are theoretically possible, there are a

lot of practical diculties, largely due to the following
situation. The owners of the PRDC notes, usually retail
investors, don't hedge their risks in the market. Only the
banks, which are all short the notes, actively hedge and
rebalance their positions. In other words, if there is a signicant move in FX, for example, all the PRDC books
will need the same kind of FX volatility rebalancing at
the same time. The note holders would be the natural
counterparty for the hedge, but they don't take part in
this market (similar to buyers of portfolio insurance in
1987). This situation often creates one way markets

320

CHAPTER 14. COMBINATIONS, EXOTIC OPTIONS, OTHER DERIVATIVES, ETC.

and sometimes liquidity squeeze situations in long term for real estate derivatives are: hedging positions, preFX volatilities, basis swaps or long end AUD interest rate investing assets and re-allocating a portfolio. The major
swaps.
products within real estate derivatives are: swaps, futures
The volume of PRDC notes issued has been so large that contracts, options (calls and puts) and structured prodthe hedging and rebalancing requirements far exceed the ucts. Each of these products can use a dierent real esavailable liquidity in several key markets. However ev- tate index. Further, each property type and region can be
ery model is derived under the assumption that there is used as a reference point for any real estate derivative.
sucient liquidity - in other words, they are potentially
mispricing the trades because in this market, a few of the
key standard BlackScholes assumptions (such as zero
transaction cost, unlimited liquidity, no jumps in price)
break down. No active secondary market ever existed for
PRDC and banks usually mark their books to some consensus level provided by an independent company. Anecdotal evidence indicates that nobody would show a bid
anywhere close to that consensus level.

14.23.1 Applications
Swap

The most basic form of real estate derivative is a swap

transaction, in which one investor, or one side, goes long
and the other side goes short (nance). An investor would
want to execute a swap if they thought that the market, or
sector, was likely to appreciate, in which case they would
14.22.6 PRDC during the Subprime Crisis go long. Alternatively, if an investors view was that the
market would depreciate from that point, they would go
PRDC has been the subject of much attention in the mar- short, or take the other side of that trade.
ket during the subprime mortgage crisis. By the nature of
the trade, investment banks hedging the risks for PRDC
structured note issuers will have a short cross gamma po- Options
sition between FX volatility, interest rate and FX. In a
volatile market where market parameters move in large One can apply options to real estate. A real estate Option
and correlated steps, investment banks are forced to re- is a contract based on a time horizon and an expected
balance their hedges at a loss, often daily.
property value. It is developed based on nancial options
In particular, when FX spot goes up, the hedger for a contracts and adopted to individual real estate assets.
PRDC note is expected to pay more coupons on a PRDC
note. Thus, the hedger is more likely to call the note, reducing the expected duration of the note. In this situation,
the hedger has to partially unwind the hedges done at the
inception of the PRDC note. For example, he would have
to pay swaps in the foreign currency. If FX spot moves in
a correlated fashion with the foreign currency swap rate
(that is, foreign currency swap rate increases as FX spot
increases), he would need to pay a higher swap rate as
FX spot goes up, and receive a lower swap rate as FX
spot goes down. This is an example of how the hedger of
a PRDC note is short cross gamma.

Call With the real estate call option, property owner

can sell an option in exchange for debt-free cash today.
Investor, who buys the real estate call option benets from
property price appreciation and price volatility.

Put With the real estate put option (Selling price decline insurance) investor can sell an option thus the investor underwrites price decline insurance. Property
owner, who buys the option, is protected against price deThis was the main driver behind the increased market cline of the property.
volatility in FX skew, long dated FX volatility, long dated
Japanese Yen and Australian dollar interest rate, especially during the last quarter of 2008.
14.23.2 Derivative eciencies
Owning real estate assets is costly, and the transaction
costs associated with purchasing commercial real estate
can be prohibitive. Typical transaction costs can equal
500 - 800 basis points per transaction. Industry estimates
[1] Structured Notes Market.
suggest that transaction costs for commercial real estate
easily surpass $10$12 billion annually. Since the US
real estate derivative market is new, the transaction costs
14.23 Real estate derivatives
are at this point variable. However, based on derivatives
in other markets, it is anticipated that the costs will be
A real estate derivative is a nancial instrument whose well below the 500-800 basis points required to invest in
value is based on the price of real estate. The core uses actual real estate.

14.22.7

References

14.24. SYNTHETIC UNDERLYING POSITION

14.23.3

Market growth

The market for real estate derivatives was long overdue.

Real Estate is the only major asset class that only recently
developed a derivatives market. According to the Pension
Real Estate Associations Plan Sponsor Research Report,
pension funds allocate approximately 6.0% of their assets
to real estate, making it one of the largest investable asset
classes, after equities and xed income. Because of the
signicant transactions costs involved with investing in
real estate, derivatives can improve the eciency of the
market.

321

14.24 Synthetic underlying position

In nance, a synthetic position is a way to create the
payo of a nancial instrument using other nancial instruments.
A synthetic position can be created by buying or selling
the underlying nancial instruments and/or derivatives.
If you buy several instruments which have the same
payo as investing in a share, you have a synthetic underlying position. In a similar way, a synthetic option position can be created.

For example, a position which is long a 60-strike call and

short a 60-strike put will always result in purchasing the
The market for US real estate derivatives, while in a underlying asset for 60 at exercise or expiration. If the
nascent stage, made signicant progress in 2007. There underlying asset is above 60, the call is in the money
are now a diverse set of indices and methodologies be- and will be exercised; if the underlying asset is below 60
ing used to create and structure real estate derivatives, for then the short put position will be assigned, resulting in a
(forced) purchase of the underlying at 60.
both residential and commercial real estate.
USA

One advantage of a synthetic position over buying or

shorting the underlying stock is: there is no need to borUK
row the stock if you are short selling it. Another advantage is that one need not worry about dividend payments
In the UK, the market for property derivatives did not on the shorted stock.(if any, declared by the underlying
begin until 2004. However, since the markets inception, security.)
the growth has been signicant. Through the third quarter
of 2007, trades with an outstanding notional value of 7.9 When the underlying asset is a stock, a synthetic underbillion pounds have been executed. The U.S. market is lying position is sometimes called a synthetic stock.
still emerging, and has been limited somewhat over the
last year by the global credit crunch and uncertain values
14.24.1 Synthetic long put
of mortgage-backed securities. However, the market in
the U.S. is now emerging quickly, with over $500 million
The synthetic long put position consists of three elements:
worth of transactions to date in 2007.
shorting one stock, holding one European call option and
holding KerT dollars in your bank account.
(Here K is the strike price of the option, and r is the
continuously compounded interest rate, T is the time to
Taking the AUD 139.5 billion in Australian residential expiration and S is the spot price of the stock at option
and commercial property sales recorded in 2006, and ap- expiration.)
plying a 1-to-1 derivatives-to-underlying ratio, the poten- At expiry you have to repay the stock, which gives a cashtial PD market would be larger than the $89 billion Aus- ow S . The bank account will give a cashow of K
tralian credit derivatives market. A 2-to-1 ratio would dollars. Moreover, the European call gives a cashow
make it more active than the $215 billion interest rate op- of max(0, S K) . The total cashow is K S +
tions sector, and a 3-to-1 ratio would put it within reach max(0, S K) = max(0, K S) . We see that the
of the $472 billion ASX options industry. [1]
total cashow at expiry is exactly the cashow of a EuroAustralia

RP Data-Rismark indices is regarded as the market leader pean put option.

of Australias Property Derivatives Market. [2]

14.24.2 References
14.23.4

References

[1] Australias Property Derivatives Market. Seek Estate. 2

June 2014.

14.25 Synthetic underlying position

[2] New ways to prot from Australian Property Boom.

Seek Estate. 2 June 2014.

In nance, a synthetic position is a way to create the

payo of a nancial instrument using other nancial in-

322

CHAPTER 14. COMBINATIONS, EXOTIC OPTIONS, OTHER DERIVATIVES, ETC.

struments.
A synthetic position can be created by buying or selling
the underlying nancial instruments and/or derivatives.
If you buy several instruments which have the same
payo as investing in a share, you have a synthetic underlying position. In a similar way, a synthetic option position can be created.
For example, a position which is long a 60-strike call and
short a 60-strike put will always result in purchasing the
underlying asset for 60 at exercise or expiration. If the
underlying asset is above 60, the call is in the money
and will be exercised; if the underlying asset is below 60
then the short put position will be assigned, resulting in a
(forced) purchase of the underlying at 60.
One advantage of a synthetic position over buying or
shorting the underlying stock is: there is no need to borrow the stock if you are short selling it. Another advantage is that one need not worry about dividend payments
on the shorted stock.(if any, declared by the underlying
security.)
When the underlying asset is a stock, a synthetic underlying position is sometimes called a synthetic stock.

14.25.1

Synthetic long put

The synthetic long put position consists of three elements:

shorting one stock, holding one European call option and
holding KerT dollars in your bank account.
(Here K is the strike price of the option, and r is the
continuously compounded interest rate, T is the time to
expiration and S is the spot price of the stock at option
expiration.)
At expiry you have to repay the stock, which gives a cashow S . The bank account will give a cashow of K
dollars. Moreover, the European call gives a cashow
of max(0, S K) . The total cashow is K S +
max(0, S K) = max(0, K S) . We see that the
total cashow at expiry is exactly the cashow of a European put option.

14.25.2

References

Chapter 15

Swaps
15.1 Swaps
A swap is a derivative in which two counterparties
exchange cash ows of one partys nancial instrument
for those of the other partys nancial instrument. The
benets in question depend on the type of nancial instruments involved. For example, in the case of a swap
involving two bonds, the benets in question can be the
periodic interest (coupon) payments associated with such
bonds. Specically, two counterparties agree to exchange one stream of cash ows against another stream.
These streams are called the legs of the swap. The swap
agreement denes the dates when the cash ows are to be
paid and the way they are accrued and calculated.[1] Usually at the time when the contract is initiated, at least one
of these series of cash ows is determined by an uncertain
variable such as a oating interest rate, foreign exchange
rate, equity price, or commodity price.[1]

The Bank for International Settlements (BIS) publishes

statistics on the notional amounts outstanding in the OTC
derivatives market. At the end of 2006, this was USD
415.2 trillion, more than 8.5 times the 2006 gross world
product. However, since the cash ow generated by
a swap is equal to an interest rate times that notional
amount, the cash ow generated from swaps is a substantial fraction of but much less than the gross world
productwhich is also a cash-ow measure. The majority of this (USD 292.0 trillion) was due to interest rate
swaps. These split by currency as:

The cash ows are calculated over a notional principal

amount. Contrary to a future, a forward or an option,
the notional amount is usually not exchanged between
counterparties. Consequently, swaps can be in cash or
collateral.
Swaps can be used to hedge certain risks such as interest The CDS and currency swap markets are dwarfed by the interest
rate risk, or to speculate on changes in the expected di- rate swap market. All three markets peaked in mid-2008.
Source: BIS Semiannual OTC derivatives statistics at endrection of underlying prices.[2]
December 2008

Swaps were rst introduced to the public in 1981

when IBM and the World Bank entered into a swap
agreement.[3] Today, swaps are among the most heavily
traded nancial contracts in the world: the total amount
of interest rates and currency swaps outstanding is more
thn $348 trillion in 2010, according to Bank for International Settlements (BIS).

15.1.1

Swap market

Most swaps are traded over-the-counter (OTC), tailormade for the counterparties. Some types of swaps are
also exchanged on futures markets such as the Chicago
Mercantile Exchange, the largest U.S. futures market, the
Chicago Board Options Exchange, IntercontinentalExchange and Frankfurt-based Eurex AG.

Source: The Global OTC Derivatives Market at endDecember 2004, BIS, , OTC Derivatives Market
Activity in the Second Half of 2006, BIS,

Usually, at least one of the legs has a rate that is variable.

It can depend on a reference rate, the total return of a
swap, an economic statistic, etc. The most important criterion is that it comes from an independent third party,
to avoid any conict of interest. For instance, LIBOR
is published by the British Bankers Association, an independent trade body but this rate is known to be rigged
(Barclays and others banks have been convicted in the
2010-2012 LIBOR scandal).

323

324

15.1.2

CHAPTER 15. SWAPS

Types of swaps

Currency swaps

The ve generic types of swaps, in order of their quantita- Main article: Currency swap
tive importance, are: interest rate swaps, currency swaps,
credit swaps, commodity swaps and equity swaps. There A currency swap involves exchanging principal and xed
are also many other types of swaps.
rate interest payments on a loan in one currency for principal and xed rate interest payments on an equal loan in
another currency. Just like interest rate swaps, the currency swaps are also motivated by comparative advantage.
Currency swaps entail swapping both principal and
Interest rate swaps
interest between the parties, with the cashows in one direction being in a dierent currency than those in the opMain article: Interest rate swap
posite direction. It is also a very crucial uniform pattern
The most common type of swap is a plain Vanilla in- in individuals and customers.
Commodity swaps
Main article: Commodity swap
A commodity swap is an agreement whereby a oating
(or market or spot) price is exchanged for a xed price
over a specied period. The vast majority of commodity
swaps involve crude oil.
A is currently paying oating, but wants to pay xed. B is currently paying xed but wants to pay oating. By entering into
an interest rate swap, the net result is that each party can 'swap'
their existing obligation for their desired obligation. Normally,
the parties do not swap payments directly, but rather each sets up
a separate swap with a nancial intermediary such as a bank.
In return for matching the two parties together, the bank takes a
spread from the swap payments.

Subordinated risk swaps

A subordinated risk swap (SRS), or equity risk swap, is a

contract in which the buyer (or equity holder) pays a premium to the seller (or silent holder) for the option to transfer certain risks. These can include any form of equity,
management or legal risk of the underlying (for example a
company). Through execution the equity holder can (for
terest rate swap. It is the exchange of a xed rate loan to example) transfer shares, management responsibilities or
a oating rate loan. The life of the swap can range from else. Thus, general and special entrepreneurial risks can
be managed, assigned or prematurely hedged. Those in2 years to over 15 years.
struments are traded over-the-counter (OTC) and there
The reason for this exchange is to take benet from are only a few specialized investors worldwide.
comparative advantage. Some companies may have comparative advantage in xed rate markets, while other companies have a comparative advantage in oating rate mar- Other variations
kets. When companies want to borrow, they look for
cheap borrowing, i.e. from the market where they have There are myriad dierent variations on the vanilla swap
comparative advantage. However, this may lead to a com- structure, which are limited only by the imagination of
pany borrowing xed when it wants oating or borrowing nancial engineers and the desire of corporate treasurers
oating when it wants xed. This is where a swap comes and fund managers for exotic structures.[1]
in. A swap has the eect of transforming a xed rate loan
into a oating rate loan or vice versa.
A total return swap is a swap in which party A pays
For example, party B makes periodic interest payments to
party A based on a variable interest rate of LIBOR +70
basis points. Party A in return makes periodic interest
payments based on a xed rate of 8.65%. The payments
are calculated over the notional amount. The rst rate is
called variable because it is reset at the beginning of each
interest calculation period to the then current reference
rate, such as LIBOR. In reality, the actual rate received
by A and B is slightly lower due to a bank taking a spread.

the total return of an asset, and party B makes periodic interest payments. The total return is the capital gain or loss, plus any interest or dividend payments. Note that if the total return is negative, then
party A receives this amount from party B. The parties have exposure to the return of the underlying
stock or index, without having to hold the underlying
assets. The prot or loss of party B is the same for
him as actually owning the underlying asset.

15.1. SWAPS

325

An option on a swap is called a swaption. These equivalent to a long position in a xed-rate bond (i.e. reprovide one party with the right but not the obliga- ceiving xed interest payments), and a short position in a
tion at a future time to enter into a swap.
oating rate note (i.e. making oating interest payments):
A variance swap is an over-the-counter instrument
that allows one to speculate on or hedge risks assoVswap = Bfixed Bfloating
ciated with the magnitude of movement, a CMS, is
a swap that allows the purchaser to x the duration From the point of view of the xed-rate payer, the swap
of received ows on a swap.
can be viewed as having the opposite positions. That is,
An Amortising swap is usually an interest rate swap
in which the notional principal for the interest payments declines during the life of the swap, perhaps
at a rate tied to the prepayment of a mortgage or to
an interest rate benchmark such as the LIBOR. It
is suitable to those customers of banks who want to
manage the interest rate risk involved in predicted
funding requirement, or investment programs.
A Zero coupon swap is of use to those entities
which have their liabilities denominated in oating
rates but at the same time would like to conserve
cash for operational purposes.
A Deferred rate swap is particularly attractive to
those users of funds that need funds immediately but
do not consider the current rates of interest very attractive and feel that the rates may fall in future.

Vswap = Bfloating Bfixed

Similarly, currency swaps can be regarded as having positions in bonds whose cash ows correspond to those in
the swap. Thus, the home currency value is:
Vswap = Bdomestic S0 Bforeign , where Bdomestic
is the domestic cash ows of the swap, Bforeign
is the foreign cash ows of the LIBOR is the
rate of interest oered by banks on deposit
from other banks in the eurocurrency market. One-month LIBOR is the rate oered for
1-month deposits, 3-month LIBOR for three
months deposits, etc.

LIBOR rates are determined by trading between banks

An Accrediting swap is used by banks which have and change continuously as economic conditions change.
agreed to lend increasing sums over time to its cus- Just like the prime rate of interest quoted in the domestomers so that they may fund projects.
tic market, LIBOR is a reference rate of interest in the
international market.
A Forward swap is an agreement created through
the synthesis of two swaps diering in duration
for the purpose of fullling the specic time-frame Arbitrage arguments
needs of an investor. Also referred to as a forward
start swap, delayed start swap, and a deferred start As mentioned, to be arbitrage free, the terms of a swap
contract are such that, initially, the NPV of these future
swap.
cash ows is equal to zero. Where this is not the case,
arbitrage would be possible.

15.1.3

Valuation

Further information: Rational pricing Swaps and

Arbitrage
The value of a swap is the net present value (NPV) of
all estimated future cash ows. A swap is worth zero
when it is rst initiated, however after this time its value
may become positive or negative.[1] There are two ways
to value swaps: in terms of bond prices, or as a portfolio
of forward contracts.[1]
Using bond prices
While principal payments are not exchanged in an interest rate swap, assuming that these are received and paid
at the end of the swap does not change its value. Thus,
from the point of view of the oating-rate payer, a swap is

For example, consider a plain vanilla xed-to-oating interest rate swap where Party A pays a xed rate, and Party
B pays a oating rate. In such an agreement the xed rate
would be such that the present value of future xed rate
payments by Party A are equal to the present value of
the expected future oating rate payments (i.e. the NPV
is zero). Where this is not the case, an Arbitrageur, C,
could:
1. assume the position with the lower present value of
payments, and borrow funds equal to this present
value
2. meet the cash ow obligations on the position by using the borrowed funds, and receive the corresponding payments - which have a higher present value
3. use the received payments to repay the debt on the
borrowed funds

326

CHAPTER 15. SWAPS

4. pocket the dierence - where the dierence between

the present value of the loan and the present value
of the inows is the arbitrage prot.

Bank for International Settlements

International Swaps and Derivatives Association

First take, Dodd-Franks SECs Cross-Border

Subsequently, once traded, the price of the Swap must
Derivatives Rule
equate to the price of the various corresponding instruments as mentioned above. Where this is not true, an
arbitrageur could similarly short sell the overpriced instrument, and use the proceeds to purchase the correctly 15.2 Swap rate
priced instrument, pocket the dierence, and then use
payments generated to service the instrument which he Swap rate is the xed rate that receiver demands in exis short.
change for the uncertainty of having to pay the short-term
LIBOR (oating) rate over time. At any given time, the
markets forecast of what LIBOR will be in the future is
15.1.4 See also
reected in the forward LIBOR curve. At the time of
the swap agreement, the total value of the swaps xed
Constant maturity swap
rate ows will be equal to the value of expected oating
rate payments implied by the forward LIBOR curve. As
Credit default swap
forward expectations for LIBOR change, so will the xed
Cross currency swap
rate that investors demand to enter into new swaps. Swaps
are typically quoted in this xed rate, or alternatively in
Equity swap
the swap spread, which is the dierence between the
swap rate and the U.S. Treasury bond yield (or equiva Foreign exchange swap
lent local government bond yield for non-U.S. swaps) for
the same maturity.
Fuel price risk management
Interest rate swap
PnL Explained
Swap Execution Facility
Total return swap

In most emerging markets with underdeveloped government bond markets, the swap curve is more complete than
the treasury yield curve, and is thus used as the benchmark curve.[1]

15.2.1 References

Variance swap
Yield curve

15.1.5

References

Financial Institutions Management, Saunders A. &

Cornett M., McGraw-Hill Irwin 2006
[1] John C Hull, Options, Futures and Other Derivatives (6th
edition), New Jersey: Prentice Hall, 2006, 149
[2] http://chicagofed.org/webpages/publications/
understanding_derivatives/index.cfm
[3] Ross, Westereld, & Jordan (2010). Fundamentals of
Corporate Finance (9th, alternate ed.). McGraw Hill. p.
746.

[1] Mathieson, Donald J; Schinasi, Garry J. International capital markets: developments, prospects, and key policy issues. International Monetary Fund. ISBN 1-55775-9499.

15.3 Variance swap

A variance swap is an over-the-counter nancial derivative that allows one to speculate on or hedge risks associated with the magnitude of movement, i.e. volatility, of
some underlying product, like an exchange rate, interest
rate, or stock index.

One leg of the swap will pay an amount based upon the
realised variance of the price changes of the underlying
product. Conventionally, these price changes will be daily
log returns, based upon the most commonly used closing
price. The other leg of the swap will pay a xed amount,
15.1.6 External links
which is the strike, quoted at the deals inception. Thus
Understanding Derivatives: Markets and Infrastruc- the net payo to the counterparties will be the dierence
ture Federal Reserve Bank of Chicago, Financial between these two and will be settled in cash at the expiration of the deal, though some cash payments will likely
Markets Group
be made along the way by one or the other counterparty
swaps-rates.com, interest swap rates statistics online to maintain agreed upon margin.

15.3. VARIANCE SWAP

15.3.1

Structure and features

327

15.3.2 Pricing and valuation

The features of a variance swap include:

the variance strike
the realized variance
the vega notional: Like other swaps, the payo is
determined based on a notional amount that is never
exchanged. However, in the case of a variance swap,
the notional amount is specied in terms of vega, to
convert the payo into dollar terms.

The variance swap may be hedged and hence priced using

a portfolio of European call and put options with weights
inversely proportional to the square of strike.[2][3]
Any volatility smile model which prices vanilla options
can therefore be used to price the variance swap. For example, using the Heston model, a closed-form solution
can be derived for the fair variance swap rate. Care must
be taken with the behaviour of the smile model in the
wings as this can have a disproportionate eect on the
price.

The payo of a variance swap is given as follows:

We can derive the payo of a variance swap using Itos

Lemma. We rst assume that the underlying stock is described as follows:

2
2
Nvar (realised
strike
)

dSt
St

where:

Applying Itos formula, we get:

)
(
2
d(log St ) = 2 dt + dZt

= dt + dZt

Nvar = variance notional (a.k.a. variance units),

dSt
St

2
realised
= annualised realised variance, and

Taking integrals, the total variance is:

)
(
(
)
T 2
T dSt
ST
1
2
Variance = T dt = T
ln S0
St

2
strike
= variance strike.[1]

The annualised realised variance is calculated based on

a prespecied set of sampling points over the period. It
does not always coincide with the classic statistical definition of variance as the contract terms may not subtract the mean. For example, suppose that there are
n+1 sample points S0 , S1 , ..., Sn . Dene, for i=1 to n,
Ri = ln(Si /Si-1 ), the natural log returns. Then
2
realised
=

A
n

n
i=1

Ri2

where A is an annualisation factor normally chosen to be

approximately the number of sampling points in a year
(commonly 252). It can be seen that subtracting the mean
return will decrease the realised variance. If this is done,
it is common to use n 1 as the divisor rather than n ,
corresponding to an unbiased estimate of the sample variance.

d(log St ) =

2
2

dt

We can see that the total variance consists of a rebalanced

hedge of S1t and short a log contract.
Using a static replication argument [4] , i.e., any twice
continuously dierentiable contract can be replicated using a bond, a future and innitely many puts and calls,
we can show that a short log contract position is equal to
being short a futures contract and a collection of puts and
calls:
(
)

ln SST
= STSS
+
(K ST )+ dK

K2 +

KS

(ST K)+ dK
K2

KS

Taking expectations and setting the value of the variance

swap equal to zero, we can rearrange the formula to solve
for the fair variance swap strike:
(

( )
S
(
)
1
2
Kvar = T rT SS0 erT 1 log SS0 + erT
K 2 P (K)dK +
0

It is market practice to determine the number of contract Where:

S0 is the initial price of the underlying security,
units as follows:
S > 0 is an arbitrary cuto,
K is the strike of the each option in the collection of options used.
Nvol
Nvar =
2strike
Often the cuto S is chosen to be the current forward
price S = F0 = S0 erT , in which case the fair variance
where Nvol is the corresponding vega notional for a swap strike can be written in the simpler form:
(
)
volatility swap.[1] This makes the payo of a variance
F
0 1
1
swap comparable to that of a volatility swap, another less K
2erT
var = T
K 2 P (K)dK +
K 2 C(K)dK
popular instrument used to trade volatility.
0
F0

328

CHAPTER 15. SWAPS

15.3.3

Uses

Many traders nd variance swaps interesting or useful for

their purity. An alternative way of speculating on volatility is with an option, but if one only has interest in volatility risk, this strategy will require constant delta hedging,
so that direction risk of the underlying security is approximately removed. What is more, a replicating portfolio of
a variance swap would require an entire strip of options,
which would be very costly to execute. Finally, one might
often nd the need to be regularly rolling this entire strip
of options so that it remains centered around the current
price of the underlying security.
The advantage of variance swaps is that they provide pure
exposure to the volatility of the underlying price, as opposed to call and put options which may carry directional
risk (delta). The prot and loss from a variance swap
depends directly on the dierence between realized and
implied volatility.[5]
Another aspect that some speculators may nd interesting is that the quoted strike is determined by the implied volatility smile in the options market, whereas the
ultimate payout will be based upon actual realized variance. Historically, implied variance has been above realized variance,[6] a phenomenon known as the Variance
risk premium, creating an opportunity for volatility arbitrage, in this case known as the rolling short variance
trade. For the same reason, these swaps can be used to
hedge Options on Realized Variance.

15.3.4

Related instruments

15.3.5

References

15.4 Forex swap

Not to be confused with Currency swap.
In nance, a foreign exchange swap, forex swap, or
FX swap is a simultaneous purchase and sale of identical
amounts of one currency for another with two dierent
value dates (normally spot to forward).[1] see Foreign exchange derivative. Foreign Exchange Swap allows sums
of a certain currency to be used to fund charges designated in another currency without acquiring foreign exchange risk. It permits companies that have funds in different currencies to manage them eciently.[2] swap contract: swap contract is an agreement between two parties to exchange a cash ow in one currency against a
cash ow in another currency according to predetermined
terms and conditions.

15.4.1 Structure
A foreign exchange swap has two legsa spot transaction and a forward transactionthat are executed simultaneously for the same quantity, and therefore oset each
other. Forward foreign exchange transactions occur if
both companies have a currency the other needs. It prevents negative foreign exchange risk for either party.[3]
Foreign exchange spot transactions are similar to forward
foreign exchange transactions in terms of how they are
agreed upon; however, they are planned for a specic date
in the very near future, usually within the same week.

It is also common to trade forward-forward, where both

Closely related strategies include straddle, volatility swap, transactions are for (dierent) forward dates.
correlation swap, gamma swap, conditional variance
swap, corridor variance swap, forward-start variance
swap, option on realized variance and correlation trading. 15.4.2 Uses
The most common use of foreign exchange swaps is for
institutions to fund their foreign exchange balances.

Once a foreign exchange transaction settles, the holder is

left with a positive (or long) position in one currency,
and a negative (or short) position in another. In order to
[2] Demeter, Derman, Kamal, Zou (1999). More Than collect or pay any overnight interest due on these foreign
You Ever Wanted To Know About Volatility Swaps. balances, at the end of every day institutions will close out
Goldman Sachs Quantitative Strategies Research Notes.
any foreign balances and re-institute them for the follow[3] Bossu, Strasser, Guichard (2005). Just What You Need ing day. To do this they typically use tom-next swaps,
To Know About Variance Swaps. JPMorgan Equity buying (or selling) a foreign amount settling tomorrow,
Derivatives report.
and then doing the opposite, selling (or buying) it back
[4] Carr, Madan (1998). Towards a Theory of Volatility settling the day after.
[1] Variance and Volatility Swaps. FinancialCAD Corporation. Retrieved 2009-09-29.

Trading. In Volatility: New Estimation Techniques for

Pricing Derivatives, R. Jarrow (ed.) RISK Publications,
London.
[5] Curnutt, Dean (February 2000). The Art of the Variance
Swap. Derivatives Strategy. Retrieved 2008-09-29.

The interest collected or paid every night is referred to as

the cost of carry. As currency traders know roughly how
much holding a currency position will make or cost on a
daily basis, specic trades are put on based on this; these
are referred to as carry trades.

[6] Carr, Wu (2007). Variance Risk Premia. AFA 2005

Philadelphia Meetings.

Companies may also use them to avoid foreign exchange

risk.

15.5. BASIS SWAP

329

15.4.4 Related instruments

Example:
A British Company may be long EUR from
sales in Europe but operate primarily in Britain
using GBP. However, they know that they
need to pay their manufacturers in Europe in
1 months time.
They could of course SPOT Sell their EUR and
buy GBP to cover their expenses in Britain, and
then in one month SPOT Buy EUR and sell
GBP to pay their business partners in Europe.
However, this exposes them to FX risk. If
Britain has nancial trouble and the EURGBP
exchange rate goes against them, they may
have to spend a lot more GBP to get the same
amount of EUR.
Therefore they create a 1M Swap, where they
Sell EUR and Buy GBP on SPOT and simultaneously Buy EUR and Sell GBP on a 1 Month
(1M) forward. This signicantly reduces their
risk as they know that they will be able to purchase EUR reliably, while still being able to use
the money for their domestic transactions in the
meantime.

15.4.3

A foreign exchange swap should not be confused with a

currency swap, which is a rarer long-term transaction governed by dierent rules.

15.4.5 See also

Cross currency swap
Foreign exchange market
Forward exchange rate
Interest rate parity
Overnight indexed swap

15.4.6 References
[1] Reuters Glossary, FX Swap
[2] Foreign Exchange Swap Transaction
[3] Forward Currency Contract

15.5 Basis swap

Pricing

A basis swap is an interest rate swap which involves the

exchange of two oating rate nancial instruments. A baMain article: Interest rate parity
sis swap functions as a oating-oating interest rate swap
under which the oating rate payments are referenced to
The relationship between spot and forward is known as dierent bases.
the interest rate parity, which states that
(
F =S

1 + rd T
1 + rf T

15.5.1 Usage of basis swaps for hedging

)
,

where
F = forward rate
S = spot rate
r = simple interest rate of the term currency
r = simple interest rate of the base currency
T = tenor (calculated according to the appropriate
day count convention)
The forward points or swap points are quoted as the difference between forward and spot, F - S, and is expressed
as the following:

Basis risk occurs for positions that have at least one paying
and one receiving stream of cash ows that are driven by
dierent factors and the correlation between those factors
is less than one. Entering into a Basis Swap may oset
the eect of gains or losses resulting from changes in the
basis, thus reducing basis risk.
1. against exposure to currency uctuations (for example, 1 mo USD LIBOR for 1 mo GBP LIBOR)
2. against one index in the favor of another (for example, 1 mo USD T-bill for 1 mo USD LIBOR)
3. dierent points on a yield curve (for example, 1 mo
USD LIBOR for 6 mo USD LIBOR)

)
15.5.2 Basis swaps in energy commodities
S(rd rf )T
1 + rd T
1 =
S (rd rf ) T,
1 + rf T
1 + rf T
In energy markets, a basis swap is a swap on the price
if rf T is small. Thus, the value of the swap points is dierential for a product and a major index product (e.g.
roughly proportional to the interest rate dierential.
Brent Crude or Henry Hub gas).
(

F S = S

330

15.5.3

CHAPTER 15. SWAPS

See also

Interest rate swap

15.7 Currency swap

Not to be confused with Foreign exchange swap.

Basis trading

15.6 Constant maturity swap

A constant maturity swap, also known as a CMS, is
a swap that allows the purchaser to x the duration of
received ows on a swap.
The oating leg of an interest rate swap typically resets
against a published index. The oating leg of a constant
maturity swap xes against a point on the swap curve on
a periodic basis.
A constant maturity swap is an interest rate swap where
the interest rate on one leg is reset periodically, but with
reference to a market swap rate rather than LIBOR. The
other leg of the swap is generally LIBOR, but may be a
xed rate or potentially another constant maturity rate.
Constant maturity swaps can either be single currency or
cross currency swaps. Therefore, the prime factor for a
constant maturity swap is the shape of the forward implied yield curves. A single currency constant maturity
swap versus LIBOR is similar to a series of dierential
interest rate xes (or DIRF) in the same way that an
interest rate swap is similar to a series of forward rate
agreements. Valuation of constant maturity swaps depend on volatilities of dierent forward rates and therefore requires a stochastic yield curve model or some approximated methodology like a convexity adjustment, see
for example Brigo and Mercurio (2006).

15.6.1

Example

A customer believes that the six-month LIBOR rate will

fall relative to the three-year swap rate for a given currency. To take advantage of this curve steepening, he
buys a constant maturity swap paying the six-month LIBOR rate and receiving the three-year swap rate.

15.6.2

References

Damiano Brigo and Fabio Mercurio (2006).

Interest-Rate Models: Theory and Practice - with
Smile, Ination and Credit, Springer Verlag, 2nd
ed. 2006.
Constant Maturity Swaps, Forward Measure and LIBOR Market Model, Dariusz Gatarek.

15.6.3

External links

Interest Rate Exotics: The Gamma Trap Risk Magazine (2006), Navroz Patel

A currency swap is a foreign-exchange agreement between two institutions to exchange aspects (namely the
principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present
value loan in another currency; see foreign exchange
derivative. Currency swaps are motivated by comparative
advantage.[1] A currency swap should be distinguished
from interest rate swap, for in currency swap, both principal and interest of loan is exchanged from one party to
another party for mutual benets.[2]

15.7.1 Structure
Currency swaps are over-the-counter derivatives, and are
closely related to interest rate swaps. However, unlike
interest rate swaps, currency swaps can involve the exchange of the principal.[1] There are three dierent ways
in which currency swaps can exchange loans:
1. The simplest currency swap structure is to exchange
only the principal with the counterparty at a specied point in the future at a rate agreed now. Such
an agreement performs a function equivalent to a
forward contract or futures. The cost of nding
a counterparty (either directly or through an intermediary), and drawing up an agreement with
them, makes swaps more expensive than alternative
derivatives (and thus rarely used) as a method to x
shorter term forward exchange rates. However for
the longer term future, commonly up to 10 years,
where spreads are wider for alternative derivatives,
principal-only currency swaps are often used as a
cost-eective way to x forward rates. This type of
currency swap is also known as an FX-swap.[3]
2. Another currency swap structure is to combine the
exchange of loan principal, as above, with an interest rate swap. In such a swap, interest cash ows are
not netted before they are paid to the counterparty
(as they would be in a vanilla interest rate swap) because they are denominated in dierent currencies.
As each party eectively borrows on the others behalf, this type of swap is also known as a back-toback loan.[3]
3. Last here, but certainly not least important, is to
swap only interest payment cash ows on loans of
the same size and term. Again, as this is a currency
swap, the exchanged cash ows are in dierent denominations and so are not netted. An example of
such a swap is the exchange of xed-rate US dollar interest payments for oating-rate interest payments in Euro. This type of swap is also known as a

15.7. CURRENCY SWAP

331

cross-currency interest rate swap, or cross currency the 100 million to the swap bank who will pass it on to
swap.[4]
the U.S. Piper Company to nance the construction of its
British distribution center. The Piper Company will issue
5-year $150 million bonds. The Piper Company will then
15.7.2 Uses
pass the $150 million to swap bank that will pass it on to
the British Petroleum Company who will use the funds to
Currency swaps have three main uses:
nance the construction of its U.S. renery.
To secure cheaper debt (by borrowing at the best
Agreement 2:
available rate regardless of currency and then swapping for debt in desired currency using a back-to- The British company, with its U.S. asset (renery), will
back-loan).[3]
pay the 10% interest on $150 million ($15 million) to
To hedge against (reduce exposure to) exchange rate the swap bank who will pass it on to the American company so it can pay its U.S. bondholders. The American
uctuations.[3]
company, with its British asset (distribution center), will
To defend against nancial turmoil by allowing a pay the 7.5% interest on 100 million ((.075)( 100m) =
country beset by a liquidity crisis to borrow money 7.5 million), to the swap bank who will pass it on to the
British company so it can pay its British bondholders.
from others with its own currency.
Hedging example
For instance, a US-based company needing to borrow
Swiss francs, and a Swiss-based company needing to borrow a similar present value in US dollars, could both reduce their exposure to exchange rate uctuations by arranging either of the following:

Agreement 3:
At maturity, the British company will pay $150 million
to the swap bank who will pass it on to the American
company so it can pay its U.S. bondholders. At maturity,
the American company will pay 100 million to the swap
bank who will pass it on to the British company so it can
pay its British bondholders.

If the companies have already borrowed in the currencies each needs the principal in, then exposure is 15.7.4 Abuses
reduced by swapping cash ows only, so that each
companys nance cost is in that companys domes- In the 1990s Goldman Sachs and other US banks oered
tic currency.
Mexico, currency swaps and loans using Mexican oil reserves as collateral and as a means of payment.
Alternatively, the companies could borrow in their
own domestic currencies (and may well each have The collateral of Mexican oil was valued at $23.00 per
comparative advantage when doing so), and then barrel.
get the principal in the currency they desire with a In May 2011, Charles Munger of Berkshire Hathaway
principal-only swap.
Inc. accused international investment banks of facilitating market abuse by national governments. For example,
Goldman Sachs helped Greece raise $1 billion of o15.7.3 Examples
balance-sheet funding in 2002 through a currency swap,
allowing the government to hide debt.[5] Greece had preSuppose the British Petroleum Company plans to issue
viously succeeded in getting clearance to join the euro on
ve-year bonds worth 100 million at 7.5% interest, but
1 January 2001, in time for the physical launch in 2002,
actually needs an equivalent amount in dollars, $150 milby faking its decit gures.[6]
lion (current $/ rate is $1.50/), to nance its new rening facility in the U.S. Also, suppose that the Piper Shoe
Company, a U. S. company, plans to issue $150 million 15.7.5 History
in bonds at 10%, with a maturity of ve years, but it really needs 100 million to set up its distribution center in Currency swaps were originally conceived in the 1970s to
London. To meet each others needs, suppose that both circumvent foreign exchange controls in the United Kingcompanies go to a swap bank that sets up the following dom. At that time, UK companies had to pay a premium
agreements:
to borrow in US Dollars. To avoid this, UK companies
set up back-to-back loan agreements with US companies
wishing to borrow Sterling.[7] While such restrictions on
currency exchange have since become rare, savings are
The British Petroleum Company will issue 5-year 100 still available from back-to-back loans due to comparative
million bonds paying 7.5% interest. It will then deliver advantage.
Agreement 1:

332

CHAPTER 15. SWAPS

The rst formal currency swap, as opposed to the then

used parallel loans structure, was transacted by Citicorp
International Bank for a $US100,000,000 10 year US
Dollar Sterling swap between Mobil Oil Corporation and
General Electric Corporation Ltd (UK). The concept of
the interest rate swap was developed by the Citicorp International Swap unit but cross-currency interest rate swaps
were introduced by the World Bank in 1981 to obtain
Swiss francs and German marks by exchanging cash ows
with IBM. This deal was brokered by Salomon Brothers
with a notional amount of $210 million and a term of over
ten years.[8]
During the global nancial crisis of 2008, the currency
swap transaction structure was used by the United States
Federal Reserve System to establish central bank liquidity swaps. In these, the Federal Reserve and the central
bank of a developed[9] or stable emerging[10] economy
agree to exchange domestic currencies at the current prevailing market exchange rate & agree to reverse the swap
at the same exchange rate at a xed future date. The
aim of central bank liquidity swaps is to provide liquidity in U.S. dollars to overseas markets.[11] While central bank liquidity swaps and currency swaps are structurally the same, currency swaps are commercial transactions driven by comparative advantage, while central
bank liquidity swaps are emergency loans of US Dollars
to overseas markets, and it is currently unknown whether
or not they will be benecial for the Dollar or the US in
the long-term.[12]

Wales (Milton Keynes). 2008 [2007]. pp. 4623. ISBN

978-1-84152-569-3.
[4] http://www.isda.org/educat/faqs.html#22
[5] Wall Street Bankers Share Blame for Europe Crisis, Berkshires Munger Says Bloomberg, 2 May 2011
[6] Greece admits fudging euro entry, BBC
[7] Coyle, Brian (2000-05-30). Currency Swaps. ISBN
9780852974360.
[8] http://faculty.london.edu/ruppal/zenSlides/zCH10%
20Swaps.slide.doc
[9] http://www.federalreserve.gov/newsevents/press/
monetary/20081029b.htm
[10] Chan, Fiona (2008-10-31). Fed swap line for S'pore.
The Straits Times. Retrieved 2008-10-31.
[11] http://www.federalreserve.gov/monetarypolicy/bst_
liquidityswaps.htm
[12] http://www.moslereconomics.com/2009/04/13/
fed-foreign-currency-swap-lines/
[13] http://www.chinadaily.com.cn/china/2009-03/31/
content_7635007.htm

The Peoples Republic of China has multiple year currency swap agreements of the Renminbi with Argentina, [14] China signs 700 mln yuan currency swap deal with
Uzbekistan. Reuters. 2011-04-19.
Belarus, Brazil, Hong Kong, Iceland, Indonesia,
Malaysia, Singapore, South Korea, United Kingdom and
Uzbekistan that perform a similar function to central [15] http://uzpedia.blogspot.com/2011/04/
uzbekistan-signs-currency-swap-deal.html
bank liquidity swaps.[13][14][15][16][17]
South Korea and Indonesia signed a won-rupiah currency
swap deal worth US$10 billion in October, 2013. The
two nations can exchange up to 10.7 trillion won or 115
trillion rupiah for three years. The three-year currency
swap could be renewed if both sides agree at the time of
expiration. It is anticipated to promote bilateral trade and
strengthen nancial cooperation for the economic development of the two countries. The arrangement also ensures the settlement of trade in local currency between the
two countries even in times of nancial stress to support
regional nancial stability. As of 2013, South Korea imported goods worth $13.2 billion from Indonesia, while
its exports reached $11.6 billion.

15.7.6

References

[1] http://www.finpipe.com/currswaps.htm
[2] http://chicagofed.org/webpages/publications/
understanding_derivatives/index.cfm
[3] Financial Management Study Manual - ICAEW (second
ed.). Institute of Chartered Accountants in England &

[16] http://www.ft.com/intl/cms/s/0/
015f526a-bc07-11e1-9aff-00144feabdc0.html
[17] UK and China in 21bn currency swap deal. BBC News.
2013-06-23.

18.
^ http://www.reuters.com/article/2013/04/13/
us-china-france-currency-idUSBRE93C01S20130413

15.7.7 External links

Understanding Derivatives: Markets and Infrastucture Federal Reserve Bank of Chicago, Financial
Markets Group
Bank of England announces Peoples Bank of China
swap line, June 2013
Peoples Bank of China's second-biggest swap line
with European Central Bank, October 2013

15.8. EQUITY SWAP

15.8 Equity swap

333
portfolio to have exposure to the equity markets either as
a hedge or a position. The portfolio manager would enter
into a swap in which he would receive the return of the
S&P 500 and pay the counterparty a xed rate generated
form his portfolio. The payment the manager receives
will be equal to the amount he is receiving in xed-income
payments, so the managers net exposure is solely to the
S&P 500. These types of swaps are usually inexpensive
and require little in term of administration.

An equity swap is a nancial derivative contract (a swap)

where a set of future cash ows are agreed to be exchanged between two counterparties at set dates in the future. The two cash ows are usually referred to as legs
of the swap; one of these legs is usually pegged to a
oating rate such as LIBOR. This leg is also commonly
referred to as the oating leg. The other leg of the swap
is based on the performance of either a share of stock or
a stock market index. This leg is commonly referred to
as the equity leg. Most equity swaps involve a oating 15.8.2 Applications
leg vs. an equity leg, although some exist with two equity
Typically equity swaps are entered into in order to avoid
legs.
transaction costs (including Tax), to avoid locally based
An equity swap involves a notional principal, a specied dividend taxes, limitations on leverage (notably the US
tenor and predetermined payment intervals.
margin regime) or to get around rules governing the parEquity swaps are typically traded by Delta One trading ticular type of investment that an institution can hold.
desks.
Equity swaps also provide the following benets over
plain vanilla equity investing:

15.8.1

Examples

Parties may agree to make periodic payments or a single

payment at the maturity of the swap (bullet swap).
Take a simple index swap where Party A swaps
5,000,000 at LIBOR + 0.03% (also called LIBOR + 3
basis points) against 5,000,000 (FTSE to the 5,000,000
notional).
In this case Party A will pay (to Party B) a oating interest
rate (LIBOR +0.03%) on the 5,000,000 notional and
would receive from Party B any percentage increase in the
FTSE equity index applied to the 5,000,000 notional.
In this example, assuming a LIBOR rate of 5.97%
p.a. and a swap tenor of precisely 180 days, the
oating leg payer/equity receiver (Party A) would owe
(5.97%+0.03%)*5,000,000*180/360 = 150,000 to
the equity payer/oating leg receiver (Party B).
At the same date (after 180 days) if the FTSE had appreciated by 10% from its level at trade commencement,
Party B would owe 10%*5,000,000 = 500,000 to Party
A. If, on the other hand, the FTSE at the six-month mark
had fallen by 10% from its level at trade commencement, Party A would owe an additional 10%*5,000,000
= 500,000 to Party B, since the ow is negative.
For mitigating credit exposure, the trade can be reset, or
marked-to-market during its life. In that case, appreciation or depreciation since the last reset is paid and the
notional is increased by any payment to the oating leg
payer (pricing rate receiver) or decreased by any payment
from the oating leg payer (pricing rate receiver).
Equity swaps have many applications. For example, a
portfolio manager with XYZ Fund can swap the funds
returns for the returns of the S&P 500 (capital gains, dividends and income distributions.) They most often occur
when a manager of a xed income portfolio wants the

An investor in a physical holding of shares loses possession on the shares once he sells his position. However, using an equity swap the investor can pass on
the negative returns on equity position without losing the possession of the shares and hence voting
rights.
For example, lets say A holds 100 shares of
a Petroleum Company. As the price of crude
falls the investor believes the stock would start
giving him negative returns in the short run.
However, his holding gives him a strategic voting right in the board which he does not want
to lose. Hence, he enters into an equity swap
deal wherein he agrees to pay Party B the return on his shares against LIBOR+25bps on a
notional amt. If A is proven right, he will get
money from B on account of the negative return on the stock as well as LIBOR+25bps on
the notional. Hence, he mitigates the negative
returns on the stock without losing on voting
rights.
It allows an investor to receive the return on a security which is listed in such a market where he cannot
invest due to legal issues.
For example, lets say A wants to invest in company X listed in Country C. However, A is not
allowed to invest in Country C due to capital
control regulations. He can however, enter into
a contract with B, who is a resident of C, and
ask him to buy the shares of company X and
provide him with the return on share X and he
agrees to pay him a xed / oating rate of return.

334

CHAPTER 15. SWAPS

Equity swaps, if eectively used, can make investment

barriers vanish and help an investor create leverage similar to those seen in derivative products.
Investment banks that oer this product usually take a
riskless position by hedging the clients position with the
underlying asset. For example, the client may trade a
swap - say Vodafone. The bank credits the client with
1,000 Vodafone at GBP1.45. The bank pays the return
on this investment to the client, but also buys the stock in
the same quantity for its own trading book (1,000 Vodafone at GBP1.45). Any equity-leg return paid to or due
from the client is oset against realised prot or loss on its
own investment in the underlying asset. The bank makes
its money through commissions, interest spreads and dividend rake-o (paying the client less of the dividend than
it receives itself). It may also use the hedge position stock
(1,000 Vodafone in this example) as part of a funding
transaction such as stock lending,repo or as collateral for
a loan.

15.8.3

See also

Interest payment (LIBOR rate plus spread)

Loss in value of the reference asset

Bank A
(Protection Buyer)

Increase in value of the reference asset

Bank B
(Protection Seller)

Interest rate payments (from ref asset)

Interest payment

Reference asset

Diagram explaining Total return swap

15.10.1 Contract denition

A swap agreement in which one party makes payments
based on a set rate, either xed or variable, while the other
party makes payments based on the return of an underlying asset, which includes both the income it generates
and any capital gains. In total return swaps, the underlying asset, referred to as the reference asset, is usually an
equity index, loans, or bonds. This is owned by the party
receiving the set rate payment.

15.9 Ination swap

Total return swaps allow the party receiving the total return to gain exposure and benet from a reference asset
without actually having to own it. These swaps are popular with hedge funds because they get the benet of a
large exposure with a minimal cash outlay. [1]

An ination swap is the linear form of an ination

derivative, an over-the-counter and exchange-traded
derivatives that is used to transfer ination risk from one
counterparty to another.

Less common, but related, are the partial return swap and
the partial return reverse swap agreements, which usually involve 50% of the return, or some other specied
amount. Reverse swaps involve the sale of the asset with
the seller then buying the returns, usually on equities.

Contract for dierence

Limited price ination (LPI) swaps are ination swaps

which are capped and oored between 0% and 5%.
15.10.2

15.9.1

See also

Year-on-Year Ination-Indexed Swap

Zero-Coupon Ination-Indexed Swap

15.9.2

External links

Ination-Indexed Investors Association

Advantage of using Total Return

Swaps

The TRORS allows one party (bank B) to derive the economic benet of owning an asset without putting that asset on its balance sheet, and allows the other (bank A,
which does retain that asset on its balance sheet) to buy
protection against loss in its value.[2]
TRORS can be categorised as a type of credit derivative, although the product combines both market risk and
credit risk, and so is not a pure credit derivative.

Ination swaps can be indexed to the ination bond or the 15.10.3 Users
ination index.
Hedge funds use Total Return Swaps to obtain leverage
on the Reference Assets: they can receive the return of
the asset, typically from a bank (which has a funding cost
15.10 Total return swap
advantage), without having to put out the cash to buy the
Total return swap, or TRS (especially in Europe), or Asset. They usually post a smaller amount of collateral
total rate of return swap, or TRORS, or Cash Settled upfront, thus obtaining leverage.
Equity Swap is a nancial contract that transfers both the Hedge funds (such as The Childrens Investment Fund
credit risk and market risk of an underlying asset.
(TCI)) have attempted to use Total Return Swaps to side-

15.12. CORRELATION SWAP

step public disclosure requirements enacted under the
Williams Act. As discussed in CSX Corp. v. The Childrens Investment Fund Management, TCI argued that it
was not the benecial owner of the shares referenced by
its Total Return Swaps and therefore the swaps did not
require TCI to publicly disclose that it had acquired a
stake of more than 5% in CSX. The United States District
Court rejected this argument and enjoined TCI from further violations of Section 13(d) Securities Exchange Act
and the SEC-Rule promulgated thereunder.[3]

335
Unlike a stock option, whose volatility exposure is contaminated by its stock price dependence, these swaps provide pure exposure to volatility alone. This is truly the
case only for forward starting volatility swaps. However,
once the swap has its asset xings its mark-to-market
value also depends on the current asset price. One can use
these instruments to speculate on future volatility levels,
to trade the spread between realized and implied volatility, or to hedge the volatility exposure of other positions
or businesses.

Total Return Swaps are also very common in many

structured nance transactions such as collateralized debt 15.11.1 See also
obligations (CDOs). CDO Issuers often enter TRS agreements as protection seller in order to leverage the returns
Variance swap
for the structures debt investors. By selling protection,
Volatility (nance)
the CDO gains exposure to the underlying asset(s) without having to put up capital to purchase the assets outright. The CDO gains the interest receivable on the reference asset(s) over the period while the counterparty mit- 15.11.2 References
igates their market risk.

15.11.3 External links

15.10.4

References

Prepackaged Volatility Plays

[1] , Investopedia.
[2] Dufey, Gunter; Rehm, Florian (2000).
An Introduction to Credit Derivatives (Teaching Note)".
hdl:2027.42/35581.
[3] 562 F.Supp.2d 511 (S.D.N.Y. 2008), see also

15.10.5

External links

15.12 Correlation swap

A correlation swap is an over-the-counter nancial
derivative that allows one to speculate on or hedge risks
associated with the observed average correlation, of a
collection of underlying products, where each product
has periodically observable prices, as with a commodity,
exchange rate, interest rate, or stock index.

Total Return Swap article on Financial-edu.com

https://www.youtube.com/watch?v=G_
42YuJOu4A

15.10.6

See also

Repurchase agreement
Credit derivative

15.11 Volatility swap

15.12.1 Payo Denition

The xed leg of a correlation swap pays the notional Ncorr
times the agreed strike strike , while the oating leg pays
the realized correlation realized . The contract value at
expiration from the pay-xed perspective is therefore

Ncorr (realized strike )

Given a set of nonnegative weights wi on n securities, the
realized correlation is dened as the weighted average of
all pairwise correlation coecients i,j :

In nance, a volatility swap is a forward contract on

the future realised volatility of a given underlying asset.

Volatility swaps allow investors to trade the volatility of

i=j wi wj i,j
an asset directly, much as they would trade a price index. realized := wi wj
i=j

The underlying is usually a foreign exchange (FX) rate

(very liquid market) but could be as well a single name
equity or index. However, the variance swap is preferred
in the equity market because it can be replicated with a
linear combination of options and a dynamic position in
futures.

Typically i,j would be calculated as the Pearson correlation coecient between the daily log-returns of assets i
and j, possibly under zero-mean assumption.
Most correlation swaps trade using equal weights, in
which case the realized correlation formula simplies to:

336

realized

CHAPTER 15. SWAPS

2
=
i,j
n(n 1) i<j

15.12.2

Pricing and valuation

No industry-standard models yet exist that have stochastic

correlation and are arbitrage-free.

15.12.3

See also

Variance swap
Rainbow option

15.12.4

References

15.13 Conditional variance swap

A conditional variance swap is a type of swap derivative
product that allows investors to take exposure to volatility
in the price of an underlying security only while the underlying security is within a pre-specied price range.
This ability could be useful for hedging complex volatility exposures, making a bet on the volatility levels contained in the skew of the underlying securitys price, or
buying/selling variance at more attractive levels given a
view on the underlying security.[1]

15.13.1

History

Regular variance swap were introduced rst, and became

a popular instrument for hedging against the eect of
volatility on option prices. Thus, the market for these securities became increasingly liquid, and pricing for these
swaps became more ecient. However, investors noticed
that to a certain extent the price levels for these variance
swaps still deviated from the theoretical price that would
have resulted from replicating the portfolio of options underlying the swaps using options pricing formulas such as
the Black-Scholes model. This was partly because the
construction of the replicating portfolio includes a relatively large contribution from out-of-the-money options,
which can often be illiquid and result in a pricing discrepancy in the overall swap. Conditional swaps mitigate this
problem by limiting the hedge to strikes within an upper and lower level of the underlying security. Thus, the
volatility exposure is limited to when the underlying security lies within this corridor.[1] Another problem in replicating variance swaps is that dealers rarely use a large collection of options over a large range to hedge a variance
swap due to transaction costs and the cost of managing a
large number of options. A conditional variance swap is
attractive as it is easier to hedge and better ts the payo
prole of hedges used in practice.

15.13.2 Notes
[1] Allen, Peter; Einchcomb, Stephen, and Granger, Nicolas.
Conditional Variance Swaps: Product Note. JPMorgan, 3
April 2006.

Chapter 16

Asset Based Securities

16.1 Asset-backed security

issued bonds.

An asset-backed security (ABS) is a security whose income payments and hence value is derived from and collateralized (or backed) by a specied pool of underlying assets. The pool of assets is typically a group of
small and illiquid assets which are unable to be sold individually. Pooling the assets into nancial instruments allows them to be sold to general investors, a process called
securitization, and allows the risk of investing in the underlying assets to be diversied because each security will
represent a fraction of the total value of the diverse pool
of underlying assets. The pools of underlying assets can
include common payments from credit cards, auto loans,
and mortgage loans, to esoteric cash ows from aircraft
leases, royalty payments and movie revenues.
Often a separate institution, called a special purpose vehicle, is created to handle the securitization of asset backed
securities. The special purpose vehicle, which creates and
sells the securities, uses the proceeds of the sale to pay
back the bank that created, or originated, the underlying assets. The special purpose vehicle is responsible for
bundling the underlying assets into a specied pool that
will t the risk preferences and other needs of investors
who might want to buy the securities, for managing credit
risk often by transferring it to an insurance company
after paying a premium and for distributing payments
from the securities. As long as the credit risk of the underlying assets is transferred to another institution, the
originating bank removes the value of the underlying assets from its balance sheet and receives cash in return as
the asset backed securities are sold, a transaction which
can improve its credit rating and reduce the amount of
capital that it needs. In this case, a credit rating of the
asset backed securities would be based only on the assets
and liabilities of the special purpose vehicle, and this rating could be higher than if the originating bank issued
the securities because the risk of the asset backed securities would no longer be associated with other risks that
the originating bank might bear. A higher credit rating
could allow the special purpose vehicle and, by extension,
the originating institution to pay a lower interest rate (and
hence, charge a higher price) on the asset-backed securities than if the originating institution borrowed funds or

Thus, one incentive for banks to create securitized assets

is to remove risky assets from their balance sheet by having another institution assume the credit risk, so that they
(the banks) receive cash in return. This allows banks to
invest more of their capital in new loans or other assets
and possibly have a lower capital requirement.

16.1.1 Denition
An asset-backed security is sometimes used as an umbrella term for a type of security backed by a pool of
assets,[1] and sometimes for a particular type of that security one backed by consumer loans[2] or loans, leases
or receivables other than real estate.[3] In the rst case,
collateralized debt obligations (cdo, securities backed by
debt obligations often other asset-backed securities)
and mortgage-backed securities (mbs, where the assets
are mortgages), are subsets, dierent kinds of assetbacked securities. (Example: The capital market in
which asset-backed securities are issued and traded is
composed of three main categories: ABS, MBS and
CDOs. (italics added) [4] ). In the second case, an assetbacked security or at least the abbreviation ABS
refers to just one of the subsets, one backed by consumerbacked products, and is distinct from a MBS or CDO,
(example: As a rule of thumb, securitization issues
backed by mortgages are called MBS, and securitization
issues backed by debt obligations are called CDO .... Securitization issues backed by consumer-backed products
car loans, consumer loans and credit cards, among others are called ABS ... (italics added)[2][5]

16.1.2 Structure
On January 18, 2005, the United States Securities and
Exchange Commission (SEC) promulgated Regulation
AB which included a nal denition of Asset-Backed
Securities.[6]

337

Denition of ABS. The term asset-backed

security is currently dened in Form S-3 to
mean a security that is primarily serviced by

338

CHAPTER 16. ASSET BASED SECURITIES

the cash ows of a discrete pool of receivables
or other nancial assets, either xed or revolving, that by their terms convert into cash within
a nite time period plus any rights or other assets designed to assure the servicing or timely
distribution of proceeds to the security holders.
The SEC has interpreted the phrase convert
into cash by their terms to exclude most assets that require active behavior to acquire cash
such as the selling of non-performing assets
and physical property. It has also interpreted
the phrase discrete pool to exclude those that
can change in composition over time.
Lease-Backed Securities. The new rule
expands the denition of asset-backed
security to include lease-backed securities as long as the residual value of the
leased property is less than 50% of the
original securitized pool balance (or less
than 65% in the case of motor vehicle
leases). However, such securities may be
shelf-registered on Form S-3 only if the
residual value of the leased property represents less than 20% of the original securitized pool balance (or less than 65%
in the case of motor vehicle leases).
Delinquent and Non-performing Assets.
The new rules provide that a security may
be considered to be an asset-backed security even if the underlying asset pool
has total delinquencies of up to 50% at
the time of the proposed oering as long
as the original asset pool does not include
any non-performing assets. However,
consistent with current practice, shelf
registration on [Form S-3] {lacks denition} will be available only if delinquent
assets constitute 20% or less of the original asset pool. An asset is considered
to be non-performing if it satises the
charge-o policies of the sponsor (or applicable bank regulatory agencies) or if it
would be considered a charged-o asset
under the terms of the applicable transaction documents.
Exceptions to the Discrete Pool Requirement. The new rules generally codify the SEC stas position that a security must be backed by a discrete pool
of assets in order to be considered an
ABS. However, the new rules establish
the following exceptions to address market practices.
(1) Any security issued in a [master trust structure] {lacks deni-

tion} would meet the denition

of asset-backed security without
limitation.
(2) asset-backed securities will
also include securities with a prefunding period of up to one year
during which up to 50% of the offering proceeds (or, in the case of
master trusts, up to 50% of the aggregate principal balance of the total asset pool whose cash ows support the ABS) may be used for subsequent purchases of pool assets.
(3) The new rules also include
within the denition of assetbacked security securities with revolving periods during which new
nancial assets may be acquired. In
the case of revolving assets such as
credit cards, dealer oorplan and
home equity lines of credit, there is
no limit to the length of the revolving period or the amount of new assets that can be purchased during
that time. For securities backed by
receivables or other nancial assets
that do not arise under revolving
accounts, such as automobile loans
and mortgage loans, an unlimited
revolving period will be permitted
for up to three years. However, the
new assets added to the pool during
the revolving period must be of the
same general character as the original pool assets.
According to Thomson Financial League Tables, US issuance (excluding mortgage-backed securities) was:
2004: USD 857 billion (1,595 issues)
2003: USD 581 billion (1,175 issues)

16.1.3 Types
Home equity loans
Securities collateralized by home equity loans (HELs)
are currently the largest asset class within the ABS market. Investors typically refer to HELs as any nonagency
loans that do not t into either the jumbo or alt-A loan
categories. While early HELs were mostly second lien
subprime mortgages, rst-lien loans now make up the majority of issuance. Subprime mortgage borrowers have a
less than perfect credit history and are required to pay

16.1. ASSET-BACKED SECURITY

interest rates higher than what would be available to a
typical agency borrower. In addition to rst and secondlien loans, other HE loans can consist of high loan to
value (LTV) loans, re-performing loans, scratch and dent
loans, or open-ended home equity lines of credit (HELOC),which homeowners use as a method to consolidate
debt.[7]
Auto loans
The second largest subsector in the ABS market is auto
loans. Auto nance companies issue securities backed
by underlying pools of auto-related loans. Auto ABS
are classied into three categories: prime, nonprime, and
subprime:
Prime auto ABS are collaterized by loans made to
borrowers with strong credit histories.
Nonprime auto ABS consist of loans made to lesser
credit quality consumers, which may have higher cumulative losses.

339
Student loans
ABS collateralized by student loans (SLABS) comprise
one of the four (along with home equity loans, auto loans
and credit card receivables) core asset classes nanced
through asset-backed securitizations and are a benchmark
subsector for most oating rate indices . Federal Family Education Loan Program (FFELP) loans are the most
common form of student loans and are guaranteed by the
U.S. Department of Education (USDE) at rates ranging from 95%98% (if the student loan is serviced by a
servicer designated as an exceptional performer by the
USDE the reimbursement rate was up to 100%). As a
result, performance (other than high cohort default rates
in the late 1980s) has historically been very good and
investors rate of return has been excellent. The College Cost Reduction and Access Act became eective
on October 1, 2007 and signicantly changed the economics for FFELP loans; lender special allowance payments were reduced, the exceptional performer designation was revoked, lender insurance rates were reduced,
and the lender paid origination fees were doubled.

A second, and faster growing, portion of the student loan

Subprime borrowers will typically have lower in- market consists of non-FFELP or private student loans.
Though borrowing limits on certain types of FFELP loans
comes, tainted credited histories, or both.
were slightly increased by the student loan bill referenced
above, essentially static borrowing limits for FFELP loans
Owner trusts are the most common structure used when
and increasing tuition are driving students to search for
issuing auto loans and allow investors to receive interest
alternative lenders. Students utilize private loans to bridge
and principal on sequential basis. Deals can also be structhe gap between amounts that can be borrowed through
tured to pay on a pro-rata or combination of the two.[7]
federal programs and the remaining costs of education.[7]
Credit card receivables
Securities backed by credit card receivables have been
benchmark for the ABS market since they were rst introduced in 1987. Credit card holders may borrow funds on
a revolving basis up to an assigned credit limit. The borrowers then pay principal and interest as desired, along
with the required minimum monthly payments. Because
principal repayment is not scheduled, credit card debt
does not have an actual maturity date and is considered a
nonamortizing loan.[7]
ABS backed by credit card receivables are issued out of
trusts that have evolved over time from discrete trusts to
various types of master trusts of which the most common
is the de-linked master trust. Discrete trusts consist of a
xed or static pool of receivables that are tranched into
senior/subordinated bonds. A master trust has the advantage of oering multiple deals out of the same trust as the
number of receivables grows, each of which is entitled to
a pro-rata share of all of the receivables. The delinked
structures allow the issuer to separate the senior and subordinate series within a trust and issue them at dierent
points in time. The latter two structures allow investors to
benet from a larger pool of loans made over time rather
than one static pool.[7]

The United States Congress created the Student Loan

Marketing Association (Sallie Mae) as a government
sponsored enterprise to purchase student loans in the secondary market and to securitize pools of student loans.
Since its rst issuance in 1995, Sallie Mae is now the
major issuer of SLABS and its issues are viewed as the
benchmark issues. Although to a few this may have been
unfair or inationary, it appeared to have been legitimate.

Stranded cost utilities

Rate reduction bonds (RRBs) came about as the result of
the Energy Policy Act of 1992, which was designed to increase competition in the US electricity market. To avoid
any disruptions while moving from a non-competitive to
a competitive market, regulators have allowed utilities to
recover certain transition costs over a period of time.
These costs are considered nonbypassable and are added
to all customer bills. Since consumers usually pay utility
bills before any other, chargeos have historically been
low. RRBs oerings are typically large enough to create
reasonable liquidity in the aftermarket, and average life
extension is limited by a true up mechanism.[7]

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CHAPTER 16. ASSET BASED SECURITIES

Solar photovoltaics

Indeed, market participants sometimes view the highestrated credit card and automobile securities as having deRecently, securitization has been proposed and used to fault risk close to that of the highest-rated mortgageaccelerate development of solar photovoltaic projects by backed securities, which are reportedly viewed as subproviding access to capital.[8] For example, SolarCity of- stitute for the default risk-free Treasury securities.[11]
fered, the rst U.S. asset backed security in the solar industry in 2013.[9]

16.1.5 Securitization
Others

Main article: Securitization transaction

See also: Credit enhancement

There are many other cash-ow-producing assets, including manufactured housing loans, equipment leases and
loans, aircraft leases, trade receivables, dealer oor plan Securitization is the process of creating asset-backed seloans, and royalties.[7] Intangibles are another emerging curities by transferring assets from the issuing company
to a bankruptcy remote entity. Credit enhancement is an
asset class.[10]
integral component of this process as it creates a security
that has a higher rating than the issuing company, which
allows the issuing company to monetize its assets while
16.1.4 Trading asset-backed securities
paying a lower rate of interest than would be possible via
In the United States, the process for issuing asset-backed a secured bank loan or debt issuance by the issuing comsecurities in the primary market is similar to that of issu- pany.
ing other securities, such as corporate bonds, and is governed by the Securities Act of 1933, and the Securities
Exchange Act of 1934, as amended. Publicly issued 16.1.6 ABS indices
asset-backed securities have to satisfy standard SEC registration and disclosure requirements, and have to le pe- See also: asset-backed securities index
riodic nancial statements. [11]
The Process of trading asset-backed securities in the
secondary market is similar to that of trading corporate
bonds, and also to some extent, mortgage-backed securities. Most of the trading is done in over-the-counter
markets, with telephone quotes on a security basis. There
appear to be no publicly available measures of trading volume, or of number of dealers trading in these securities.

On January 17, 2006, CDS Indexco and Markit launched

ABX.HE, a synthetic asset-backed credit derivative index, with plans to extend the index to other underlying
asset types other than home equity loans.[12] ABS indices
allow investors to gain broad exposure to the subprime
market without holding the actual asset-backed securities.

[11]

A survey by the Bond Market Association shows that at

the end of 2004, in the United States and Europe there
were 74 electronic trading platforms for trading xedincome securities and derivatives, with 5 platforms for
asset-backed securities in the United States, and 8 in Europe. [11]

16.1.7 Advantages and disadvantages

A signicant advantage of asset-backed securities for
loan originators (with associated disadvantages for investors) is that they bring together a pool of nancial assets that otherwise could not easily be traded in their existing form. By pooling together a large portfolio of these
illiquid assets they can be converted into instruments that
may be oered and sold freely in the capital markets. The
tranching of these securities into instruments with theoretically dierent risk/return proles facilitates marketing of the bonds to investors with dierent risk appetites
and investing time horizons.

Discussions with market participants show that compared to Treasury securities and mortgage-backed securities, many asset-backed securities are not liquid, and
their prices are not transparent. This is partly because
asset-backed securities are not as standardized as Treasury securities, or even mortgage-backed securities, and
investors have to evaluate the dierent structures, maturity proles, credit enhancements, and other features of
Asset backed securities provide originators with the folan asset-backed security before trading it.[11]
lowing advantages, each of which directly adds to investor
The price of an asset-backed security is usually quoted
risk:
as a spread to a corresponding swap rate. For example,
the price of a credit card-backed, AAA rated security
Selling these nancial assets to the pools reduces
with a two-year maturity by a benchmark issuer might
their risk-weighted assets and thereby frees up their
be quoted at 5 basis points (or less) to the two-year swap
capital, enabling them to originate still more loans.
rate. [11]

16.1. ASSET-BACKED SECURITY

Asset-backed securities lower their risk. In a worstcase scenario where the pool of assets performs very
badly, the owner of ABS (which is either the issuer,
or the guarantor, or the re-modeler, or the guarantor
of the last resort) might pay the price of bankruptcy
rather than the originator. In case the originator
or the issuer is made to pay the price of the same,
it amounts to re-inventing of the lending practices,
restructuring from other protable avenues of the
functioning of the originator as well as the norms
of the issuance of the same and consolidation in
the form of either merger or benchmarking (internal same sector, external dierent sector).
This risk is measured and contained by the lender of last
resort from time to time auctions and other Instruments
that are used to re-inject the same bad loans held over
a longer time duration to the appropriate buyers over a
period of time based on the instruments available for the
bank to carry out its business as per the business charter
or the licensings granted to the specic banks. The risk
can also be diversied by using the alternate geographies,
or alternate vehicles of investments and alternate division
of the bank, depending on the type and magnitude of the
risk.
The exposure of these renanced loans to bad credit
(Type II) decisions (particularly in the banking sector,
unscrupulous lending or the adverse selection of credits)
is hedged against by the sellers of the same, or the restructurers of the same. Thinking of securitization (insurance) as a panacea for all the ills of bad credit decisions might lead to the hedging of the risk by the transfer
of the hot potato from one issuer to another without the
actual asset against which the loan is backed reaching an
upswing in value, either by the demand-supply mismatch
being addressed or by one of the following factors:

341
a trade-o of the loan granted against or the addition of
goods or services.
This is totally built up in any bank based on the terms
of these deposits, and dynamic updation of the same
as regards to the extent of the exposure or bad credit
to be faced, as guided by the accounting standards,
and adjudged by the nancial and non-market (diversiable) risks, with a contingency for the market (nondiversiable) risks, for the specied types of the accounting headers as found in the balance sheets or the reporting
or recognition (company based declaration of the standards) of the same as short term, long term as well as
medium term debt and depreciation standards.
The issuance of the accounting practices and standards as
regards to the dierent holding patterns, adds to the accountability that is sought, in case the problem increases
in magnitude.
The originators earn fees from originating the loans,
as well as from servicing the assets throughout their
life.
The ability to earn substantial fees from originating and
securitizing loans, coupled with the absence of any residual liability, skews the incentives of originators in favor
of loan volume rather than loan quality. This is an intrinsic structural aw in the loan-securitization market that
was directly responsible for both the credit bubble of the
mid-2000s (decade) as well as the credit crisis, and the
concomitant banking crisis, of 2008.

The nancial institutions that originate the loans sell

a pool of cashow-producing assets to a specially created third party that is called a special-purpose vehicle (SPV)". The SPV (securitization, credit derivatives,
commodity derivative, commercial paper based temporary capital and funding sought for the running, merger
The economic productivity of the business cycle be- activities of the company, external funding in the form
ing reversed from downturn to upturn (monetary of venture capitalists, angel investors etc. being a few of
and scal measures)
them) is designed to insulate investors from the credit
risk (availability as well as issuance of credit in terms of
More buyers than sellers in the market
assessment of bad loans or hedging of the already available good loans as part of the practice) of the originating
A breakthrough innovation.
nancial institution.

On a day-to-day basis the transferring of the loans from The SPV then sells the pooled loans to a trust, which isthe
sues interest bearing securities that can achieve a credit
rating separate from the nancial institution that origi Sub-ordinate debt (freshly made and highly collater- nates the loan. The typically higher credit rating is given
because the securities that are used to fund the securitialized debt) to the
zation rely solely on the cash ow created by the assets,
Sub-ordinate realizable
not on the payment promise of the issuer.
Sub-ordinate non-realizable
Senior as well as bad (securitized) debt might be a better
way to distinguish between the assets that might require
or be found eligible for re-insurance or write o or impaired against the assets of the collaterals or is realized as

The monthly payments from the underlying assets loans

or receivables typically consist of principal and interest,
with principal being scheduled or unscheduled. The cash
ows produced by the underlying assets can be allocated
to investors in dierent ways. Cash ows can be directly
passed through to investors after administrative fees are

342

CHAPTER 16. ASSET BASED SECURITIES

subtracted, thus creating a pass-through security; alter- 16.1.9 References

natively, cash ows can be carved up according to specied rules and market demand, thus creating structured [1] assets that otherwise could not be traded has been securitized. MBS and CDO compared: an empirical analysis
securities. [13]
This is an organized way of functioning of the credit markets at least in the Developed Primary non-tradable in the
open market, company to company, bank to bank dealings to keep the markets running, aoat as well as operational and provision of the liquidity by the liquidity
providers in the market, which is very well scrutinized for
any aberration, excessive instrument based hedging and
market manipulation or outlier, volumes based trades
or any such anomalies, block trades 'company treasury'
based decision without proper and posterior/prior intimation, by the respective regulators as directed by the law
and as spotted in the regular hours of trading in the premarket/after-hours trading or in the event based specic
stocks and corrected and scrutinized for insider trading
in the form of cancellation of the trades, re-issuance of
the amount of the cancelled trades or freezing of the markets (specic securities being taken o the trading list for
the duration of time) in event of a pre-set, dened by the
maximum and minimum uctuation in the trading in the
secondary market that is the over the counter markets.
Generally the Primary markets are more scrutinized by
the same commission but this market comes under the
category of institutional and company related trades and
underwritings, as well as guarantees and hence is governed by the broader set of rules as directed in the corporate and business law and reporting standards governing
the business in the specic geography.

16.1.8

See also

[2] Vink, Dennis. ABS, MBS and CDO compared: an empirical analysis (PDF). August 2007. Munich Personal
RePEc Archive. Retrieved 13 July 2013.
[3] Asset-Backed Security ABS. Investopedia. Retrieved
14 Juley 2013. Check date values in: |accessdate= (help)
[4] source: Vink, Dennis. ABS, MBS and CDO compared:
an empirical analysis (PDF). August 2007. Munich Personal RePEc Archive. Retrieved 13 July 2013.
[5] see also What are Asset-Backed Securities?". SIFMA.
Retrieved 13 July 2013. Asset-backed securities, called
ABS, are bonds or notes backed by nancial assets. Typically these assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans,
manufactured-housing contracts and home-equity loans.
[6] Financial Services Alert Goodwin and Procter, January
18th 2005, Vol. 8 NO. 22
[7] [Fixed Income Sectors: Asset-Backed Securities: A
primer on asset-backed securities, Dwight Asset management Company 2005]
[8] T. Alata and J.M. Pearce, "Securitization of residential
solar photovoltaic assets: Costs, risks and uncertainty",
Energy Policy, 67, pp. 488498 (2014). DOI: http://dx.
doi.org/10.1016/j.enpol.2013.12.045 open access
[9] Done Deal:
The First Securitization Of
Rooftop Solar Assets Forbes URL: http:
//www.forbes.com/sites/uciliawang/2013/11/21/
done-deal-the-first-securitization-of-rooftop-solar-assets/

Asset-backed commercial paper

[10] Intangible Asset Finance

A notes

[11] T Sabarwal Common Structures of Asset-Backed Securities and Their Risks, December 29, 2005

Asset-based lending
Asset-based loan
Collateralized debt obligation
Credit enhancement
Mortgage-backed security
Pooled investment
Privatization
Securitization transaction
Structured nance
Tranche
Thomson Financial League Tables

[12] Markit
[13] Fixed Income Sectors: Asset-Backed Securities,
Dwight Asset Management Company, 2005.

16.1.10 Further reading

Jason H. P. Kravitt, Securitization of Financial Assets, Second Edition, Aspen Publishers, New York,
New York, 2005.
Steven L. Schwarcz, Structured Finance A Guide to
the Fundamentals of Asset Securitization, November
1990, Second Printing, Practicing Law Institute.
McLean, Bethany (2007). Asset Backed Securities: The Dangers of Investing in Subprime Debt,
Fortune.

16.2. MORTGAGE-BACKED SECURITY

Non-U.S. Asset-Backed Securities: Spread Determinants and Over-Reliance on Credit Ratings, Frank
J. Fabozzi, EDHEC Business School, and Dennis
Vink, Nyenrode Business Universiteit (2009). Yale
International Center for Finance working paper.

343
by investment banks were a major issue in the subprime
mortgage crisis of 20068.

The total face value of an MBS decreases over time, because like mortgages, and unlike bonds, and most other
xed-income securities, the principal in an MBS is not
paid
back as a single payment to the bond holder at ma Signoriello, Vincent J. (1991), Commercial Loan
turity
but rather is paid along with the interest in each pePractices and Operations, Chapter 7 Loan Sales,
riodic
payment (monthly, quarterly, etc.). This decrease
ISBN 978-1-55520-134-0.
in face value is measured by the MBSs factor, the per Zweig, Philip L. (2002). Asset-Backed Securi- centage of the original face that remains to be repaid.
ties. In David R. Henderson (ed.). Concise Encyclopedia of Economics (1st ed.). Library of Economics and Liberty. OCLC 317650570, 50016270 16.2.1 Securitization
and 163149563
Asset Backed Securities (Frank J. Fabozzi Series)

16.1.11

External links

Leading Investment Bankers in the Asset-Backed

Securities Market, according to Asset-Backed Alert
Asset Backed Securities Video produced by DW
(Deutsche Welle)

16.2 Mortgage-backed security

A mortgage-backed security (MBS) is a type of assetbacked security that is secured by a mortgage, or more
commonly a collection (pool) of sometimes hundreds
of mortgages. The mortgages are sold to a group of individuals (a government agency or investment bank) that
"securitizes", or packages, the loans together into a security that can be sold to investors. The mortgages of
an MBS may be residential or commercial, depending on
whether it is an Agency MBS or a Non-Agency MBS;
in the United States they may be issued by structures
set up by government-sponsored enterprises like Fannie
Mae or Freddie Mac, or they can be private-label, issued by structures set up by investment banks. The structure of the MBS may be known as pass-through, where
the interest and principal payments from the borrower or
homebuyer pass through it to the MBS holder, or it may
be more complex, made up of a pool of other MBSs.
Other types of MBS include collateralized mortgage obligations (CMOs, often structured as real estate mortgage
investment conduits) and collateralized debt obligations
(CDOs).[1]

Value of mortgage-backed security issuances in $USD trillions,

1990-2009. (source: sifma statistics, structured nance)

The process of securitization is complicated and depends greatly on the jurisdiction within which the process is conducted. Among other things, securitization
distributes risk and permits investors to choose dierent
levels of investment and risk.[3] The basics are:
1. Mortgage loans (mortgage notes) are purchased
from banks and other lenders, and possibly assigned
to a special purpose vehicle (SPV).
2. The purchaser or assignee assembles these loans into
collections, or pools.
3. The purchaser or assignee securitizes the pools by
issuing mortgage-backed securities.
While a residential mortgage-backed security (RMBS) is
secured by single-family or two- to four-family real estate, a commercial mortgage-backed security (CMBS) is
secured by commercial and multi-family properties, such
as apartment buildings, retail or oce properties, hotels, schools, industrial properties, and other commercial
sites. A CMBS is usually structured as a dierent type of
security than an RMBS.

The shares of subprime MBSs issued by various structures, such as CMOs, are not identical but rather issued as
tranches (French for slices), each with a dierent level
of priority in the debt repayment stream, giving them different levels of risk and reward. Tranchesespecially
the lower-priority, higher-interest tranchesof an MBS These securitization trusts may be structured by
are/were often further repackaged and resold as colla- government-sponsored enterprises as well as by private
terized debt obligations.[2] These subprime MBSs issued entities that may oer credit enhancement features to

344

CHAPTER 16. ASSET BASED SECURITIES

mitigate the risk of prepayment and default associated

with these mortgages. Since residential mortgage holders
in the United States have the option to pay more than
the required monthly payment (curtailment) or to pay o
the loan in its entirety (prepayment), the monthly cash
ow of an MBS is not known in advance, and an MBS
therefore presents a risk to investors.

US government

The securitization of mortgages in the 1970s had the advantage of providing more capital for housing at a time
when the demographic bulge of baby boomers created a
housing shortage and ination was undermining a traditional source of housing funding, the savings and loan associations (or thrifts), which were limited to providing
uncompetitive 5.75% interest rates on savings accounts
and consequently losing savers money to money market
funds. Unlike the traditional localized, inecient mortgage market where there might be a shortage or surplus
of funds at any one time, MBSs were national in scope
and regionally diversied.[8]

Securitization

As part of the New Deal following the Great Depression,

the US federal government created the Federal Housing
Administration (FHA) with the National Housing Act of
1934 to assist in the construction, acquisition, and rehabilitation of residential properties.[12] The FHA helped
develop and standardize the xed-rate mortgage as an alIn the United States, the most common securitization
ternative to the balloon payment mortgage by insuring
trusts are sponsored by Fannie Mae and Freddie Mac,
them, and helped the mortgage design garner usage.[13]
US government-sponsored enterprises. Ginnie Mae, a
US government-sponsored enterprise backed by the full In 1938, the government also created the governmentfaith and credit of the US government, guarantees that sponsored corporation Fannie Mae to create a liquid secits investors receive timely payments but buys limited ondary market in these mortgages and thereby free up
numbers of mortgage notes. Some private institutions the loan originators to originate more loans, primarily
also securitize mortgages, known as private-label mort- by buying FHA-insured mortgages.[14] As part of the
gage securities.[4][5] Issuances of private-label mortgage- Housing and Urban Development Act of 1968, Fannie
backed securities increased dramatically from 2001 to Mae was split into the current Fannie Mae and Ginnie
2007 and then ended abruptly in 2008, when real es- Mae to support the FHA-insured mortgages, as well as
tate markets began to falter.[6] An example of a private- Veterans Administration (VA) and Farmers Home Adlabel issuer is the real estate mortgage investment conduit ministration (FmHA) insured mortgages, with the full
(REMIC), a tax-structure entity usually used for CMOs; faith and credit of the US government.[15] In 1970, the
among other things, a REMIC structure avoids so-called federal government authorized Fannie Mae to purchase
private mortgagesthat is, those not insured by the FHA,
double taxation.[7]
VA, or FmHA, and created Freddie Mac to perform a
role similar to that of Fannie Mae.[15] Ginnie Mae does
not invest in private mortgages.
Advantages and disadvantages

However, mortgage-backed securities also lead inexorably to the rise of the subprime industry and created
hidden, systemic risks. They also undid the connection between borrowers and lenders. Historically, less
than 2% of people lost their homes to foreclosure, but
with securitization, once a lender sold a mortgage, it no
longer had a stake in whether the borrower could make
his or her payments.[9]

16.2.2

History

Among the early examples of mortgage-backed securities in the United States were the farm railroad mortgage
bonds of the mid-19th century which contributed to the
panic of 1857.[10] There was also an extensive commercial MBS market in the 1920s.[11]

Ginnie Mae guaranteed the rst mortgage pass-through

security of an approved lender in 1968.[16] In 1971, Freddie Mac issued its rst mortgage pass-through, called a
participation certicate, composed primarily of private
mortgages.[16] In 1981, Fannie Mae issued its rst mortgage pass-through, called a mortgage-backed security.[17]
In 1983, Freddie Mac issued the rst collateralized mortgage obligation.[18]
In 1960 the government enacted the Real Estate Investment Trust Act to allow the creation of the real estate
investment trust (REIT) to encourage real estate investment, and in 1977 Bank of America issued the rst private label pass-through.[19] In 1983 the Federal Reserve
Board amended Regulation T to allow broker-dealers
to use pass-throughs as margin collateral, equivalent to
over-the-counter non-convertible bonds.[20] In 1984 the
government passed the Secondary Mortgage Market Enhancement Act to improve the marketability of private
label pass-throughs,[19] which declared nationally recognized statistical rating organization AA-rated mortgagebacked securities to be legal investments equivalent to
Treasury securities and other federal government bonds
for federally charted banks (such as federal savings banks
and federal savings associations), state-chartered nancial institutions (such as depository banks and insurance
companies) unless overridden by state law before October 1991 (which 21 states did[21] ), and Department of
Laborregulated pension funds.[22]

16.2. MORTGAGE-BACKED SECURITY

The Tax Reform Act of 1986 allowed the creation of
the tax-exempt real estate mortgage investment conduit
(REMIC) special purpose vehicle for the express purpose
of issuing pass-throughs.[23] The Tax Reform Act significantly contributed to the savings and loan crisis of the
1980s and 1990s that resulted in the Financial Institutions
Reform, Recovery and Enforcement Act of 1989, which
dramatically changed the savings and loan industry and its
federal regulation, encouraging loan origination.[24][25]
Subprime mortgage crisis
Low-quality mortgage-backed securities backed by
subprime mortgages played a major role in the 200712
global nancial crisis. By 2012 the market for highquality mortgage-backed securities had recovered and
was a prot center for US banks.[26]

16.2.3

Types

345
the trust must have, with limited exceptions, only a
single class of ownership interests.[27]
A residential mortgage-backed security
(RMBS) is a pass-through MBS backed by
mortgages on residential property.
A commercial mortgage-backed security
(CMBS) is a pass-through MBS backed by
mortgages on commercial property.
A collateralized mortgage obligation, or paythrough bond, is a debt obligation of a legal entity that is collateralized by the assets it owns. Paythrough bonds are typically divided into classes
that have dierent maturities and dierent priorities for the receipt of principal and in some
cases of interest.[28] They often contain a sequential pay security structure, with at least two classes
of mortgage-backed securities issued, with one class
receiving scheduled principal payments and prepayments before any other class.[29] Pay-through securities are classied as debt for income tax purposes.[30]
A stripped mortgage-backed security (SMBS) where
each mortgage payment is partly used to pay down
the loans principal and partly used to pay the interest
on it. These two components can be separated to
create SMBSs, of which there are two subtypes:
An interest-only stripped mortgage-backed security (IO) is a bond with cash ows backed
by the interest component of property owners
mortgage payments.
A net interest margin security (NIMS)
is re-securitized residual interest of a
mortgage-backed security[31]
A principal-only stripped mortgage-backed security (PO) is a bond with cash ows backed by
the principal repayment component of property owners mortgage payments.

Most bonds backed by mortgages are classied as an

MBS. This can be confusing, because a security derived
from an MBS is also called an MBS. To distinguish
the basic MBS bond from other mortgage-backed instruments, the qualier pass-through is used, in the same way There are a variety of underlying mortgage classications
that vanilla designates an option with no special fea- in the pool:
tures.
Prime mortgages are conforming mortgages with
Subtypes of mortgage-backed security include:
prime borrowers, full documentation (such as verication of income and assets), strong credit scores,
Pass-through securities are issued by a trust and aletc.
locate the cash ows from the underlying pool to
the securities holders on a pro rata basis. A trust
Alt-A mortgages are an ill-dened category, generthat issues pass-through certicates is taxed under
ally prime borrowers but non-conforming in some
the grantor trust rules of the Internal Revenue Code.
way, often lower documentation (or in some other
Under these rules, the holder of a pass-through cerway: vacation home, etc.)[32] Alt-A mortgages tend
to be larger in size than subprime loans and have
ticate is taxed as a direct owner of the portion of the
signicantly higher credit quality. For example, an
trust allocatable to the certicate. In order for the
Alt-A loan might be to an individual with multiissuer to be recognized as a trust for tax purposes,
ple and varying sources of income; non-owner octhere can be no signicant power under the trust
cupied, investment properties are often Alt-A loans.
agreement to change the composition of the asset
Because Alt-A loans are not conforming loans, they
pool or otherwise to reinvest payments received, and

346

CHAPTER 16. ASSET BASED SECURITIES

are not eligible for purchase by Fannie Mae or Fred- credit disparities. However, in some respects, particudie Mac.[33]
larly where subprime and other riskier mortgages are involved, the secondary mortgage market may exacerbate
Subprime mortgages have weaker credit scores, no certain risks and volatility.[3]
verication of income or assets, etc.
Jumbo mortgage when the size of the loan is bigger
than the conforming loan amount as set by Fannie
Mae or Freddie Mac. As such, the mortgage rates
on jumbo loans are somewhat higher than for con- TBAs
forming loans.[33]
TBAsshort for to-be-announced securitiesinvolve
These types are not limited to Mortgage Backed Securi- a special type of trading of mortgage-backed securities. Bonds backed by mortgages but that are not MBSs ties. TBAs are the most liquid and important secondary
mortgage market, with volume in the trillions of dolcan also have these subtypes.
lars annually.[36] TBAs are traded by MBS traders with
There are two types of classications based on the issuer notional amounts. There are settlement days when the
of the security:
traders have to make good on their trades. At that time,
they choose fractions from various pools to make up their
Agency, or government, issued securities by TBA. Only agency mortgage-backed securities trade in
government-sponsored enterprise issuers, such as the TBA market.[36] In a TBA transaction, the parties
Fannie Mae, Freddie Mac, and Ginnie Mae.
agree on a price for delivering a given volume of Agency
Pass-Through Mortgage-Backed Securities at a specied
Fannie Mae and Freddie Mac sell short term
future date. The distinguishing feature of a TBA trans(36 month) bills at auction on a weekly
action is that the actual identity of the securities to be
[34]
schedule,
and longer-term (110 year)
delivered at settlement is not specied on the date of ex[35]
notes at monthly auctions.
ecution (Trade Date). Instead, the parties to the trade
The underlying mortgages for Agency MBS agree on only ve general parameters of the securities to
are one to four-single family residential mort- be delivered: issuer, mortgage type, maturity, coupon,
gages only.
and month of settlement.[37]
Non-agency, or private-label, securities by nongovernmental issuers, such as trusts and other
special purpose entities like real estate mortgage investment conduits.

TBAs are critical in determining the ultimate interest

rates that mortgage borrowers pay, since mortgage originators can lock in rates and use TBAs to hedge their exposure. TBAs are also used to hedge many non-TBA eligible mortgage products, such as hybrid ARMs and non The underlying mortgages for Non-Agency agency mortgages.[36]
MBS are backed by second mortgage loans,
manufactured housing loans, and a variety of
commercial real estate loans, in addition to
single family residential mortgages.
Covered bonds

Secondary mortgage market

Main article: covered bond
The secondary mortgage market is the market where a
network of lenders sell, and investors buy, existing mortgages or MBS. A large percentage of newly originated
mortgages are sold by their originators into this large and
liquid market where they are packaged into MBS and sold
to public and private investors, including Fannie Mae,
Freddie Mac, pension funds, insurance companies, mutual funds and hedge funds.
Because of the long-term nature of mortgages, the secondary market is an essential factor in maintaining lender
liquidity. The infusion of capital from investors provides
mortgage lenders such as banks, thrifts, mortgage bankers
and other loan originators with a market for their loans. In
addition to providing liquidity and increasing overall eciency, the secondary market can smooth out geographic

In Europe there exists a type of asset-backed bond called

a covered bond, commonly known by the German term
Pfandbriefe. Covered bonds were rst created in 19thcentury Germany when Frankfurter Hypo began issuing
mortgage covered bonds. The market has been regulated
since the creation of a law governing the securities in
Germany in 1900. The key dierence between covered
bonds and mortgage-backed or asset-backed securities is
that banks that make loans and package them into covered bonds keep those loans on their books. This means
that when a company with mortgage assets on its books
issues the covered bond, its balance sheet grows, which
would not occur if it issued an MBS, although it may still
guarantee the securities payments.

16.2. MORTGAGE-BACKED SECURITY

347

16.2.5 Criticisms

Risk, Return, Rating & Yield relate

16.2.4

Critics have suggested that the complexity inherent in securitization can limit investors ability to monitor risks,
and that competitive securitization markets with multiple
securitizers may be particularly prone to sharp declines
in underwriting standards. Private, competitive mortgage
securitization is believed to have played an important role
in the US subprime mortgage crisis.[38] In addition, o
balance sheet treatment for securitizations coupled with
guarantees from the issuer are said to make the securitizing rms leverage less transparent, thereby facilitating
risky capital structures and allowing credit risk underpricing. Obalance sheet securitizations are believed to
have played a large role in the high leverage ratio of US
nancial institutions before the nancial crisis.[39]

Uses
16.2.6 Market size and liquidity

There are many reasons for mortgage originators to nance their activities by issuing mortgage-backed securiAs of the second quarter of 2011, there was about $13.7
ties. Mortgage-backed securities:
trillion in total outstanding US mortgage debt.[40] There
were about $8.5 trillion in total US mortgage-related
1. transform relatively illiquid, individual nancial as- securities.[41] About $7 trillion of that was securitized
sets into liquid and tradable capital market instru- or guaranteed by government-sponsored enterprises or
ments
government agencies, the remaining $1.5 trillion being
pooled by private mortgage conduits.[40]
2. allow mortgage originators to replenish their funds,
which can then be used for additional origination ac- According to the Bond Market Association, gross US issuance of agency MBS was (see also chart above):
tivities
3. can be used by Wall Street banks to monetize the
credit spread between the origination of an underlying mortgage (private market transaction) and the
yield demanded by bond investors through bond issuance (typically a public market transaction)

2005: USD 0.967 trillion

4. are often a more ecient and lower-cost source of

nancing in comparison with other bank and capital
markets nancing alternatives.

2002: USD 1.444 trillion

2004: USD 1.019 trillion

2003: USD 2.131 trillion

2001: USD 1.093 trillion

5. allow issuers to diversify their nancing sources by

16.2.7 Pricing
oering alternatives to more traditional forms of
debt and equity nancing
Valuation
6. allow issuers to remove assets from their balance
sheet, which can help to improve various nancial The weighted-average maturity (WAM) and weighted avratios, utilize capital more eciently, and achieve erage coupon (WAC) are used for valuation of a passthrough MBS, and they form the basis for computing cash
compliance with risk-based capital standards
ows from that mortgage pass-through. Just as this article describes a bond as a 30-year bond with 6% coupon
The high liquidity of most mortgage-backed securities rate, this article describes a pass-through MBS as a $3
means that an investor wishing to take a position need not billion pass-through with 6% pass-through rate, a 6.5%
deal with the diculties of theoretical pricing described WAC, and 340-month WAM. The pass-through rate is
below; the price of any bond is essentially quoted at fair dierent from the WAC; it is the rate that the investor
value, with a very narrow bid/oer spread.
would receive if he/she held this pass-through MBS, and
Reasons (other than investment or speculation) for enter- the pass-through rate is almost always less than the WAC.
ing the market include the desire to hedge against a drop The dierence goes to servicing costs (i.e., costs incurred
in prepayment rates (a critical business risk for any com- in collecting the loan payments and transferring the paypany specializing in renancing).
ments to the investors.)

348
To illustrate these concepts, consider a mortgage pool
with just three mortgage loans that have the following outstanding mortgage balances, mortgage rates, and months
remaining to maturity:

Weighted-average maturity The weighted-average

maturity (WAM) of a pass-through MBS is the average
of the maturities of the mortgages in the pool, weighted
by their balances at the issue of the MBS. Note that this
is an average across mortgages, as distinct from concepts
such as weighted-average life and duration, which are averages across payments of a single loan.

CHAPTER 16. ASSET BASED SECURITIES

Interest rate risk and prepayment risk Theoretical
pricing models must take into account the link between
interest rates and loan prepayment speed. Mortgage prepayments are usually made because a home is sold or because the homeowner is renancing to a new mortgage,
presumably with a lower rate or shorter term. Prepayment is classied as a risk for the MBS investor despite
the fact that they receive the money, because it tends to
occur when oating rates drop and the xed income of
the bond would be more valuable (negative convexity).
In other words, the proceeds received would need to be
reinvested at a lower interest rate.[7] Hence the term prepayment risk.

Professional investors generally use arbitrage-pricing

models to value MBS. These models deploy interest
rate scenarios consistent with the current yield curve as
drivers of the econometric prepayment models that models homeowner behavior as a function of projected mortgage rates. Given the market price, the model produces
WAM = (22.22% 300) + (44.44% 260) + (33.33% an option-adjusted spread, a valuation metric that takes
280) = 66.66 + 115.55 + 93.33 = 275.55 months
into account the risks inherent in these complex securities. [44]
The weightings are computed by dividing each outstanding loan amount by total amount outstanding in the mortgage pool (i.e., $900,000). These amounts are the outstanding amounts at the issuance or initiation of the MBS.
The WAM for the above example is computed as follows:

There are other drivers of the prepayment function (or

Weighted-average coupon The weighted-average prepayment risk), independent of the interest rate, such
coupon (WAC) of a pass-through MBS is the average of as:
the coupons of the mortgages in the pool, weighted by
their original balances at the issuance of the MBS. For
economic growth, which is correlated with increased
the above example this is:
turnover in the housing market
WAC = (22.22% 6.00%) + (44.44% 6.25%) +
(33.33% 6.50%) = 1.33% + 2.77% + 2.166% =
6.277%

Theoretical pricing

home prices ination

unemployment
regulatory risk (if borrowing requirements or tax
laws in a country change this can change the market profoundly)

demographic trends, and a shifting risk aversion proPricing a vanilla corporate bond is based on two sources
le, which can make xed rate mortgages relatively
of uncertainty: default risk (credit risk) and interest rate
more or less attractive
(IR) exposure.[42] The MBS adds a third risk: early redemption (prepayment). The number of homeowners
in residential MBS securitizations who prepay increases Credit risk Main article: Credit risk
when interest rates decrease. One reason for this phenomenon is that homeowners can renance at a lower
The credit risk of mortgage-backed securities depends on
xed interest rate. Commercial MBS often mitigate this
the likelihood of the borrower paying the promised cash
[43]
risk using call protection.
ows (principal and interest) on time. The credit rating
Since these two sources of risk (IR and prepayment) are of MBS is fairly high because:
linked, solving mathematical models of MBS value is a
dicult problem in nance. The level of diculty rises
1. Most mortgage originations include research on the
with the complexity of the IR model and the sophisticamortgage borrowers ability to repay, and will try to
tion of the prepayment IR dependence, to the point that
lend only to the creditworthy. An important excepno closed-form solution (i.e., one that could be written
tion to this is no-doc or low-doc loans.
down) is widely known. In models of this type, numerical
methods provide approximate theoretical prices. These
2. Some MBS issuers, such as Fannie Mae, Freddie
are also required in most models that specify the credit
Mac, and Ginnie Mae, guarantee against homerisk as a stochastic function with an IR correlation. Pracowner default risk. In the case of Ginnie Mae, this
titioners typically use specialised Monte Carlo methods
guarantee is backed with the full faith and credit of
or modied Binomial Tree numerical solutions.
the US federal government.[45] This is not the case

16.2. MORTGAGE-BACKED SECURITY

with Fannie Mae and Freddie Mac, but these two entities have lines of credit with the US federal government; however, these lines of credit are extremely
small compared to the average amount of money circulated through these entities in one days business.
Additionally, Fannie Mae and Freddie Mac generally require private mortgage insurance on loans in
which the borrower provides a down payment that is
less than 20% of the property value.

349
agency, coupon, and dollar amount are revealed. A specic pool whose characteristics are known would usually
trade TBA plus {x} ticks or a pay-up, depending on
characteristics. These are called specied pools, since
the buyer species the pool characteristic he/she is willing
to pay up for.

The price of an MBS pool is inuenced by prepayment

speed, usually measured in units of CPR or PSA. When
a mortgage renances or the borrower prepays during the
3. Pooling many mortgages with uncorrelated default month, the prepayment measurement increases.
probabilities creates a bond with a much lower prob- If the lovina acquired a pool at a premium (>100), as is
ability of total default, in which no homeowners are common for higher coupons, then they are at risk for preable to make their payments (see Copula). Although payment. If the purchase price was 105, the investor loses
the risk neutral credit spread is theoretically identi- 5 cents for every dollar prepaid, which may signicantly
cal between a mortgage ensemble and the average decrease the yield. This is likely to happen as holders of
mortgage within it, the chance of catastrophic loss higher-coupon MBSs have a good incentive to renance.
is reduced.
Conversely, it may be advantageous to the bondholder for
4. If the property owner should default, the property re- the borrower to prepay if the low-coupon MBS pool was
mains as collateral. Although real estate prices can bought at a discount (<100). This is due to the fact that
move below the value of the original loan, this in- when the borrower pays back the mortgage, he does so
creases the solidity of the payment guarantees and at par. So if the investor bought a bond at 95 cents
on the dollar, as the borrower prepays he or she gets the
deters borrower default.
full dollar back and his or her yield increases. However,
this is unlikely to happen, as borrowers with low-coupon
If the MBS was not underwritten by the original real es- mortgages have very little incentive to renance.
tate and the issuers guarantee, the rating of the bonds
would be much lower. Part of the reason is the expected The price of an MBS pool is also inuenced by the loan
adverse selection against borrowers with improving credit balance. Common specications for MBS pools are loan
(from MBSs pooled by initial credit quality) who would amount ranges that each mortgage in the pool must pass.
have an incentive to renance (ultimately joining an MBS Typically, high-premium (high-coupon) MBSs backed by
mortgages with an original loan balance no larger than
pool with a higher credit rating).
$85,000 command the largest pay-ups. Even though the
borrower is paying an above market yield, he or she is
dissuaded from renancing a small loan balance due to
Real-world pricing
the high xed cost involved.
Because of the diversity in MBS types, there is wide va- Low Loan Balance: < $85,000
riety of pricing sources. In general, the more uniform or Mid Loan Balance: $85,000$110,000
liquid the MBS, the greater the transparency or availabil- High Loan Balance: $110,000$150,000
ity of prices.[36] Most traders and money managers use Super High Loan Balance: $150,000$175,000
Bloomberg and Intex to analyze MBS pools and more eso- TBA: > $175,000
teric products such as CDOs, although tools such as Citis
The Yield Book and Barclays POINT are also prevalent The plurality of factors makes it dicult to calculate the
across Wall Street, especially for multiasset class man- value of an MBS security. Often market participants do
agers. Some institutions have also developed their own not concur, resulting in large dierences in quoted prices
proprietary software. Tradeweb is used by the largest for the same instrument. Practitioners constantly try to
bond dealers (the primaries) to transact round lots ($1 improve prepayment models and hope to measure values for input variables implied by the market. Varying
million and larger).
liquidity premiums for related instruments and changing
Complex structured products tend to trade less frequently liquidity over time make this a dicult task. One facand involve more negotiation. Prices for these more com- tor used to express price of an MBS security is the pool
plicated MBSs, as well as for CMOs and CDOs, tend to factor.
be more subjective, often available only from dealers.[36]
For vanilla or generic 30-year pools (FN/FG/GN)
with coupons of 3.5%7%, one can see the prices posted 16.2.8 Recording and Mortgage Electronic
on a TradeWeb screen by the primaries called To Be AlRegistration Systems
located (TBA). This is due to the actual pools not being
shown. These are forward prices for the next 3 delivery One critical component of the securitization system in
months since pools have not been cut; only the issuing the US market is the Mortgage Electronic Registration

350

CHAPTER 16. ASSET BASED SECURITIES

Systems (MERS) created in the 1990s, which created a

private system wherein underlying mortgages were assigned and reassigned outside of the traditional countylevel recording process. The legitimacy and overall accuracy of this alternative recording system have faced serious challenges with the onset of the mortgage crisis: as
the US courts ood with foreclosure cases, the inadequacies of the MERS model are being exposed, and both local and federal governments have begun to take action
through suits of their own and the refusal (in some jurisdictions) of the courts to recognize the legal authority
of MERS assignments.[46][47] The assignment of mortgage (deed of trust) and note (obligation to pay the debt)
paperwork outside of the traditional US county courts
(and without recordation fee payment) is subject to legal challenge. Legal inconsistencies in MERS originally
appeared trivial, but they may reect dysfunctionality in
the entire US mortgage securitization industry.

[11] Securitization in the 1920s. Nber.org. Retrieved 201408-23.

[12] Fabozzi & Modigliani 1992, pp. 1819.
[13] Fabozzi & Modigliani 1992, p. 19.
[14] Fabozzi & Modigliani 1992, pp. 1920.
[15] Fabozzi & Modigliani 1992, p. 20.
[16] Fabozzi & Modigliani 1992, p. 21.
[17] Fabozzi & Modigliani 1992, p. 23.
[18] Fabozzi & Modigliani 1992, p. 25.
[19] Fabozzi & Modigliani 1992, p. 31.
[20] Fabozzi & Modigliani 1992, p. 34.

A notes

[21] The 21 states that utilized the exemption provisions were

Alaska, Arkansas, Colorado, Connecticut, Delaware,
Florida, Georgia, Illinois, Kansas, Maryland, Michigan,
Missouri, Nebraska, New Hampshire, New York, North
Carolina, Ohio, South Dakota, Utah, Virginia, and West
Virginia.

Bank of America Home Loans

[22] Fabozzi & Modigliani 1992, p. 32.

Dollar roll

[23] Fabozzi & Modigliani 1992, pp. 3334.

New Century

[24] Cebula, Richard J.; Hung, Chao-shun (1992). The Savings

and Loan Crisis. p. 57. ISBN 978-0-8403-7620-6. The
Tax Reform Act of 1986 signicantly acted to reduce real
estate values and to weaken the prot positions of Savings
and Loans...

16.2.9

See also

United States housing bubble

16.2.10

References

[1] Lemke, Lins and Picard, Mortgage-Backed Securities,

Chapters 4 and 5 (Thomson West, 2013 ed.).
[2] How can mortgage-backed securities bring down the U.S.
economy?| Josh Clark| How Stu Works
[3] Lemke, Lins and Picard, Mortgage-Backed Securities,
Chapter 1 (Thomson West, 2013 ed.).
[4] Mortgage-Backed securities. U.S. Securities and Exchange Commission.
[5] Risk Glossary.
[6] The Budget and Economic Outlook: Fiscal Years 2010
to 2020 - CBO. Cbo.gov. 2010-01-26. Retrieved 201408-23.
[7] Lemke, Lins and Picard, Mortgage-Backed Securities,
Chapter 4 (Thomson West, 2013 ed.).
[8] All the Devils Are Here, MacLean and Nocera, p.5
[9] All the Devils Are Here, MacLean and Nocera, p.19
[10] ""Dj Vu All Over Again: Agency, Uncertainty, Leverage and the Panic of 1857, Timothy J. Riddiough
and Howard E. Thompson, 2012. Papers.ssrn.com.
doi:10.2139/ssrn.2042316. Retrieved 2014-08-23.

[25] Fabozzi & Modigliani 1992, p. 26.

[26] Peter Eavis (August 8, 2012). With Rates Low, Banks
Increase Mortgage Prot (DEALBOOK BLOG). The
New York Times. Retrieved August 9, 2012.
[27] Trust must satisfy the restrictions of Treas. Reg.
301.7701-4(c) to prevent recharacterization of the trust
as a business entity for tax purposes.
[28] Joseph G. Haubrich, Derivative Mechanics: The CMO,
Economic Commentary, Federal Reserve Bank of Cleveland, Issue Q I, pages 13-19, (1995).
[29] These securities are referred to as Fast-pay, Slow-pay securities.
[30] IRC 385.
[31] Keith L. Krasney, Legal Structure of Net Interest
Margin Securities, The Journal of Structured Finance,
Spring 2007, Vol.
13, No.
1: pp.
54-59,
doi:10.3905/jsf.2007.684867
[32] A Journey to the Alt-A Zone: A Brief Primer on AltA Mortgage Loans (PDF). Nomura Fixed Income Research.
[33] Lemke, Lins and Picard, Mortgage-Backed Securities,
Chapter 3 (Thomson West, 2013 ed.).

16.3. COLLATERALIZED MORTGAGE OBLIGATION

[34] Fannie Mae, Freddie Mac 2013 bill sale calendar.

Reuters. Retrieved 1/11/2013. Check date values in: |accessdate= (help)
[35] Freddie Mac, Fannie Mae and FHLB 2013 note calendar. Reuters. Retrieved 1/11/2013. Check date values
in: |accessdate= (help)
[36] Lemke, Lins and Picard, Mortgage-Backed Securities,
Chapter 5 (Thomson West, 2013 ed.).
[37] Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Notice of Filing of Proposed Rule
Change Relating to Post-Trade Transparency for Agency
Pass-Through Mortgage-Backed Securities Traded TBA
(PDF). SEC.
[38] Michael Simkovic, Competition and Crisis in Mortgage Securitization
[39] Michael Simkovic, Secret Liens and the Financial Crisis
of 2008, American Bankruptcy Law Journal, Vol. 83, p.
253, 2009
[40] Federal Reserve Statistical Release. Federalreserve.gov.
2009-03-27. Retrieved 2014-08-23.

351

16.2.12 External links

Vink, Dennis and Thibeault, Andr (2008). ABS,
MBS and CDO Compared: An Empirical Analysis
The Journal of Structured Finance
More Mortgage Madness by Kai Wright, The Nation, April 29, 2009
MBS Basics by Mortgage News Daily, MBS Commentary
http://www.slate.com/articles/news_and_politics/
explainer/2008/03/what_is_a_mortgagebacked_
security.html] What Is a Mortgage-Backed Security? by Chris Wilson, in Slate Magazine
TBA Trading and Liquidity in the Agency MBS
Market, by the Federal Reserve Bank of New York

16.3 Collateralized mortgage obligation

A collateralized mortgage obligation (CMO) is a type

of complex debt security that repackages and directs the
payments of principal and interest from a collateral pool
to dierent types and maturities of securities, thereby
[42] Ross, Stephen A. et al. (2004). Essentials of Corporate
meeting investor needs.[1] CMOs were rst created in
Finance, Fourth Edition. McGraw-Hill/Irwin. pp. 158,
1983 by the investment banks Salomon Brothers and First
186. ISBN 0-07-251076-5.
Boston for the U.S. mortgage liquidity provider Freddie
[43] LaCour-Little, Michael. Call Protection In Mortgage Mac. (The Salomon Brothers team was led by GorContracts (PDF). AREUEA. p. 2. Retrieved 30 Novem- don Taylor. The First Boston team was led by Dexter
ber 2012.
Senft[2] ).
[41] Securities Industry and Financial Markets Association
Statistical Release

[44] Hayre 2001, p. 29.

[45] Mortgage-backed securities are oering decent returns.
USA Today. October 21, 2010.
[46]
[47] HSBC Bank USA, N.A. v Taher (2011 NY Slip Op
51208(U))". Nycourts.gov. Retrieved 2014-08-23.

16.2.11

Bibliography

Lemke, Thomas P.; Lins, Gerald T.; Picard, Marie

E. (2013). Mortgage-Backed Securities. Thomson
West.
Fabozzi, Frank J.; Modigliani, Franco (1992).
Mortgage and Mortgage-backed Securities Markets.
Harvard Business School Press. ISBN 0-87584322-0.

Legally, a CMO is a debt security issued by an abstraction - a special purpose entity - and is not a debt
owed by the institution creating and operating the entity. The entity is the legal owner of a set of mortgages, called a pool. Investors in a CMO buy bonds issued by the entity, and they receive payments from the
income generated by the mortgages according to a dened set of rules. With regard to terminology, the mortgages themselves are termed collateral, 'classes refers to
groups of mortgages issued to borrowers of roughly similar credit worthiness, tranches are specied fractions or
slices, metaphorically speaking, of a pool of mortgages
and the income they produce that are combined into an
individual security, while the structure is the set of rules
that dictates how the income received from the collateral
will be distributed. The legal entity, collateral, and structure are collectively referred to as the deal. Unlike traditional mortgage pass-through securities, CMOs feature
dierent payment streams and risks, depending on investor preferences.[1] For tax purposes, CMOs are generally structured as Real Estate Mortgage Investment Conduits, which avoid the potential for double-taxation.[3]

Hayre, Lakhbir (2001). Salomon Smith Barney

Guide to Mortgage-Backed and Asset-Backed Secu- Investors in CMOs include banks, hedge funds, insurance
companies, pension funds, mutual funds, government
rities. Wiley. ISBN 978-0-471-38587-5.

352

CHAPTER 16. ASSET BASED SECURITIES

agencies, and most recently central banks. This article

focuses primarily on CMO bonds as traded in the United
States of America.

agencies Fannie Mae or Freddie Mac, certain investors may not agree with the risk reward tradeo
of the interest rate earned versus the potential loss of
principal due to the borrower not paying. The latter
event is known as default risk.

The term collateralized mortgage obligation technically

refers to a security issued by specic type of legal entity
dealing in residential mortgages, but investors also freSalomon Brothers and First Boston created the CMO
quently refer to deals put together using other types of
concept to address these issues. A CMO is essentially
entities such as real estate mortgage investment conduits
a way to create many dierent kinds of bonds from the
as CMOs.
same mortgage loan so as to please many dierent kinds
of investors. For example:

16.3.1

Purpose

The most basic way a mortgage loan can be transformed

into a bond suitable for purchase by an investor would
simply be to split it. For example, a $300,000 30 year
mortgage with an interest rate of 6.5% could be split into
300 1000 dollar bonds. These bonds would have a 30 year
amortization, and an interest rate of 6.00% for example
(with the remaining .50% going to the servicing company
to send out the monthly bills and perform servicing work).
However, this format of bond has various problems for
various investors
Even though the mortgage is 30 years, the borrower
could theoretically pay o the loan earlier than 30
years, and will usually do so when rates have gone
down, forcing the investor to have to reinvest his
money at lower interest rates, something he may
have not planned for. This is known as prepayment
risk.
A 30 year time frame is a long time for an investors
money to be locked away. Only a small percentage of investors would be interested in locking away
their money for this long. Even if the average home
owner renanced their loan every 10 years, meaning
that the average bond would only last 10 years, there
is a risk that the borrowers would not renance, such
as during an extending high interest rate period, this
is known as extension risk. In addition, the longer
time frame of a bond, the more the price moves up
and down with the changes of interest rates, causing
a greater potential penalty or bonus for an investor
selling his bonds early. This is known as interest rate
risk.
Most normal bonds can be thought of as interest
only loans, where the borrower borrows a xed
amount and then pays interest only before returning the principal at the end of a period. On a normal mortgage, interest and principal are paid each
month, causing the amount of interest earned to decrease. This is undesirable to many investors because they are forced to reinvest the principal. This
is known as reinvestment risk.

A group of mortgages could create 4 dierent

classes of bonds. The rst group would receive any
prepayments before the second group would, and so
on. Thus the rst group of bonds would be expected
to pay o sooner, but would also have a lower interest rate. Thus a 30 year mortgage is transformed
into bonds of various lengths suitable for various investors with various goals.
A group of mortgages could create 4 dierent
classes of bonds. Any losses would go against the
rst group, before going against the second group,
etc. The rst group would have the highest interest
rate, while the second would have slightly less, etc.
Thus an investor could choose the bond that is right
for the risk they want to take (i.e. a conservative
bond for an insurance company, a speculative bond
for a hedge fund).
A group of mortgages could be split into principalonly and interest-only bonds. The principal-only
bonds would sell at a discount, and would thus be
zero coupon bonds (e.g., bonds that you buy for
$800 each and which mature at $1,000, without
paying any cash interest). These bonds would satisfy investors who are worried that mortgage prepayments would force them to re-invest their money
at the exact moment interest rates are lower; countering this, principal only investors in such a scenario would also be getting their money earlier rather
than later, which equates to a higher return on their
zero-coupon investment. The interest-only bonds
would include only the interest payments of the underlying pool of loans. These kinds of bonds would
dramatically change in value based on interest rate
movements, e.g., prepayments mean less interest
payments, but higher interest rates and lower prepayments means these bonds pay more, and for a
longer time. These characteristics allow investors
to choose between interest-only (IO) or principalonly (PO) bonds to better manage their sensitivity
to interest rates, and can be used to manage and oset the interest rate-related price changes in other
investments.[4]

Whenever a group of mortgages is split into dierent

On loans not guaranteed by the quasi-governmental classes of bonds, the risk does not disappear. Rather, it is

16.3. COLLATERALIZED MORTGAGE OBLIGATION

353

reallocated among the dierent classes. Some classes re- Excess spread
ceive less risk of a particular type; other classes more risk
of that type. How much the risk is reduced or increased Another way to enhance credit protection is to issue
for each class depends on how the classes are structured. bonds that pay a lower interest rate than the underlying
mortgages. For example, if the weighted average interest
rate of the mortgage pool is 7%, the CMO issuer could
choose to issue bonds that pay a 5% coupon. The addi16.3.2 Credit protection
tional interest, referred to as excess spread, is placed
CMOs are most often backed by mortgage loans, which into a spread account until some or all of the bonds in
are originated by thrifts (savings and loans), mortgage the deal mature. If some of the mortgage loans go delincompanies, and the consumer lending units of large com- quent or default, funds from the excess spread account can
mercial banks. Loans meeting certain size and credit be used to pay the bondholders. Excess spread is a very
criteria can be insured against losses resulting from bor- eective mechanism for protecting bondholders from derower delinquencies and defaults by any of the Gov- faults that occur late in the life of the deal because by that
ernment Sponsored Enterprises (GSEs) (Freddie Mac, time the funds in the excess spread account will be suFannie Mae, or Ginnie Mae). GSE guaranteed loans can cient to cover almost any losses.
serve as collateral for Agency CMOs, which are subject
to interest rate risk but not credit risk. Loans not meeting
these criteria are referred to as Non-Conforming, and 16.3.3 Prepayment tranching
can serve as collateral for private label mortgage bonds,
which are also called whole loan CMOs. Whole loan The principal (and associated coupon) stream for CMO
CMOs are subject to both credit risk and interest rate collateral can be structured to allocate prepayment risk.
risk. Issuers of whole loan CMOs generally structure Investors in CMOs wish to be protected from prepayment
their deals to reduce the credit risk of all certain classes risk as well as credit risk. Prepayment risk is the risk that
of bonds (Senior Bonds) by utilizing various forms of the term of the security will vary according to diering
rates of repayment of principal by borrowers (repayments
credit protection in the structure of the deal.
from renancings, sales, curtailments, or foreclosures).
If principal is prepaid faster than expected (for example, if mortgage rates fall and borrowers renance), then
Credit tranching
the overall term of the mortgage collateral will shorten,
The most common form of credit protection is called and the principal returned at par will cause a loss for precredit tranching. In the simplest case, credit tranching mium priced collateral. This prepayment risk cannot be
means that any credit losses will be absorbed by the most removed, but can be reallocated between CMO tranches
junior class of bondholders until the principal value of so that some tranches have some protection against this
their investment reaches zero. If this occurs, the next risk, whereas other tranches will absorb more of this risk.
class of bonds absorb credit losses, and so forth, until - To facilitate this allocation of prepayment risk, CMOs
nally the senior bonds begin to experience losses. More are structured such that prepayments are allocated befrequently, a deal is embedded with certain triggers re- tween bonds using a xed set of rules. The most common
lated to quantities of delinquencies or defaults in the loans schemes for prepayment tranching are described below.
backing the mortgage pool. If a balance of delinquent
loans reaches a certain threshold, interest and principal Sequential tranching (or by time)
that would be used to pay junior bondholders is instead
directed to pay o the principal balance of senior bond- All of the available principal payments go to the rst seholders, shortening the life of the senior bonds.
quential tranche, until its balance is decremented to zero,
then to the second, and so on. There are several reasons
that this type of tranching would be done:
Overcollateralization
In CMOs backed by loans of lower credit quality, such
as subprime mortgage loans, the issuer will sell a quantity
of bonds whose principal value is less than the value of
the underlying pool of mortgages. Because of the excess
collateral, investors in the CMO will not experience losses
until defaults on the underlying loans reach a certain level.
If the overcollateralization turns into undercollateralization (the assumptions of the default rate were inadequate), then the CMO defaults. CMOs have contributed
to the subprime mortgage crisis.

The tranches could be expected to mature at very

dierent times and therefore would have dierent
yields that correspond to dierent points on the yield
curve.
The underlying mortgages could have a great deal
of uncertainty as to when the principal will actually
be received since home owners have the option to
make their scheduled payments or to pay their loan
o early at any time. The sequential tranches each
have much less uncertainty.

354
Parallel tranching
This simply means tranches that pay down pro rata. The
coupons on the tranches would be set so that in aggregate
the tranches pay the same amount of interest as the underlying mortgages. The tranches could be either xed rate
or oating rate. If they have oating coupons, they would
have a formula that make their total interest equal to the
collateral interest. For example, with collateral that pays
a coupon of 8%, you could have two tranches that each
have half of the principal, one being a oater that pays
LIBOR with a cap of 16%, the other being an inverse
oater that pays a coupon of 16% minus LIBOR.
A special case of parallel tranching is known as the
IO/PO split. IO and PO refer to Interest Only and
Principal Only. In this case, one tranche would have
a coupon of zero (meaning that it would get no interest at all) and the other would get all of the interest. These bonds could be used to speculate on
prepayments. A principal only bond would be sold
at a deep discount (a much lower price than the underlying mortgage) and would rise in price rapidly
if many of the underlying mortgages were prepaid.
The interest only bond would be very protable if
few of the mortgages prepaid, but could get very little money if many mortgages prepaid.

CHAPTER 16. ASSET BASED SECURITIES

whichever rate is lower, so it will change prepayment
at one PSA for the rst part of its life, then switch
to the other rate. The ability to stay on this schedule
is maintained by a support bond, which absorbs excess prepayments, and will receive less prepayments
to prevent extension of average life. However, the
PAC is only protected from extension to the amount
that prepayments are made on the underlying MBSs.
When the principal of that bond is exhausted, the
CMO is referred to as a busted PAC, or busted
collar.
Target Amortization Class (TAC) bonds are similar
to PAC bonds, but they do not provide protection
against extension of average life. The schedule of
principal payments is created by using just a single
PSA.
Very accurately dened maturity (VADM) bonds
Very accurately dened maturity (VADM) bonds are similar to PAC bonds in that they protect against both extension and contraction risk, but their payments are supported in a dierent way. Instead of a support bond, they
are supported by accretion of a Z bond. Because of this,
a VADM tranche will receive the scheduled prepayments
even if no prepayments are made on the underlying.

Z bonds

Non-accelerating senior (NAS)

This type of tranche supports other tranches by not receiving an interest payment. The interest payment that
would have accrued to the Z tranche is used to pay o
the principal of other bonds, and the principal of the Z
tranche increases. The Z tranche starts receiving interest
and principal payments only after the other tranches in
the CMO have been fully paid. This type of tranche is
often used to customize sequential tranches, or VADM
tranches.

NAS bonds are designed to protect investors from volatility and negative convexity resulting from prepayments.
NAS tranches of bonds are fully protected from prepayments for a specied period, after which time prepayments are allocated to the tranche using a specied step
down formula. For example, an NAS bond might be protected from prepayments for ve years, and then would
receive 10% of the prepayments for the rst month, then
20%, and so on. Recently, issuers have added features to
accelerate the proportion of prepayments owing to the
NAS class of bond in order to create shorter bonds and
reduce extension risk. NAS tranches are usually found
in deals that also contain short sequentials, Z-bonds, and
credit subordination. A NAS tranche receives principal
payments according to a schedule which shows for a given
month the share of pro rata principal that must be distributed to the NAS tranche.

Schedule bonds (also called PAC or TAC bonds)

This type of tranching has a bond (often called a PAC
or TAC bond) which has even less uncertainty than a sequential bond by receiving prepayments according to a
dened schedule. The schedule is maintained by using
support bonds (also called companion bonds) that absorb
the excess prepayments.

NASquential
Planned Amortization Class (PAC) bonds have a
principal payment rate determined by two dierent
prepayment rates, which together form a band (also
called a collar). Early in the life of the CMO, the
prepayment at the lower PSA will yield a lower prepayment. Later in the life, the principal in the higher
PSA will have declined enough that it will yield a
lower prepayment. The PAC tranche will receive

NASquentials were introduced in mid-2005 and represented an innovative structural twist, combining the
standard NAS (Non-Accelerated Senior) and Sequential structures. Similar to a sequential structure, the
NASquentials are tranched sequentially, however, each
tranche has a NAS-like hard lockout date associated with
it. Unlike with a NAS, no shifting interest mechanism

16.3. COLLATERALIZED MORTGAGE OBLIGATION

355

is employed after the initial lockout date. The resulting culated as (6 / 6.5) * $100mm, the principal of the PO is
bonds oer superior stability versus regular sequentials, calculated as balance from $100mm.
and yield pickup versus PACs. The support-like cashows falling out on the other side of NASquentials are
sometimes referred to as RUSquentials (Relatively Un- IO/PO pair
stable Sequentials).
The simplest coupon tranching is to allocate the coupon
stream to an IO, and the principal stream to a PO. This
is generally only done on the whole collateral without any
16.3.4 Coupon tranching
prepayment tranching, and generates strip IOs and strip
The coupon stream from the mortgage collateral can POs. In particular FNMA and FHLMC both have extenalso be restructured (analogous to the way the princi- sive strip IO/PO programs (aka Trusts IO/PO or SMBS)
pal stream is structured). This coupon stream alloca- which generate very large, liquid strip IO/PO deals at regtion is performed after prepayment tranching is com- ular intervals.
plete. If the coupon tranching is done on the collateral without any prepayment tranching, then the resulting
tranches are called 'strips. The benet is that the result- Floater/inverse pair
ing CMO tranches can be targeted to very dierent sets
of investors. In general, coupon tranching will produce a The construction of CMO Floaters is the most eective
means of getting additional market liquidity for CMOs.
pair (or set) of complementary CMO tranches.
CMO oaters have a coupon that moves in line with a
given index (usually 1 month LIBOR) plus a spread, and
is thus seen as a relatively safe investment even though
IO/discount xed rate pair
the term of the security may change. One feature of
A xed rate CMO tranche can be further restructured into CMO oaters that is somewhat unusual is that they have
an Interest Only (IO) tranche and a discount coupon xed a coupon cap, usually set well out of the money (e.g. 8%
rate tranche. An IO pays a coupon only based on a no- when LIBOR is 5%) In creating a CMO oater, a CMO
tional principal, it receives no principal payments from Inverse is generated. The CMO inverse is a more comamortization or prepayments. Notional principal does not plicated instrument to hedge and analyse, and is usually
have any cash ows but shadows the principal changes sold to sophisticated investors.
of the original tranche, and it is this principal o which The construction of a oater/inverse can be seen in two
the coupon is calculated. For example a $100mm PAC stages. The rst stage is to synthetically raise the eectranche o 6% collateral with a 6% coupon ('6 o 6' or tive coupon to the target oater cap, in the same way as
'6-squared') can be cut into a $100mm PAC tranche with done for the PO/Premium xed rate pair. As an exama 5% coupon (and hence a lower dollar price) called a '5 ple using $100mm 6% collateral, targeting an 8% cap,
o 6', and a PAC IO tranche with a notional principal of we generate $25mm of PO and $75mm of '8 o 6'. The
$16.666667mm and paying a 6% coupon. Note the re- next stage is to cut up the premium coupon into a oater
sulting notional principle of the IO is less than the original and inverse coupon, where the oater is a linear function
principal. Using the example, the IO is created by taking of the index, with unit slope and a given oset or spread.
1% of coupon o the 6% original coupon gives an IO of In the example, the 8% coupon of the '8 o 6' is cut into
1% coupon o $100mm notional principal, but this is by a oater coupon of:
convention 'normalized' to a 6% coupon (as the collateral was originally 6% coupon) by reducing the notional 1 * LIBOR + 0.40%
principal to $16.666667mm ($100mm / 6).
(indicating a 0.40%, or 40bps, spread in this example)
PO/premium xed rate pair
Similarly if a xed rate CMO tranche coupon is desired
to be increased, then principal can be removed to form
a Principal Only (PO) class and a premium xed rate
tranche. A PO pays no coupon, but receives principal
payments from amortization and prepayments. For example a $100mm sequential (SEQ) tranche o 6% collateral with a 6% coupon ('6 o 6') can be cut into an
$92.307692mm SEQ tranche with a 6.5% coupon (and
hence a higher dollar price) called a '6.5 o 6', and a SEQ
PO tranche with a principal of $7.692308mm and paying
a no coupon. The principal of the premium SEQ is cal-

The inverse formula is simply the dierence of the original premium xed rate coupon less the oater formula.
In the example:
8% - (1 * LIBOR + 0.40%) = 7.60% - 1 * LIBOR
The oater coupon is allocated to the premium xed rate
tranche principal, in the example the $75mm '8 o 6',
giving the oater tranche of '$75mm 8% cap + 40bps LIBOR SEQ oater'. The oater will pay LIBOR + 0.40%
each month on an original balance of $75mm, subject to
a coupon cap of 8%.
The inverse coupon is to be allocated to the PO principal, but has been generated of the notional principal of
the premium xed rate tranche (in the example the PO

356

CHAPTER 16. ASSET BASED SECURITIES

principal is $25mm but the inverse coupon is notionalized o $75mm). Therefore the inverse coupon is 'renotionalized' to the smaller principal amount, in the example this is done by multiplying the coupon by ($75mm
/$25mm) = 3. Therefore the resulting coupon is:

Mortgage-backed security
Real estate mortgage investment conduit

16.3.7 References

3 * (7.60% - 1 * LIBOR) = 22.8% - 3 * LIBOR

In the example the inverse generated is a '$25mm 3 times
levered 7.6 strike LIBOR SEQ inverse'.

[1] Lemke, Lins and Picard, Mortgage-Backed Securities,

Chapter 4 (Thomson West, 2013 ed.).
[2] FIAS: Dexter Senft

Other structures

[3] Lemke, Lins and Picard, Mortgage-Backed Securities,

4:20 (Thomson West, 2013 ed.).

Other structures include Inverse IOs, TTIBs, Digital

TTIBs/Superoaters, and 'mountain' bonds. A special
class of IO/POs generated in non-agency deals are WAC
IOs and WAC POs, which are used to build a xed pass
through rate on a deal.

[4] The Various Types of CMOs

16.3.5

Attributes of IOs and POs

Interest only (IO)

An interest only (IO) strip may be carved from collateral
securities to receive just the interest portion of a payment.
Once an underlying debt is paid o, that debts future
stream of interest is terminated. Therefore, IO securities
are highly sensitive to prepayments and/or interest rates
and bear more risk. (These securities usually have a negative eective duration.) IOs have investor demand due
to their negative duration acting as a hedge against conventional securities in a portfolio, their generally positive
carry (net cashow), and their implicit leverage (low dollar price versus potential price action).
Principal only (PO)
A principal only (PO) strip may be carved from collateral
securities to receive just the principal portion of a payment. A PO typically has more eective duration than
its collateral. (One may think of this in two ways: 1. The
increased eective duration must balance the matching
IOs negative eective duration to equal the collaterals
eective duration, or 2. Bonds with lower coupons usually have higher eective durations and a PO has no [zero]
coupon.) POs have investor demand as hedges against IO
type streams (e.g. mortgage servicing).

16.3.6

See also

Asset-backed security
Collateralized debt obligation (CDO)
Collateralized fund obligation (CFO)
GNMA

Chapter 17

Other Risks
17.1 Market Risk

However, VaR contains a number of limiting assumptions

that constrain its accuracy. The rst assumption is that
Market risk is the risk of losses in positions arising from the composition of the portfolio measured remains unchanged over the specied period. Over short time horimovements in market prices.[1]
zons, this limiting assumption is often regarded as reasonable. However, over longer time horizons, many of the
positions in the portfolio may have been changed. The
17.1.1 Types
VaR of the unchanged portfolio is no longer relevant.
Some market risks include:

The Variance Covariance and Historical Simulation approach to calculating VaR also assumes that historical
Equity risk, the risk that stock or stock indices (e.g. correlations are stable and will not change in the future
Euro Stoxx 50, etc. ) prices and/or their implied or breakdown under times of market stress.
volatility will change.
In addition, care has to be taken regarding the intervening cash ow, embedded options, changes in oating rate
Interest rate risk, the risk that interest rates (e.g. interest rates of the nancial positions in the portfolio.
Libor, Euribor, etc.) and/or their implied volatility They cannot be ignored if their impact can be large.
will change.
Currency risk, the risk that foreign exchange rates 17.1.4
(e.g. EUR/USD, EUR/GBP, etc.) and/or their implied volatility will change.

Use in annual reports of U.S. corporations

In the United States, a section on market risk is mandated

Commodity risk, the risk that commodity prices (e.g. by the SEC[2] in all annual reports submitted on Form
corn, copper, crude oil, etc.) and/or their implied 10-K. The company must detail how its own results may
volatility will change.
depend directly on nancial markets. This is designed to
show, for example, an investor who believes he is investing in a normal milk company, that the company is in fact
17.1.2 Risk management
also carrying out non-dairy activities such as investing in
complex derivatives or foreign exchange futures.
All businesses take risks based on two factors: the probability an adverse circumstance will come about and the
cost of such adverse circumstance. Risk management is 17.1.5 References
the study of how to control risks and balance the possi[1] Bank for International Settlements: A glossary of terms
bility of gains.
used in payments and settlement systems

17.1.3

Measuring the potential

amount due to market risk

loss

[2] FAQ on the United States SEC Market Disclosure Rules

Dorfman, Mark S. (1997). Introduction to Risk

Management and Insurance (6th ed.). Prentice Hall.
ISBN 0-13-752106-5.

As with other forms of risk, the potential loss amount due

to market risk may be measured in a number of ways or
conventions. Traditionally, one convention is to use value
at risk (VaR). The conventions of using VaR are well es- 17.1.6 See also
tablished and accepted in the short-term risk management
Systemic risk
practice.
357

358

CHAPTER 17. OTHER RISKS

Cost risk

Foreign investment risk

Demand risk

Risk of rapid and extreme changes in value due to:

smaller markets; diering accounting, reporting, or
auditing standards; nationalization, expropriation or conscatory taxation; economic conict; or political or diplomatic changes. Valuation, liquidity, and regulatory issues
may also add to foreign investment risk.

Risk modeling
Risk attitude
Modern portfolio theory
Risk Return Ratio

17.1.7

External links

Liquidity risk
Main article: Liquidity risk
See also: Liquidity

Managing market risks by forward pricing

How hedge funds limit exposure to market risk

17.2 Financial risk

Financial risk is an umbrella term for multiple types of
risk associated with nancing, including nancial transactions that include company loans in risk of default.[1][2]
Risk is a term often used to imply downside risk, meaning
the uncertainty of a return and the potential for nancial
loss.[3][4]
A science has evolved around managing market and nancial risk under the general title of modern portfolio
theory initiated by Dr. Harry Markowitz in 1952 with
his article, Portfolio Selection.[5] In modern portfolio
theory, the variance (or standard deviation) of a portfolio
is used as the denition of risk.

This is the risk that a given security or asset cannot be

traded quickly enough in the market to prevent a loss (or
make the required prot). There are two types of liquidity
risk:
Asset liquidity - An asset cannot be sold due to lack
of liquidity in the market - essentially a sub-set of
market risk. This can be accounted for by:
Widening bid-oer spread
Making explicit liquidity reserves
Lengthening holding period for VaR calculations
Funding liquidity - Risk that liabilities:
Cannot be met when they fall due
Can only be met at an uneconomic price
Can be name-specic or systemic

17.2.1

Types of risk

Asset-backed risk

Market risk

Main article: Market risk

Risk that the changes in one or more assets that support an
asset-backed security will signicantly impact the value
of the supported security. Risks include interest rate, The four standard market risk factors are equity risk, interest rate risk, currency risk, and commodity risk:
term modication, and prepayment risk.
Credit risk
Main article: Credit risk
Credit risk, also called default risk, is the risk associated
with a borrower going into default (not making payments
as promised). Investor losses include lost principal and
interest, decreased cash ow, and increased collection
costs. An investor can also assume credit risk through
direct or indirect use of leverage. For example, an investor may purchase an investment using margin. Or an
investment may directly or indirectly use or rely on repo,
forward commitment, or derivative instruments.

Equity risk is the risk that stock prices in general

(not related to a particular company or industry) or
the implied volatility will change.
Interest rate risk is the risk that interest rates or the
implied volatility will change.
Currency risk is the risk that foreign exchange rates
or the implied volatility will change, which aects,
for example, the value of an asset held in that currency.
Commodity risk is the risk that commodity prices
(e.g. corn, copper, crude oil) or implied volatility
will change.

17.2. FINANCIAL RISK

Operational risk
Main article: Operational risk

Other risks
Reputational risk
Legal risk
IT risk

359
the same direction causing severe nancial stress to market participants who had believed that their diversication
would protect them against any plausible market conditions, including funds that had been explicitly set up to
avoid being aected in this way [9]
Diversication has costs. Correlations must be identied
and understood, and since they are not constant it may be
necessary to rebalance the portfolio which incurs transaction costs due to buying and selling assets. There is
also the risk that as an investor or fund manager diversies their ability to monitor and understand the assets may
decline leading to the possibility of losses due to poor decisions or unforeseen correlations.

Model risk
Main article: Model risk

17.2.3 Hedging

Hedging is a method for reducing risk where a combination of assets are selected to oset the movements of each
other. For instance when investing in a stock it is possi17.2.2 Diversication
ble to buy an option to sell that stock at a dened price
at some point in the future. The combined portfolio of
Main article: Diversication (nance)
stock and option is now much less likely to move below
a given value. As in diversication there is a cost, this
Financial risk, market risk, and even ination risk, can at time in buying the option for which there is a premium.
Derivatives are used extensively to mitigate many types
least partially be moderated by forms of diversication.
of risk.[10]
The returns from dierent assets are highly unlikely to be
perfectly correlated and the correlation may sometimes
be negative. For instance, an increase in the price of 17.2.4 Financial / Credit risk related
oil will often favour a company that produces it,[6] but
acronyms
negatively impact the business of a rm such an airline
[7]
whose variable costs are heavily based upon fuel. HowACPM Active credit portfolio management
ever, share prices are driven by many factors, such as the
general health of the economy which will increase the EAD Exposure at default
correlation and reduce the benet of diversication. If EL Expected loss
one constructs a portfolio by including a wide variety of
equities, it will tend to exhibit the same risk and return ERM Enterprise risk management
characteristics as the market as a whole, which many in- LGD Loss given default
vestors see as an attractive prospect, so that index funds
have been developed that invest in equities in proportion PD Probability of default
to the weighting they have in some well known index such KMV quantitative credit analysis solution developed by
as the FTSE.
credit rating agency Moodys
However, history shows that even over substantial periods VaR value at risk, a common methodology for measuring
of time there is a wide range of returns that an index fund risk due to market movements
may experience; so an index fund by itself is not fully diversied. Greater diversication can be obtained by diversifying across asset classes; for instance a portfolio of 17.2.5 See also
many bonds and many equities can be constructed in or Beta
der to further narrow the dispersion of possible portfolio
outcomes.
Capital asset pricing model
A key issue in diversication is the correlation between
Cost of capital
assets, the benets increasing with lower correlation.
However this is not an observable quantity, since the fu Downside beta
ture return on any asset can never be known with complete certainty. This was a serious issue in the Late-2000s
Downside risk
recession when assets that had previously had small or
even negative correlations[8] suddenly starting moving in
Insurance

360

CHAPTER 17. OTHER RISKS

Macro risk
Modern portfolio theory
Optimism bias
Reinvestment risk
Risk attitude
Risk measure
RiskLab
Risk premium
Systemic risk
Upside beta
Upside risk
Value at risk

17.2.6

References

[1] Financial Risk: Denition. Investopedia. Retrieved

October 2011.
[2] In Wall Street Words. Credo Reference. 2003. Retrieved October 2011.
[3] McNeil, Alexander J.; Frey, Rdiger; Embrechts, Paul
(2005). Quantitative risk management: concepts, techniques and tools. Princeton University Press. pp. 23.
ISBN 978-0-691-12255-7.
[4] Horcher, Karen A. (2005). Essentials of nancial risk
management. John Wiley and Sons. pp. 13. ISBN 9780-471-70616-8.
[5] Markowitz, H.M. (March 1952). Portfolio Selection.
The Journal of Finance 7 (1): 7791.
doi:10.2307/2975974.
[6] Another record prot for Exxon. BBC News. 31 July
2008.
[7] Crawley, John (16 May 2011). U.S. airline shares up as
oil price slides. Reuters.
[8] http://www.eurojournals.com/irjfe_35_14.pdf
[9] http://web.mit.edu/alo/www/Papers/august07.pdf
[10] http://www.chicagofed.org/webpages/publications/
understanding_derivatives/index.cfm

17.2.7 External links

Bartram, Shnke M.; Brown, Gregory W.; Waller,
William (August 2013). How Important is Financial Risk?". Journal of Financial and Quantitative
Analysis. forthcoming.
Risk.net Financial Risk Management News &
Analysis
MacroRisk Analytics Patented and proprietary
macro risk measurements and tools for investors
since 1999.
Elements of Financial Risk Management, 2nd Edition
Quantitative Risk Management: A Practical Guide
to Financial Risk
Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank of Chicago, Financial
Markets Group
Financial Risks Management of International Investments in Forex

17.3 Liquidity risk

In nance, liquidity risk is the risk that a given security
or asset cannot be traded quickly enough in the market to
prevent a loss (or make the required prot).

17.3.1 Types of liquidity risk

Market liquidity An asset cannot be sold due to lack
of liquidity in the market essentially a sub-set of market
risk.[1] This can be accounted for by:
Widening bid/oer spread
Making explicit liquidity reserves
Lengthening holding period for VaR calculations
Funding liquidity Risk that liabilities:
Cannot be met when they fall due
Can only be met at an uneconomic price
Can be name-specic or systemic[1]

17.3. LIQUIDITY RISK

17.3.2

Causes of liquidity risk

Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody
in the market wants to trade for that asset. Liquidity risk
becomes particularly important to parties who are about
to hold or currently hold an asset, since it aects their
ability to trade.

361
plemented with stress testing. Look at net cash ows on a
day-to-day basis assuming that an important counterparty
defaults.

Analyses such as these cannot easily take into account

contingent cash ows, such as cash ows from derivatives or mortgage-backed securities. If an organizations
cash ows are largely contingent, liquidity risk may be assessed using some form of scenario analysis. A general
approach using scenario analysis might entail the followManifestation of liquidity risk is very dierent from a
ing high-level steps:
drop of price to zero. In case of a drop of an assets price
to zero, the market is saying that the asset is worthless.
Construct multiple scenarios for market movements
However, if one party cannot nd another party interested
and defaults over a given period of time
in trading the asset, this can potentially be only a problem of the market participants with nding each other.[2]
Assess day-to-day cash ows under each scenario.
This is why liquidity risk is usually found to be higher in
emerging markets or low-volume markets.
Because balance sheets dier so signicantly from one
Liquidity risk is nancial risk due to uncertain liquidity.
organization to the next, there is little standardization in
An institution might lose liquidity if its credit rating falls,
how such analyses are implemented.
it experiences sudden unexpected cash outows, or some
other event causes counterparties to avoid trading with Regulators are primarily concerned about systemic implior lending to the institution. A rm is also exposed to cations of liquidity risk.
liquidity risk if markets on which it depends are subject
to loss of liquidity.
Market and funding liquidity risks compound each other
as it is dicult to sell when other investors face funding
problems and it is dicult to get funding when the collateral is hard to sell.[1] Liquidity risk also tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that
position at short notice will compound its market risk.
Suppose a rm has osetting cash ows with two dierent counterparties on a given day. If the counterparty that
owes it a payment defaults, the rm will have to raise cash
from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is
compounding credit risk.
A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk
examplethe two payments are osetting, so they entail
credit risk but not market risk. Another example is the
1993 Metallgesellschaft debacle. Futures contracts were
used to hedge an Over-the-counter nance OTC obligation. It is debatable whether the hedge was eective
from a market risk standpoint, but it was the liquidity crisis caused by staggering margin calls on the futures that
forced Metallgesellschaft to unwind the positions.
Accordingly, liquidity risk has to be managed in addition
to market, credit and other risks. Because of its tendency
to compound other risks, it is dicult or impossible to
isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do
not exist. Certain techniques of asset liability management can be applied to assessing liquidity risk. A simple
test for liquidity risk is to look at future net cash ows on
a day-by-day basis. Any day that has a sizeable negative
net cash ow is of concern. Such an analysis can be sup-

17.3.3 Pricing of liquidity risk

Risk-averse investors naturally require higher expected

return as compensation for liquidity risk. The liquidityadjusted CAPM pricing model therefore states that, the
higher an assets market-liquidity risk, the higher its required return.[3]

17.3.4 Measures of liquidity risk

Liquidity gap
Culp denes the liquidity gap as the net liquid assets of
a rm. The excess value of the rms liquid assets over
its volatile liabilities. A company with a negative liquidity gap should focus on their cash balances and possible
unexpected changes in their values.
As a static measure of liquidity risk it gives no indication
of how the gap would change with an increase in the rms
marginal funding cost.
Liquidity risk elasticity
Culp denotes the change of net of assets over funded liabilities that occurs when the liquidity premium on the
banks marginal funding cost rises by a small amount as
the liquidity risk elasticity. For banks this would be measured as a spread over libor, for nonnancials the LRE
would be measured as a spread over commercial paper
rates.
Problems with the use of liquidity risk elasticity are that
it assumes parallel changes in funding spread across all

362

CHAPTER 17. OTHER RISKS

maturities and that it is only accurate for small changes in Liquidity at risk
funding spreads.
Alan Greenspan (1999) discusses management of foreign
exchange reserves. The Liquidity at risk measure is sug17.3.5 Measures of asset liquidity
gested. A countrys liquidity position under a range of
possible outcomes for relevant nancial variables (exBid-oer spread
change rates, commodity prices, credit spreads, etc.) is
considered. It might be possible to express a standard in
The bid-oer spread is used by market participants as an terms of the probabilities of dierent outcomes. For exasset liquidity measure. To compare dierent products ample, an acceptable debt structure could have an average
the ratio of the spread to the products bid price can be maturityaveraged over estimated distributions for relused. The smaller the ratio the more liquid the asset is.
evant nancial variablesin excess of a certain limit. In
This spread is composed of operational, administrative, addition, countries could be expected to hold sucient
and processing costs as well as the compensation required liquid reserves to ensure that they could avoid new borfor the possibility of trading with a more informed trader. rowing for one year with a certain ex ante probability,
such as 95 percent of the time.[7]
Market depth
Hachmeister refers to market depth as the amount of
an asset that can be bought and sold at various bid-ask
spreads. Slippage is related to the concept of market
depth. Knight and Satchell mention a ow trader needs to
consider the eect of executing a large order on the market and to adjust the bid-ask spread accordingly. They
calculate the liquidity cost as the dierence of the execution price and the initial execution price.

Scenario analysis-based contingency plans

The FDIC discuss liquidity risk management and write
Contingency funding plans should incorporate events
that could rapidly aect an institutions liquidity, including a sudden inability to securitize assets, tightening of
collateral requirements or other restrictive terms associated with secured borrowings, or the loss of a large depositor or counterparty.[8] Greenspans liquidity at risk
concept is an example of scenario based liquidity risk
management.

Immediacy
Immediacy refers to the time needed to successfully trade Diversication of liquidity providers
a certain amount of an asset at a prescribed cost.
If several liquidity providers are on call then if any of
those providers increases its costs of supplying liquidity,
Resilience
the impact of this is reduced. The American Academy
of Actuaries wrote While a company is in good nanHachmeister identies the fourth dimension of liquidity cial shape, it may wish to establish durable, ever-green
as the speed with which prices return to former levels after (i.e., always available) liquidity lines of credit. The credit
a large transaction. Unlike the other measures resilience issuer should have an appropriately high credit rating to
can only be determined over a period of time.
increase the chances that the resources will be there when
needed. [9]

17.3.6

Managing liquidity risk

Derivatives

Liquidity-adjusted value at risk

Bhaduri, Meissner and Youn discuss ve derivatives creLiquidity-adjusted VAR incorporates exogenous liquid- ated specically for hedging liquidity risk.:
ity risk into Value at Risk. It can be dened at VAR +
ELC (Exogenous Liquidity Cost). The ELC is the worst
Withdrawal option: A put of the illiquid underlying
expected half-spread at a particular condence level.[4]
at the market price.
Another adjustment, introduced in the 1970s with a reg Bermudan-style return put option: Right to put the
ulatory precursor to todays VAR measures,[5] is to conoption at a specied strike.
sider VAR over the period of time needed to liquidate
the portfolio. VAR can be calculated over this time pe Return swap: Swap the underlyings return for LIriod. The BIS mentions "... a number of institutions are
BOR paid periodicially.
exploring the use of liquidity adjusted-VAR, in which the
Return swaption: Option to enter into the return
holding periods in the risk assessment are adjusted by the
swap.
length of time required to unwind positions. [6]

17.3. LIQUIDITY RISK

363

Liquidity option: Knock-in barrier option, where stress, cuts on AAA-rated commercial mortgages would
the barrier is a liquidity metric.
increase from 2% to 10%, and similarly for other securitiles. In response to this, LTCM had negotiated long-term
nancing with margins xed for several weeks on many
17.3.7 Case studies
of their collateralized loans. Due to an escalating liquidity spiral, LTCM could ultimately not fund its positions in
Amaranth Advisors LLC 2006
spite of its numerous measures to control funding risk.[1]
Amaranth Advisors lost roughly $6bn in the natural gas
futures market back in September 2006. Amaranth had 17.3.8 References
a concentrated, undiversied position in its natural gas
strategy. The trader had used leverage to build a very [1] Brunnermeier, Markus; Lasse H. Pedersen (2009).
Market Liquidity and Funding Liquidity (PDF).
large position. Amaranths positions were staggeringly
Review of Financial Studies 22 (6): 22012238.
large, representing around 10% of the global market in
doi:10.1093/rfs/hhn098. Retrieved August 8, 2012.
[10]
natural gas futures.
Chincarini notes that rms need
to manage liquidity risk explicitly. The inability to sell [2] Darrel Due; Nicolae Grleanu; Lasse Heje Pedersen
a futures contract at or near the latest quoted price is
(November 2005). Over-the-counter markets (PDF).
related to ones concentration in the security. In AmaEconometrica 73 (6): 18151847. doi:10.1111/j.14680262.2005.00639.x. Retrieved August 8, 2012.
ranths case, the concentration was far too high and there
were no natural counterparties when they needed to unwind the positions.[11] Chincarini (2006) argues that part [3] Viral Acharya and Lasse Heje Pedersen, Asset pricing
with liquidity risk. Journal of Financial Economics 77,
of the loss Amaranth incurred was due to asset illiquidity.
2005.
http://pages.stern.nyu.edu/~{}lpederse/papers/
Regression analysis on the 3 week return on natural gas
liquidity_risk.pdf
future contracts from August 31, 2006 to September 21,
2006 against the excess open interest suggested that con- [4] Arnaud Bervas (2006). Market Liquidity and its incorporation into Risk Management (PDF). Financial Stability
tracts whose open interest was much higher on August 31,
Review 8: 6379.
2006 than the historical normalized value, experienced
[12]
larger negative returns.
[5] Glyn A. Holton (2013). Value-at-Risk: Theory and Practice, Second Edition. Retrieved July 2, 2013.

Northern Rock 2007

Main article: Nationalisation of Northern Rock
Northern Rock suered from funding liquidity risk in
September 2007 following the subprime crisis. The rm
suered from liquidity issues despite being solvent at
the time, because maturing loans and deposits could not
be renewed in the short-term money markets.[13] In response, the FSA now places greater supervisory focus on
liquidity risk especially with regard to high-impact retail
rms.[14]
LTCM 1998
Long-Term Capital Management (LTCM) was bailed out
by a consortium of 14 banks in 1998 after being caught
in a cash-ow crisis when economic shocks resulted in
excessive mark-to-market losses and margin calls. The
fund suered from a combination of funding and asset
liquidity. Asset liquidity arose from LTCM failure to
account for liquidity becoming more valuable (as it did
following the crisis). Since much of its balance sheet
was exposed to liquidity risk premium its short positions
would increase in price relative to its long positions. This
was essentially a massive, unhedged exposure to a single
risk factor.[15] LTCM had been aware of funding liquidity risk. Indeed, they estimated that in times of severe

[6] Final Report of the Multidisciplinary Working Group

on Enhanced Disclosure. Bank for International Settlements. April 2001. Retrieved August 8, 2012.
[7] Mr Greenspan discusses recent trends in the management
of foreign exchange reserves (PDF). Bank for International Settlements. April 29, 1999. Retrieved August 8,
2012.
[8] Liquidity Risk Management (PDF). Federal Deposit Insurance Corporation. 2008. Retrieved August 8, 2012.
[9] Report of the Life Liquidity Work Group of the American Academy of Actuaries to the NAICs Life Liquidity Working Group (PDF). Boston, MA: American
Academy of Actuaries. December 2, 2000. Retrieved
August 8, 2012.
[10] Satyajit Das (January 26, 2007). The More Things
Change... Amaranth. Retrieved August 8, 2012.
[11] Ludwig Chincarini (2008). Natural Gas Futures and
Spread Position Risk: Lessons from the Collapse of Amaranth Advisors L.L.C.. Journal of Applied Finance.
SSRN 1086865.
[12] Ludwig B. Chincarini (2006). The Amaranth Debacle
A Failure of Risk Measures or a failure of Risk Management?". SSRN 952607.
[13] Hyun Song Shin (August 2008). Reections on Modern
Bank Runs: A Case Study of Northern Rock (PDF). Retrieved August 9, 2012.

364

CHAPTER 17. OTHER RISKS

[14] FSA moves to enhance supervision in wake of Northern

Rock. Financial Services Authority. March 26, 2008.
Retrieved August 9, 2012.
[15] Sungard Ambit. Long-Term Capital Management Case
Study. ERisk. Archived from the original on 2011-0718.

17.3.9

or exacerbated by idiosyncratic events or conditions in nancial intermediaries.[3] It refers to the risks imposed
by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially
bankrupt or bring down the entire system or market.[4] It
is also sometimes erroneously referred to as "systematic
risk".

Further reading

Yakov Amihud, Haim Mendelson, and Lasse H. 17.4.1 Explanation

Pedersen (2013). Market Liquidity: Asset Pricing, Risk, and Crises. Cambridge University Press. Systemic risk has been associated with a bank run which
has a cascading eect on other banks which are owed
ISBN 9780521139656.
money by the rst bank in trouble, causing a cascading
Crockford, Neil (1986). An Introduction to Risk failure. As depositors sense the ripple eects of default,
Management (2nd ed.). Woodhead-Faulkner. ISBN and liquidity concerns cascade through money markets, a
0-85941-332-2.
panic can spread through a market, with a sudden ight
to quality, creating many sellers but few buyers for illiq van Deventer, Donald R., Kenji Imai and Mark
uid assets. These interlinkages and the potential clusMesler (2004). Advanced Financial Risk Managetering of bank runs are the issues which policy makers
ment: Tools and Techniques for Integrated Credit
consider when addressing the issue of protecting a sysRisk and Interest Rate Risk Management. John Witem against systemic risk.[1][5] Governments and market
ley. ISBN 978-0-470-82126-8.
monitoring institutions (such as the U.S. Securities and
Culp, Christopher L. (2001). The Risk Management Exchange Commission (SEC), and central banks) often
Process. Wiley Finance. ISBN 978-0-471-40554-2. try to put policies and rules in place with the ostensible
justication of safeguarding the interests of the market
Hachmeister, Alexandra (2007). Informed Traders as a whole, claiming that the trading participants in nanas Liquidity Providers. DUV. ISBN 978-3-8350- cial markets are entangled in a web of dependencies aris0755-0.
ing from their interlinkage. In simple English, this means
that some companies are viewed as too big and too in Bhaduri, R., G. Meissner and J. Youn (2007). Hedg- terconnected to fail. Policy makers frequently claim that
ing Liquidity Risk. Journal of Alternative Invest- they are concerned about protecting the resiliency of the
ments, Winter 2007.
system, rather than any one individual in that system.[5]
John L. Knight, Stephen Satchell (2003). Forecast- Systemic risk should not be confused with market or price
ing Volatility in the Financial Markets. Butterworth- risk as the latter is specic to the item being bought or sold
Heinemann. ISBN 978-0-7506-5515-6.
and the eects of market risk are isolated to the entities
dealing in that specic item. This kind of risk can be mitigated by hedging an investment by entering into a mirror
17.3.10 External links
trade.
Insurance is often easy to obtain against systemic risks
because a party issuing that insurance can pocket the pre Bank Liquidity Requirements: An Introduction and miums, issue dividends to shareholders, enter insolvency
Overview by Douglas J. Elliott, The Brookings In- proceedings if a catastrophic event ever takes place, and
stitution
hide behind limited liability. Such insurance, however, is
not eective for the insured entity.
Papers about Liquidity Risk on DefaultRisk.com

Not to be confused with systematic risk.

One argument that was used by nancial institutions to

obtain special advantages in bankruptcy for derivative
contracts was a claim that the market is both critical and
fragile.[1][5][6][7]

In nance, systemic risk is the risk of collapse of an entire nancial system or entire market, as opposed to risk
associated with any one individual entity, group or component of a system, that can be contained therein without
harming the entire system.[1][2] It can be dened as nancial system instability, potentially catastrophic, caused

Systemic risk can also be dened as the likelihood and degree of negative consequences to the larger body. With
respect to federal nancial regulation, the systemic risk of
a nancial institution is the likelihood and the degree that
the institutions activities will negatively aect the larger
economy such that unusual and extreme federal intervention would be required to ameliorate the eects.[8]

17.4 Systemic risk

17.4. SYSTEMIC RISK

A general denition of Systemic Risk which is not limited by its mathematical approaches, model assumptions
or focus on one institution; and which is also the rst operationalizable denition of Systemic Risk encompassing
the systemic character of nancial, political, environmental, and many other risks is available since 2010.[9]

17.4.2

365
net negative impact to the larger economy of an institutions failure to be able to conduct its ongoing business.
The impact is measured not just on the institutions products and activities, but also the economic multiplier of
all other commercial activities dependent specically on
that institution. It is also dependent on how correlated an
institutions business is with other systemic risk.[11]

Measurement of systemic risk

TBTF/TICTF

SRISK

A nancial institution represents a systemic risk if it becomes undercapitalized when the nancial system as a
whole is undercapitalized. In a single risk factor model,
Brownlees and Engle,[12] build a systemic risk measure
named SRISK. SRISK can be interpreted as the amount
of capital that needs to be injected into a nancial rm
as to restore a certain form of minimal capital requirement. SRISK has several nice properties: SRISK is expressed in monetary terms and is, therefore, easy to interpret. SRISK can be easily aggregated across rms to provide industry and even country specic aggregates. Last,
the computation of SRISK involves variables which may
be viewed on their own as risk measures, namely the size
of the nancial rm, the leverage (ratio of assets to market capitalization), and a measure of how the return of
the rm evolves with the market (some sort of time varying conditional beta but with emphasis on the tail of the
distribution). Because these three dimensions matter simultaneously in the SRISK measure, one may expect to
Too Big To Fail: The traditional analysis for assessing obtain a more balanced indicator than if one had used
the risk of required government intervention is the Too either one of the three risk variables individually.
Big to Fail Test (TBTF). TBTF can be measured in terms
of an institutions size relative to the national and inter- Whereas the initial Brownlees and Engle model is tailored
market, the extension by Engle, Jondeau, and
national marketplace, market share concentration (using to the US [13]
Rockinger
allows for various factors, time varying pathe Herndahl-Hirschman Index for example), and comrameters,
and
is therefore more adapted to the European
petitive barriers to entry or how easily a product can be
market. One factor captures worldwide variations of substituted. While there are large companies in most
nancial marketplace segments, the national insurance nancial markets, another one the variations of European
markets. Then this extension allows for a country specic
marketplace is spread among thousands of companies,
and the barriers to entry in a business where capital is factor. By taking into account dierent factors, one captures the notion that shocks to the US or Asian markets
the primary input are relatively minor. The policies of
one homeowners insurer can be relatively easily substi- may aect Europe but also that bad news within Europe
(such as the news about a potential default of one of the
tuted for another or picked up by a state residual market
provider, with limits on the underwriting uidity primar- countries) matters for Europe. Also, there may be counily stemming from state-by-state regulatory impediments, try specic news that do not aect Europe nor the USA
such as limits on pricing and capital mobility. During the but matter for a given country. Empirically the last factor
recent nancial crisis, the collapse of the American In- is found to be less relevant than the worldwide or Euroternational Group (AIG) posed a signicant systemic risk pean factor.
to the nancial system. There are arguably either no or Since RISK is measured in terms of currency, the inextremely few insurers that are TBTF in the U.S. market- dustry aggregates may also be related to Gross Domestic Product. As such one obtains a measure of domestic
place.
Too Interconnected to Fail: A more useful systemic systemically important banks.
According to the Property Casualty Insurers Association
of America, there are two key assessments for measuring
systemic risk, the "too big to fail" (TBTF) and the too
interconnected to fail (TICTF) tests. First, the TBTF
test is the traditional analysis for assessing the risk of required government intervention. TBTF can be measured
in terms of an institutions size relative to the national and
international marketplace, market share concentration,
and competitive barriers to entry or how easily a product can be substituted. Second, the TICTF test is a measure of the likelihood and amount of medium-term net
negative impact to the larger economy of an institutions
failure to be able to conduct its ongoing business. The
impact is measure beyond the institutions products and
activities to include the economic multiplier of all other
commercial activities dependent specically on that institution. The impact is also dependent on how correlated
an institutions business is with other systemic risks.[10]

risk measure than a traditional TBTF test is a Too Interconnected to Fail (TICTF) assessment. An intuitive
TICTF analysis has been at the heart of most recent federal nancial emergency relief decisions. TICTF is a
measure of the likelihood and amount of medium-term

The SRISK Systemic Risk Indicator is computed automatically on a weekly basis and made available to the
community. For the US model SRISK and other statistics may be found under the Volatility Lab of NYU Stern
School website and for the European model under the

366

CHAPTER 17. OTHER RISKS

Center of Risk Management (CRML) website of HEC

Lausanne.

17.4.3

its debt. The equilibrium price equations, or liquidation

value equations,[16] at maturity are now given by

Valuation of assets and derivatives r = min{d , a + 0.05s + 0.2r }

1
1 1
2
2
under systemic risk

Inadequacy of classic valuation models

One problem when it comes to the valuation of derivatives, debt, or equity under systemic risk is that nancial
interconnectedness has to be modelled. One particular
problem is posed by closed valuations chains, as exemplied here for four rms A, B, C, and D:
B might hold shares of A, C holds some debt
of B, D owns a derivative issued by C, and A
owns some debt of D.[14]

r2 = min{d2 , a2 + 0.03s1 + 0.1r1 }

s1 = (a1 + 0.05s2 + 0.2r2 d1 )+
s2 = (a2 + 0.03s1 + 0.1r1 d2 )+ .
This example demonstrates, that systemic risk in the form
of nancial interconnectedness can already lead to a nontrivial, non-linear equation system for the asset values if
only two rms are involved.

Over- and underestimation of default probabilities

It is known that modelling credit risk while ignoring
cross-holdings of debt or equity can lead to an underFor instance, the share price of A could inuence all other , but also an over-estimation of default probabilities.[17]
The need for proper structural models of nancial interasset values, including itself.
connectedness in quantitative risk management - be it in
research or practice - is therefore obvious.
The Merton (1974) model Situations as the one explained earlier, which are present in mature nancial markets, cannot be modelled within the single-rm Merton Structural models under nancial interconnectedmodel,[15] but also not by its straightforward extensions ness
to multiple rms with potentially correlated assets.[14] To
demonstrate this, consider two nancial rms, i = 1, 2 , The rst authors to consider structural models for nanwith limited liability, which both own system-exogenous cial systems where each rm could own debt of any other
assets of a value ai 0 at a maturity T 0 , and which rm were Eisenberg and Noe in 2001.[18] In their model,
both owe a single amount of zero coupon debt di 0 no equity could be cross-owned, and debt had to be of
, due at time T . System-exogenous here refers to the one seniority level, only. In 2002, Suzuki published a
assumption, that the business asset ai is not inuenced by model in which equity could be cross-owned as well.[19]
the rms in the considered nancial system. In the classic His model was developed independently of Eisenberg and
single rm Merton model,[15] it now holds at maturity for Noes. Elsingers publication of 2009[20] was the rst in
the equity si 0 and for the recovery value ri 0 of which debt could be of dierent seniorities, hence allowing to model, for instance, senior and junior debt,
the debt, that
while correctly accounting for the order of priority. His
model allowed equity cross-ownership, too. With Fischer (2014), the rst model which also allowed derivari = min{di , ai }
tives was introduced.[16] The fact that Elsinger was unaware of Suzukis publications, Fischer was unaware of
and
Elsingers, and the fact that other authors re-discovered
parts of Suzukis and Elsingers results[14] [21] [22] shows
that the research in this eld is still somewhat unconsolisi = (ai di )+ .
dated.
Equity and debt recovery value, si and ri , are thus
uniquely and immediately determined by the value ai of
the exogenous business assets. Assuming that the ai are, Risk-neutral valuation: price indeterminacy and
for instance, dened by a Black-Scholes dynamic (with open problems
or without correlations), risk-neutral no-arbitrage pricing
Generally speaking, risk-neutral pricing in structural
of debt and equity is straightforward.
models of nancial interconnectedness requires unique
equilibrium prices at maturity in dependence of the exNon-trivial asset value equations Consider now again ogenous asset price vector, which can be random. While
two such rms, but assume that rm 1 owns 5% of rm nancially interconnected systems with debt and equity
twos equity and 20% of its debt. Similarly, assume cross-ownership without derivatives are fairly well unthat rm 2 owns 3% of rm ones equity and 10% of derstood in the sense that relatively weak conditions on

17.4. SYSTEMIC RISK

367

the ownership structures in the form of ownership matrices are required to warrant uniquely determined price
equilibria,[14][19][20] the Fischer (2014) model needs very
strong conditions on derivatives - which are dened in dependence on any other liability of the considered nancial system - to be able to guarantee uniquely determined
prices of all system-endogenous liabilities. Furthermore,
it is known that there exist examples with no solutions at
all, nitely many solutions (more than one), and innitely
many solutions.[14][16] At present, it is unclear how weak
conditions on derivatives can be chosen to still be able to
apply risk-neutral pricing in nancial networks with systemic risk. It is noteworthy, that the price indeterminacy
that evolves from multiple price equilibria is fundamentally dierent from price indeterminacy that stems from
market incompleteness.[16]

17.4.6 Regulation
One of the main reasons for regulation in the marketplace is to reduce systemic risk.[5] However, regulation
arbitrage the transfer of commerce from a regulated
sector to a less regulated or unregulated sector brings
markets a full circle and restores systemic risk. For example, the banking sector was brought under regulations
in order to reduce systemic risks. Since the banks themselves could not give credit where the risk (and therefore
returns) were high, it was primarily the insurance sector
which took over such deals. Thus the systemic risk migrated from one sector to another and proves that regulation of only one industry cannot be the sole protection
against systemic risks.[27]

17.4.7 Project risks

17.4.4

Factors

In the elds of project management and cost engineering,

systemic risks include those risks that are not unique to
Factors that are found to support systemic risks are:
a particular project and are not readily manageable by a
project team at a given point in time. These risks may be
1. Economic implications of models are not well un- driven by the nature of a companys project system (e.g.,
derstood. Though each individual model may be funding projects before the scope is dened), capabilities,
made accurate, the facts that (1) all models across or culture. They may also be driven by the level of techthe board use the same theoretical basis, and (2) the nology in a project or the complexity of a projects scope
relationship between nancial markets and the econ- or execution strategy.[28]
omy is not known lead to aggravation of systemic
risks.
[23]

17.4.8 Systemic risk and insurance

2. Liquidity risks are not accounted for in pricing models used in trading on the nancial markets. Since all In February 2010, international insurance economics
models are not geared towards this scenario, all par- think tank, The Geneva Association, published a 110ticipants in an illiquid market using such models will page analysis of the role of insurers in systemic risk.[29]
face systemic risks.
In the report, the diering roles of insurers and banks in
the global nancial system and their impact on the crisis
are examined (See also CEA report, Why Insurers Dier
17.4.5 Diversication
from Banks).[30] A key conclusion of the analysis is that
Risks can be reduced in four main ways: Avoidance, Di- the core activities of insurers and reinsurers do not pose
versication, Hedging and Insurance by transferring risk. systemic risks due to the specic features of the industry:
Systematic risk, also called market risk or un-diversiable
Insurance is funded by up-front premia, giving insurrisk, is a risk of security that cannot be reduced through
ers strong operating cash-ow without the requirediversication. Participants in the market, like hedge
ment for wholesale funding;
funds, can be the source of an increase in systemic risk[24]
and transfer of risk to them may, paradoxically, increase
Insurance policies are generally long-term, with conthe exposure to systemic risk.
trolled outows, enabling insurers to act as stabilisUntil recently, many theoretical models of nance
ers to the nancial system;
pointed towards the stabilizing eects of diversied (i.e.,
During the hard test of the nancial crisis, insurers
dense) nancial system. Nevertheless, some recent work
maintained relatively steady capacity, business volhas started to challenge this view, investigating conditions
umes and prices.
under which diversication may have ambiguous eects
on systemic risk.[25][26] Within a certain range, nancial
interconnections serve as shock-absorber (i.e., connectiv- Applying the most commonly cited denition of systemic
ity engenders robustness and risk-sharing prevails). But risk, that of the Financial Stability Board (FSB), to the
beyond the tipping point, interconnections might serve as core activities of insurers and reinsurers, the report conshock-amplier (i.e., connectivity engenders fragility and cludes that none are systemically relevant for at least one
risk-spreading prevails).
of the following reasons:

368

CHAPTER 17. OTHER RISKS

Their limited size means that there would not be dis- to systemic risks generated in other parts of the nancial
ruptive eects on nancial markets;
sector. For most classes of insurance, however, there is
little evidence of insurance either generating or amplify An insurance insolvency develops slowly and can of- ing systemic risk, within the nancial system itself or in
ten be absorbed by, for example, capital raising, or, the real economy.[31]
in a worst case, an orderly wind down;
Other organisations such as the CEA and the Property
The features of the interrelationships of insurance Casualty Insurers Association of America (PCI)[32] have
activities mean that contagion risk would be limited. issued reports on the same subject.
The report underlines that supervisors and policymakers
should focus on activities rather than nancial institutions
when introducing new regulation and that upcoming insurance regulatory regimes, such as Solvency II in the European Union, already adequately address insurance activities.
However, during the nancial crisis, a small number
of quasi-banking activities conducted by insurers either
caused failure or triggered signicant diculties. The
report therefore identies two activities which, when conducted on a widespread scale without proper risk control
frameworks, have the potential for systemic relevance.
Derivatives trading on non-insurance balance sheets;
Mis-management of short-term funding from commercial paper or securities lending.

17.4.9 Discussion
Systemic risk evaluates the likelihood and degree of negative consequences to the larger body. The term systemic risk is frequently used in recent discussions related
to the economic crisis, such as the Subprime mortgage
crisis. The systemic risk of a nancial institution is the
likelihood and the degree that the institutions activities
will negatively aect the larger economy such that unusual and extreme federal intervention would be required
to ameliorate the eects. The failing of nancial rms in
2008 caused systemic risk to the larger economy. Chairman Barney Frank has expressed concerns regarding the
vulnerability of highly leveraged nancial systems to systemic risk and the US government has debated how to
address nancial services regulatory reform and systemic
risk.[33][34]

The industry has put forward ve recommendations to address these particular activities and strengthen nancial 17.4.10
stability:
The implementation of a comprehensive, integrated
and principle-based supervision framework for insurance groups, in order to capture, among other
things, any non-insurance activities such as excessive derivative activities.

See also

Category:Behavioral and social facets of systemic

risk
Bank run
Financial crisis

Strengthening liquidity risk management, particularly to address potential mis-management issues related to short-term funding.

Macroprudential policy

Enhancement of the regulation of nancial guarantee insurance, which has a very dierent business
model than traditional insurance.

Moral hazard

The establishment of macro-prudential monitoring

with appropriate insurance representation.

Taleb Distribution

The strengthening of industry risk management

practices to build on the lessons learned by the industry and the sharing experiences with supervisors
on a global scale.

Modern portfolio theory

Risk modeling

GlassSteagall Act
Monetary economics
Internal contradictions of capital accumulation

Since the publication of The Geneva Association statement, in June 2010, the International Association of In- 17.4.11 Further reading
surance Supervisors (IAIS) issued its position statement
Website dedicated to systemic risk: http://www.
on key nancial stability issues. A key conclusion of the
systemic-risk-hub.org/
statement was that, The insurance sector is susceptible

17.4. SYSTEMIC RISK

Bartram, Shnke M.; Brown, Gregory W.; Hund,
John (December 2007). Estimating Systemic
Risk in the International Financial System. Journal of Financial Economics 86 (3): 835869.
doi:10.1016/j.jneco.2006.10.001.

369
Zeyu Zheng, Boris Podobnik, Ling Feng and
Baowen Li, Changes in Cross-Correlations as an
Indicator for Systemic Risk (Scientic Reports 2:
888 (2012)).

Fischer, Tom (2014). NO-ARBITRAGE PRIC- 17.4.12 References

ING UNDER SYSTEMIC RISK: ACCOUNTING FOR CROSS-OWNERSHIP. Mathemati- [1] Banking and currency crises and systemic risk, George G.
Kaufman (World Bank), Internet Archive
cal Finance 24 (1): 97124. doi:10.1111/j.14679965.2012.00526.x. (Published online: 19 Jun
[2] What is systemic risk anyway?, Gerald P. Dwyer
2012)
Gray, Dale F. and Andreas A. Jobst, 2011,
"Modelling Systemic Financial Sector and
Sovereign Risk, Sveriges Riksbank Economic
Review, No. 2, pp. 68106.
Gray, Dale F. and Andreas A. Jobst, 2009, Higher
Moments and Multivariate Dependence of Implied
Volatilities from Equity Options as Measures of
Systemic Risk, Global Financial Stability Report,
Chapter 3, April (Washington: International Monetary Fund), pp. 12831.
Gray, Dale F. and Andreas A. Jobst, New Directions in Financial Sector and Sovereign Risk Management, Journal of Investment Management, Vol.
8, No.1, pp.2338.
Gray, Dale F. and Andreas A. Jobst, 2011, Modeling Systemic and Sovereign Risk, in: Berd, Arthur
(ed.) Lessons from the Financial Crisis (London:
RISK Books), pp. 14385.
Gray, Dale F. and Andreas A. Jobst, 2011, Systemic Contingent Claims Analysis A Model Approach to Systemic Risk, in: LaBrosse, John R.,
Olivares-Caminal, Rodrigo and Dalvinder Singh
(eds.) Managing Risk in the Financial System (London: Edward Elgar), pp. 93110.

[3] Systemic Risk: Relevance, Risk Management Challenges

and Open Questions, Tom Daula
[4] Systemic Risk, Steven L. Schwarcz
[5] Containing Systemic Risk, CRMPG III, August 6, 2008
[6] What is Systemic Risk
[7] The Economics of Legal Tender Laws, Jorg Guido Hulsmann (includes detailed commentary on systemic risk inherent in FRB)
[8] Systemic Risk, Property Casualty Insurers Association of
America
[9] Market Dynamics & Systemic Risk, Milan Boran
[10] PCI Denition of Systemic Risk
[11] Too Big to Fail, Property Casualty Insurers Association of
America
[12] Brownlees, C.T., Engle, R.F., 2010. Volatility, correlation and tails for systemic risk measurement,
[13] Engle, R.F., Jondeau, E., Rockinger, M., 2012. Systemic
Risk in Europe
[14] Fischer, Tom (2014). Valuation in the structural model
of systemic interconnectedness (PDF). Presentation at
the Frankfurt MathFinance Colloquium, November 27,
2014.

Gray, Dale F., Andreas A. Jobst, and Samuel Malone, 2010, Quantifying Systemic Risk and Reconceptualizing the Role of Finance for Economic
Growth, Journal of Investment Management, Vol.
8, No.2, pp. 90110.

[15] Merton, R.C. (1974). On the pricing of corporate

debt: the risk structure of interest rates. Journal
of Finance 29 (2): 449470. doi:10.1111/j.15406261.1974.tb03058.x.

Hansen, Lars Peter. Challenges in Identifying and

Measuring Systemic Risk (PDF). National Bureau
of Economic Research. Retrieved 6 March 2013.

[16] Fischer, Tom (2014).

NO-ARBITRAGE PRICING UNDER SYSTEMIC RISK: ACCOUNTING
FOR CROSS-OWNERSHIP. Mathematical Finance
24 (1): 97124 (Published online: 19 Jun 2012).
doi:10.1111/j.1467-9965.2012.00526.x.

Jobst, Andreas A., 2012, "Systemic Risk in the

Insurance Sector-General Issues and a First As- [17] Karl, S.; Fischer, T. (2014). Cross-ownership as
a structural explanation for over- and underestimasessment of Large Commercial (Re-)Insurers in
tion of default probability. Quantitative Finance 14
Bermuda, Working paper (March 14).
(6): 10311046 (Published online: 18 Nov 2013).
Williams, Mark T. (March 2010). Uncontrolled
Risk: The Lessons of Lehman Brothers and How
Systemic Risk Can Still Bring Down the World Financial System. Mcgraw-Hill.

doi:10.1080/14697688.2013.834377.
[18] Eisenberg, L.; Noe, T.H. (2001). Systemic Risk in Financial Systems. Management Science 47 (2): 236249.
doi:10.1287/mnsc.47.2.236.9835.

370

CHAPTER 17. OTHER RISKS

[19] Suzuki, T. (2002). Valuing Corporate Debt: The Eect

of Cross-Holdings of Stock and Debt (PDF). Journal of
the Operations Research Society of Japan 45 (2): 123144.

17.5.1 Properties of systematic risk

Systematic or aggregate risk arises from market structure or dynamics which produce shocks or uncertainty
faced by all agents in the market; such shocks could arise
from government policy, international economic forces,
[21] Gouriroux, C.; Ham, J.-C.; Monfort, A. (2012). or acts of nature. In contrast, specic risk (sometimes
Bilateral exposures and systemic solvency risk. Cana- called residual risk or idiosyncratic risk) is risk to which
dian Journal of Economics 45 (4): 12731309 (Pub- only specic agents or industries are vulnerable (and is
lished online: 09 Nov 2012). doi:10.1111/j.1540- uncorrelated with broad market returns). Due to the id5982.2012.01750.x.
iosyncratic nature of unsystematic risk, it can be reduced
[22] Gouriroux, C.; Ham, J.-C.; Monfort, A. (2013). or eliminated through diversication; but since all marLiquidation equilibrium with seniority and hidden ket actors are vulnerable to systematic risk, it cannot be
CDO. Journal of Banking & Finance 37: 52615274. limited through diversication (but it may be insurable).
doi:10.1016/j.jbankn.2013.04.016.
As a result, assets whose expected returns are negatively
correlated with broader market returns command higher
[23] Reto R. Gallati. Risk management and capital adequacy.
prices than assets not possessing this property.
Retrieved 2008-09-18.
[20] Elsinger, H. (2009). Financial Networks, Cross Holdings, and Limited Liability. Working Paper 156, Oesterreichische Nationalbank, Wien.

In some cases, aggregate risk exists due to institutional

or other constraints on market completeness. For counRethinking the Financial Network
tries or regions lacking access to broad hedging markets, events like earthquakes and adverse weather shocks
Paolo Tasca and Stefano Battiston. Diversication and
can also act as costly aggregate risks. Robert Shiller has
Financial Stability. SSRN 1878596.
found that, despite the globalization progress of recent
Franklin Allen and Douglas Gale. Systemic Risk and decades, country-level aggregate income risks are still
Regulation (PDF). Retrieved 2008-09-18.
signicant and could potentially be reduced through the
creation of better global hedging markets (thereby poSystemic Risks in Projects
tentially becoming idiosyncratic, rather than aggregate,
Systemic Risk in InsuranceAn analysis of insurance and risks).[1] Specically, Shiller advocated for the creation
nancial stability (2010) The Geneva Association
of macro futures markets. The benets of such a mechaCEA (June 2010) Insurance: a unique sectorWhy In- nism would depend on the degree to which macro condisurers Dier from Banks
tions are correlated across countries.

[24] Systemic risk and hedge funds

[25]
[26]
[27]
[28]
[29]
[30]

[31] IAIS (June 2010) International Association of Insurance

Supervisors (IAIS) position statement on key nancial stability issues
[32] PCI (2009) Systemic Risk Dened
[33] Systemic Risk Focus
[34] Addressing Systemic Risk

17.5 Systematic risk

Not to be confused with systemic risk.
In nance and economics, systematic risk (in economics
often called aggregate risk or undiversiable risk) is
vulnerability to events which aect aggregate outcomes
such as broad market returns, total economy-wide resource holdings, or aggregate income. In many contexts,
events like earthquakes and major weather catastrophes
pose aggregate risksthey aect not only the distribution but also the total amount of resources. If every possible outcome of a stochastic economic process is characterized by the same aggregate result (but potentially different distributional outcomes), then the process has no
aggregate risk.

17.5.2 Systematic risk in nance

Systematic risk plays an important role in portfolio allocation.[2] Risk which cannot be eliminated through diversication commands returns in excess of the risk-free rate
(while idiosyncratic risk does not command such returns
since it can be diversied). Over the long run, a welldiversied portfolio provides returns which correspond
with its exposure to systematic risk; investors face a tradeo between returns and systematic risk. Therefore, an
investors desired returns correspond with their desired
exposure to systematic risk and corresponding asset selection. Investors can only reduce a portfolios exposure
to systematic risk by sacricing returns.
An important concept for evaluating an assets exposure
to systematic risk is Beta. Since Beta indicates the degree to which an assets expected return is correlated with
broader market outcomes, it is simply an indicator of an
assets vulnerability to systematic risk. Hence, the capital
asset pricing model (CAPM) directly ties an assets equilibrium price to its exposure to systematic risk.

17.5. SYSTEMATIC RISK

371

A simple example

Example: ArrowDebreu equilibrium

Consider an investor who purchases stock in many rms

from most global industries. This investor is vulnerable
to systematic risk but has diversied away the eects of
idiosyncratic risks on his portfolio value; further reduction in risk would require him to acquire risk-free assets
with lower returns (such as U.S. Treasury securities). On
the other hand, an investor who invests all of his money
in one industry whose returns are typically uncorrelated
with broad market outcomes (Beta close to zero) has limited his exposure to systematic risk but, due to lack of
diversication, is highly vulnerable to idiosyncratic risk.

The following example is from Mas-Colell, Whinston,

and Green (1995).[5] Consider a simple exchange economy with two identical agents, one (divisible) good, and
two potential states of the world (which occur with some
probability). Each agent has a utility function of the form
1 ui (x1i )+2 ui (x2i ) where 1 and 2 are the probabilities of states 1 and 2 occurring, respectively. In state
1, agent 1 is endowed with one unit of the good while
agent 2 is endowed with nothing. In state 2, agent 2 is endowed with one unit of the good while agent 1 is endowed
with nothing. That is, 1 = (1, 0) , 2 = (0, 1) . Then
the aggregate endowment of this economy is one good
regardless of which state is realized; that is, the economy
has no aggregate risk. It can be shown that, if agents are
allowed to make trades, the ratio of the price of a claim
on the good in state 1 to the price of a claim on the good
in state 2 is equal to the ratios of their respective probabilities of occurrence (and, hence, the marginal rates of substitution of each agent are also equal to this ratio). That
is, p1 /p2 = 1 /2 . If allowed to do so, agents make
trades such that their consumption is equal in either state
of the world.

17.5.3

Aggregate risk in economics

Aggregate risk can be generated by a variety of sources.

Fiscal, monetary, and regulatory policy can all be sources
of aggregate risk. In some cases, shocks from phenomena like weather and natural disaster can pose aggregate
risks. Small economies can also be subject to aggregate
risks generated by international conditions such as terms Now consider an example with aggregate risk. The econof trade shocks.
omy is the same as that described above except for enAggregate risk has potentially large implications for eco- dowments: in state 1, agent 1 is endowed two units of the
nomic growth. For example, in the presence of credit ra- good while agent 2 still receives zero units; and in state 2,
tioning, aggregate risk can cause bank failures and hinder agent 2 still receives one unit of the good while agent 1 recapital accumulation.[3] Banks may respond to increases ceives nothing. That is, 1 = (2, 0) , 2 = (0, 1) . Now,
in protability-threatening aggregate risk by raising stan- if state 1 is realized, the aggregate endowment is 2 units;
dards for quality and quantity credit rationing to reduce but if state 2 is realized, the aggregate endowment is only
monitoring costs; but the practice of lending to small 1 unit; this economy is subject to aggregate risk. Agents
numbers of borrowers reduces the diversication of bank cannot fully insure and guarantee the same consumption
portfolios (concentration risk) while also denying credit in either state. It can be shown that, in this case, the price
to some potentially productive rms or industries. As a ratio will be less than the ratio of probabilities of the two
result, capital accumulation and the overall productivity states: p1 /p2 < 1 /2 , so p1 /1 < p2 /2 . So, for
example, if the two states occur with equal probability,
level of the economy can decline.
then p1 < p2 . This is the well-known nance result that
In economic modeling, model outcomes depend heavily the contingent claim that delivers more resources in the
on the nature of risk. Modelers often incorporate ag- state of low market returns has a higher price.
gregate risk through shocks to endowments (budget constraints), productivity, monetary policy, or external factors like terms of trade. Idiosyncratic risks can be intro- Aggregate risk in heterogeneous agent models
duced through mechanisms like individual labor productivity shocks; if agents possess the ability to trade assets While the inclusion of aggregate risk is common in
and lack borrowing constraints, the welfare eects of id- macroeconomic models, considerable challenges arise
iosyncratic risks are minor. The welfare costs of aggre- when researchers attempt to incorporate aggregate ungate risk, though, can be signicant.
certainty into models with heterogeneous agents. In this
Under some conditions, aggregate risk can arise from
the aggregation of micro shocks to individual agents.
This can be the case in models with many agents and
strategic complementarities;[4] situations with such characteristics include: innovation, search and trading, production in the presence of input complementarities, and
information sharing. Such situations can generate aggregate data which are empirically indistinguishable from a
data-generating process with aggregate shocks.

case, the entire distribution of allocational outcomes is

a state variable which must be carried across periods.
This gives rise to the well-known curse of dimensionality. One approach to the dilemma is to let agents ignore
attributes of the aggregate distribution, justifying this assumption by referring to bounded rationality. Den Haan
(2010) evaluates several algorithms which have been applied to solving the Krusell and Smith (1998) model,
showing that solution accuracy can depend heavily on so-

372

CHAPTER 17. OTHER RISKS

lution method.[6][7] Researchers should carefully consider 17.6.1 Denition

the results of accuracy tests while choosing solution methUnder these conditions, the spot price of the asset, and
ods and pay particular attention to grid selection.
the futures price, do not converge on the expiration date
of the future. The amount by which the two quantities
dier measures the value of the basis risk. That is,
17.5.4 See also
Modern portfolio theory

Basis = Spot price of hedged asset - Futures price of contract

Capital asset pricing model

Risk modeling
Taleb distribution

17.6.2 Examples
Some examples of basis risks are:
1. Treasury bill future being hedged by two year Bond,
there lies the risk of not uctuating as desired.

17.5.5

References

[1] Shiller, R. (1995).

Aggregate Income Risks and
Hedging Mechanisms. Quarterly Review of Economics
and Finance 35 (2): 119152. doi:10.1016/10629769(95)90018-7.
[2] Maginn, J.; Tuttle, D.; McLeavey, D.; Pinto, J. (2007).
Managing Investment Portfolios: A Dynamic Process.
Hoboken, New Jersey: John Wiley & Sons. pp. 231245.
[3] Elosegui, P. L. (2003). Aggregate Risk, Credit Rationing, and Capital Accumulation. Quarterly Journal of Economics and Finance 43 (4): 668696.
doi:10.1016/S1062-9769(03)00040-1.
[4] Jovanovic, B. (1987). Micro Shocks and Aggregate
Risk. Quarterly Journal of Economics 102 (2): 395410.
doi:10.2307/1885069.
[5] Mas-Colell, A.; Whinston, M.; Green, J. (1995). Microeconomic Theory. New York: Oxford University
Press. pp. 692693.
[6] den Haan, W. (2010). Comparison of Solutions to the
Incomplete Markets Model with Aggregate Uncertainty.
Journal of Economics Dynamics and Control 34 (1): 427.
doi:10.1016/j.jedc.2008.12.010.
[7] Krusell, P.; Smith Jr., A. (1998). Income and Wealth
Heterogeneity in the Macroeconomy. Journal of Political
Economy 106 (5): 867896. JSTOR 250034.

17.6 Basis risk

Basis risk in nance is the risk associated with imperfect hedging. It arises because of the dierence between
the price of the asset to be hedged and the price of the
asset serving as the hedge, or because of a mismatch between the expiration date of the hedge asset and the actual
selling date of the asset (calendar basis risk), oras in
energydue to the dierence in the location of the asset
to be hedged and the asset serving as the hedge (locational
basis risk).

2. Foreign currency exchange rate (FX) hedge using a

non-deliverable forward contract (NDF): the NDF xing
might vary substantially from the actual available spot rate
on the market on xing date.
Over-the-counter (OTC) derivatives can help minimize
basis risk by creating a perfect hedge. This is because
OTC derivatives can be tailored to t the exact risk needs
of a hedger.[1]

17.6.3 References
Notes
[1] http://chicagofed.org/digital_assets/publications/
understanding_derivatives/understanding_derivatives_
chapter_3_over_the_counter_derivatives.pdf

See also
Financial risk
Uncertainty
Financial risk management
List of nance topics
External links
Understanding Derivatives: Markets and Infrastructure - Chapter 3, Over-the-Counter (OTC) Derivatives Federal Reserve Bank of Chicago, Financial
Markets Group

17.7 Pin risk

Pin risk occurs when the market price of the underlier of
an option contract at the time of the contracts expiration
is close to the options strike price. In this situation, the
underlier is said to have pinned. The risk to the writer

17.7. PIN RISK

(seller) of the option is that they cannot predict with certainty whether the option will be exercised or not. So the
writer cannot hedge his position precisely and may end
up with a loss or gain. There is a chance that the price of
the underlier may move adversely, resulting in an unanticipated loss to the writer. In other words, an option position may result in a large, undesired risky position in the
underlier immediately after expiration, regardless of the
actions of the writer.

17.7.1

373
result of the puts being exercised. In fact, only 49 of the
contracts are exercised, meaning that the trader must buy
4900 shares of the underlier. If at the close on Friday, October 19th, the traders position in XYZ stock was short
7,500 shares, then on Monday, October 22, the trader
would still be short 2600 shares, instead of at as the
trader had hoped. The trader must now buy back these
2600 shares in order to avoid being exposed to risk that
XYZ will increase in price.

Background

Sellers of option contracts often hedge them to create

delta neutral portfolios. The objective is to minimize risk
due to the movement of the underliers price, while implementing whatever strategy led to the sale of the options in the rst place. For instance, a seller of a call may
hedge by buying just enough of the underlier to create a
delta neutral portfolio. As time passes, the option seller
adjusts his hedge position by buying or selling some quantity of the underlier to counteract changes in the price of
the underlier.

17.7.3 Management of pin risk

On the day that an option expiresfor U.S. exchange

traded equity options this is the Saturday following the
third Friday of the monthif an options underlier is
close to pinning, the trader must pay close attention. A
small movement of the underliers price through the strike
(e.g. from below the strike price to above, or vice versa)
can have a large impact on the traders net position in
At expiration, usually either
the underlier on the trading day after expiration. For instance, if an option goes from being in the money to out
the option is in the money, and the seller has bought of the money, the trader must rapidly trade enough of the
or sold enough of the underlier to satisfy his obliga- underlier so that the position after expiration will be at.
tion under the option contract, or
For example, a trader is long 10 calls struck at $90.00 on
IBM stock, and ve minutes before the close of trading,
the option is out of the money, and the option will IBMs stock price is $89.75. These calls are out of the
expire worthless, and the seller of the option would money and therefore will expire worthless at this price.
have no position in the underlier.
However, two minutes before the close of trading, IBMs
price suddenly moves to $90.26. These options are now in
However, the cost to the option buyer of exercising the the money, and the trader will now want to exercise them.
option is not zero. For instance, the buyers broker may However, to do so, the trader should rst sell 1000 shares
charge transaction fees to exercise the option to buy or sell of IBM at $90.26. This is done so that the trader will be
the underlier. If these costs are greater than the amount at IBM stock after expiration. Thirty seconds before the
the option is in the money, the owner of the option may close, IBM drops back to $89.95. The calls are now out
rationally choose not to exercise. Thus, the option seller of the money, and the trader must quickly buy back the
may end up with an unexpected position in the under- stock. Option traders with a broad portfolio of options
lier and thus risk losing value if the underliers price then can be very busy on Expiration Friday.
moves adversely before the option seller can eliminate Pinning of a stock to a particular strike can be exploited
this position, perhaps not until the next trading day. The by options traders. One way is to sell both a put and a
costs of exercise dier from trader to trader, and there- call struck at the pinned value. As noted above, stocks
fore the option seller may not be able to predict whether can break their pin and move o the strike, so the trader
the options will be exercised or not.
must keep a careful eye on his positions.

17.7.2

Example

A trader has sold 75 put contracts on XYZ Corp. stock,

struck at $50 and expiring on Saturday, October 20,
2012. On Friday, October 19the last day these contracts are tradedXYZ stock closes at $49.97, which
means the options are $0.03 in-the-money. Because each
contract represents an obligation to buy 100 shares of
XYZ stock at $50.00, the trader will have to buy anywhere from 0 shares to 7500 shares of XYZ stock as a

In this market, the last available price of the underlier,

which is used to determine whether an option is automatically exercised, is the price of the regular-hours trade
reported last to the Options Clearing Corporation at or
before 4:01:30 pm ET on the Friday before expiration.
This trade will have occurred during normal hours, i.e.
before 4:00 pm. It can be any size and come from any
participating exchange. The OCC reports this price tentatively at 4:15 pm, but, to allow time for exchanges to
correct errors the OCC does not make the price ocial
until 5:30 pm. [1]

374

17.7.4

CHAPTER 17. OTHER RISKS

References

[1] OCC Infomemo 30048: Underlying Prices for Expiration Accessed Jan 21, 2012

17.7.5

See also

Option (nance)
Volatility arbitrage
Delta neutral

Chapter 18

Regulation
18.1 Financial regulation

Supervision of listed companies

Financial regulation is a form of regulation or supervision, which subjects nancial institutions to certain requirements, restrictions and guidelines, aiming to maintain the integrity of the nancial system. This may be
handled by either a government or non-government organization. Financial regulation has also inuenced the
structure of banking sectors, by decreasing borrowing
costs and increasing the variety of nancial products
available.

Financial regulators ensures that listed companies and

market participants comply with various regulations under the trading acts. The trading acts demands that listed
companies publish regular nancial reports, ad hoc notications or directors dealings. Whereas market participants are required to Publish major shareholder notications. The objective of monitoring compliance by listed
companies with their disclosure requirements is to ensure
that investors have access to essential and adequate information for making an informed assessment of listed
companies and their securities.[7][8][9]

18.1.1

Aims of regulation
Supervision of investment management

The objectives of nancial regulators are usually:[1]

Asset management supervision or investment acts ensures

market condence to maintain condence in the the frictionless operation of those vehicles.[10]
nancial system
nancial stability contributing to the protection Supervision of banks and nancial services providers
and enhancement of stability of the nancial system
Banking acts lays down rules for banks which they have
consumer protection securing the appropriate de- to observe when they are being established and when they
gree of protection for consumers.
are carrying on their business. These rules are designed to
prevent unwelcome developments that might disrupt the
reduction of nancial crime reducing the extent
smooth functioning of the banking system. Thus ensuring
to which it is possible for a regulated business to be
a strong and ecient banking system.[11][12]
used for a purpose connected with nancial crime.

18.1.2

18.1.3 Authority by country

Structure of supervision

See main article List of nancial regulatory auActs empower organizations, government or nonthorities by country
government, to monitor activities and enforce actions.[2]
There are various setups and combinations in place for
The following is a short listing of regulatory authorities in
the nancial regulatory structure around the global.[3][4]
various jurisdictions, for a more complete listing, please
Leaf parts are in any case:
see list of nancial regulatory authorities by country.
United States

Supervision of stock exchanges

Exchange acts ensure that trading on the exchanges is
conducted in a proper manner. Most prominent the pricing process, execution and settlement of trades, direct and
ecient trade monitoring.[5][6]
375

U.S. Securities and Exchange Commission

(SEC)
Financial Industry Regulatory Authority
(FINRA)

376

CHAPTER 18. REGULATION

Swiss Financial Market Supervisory Authority
(FINMA), Switzerland
Peoples Republic of China
China Securities Regulatory Commission
(CSRC)
China Insurance Regulatory Commission
(CIRC)
China Banking
(CBRC)

Number of countries having a banking crisis in each year since

1800. This is based on www.reinhartandrogoff.com (web site
for This Time is Dierent: Eight Centuries of Financial Folly),
which covers only 70 countries. The general upward trend might
be attributed to many factors. One of these is a gradual increase in the percent of people who receive money for their labor. The dramatic feature of this graph is the virtual absence
of banking crises during the period of the Bretton Woods agreement, 1945 to 1971. This analysis is similar to Figure 10.1
in Reinhart and Rogo (2009). For more details see the help
le for bankingCrises in the Ecdat package available from the
Comprehensive R Archive Network (CRAN).

Regulatory

Commission

Unique jurisdictions
In most cases, nancial regulatory authorities regulate all
nancial activities. But in some cases, there are specic
authorities to regulate each sector of the nance industry,
mainly banking, securities, insurance and pensions markets, but in some cases also commodities, futures, forwards, etc. For example, in Australia, the Australian Prudential Regulation Authority (APRA) supervises banks
and insurers, while the Australian Securities and Investments Commission (ASIC) is responsible for enforcing
nancial services and corporations laws.

Commodity Futures Trading Commission Sometimes more than one institution regulates and supervises the banking market, normally because, apart
(CFTC)
from regulatory authorities, central banks also regulate
Federal Reserve System (Fed)
the banking industry. For example, in the USA bank Federal Deposit Insurance Corporation ing is regulated by a lot of regulators, such as the Federal
(FDIC)
Reserve System, the Federal Deposit Insurance Corpo Oce of the Comptroller of the Currency ration, the Oce of the Comptroller of the Currency,
the National Credit Union Administration, the Oce
(OCC)
of Thrift Supervision, as well as regulators at the state
National Credit Union Administration
level.[13]
(NCUA)
In addition, there are also associations of nancial
Oce of Thrift Supervision (OTS)
regulatory authorities. In the European Union, there
Consumer Financial Protection Bureau
are the Committee of European Securities Regulators
(CFPB)
(CESR), the Committee of European Banking Supervisors (CEBS) and the Committee of European Insur United Kingdom
ance and Occupational Pensions Supervisors (CEIOPS),
Financial Conduct Authority (FCA)
which are Level-3 committees of the EU in the
Lamfalussy process. And, at a world level, we have
Prudential Regulation Authority (PRA)
the International Organization of Securities Commissions
Financial Services Agency (FSA), Japan
(IOSCO), the International Association of Insurance Su Federal Financial Supervisory Authority (BaFin), pervisors, the Basel Committee on Banking Supervision,
the Joint Forum, and the Financial Stability Board.
Germany
The structure of nancial regulation has changed significantly in the past two decades, as the legal and geographic boundaries between markets in banking, securi(MAS), ties, and insurance have become increasingly blurred
and globalized.

Autorit des marchs nanciers (France) (AMF),

France
Monetary
Singapore

Authority

of

Singapore

18.2. US FEDERAL RESERVE

18.1.4

Regulatory reliance on credit rating

agencies

Think-tanks such as the World Pensions Council (WPC)

have argued that most European governments pushed
dogmatically for the adoption of the Basel II recommendations, adopted in 2005, transposed in European
Union law through the Capital Requirements Directive
(CRD), eective since 2008. In essence, they forced European banks, and, more importantly, the European Central Bank itself e.g. when gauging the solvency of EUbased nancial institutions, to rely more than ever on the
standardized assessments of credit risk marketed by two
private US agencies- Moodys and S&P, thus using public
policy and ultimately taxpayers money to strengthen an
anti-competitive duopolistic industry.

18.1.5

See also

LabEx ReFi - European Laboratory on Financial

Regulation
Bank regulation
Insurance law

377

[9] Borsa Italiana listed stock supervision

[10] US SEC Division of Investment Management
[11] Reserve Bank of India, Department of Banking Supervision
[12] Luxembourg CSSF Supervision of Banks
[13] list of state banking authorities. State Banking Authorities. Consumer Action Website. Retrieved August 5,
2011.

18.1.7 Further reading

Ely, Bert (2008), Financial Regulation, in David
R. Henderson (ed.), Concise Encyclopedia of
Economics (2nd ed.), Indianapolis: Library of
Economics and Liberty, ISBN 978-0865976658,
OCLC 237794267
Reinhart, Carmen; Rogo, Rogo (2009), This
Time is Dierent: Eight Centuries of Financial Folly,
Princeton U. Pr., ISBN 978-0-691-15264-6
Simpson, D., Meeks, G., Klumpes, P., & Andrews,
P. (2000). Some cost-benet issues in nancial regulation. London: Financial Services Authority.

Global nancial system

Regulation of commodity markets
Group of Thirty
Regulatory capture
Securities Commission
International Organization of Securities Commissions
International Centre for Financial Regulation
Finance
Financial repression

18.1.6

References

[1] UK FSA statutory objectives

[2] What is Financial Regulation Trying to Achieve?, Riccardo
De Caria
[3] Luxembourg CSSF structure and organisation

18.1.8 External links

Securities Lawyers Deskbook from the University
of Cincinnati College of Law
FINRA Information
The Compliance Exchange Jonathan Halseys nancial regulation research resource
ICFR (The International Centre for Financial Regulation)
Ana Carvajal, Jennifer Elliott: IMF Study Points to
Gaps in Securities Market Regulation
IOSCO: Objectives and Principles of Securities
Regulation (PDF-Datei 67 Seiten)
The Samuel & Ronnie Heyman Center on Corporate
Governance The Samuel & Ronnie Heyman Center
on Corporate Governance
The Institute for Financial Market Regulation The
Institute for Financial Market Regulation

[4] German BAFin supervision organisation

[5] Suisse nma stock exchange supervision
[6] German BAFin stock exchange supervision
[7] Finland FSA supervion of listed companies
[8] Saudi Arabia market supervision

18.2 US Federal Reserve

The Fed redirects here. For the Welsh trade union, see
South Wales Miners Federation. For other uses, see The
Fed (disambiguation).

378
The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central
banking system of the United States. It was created on
December 23, 1913, with the enactment of the Federal
Reserve Act, largely in response to a series of nancial
panics, particularly a severe panic in 1907.[2][3][4][5][6][7]
Over time, the roles and responsibilities of the Federal Reserve System have expanded, and its structure
has evolved.[3][8] Events such as the Great Depression in
the 1930s were major factors leading to changes in the
system.[9]
The U.S. Congress established three key objectives for
monetary policy in the Federal Reserve Act: Maximum
employment, stable prices, and moderate long-term interest rates.[10] The rst two objectives are sometimes referred to as the Federal Reserves dual mandate.[11] Its
duties have expanded over the years, and as of 2009 also
include supervising and regulating banks, maintaining the
stability of the nancial system and providing nancial
services to depository institutions, the U.S. government,
and foreign ocial institutions.[12] The Fed conducts research into the economy and releases numerous publications, such as the Beige Book.

CHAPTER 18. REGULATION

is maintained. In 2010, the Federal Reserve made a prot
of $82 billion and transferred $79 billion to the U.S. Treasury.[22]

18.2.1 Purpose

The Eccles Building in Washington, D.C., which serves as the

Federal Reserve Systems headquarters.

The primary motivation for creating the Federal Reserve

System was to address banking panics.[3] Other purposes
are stated in the Federal Reserve Act, such as to furnish an elastic currency, to aord means of rediscounting commercial paper, to establish a more eective supervision of banking in the United States, and for other
purposes.[23] Before the founding of the Federal Reserve
System, the United States underwent several nancial
crises. A particularly severe crisis in 1907 led Congress
to enact the Federal Reserve Act in 1913. Today the Federal Reserve System has responsibilities in addition to ensuring the stability of the nancial system.[24]

The Federal Reserve Systems structure is composed of

the presidentially appointed Board of Governors or Federal Reserve Board (FRB), partially presidentially appointed Federal Open Market Committee (FOMC), non
presidentially appointed twelve regional Federal Reserve
Banks located in major cities throughout the nation, numerous privately owned U.S. member banks and various
advisory councils.[13][14][15] The federal government sets
the salaries of the Boards seven governors. Nationally
chartered commercial banks are required to hold stock
functions of the Federal Reserve System
in the Federal Reserve Bank of their region, which en- Current [12][24]
include:
titles them to elect some of their board members. The
FOMC sets monetary policy and consists of all seven
members of the Board of Governors and the twelve re To address the problem of banking panics
gional bank presidents, though only ve bank presidents
To serve as the central bank for the United States
vote at any given time: the president of the New York Fed
and four others who rotate through one-year terms. Thus
To strike a balance between private interests of
the Federal Reserve System has both private and public
banks and the centralized responsibility of governcomponents to serve the interests of the general public
ment
[16][17][18][19]
and private banks.
The structure is considered unique among central banks. It is also unusual in that
To supervise and regulate banking institutions
the United States Department of the Treasury, an entity
To protect the credit rights of consumers
outside of the central bank, creates the currency used.[20]
The Fed considers the Federal Reserve System an inde To manage the nations money supply through
pendent central bank because its monetary policy decimonetary policy to achieve the sometimessions do not have to be approved by the President or anyconicting goals of
one else in the executive or legislative branches of government, it does not receive funding appropriated by the
maximum employment
Congress, and the terms of the members of the Board of
stable prices, including prevention of either
Governors span multiple presidential and congressional
ination or deation[25]
[21]
terms.
moderate long-term interest rates
The U.S. Government receives all of the systems annual prots, after a statutory dividend of 6% on member
To maintain the stability of the nancial system and
banks capital investment is paid, and an account surplus
contain systemic risk in nancial markets

18.2. US FEDERAL RESERVE

379

To provide nancial services to depository institutions, the U.S. government, and foreign ocial institutions, including playing a major role in operating
the nations payments system

elastic currency in the Federal Reserve Act does not imply only the ability to expand the money supply, but also
the ability to contract the money supply. Some economic
theories have been developed that support the idea of expanding or shrinking a money supply as economic condi To facilitate the exchange of payments among tions warrant. Elastic currency is dened by the Federal
regions
Reserve as:[27]
To respond to local liquidity needs
Currency that can, by the actions of the
To strengthen U.S. standing in the world economy
central monetary authority, expand or contract
in amount warranted by economic conditions.
Addressing the problem of bank panics

Monetary policy of the Federal Reserve System is based

Further information: bank run and fractional-reserve partially on the theory that it is best overall to expand
or contract the money supply as economic conditions
banking
change.
Banking institutions in the United States are required to
hold reserves amounts of currency and deposits in other
banks equal to only a fraction of the amount of the
banks deposit liabilities owed to customers. This practice
is called fractional-reserve banking. As a result, banks
usually invest the majority of the funds received from depositors. On rare occasions, too many of the banks customers will withdraw their savings and the bank will need
help from another institution to continue operating; this
is called a bank run. Bank runs can lead to a multitude
of social and economic problems. The Federal Reserve
System was designed as an attempt to prevent or minimize the occurrence of bank runs, and possibly act as a
lender of last resort when a bank run does occur. Many
economists, following Milton Friedman, believe that the
Federal Reserve inappropriately refused to lend money to
small banks during the bank runs of 1929.[26]

The monthly changes in the currency component of the U.S.

money supply show currency being added into (% change greater
than zero) and removed from circulation (% change less than
zero). The most noticeable changes occur around the Christmas
holiday shopping season as new currency is created so people can
make withdrawals at banks, and then removed from circulation
afterwards, when less cash is demanded.

Check clearing system Because some banks refused

to clear checks from certain others during times of economic uncertainty, a check-clearing system was created
in the Federal Reserve system. It is briey described in
The Federal Reserve System Purposes and Functions as
follows:[28]
By creating the Federal Reserve System,
Congress intended to eliminate the severe nancial crises that had periodically swept the
nation, especially the sort of nancial panic
that occurred in 1907. During that episode,
payments were disrupted throughout the country because many banks and clearinghouses refused to clear checks drawn on certain other
banks, a practice that contributed to the failure of otherwise solvent banks. To address
these problems, Congress gave the Federal Reserve System the authority to establish a nationwide check-clearing system. The System,
then, was to provide not only an elastic currency that is, a currency that would expand
or shrink in amount as economic conditions
warranted but also an ecient and equitable
check-collection system.
Lender of last resort In the United States, the Federal
Reserve serves as the lender of last resort to those institutions that cannot obtain credit elsewhere and the collapse
of which would have serious implications for the economy. It took over this role from the private sector clearing houses which operated during the Free Banking Era;
whether public or private, the availability of liquidity was
intended to prevent bank runs.[29]

Fluctuations Through its discount window and credit

Elastic currency One way to lessen the likelihood and operations, Reserve Banks provide liquidity to banks to
the eect of bank runs is to have a money supply that meet short-term needs stemming from seasonal uctucan expand when money is needed. The use of the term ations in deposits or unexpected withdrawals. Longer

380
term liquidity may also be provided in exceptional circumstances. The rate the Fed charges banks for these
loans is called the discount rate (ocially the primary
credit rate).
By making these loans, the Fed serves as a buer against
unexpected day-to-day uctuations in reserve demand
and supply. This contributes to the eective functioning
of the banking system, alleviates pressure in the reserves
market and reduces the extent of unexpected movements in the interest rates.[30] For example, on September 16, 2008, the Federal Reserve Board authorized an
$85 billion loan to stave o the bankruptcy of international insurance giant American International Group
(AIG).[31][32]
Central bank

CHAPTER 18. REGULATION

cal Federal Reserve Bank.[35][36] These balances are the
namesake reserves of the Federal Reserve System. The
purpose of keeping funds at a Federal Reserve Bank is
to have a mechanism for private banks to lend funds to
one another. This market for funds plays an important
role in the Federal Reserve System as it is what inspired
the name of the system and it is what is used as the basis
for monetary policy. Monetary policy is put into eect
partly by inuencing how much interest the private banks
charge each other for the lending of these funds.
Federal reserve accounts contain federal reserve credit,
which can be converted into federal reserve notes. Private banks maintain their bank reserves in federal reserve
accounts.
Balance between private banks and responsibility of
governments

Further information: Central bank

In its role as the central bank of the United States, the The system was designed out of a compromise between
the competing philosophies of privatization and government regulation. In 2006 Donald L. Kohn, vice chairman
of the Board of Governors, summarized the history of
this compromise:[37]

Obverse of a Federal Reserve $1 note issued in 2009.

Fed serves as a bankers bank and as the governments

bank. As the bankers bank, it helps to assure the safety
and eciency of the payments system. As the governments bank, or scal agent, the Fed processes a variety
of nancial transactions involving trillions of dollars. Just
as an individual might keep an account at a bank, the U.S.
Treasury keeps a checking account with the Federal Reserve, through which incoming federal tax deposits and
outgoing government payments are handled. As part of
this service relationship, the Fed sells and redeems U.S.
government securities such as savings bonds and Treasury
bills, notes and bonds. It also issues the nations coin and
paper currency. The U.S. Treasury, through its Bureau
of the Mint and Bureau of Engraving and Printing, actually produces the nations cash supply and, in eect, sells
the paper currency to the Federal Reserve Banks at manufacturing cost, and the coins at face value. The Federal
Reserve Banks then distribute it to other nancial institutions in various ways.[33] During the Fiscal Year 2008,
the Bureau of Engraving and Printing delivered 7.7 billion notes at an average cost of 6.4 cents per note.[34]
Federal funds Main article: Federal funds

Agrarian and progressive interests, led by

William Jennings Bryan, favored a central
bank under public, rather than banker, control.
But the vast majority of the nations bankers,
concerned about government intervention in
the banking business, opposed a central bank
structure directed by political appointees.
The legislation that Congress ultimately
adopted in 1913 reected a hard-fought battle to balance these two competing views and
created the hybrid public-private, centralizeddecentralized structure that we have today.
In the current system, private banks are for-prot businesses but government regulation places restrictions on
what they can do. The Federal Reserve System is a part
of government that regulates the private banks. The balance between privatization and government involvement
is also seen in the structure of the system. Private banks
elect members of the board of directors at their regional
Federal Reserve Bank while the members of the Board
of Governors are selected by the President of the United
States and conrmed by the Senate. The private banks
give input to the government ocials about their economic situation and these government ocials use this
input in Federal Reserve policy decisions. In the end,
private banking businesses are able to run a protable
business while the U.S. government, through the Federal
Reserve System, oversees and regulates the activities of
the private banks.

Federal funds are the reserve balances (also called Federal Government regulation and supervision The FedReserve Deposits) that private banks keep at their lo- eral Banking Agency Audit Act, enacted in 1978 as Pub-

18.2. US FEDERAL RESERVE

381
Washington lobbying oce of Enron Corp. and was adviser to all three of the Clinton administration's Treasury
secretaries.[43][44][45][46]
The Board of Governors in the Federal Reserve System
has a number of supervisory and regulatory responsibilities in the U.S. banking system, but not complete responsibility. A general description of the types of regulation
and supervision involved in the U.S. banking system is
given by the Federal Reserve:[47]

Ben Bernanke (lower-right), Former Chairman of the Federal

Reserve Board of Governors, at a House Financial Services Committee hearing on February 10, 2009. Members of the Board frequently testify before congressional committees such as this one.
The Senate equivalent of the House Financial Services Committee is the Senate Committee on Banking, Housing, and Urban
Aairs.

lic Law 95-320 and 31 U.S.C. section 714 establish that

the Board of Governors of the Federal Reserve System
and the Federal Reserve banks may be audited by the
Government Accountability Oce (GAO).[38] The GAO
has authority to audit check-processing, currency storage
and shipments, and some regulatory and bank examination functions, however there are restrictions to what the
GAO may audit. Audits of the Reserve Board and Federal Reserve banks may not include:
1. transactions for or with a foreign central bank or
government, or nonprivate international nancing
organization;
2. deliberations, decisions, or actions on monetary policy matters;
3. transactions made under the direction of the Federal
Open Market Committee; or
4. a part of a discussion or communication among or
between members of the Board of Governors and
ocers and employees of the Federal Reserve System related to items (1), (2), or (3).[39][40]
The nancial crisis which began in 2007, corporate
bailouts, and concerns over the Feds secrecy have
brought renewed concern regarding ability of the Fed
to eectively manage the national monetary system.[41]
A July 2009 Gallup Poll found only 30% of Americans
thought the Fed was doing a good or excellent job, a rating even lower than that for the Internal Revenue Service,
which drew praise from 40%.[42] The Federal Reserve
Transparency Act was introduced by congressman Ron
Paul in order to obtain a more detailed audit of the Fed.
The Fed has since hired Linda Robertson who headed the

The Board also plays a major role in the

supervision and regulation of the U.S. banking system. It has supervisory responsibilities
for state-chartered banks[48] that are members
of the Federal Reserve System, bank holding
companies (companies that control banks), the
foreign activities of member banks, the U.S.
activities of foreign banks, and Edge Act and
agreement corporations (limited-purpose institutions that engage in a foreign banking business). The Board and, under delegated authority, the Federal Reserve Banks, supervise
approximately 900 state member banks and
5,000 bank holding companies. Other federal
agencies also serve as the primary federal supervisors of commercial banks; the Oce of
the Comptroller of the Currency supervises national banks, and the Federal Deposit Insurance Corporation supervises state banks that
are not members of the Federal Reserve System.
Some regulations issued by the Board apply to the entire banking industry, whereas others apply only to member banks, that is, state
banks that have chosen to join the Federal Reserve System and national banks, which by law
must be members of the System. The Board
also issues regulations to carry out major federal laws governing consumer credit protection, such as the Truth in Lending, Equal Credit
Opportunity, and Home Mortgage Disclosure
Acts. Many of these consumer protection regulations apply to various lenders outside the
banking industry as well as to banks.
Members of the Board of Governors are
in continual contact with other policy makers
in government. They frequently testify before
congressional committees on the economy,
monetary policy, banking supervision and regulation, consumer credit protection, nancial
markets, and other matters.
The Board has regular contact with members of the Presidents Council of Economic
Advisers and other key economic ocials. The
Chair also meets from time to time with the
President of the United States and has regular
meetings with the Secretary of the Treasury.
The Chair has formal responsibilities in the in-

382

CHAPTER 18. REGULATION

ternational arena as well.

cess to Reserve Bank payment services. It also encourages competition between the Reserve Banks and privatesector providers of payment services by requiring the ReRegulatory and oversight responsibilities The board serve Banks to charge fees for certain payments services
of directors of each Federal Reserve Bank District also listed in the act and to recover the costs of providing these
has regulatory and supervisory responsibilities. If the services over the long run.
board of directors of a district bank has judged that a
The Federal Reserve plays a vital role in both the namember bank is performing or behaving poorly, it will
tions retail and wholesale payments systems, providreport this to the Board of Governors. This policy is deing a variety of nancial services to depository instituscribed in United States Code:[49]
tions. Retail payments are generally for relatively smalldollar amounts and often involve a depository instituEach Federal reserve bank shall keep itself
tions retail clients individuals and smaller businesses.
informed of the general character and amount
The Reserve Banks retail services include distributing
of the loans and investments of its member
currency and coin, collecting checks, and electronically
banks with a view to ascertaining whether untransferring funds through the automated clearinghouse
due use is being made of bank credit for the
system. By contrast, wholesale payments are generspeculative carrying of or trading in securities,
ally for large-dollar amounts and often involve a deposireal estate, or commodities, or for any other
tory institutions large corporate customers or counterparpurpose inconsistent with the maintenance of
ties, including other nancial institutions. The Reserve
sound credit conditions; and, in determining
Banks wholesale services include electronically transferwhether to grant or refuse advances, redisring funds through the Fedwire Funds Service and transcounts, or other credit accommodations, the
ferring securities issued by the U.S. government, its agenFederal reserve bank shall give consideration to
cies, and certain other entities through the Fedwire Secusuch information. The chairman of the Federal
rities Service. Because of the large amounts of funds that
reserve bank shall report to the Board of Govmove through the Reserve Banks every day, the System
ernors of the Federal Reserve System any such
has policies and procedures to limit the risk to the Reserve
undue use of bank credit by any member bank,
Banks from a depository institutions failure to make or
together with his recommendation. Whenever,
settle its payments.
in the judgment of the Board of Governors
The Federal Reserve Banks began a multi-year restrucof the Federal Reserve System, any member
turing of their check operations in 2003 as part of a longbank is making such undue use of bank credit,
term strategy to respond to the declining use of checks
the Board may, in its discretion, after reasonby consumers and businesses and the greater use of elecable notice and an opportunity for a hearing,
tronics in check processing. The Reserve Banks will have
suspend such bank from the use of the credit
reduced the number of full-service check processing lofacilities of the Federal Reserve System and
cations from 45 in 2003 to 4 by early 2011.[51]
may terminate such suspension or may renew
it from time to time.

18.2.2 Structure
National payments system
The Federal Reserve plays an important role in the U.S.
payments system. The twelve Federal Reserve Banks
provide banking services to depository institutions and
to the federal government. For depository institutions,
they maintain accounts and provide various payment services, including collecting checks, electronically transferring funds, and distributing and receiving currency and
coin. For the federal government, the Reserve Banks act
as scal agents, paying Treasury checks; processing electronic payments; and issuing, transferring, and redeeming
U.S. government securities.[50]

Main article: Structure of the Federal Reserve System

The Federal Reserve System has a unique structure

In passing the Depository Institutions Deregulation and

Monetary Control Act of 1980, Congress rearmed its
intention that the Federal Reserve should promote an ef- Organization of the Federal Reserve System
cient nationwide payments system. The act subjects
all depository institutions, not just member commercial that is both public and private[52] and is described as
banks, to reserve requirements and grants them equal ac- independent within the government rather than in-

18.2. US FEDERAL RESERVE

dependent of government.[53] The System does not require public funding, and derives its authority and purpose from the Federal Reserve Act, which was passed by
Congress in 1913 and is subject to Congressional modication or repeal.[54] The four main components of the
Federal Reserve System are (1) the Board of Governors,
(2) the Federal Open Market Committee, (3) the twelve
regional Federal Reserve Banks, and (4) the member
banks throughout the country.
Board of Governors
Main article: Federal Reserve Board of Governors
The seven-member Board of Governors is a federal
agency. It is charged with the overseeing of the 12 District Reserve Banks and setting national monetary policy.
It also supervises and regulates the U.S. banking system
in general.[55] Governors are appointed by the President
of the United States and conrmed by the Senate for
staggered 14-year terms.[30] One term begins every two
years, on February 1 of even-numbered years, and members serving a full term cannot be renominated for a second term.[56] "[U]pon the expiration of their terms of ofce, members of the Board shall continue to serve until
their successors are appointed and have qualied. The
law provides for the removal of a member of the Board
by the President for cause.[57] The Board is required to
make an annual report of operations to the Speaker of the
U.S. House of Representatives.

383
ber nominations noted.[63] The two other Obama nominees in 2011, Yellen and Raskin,[64] were conrmed in
September.[65] One of the vacancies was created in 2011
with the resignation of Kevin Warsh, who took oce in
2006 to ll the unexpired term ending January 31, 2018,
and resigned his position eective March 31, 2011.[66][67]
In March 2012, U.S. Senator David Vitter (R, LA) said
he would oppose Obamas Stein and Powell nominations,
dampening near-term hopes for approval.[68] However
Senate leaders reached a deal, paving the way for armative votes on the two nominees in May 2012 and bringing
the board to full strength for the rst time since 2006[69]
with Dukes service after term end. Later, on January 6,
2014, the United States Senate conrmed Yellens nomination to be Chair of the Federal Reserve Board of Governors; she is slated to be the rst woman to hold the position and will become Chair on February 1, 2014.[70] Subsequently, President Obama nominated Stanley Fischer
to replace Yellen as the Vice Chair.[71]
In April 2014, Stein announced he was leaving to return
to Harvard May 28 with four years remaining on his term.
At the time of the announcement, the FOMC already
is down three members as it awaits the Senate conrmation of ... Fischer and Lael Brainard, and as [President]
Obama has yet to name a replacement for ... Duke. ...
Powell is still serving as he awaits his conrmation for a
second term.[72]
Allan R. Landon, 65, former president and CEO of the
Bank of Hawaii, was nominated in early 2015 by President Barack Obama to the Board.[73]

The Chair and Vice Chair of the Board of Governors are

appointed by the President from among the sitting GovFederal Open Market Committee
ernors. They both serve a four-year term and they can
be renominated as many times as the President chooses,
Main article: Federal Open Market Committee
until their terms on the Board of Governors expire.[58]
The Federal Open Market Committee (FOMC) consists
List of members of the Board of Governors The of 12 members, seven from the Board of Governors and
current members of the Board of Governors are as 5 of the regional Federal Reserve Bank presidents. The
follows:[56]
FOMC oversees open market operations, the principal
tool of national monetary policy. These operations affect the amount of Federal Reserve balances available to
Nominations, conrmations and resignations In depository institutions, thereby inuencing overall monlate December 2011, President Barack Obama nomi- etary and credit conditions. The FOMC also directs opnated Stein, a Harvard University nance professor and a erations undertaken by the Federal Reserve in foreign exDemocrat, and Powell, formerly of Dillon Read, Bankers change markets. The president of the Federal Reserve
Trust[61] and The Carlyle Group[62] and a Republican. Bank of New York is a permanent member of the FOMC;
Both candidates also have Treasury Department experi- the presidents of the other banks rotate membership at
ence in the Obama and George H.W. Bush administra- two- and three-year intervals. All Regional Reserve Bank
tions respectively.[61]
presidents contribute to the committees assessment of
Obama administration ocials [had] regrouped to iden- the economy and of policy options, but only the ve presitify Fed candidates after Peter Diamond, a Nobel Prize- dents who are then members of the FOMC vote on policy
winning economist, withdrew his nomination to the board decisions. The FOMC determines its own internal orgain June [2011] in the face of Republican opposition. nization and, by tradition, elects the Chair of the Board
Richard Clarida, a potential nominee who was a Trea- of Governors as its chair and the president of the Fedsury ocial under George W. Bush, pulled out of con- eral Reserve Bank of New York as its vice chair. It is
sideration in August [2011]", one account of the Decem- informal policy within the FOMC for the Board of Gov-

384

CHAPTER 18. REGULATION

ernors and the New York Federal Reserve Bank president

to vote with the Chair of the FOMC; anyone who is not
an expert on monetary policy traditionally votes with the
chair as well; and in any vote no more than two FOMC
members can dissent.[74] Formal meetings typically are
held eight times each year in Washington, D.C. Nonvoting Reserve Bank presidents also participate in Committee deliberations and discussion. The FOMC generally
meets eight times a year in telephone consultations and
other meetings are held when needed.[75]
Federal Advisory Council
Main article: Federal Advisory Council

The twelve Reserve Banks buildings in 1936

The Federal Advisory Council, composed of twelve repA members are chosen by the regional Banks shareholdresentatives of the banking industry, advises the Board on
ers, and are intended to represent member banks interall matters within its jurisdiction.
ests. Member banks are divided into three categories:
large, medium, and small. Each category elects one of
the three class A board members. Class B board memFederal Reserve Banks
bers are also nominated by the regions member banks,
but class B board members are supposed to represent the
Main article: Federal Reserve Bank
There are 12 Federal Reserve Banks located in Boston, interests of the public. Lastly, class C board members
are nominated by the Board of Governors, and are also
intended to represent the interests of the public.[77]

Map of the twelve Federal Reserve Districts, with the twelve Federal Reserve Banks marked as black squares, and all Branches
within each district (24 total) marked as red circles. The Washington DC Headquarters is marked with a star. (Also, a 25th
branch in Bualo, NY had been closed in 2008.)

A member bank is a private institution and owns stock in

its regional Federal Reserve Bank. All nationally chartered banks hold stock in one of the Federal Reserve
Banks. State chartered banks may choose to be members (and hold stock in their regional Federal Reserve
bank), upon meeting certain standards. About 38% of
U.S. banks are members of their regional Federal Reserve
Bank.[78] The amount of stock a member bank must own
is equal to 3% of its combined capital and surplus.[79][80]
However, holding stock in a Federal Reserve bank is not
like owning stock in a publicly traded company. These
stocks cannot be sold or traded, and member banks do
not control the Federal Reserve Bank as a result of owning this stock. The charter and organization of each Federal Reserve Bank is established by law and cannot be
altered by the member banks. Member banks, do however, elect six of the nine members of the Federal Reserve Banks boards of directors.[30][81] From the prots
of the Regional Bank of which it is a member, a member
bank receives a dividend equal to 6% of their purchased
stock.[16] The remainder of the regional Federal Reserve
Banks prots is given over to the United States Treasury
Department. In 2009, the Federal Reserve Banks distributed $1.4 billion in dividends to member banks and
returned $47 billion to the U.S. Treasury.[82]

New York, Philadelphia, Cleveland, Richmond, Atlanta,

Chicago, St. Louis, Minneapolis, Kansas City, Dallas,
and San Francisco. Each reserve Bank is responsible for
member banks located in its district. The size of each district was set based upon the population distribution of the
United States when the Federal Reserve Act was passed.
Each regional Bank has a president, who is the chief executive ocer of their Bank. Each regional Reserve Banks
president is nominated by their Banks board of directors, but the nomination is contingent upon approval by
the Board of Governors. Presidents serve ve-year terms Legal status of regional Federal Reserve Banks The
and may be reappointed.[76]
Federal Reserve Banks have an intermediate legal staEach regional Banks board consists of nine members. tus, with some features of private corporations and some
Members are broken down into three classes: A, B, and features of public federal agencies. The United States
C. There are three board members in each class. Class has an interest in the Federal Reserve Banks as tax-

18.2. US FEDERAL RESERVE

exempt federally created instrumentalities whose prots
belong to the federal government, but this interest is not
proprietary.[83] In Lewis v. United States,[84] the United
States Court of Appeals for the Ninth Circuit stated that:
The Reserve Banks are not federal instrumentalities for
purposes of the FTCA [the Federal Tort Claims Act], but
are independent, privately owned and locally controlled
corporations. The opinion went on to say, however, that:
The Reserve Banks have properly been held to be federal instrumentalities for some purposes. Another relevant decision is Scott v. Federal Reserve Bank of Kansas
City,[83] in which the distinction is made between Federal
Reserve Banks, which are federally created instrumentalities, and the Board of Governors, which is a federal
agency.

385
sion of prior nancial reporting practices. Greater transparency is oered with more frequent disclosure and
more detail.
November 7, 2008, Bloomberg L.P. News brought a lawsuit against the Board of Governors of the Federal Reserve System to force the Board to reveal the identities
of rms for which it has provided guarantees during the
Late-2000s nancial crisis.[89] Bloomberg, L.P. won at
the trial court[90] and the Feds appeals were rejected at
both the United States Court of Appeals for the Second
Circuit and the U.S. Supreme Court. The data was released on March 31, 2011.[91][92]

18.2.3 Monetary policy

Regarding the structural relationship between the twelve

Federal Reserve banks and the various commercial Further information: Monetary policy of the United
(member) banks, political science professor Michael D. States
Reagan has written that:[85]
... the ownership of the Reserve Banks
by the commercial banks is symbolic; they do
not exercise the proprietary control associated
with the concept of ownership nor share, beyond the statutory dividend, in Reserve Bank
prots. ... Bank ownership and election at
the base are therefore devoid of substantive signicance, despite the supercial appearance of
private bank control that the formal arrangement creates.
Member banks
According to the web site for the Federal Reserve Bank
of Richmond, "[m]ore than one-third of U.S. commercial banks are members of the Federal Reserve System.
National banks must be members; state chartered banks
may join by meeting certain requirements.[86]
Accountability
The GAO and an outside auditor regularly audit the Board
of Governors, the Federal Reserve banks, and individual member banks. in a limited fashion. Audits do not
cover most of the Feds monetary policy actions or decisions, including discount window lending (direct loans
to nancial institutions), open-market operations and any
other transactions made under the direction of the Federal Open Market Committee ...[nor may the GAO audit] dealings with foreign governments and other central banks.[87] Various statutory changes, including the
Federal Reserve Transparency Act, have been proposed
to broaden the scope of the audits.
As of August 27, 2012, the Federal Reserve Board has
been publishing unaudited nancial reports for the Federal Reserve banks every quarter.[88] This is an expan-

The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to
inuence the availability and cost of money and credit to
help promote national economic goals. What happens to
money and credit aects interest rates (the cost of credit)
and the performance of an economy. The Federal Reserve Act of 1913 gave the Federal Reserve authority to
set monetary policy in the United States.[93][94]

Interbank lending
The Federal Reserve sets monetary policy by inuencing
the Federal funds rate, which is the rate of interbank lending of excess reserves. The rate that banks charge each
other for these loans is determined in the interbank market and the Federal Reserve inuences this rate through
the three tools of monetary policy described in the
Tools section below. The Federal funds rate is a shortterm interest rate that the FOMC focuses on, which affects the longer-term interest rates throughout the economy. The Federal Reserve summarized its monetary policy in 2005:
The Federal Reserve implements U.S.
monetary policy by aecting conditions in the
market for balances that depository institutions hold at the Federal Reserve Banks...By
conducting open market operations, imposing reserve requirements, permitting depository institutions to hold contractual clearing
balances, and extending credit through its discount window facility, the Federal Reserve exercises considerable control over the demand
for and supply of Federal Reserve balances
and the federal funds rate. Through its control of the federal funds rate, the Federal Reserve is able to foster nancial and monetary

386

CHAPTER 18. REGULATION

conditions consistent with its monetary policy
objectives.[95]

securities aects the federal funds rate, because primary

dealers have accounts at depository institutions.[100]

Percent

The Federal Reserve education website describes open

Eects on the quantity of reserves that banks use to make market operations as follows:[94]
loans inuence the economy. Policy actions that add reserves to the banking system encourage lending at lower
Open market operations involve the buying
interest rates thus stimulating growth in money, credit,
and selling of U.S. government securities (fedand the economy. Policy actions that absorb reserves
eral agency and mortgage-backed). The term
work in the opposite direction. The Feds task is to supply
'open market' means that the Fed doesn't deenough reserves to support an adequate amount of money
cide on its own which securities dealers it will
and credit, avoiding the excesses that result in ination
do business with on a particular day. Rather,
and the shortages that stie economic growth.[96]
the choice emerges from an 'open market' in
which the various securities dealers that the
Fed does business with the primary dealers
Tools
compete on the basis of price. Open market
operations are exible and thus, the most freThere are three main tools of monetary policy that the
quently used tool of monetary policy.
Federal Reserve uses to inuence the amount of reserves
[93]
Open market operations are the primary
in private banks:
tool used to regulate the supply of bank reserves. This tool consists of Federal Reserve
Federal funds rate and open market operations
purchases and sales of nancial instruments,
Further information: open market operations, money creusually securities issued by the U.S. Treasury,
ation and federal funds rate
Federal agencies and government-sponsored
The Federal Reserve System implements monetary polenterprises. Open market operations are carried out by the Domestic Trading Desk of the
Federal Funds Rate (effective)
Federal Reserve Bank of New York under di1954-06 to 2014-05
rection from the FOMC. The transactions are
20
18
undertaken with primary dealers.
16
The Feds goal in trading the securities is to
14
aect
the federal funds rate, the rate at which
12
10
banks borrow reserves from each other. When
8
the Fed wants to increase reserves, it buys se6
curities and pays for them by making a deposit
4
2
to the account maintained at the Fed by the
0
primary dealers bank. When the Fed wants
1952 1958 1964 1970 1976 1982 1988 1994 2000 2006 2012 2018
Date
to reduce reserves, it sells securities and collects from those accounts. Most days, the Fed
The eective federal funds rate charted over more than fty
does not want to increase or decrease reserves
years.
permanently so it usually engages in transactions reversed within a day or two. That means
icy largely by targeting the federal funds rate. This is the
that a reserve injection today could be withinterest rate that banks charge each other for overnight
drawn tomorrow morning, only to be renewed
loans of federal funds, which are the reserves held by
at some level several hours later. These shortbanks at the Fed. This rate is actually determined by the
term transactions are called repurchase agreemarket and is not explicitly mandated by the Fed. The
ments (repos) the dealer sells the Fed a secuFed therefore tries to align the eective federal funds rate
rity and agrees to buy it back at a later date.
with the targeted rate by adding or subtracting from the
money supply through open market operations. The Fedagreements Further
information:
eral Reserve System usually adjusts the federal funds rate Repurchase
repurchase agreement
target by 0.25% or 0.50% at a time.
Open market operations allow the Federal Reserve to increase or decrease the amount of money in the banking system as necessary to balance the Federal Reserves
dual mandates. Open market operations are done through
the sale and purchase of United States Treasury security,
sometimes called Treasury bills or more informally Tbills or Treasuries. The Federal Reserve buys Treasury bills from its primary dealers. The purchase of these

To smooth temporary or cyclical changes in the money

supply, the desk engages in repurchase agreements (repos) with its primary dealers. Repos are essentially secured, short-term lending by the Fed. On the day of the
transaction, the Fed deposits money in a primary dealers
reserve account, and receives the promised securities as
collateral. When the transaction matures, the process

18.2. US FEDERAL RESERVE

unwinds: the Fed returns the collateral and charges the
primary dealer's reserve account for the principal and accrued interest. The term of the repo (the time between
settlement and maturity) can vary from 1 day (called an
overnight repo) to 65 days.[101]
Discount rate Further information: discount window
The Federal Reserve System also directly sets the discount rate, which is the interest rate for discount window lending, overnight loans that member banks borrow
directly from the Fed. This rate is generally set at a rate
close to 100 basis points above the target federal funds
rate. The idea is to encourage banks to seek alternative
funding before using the discount rate option.[102] The
equivalent operation by the European Central Bank is referred to as the "marginal lending facility".[103]

387
called the Primary Dealer Credit Facility (PDCF), was
announced on March 16, 2008.[113] The PDCF was a
fundamental change in Federal Reserve policy because
now the Fed is able to lend directly to primary dealers,
which was previously against Fed policy.[114] The dierences between these three new facilities is described by
the Federal Reserve:[115]
The Term Auction Facility program offers term funding to depository institutions
via a bi-weekly auction, for xed amounts of
credit. The Term Securities Lending Facility will be an auction for a xed amount of
lending of Treasury general collateral in exchange for OMO-eligible and AAA/Aaa rated
private-label residential mortgage-backed securities. The Primary Dealer Credit Facility
now allows eligible primary dealers to borrow
at the existing Discount Rate for up to 120
days.

Both the discount rate and the federal funds rate inuence
the prime rate, which is usually about 3 percent higher
than the federal funds rate.
Some of the measures taken by the Federal Reserve to
address this mortgage crisis have not been used since The
[116]
The Federal Reserve gives a brief
Reserve requirements Another instrument of mone- Great Depression.
summary
of
these
new
facilities:[117]
tary policy adjustment employed by the Federal Reserve
System is the fractional reserve requirement, also known
as the required reserve ratio.[104] The required reserve ratio sets the balance that the Federal Reserve System requires a depository institution to hold in the Federal Reserve Banks,[95] which depository institutions trade in the
federal funds market discussed above.[105] The required
reserve ratio is set by the Board of Governors of the
Federal Reserve System.[106] The reserve requirements
have changed over time and some of the history of these
changes is published by the Federal Reserve.[107]

As the economy has slowed in the last nine

months and credit markets have become unstable, the Federal Reserve has taken a number of
steps to help address the situation. These steps
have included the use of traditional monetary
policy tools at the macroeconomic level as well
as measures at the level of specic markets to
provide additional liquidity.
The Federal Reserves response has continued to evolve since pressure on credit markets began to surface last summer, but all these
measures derive from the Feds traditional open
market operations and discount window tools
by extending the term of transactions, the type
of collateral, or eligible borrowers.

As a response to the nancial crisis of 2008, the Federal Reserve now makes interest payments on depository
institutions required and excess reserve balances. The
payment of interest on excess reserves gives the central
bank greater opportunity to address credit market conditions while maintaining the federal funds rate close to the
target rate set by the FOMC.[108]
A fourth facility, the Term Deposit Facility, was announced December 9, 2009, and approved April 30,
2010, with an eective date of June 4, 2010.[118] The
New facilities In order to address problems related to Term Deposit Facility allows Reserve Banks to oer term
the subprime mortgage crisis and United States housing deposits to institutions that are eligible to receive earnings
bubble, several new tools have been created. The rst new on their balances at Reserve Banks. Term deposits are intool, called the Term Auction Facility, was added on De- tended to facilitate the implementation of monetary polcember 12, 2007. It was rst announced as a temporary icy by providing a tool by which the Federal Reserve can
tool[109] but there have been suggestions that this new tool manage the aggregate quantity of reserve balances held
may remain in place for a prolonged period of time.[110] by depository institutions. Funds placed in term deposits
Creation of the second new tool, called the Term Se- are removed from the accounts of participating institucurities Lending Facility, was announced on March 11, tions for the life of the term deposit and thus drain reserve
2008.[111] The main dierence between these two facil- balances from the banking system.
ities is that the Term Auction Facility is used to inject
cash into the banking system whereas the Term Securities Lending Facility is used to inject treasury securities Term auction facility Further information: Term
into the banking system.[112] Creation of the third tool, auction facility

388

CHAPTER 18. REGULATION

The Term Auction Facility is a program in which

the Federal Reserve auctions term funds to depository
institutions.[109] The creation of this facility was announced by the Federal Reserve on December 12, 2007,
and was done in conjunction with the Bank of Canada,
the Bank of England, the European Central Bank, and
the Swiss National Bank to address elevated pressures in
short-term funding markets.[119] The reason it was created is because banks were not lending funds to one another and banks in need of funds were refusing to go to
the discount window. Banks were not lending money to
each other because there was a fear that the loans would
not be paid back. Banks refused to go to the discount
window because it is usually associated with the stigma
of bank failure.[120][121][122] [123] Under the Term Auction Facility, the identity of the banks in need of funds is
protected in order to avoid the stigma of bank failure.[124]
Foreign exchange swap lines with the European Central
Bank and Swiss National Bank were opened so the banks
in Europe could have access to U.S. dollars.[124] Federal
Reserve Chairman Ben Bernanke briey described this
facility to the U.S. House of Representatives on January
17, 2008:
the Federal Reserve recently unveiled a
term auction facility, or TAF, through which
prespecied amounts of discount window
credit can be auctioned to eligible borrowers. The goal of the TAF is to reduce the incentive for banks to hoard cash and increase
their willingness to provide credit to households and rms...TAF auctions will continue
as long as necessary to address elevated pressures in short-term funding markets, and we
will continue to work closely and cooperatively
with other central banks to address market
strains that could hamper the achievement of
our broader economic objectives.[125]
It is also described in the Term Auction Facility FAQ[109]
The TAF is a credit facility that allows a
depository institution to place a bid for an advance from its local Federal Reserve Bank at an
interest rate that is determined as the result of
an auction. By allowing the Federal Reserve to
inject term funds through a broader range of
counterparties and against a broader range of
collateral than open market operations, this facility could help ensure that liquidity provisions
can be disseminated eciently even when the
unsecured interbank markets are under stress.
In short, the TAF will auction term funds of
approximately one-month maturity. All depository institutions that are judged to be in sound
nancial condition by their local Reserve Bank

and that are eligible to borrow at the discount

window are also eligible to participate in TAF
auctions. All TAF credit must be fully collateralized. Depositories may pledge the broad
range of collateral that is accepted for other
Federal Reserve lending programs to secure
TAF credit. The same collateral values and
margins applicable for other Federal Reserve
lending programs will also apply for the TAF.
Term securities lending facility The Term Securities Lending Facility is a 28-day facility that will oer
Treasury general collateral to the Federal Reserve Bank
of New Yorks primary dealers in exchange for other
program-eligible collateral. It is intended to promote liquidity in the nancing markets for Treasury and other
collateral and thus to foster the functioning of nancial
markets more generally.[126] Like the Term Auction Facility, the TSLF was done in conjunction with the Bank
of Canada, the Bank of England, the European Central
Bank, and the Swiss National Bank. The resource allows
dealers to switch debt that is less liquid for U.S. government securities that are easily tradable. It is anticipated by
Federal Reserve ocials that the primary dealers, which
include Goldman Sachs Group. Inc., J.P. Morgan Chase,
and Morgan Stanley, will lend the Treasuries on to other
rms in return for cash. That will help the dealers nance
their balance sheets. The currency swap lines with the
European Central Bank and Swiss National Bank were
increased.
Primary dealer credit facility The Primary Dealer
Credit Facility (PDCF) is an overnight loan facility that
will provide funding to primary dealers in exchange
for a specied range of eligible collateral and is intended to foster the functioning of nancial markets more
generally.[115] This new facility marks a fundamental
change in Federal Reserve policy because now primary
dealers can borrow directly from the Fed when this previously was not permitted.
Interest on reserves Main article: Interest on excess
reserves in the United States
As of October 2008, the Federal Reserve banks will pay
interest on reserve balances (required & excess) held by
depository institutions. The rate is set at the lowest federal
funds rate during the reserve maintenance period of an
institution, less 75bp.[127] As of October 23, 2008, the
Fed has lowered the spread to a mere 35 bp.[128]
Term deposit facility The Term Deposit Facility is a
program through which the Federal Reserve Banks will
oer interest-bearing term deposits to eligible institutions. By removing excess deposits from participating

18.2. US FEDERAL RESERVE

banks, the overall level of reserves available for lending is
reduced, which should result in increased market interest
rates, acting as a brake on economic activity and ination.
The Federal Reserve has stated that:
Term deposits will be one of several tools
that the Federal Reserve could employ to drain
reserves when policymakers judge that it is appropriate to begin moving to a less accommodative stance of monetary policy. The development of the TDF is a matter of prudent
planning and has no implication for the nearterm conduct of monetary policy.[129]
The Federal Reserve initially authorized up to ve smallvalue oerings are designed to ensure the eectiveness
of TDF operations and to provide eligible institutions
with an opportunity to gain familiarity with term deposit procedures.[130] After three of the oering auctions were successfully completed, it was announced
that small-value auctions would continue on an ongoing
basis.[131]
The Term Deposit Facility is essentially a tool available
to reverse the eorts that have been employed to provide liquidity to the nancial markets and to reduce the
amount of capital available to the economy. As stated in
Bloomberg News:
Policy makers led by Chairman Ben S.
Bernanke are preparing for the day when they
will have to start siphoning o more than $1
trillion in excess reserves from the banking system to contain ination. The Fed is charting an eventual return to normal monetary policy, even as a weakening near-term outlook has
raised the possibility it may expand its balance
sheet.[132]
Chairman Ben S. Bernanke, testifying before House
Committee on Financial Services, described the Term
Deposit Facility and other facilities to Congress in the following terms:
Most importantly, in October 2008 the
Congress gave the Federal Reserve statutory
authority to pay interest on balances that banks
hold at the Federal Reserve Banks. By increasing the interest rate on banks reserves, the Federal Reserve will be able to put signicant upward pressure on all short-term interest rates,
as banks will not supply short-term funds to
the money markets at rates signicantly below
what they can earn by holding reserves at the
Federal Reserve Banks. Actual and prospective increases in short-term interest rates will
be reected in turn in higher longer-term interest rates and in tighter nancial conditions
more generally....

389
As an additional means of draining reserves, the Federal Reserve is also developing
plans to oer to depository institutions term
deposits, which are roughly analogous to certicates of deposit that the institutions oer to
their customers. A proposal describing a term
deposit facility was recently published in the
Federal Register, and the Federal Reserve is nalizing a revised proposal in light of the public comments that have been received. After
a revised proposal is reviewed by the Board,
we expect to be able to conduct test transactions this spring and to have the facility available if necessary thereafter. The use of reverse
repos and the deposit facility would together allow the Federal Reserve to drain hundreds of
billions of dollars of reserves from the banking
system quite quickly, should it choose to do so.
When these tools are used to drain reserves
from the banking system, they do so by replacing bank reserves with other liabilities; the
asset side and the overall size of the Federal
Reserves balance sheet remain unchanged. If
necessary, as a means of applying monetary restraint, the Federal Reserve also has the option of redeeming or selling securities. The redemption or sale of securities would have the
eect of reducing the size of the Federal Reserves balance sheet as well as further reducing
the quantity of reserves in the banking system.
Restoring the size and composition of the balance sheet to a more normal conguration is a
longer-term objective of our policies. In any
case, the sequencing of steps and the combination of tools that the Federal Reserve uses
as it exits from its currently very accommodative policy stance will depend on economic and
nancial developments and on our best judgments about how to meet the Federal Reserves
dual mandate of maximum employment and
price stability.
In sum, in response to severe threats to
our economy, the Federal Reserve created a
series of special lending facilities to stabilize
the nancial system and encourage the resumption of private credit ows to American families and businesses. As market conditions and
the economic outlook have improved, these
programs have been terminated or are being
phased out. The Federal Reserve also promoted economic recovery through sharp reductions in its target for the federal funds rate
and through large-scale purchases of securities.
The economy continues to require the support
of accommodative monetary policies. However, we have been working to ensure that we
have the tools to reverse, at the appropriate
time, the currently very high degree of mon-

390

CHAPTER 18. REGULATION

etary stimulus. We have full condence that,
when the time comes, we will be ready to do
so.[133]

Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility The Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (ABCPMMMFLF) was also called the AMLF. The
Facility began operations on September 22, 2008, and
was closed on February 1, 2010.[134]

the market has shrunk from more than $2.2 trillion.[135]

This program lent out a total $738 billion before it was
closed. Forty-ve out of 81 of the companies participating in this program were foreign rms. Research shows
that Troubled Asset Relief Program (TARP) recipients
were twice as likely to participate in the program than
other commercial paper issuers who did not take advantage of the TARP bailout. The Fed incurred no losses
from the CPFF.[136]

Quantitative policy A little-used tool of the Federal

Reserve is the quantitative policy. With that the Federal
Reserve actually buys back corporate bonds and mortgage
backed securities held by banks or other nancial institutions. This in eect puts money back into the nancial
institutions and allows them to make loans and conduct
Collateral eligible for pledge under the Facility was re- normal business. The Federal Reserve Board used this
quired to meet the following criteria:
policy in the early 1990s when the U.S. economy experienced the savings and loan crisis.
was purchased by Borrower on or after September The bursting of the United States housing bubble
19, 2008 from a registered investment company that prompted the Fed to buy mortgage-backed securities for
held itself out as a money market mutual fund;
the rst time in November 2008. Over six weeks, a total
All U.S. depository institutions, bank holding companies
(parent companies or U.S. broker-dealer aliates), or
U.S. branches and agencies of foreign banks were eligible
to borrow under this facility pursuant to the discretion of
the FRBB.

of $1.25 trillion were purchased in order to stabilize the

was purchased by Borrower at the Funds acquisition
housing market, about one-fth of all U.S. governmentcost as adjusted for amortization of premium or acbacked mortgages.[137]
cretion of discount on the ABCP through the date
of its purchase by Borrower;
was rated at the time pledged to FRBB, not lower 18.2.4 History
than A1, F1, or P1 by at least two major rating agencies or, if rated by only one major rating agency, the Main article: History of the Federal Reserve
ABCP must have been rated within the top rating
category by that agency;
was issued by an entity organized under the laws of Central banking in the United States
the United States or a political subdivision thereof
under a program that was in existence on September Main article: History of central banking in the United
States
18, 2008; and
had a stated maturity that did not exceed 120 days if The rst attempt at a national currency was during the
the Borrower was a bank or 270 days for non-bank American Revolutionary War. In 1775 the ContinenBorrowers.
tal Congress, as well as the states, began issuing paper
currency, calling the bills "Continentals". The ContinenCommercial Paper Funding Facility On October 7, tals were backed only by future tax revenue, and were
2008, the Federal Reserve further expanded the collat- used to help nance the Revolutionary War. Overprinteral it will loan against to include commercial paper us- ing, as well as British counterfeiting, caused the value of
ing the new Commercial Paper Funding Facility (CPFF). the Continental to diminish quickly. This experience with
The action made the Fed a crucial source of credit for paper money led the United States to strip the power to
a draft of the
non-nancial businesses in addition to commercial banks issue Bills of Credit (paper money) from
[138]
as
well as bannew
Constitution
on
August
16,
1787,
and investment rms. Fed ocials said they'll buy as
ning
such
issuance
by
the
various
states,
and
limiting the
much of the debt as necessary to get the market functionstates
ability
to
make
anything
but
gold
or
silver
coin legal
ing again. They refused to say how much that might be,
[139]
tender
on
August
28.
but they noted that around $1.3 trillion worth of commercial paper would qualify. There was $1.61 trillion in outstanding commercial paper, seasonally adjusted, on the
market as of October 1, 2008, according to the most recent data from the Fed. That was down from $1.70 trillion in the previous week. Since the summer of 2007,

In 1791, the government granted the First Bank of the

United States a charter to operate as the U.S. central bank
until 1811.[140] The First Bank of the United States came
to an end under President Madison because Congress
refused to renew its charter. The Second Bank of the

18.2. US FEDERAL RESERVE

391
Banking. Historical Beginnings... The Federal
Reserve (PDF). 1999.
Creation of First and Second Central Bank The rst
U.S. institution with central banking responsibilities was
the First Bank of the United States, chartered by Congress
and signed into law by President George Washington on
February 25, 1791, at the urging of Alexander Hamilton.
This was done despite strong opposition from Thomas
Jeerson and James Madison, among numerous others.
The charter was for twenty years and expired in 1811 under President Madison, because Congress refused to renew it.[142]

Federal Reserve Bank coin bag. coton 17x30cm

In 1816, however, Madison revived it in the form of the

Second Bank of the United States. Years later, early renewal of the banks charter became the primary issue
in the reelection of President Andrew Jackson. After
Jackson, who was opposed to the central bank, was reelected, he pulled the governments funds out of the bank.
Nicholas Biddle, President of the Second Bank of the
United States, responded by contracting the money supply to pressure Jackson to renew the banks charter forcing the country into a recession, which the bank blamed
on Jacksons policies . Interestingly, Jackson is the only
President to completely pay o the national debt. The
banks charter was not renewed in 1836. From 1837 to
1862, in the Free Banking Era there was no formal central
bank. From 1862 to 1913, a system of national banks was
instituted by the 1863 National Banking Act. A series of
bank panics, in 1873, 1893, and 1907,[5][6][7] provided
demand for the creation of a centralized banking system.

United States was established in 1816, and lost its authority to be the central bank of the U.S. twenty years
later under President Jackson when its charter expired. Creation of Third Central Bank Main article:
Both banks were based upon the Bank of England.[141] History of the Federal Reserve System
Ultimately, a third national bank, known as the Federal
Reserve, was established in 1913 and still exists to this
The main motivation for the third central banking system
day.
came from the Panic of 1907, which caused renewed demands for banking and currency reform.[5][6][7][143] During the last quarter of the 19th century and the beTimeline of central banking in the United States
ginning of the 20th century the United States economy
went through a series of nancial panics.[144] According
17911811: First Bank of the United States
to many economists, the previous national banking sys 18111816: No central bank
tem had two main weaknesses: an inelastic currency and
a lack of liquidity.[144] In 1908, Congress enacted the
18161836: Second Bank of the United States
Aldrich-Vreeland Act, which provided for an emergency
18371862: Free Bank Era
currency and established the National Monetary Commission to study banking and currency reform.[145] The
18461921: Independent Treasury System
National Monetary Commission returned with recommendations which were repeatedly rejected by Congress.
18631913: National Banks
A revision crafted during a secret meeting on Jekyll Is 1913 present: Federal Reserve System
land by Senator Aldrich and representatives of the nations top nance and industrial groups later became the
Sources:
Remarks by Chairman Alan
basis of the Federal Reserve Act.[146][147] The House
Greenspan Our banking history"". May
voted on December 22, 1913, with 298 yeas to 60 nays,
2, 1998. History of the Federal Reserve.
and the Senate voted 4325 on December 23, 1913.[148]
Chapter 1. Early Experiments in Central
President Woodrow Wilson signed the bill later that

392

CHAPTER 18. REGULATION

day.[149]

ically strategic locations, and a uniform elastic currency

based on gold and commercial paper. Aldrich believed a
central banking system with no political involvement was
Federal Reserve Act Main article: Federal Reserve best, but was convinced by Warburg that a plan with no
Act
public control was not politically feasible.[150] The comThe head of the bipartisan National Monetary Commis- promise involved representation of the public sector on
the Board of Directors.[151]
Aldrichs bill met much opposition from politicians. Critics charged Aldrich of being biased due to his close ties
to wealthy bankers such as J. P. Morgan and John D.
Rockefeller, Jr., Aldrichs son-in-law. Most Republicans
favored the Aldrich Plan,[151] but it lacked enough support in Congress to pass because rural and western states
viewed it as favoring the eastern establishment.[2] In
contrast, progressive Democrats favored a reserve system
owned and operated by the government; they believed
that public ownership of the central bank would end Wall
Streets control of the American currency supply.[151]
Conservative Democrats fought for a privately owned, yet
decentralized, reserve system, which would still be free of
Wall Streets control.[151]

Newspaper clipping, December 24, 1913

The original Aldrich Plan was dealt a fatal blow in 1912,

when Democrats won the White House and Congress.[150]
Nonetheless, President Woodrow Wilson believed that
the Aldrich plan would suce with a few modications. The plan became the basis for the Federal Reserve Act, which was proposed by Senator Robert Owen
in May 1913. The primary dierence between the two
bills was the transfer of control of the Board of Directors (called the Federal Open Market Committee in the
Federal Reserve Act) to the government.[2][142] The bill
passed Congress on December 23, 1913,[152][153] on a
mostly partisan basis, with most Democrats voting yea
and most Republicans voting nay.[142]

sion was nancial expert and Senate Republican leader

Nelson Aldrich. Aldrich set up two commissions one
Key laws
to study the American monetary system in depth and
the other, headed by Aldrich himself, to study the EuKey laws aecting the Federal Reserve have been:[154]
ropean central banking systems and report on them.[145]
Aldrich went to Europe opposed to centralized banking,
Federal Reserve Act
but after viewing Germanys monetary system he came
away believing that a centralized bank was better than the
GlassSteagall Act
government-issued bond system that he had previously
supported.
Banking Act of 1935
In early November 1910, Aldrich met with ve well
Employment Act of 1946
known members of the New York banking community to
devise a central banking bill. Paul Warburg, an attendee
Federal Reserve-Treasury Department Accord of
of the meeting and longtime advocate of central banking
1951
in the U.S., later wrote that Aldrich was bewildered at
all that he had absorbed abroad and he was faced with
Bank Holding Company Act of 1956 and the
the dicult task of writing a highly technical bill while
amendments of 1970
being harassed by the daily grind of his parliamentary
[150]
After ten days of deliberation, the bill, which
duties.
Federal Reserve Reform Act of 1977
would later be referred to as the Aldrich Plan, was
agreed upon. It had several key components, including a
International Banking Act of 1978
central bank with a Washington-based headquarters and
Full Employment and Balanced Growth Act (1978)
fteen branches located throughout the U.S. in geograph-

18.2. US FEDERAL RESERVE

393

Depository Institutions Deregulation and Monetary of households had fallen signicantly, citing a 2014 paControl Act (1980)
per by the Russell Sage Foundation which found that the
median net worth of American households had dropped
Financial Institutions Reform, Recovery and En- from $87,992 in 2003 to $56,335 in 2013, a 36 percent
forcement Act of 1989
decline.[162] (See more at Distribution of wealth).
Federal Deposit Insurance Corporation Improvement Act of 1991
Money supply
GrammLeachBliley Act (1999)
Financial Services Regulatory Relief Act (2006)

Further information: Money supply

The most common measures are named M0 (narrowest),

Emergency Economic Stabilization Act (2008)

11,000
10,000

18.2.5

Measurement of economic variables

9,000

Billions of US dollars

DoddFrank Wall Street Reform and Consumer

Protection Act (2010)

M3
M2

8,000
7,000
6,000

M1
currency

5,000
4,000
3,000
2,000

The Federal Reserve records and publishes large amounts

of data. A few websites where data is published are
at the Board of Governors Economic Data and Research page,[155] the Board of Governors statistical releases and historical data page,[156] and at the St. Louis
Feds FRED (Federal Reserve Economic Data) page.[157]
The Federal Open Market Committee (FOMC) examines
many economic indicators prior to determining monetary
policy.[158]
M1, M2, and M3. In the United States they are dened
Some criticism involves economic data compiled by the by the Federal Reserve as follows:
1,000

Percentage of total

Fed. The Fed sponsors much of the monetary economics

research in the U.S., and Lawrence H. White objects that
this makes it less likely for researchers to publish ndings
challenging the status quo.[159]

1960
100

1965

1970

1975

1980

1985

1990

1995

2000

2005

1965

1970

1975

1980

1985

1990

1995

2000

2005

80
60
40
20

0
1960

The Federal Reserve stopped publishing M3 statistics in

March 2006, saying that the data cost a lot to collect but
did not provide signicantly useful information.[163] The
other three money supply measures continue to be provided in detail.

Net worth of households and nonprot organizations

Personal consumption expenditures price index
Further information: Personal consumption expenditures
price index

Total Net Worth Balance Sheet of Households and Nonprot

Organizations 1949-2012

The net worth of households and nonprot organizations

in the United States is published by the Federal Reserve
in a report titled Flow of Funds.[160] At the end of the
third quarter of scal year 2012, this value was $64.8
trillion. At the end of the rst quarter of scal year
2014, this value was $95.5 trillion;[161] however, in July
2014 the New York Times reported the median net worth

The Personal consumption expenditures price index, also

referred to as simply the PCE price index, is used as one
measure of the value of money. It is a United Stateswide indicator of the average increase in prices for all
domestic personal consumption. Using a variety of data
including United States Consumer Price Index and U.S.
Producer Price Index prices, it is derived from the largest
component of the Gross Domestic Product in the BEAs
National Income and Product Accounts, personal consumption expenditures.
One of the Feds main roles is to maintain price stability,
which means that the Feds ability to keep a low ination
rate is a long-term measure of the their success.[164] Although the Fed is not required to maintain ination within
a specic range, their long run target for the growth of the
PCE price index is between 1.5 and 2 percent.[165] There
has been debate among policy makers as to whether or

394

CHAPTER 18. REGULATION

not the Federal Reserve should have a specic ination Most mainstream economists favor a low, steady rate of
targeting policy.[166][167][168]
ination.[170] Low (as opposed to zero or negative) ination may reduce the severity of economic recessions
by enabling the labor market to adjust more quickly in a
Ination and the economy There are two types of in- downturn, and reduce the risk that a liquidity trap preation that are closely tied to each other. Monetary ina- vents monetary policy from stabilizing the economy.[171]
tion is an increase in the money supply. Price ination is The task of keeping the rate of ination low and stable is
a sustained increase in the general level of prices, which usually given to monetary authorities.
is equivalent to a decline in the value or purchasing power
of money. If the supply of money and credit increases too
rapidly over many months (monetary ination), the result Unemployment rate
will usually be price ination. Price ination does not always increase in direct proportion to monetary ination;
it is also aected by the velocity of money and other factors. With price ination, a dollar buys less and less over
time.
The second way that ination can occur and the more frequent way is by an increase in the velocity of money. This
has only been measured since the mid-'50s. A healthy
economy usually has a velocity of 1.8 to 2.3. If the velocity is too high, then this means that people are not holding on to their money and spending it as fast as they get it.
Ination happens when too many dollars are chasing too
few goods. If people are spending as soon as they get it,
then there are more active dollars in the marketplace,
as opposed to sitting in a bank account. This will also
cause a price increase.[94]
United States unemployment rates 19752010 showing variance
The eects of monetary and price ination include:[94]

between the fty states

Further information: Unemployment rate United States

Price ination makes workers worse o if their in- Bureau of Labor Statistics and List of U.S. states by
comes don't rise as rapidly as prices.
unemployment rate
Pensioners living on a xed income are worse o
if their savings do not increase more rapidly than One of the stated goals of monetary policy is maximum
employment. The unemployment rate statistics are colprices.
lected by the Bureau of Labor Statistics, and like the
Lenders lose because they will be repaid with dollars PCE price index are used as a barometer of the nations
economic health, and thus as a measure of the success
that aren't worth as much.
of an administrations economic policies. Since 1980,
Savers lose because the dollar they save today will both parties have made progressive changes in the basis
for calculating unemployment, so that the numbers now
not buy as much when they are ready to spend it.
quoted cannot be compared directly to the corresponding
Debtors win because the dollar they borrow today rates from earlier administrations, or to the rest of the
[172]
will be repaid with dollars that aren't worth as much. world.
Businesses and people will nd it harder to plan
and therefore may decrease investment in future 18.2.6 Budget
projects.
The Federal Reserve is self-funded. The vast majority
(90%+) of Fed revenues come from open market oper Owners of nancial assets suer.
ations, specically the interest on the portfolio of Trea Interest rate-sensitive industries, like mortgage com- sury securities as well as capital gains/losses that may
panies, suer as monetary ination drives up long- arise from the buying/selling of the securities and their
term interest rates and Federal Reserve tightening derivatives as part of Open Market Operations. The balance of revenues come from sales of nancial services
raises short-term rates.
(check and electronic payment processing) and discount
Developed-market currencies become weaker window loans.[173] The Board of Governors (Federal Reagainst emerging markets.[169]
serve Board) creates a budget report once per year for

18.2. US FEDERAL RESERVE

395

Congress. There are two reports with budget information. The one that lists the complete balance statements
with income and expenses as well as the net prot or loss
is the large report simply titled, Annual Report. It also
includes data about employment throughout the system.
The other report, which explains in more detail the expenses of the dierent aspects of the whole system, is
called Annual Report: Budget Review. These are comprehensive reports with many details and can be found at
the Board of Governors website under the section Reports to Congress[174]
Total combined liabilities for all 12 Federal Reserve Banks

18.2.7

Net worth

Balance sheet
One of the keys to understanding the Federal Reserve is
the Federal Reserve balance sheet (or balance statement).
In accordance with Section 11 of the Federal Reserve
Act, the Board of Governors of the Federal Reserve System publishes once each week the Consolidated Statement of Condition of All Federal Reserve Banks showing the condition of each Federal Reserve bank and a consolidated statement for all Federal Reserve banks. The
Board of Governors requires that excess earnings of the
Reserve Banks be transferred to the Treasury as interest
on Federal Reserve notes.[175][176]
Below is the balance sheet as of July 6, 2011 (in billions
of dollars):
NOTE: The Fed balance sheet shown in this article has assets, liabilities and net equity that do not add up correctly.
The Fed balance sheet is missing the item Reserve Balances with Federal Reserve Banks which would make
the gures balance.

value reported here is based on a statutory valuation

of $42 2/9 per ne troy ounce. As of March 2009,
the market value of that gold is around $247.8 billion.
The Fed holds more than $1.8 billion in coinage, not
as a liability but as an asset. The Treasury Department is actually in charge of creating coins and U.S.
Notes. The Fed then buys coinage from the Treasury
by increasing the liability assigned to the Treasurys
account.
The Fed holds at least $534 billion of the national
debt. The securities held outright value used to directly represent the Feds share of the national debt,
but after the creation of new facilities in the winter
of 20072008, this number has been reduced and
the dierence is shown with values from some of
the new facilities.
The Fed has no assets from overnight repurchase
agreements. Repurchase agreements are the primary asset of choice for the Fed in dealing in the
open market. Repo assets are bought by creating
depository institution liabilities and directed to the
bank the primary dealer uses when they sell into the
open market.
The more than $1 trillion in Federal Reserve Note
liabilities represents nearly the total value of all dollar bills in existence; over $176 billion is held by the
Fed (not in circulation); and the net gure of $863
billion represents the total face value of Federal Reserve Notes in circulation.

Total combined assets for all 12 Federal Reserve Banks

Analyzing the Federal Reserves balance sheet reveals a

number of facts:
The Fed has over $11 billion in gold stock (certicates), which represents the Feds nancial interest in the statutory-determined value of gold turned
over to the U.S. Treasury in accordance with the
Gold Reserve Act on January 30, 1934.[177] The

The $916 billion in deposit liabilities of depository

institutions shows that dollar bills are not the only
source of government money. Banks can swap deposit liabilities of the Fed for Federal Reserve Notes
back and forth as needed to match demand from customers, and the Fed can have the Bureau of Engraving and Printing create the paper bills as needed to
match demand from banks for paper money. The
amount of money printed has no relation to the
growth of the monetary base (M0).

396

CHAPTER 18. REGULATION

The $93.5 billion in Treasury liabilities shows that

the Treasury Department does not use private banks
but rather uses the Fed directly (the lone exception
to this rule is Treasury Tax and Loan because the
government worries that pulling too much money
out of the private banking system during tax time
could be disruptive).
The $1.6 billion foreign liability represents the
amount of foreign central bank deposits with the
Federal Reserve.

Federal Reserve Statistical Release

Free banking
Gold standard
Government debt
Greenspan put
History of Federal Open Market Committee actions
Independent Treasury

The $9.7 billion in 'other liabilities and accrued div Legal Tender Cases
idends represents partly the amount of money owed
so far in the year to member banks for the 6% div List of economic reports by U.S. government agenidend on the 3% of their net capital they are recies
quired to contribute in exchange for nonvoting stock
Title 12 of the Code of Federal Regulations
their regional Reserve Bank in order to become a
member. Member banks are also subscribed for
United States Bullion Depository known as Fort
an additional 3% of their net capital, which can be
Knox
called at the Federal Reserves discretion. All nationally chartered banks must be members of a Federal Reserve Bank, and state-chartered banks have 18.2.10 References
the choice to become members or not.
Total capital represents the prot the Fed has
earned, which comes mostly from assets they purchase with the deposit and note liabilities they create. Excess capital is then turned over to the Treasury Department and Congress to be included into
the Federal Budget as Miscellaneous Revenue.
In addition, the balance sheet also indicates which assets
are held as collateral against Federal Reserve Notes.

18.2.8

Criticism

Main article: Criticism of the Federal Reserve

The Federal Reserve System has faced various criticisms
since its inception in 1913. Critique of the organization
and system has come from sources such as writers, journalists, economists, and nancial institutions as well as
politicians, various government employees, and its own
Chairmen.[142][178][179][180]

18.2.9

See also

Consumer Leverage Ratio

Core ination
Farm Credit System
Fed model
Federal Home Loan Banks
Federal Reserve Police

[1] The Federal Reserve Bank Discount Window & Payment

System Risk Website.
[2] Born of a panic: Forming the Federal Reserve System.
The Federal Reserve Bank of Minneapolis. August 1988.
[3] BoG 2006, pp. 1 Just before the founding of the Federal
Reserve, the nation was plagued with nancial crises. At
times, these crises led to 'panics,' in which people raced
to their banks to withdraw their deposits. A particularly
severe panic in 1907 resulted in bank runs that wreaked
havoc on the fragile banking system and ultimately led
Congress in 1913 to write the Federal Reserve Act. Initially created to address these banking panics, the Federal
Reserve is now charged with a number of broader responsibilities, including fostering a sound banking system and
a healthy economy.
[4] BoG 2005, pp. 12
[5] Panic of 1907: J.P. Morgan Saves the Day.
history.com. Retrieved December 6, 2014.

U-s-

[6] Born of a Panic: Forming the Fed System - The Region

- Publications & Papers - The Federal Reserve Bank of
Minneapolis. Minneapolisfed.org. Retrieved December
6, 2014.
[7] History, Travel, Arts, Science, People, Places - Smithsonian. Smithsonianmag.com. Retrieved December 6,
2014.
[8] BoG 2005, pp. 1 It was founded by Congress in 1913 to
provide the nation with a safer, more exible, and more
stable monetary and nancial system. Over the years, its
role in banking and the economy has expanded.
[9] Patrick, Sue C. (1993). Reform of the Federal Reserve System in the Early 1930s: The Politics of Money and Banking.
Garland. ISBN 978-0-8153-0970-3.

18.2. US FEDERAL RESERVE

[10] 12 U.S.C. 225a

[11] The Congress established two key objectives for monetary policy-maximum employment and stable prices-in
the Federal Reserve Act. These objectives are sometimes
referred to as the Federal Reserves dual mandate. Federalreserve.gov. January 25, 2012. Retrieved April 30,
2012.
[12] FRB: Mission. Federalreserve.gov. November 6, 2009.
Retrieved October 29, 2011.
[13] BoG 2005, pp. v (See structure)
[14] Federal Reserve Districs. Federal Reserve Online. n.d.
Retrieved August 29, 2011.
[15]
[16] FAQ Who owns the Federal Reserve?". Federal Reserve website.
[17] Lapidos, Juliet (September 19, 2008). Is the Fed Private
or Public?". Slate. Retrieved August 29, 2011.
[18] Toma, Mark (February 1, 2010). Federal Reserve System. EH. Net Encyclopedia. Economic History Association. Retrieved February 27, 2011.
[19] Who owns the Federal Reserve Bank?". FactCheck.
March 31, 2008. Retrieved February 26, 2014.
[20] Coins and Currency. US Dept of Treasury website. August 24, 2011. Retrieved August 29, 2011.
[21] From Who owns the Federal Reserve?", Current FAQs,
Board of Governors of the Federal Reserve System, at .
[22] Appelbaum, Binyamin (March 22, 2011). Fed Had
Prot From Investments of $82 Billion Last Year. The
New York Times. Retrieved March 22, 2011.
[23] Federal Reserve Act. Board of Governors of the Federal Reserve System. May 14, 2003. Archived from the
original on May 17, 2008.
[24] BoG 2006, pp. 1
[25] Remarks by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C. (November
21, 2002). Deation: Making Sure It Doesn't Happen Here. Board of Governors of the Federal Reserve
System. Retrieved October 29, 2011.
[26] Bernanke, Ben (October 24, 2003). Remarks by Governor Ben S. Bernanke: At the Federal Reserve Bank of Dallas Conference on the Legacy of Milton and Rose Friedmans Free to Choose, Dallas, Texas (TEXT).
[27] BoG 2005, pp. 113
[28] BoG 2005, pp. 83
[29] lender of last resort, Federal Reserve Bank of Minneapolis, Retrieved May 21, 2010
[30] The Federal Reserve, Monetary Policy and the Economy
Everyday Economics FRB Dallas. Dallasfed.org.
Retrieved August 29, 2011.

397

[31] Press Release: Federal Reserve Board, with full support

of the Treasury Department, authorizes the Federal Reserve Bank of New York to lend up to $85 billion to the
American International Group (AIG)". Board of Governors of the Federal Reserve. September 16, 2008. Retrieved August 29, 2011.
[32] Andrews, Edmund L.; de la Merced, Michael J.; Walsh,
Mary Williams (September 16, 2008). Feds $85 Billion
Loan Rescues Insurer. The New York Times. Retrieved
September 17, 2008.
[33] How Currency Gets into Circulation. Federal Reserve
Bank of New York. June 2008. Retrieved August 29,
2011.
[34] Annual Production Figures. Bureau of Engraving and
Printing. Retrieved August 29, 2011.
[35] Federal Funds. Federal Reserve Bank of New York.
August 2007. Retrieved August 29, 2011.
[36] Cook, Timothy Q.; Laroche, Robert K., eds. (1993).
Instruments of the Money Market (PDF). Federal Reserve Bank of Richmond. Retrieved August 29, 2011.
[37] FRB: Speech-Kohn, The Evolving Role of the Federal
Reserve Banks. Federalreserve.gov. November 3, 2006.
Retrieved August 29, 2011.
[38] Frequently Asked Questions Federal Reserve System.
Retrieved February 19, 2010. The Board of Governors,
the Federal Reserve Banks, and the Federal Reserve System as a whole are all subject to several levels of audit and
review. Under the Federal Banking Agency Audit Act, the
Government Accountability Oce (GAO) has conducted
numerous reviews of Federal Reserve activities
[39] Federal Reserve System Current and Future Challenges
Require System wide Attention: Statement of Charles A.
Bowsher (PDF). United States General Accounting Ofce. July 26, 1996. Retrieved August 29, 2011. Under
the Federal Banking Agency Audit Act, 31 U.S.C. section 714(b), our audits of the Federal Reserve Board and
Federal Reserve banks may not include (1) transactions
for or with a foreign central bank or government, or nonprivate international nancing organization; (2) deliberations, decisions, or actions on monetary policy matters; (3)
transactions made under the direction of the Federal Open
Market Committee; or (4) a part of a discussion or communication among or between members of the Board of
Governors and ocers and employees of the Federal Reserve System related to items (1), (2), or (3). See Federal
Reserve System Audits: Restrictions on GAOs Access
(GAO/T-GGD-94-44), statement of Charles A. Bowsher.
The real purpose of this historic duck hunt was to formulate a plan for U.S. banking and currency reform that
Aldrich could present to Congress.
[40] About The Audit. Audit the Fed Coalition. 2009. Retrieved August 29, 2011. The Audit the Fed Coalition asserts that although the Fed is currently audited by outside
agencies, these audits are not thorough and do not include
monetary policy decisions or agreements with foreign central banks and governments. According to the Coaliition,
the crucial issue of Federal Reserve transparency requires

398

CHAPTER 18. REGULATION

an analysis of 31 USC 714, the section of U.S. Code which

establishes that the Federal Reserve may be audited by the
Government Accountability Oce (GAO), but which simultaneously severely restricts what the GAO may in fact
audit. The coalition argues that the GAO is allowed to
audit only check-processing, currency storage and shipments, and some regulatory and bank examination functions, etc. The Coalition contends that the most important
matters, which directly aect the strength of the dollar
and the health of the nancial system, are immune from
oversight.
[41] An Open Letter to the U.S. House of Representatives.
Audit the Fed Coalition. 2009. Retrieved August 29,
2011.
[42] Reddy, Sudeep (November 23, 2009). Congress Grows
Fed Up Despite Central Banks Push. The Wall Street
Journal. Retrieved August 29, 2011.The Feds ability to
inuence Congress is diluted by public anger. A July 2009
Gallup Poll found only 30% Americans thought the Fed
was doing a good or excellent job, a rating even lower than
that for the Internal Revenue Service, which drew praise
from 40%.

[54] Is The Fed Public Or Private?" Federal Reserve Bank of

Philadelphia. Retrieved June 29, 2012.
[55] 12 U.S.C. 247.
[56] FRB: Board Members. Federalreserve.gov. July 20,
2011. Retrieved August 29, 2011.
[57] See 12 U.S.C. 242.
[58] See 12 U.S.C. 241
[59] Membership of the Board of Governors of the Federal
Reserve System, 1914Present. Federalreserve.gov. Retrieved January 11, 2014.
[60] Schroeder, Robert, Senate conrms Obamas Fed nominees, MarketWatch, June 12, 2014. Retrieved June 12,
2014.
[61] Goldstein, Steve (December 27, 2011). Obama to nominate Stein, Powell to Fed board. MarketWatch. Retrieved
December 27, 2011.
[62] Jerome Powell: Visiting Scholar. Bipartisan Policy
Center. Retrieved December 27, 2011.

[43] Schmidt, Robert (June 5, 2009). Fed Intends to Hire

Lobbyist in Campaign to Buttress Its Image. Bloomberg.
Retrieved August 29, 2011.

[63] Lanman, Scott; Runningen, Roger (December 27, 2011).

Obama to Choose Powell, Stein for Fed Board.
Bloomberg LP. Retrieved December 27, 2011.

[44] Board Actions taken during the week ending July 25,
2009. Retrieved August 29, 2011.

[64] Robb, Greg (April 29, 2010). Obama nominates 3 to

Federal Reserve board. MarketWatch. Retrieved April
29, 2010.

[45] VP Linda Robertson to join Federal Reserve System.

The Johns Hopkins University. Retrieved August 29,
2011.
[46] Mark Calabria, Bert Ely, Congressman Ron Paul, Gilbert
Schwartz (June 24, 2009). Ron Paul: Bringing Transparency to the Federal Reserve. Cato Institute: FORA.tv.
Event occurs at 00:11:04. Retrieved August 29, 2011.
[47] BoG 2005, pp. 45
[48] See example: Advantages of Being/Becoming a State
Chartered Bank. Arkansas State Bank Department.
March 31, 2009. Retrieved August 29, 2011.
[49] U.S. Code Title 12, Chapter 3, Subchapter 7, Section
301. Powers and duties of board of directors; suspension of member bank for undue use of bank credit.
Law.cornell.edu. June 22, 2010. Retrieved August 29,
2011.
[50] BoG 2005, pp. 8385
[51] Federal Reserve Board: Payments Systems. Federalreserve.gov. July 21, 2011. Retrieved August 29, 2011.
[52] The Role of the Federal Reserve System. Innovation
and Education: Renewing the Northeast Ohio Economy.
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[65] Lanman, Scott (September 30, 2010). Yellen, Raskin

Win Senate Approval for Fed Board of Governors.
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[66] Censky, Annalyn (February 10, 2011). Fed ination
hawk Warsh resigns. CNNMoney. Retrieved December
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[67] Chan, Sewell (February 10, 2011). Sole Fed Governor
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Times. Retrieved December 27, 2011.
[68] Robb, Greg (March 28, 2012). Senator to block quick
vote on Fed picks: report. MarketWatch. Retrieved
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[69] Robb, Greg, Stein sworn in as Fed governor, MarketWatch, May 30, 2012. Retrieved May 30, 2012.
[70] Lowrey, Annie (January 6, 2014). Senate Conrms
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[71] Fischer to Serve as Vice Chairman of the Federal Reserve. Israel National News. Retrieved January 11,
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[73] Appelbaum, Binyamin, Allan Landon, Community
Banker, Nominated to Federal Reserve, New York
Times, January 6, 2015. Retrieved January 6, 2015.

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August 29, 2011.
2011.
[88] Press Release: Federal Reserve Board begins practice of [108] FRB: Press Release Board announces that it will bepublishing Reserve Bank nancial reports on a quarterly
gin to pay interest on depository institutions required and
basis. Federal Reserve Bank. August 27, 2012. Reexcess reserve balances. Federal Reserve. October 6,
trieved November 24, 2012.
2008. Retrieved August 29, 2011.
[89] Ryan Chittum (August 25, 2009). Bloomberg Wins Its [109] FRB: Temporary Auction Facility FAQ. FederalreLawsuit Against the Federal Reserve. Columbia Journalserve.gov. January 12, 2009. Retrieved August 29, 2011.
ism Review. Retrieved November 24, 2012.
[110] FRB: Press Release Federal Reserve intends to con[90] Docket entry 31, Bloomberg, L.P. v. Board of Governors
tinue term TAF auctions as necessary. Federalreof the Federal Reserve System, case no. 1:08-cv-09595serve.gov. December 21, 2007. Retrieved August 29,
LAP, U.S. District Court for the District of New York.
2011.

400

CHAPTER 18. REGULATION

[111] FRB press release: Announcement of the creation of [122] A dirty job, but someone has to do it. economist.com.
the Term Securities Lending Facility. Federal Reserve.
December 13, 2007. Retrieved August 29, 2011. The
March 11, 2008. Retrieved August 29, 2011.
Feds discount window, for instance, through which it
lends direct to banks, has barely been approached, de[112] Fed Seeks to Limit Slump by Taking Mortgage Debt.
spite the soaring spreads in the interbank market. The
bloomberg.com. March 12, 2008. The step goes beyond
quarter-point cuts in its federal funds rate and discount
past initiatives because the Fed can now inject liquidity
rate on December 11 were followed by a steep sell-o in
without ooding the banking system with cash...Unlike
the stockmarket...The hope is that by extending the matuthe newest tool, the past steps added cash to the bankrity of central-bank money, broadening the range of coling system, which aects the Feds benchmark interest
lateral against which banks can borrow and shifting from
rate...By contrast, the TSLF injects liquidity by lending
direct lending to an auction, the central bankers will bring
Treasuries, which doesn't aect the federal funds rate.
down spreads in the one- and three-month money markets.
That leaves the Fed free to address the mortgage crisis
There will be no net addition of liquidity. What the central
directly without concern about adding more cash to the
bankers add at longer-term maturities, they will take out in
system than it wants
the overnight market. But there are risks. The rst is that,
for all the fanfare, the central banks plan will make little
[113] Federal Reserve Announces Establishment of Primary
dierence. After all, it does nothing to remove the fundaDealer Credit Facility Federal Reserve Bank of New
mental reason why investors are worried about lending to
York. Newyorkfed.org. March 16, 2008. Retrieved Aubanks. This is the uncertainty about potential losses from
gust 29, 2011.
subprime mortgages and the products based on them, and
given that uncertainty the banks own desire to hoard
[114] Lanman, Scott (March 20, 2008). Fed Says Secucapital against the chance that they will have to strengthen
rities Firms Borrow $28.8 Bln With New Financing.
their balance sheets.
Bloomberg.com. Retrieved August 29, 2011.
[123] Unclogging the system. economist.com. December 13,
2007. Retrieved August 29, 2011.
[115] Primary Dealer Credit Facility: Frequently Asked Questions Federal Reserve Bank of New York. Newyork[124] Robb, Greg (December 12, 2007). Fed, top central
fed.org. February 3, 2009. Retrieved August 29, 2011.
banks to ood markets with cash. Marketwatch.com.
Retrieved August 29, 2011.
[116] Fed Announces Emergency Steps to Ease Credit Crisis
Economy. Cnbc.com. Reuters. March 17, 2008. Re- [125]
trieved August 29, 2011.
[126] Term Securities Lending Facility: Frequently Asked
Questions. Newyorkfed.org. Retrieved December 6,
[117] Federal Reserve Bank of Atlanta Examining the Fed2014.
eral Reserves New Liquidity Measures. Frbatlanta.org.
April 15, 2008. Retrieved August 29, 2011.
[127] Interest on Required Reserve Balances and Excess Balances. Federal Reserve Board. October 6, 2008. Re[118] Reserve Requirements of Depository Institutions Policy
trieved October 14, 2008.
on Payment System Risk, 75 Federal Register 86 (May
5, 2010), pp. 2438424389.

[128] Press Release October 22, 2008. Federal Reserve

Board. October 22, 2008. Retrieved October 22, 2008.

[119] Announcement of the creation of the Term Auction Facility FRB: Press Release Federal Reserve and other [129] Federal Reserve Board approves amendments to Regulacentral banks announce measures designed to address eltion D authorizing Reserve Banks to oer term deposits.
evated pressures in short-term funding markets. federalFederalreserve.gov. April 30, 2010. Retrieved August 29,
reserve.gov. December 12, 2007.
2011.

[120] US banks borrow $50bn via new Fed facility. Financial [130] Board authorizes small-value oerings of term deposits
under the Term Deposit Facility. Federalreserve.gov.
Times. February 18, 2008. Before its introduction, banks
May 10, 2010. Retrieved August 29, 2011.
either had to raise money in the open market or use the
so-called discount window for emergencies. However,
[131] Board authorizes ongoing small-value oerings of term
last year many banks refused to use the discount window,
deposits under the Term Deposit Facility. Federalreeven though they found it hard to raise funds in the market,
serve.gov. September 8, 2010. Retrieved August 29,
because it was associated with the stigma of bank failure
2011.
[121] Fed Boosts Next Two Special Auctions to $30 Billion. [132] Zumbrun, Joshua (September 8, 2010). Fed to Sell Term
Bloomberg. January 4, 2008. The Board of Governors
Deposits to Ensure Exit 'Readiness". Bloomberg. Reof the Federal Reserve System established the temporary
trieved September 10, 2010.
Term Auction Facility, dubbed TAF, in December to provide cash after interest-rate cuts failed to break banks re- [133] Testimony before the House Committee on Financial Services regarding Unwinding Emergency Federal Reserve
luctance to lend amid concern about losses related to subLiquidity Programs and Implications for Economic Reprime mortgage securities. The program will make fundcovery. March 25, 2010., also at GPO Access Serial No.
ing from the Fed available beyond the 20 authorized pri111118 Retrieved September 10, 2010
mary dealers that trade with the central bank

18.2. US FEDERAL RESERVE

401

[134] Asset-Backed Commercial Paper Money Market Mutual [147] Papers of Frank A.Vanderlip I wish I could sit down
Fund Liquidity Facility. Board of Governors of the Fedwith you and half a dozen others in the sort of conference
eral Reserve System. Retrieved May 27, 2010.
that created the Federal Reserve Act"" (PDF). Retrieved
April 30, 2012.
[135] Fed Action
[148] The Federal Reserve Act of 1913 A Legislative His[136] Wilson, Linus; Wu, Yan (August 22, 2011). Does Retory. Llsdc.org. Retrieved April 30, 2012.
ceiving TARP Funds Make it Easier to Roll Your Commercial Paper Onto the Fed?". Social Science Electronic [149] Axes His Signature at 6:02 P.M., Using Four Gold
Publishing. SSRN 1911454.
Pens.. New York Times. December 24, 1913. Retrieved
April 30, 2012.
[137] Federal Reserve Mortgage Purchase Program: Planet
Money. NPR. August 26, 2010. Retrieved August 29, [150] Paul Warburgs Crusade to Establish a Central Bank in
2011.
the United States. The Federal Reserve Bank of Minneapolis.
[138] ""Mr. Govr. MORRIS moved to strike out and emit bills
on the credit of the U. States If the United States had
[151] Americas Unknown Enemy: Beyond Conspiracy.
credit such bills would be unnecessary: if they had not,
American Institute of Economic Research.
unjust & useless. ... On the motion for striking out N. H.
ay. Mas. ay. Ct ay. N. J. no. Pa. ay. Del. ay. Md. no. Va. [152] Congressional Record House. Scribd.com. December
ay. N. C. ay. S. C. ay. Geo. ay."". Avalon.law.yale.edu.
22, 1913. p. 1465. Retrieved August 29, 2011.
Retrieved April 30, 2012.
[153] Congressional Record Senate. Scribd.com. Decem[139] US Constitution Article 1, Section 10. no state shall
ber 23, 1913. p. 1468. Retrieved August 29, 2011.
..emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts;"
[154] BoG 2005, pp. 2
[140] Flamme, Karen. 1995 Annual Report: A Brief History [155] FRB: Economic Research & Data. Federalreserve.gov.
of Our Nations Paper Money. Federal Reserve Bank of
August 24, 2011. Retrieved August 29, 2011.
San Francisco. Retrieved August 26, 2010.
[156] Federal Reserve Board Statistics: Releases and Histor[141] British Parliamentary reports on international nance: the
ical Data. Federalreserve.gov. May 10, 2010. Retrieved
Cunlie Committee and the Macmillan Committee reports.
August 29, 2011.
Ayer Publishing. 1978. ISBN 978-0-405-11212-6. description of the founding of Bank of England: 'Its foun- [157] St. Louis Fed: Economic Data FRED. Redation in 1694 arose out the diculties of the Governsearch.stlouisfed.org. August 20, 2011. Retrieved August
ment of the day in securing subscriptions to State loans.
29, 2011.
Its primary purpose was to raise and lend money to the
State and in consideration of this service it received under [158] Federal Reserve Education Economic Indicators
its Charter and various Act of Parliament, certain privileges of issuing bank notes. The corporation commenced, [159] White, Lawrence H. (August 2005). The Federal Reserve Systems Inuence on Research in Monetary Ecowith an assured life of twelve years after which the Govnomics. Econ Journal Watch 2 (2): 325354. Retrieved
ernment had the right to annul its Charter on giving one
August 29, 2011.
years notice. Subsequent extensions of this period coincided generally with the grant of additional loans to the
[160] FRB: Z.1 Release Flow of Funds Accounts of the United
State'
States, Release Dates See the pdf documents from 1945
to 2007. The value for each year is on page 94 of each
[142] Johnson, Roger (December 1999). Historical Begindocument (the 99th page in a pdf viewer) and duplicated
nings... The Federal Reserve (PDF). Federal Reserve
on page 104 (109th page in pdf viewer). It gives the total
Bank of Boston. p. 8. Retrieved July 23, 2010.
assets, total liabilities, and net worth. This chart is of the
[143] Herrick, Myron (March 1908). The Panic of 1907 and
net worth.
Some of Its Lessons. Annals of the American Academy of
Political and Social Science. Retrieved August 29, 2011. [161] Balance Sheet of Households and Nonprot Organizations, June 5, 2014
[144] Flaherty, Edward (June 16, 1997). A Brief History of
Central Banking in the United States. Netherlands: Uni- [162] Bernasek, Anna (July 26, 2014). The Typical Houseversity of Groningen.
hold, Now Worth a Third Less. New York Times (New
York Times). Retrieved July 28, 2014.
[145] Whithouse, Michael (May 1989). Paul Warburgs Crusade to Establish a Central Bank in the United States. [163] Discontinuance of M3. Federalreserve.gov. November
The Federal Reserve Bank of Minneapolis. Retrieved Au10, 2005. Retrieved August 29, 2011.
gust 29, 2011.
[164] BoG 2006, pp. 10
[146] For years members of the Jekyll Island Club would recount the story of the secret meeting and by the 1930s the [165] Is the Feds Denition of Price Stability Evolving?"
(PDF). Federal Reserve Bank of St. Louis. November
narrative was considered a club tradition.. Jekyllislandhistory.com. Retrieved April 30, 2012.
9, 2010. Retrieved February 13, 2011.

402

CHAPTER 18. REGULATION

[166] Remarks by Governor Ben S. Bernanke A perspective

on ination targeting. Federalreserve.gov. March 25,
2003. Retrieved August 29, 2011.
[167] Whats The Fuss Over Ination Targeting?". Businessweek.com. November 7, 2005. Retrieved August 29,
2011.
[168] Bernanke, Ben S. (2005). The Ination-Targeting Debate.
University of Chicago Press. ISBN 978-0-226-04471-2.
Retrieved August 29, 2011.
[169] Lanman, S. and Kennedy, S. (September 19, 2011).
Bernanke Joins King Tolerating Ination. Bloomberg.
Retrieved September 21, 2011.
[170] Hummel, Jerey Rogers. Death and Taxes, Including
Ination: the Public versus Economists (January 2007).
p.56
[171] "Escaping from a Liquidity Trap and Deation: The Foolproof Way and Others" Lars E.O. Svensson, Journal of
Economic Perspectives, Volume 17, Issue 4 Fall 2003,
p145-166
[172] Phillips, Kevin (May 2008). Numbers Racket Why the
Economy is Worse than We Know (PDF). Harpers Magazine: 4347. Retrieved August 29, 2011.
[173] Chicago Fed Demonstrating Knowledge of the Fed:
[174] Federal Reserve Board A-Z Listing of Board Publications. Federalreserve.gov. August 10, 2011. Retrieved
August 29, 2011.
[175] 96th Annual Report 2008 Federal Reserve (PDF).
Board of Governors of the Federal Reserve System. June
2009. Retrieved August 29, 2011.
[176] Factors Aecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve
Banks. Federal Reserve. Retrieved March 20, 2008.
[177] The Federal Reserve Does Not Own Any Gold at All.
Gold News. June 2, 2011. Retrieved August 29, 2011.
[178] http://www.c-span.org/video/?61272-1/
book-discussion-road-serfdom
[179] Rising Security as Banks Hire from the Fed. The New
York Times. 19 November 2014. Retrieved December 6,
2014.
[180] htthttp://www.scribd.com/doc/16502353/
Congressional-Record-June-10-1932-Louis-T-McFadden

Changing the Federal Reserves Mandate: An Economic Analysis Congressional Research Service
Federal Reserve: Unconventional Monetary Policy
Options Congressional Research Service
Epstein, Lita & Martin, Preston (2003). The Complete Idiots Guide to the Federal Reserve. Alpha
Books. ISBN 0-02-864323-2.
Greider, William (1987). Secrets of the Temple. Simon & Schuster. ISBN 0-671-67556-7; nontechnical book explaining the structures, functions, and
history of the Federal Reserve, focusing specically
on the tenure of Paul Volcker
R. W. Hafer. The Federal Reserve System: An Encyclopedia. Greenwood Press, 2005. 451 pp, 280
entries; ISBN 0-313-32839-0.
Meltzer, Allan H. A History of the Federal Reserve,
Volume 1: 19131951 (2004) ISBN 978-0-22651999-9 (cloth) and ISBN 978-0-226-52000-1 (paper)
Meltzer, Allan H. A History of the Federal Reserve,
Volume 2: Book 1, 19511969 (2009) ISBN 978-0226-52001-8
Meltzer, Allan H. A History of the Federal Reserve,
Volume 2: Book 2, 19691985 (2009) ISBN 9780-226-51994-4; In three volumes published so far,
Meltzer covers the rst 70 years of the Fed in considerable detail
Meyer, Laurence H. (2004). A Term at the Fed:
An Insiders View. HarperBusiness. ISBN 0-06054270-5; focuses on the period from 1996 to 2002,
emphasizing Alan Greenspans chairmanship during the 1997 Asian nancial crisis, the stock market
boom and the nancial aftermath of the September
11, 2001 attacks.
Woodward, Bob. Maestro: Greenspans Fed and
the American Boom (2000) study of Greenspan in
1990s.
Historical

18.2.11

Bibliography

Recent
The Federal Reserve System: Purposes and Functions. Board of Governors of the Federal Reserve
System. 2005.
The Federal Reserve in Plain English. Board of Governors of the Federal Reserve System. 2006. from
the St. Louis Fed

J. Lawrence Broz. The International Origins of the

Federal Reserve System. Cornell University Press.
1997.
Vincent P. Carosso, The Wall Street Trust from
Pujo through Medina, Business History Review
(1973) 47:421-37
Chandler, Lester V. American Monetary Policy,
192841. (1971).

18.3. SECURITIES AND EXCHANGE COMMISSION

Epstein, Gerald and Thomas Ferguson. Monetary
Policy, Loan Liquidation and Industrial Conict:
Federal Reserve System Open Market Operations in
1932. Journal of Economic History 44 (December
1984): 95784. in JSTOR

403
Wells, Donald R. The Federal Reserve System: A
History (2004)
West, Robert Craig. Banking Reform and the Federal Reserve, 18631923 (1977)

Milton Friedman and Anna Jacobson Schwartz, A

Monetary History of the United States, 18671960
(1963)

Wicker, Elmus. A Reconsideration of Federal

Reserve Policy during the 19201921 Depression,
Journal of Economic History (1966) 26: 223238,
in JSTOR

Goddard, Thomas H. (1831). History of Banking

Institutions of Europe and the United States. Carvill.
pp. 48.

Wicker, Elmus. Federal Reserve Monetary Policy,

191733. (1966).

Paul J. Kubik, Federal Reserve Policy during

the Great Depression: The Impact of Interwar
Attitudes regarding Consumption and Consumer
Credit. Journal of Economic Issues. Volume: 30.
Issue: 3. Publication Year: 1996. pp. 829+.
Link, Arthur. Wilson: The New Freedom (1956) pp.
199240.

Wicker, Elmus. The Great Debate on Banking Reform: Nelson Aldrich and the Origins of the Fed Ohio
State University Press, 2005.
Wood, John H. A History of Central Banking in
Great Britain and the United States (2005)
Wueschner; Silvano A. Charting Twentieth-Century
Monetary Policy: Herbert Hoover and Benjamin
Strong, 19171927 Greenwood Press. (1999)

Livingston, James. Origins of the Federal Reserve

System: Money, Class, and Corporate Capitalism,
18901913 (1986), Marxist approach to 1913 pol- 18.2.12 External links
icy
Federal Reserve
Marrs, Jim (2000). Secrets of Money and the Federal Reserve System. Rule by Secrecy (HarperCollins): 6478.
18.3 Securities and

Exchange

Commission
Mayhew, Anne. Ideology and the Great Depression: Monetary History Rewritten. Journal of Economic Issues 17 (June 1983): 35360.
Securities and Exchange Commission redirects here.
For other uses, see Securities and Exchange Commission
Mullins, Eustace C. Secrets of the Federal Reserve,
(disambiguation).
1952. John McLaughlin. ISBN 0-9656492-1-0
Roberts, Priscilla. "'Quis Custodiet Ipsos Custodes?' The Federal Reserve Systems Founding Fathers and Allied Finances in the First World War,
Business History Review (1998) 72: 585603
Rothbard, Murray (2007). The Case Against the
Fed. Ludwig von Mises Institute. ISBN 9781467934893.

The U.S. Securities and Exchange Commission (SEC)

is an agency of the United States federal government.
It holds primary responsibility for enforcing the federal
securities laws, proposing securities rules, and regulating
the securities industry, the nations stock and options exchanges, and other activities and organizations, including
the electronic securities markets in the United States.[2]

In addition to the Securities Exchange Act of 1934, which

Bernard Shull, The Fourth Branch: The Federal created it, the SEC enforces the Securities Act of 1933,
Reserves Unlikely Rise to Power and Inuence the Trust Indenture Act of 1939, the Investment Com(2005) ISBN 1-56720-624-7
pany Act of 1940, the Investment Advisers Act of 1940,
Steindl, Frank G. Monetary Interpretations of the the SarbanesOxley Act of 2002, and other statutes. The
SEC was created by Section 4 of the Securities Exchange
Great Depression. (1995).
Act of 1934 (now codied as 15 U.S.C. 78d and com Temin, Peter. Did Monetary Forces Cause the Great monly referred to as the Exchange Act or the 1934 Act).
Depression? (1976).
Timberlake, Richard H. (2008). Federal Reserve
System. In David R. Henderson (ed.). Concise
Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty. ISBN 9780865976658. OCLC 237794267.

18.3.1 Overview
The SEC has a three-part mission: to protect investors;
maintain fair, orderly, and ecient markets; and facilitate
capital formation. [3]

404

CHAPTER 18. REGULATION

The enforcement authority it received from Congress enables the SEC to bring civil enforcement actions against
individuals or companies alleged to have committed
accounting fraud, provided false information, or engaged
in insider trading or other violations of the securities law.
The SEC also works with criminal law enforcement agencies to prosecute individuals and companies alike for offenses that include a criminal violation.
To achieve its mandate, the SEC enforces the statutory
requirement that public companies submit quarterly and
annual reports, as well as other periodic reports. In addition to annual nancial reports, company executives must
provide a narrative account, called the "management discussion and analysis" (MD&A), that outlines the previous
year of operations and explains how the company fared in
that time period. MD&A will usually also touch on the
upcoming year, outlining future goals and approaches to
new projects. In an attempt to level the playing eld for
all investors, the SEC maintains an online database called
EDGAR (the Electronic Data Gathering, Analysis, and
Retrieval system) online from which investors can access
Joseph P. Kennedy, Sr., the inaugural Chairman of the SEC
this and other information led with the agency.
Quarterly and semiannual reports from public companies are crucial for investors to make sound decisions
when investing in the capital markets. Unlike banking,
investment in the capital markets is not guaranteed by
the federal government. The potential for big gains needs
to be weighed against equally likely losses. Mandatory
disclosure of nancial and other information about the
issuer and the security itself gives private individuals as
well as large institutions the same basic facts about the
public companies they invest in, thereby increasing public scrutiny while reducing insider trading and fraud.

ings across state lines through the mail.[5] After holding

hearings on abuses on interstate frauds (commonly known
as the Pecora Commission), Congress passed the Securities Act of 1933 (15 U.S.C. 77a), which regulates
interstate sales of securities (original issues) at the federal level. The subsequent Securities Exchange Act of
1934 (15 U.S.C. 78d) regulates sales of securities in
the secondary market. Section 4 of the 1934 act created
the U.S. Securities and Exchange Commission to enforce
the federal securities laws; both laws are considered parts
The SEC makes reports available to the public through of Franklin D. Roosevelt's New Deal raft of legislation.
the EDGAR system. The SEC also oers publications The Securities Act of 1933 is also known as the Truth
on investment-related topics for public education. The in Securities Act and the Federal Securities Act, or
same online system also takes tips and complaints from just the 1933 Act. Its goal was to increase public trust
investors to help the SEC track down violators of the se- in the capital markets by requiring uniform disclosure
curities laws. The SEC adheres to a strict policy of never of information about public securities oerings. The
commenting on the existence or status of an ongoing in- primary drafters of 1933 Act were Huston Thompson,
vestigation.
a former Federal Trade Commission (FTC) chairman,

18.3.2

History

Prior to the enactment of the federal securities laws and

the creation of the SEC, there existed so-called blue sky
laws. They were enacted and enforced at the state level,
and regulated the oering and sale of securities to protect
the public from fraud. Though the specic provisions of
these laws varied among states, they all required the registration of all securities oerings and sales, as well as of
every U.S. stockbroker and brokerage rm.[4]
However, these blue sky laws were generally found to be
ineective. For example, the Investment Bankers Association told its members as early as 1915 that they
could ignore blue sky laws by making securities oer-

and Walter Miller and Ollie Butler, two attorneys in the

Commerce Department's Foreign Service Division, with
input from Supreme Court Justice Louis Brandeis. For
the rst year of the laws enactment, the enforcement of
the statute rested with the Federal Trade Commission, but
this power was transferred to the SEC following its creation in 1934. (Interestingly, the rst, rejected draft of
the Securities Act written by Samuel Untermyer vested
these powers in the U.S. Post Oce, because Untermyer
believed that only by vesting enforcement powers with
the postal service could the constitutionality of the act
be assured.[5] ) The law requires that issuing companies
register distributions of securities with the SEC prior to
interstate sales of these securities, so that investors may
have access to basic nancial information about issuing
companies and risks involved in investing in the securi-

18.3. SECURITIES AND EXCHANGE COMMISSION

405

ties in question. Since 1994, most registration statements

(and associated materials) led with the SEC can be accessed via the SECs online system, EDGAR.[6]
The Securities Exchange Act of 1934 is also known as
the Exchange Act or the 1934 Act. This act regulates secondary trading between individuals and companies which are often unrelated to the original issuers of
securities. Entities under the SECs authority include securities exchanges with physical trading oors such as the
New York Stock Exchange (NYSE), self-regulatory organizations (SROs) such as the National Association of Securities Dealers (NASD), the Municipal Securities Rulemaking Board (MSRB), online trading platforms such as
the NASDAQ Stock Market (NASDAQ) and alternative
trading systems (ATSs), and any other persons (e.g., securities brokers) engaged in transactions for the accounts
of others.[7]
President Roosevelt appointed Joseph P. Kennedy, Sr.,
father of President John F. Kennedy, to serve as the U.S. Securities and Exchange Commission headquarters in
rst Chairman of the SEC, along with James M. Lan- Washington, D.C., near Union Station.
dis (one of the architects of the 1934 Act and other New
Deal legislation) and Ferdinand Pecora (Chief Counsel
to the United States Senate Committee on Banking and
Currency during its investigation of Wall Street banking
and stock brokerage practices). Other prominent SEC
commissioners and chairmen include William O. Douglas (who went on to be a U.S. Supreme Court justice),
Jerome Frank (one of the leaders of the legal realism
movement), and William J. Casey (who later headed the
Central Intelligence Agency under President Ronald Reagan).

18.3.3

Organizational structure

Commission members
Main article: Securities and Exchange Commission appointees
Non-partisan, no more than three Commissioners may
belong to the same political party. The President also
designates one of the Commissioners as Chairman, the Mary Jo White
SECs top executive. However, the President does not
possess the power to re the appointed Commissioners,
a provision that was made to ensure the independence of Divisions
the SEC. This issue arose during the 2008 Presidential
Election in connection with the ensuing Financial Crises. Within the SEC, there are ve divisions. Headquartered
in Washington, D.C., the SEC has 11 regional oces
Currently, the SEC Commissioners are:[8]
throughout the US.
Mary L. Schapiro served as the 29th Chairman of the
The SECs divisions are:[10]
SEC from January 2009 through December 2012. She
was succeeded by Elisse B. Walter, and on January 24,
2013, President Obama nominated Mary Jo White to re Corporation Finance
place Walter as Chairman.[9] Mary Jo White was sworn
in as Chairman on April 10, 2013.
Trading and Markets

406
Investment Management
Enforcement
Economic and Risk Analysis

CHAPTER 18. REGULATION

action in a U.S. District Court, or an administrative proceeding which is heard by an independent administrative
law judge (ALJ). The SEC does not have criminal authority, but may refer matters to state and federal prosecutors.
The director of the SECs Enforcement Division Robert
Khuzami left the oce in February 2013.[15]

Corporation Finance is the division that oversees the

Among the SECs oces are:
disclosure made by public companies, as well as the registration of transactions, such as mergers, made by com The Oce of General Counsel, which acts as the
panies. The division is also responsible for operating
agencys lawyer before federal appellate courts
EDGAR.
and provides legal advice to the Commission and
The Trading and Markets division oversees selfother SEC divisions and oces;
regulatory organizations such as the Financial Industry
Regulatory Authority (FINRA) and Municipal Securities
The Oce of the Chief Accountant, which estabRulemaking Board (MSRB) and all broker-dealer rms
lishes and enforces accounting and auditing poliand investment houses. This division also interprets procies set by the SEC. This oce has played a role
posed changes to regulations and monitors operations of
in such areas as working with the Financial Acthe industry. In practice, the SEC delegates most of its
counting Standards Board to develop Generally Acenforcement and rulemaking authority to FINRA. In fact,
cepted Accounting Principles, the Public Comall trading rms not regulated by other SROs must regpany Accounting Oversight Board in developing auister as a member of FINRA. Individuals trading securidit requirements, and the International Accounting
ties must pass exams administered by FINRA to become
Standards Board in advancing the development of
registered representatives.[11][12]
International Financial Reporting Standards;
The Investment Management Division oversees registered investment companies, which include mutual funds,
as well as registered investment advisors. These entities
are subject to extensive regulation under various federals
securities laws.[13] The Division of Investment Management administers various federal securities laws, in particular the Investment Company Act of 1940 and Investment Advisers Act of 1940. This divisions responsibilities include:[14]
assisting the Commission in interpreting laws and
regulations for the public and SEC inspection and
enforcement sta;
responding to no-action requests and requests for exemptive relief;
reviewing investment company and investment adviser lings;
assisting the Commission in enforcement matters involving investment companies and advisers; and
advising the Commission on adapting SEC rules to
new circumstances.
The Enforcement Division works with the other three
divisions, and other Commission oces, to investigate
violations of the securities laws and regulations and to
bring actions against alleged violators. The SEC generally
conducts investigations in private. The SECs sta may
seek voluntary production of documents and testimony,
or may seek a formal order of investigation from the SEC,
which allows the sta to compel the production of documents and witness testimony. The SEC can bring a civil

The Oce of Compliance, Inspections and Examinations, which inspects broker-dealers, stock exchanges, credit rating agencies, registered investment companies, including both closed-end and
open-end (mutual funds) investment companies,
money funds. and Registered Investment Advisors;
The Oce of International Aairs, which represents the SEC abroad and which negotiates international enforcement information-sharing agreements,
develops the SECs international regulatory policies
in areas such as mutual recognition, and helps develop international regulatory standards through organizations such as the International Organization of
Securities Commissions and the Financial Stability
Forum;
The Oce of Investor Education and Advocacy,
which helps educate the public about securities markets and warns investors of fraud and stock market
scams;
The Oce of Economic Analysis, which helps the
SEC estimate the economic costs and benets of its
various rules and regulations; and
The Oce of Information Technology, which supports the Commission and sta in information technology, including application development, infrastructure operations. and engineering, user support,
IT program management, capital planning, security,
and enterprise architecture.
The Inspector General. The SEC announced in January 2013 that it had named Carl Hoecker the new
inspector general.[16][17] He has a sta of 22.[18]

18.3. SECURITIES AND EXCHANGE COMMISSION

The SEC Oce of the Whistleblower [19] provides
assistance and information from a whistleblower
who knows of possible securities law violations:
this can be among the most powerful weapons in
the law enforcement arsenal of the Securities and
Exchange Commission.[20] Created by Section 922
of the Dodd-Frank Wall Street Reform and Consumer Protection Act DoddFrank Wall Street Reform and Consumer Protection Act amended the
Securities Exchange Act of 1934 (the Exchange
Act) by, among other things, adding Section 21F,
entitled Securities Whistleblower Incentives and
Protection. [21] Section 21F directs the Commission to make monetary awards to eligible individuals who voluntarily provide original information
that leads to successful Commission enforcement
actions resulting in the imposition of monetary sanctions over $1,000,000, and certain successful related
actions.[22]

407
persuasive, are not binding on the courts.
One such use, from 1975 to 2007, was with the nationally
recognized statistical rating organization (NRSRO), a
credit rating agency that issues credit ratings that the SEC
permits other nancial rms to use for certain regulatory
purposes.

18.3.5 Operations
List of major SEC enforcement actions (200912)
Main article: List of major SEC enforcement actions
(200912)
The SECs Enforcement Division brought a number of
major actions in 200912.
Regulatory action in the credit crunch

18.3.4

SEC communications

Comment letters
Comment letters are letters by the SEC to a public company raising issues and requested comments. For example, in October 2001 the SEC wrote to CA, Inc., covering 15 items, mostly about CAs accounting, including 5
about revenue recognition. The chief nancial ocer of
CA, to whom the letter was addressed, pleaded guilty to
fraud at CA in 2004.
In June 2004, the SEC announced that it would publicly
post all comment letters, to give investors access to the
information in them. An analysis of regulatory lings in
May 2006 over the prior 12 months indicated, that the
SEC had not accomplished what it said it would do. The
analysis found 212 companies that had reported receiving comment letters from the SEC, but only 21 letters for
these companies were posted on the SECs website. John
W. White, the head of the Division of Corporation Finance, told the New York Times in 2006: We have now
resolved the hurdles of posting the information.... We expect a signicant number of new postings in the coming
months.[23]

No-action letters
No-action letters are letters by the SEC sta indicating
that the sta will not recommend to the Commission that
the SEC undertake enforcement action against a person
or company if that entity engages in a particular action.
These letters are sent in response to requests made when
the legal status of an activity is not clear. These letters
are publicly released and increase the body of knowledge
on what exactly is and is not allowed. They represent
the stas interpretations of the securities laws and, while

The SEC announced on September 17, 2008, strict new

rules to prohibit all forms of "naked short selling" as a
measure to reduce volatility in turbulent markets.[24][25]
The SEC investigated cases involving individuals attempting to manipulate the market by passing false rumors about certain nancial institutions. The Commission has also investigated trading irregularities and
abusive short-selling practices. Hedge fund managers,
broker-dealers, and institutional investors were also asked
to disclose under oath certain information pertaining to
their positions in credit default swaps. The Commission
also negotiated the largest settlements in the history of
the SEC (approximately $51 billion in all) on behalf of
investors who purchased auction rate securities from six
dierent nancial institutions.
Regulatory failures
The SEC has been criticized for being too 'tentative and
fearful' in confronting wrongdoing on Wall Street", and
for doing an especially poor job of holding executives
accountable.[26][27][28]
Christopher Cox, the former SEC chairman, has recognized the organizations multiple failures in relation to the
Bernard Mado fraud.[29] Starting with an investigation
in 1992 into a Mado feeder fund that only invested with
Mado, and which, according to the SEC, promised curiously steady returns, the SEC did not investigate indications that something was amiss in Mados investment
rm.[30] The SEC has been accused of missing numerous
red ags and ignoring tips on Mados alleged fraud.[31]
As a result, Cox said that an investigation would ensue
into all sta contact and relationships with the Mado
family and rm, and their impact, if any, on decisions
by sta regarding the rm.[32] SEC Assistant Director

408
of the Oce of Compliance Investigations Eric Swanson
had met Mados niece, Shana Mado, when Swanson
was conducting an SEC examination of whether Bernard
Mado was running a Ponzi scheme because she was
the rms compliance attorney. The investigation was
closed, and Swanson subsequently left the SEC, and married Shana Mado.[33]
Approximately 45 per cent of institutional investors
thought that better oversight by the SEC could have prevented the Mado fraud.[34] Harry Markopolos complained to the SECs Boston oce in 2000, telling the
SEC sta they should investigate Mado because it was
impossible to legally make the prots Mado claimed using the investment strategies that he said he used.[35]
A similar failure occurred in the case of Allen Stanford,
who sold fake certicates of deposit to tens of thousands
of people, many of them working-class retirees. In 1997,
the SECs own examiners spotted the fraud and warned
about it. But the Enforcement division would not pursue
Stanford, despite repeated warnings by SEC examiners
over the years.[36] After the Mado fraud emerged, the
SEC nally took action against Stanford in 2009.
In June 2010, the SEC settled a wrongful termination
lawsuit with former SEC enforcement lawyer Gary J.
Aguirre, who was terminated in September 2005 following his attempt to subpoena Wall Street gure John
J. Mack in an insider trading case involving hedge fund
Pequot Capital Management;[37] Mary Jo White, who was
at the time representing Morgan Stanley later nominated
as chair of the SEC, was involved in this case.[38] While
the insider case was dropped at the time, a month prior to
the SECs settlement with Aguirre the SEC led charges
against Pequot.[37] The Senate released a report in August 2007 detailing the issue and calling for reform of the
SEC.[39]
Others have criticized the SEC for taking an overly rulebased and enforcement-focused approach to regulation,
rather than an approach that emphasizes industry-wide
safety and learning and thus ensures the reliability of the
national securities trading system.[40]

Inspector General oce failures In 2009, the Project

on Government Oversight, a government watchdog
group, sent a letter to Congress criticizing the SEC for
failing to implement more than half of the recommendations made to it by its Inspector General.[41] According to
POGO, in the prior two years, the SEC had taken no action on 27 out of 52 recommended reforms suggested in
Inspector General reports, and still had a pending status on 197 of the 312 recommendations made in audit
reports. Some of the recommendations included imposing disciplinary action on SEC employees who receive
improper gifts or other favors from nancial companies,
and investigating and reporting the causes of the failures
to detect the Mado ponzi scheme.[42]

CHAPTER 18. REGULATION

In a 2011 article by Matt Taibbi in Rolling Stone, former SEC employees were interviewed and commented
negatively on the SECs Oce of the Inspector General
(OIG). Going to the OIG was well-known to be a careerkiller.[43]
Because of concerns raised by David P. Weber, former
SEC Chief Investigator, regarding conduct by SEC Inspector General H. David Kotz, Inspector General David
C. Williams of the U.S. Postal Service was brought in
to conduct an independent, outside review of Kotzs alleged improper conduct in 2012.[44] Williams concluded
in his 66-page Report that Kotz violated ethics rules by
overseeing probes that involved people with whom he had
conicts of interest due to personal relationships.[44][45]
The report questioned Kotzs work on the Mado investigation, among others, because Kotz was a very good
friend with Markopolos.[45][46][47][48] It concluded that
while it was unclear when Kotz and Markopolos became friends, it would have violated U.S. ethics rules if
their relationship began before or during Kotzs Mado
investigation.[45] The report also found that Kotz himself
appeared to have a conict of interest and should not
have opened his Standford investigation, because he was
friends with a female attorney who represented victims of
the fraud.[46]
Destruction of documents According to former SEC
employee and whistleblower Darcy Flynn, also reported
by Taibbi, the agency routinely destroyed thousands of
documents related to preliminary investigations of alleged crimes committed by Deutsche Bank, Goldman
Sachs, Lehman Brothers, SAC Capital, and other nancial companies involved in the Great Recession that the
SEC was supposed to have been regulating. The documents included those relating to "Matters Under Inquiry",
or MUI, the name the SEC gives to the rst stages of the
investigation process. The tradition of destruction began
as early as the 1990s. This SEC activity eventually caused
a conict with the National Archives and Records Administration when it was revealed to them in 2010 by Flynn.
Flynn also described a meeting at the SEC in which top
sta discussed refusing to admit the destruction had taken
place, because it was possibly illegal.[43]
Iowa Republican Senator Charles Grassley, among others, took note of Flynns call for protection as a whistleblower, and the story of the agencys document-handling
procedures. The SEC issued a statement defending its
procedures. NPR quoted University of Denver Sturm
College of Law professor Jay Brown as saying: My initial take on this is its a tempest in a teapot, and Jacob
Frenkel, a securities lawyer in the Washington, D.C.,
area, as saying in eect theres no allegation the SEC
tossed sensitive documents from banks it got under subpoena in high-prole cases that investors and lawmakers
care about. NPR concluded its report:
The debate boils down to this: What does

18.3. SECURITIES AND EXCHANGE COMMISSION

an investigative record mean to Congress? And
the courts? Under the law, those investigative
records must be kept for 25 years. But federal ocials say no judge has ruled that papers
related to early-stage SEC inquiries are investigative records. The SECs inspector general
says hes conducting a thorough investigation
into the allegations. [Kotz] tells NPR that he'll
issue a report by the end of September.[49]

409
amending Section 18 of the 1933 Act to exempt nationally traded securities from state registration, thereby preempting state law in this area. However, NSMIA preserves the states anti-fraud authority over all securities
traded in the state.[53]
The SEC also works with federal and state law enforcement agencies to carry out actions against actors alleged
to be in violation of the securities laws.

The SEC is a member of International Organization of

Securities Commissions (IOSCO), and uses the IOSCO
Multilateral Memorandum of Understanding as well as
18.3.6 Relationship to other agencies
direct bilateral agreements with other countries securities
commissions to deal with cross-border misconduct in seIn addition to working with various self-regulatory orga- curities markets.
nizations such as the Financial Industry Regulatory Authority (FINRA), the Securities Investor Protection Corporation (SIPC), and Municipal Securities Rulemaking 18.3.7 Related legislation
Board (MSRB), the SEC also works with other federal
agencies, state securities regulators, international securi 1933: Securities Act of 1933
ties agencies, and law enforcement agencies.[50]
1934: Securities Exchange Act of 1934
In 1988 Executive Order 12631 established the Presi 1938: Temporary National Economic Committee
dents Working Group on Financial Markets. The Work(establishment)
ing Group is chaired by the Secretary of the Treasury
and includes the Chairman of the SEC, the Chairman of
1939: Trust Indenture Act of 1939
the Federal Reserve and the Chairman of the Commodity
Futures Trading Commission. The goal of the Working
1940: Investment Advisers Act of 1940
Group is to enhance the integrity, eciency, orderliness,
1940: Investment Company Act of 1940
and competitiveness of the nancial markets while maintaining investor condence.[51]
1968: Williams Act (Securities Disclosure Act)
The Securities Act of 1933 was originally administered
1982: GarnSt. Germain Depository Institutions
by the Federal Trade Commission. The Securities ExAct
change Act of 1934 transferred this responsibility from
the FTC to the SEC. The main mission of the FTC is
1999: GrammLeachBliley Act
to promote consumer protection and to eradicate anticompetitive business practices. The FTC regulates gen 2000: Commodity Futures Modernization Act of
eral business practices, while the SEC focuses on the se2000
curities markets.
2002: SarbanesOxley Act
The Temporary National Economic Committee was established by joint resolution of Congress 52 Stat. 705 on
2003: Fair and Accurate Credit Transactions Act of
June 16, 1938. It was in charge of reporting to Congress
2003
on abuses of monopoly power. The committee was de 2006: Credit Rating Agency Reform Act of 2006
funded in 1941, but its records are still under seal by order
[52]
of the SEC.
2010: DoddFrank Wall Street Reform and ConThe Municipal Securities Rulemaking Board (MSRB)
sumer Protection Act
was established in 1975 by Congress to develop rules
2012: Volcker Rule (a specic section of the Dodd
for companies involved in underwriting and trading
Frank Act)
municipal securities. The MSRB is monitored by the
SEC, but the MSRB does not have the authority to en Title 17 of the Code of Federal Regulations
force its rules.
While most violations of securities laws are enforced by
the SEC and the various SROs it monitors, state securi- 18.3.8 See also
ties regulators can also enforce statewide securities blue
Chicago Stock Exchange
sky laws.[4] States may require securities to be registered
in the state before they can be sold there. National Secu Commodity Futures Trading Commission
rities Markets Improvement Act of 1996 (NSMIA) addressed this dual system of federal-state regulation by
Financial Industry Regulatory Authority

410

CHAPTER 18. REGULATION

Financial regulation
List of nancial regulatory authorities by country
NASDAQ
New York Stock Exchange
Regulation D (SEC)
Securities Commission
Securities regulation in the United States
Stock exchange
Forms

[14] How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation (Securities and
Exchange Commission)". Sec.gov. Retrieved March 1,
2013.
[15] Protess, Ben (February 11, 2013). S.E.C.'s Revolving Door Hurts Its Eectiveness, Report Says. Dealbook.nytimes.com. Retrieved March 1, 2013.
[16] Schroeder, Peter (January 29, 2013). SEC names new
inspector general The Hills On The Money. Thehill.com. Retrieved March 1, 2013.
[17] SEC press release. Retrieved October 18, 2012

SEC ling
Form 4 (stock and stock options ownership
and exercise disclosure)
Form 8-K
Form 10-K
Form S-1 (IPO)

18.3.9

[13] Lemke and Lins, Regulation of Investment Advisers

(Thomson West, 2013 ed.); Lemke, Lins and Smith, Regulation of Investment Companies (Matthew Bender, 2013
ed.).

References

[18] Greene, Jenna,The Conversation Stopper: SEC Inspector General H. David Kotz: Staers may not like riding
the elevator with him, but the SEC is taking his advice,
Corporate Counsel, July 27, 2011. Retrieved August 18,
2011.
[19] Website for the SEC Oce of the Whistleblower.
Sec.gov. Retrieved 2013-12-05.
[20] Oce of the SEC Whistleblower. Sec.gov. Retrieved
2013-12-05.
[21] http://www.sec.gov/about/offices/owb/reg-21f.pdf

[1] FY 2014 Congressional Budget Justication (PDF). U.S.

Securities and Exchange Commission. 2013. p. 14.

[22] http://www.sec.gov/about/offices/owb/
annual-report-2012.pdf

[2] A-Z Index of U.S. Government Departments and Agencies USA.gov

[23] Gretchen Morgenson: Deafened by the S.E.C.'s Silence,

He Sued, New York Times, May 28, 2006, section 3, p. 1

[3] http://investor.gov/introduction-markets/role-sec. Missing or empty |title= (help)

[24] Lauren Tara LaCapra (17 September 2008). NakedShorts Ban Gets Chilly Reception. The street.

[4] Blue Sky laws. Seclaw.com. July 7, 2007. Retrieved

March 1, 2013.

[25] Ellis, David (September 17, 2008). Regulator enacts new

ruling banning 'naked' short selling on all public companies.. CNN. Retrieved May 26, 2010.

[5] Seligman, Joel (2003). The Transformation of Wall Street.

Aspen. pp. 45, 5152.
[6] Securities Act of 1933 (PDF). Retrieved March 1, 2013.

[26] Jason Breslow (Director) (2014-04-08). Is SEC Fearful of Wall Street? Agency Insider Says Yes. (PBS).
Retrieved 2014-12-14. Missing or empty |title= (help)

[7] Securities Exchange Act of 1934 (PDF). Retrieved

March 1, 2013.

[27] Schmidt, Robert (2014-04-08). SEC Goldman Lawyer

Says Agency Too Timid on Wall Street Misdeeds.
Bloomberg. Retrieved 2014-12-14.

[8] Current SEC Commissioners. Sec.gov. December 17,

2012. Retrieved March 1, 2013.

[28] Kidney, Jim (2014). Retirement Remarks (PDF). SEC

Union, NTEU Chapter 293. Retrieved 2014-11-20.

[9] Orol, Ronald D., Schapiro to step down from SEC,

MarketWatch, November 26, 2012. Retrieved November
26, 2012.

[29] Chung, Joanna (December 17, 2008). Financial Times:

SEC chief admits to failures in Mado case. Ft.com.
Retrieved March 1, 2013.

[10] Organization of the SEC U.S. Securities and Exchange

Commission

[30] Moyer, Liz (December 23, 2008). Could SEC Have

Stopped Mado Scam In 1992?". Forbes. Archived from
the original on February 1, 2009. Retrieved December
24, 2008.

[11] National Association of Securities Dealers. Finra.com.

Retrieved March 1, 2013.
[12] How does the NASD dier from the SEC?" Investopedia.
Investopedia Inc.

[31] Weil, Jonathan. Mado exposes double standard for

Ponzi schemes. Bloomberg News (Greater Fort Wayne
Business Weekly). Retrieved December 26, 2008.

18.4. SECURITIES AND EXCHANGE BOARD OF INDIA

411

[32] Serchuk, David (December 22, 2008). Love, Mado

And The SEC. Forbes. Retrieved December 24, 2008.

[52] National Archives. Archives.gov. Retrieved March 1,

2013.

[33] Labaton, Stephen (December 19, 2008). Unlikely Player

Pulled Into Mado Swirl. The New York Times.

[53] National Securities Markets Improvement Act. AccreditedInvestors.net.

[34] Little faith in regulators and rating agencies, as LP demand for alternatives cools o, nds survey.

18.3.10 External links

[35] Markopolos, H (2010). No One Would Listen: A True

Financial Thriller. John Wiley & Sons. pp. 5560. ISBN
0-470-55373-1.

Ocial website

[36] Kurdas, Chidem. Political Sticky Wicket: The Untouchable Ponzi Scheme of Allen Stanford.

Securities and Exchange Commission Historical Society

[37] Blaylock D. (June 2010). SEC Settles with Aguirre. Government Accountability Project.

Association of Securities and Exchange Commission Alumni (ASECA)

SEC in the Federal Register

[38] Choice of Mary Jo White to Head SEC Puts Fox In

Charge of Hen House. Rolling Stone.
[39] Committee on Finance, Committee on the Judiciary.The
Firing of an SEC Attorney and the Investigation of Pequot
Capital Management. U.S. Government Printing Oce.

18.4 Securities and

Board of India

Exchange

The Securities and Exchange Board of India (SEBI)

is the regulator for the securities market in India. It was
established in the year 1988 and given statutory powers
[41] Johnson, Fawn. (December 17, 2009) Group Alleges
on 12 April 1992 through the SEBI Act, 1992.[1]
Slack SEC Response to Internal Watchdog. NASDAQ.
[40] Preventing Crashes: Lessons for the SEC from the Airline Industry. 2015-01-06. Retrieved 2015-01-06.

[42] Brian, Danielle. (December 16, 2009) POGO Letter to

SEC Chairman Mary Schapiro regarding SECs failure to
act on hundreds of Inspector General recommendations.
The Project On Government Oversight Website.
[43]
[44]

[45]

[46]

18.4.1 History

It was established by The Government of India on 12

April 1988 and given statutory powers in 1992 with SEBI
Is the SEC Covering Up Wall Street Crimes?, Matt Taibi,
Act 1992 being passed by the Indian Parliament. SEBI
2011 August 17
has its headquarters at the business district of Bandra
Schmidt, Robert (January 25, 2013). SEC Said to Kurla Complex in Mumbai, and has Northern, Eastern,
Back Hire of U.S. Capitol Police Inspector General. Southern and Western Regional Oces in New Delhi,
Bloomberg. Retrieved February 10, 2013.
Kolkata, Chennai and Ahmedabad respectively. It has
opened local oces at Jaipur and Bangalore and is planSchmidt, Robert; Joshua Gallu (October 26, 2012).
ning to open oces at Guwahati, Bhubaneshwar, Patna,
Former SEC Watchdog Kotz Violated Ethics Rules, ReKochi and Chandigarh in Financial Year 2013 - 2014.
view Finds. Bloomberg. Retrieved February 10, 2013.
Controller of Capital Issues was the regulatory authorRobert Schmidt and Joshua Gallu (October 6, 2012).
ity before SEBI came into existence; it derived authority
Former SEC Watchdog Kotz Violated Ethics Rules, Review Finds. Business Week. Retrieved February 12, from the Capital Issues (Control) Act, 1947.
2013.

Initially SEBI was a non statutory body without any statutory power. However in 1995, the SEBI was given
[47] Sarah N. Lynch (November 15, 2012). David Weber
Lawsuit: Ex-SEC Investigator Accused Of Wanting To additional statutory power by the Government of India
Carry A Gun At Work, Suing For $20 Million. The Hu- through an amendment to the Securities and Exchange
Board of India Act, 1992. In April 1988 the SEBI was
ington Post. Retrieved February 10, 2013.
constituted as the regulator of capital markets in India
[48] David Kotz, Ex-SEC Inspector General, May Have Had under a resolution of the Government of India.
Conicts Of Interest. The Hungton Post. October 5,
2012. Retrieved February 10, 2013.

[49] Johnson, Carrie, SEC Documents Destroyed, Employee

Tells Congress, National Public Radio (transcript and audio), August 18, 2011. Retrieved 2011-08-18.
[50] Regulatory Structure
[51] U.S. Treasury

The SEBI is managed by its members, which consists of

following:
1. The chairman who is nominated by Union Government of India.
2. Two members, i.e., Ocers from Union Finance
Ministry.

412

CHAPTER 18. REGULATION

3. One member from the Reserve Bank of India.

4. The remaining ve members are nominated by
Union Government of India, out of them at least
three shall be whole-time members.

18.4.2

Organization structure

Further information: SEBI Organization Chart

3. inspect the books of accounts and call for periodical

returns from recognized stock exchanges.
4. inspect the books of accounts of a nancial intermediaries.
5. compel certain companies to list their shares in one
or more stock exchanges.
6. registration brokers.
There are two types of brokers:

Upendra Kumar Sinha was appointed chairman on 18

February 2011 replacing C. B. Bhave.[3]
[4]

The Board comprises

1. circuit broker
2. merchant broker

List of former Chairmen:[5]

SEBI committees

18.4.3

Functions and responsibilities

The Preamble of the Securities and Exchange Board of

India describes the basic functions of the Securities and
Exchange Board of India as "...to protect the interests of
investors in securities and to promote the development
of, and to regulate the securities market and for matters
connected therewith or incidental thereto.
SEBI has to be responsive to the needs of three groups,
which constitute the market:

1. Technical Advisory Committee

2. Committee for review of structure of market infrastructure institutions
3. Advisory Committee for the SEBI Investor Protection and Education Fund
4. Takeover Regulations Advisory Committee
5. Primary Market Advisory Committee (PMAC)
6. Secondary Market Advisory Committee (SMAC)

the issuers of securities

the investors
the market intermediaries.
SEBI has three functions rolled into one body: quasilegislative, quasi-judicial and quasi-executive. It drafts
regulations in its legislative capacity, it conducts investigation and enforcement action in its executive function
and it passes rulings and orders in its judicial capacity.
Though this makes it very powerful, there is an appeal
process to create accountability. There is a Securities Appellate Tribunal which is a three-member tribunal and is
headed by Mr. Justice J P Devadhar, a former judge of
the Bombay High Court.[6] A second appeal lies directly
to the Supreme Court. SEBI has taken a very proactive
role in streamlining disclosure requirements to international standards.[7]

7. Mutual Fund Advisory Committee

8. Corporate Bonds & Securitization Advisory Committee

18.4.4 Major achievements

SEBI has enjoyed success as a regulator by pushing systematic reforms aggressively and successively. SEBI is
credited for quick movement towards making the markets electronic and paperless by introducing T+5 rolling
cycle from July 2001 and T+3 in April 2002 and further
to T+2 in April 2003. The rolling cycle of T+2[8] means,
Settlement is done in 2 days after Trade date.[9] SEBI has
been active in setting up the regulations as required under
law. SEBI did away with physical certicates that were
prone to postal delays, theft and forgery, apart from making the settlement process slow and cumbersome by passing Depositories Act, 1996.[10]

SEBI has also been instrumental in taking quick and

eective steps in light of the global meltdown and the
For the discharge of its functions eciently, SEBI has Satyam asco. In October 2011, it increased the extent
and quantity of disclosures to be made by Indian corpobeen vested with the following powers:
rate promoters.[11] In light of the global meltdown, it liberalised the takeover code to facilitate investments by re1. to approve bylaws of stock exchanges.sebi
moving regulatory structures. In one such move, SEBI
2. to require the stock exchange to amend their has increased the application limit for retail investors to
bylaws.
Rs 2 lakh, from Rs 1 lakh at present.[12]
Powers

18.4. SECURITIES AND EXCHANGE BOARD OF INDIA

18.4.5

Controversies

413

[3] A rendezvous: CB Bhaves 3-years at SEBI - CNBCTV18. Moneycontrol.com. Retrieved on 2013-07-29.

Supreme Court of India heard a Public Interest Litigation

(PIL) led by India Rejuvenation Initiative that had chal- [4]
lenged the procedure for key appointments adopted by
Govt of India. The petition alleged that, The constitution [5]
of the search-cum-selection committee for recommending the name of chairman and every whole-time members of SEBI for appointment has been altered, which [6]
directly impacted its balance and could compromise the
role of the SEBI as a watchdog. [13][14] On 21 November
2011, the court allowed petitioners to withdraw the petition and le a fresh petition pointing out constitutional issues regarding appointments of regulators and their inde- [7]
pendence. The Chief Justice of India refused the nance
ministrys request to dismiss the PIL and said that the [8]
court was well aware of what was going on in SEBI.[13][15]
Hearing a similar petition led by Bangaluru-based advocate Anil Kumar Agarwal, a two judge Supreme Court [9]
bench of Justice SS Nijjar and Justice HL Gokhale issued
a notice to the Govt of India, SEBI chief UK Sinha and
[10]
Omita Paul, Secretary to the President of India.[16][17]

Microsoft Word - Boardmembers.doc (PDF). Retrieved

2012-02-28.
Former Chairmen of SEBI (PDF). SEBI. Retrieved 19
February 2011.
Govt appoints JP Devadhar as new Presiding Ocer of
Securities Appellate Tribunal - Economic Times. Articles.economictimes.indiatimes.com (2013-07-15). Retrieved on 2013-12-06.
Cyril Shro Managing Partner Mumbai & National Capital Market head Amarchand. http://barandbench.com/.
Discussion Paper Implementation of T+2 rolling settlement (PDF). SEBI. Retrieved 25 October 2012.
Sebi gets rolling on T+2 settlement schedule. economictimes. Jan 4, 2003. Retrieved 25 October 2012.
Sebis 25-year journey. Livemint (2013-05-21). Retrieved on 2013-07-29.

Further, it came into light that Dr KM Abraham (the then

whole time member of SEBI Board) had written to the [11] SEBI makes it mandatory for companies to disclose promoters shares. Economic Times. Oct 6, 2011. Retrieved
Prime Minister about malaise in SEBI. He said, The reg26 October 2012.
ulatory institution is under duress and under severe attack
from powerful corporate interests operating concertedly
to undermine SEBI. He specically said that Finance [12] Sebi doubles retail limit, tightens IPO norms. business.redi.com. Retrieved 27 Oct 2010.
Ministers oce, and especially his advisor Omita Paul,
were trying to inuence many cases before SEBI, includ- [13] Is Sebis Autonomy Under Threat?". Nov 15, 2011. Reing those relating to Sahara Group, Reliance, Bank of Ratrieved April 10, 2012.
jasthan and MCX.[18][19] ...

18.4.6

See also

National Stock Exchange of India

Forward Markets Commission (India)
Securities Commission
Financial regulation
List of nancial regulatory authorities by country
Stock exchange
Regulation D (SEC)
Institute of Chartered Accountants of India
Institute of Company Secretaries of India

18.4.7

References

[1] About SEBI. SEBI. Archived from the original on 3 Oct

2010. Retrieved 26 September 2012.
[2] http://www.sebi.gov.in/acts/EmployeeDetails.html

[14] PIL alleges nexus in Sebi appointments. Nov 5, 2011.

Retrieved April 10, 2012.
[15] SC allows eminent citizens to withdraw petition against
SEBI chiefs appointment. Nov 21, 2011. Retrieved
April 10, 2012.
[16] Notice to Centre on quo warranto against SEBI chief.
The Hindu. 26 September 2012. Retrieved 26 September
2012.
[17] SC seeks Centres reply on PIL on Sebi chairmans appointment. The Deccan Herald. 26 September 2012.
Retrieved 26 September 2012.
[18] KM Abrahams letter to PM. Prime Ministers Oce.
20 Oct 2011. Retrieved April 11, 2012.
[19] Pranab-Chidu feud may be revived over Sebi chief PIL.
Nov 12, 2011. Retrieved April 11, 2012.

18.4.8 External links

Securities and Exchange Board of India Website
A practical guide to start a stock Sub-Broker Business in India

414

18.5 Forward Markets Commission

CHAPTER 18. REGULATION

futures trading altogether.[5]
The industry was pushed underground and the prohibition
meant that development and expansion came to a halt. In
the 1970 as futures and options markets began to develop
in the rest of the world, Indian derivatives markets were
left behind. The apprehensions about the role of speculation, particularly in the conditions of scarcity, prompted
the Government to continue the prohibition well into the
1980s.

The Forward Markets Commission (FMC) is the chief

regulator of commodity futures markets in India. As of
July 2014, it regulated Rs 17 trillion[1] worth of commodity trades in India. It is headquartered in Mumbai and this
nancial regulatory agency is overseen by the Ministry of
Finance. The Commission allows commodity trading in
22 exchanges in India, of which 6 are national.Finance The result of the period of prohibition left India with
Minister Arun Jaitley announced its merger with SEBI in a large number of small and isolated regional futures
his Budget speech of 2015.
markets. The futures markets were dispersed and fragmented, with separate trading communities in dierent
regions with little contact with one another. The exchanges had not yet embrace modern technology or mod18.5.1 History
ern business practices.
Established in 1953 under the provisions of the Forward Next to the ocially approved exchanges, there were also
Contracts (Regulation) Act, 1952, it consists of not less many havala markets. Most of these unocial commodthan two but not exceeding four members appointed by ity exchanges have operated for many decades. Some
the Central Government, out of them one being nomi- unocial markets trade 2030 times the volume of the
nated by the Central Government to be the Chairman of ocial futures exchanges. They oer not only futures,
the Commission.
but also option contracts. Transaction costs are low, and
Since futures traded in India are traditionally on food
commodities, the agency was originally overseen by
Ministry of Consumer Aairs, Food and Public Distribution (India).[2]

they attract many speculators and the smaller hedgers.

Absence of regulation and proper clearing arrangements,
however, meant that these markets were mostly regulated by the reputation of the main players.

The commission appeared in the news in March 2012 for

their ban on guar gum futures trading after it said the 18.5.2 Responsibilities and functions
price quadrupled due to its use in fracking causing food
ination.[3]
The functions of the Forward Markets Commission are
In September 2013, the commission responsibility was as follows:
moved to the Ministry of Finance to reect that futures trading was becoming more and more a nancial
To advise the Central Government in respect of the
activity.[4]
recognition or the withdrawal of recognition from
Development of the Industry
India has a long history of trading commodities and considered the pioneer in some forms of derivatives trading.
The rst derivative market was set up in 1875 in Mumbai,
where cotton futures was traded. This was followed by
establishment of futures markets in edible oilseeds complex, raw jute and jute goods and bullion. This became
an active industry with volumes reported to be large.
However, in 1935 a law was passed allowing the government to in part restrict and directly control food production (Defence of India Act, 1935). This included
the ability to restrict or ban the trading in derivatives
on those food commodities. Post independence, in the
1950s, India continued to struggle with feeding its population and the government increasingly restricting trading
in food commodities. Just at the time the FMC was established, the government felt that derivative markets increased speculation which led to increased costs and price
instabilities. And in 1953 nally prohibited options and

any association or in respect of any other matter arising out of the administration of the Forward Contracts (Regulation) Act 1952.
To keep forward markets under observation and to
take such action in relation to them, as it may consider necessary, in exercise of the powers assigned
to it by or under the Act.
To collect and whenever the Commission thinks it
necessary, to publish information regarding the trading conditions in respect of goods to which any of
the provisions of the act is made applicable, including information regarding supply, demand and
prices, and to submit to the Central Government, periodical reports on the working of forward markets
relating to such goods;
To make recommendations generally with a view to
improving the organization and working of forward
markets;

18.6. FREDDIE MAC

415

To undertake the inspection of the accounts and

other documents of any recognized association or
registered association or any member of such association whenever it considers it necessary.

Fannie Mae, Freddie Mac buys mortgages on the secondary market, pools them, and sells them as a mortgagebacked security to investors on the open market. This
secondary mortgage market increases the supply of
money available for mortgage lending and increases the
It allows futures trading in 23 Fibers and Manufacturers, money available for new home purchases. The name,
15 spices, 44 edible oils, 6 pulses, 4 energy products, sin- Freddie Mac, is a variant of the initialism of the companys full name that had been adopted ocially for ease
gle vegetable, 20 metal futures, 33 others Futures.
of identication.
On September 7, 2008, Federal Housing Finance Agency
(FHFA) director James B. Lockhart III announced
he had put Fannie Mae and Freddie Mac under the
Currently Commission comprises three members among conservatorship of the FHFA (see Federal takeover of
whom
Fannie Mae and Freddie Mac). The action has been described as one of the most sweeping government inter Shri Ramesh Abhishek (Chairman) - Appointed 24 ventions in private nancial markets in decades.[4][5][6]
September 2012
Moodys gave Freddie Macs preferred stock an investment grade rating of A1 until August 22, 2008, when
M. Mathisekaran
Warren Buett said publicly that both Freddie Mac and
Shri Nagendraa Parakh - appointed July 2013
Fannie Mae had tried to attract him and others. Moodys
changed the credit rating on that day to Baa3, the lowest investment grade credit rating. Freddies senior debt
18.5.4 References
credit rating remains Aaa/AAA from each of the major
ratings agencies Moodys, S&P, and Fitch.[7]

18.5.3

Commission

[1] Highlights/ Important Developments for the fortnight

from 1.7.2014 to 15.7.2014. FMC. July 15, 2014.

[2] Gargi Parsai (10 September 2013). Forward Markets

Commission comes under Finance Ministry. The Hindu.
[3] Ram Narayan (August 8, 2012). From Food to Fracking: Guar Gum and International Regulation. RegBlog.
University of Pennsylvania Law School. Retrieved 15 August 2012.

As of the start of the conservatorship, the United States

Department of the Treasury had contracted to acquire
US$1 billion in Freddie Mac senior preferred stock, paying at a rate of 10% per year, and the total investment
may subsequently rise to as much as US$100 billion.[8]

Home loan interest rates may go down as a result and

owners of Freddie Mac debt and the Asian central banks
who had increased their holdings in these bonds may be
[4] Finance Ministry to oversee Forward Markets Commis- protected. Shares of Freddie Mac stock, however, plummeted to about one U.S. dollar on September 8, 2008,
sion. Hindu Business Line. September 10, 2013.
and dropped a further 50% on June 16, 2010, when
[5] Frida Youssef (October 2000). Integrated report on the Federal Housing Finance Agency ordered the stocks
Commodity Exchanges And Forward Market Commis- delisted.[9] In 2008, the yield on U.S Treasury securities
sion (FMC)". FMC.
rose in anticipation of increased U.S. federal debt.[10]

18.5.5

External links

For a comprehensive list of articles discussing Freddie

Mac, see Bibliography of Fannie Mae and Freddie Mac.

Forward Markets Commission Ocial Website

18.6.1 History

18.6 Freddie Mac

For the boxer and singer, see Freddie Mack.
The Federal Home Loan Mortgage Corporation
(FHLMC), known as Freddie Mac, is a public
government-sponsored enterprise (GSE), headquartered
in the Tysons Corner CDP in unincorporated Fairfax
County, Virginia.[2][3]
The FHLMC was created in 1970 to expand the
secondary market for mortgages in the US. Along with

From 1938 to 1968, the Federal National Mortgage Association (Fannie Mae) was the sole institution that bought
mortgages from depository institutions, principally savings and loan associations, which encouraged more mortgage lending and eectively insured the value of mortgages by the US government. In 1968, Fannie Mae split
into a private corporation and a publicly nanced institution. The private corporation was still called Fannie
Mae and its charter continued to support the purchase of
mortgages from savings and loan associations and other
depository institutions, but without an explicit insurance
policy that guaranteed the value of the mortgages. The

416

CHAPTER 18. REGULATION

publicly nanced institution was named the Government

National Mortgage Association (Ginnie Mae) and it explicitly guaranteed the repayments of securities backed
by mortgages made to government employees or veterans
(the mortgages themselves were also guaranteed by other
government organizations).
To provide competition for the newly private Fannie Mae
and to further increase the availability of funds to nance mortgages and home ownership, Congress then
established the Federal Home Loan Mortgage Corporation (Freddie Mac) as a private corporation through the
Emergency Home Finance Act of 1970. The charter of
Freddie Mac was essentially the same as Fannie Maes
newly private charter: to expand the secondary market
for mortgages and mortgage backed securities by buying mortgages made by savings and loan associations and
other depository institutions. Initially, Freddie Mac was
owned by the Federal Home Loan Bank System and governed by the Federal Home Loan Bank Board.
In 1989, the Financial Institutions Reform, Recovery and
Enforcement Act of 1989 (FIRREA) revised and standardized the regulation of Fannie Mae and Freddie Mac.
It also severed Freddie Macs ties to the Federal Home
Loan Bank System. The Federal Home Loan Bank Board
(FHLBB) was abolished and replaced by dierent and
separate entities. An 18-member board of directors for
Freddie Mac was formed, and subjected to oversight by
the U.S. Department of Housing and Urban Development
(HUD). Separately, The Federal Housing Finance Board
(FHFB) was created as an independent agency to take the
place of the FHLBB, to oversee the 12 Federal Home
Loan Banks (also called district banks).

Conforming loans
The GSEs are allowed to buy only conforming loans,
which limits secondary market demand for nonconforming loans. The relationship between supply
and demand typically renders the non-conforming loan
harder to sell (fewer competing buyers); thus it would
cost the consumer more (typically 1/4 to 1/2 of a
percentage point, and sometimes more, depending on
credit market conditions). OFHEO, now merged into
the new FHFA, annually sets the limit of the size of a
conforming loan in response to the October to October
change in mean home price. Above the conforming
loan limit, a mortgage is considered a jumbo loan. The
conforming loan limit is 50 percent higher in such highcost areas as Alaska, Hawaii, Guam and the US Virgin
Islands,[13] and is also higher for 24 unit properties on
a graduating scale. Modications to these limits were
made temporarily to respond to the housing crisis, see
Jumbo loan for recent events.

Guarantees and subsidies

No actual guarantees The FHLMC states, securities,

including any interest, are not guaranteed by, and are not
debts or obligations of, the United States or any agency
or instrumentality of the United States other than Freddie Mac.[14] The FHLMC and FHLMC securities are not
funded or protected by the US Government. FHLMC securities carry no government guarantee of being repaid.
This is explicitly stated in the law that authorizes GSEs,
on the securities themselves, and in public communicaIn 1995, Freddie Mac began receiving aordable housing tions issued by the FHLMC.
credit for buying subprime securities, and by 2004, HUD
suggested the company was lagging behind and should
Assumed guarantees There is a widespread belief that
do more.[11]
FHLMC securities are backed by some sort of implied
Freddie Mac was put under a conservatorship of the U.S.
federal guarantee and a majority of investors believe that
Federal government on Sunday, September 7, 2008.
the government would prevent a disastrous default. Vernon L. Smith, 2002 Nobel Laureate in economics, has
called FHLMC and FNMA implicitly taxpayer-backed
agencies. [15] The Economist has referred to the implicit
government guarantee[16] of FHLMC and FNMA.

18.6.2

Business

The then-director of the Congressional Budget Oce,

Dan L. Crippen, testied before Congress in 2001, that
Freddie Macs primary method of making money is by the debt and mortgage-backed securities of GSEs are
charging a guarantee fee on loans that it has purchased more valuable to investors than similar private securities
and securitized into mortgage-backed security (MBS) because of the perception of a government guarantee.[17]
bonds. Investors, or purchasers of Freddie Mac MBS, are
willing to let Freddie Mac keep this fee in exchange for
assuming the credit risk, that is, Freddie Macs guaran- Federal subsidies The FHLMC receives no direct fedtee that the principal and interest on the underlying loan eral government aid. However, the corporation and the
will be paid back regardless of whether the borrower ac- securities it issues are thought to benet from governtually repays. Because of Freddie Macs nancial guar- ment subsidies. The Congressional Budget Oce writes,
antee, these MBS are particularly attractive to investors There have been no federal appropriations for cash payand, like other Agency MBS, are eligible to be traded in ments or guarantee subsidies. But in the place of federal funds the government provides considerable unpriced
the to-be-announced, or TBA market.[12]

18.6. FREDDIE MAC

417

benets to the enterprises. Government-sponsored enter- added to the already large inventory of homes and stricter
prises are costly to the government and taxpayers. The lending standards made it more and more dicult for
benet is currently worth $6.5 billion annually. [18]
borrowers to get mortgages. This depreciation in home
prices led to growing losses for the GSEs, which back
the majority of US mortgages. In July 2008, the government attempted to ease market fears by reiterating their
The mortgage crisis from late 2007
view that Fannie Mae and Freddie Mac play a central
As mortgage originators began to distribute more and role in the US housing nance system. The U.S. Treamore of their loans through private label MBS, GSEs lost sury Department and the Federal Reserve took steps to
the ability to monitor and control mortgage originators. bolster condence in the corporations, including granting
Competition between the GSEs and private securitizers both corporations access to Federal Reserve low-interest
for loans further undermined GSEs power and strength- loans (at similar rates as commercial banks) and removing
ened mortgage originators. This contributed to a decline the prohibition on the Treasury Department to purchase
in underwriting standards and was a major cause of the the GSEs stock. Despite these eorts, by August 2008,
shares of both Fannie Mae and Freddie Mac had tumbled
nancial crisis.[19]
more than 90% from their one-year prior levels.
Investment bank securitizers were more willing to securitize risky loans because they generally retained minimal risk. Whereas the GSEs guaranteed the performance
of their MBS, private securitizers generally did not, and 18.6.3 Company
might only retain a thin slice of risk.[19] Often, banks
would ooad this risk to insurance companies or other Awards
counterparties through credit default swaps, making their
actual risk exposures extremely dicult for investors and
Freddie Mac was named one of the 100 Best Comcreditors to discern.[20]
panies for Working Mothers in 2004 by Working
Mothers magazine.
From 2001-2003, nancial institutions experienced high
earnings due to an unprecedented re-nancing boom
brought about by historically low interest rates. When interest rates eventually rose, nancial institutions sought
to maintain their elevated earnings levels with a shift
toward riskier mortgages and private label MBS distribution. Earnings depended on volume, so maintaining elevated earnings levels necessitated expanding the
borrower pool using lower underwriting standards and
new products that the GSEs would not (initially) securitize. Thus, the shift away from GSE securitization to
private-label securitization (PLS) also corresponded with
a shift in mortgage product type, from traditional, amortizing, xed-rate mortgages (FRMs) to nontraditional,
structurally riskier, nonamortizing, adjustable-rate mortgages (ARMs), and in the start of a sharp deterioration
in mortgage underwriting standards.[21] The growth of
PLS, however, forced the GSEs to lower their underwriting standards in an attempt to reclaim lost market share
to please their private shareholders. Shareholder pressure
pushed the GSEs into competition with PLS for market
share, and the GSEs loosened their guarantee business
underwriting standards in order to compete. In contrast,
the wholly public FHA/Ginnie Mae maintained their underwriting standards and instead ceded market share.[21]
The growth of private-label securitization and lack of regulation in this part of the market resulted in the oversupply of underpriced housing nance[21] that led, in
2006, to an increasing number of borrowers, often with
poor credit, who were unable to pay their mortgages
particularly with adjustable rate mortgages (ARM)
caused a precipitous increase in home foreclosures. As
a result, home prices declined as increasing foreclosures

Freddie Mac was ranked number 50 in Fortune

500s 2007 rankings.
Freddie Mac was ranked 20 in Forbes' Global 2,000
public companies rankings for 2008.

Credit rating
As of October 14, 2008.[22]

Investigations
In 2003, Freddie Mac revealed that it had understated
earnings by almost $5 billion, one of the largest corporate
restatements in U.S. history. As a result, in November, it
was ned $125 millionan amount called peanuts by
Forbes.[23]
On April 18, 2006, Freddie Mac was ned $3.8 million, by far the largest amount ever assessed by the Federal Election Commission, as a result of illegal campaign
contributions. Freddie Mac was accused of illegally using corporate resources between 2000 and 2003 for 85
fundraisers that collected about $1.7 million for federal
candidates. Much of the illegal fund raising beneted
members of the House Financial Services Committee, a
panel whose decisions can aect Freddie Mac. Notably,
Freddie Mac held more than 40 fundraisers for House Financial Services Chairman Michael Oxley, R-Ohio.[24]

418
Government subsidies and bailout

CHAPTER 18. REGULATION

ton, and Vice-Chairman from 1998 to 2003. In his position, Johnson earned an estimated $21 million; Raines
earned an estimated $90 million; and Gorelick earned
Both Fannie Mae and Freddie Mac often beneted from
an estimated $26 million.[37] Three of these four top exan implied guarantee of tness equivalent to truly federecutives were also involved in mortgage-related nancial
ally backed nancial groups.[25]
scandals.[38][39]
As of 2008, Fannie Mae and Freddie Mac owned or
The top 10 recipients of campaign contributions from
guaranteed about half of the U.S.'s $12 trillion mortgage
Freddie Mac and Fannie Mae during the 1989 to 2008
market.[26] This made both corporations highly susceptime period include 5 Republicans and 5 Democrats.
tible to the subprime mortgage crisis of that year. UlTop recipients of PAC money from these organizatimately, in July 2008, the speculation was made realtions include Roy Blunt (R-MO) $78,500 (total includity, when the US government took action to prevent the
ing individuals contributions $96,950), Robert Bennett
collapse of both corporations. The US Treasury Depart(R-UT) $71,499 (total $107,999), Spencer Bachus (Rment and the Federal Reserve took several steps to bolster
AL) $70,500 (total $103,300), and Kit Bond (R-MO)
condence in the corporations, including extending credit
$95,400 (total $64,000). The following Democrats relimits, granting both corporations access to Federal Received mostly individual contributions from employees,
serve low-interest loans (at similar rates as commercial
rather than PAC money: Christopher Dodd, (D-CT)
banks), and potentially allowing the Treasury Department
$116,900 (but also $48,000 from the PACs), John Kerry,
to own stock.[27] This event also renewed calls for stronger
(D-MA) $109,000 ($2,000 from PACs), Barack Obama,
regulation of GSEs by the government.
(D-IL) $120,349 (only $6,000 from the PACs), Hillary
President Bush recommended a signicant regulatory Clinton, (D-NY) $68,050 (only $8,000 from PACs).[40]
overhaul of the housing nance industry in 2003, but John McCain received $21,550 from these GSEs durmany Democrats opposed his plan, fearing that tighter ing this time, mostly individual money.[41] Freddie Mac
regulation could greatly reduce nancing for low-income also contributed $250,000 to the 2008 Republican Nahousing, both low- and high-risk.[28] Bush opposed two tional Convention in St. Paul, Minnesota according to
other acts of legislation:[29][30] Senate Bill S. 190, the Fed- FEC lings.[42] The organizers of the Democratic Naeral Housing Enterprise Regulatory Reform Act of 2005, tional Convention have not yet submitted their lings on
which was introduced in the Senate on January 26, 2005, how much they received from Freddie Mac and Fannie
sponsored by Senator Chuck Hagel and co-sponsored by Mae.[42]
Senators Elizabeth Dole and John Sununu. S. 190 was
On Oct 21, 2010 government estimates revealed that the
reported out of the Senate Banking Committee on July
bailout of Freddie Mac and Fannie Mae will likely cost
28, 2005, but never voted on by the full Senate.
taxpayers $154 billion.[43]
On May 23, 2006, the Fannie Mae and Freddie Mac regulator, the Oce of Federal Housing Enterprise Oversight,
issued the results of a 27-month-long investigation.[31]
Conservatorship
On May 25, 2006, Senator McCain joined as a cosponsor to the Federal Housing Enterprise Regulatory Main article: Federal takeover of Fannie Mae and
Reform Act of 2005 (rst put forward by Sen. Charles Freddie Mac
Hagel [R-NE])[32] where he pointed out that Fannie Mae
and Freddie Macs regulator reported that prots were
On September 7, 2008, Federal Housing Finance Agency
illusions deliberately and systematically created by the
[33]
companys senior management.
However, this regu- (FHFA) Director James B. Lockhart III announced pursuant to the nancial analysis, assessments and statutory
lation too met with opposition from both Democrats and
authority of the FHFA, he had placed Fannie Mae and
[34]
Republicans.
Freddie Mac under the conservatorship of the FHFA.
Several executives of Fannie Mae or Freddie Mac in- FHFA has stated that there are no plans to liquidate the
clude Kenneth Duberstein, former Chief of Sta to Presi- company.[4][5]
dent Reagan, advisor to John McCains Presidential Campaign in 2000, and President George W. Bushs transition The announcement followed reports two days earlier that
team leader (Fannie Mae board member 19982007);[35] the Federal government was planning to take over Fannie
Mac and had met with their CEOs on
Franklin Raines, former Budget Director for President Mae and Freddie
[44][45][46]
short
notice.
Clinton, CEO from 1999 to 2004statements about his
role as an advisor to the Obama presidential campaign Under the reported plan, the federal government, via the
have been determined to be false;[36] James Johnson, FHFA, would place the two rms into conservatorship
former aide to Democratic Vice-President Walter Mon- and for each entity, dismiss the chief executive ocer,
dale and ex-head of Obamas Vice-Presidential Selection the present board of directors, elect a new board of diCommittee, CEO from 1991 to 1998; and Jamie Gore- rectors, and cause to be issued new common stock to the
lick, former Deputy Attorney General to President Clin- federal government. The value of the common stock to

18.6. FREDDIE MAC

419

pre-conservatorship holders would be greatly diminished,

in the eort to maintain the value of company debt and
of mortgage-backed securities.[6][44][45][46]

Government sponsored enterprise

The authority of the U.S. Treasury to advance funds for

the purpose of stabilizing Fannie Mae or Freddie Mac is
limited only by the amount of debt that the entire federal
government is permitted by law to commit to. The July
30, 2008, law enabling expanded regulatory authority
over Fannie Mae and Freddie Mac increased the national
debt ceiling by US$800 billion, to a total of US$ 10.7 trillion in anticipation of the potential need for the Treasury
to have the exibility to support the federal home loan
banks.[47][48][49]

USA Funds

Securitization

Agency Securities
Mortgage law
Mortgage loan
Maxine B. Baker President and CEO of the Freddie Mac Foundation, 1997present

David Kellermann late CFO of Freddie Mac

On September 7, 2008, the U.S. Government took con Canada Mortgage and Housing Corporation
trol of both Fannie Mae and Freddie Mac. Daniel Mudd,
CEO of Fannie Mae and Richard Syron, CEO of Freddie
Mac have been replaced. Herbert M. Allison former vice 18.6.6 References
chairman of Merrill Lynch will take over Fannie Mae,
and David M Moett, former vice chairman of US Ban- [1] Federal Home Loan Mortgage Corporation Form 10corp, will take over Freddie Mac.
K (Annual Report) for scal year ended December 31,

18.6.4

Related legislation

On May 8, 2013, Representatives Scott Garrett introduced the Budget and Accounting Transparency Act of
2014 (H.R. 1872; 113th Congress) into the United States
House of Representatives during the 113th United States
Congress. The bill, if it were passed, would modify the
budgetary treatment of federal credit programs, such as
Fannie Mae and Freddie Mac.[50] The bill would require
that the cost of direct loans or loan guarantees be recognized in the federal budget on a fair-value basis using
guidelines set forth by the Financial Accounting Standards Board.[50] The changes made by the bill would
mean that Fannie Mae and Freddie Mac were counted
on the budget instead of considered separately and would
mean that the debt of those two programs would be included in the national debt.[51] These programs themselves would not be changed, but how they are accounted
for in the United States federal budget would be. The
goal of the bill is to improve the accuracy of how some
programs are accounted for in the federal budget.[52]

18.6.5

See also

Fannie Mae
Ginnie Mae
Fannie Mae and Freddie Mac: A Bibliography
Farmer Mac
Farm Credit System
Sallie Mae
Derivative (nance)

2014 (PDF). Federal Home Loan Mortgage Corporation.

Retrieved 4 April 2015.
[2] "Tysons Corner CDP, Virginia. United States Census Bureau. Retrieved on May 7, 2009.
[3] "Contact Us. Freddie Mac. Retrieved on May 12, 2009.
[4] Lockhart III, James B. (2008-09-07). Statement of
FHFA Director James B. Lockhart. Federal Housing Finance Agency. Retrieved 2008-09-07.
[5] Fact Sheet: Questions and Answers on Conservatorship
(PDF). Federal Housing Finance Agency. 2008-09-07.
Retrieved 2008-09-07.
[6] Goldfarb, Zachary A.; David Cho; Binyamin Appelbaum
(2008-09-07). Treasury to Rescue Fannie and Freddie:
Regulators Seek to Keep Firms Troubles From Setting
O Wave of Bank Failures. Washington Post. pp. A01.
Retrieved 2008-09-07.
[7] 22, 2008 Freddie Mac courts investors, Buett passes.
Associated Press via International Herald Tribune via Internet Archive. Retrieved August 6, 2011.
[8] Christie, Rebecca (September 7, 2008). Paulson Engineers U.S. Takeover of Fannie, Freddie (Update4)".
Bloomberg. Retrieved 2008-09-07.
[9] Adler, Lynn (June 16, 2010). Fannie Mae, Freddie Mac
to delist shares on NYSE. Reuters. Retrieved 2010-0616.
[10] Grynbaum, Michael and Jolly, David (September 8,
2008). U.S. Takeover of Mortgage Giants Lifts Stock
Markets. The New York Times (The New York Times
Company). Retrieved 2008-09-08.
[11] Leonnig, Carol D. (June 10, 2008). How HUD Mortgage
Policy Fed The Crisis. Washington Post.
[12] Lemke, Lins and Picard, Mortgage-Backed Securities,
Chapters 2 and 4 (Thomson West, 2013 ed.).

420

CHAPTER 18. REGULATION

[13] Conforming Loan Limit. FHFA. Retrieved 17 March

2014.

[34] Associated Press, Oct 20, 2008. MSNBC. 2008-10-19.

Retrieved 2014-06-19.

[14] Freddie Mac Debt Securities: Freddie Notes FAQ.

Freddiemac.com. Retrieved 2014-06-19.

[35] PEU Report/State of the Division (2008-09-19). State of

the Division: Knowing McCains Ken Duberstein. Stateofthedivision.blogspot.com. Retrieved 2014-06-19.

[15] Vernon L. Smith, The Clinton Housing Bubble, Wall

Street Journal, December 18, 2007, pA20
[16] The Economist, Fannie and Freddie ride again, July 5,
2007
[17] ""CBO TESTIMONY Statement of Dan L. Crippen Director, Federal Subsidies for the Housing GSEs before the
Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises Committee on Financial
Services U.S. House of Representatives, May 23, 2001"".
Cbo.gov. 2001-05-23. Retrieved 2014-06-19.
[18] Congressional Budget Oce, Assessing the Public Costs
and Benets of Fannie Mae and Freddie Mac, May 1996

[36] The
Washington
Post,
Sept
19,
2008.
Voices.washingtonpost.com. Retrieved 2014-06-19.
[37] NationalPost, Jul 11, 2008
[38] The Washington Post, Apr 6, 2005.
post.com. Retrieved 2014-06-19.

Washington-

[39] The New York Times, Apr 19, 2008

[40] OpenSecrets.org
[41] Lindsay Renick Mayer (2008-09-11). OpenSecrets.org,
Sep 11, 2008. Opensecrets.org. Retrieved 2014-06-19.
[42] Yahoo! News

[19] Michael Simkovic Competition and Crisis in Mortgage Securitization, online at http://ssrn.com/abstract=
1924831

[43] Davidson, Paul (2010-10-22). Fannie, Freddie bailout to

cost taxpayers $154 billion. USA Today.

[20] Michael Simkovic, Secret Liens and the Financial

Crisis of 2008, http://papers.ssrn.com/sol3/papers.cfm?
abstract_id=1323190

[44] Hilzenrath, David S.; Zachary A. Goldfarb (2008-09-05).

Fannie Mae, Freddie Mac to be Put Under Federal Control, Sources Say. Washington Post. Retrieved 2008-0905.

[21] A. J. Levitin, S. M. Wachter Explaining the Housing

Bubble, online at http://ssrn.com/abstract=1669401)
[22] Freddie Mac Credit Ratings. Freddiemac.com. 201403-24. Retrieved 2014-06-19.
[23] Shaking Steady Freddie. Forbes. 2003-12-11.
[24] Freddie Mac pays record $3.8 million ne - Business - US
business | NBC News. MSNBC. 2006-04-18. Retrieved
2014-06-19.
[25] Goodman, Wes and Shenn, Jody (February 20, 2009).
Fannie Mae Rescue Hindered as Asians Seek Guarantee
(Update2)". Bloomberg. Retrieved 2009-02-20.
[26] Duhigg, Charles, Loan-Agency Woes Swell From a
Trickle to a Torrent, The New York Times, Friday, July
11, 2008
[27] Luhby, Tami, , CNN Money, Monday, July 14, 2008
[28] Labaton, Steven (2003-09-11). New Agency Proposed
to Oversee Freddie Mac and Fannie Mae. New York
Times. Retrieved 2009-08-25.
[29] Statement of Administration Policy: H.R. 1461. Presidency.ucsb.edu. Retrieved 2014-06-19.
[30] Statement of Administration Policy: H.R. 1427. Presidency.ucsb.edu. 2007-05-16. Retrieved 2014-06-19.
[31] Report of the Special Examination of Fannie Mae May
2006 (PDF). Oce of Federal Housing Enterprise Oversight. May 2006.
[32] govtrack.us
[33] govtrack.us, May 25, 2006

[45] Labaton, Stephen; Andres Ross Sorkin (2008-09-05).

U.S. Rescue Seen at Hand for 2 Mortgage Giants. New
York Times. Retrieved 2008-09-05.
[46] Hilzenrath,, David S.; Neil Irwin; Zachary A. Goldfarb
(2008-09-06). U.S. Nears Rescue Plan For Fannie And
Freddie Deal Said to Involve Change of Leadership, Infusions of Capital. Washington Post. pp. A1. Retrieved
2008-09-06.
[47] Herszenhorn, David (2008-07-27). Congress Sends
Housing Relief Bill to President. New York Times. Retrieved 2008-09-06.
[48] Herszenhorn, David M. (2008-07-31). Bush Signs
Sweeping Housing Bill. New York Times. Retrieved
2008-09-06.
[49] See HR 3221, signed into law as Public Law 110-289: A
bill to provide needed housing reform and for other purposes.
Access to Legislative History: Library of Congress
THOMAS: A bill to provide needed housing reform and
for other purposes.
White House pre-signing statement: Statement of Administration Policy: H.R. 3221 Housing and Economic Recovery Act of 2008 (July 23, 2008 ). Executive oce of
the President, Oce of Management and Budget, Washington DC.
[50] H.R. 1872 - CBO (PDF). United States Congress. Retrieved 28 March 2014.
[51] Kasperowicz, Pete (28 March 2014). House to push budget reforms next week. The Hill. Retrieved 7 April 2014.
[52] Kasperowicz, Pete (4 April 2014). Next week: Bring out
the budget. The Hill. Retrieved 7 April 2014.

18.6. FREDDIE MAC

18.6.7

Further reading

Housing Policy and Debate (PDF) 3 (4). Fannie

Mae, Oce of Housing Policy Research, Washington, DC.
Labaton, Stephen; Weisman, Steven R. (2008-0711). U.S. Weighs Takeover of Two Mortgage Giants. New York Times.
Lemke, Thomas P.; Lins, Gerald T.; Picard, Marie
E. (2013). Mortgage-Backed Securities. Thomson
West.

18.6.8

External links

Ocial website
Freddie Mac Prole, BusinessWeek
Freddie Mac Prole, New York Times
Why the Mortgage Crisis Happened (broken link)

421

Chapter 19

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BOT-Superzerocool, Rwalker, Jhinman, Leptictidium, Yonidebest, Deville, Zzuuzz, Cojoco, Shawnc, VodkaJazz, DocendoDiscimus, Sardanaphalus, Veinor, SmackBot, Brick Thrower, JJay, RandomProcess, Hmains, Richfe, Honbicot, Kurt Wagner, TimBentley, GoldDragon, Jcc1, Thumperward, Sceptic~enwiki, EncMstr, Timneu22, Kevin Ryde, DHN-bot~enwiki, Trekphiler, Smallbones, Avb, J.R.
Hercules, Stevenmitchell, Tomstoner, Radagast83, Salt Yeung, Jna runn, Tesseran, Barabum, Mr.Clown, Dhaliwal, BlindWanderer,
Ckatz, Apodeictic, Mantanmoreland, Surepseh, SirFozzie, Benjai, Hu12, Levineps, Alan.ca, Surmur, Amkamk, Tron77, Bitchen, Mellery,
CmdrObot, Ale jrb, DeLarge, Kushal one, Highgamma, Ezrakilty, Danward, Fairsing, Alpalp114, Gandygatt, Gogo Dodo, BDS2006,
Lastexit, B, Underpants, Bruvajc, IJB, Bmathis, Art Markham, Thijs!bot, Epbr123, Rnvilla, Tapir Terric, Oosh, AntiVandalBot, Gioto,
Seaphoto, Figz, Goodemi, Mackan79, Silver seren, Alphachimpbot, JAnDbot, Tc-engineer, Barek, MER-C, LinkinPark, Scbomber, SiobhanHansa, Finance sta, VoABot II, Antientropic, Bjorndahl, Buettcher, Roches, Johnbibby, Terjen, LookingGlass, Chkno, Milom, AgarwalSumeet, Slash, J.delanoy, Mash morgan, Dbiel, Gtc131, Johnbod, Investor55, LordAnubisBOT, McSly, Rickycds, Rosendorf, SmilesALot, Shortseller3, Atheuz, Cometstyles, Donmike10, DMCer, Skyzim, Funandtrvl, Jmcdon10, Sam Blacketer, VolkovBot, Holme053,
Nburden, Michaelpremsrirat, Degags, Seattle Skier, Servalo, VivekVish, Tumblingsky, Muzzamo, ExtraDry, Broadbot, Samiharris, Mzmadmike, Zain Ebrahim111, Star-lists, Plazak, Jes007, Ryalla, Mshashoua, SieBot, Degourdon, TJRC, WereSpielChequers, SE7, RJaguar3,
Lmielke359, Imjagpul, Jvs, Faganp, Fratrep, Svick, Finnancier, RegentsPark, ClueBot, SaintNick~enwiki, Ezribenami, ImperfectlyInformed, DragonBot, Danausi, John Nevard, Markgriz, Ajterry, DumZiBoT, Jisp, Dylanwet, XLinkBot, Cows3034, Burkaja, Imagine Reason, Thehotshotpilot, Ajgerdeman, Addbot, Elikn23, Logrithm, Deanswift67, Bassettcat, Myhorne1, Stickb0y79, Hufggfg, MrOllie, Protonk, Almost-instinct, AndersBot, Computermadgeek, 84user, Bonewith, Equilibrium007, Lightbot, Luckas Blade, Squiretim, Luckas-bot,
Yobot, Grochim, Raheeshaikh88, Zakronian, AnomieBOT, VanishedUser sdu9aya9fasdsopa, Gnomeliberation front, Piano non troppo,
90, Friedonc, Shambalala, Bo88y0, Jhmpub, Danno uk, Alphanode, JohnnyB256, Birchcli, Kimjy575, Xqbot, Sampleson, Adcoc005,
Anna Frodesiak, FuturePrefect, Lamarka, Anime Addict AA, Uritzkup, PursuitCurve, Green Cardamom, FrescoBot, Patchy1, Jakeboening, Paul r wood, Noloop, Citation bot 1, Westmorlandia, Blinkozo, Redrose64, Beganlocal, Canbyte, Limakm, Trappist the monk, Time9,
Archon Lives, Lotje, Dinamik-bot, Gulbenk, Dusty777, L2blackbelt, Skakkle, Jw2212, Wikiborg4711, RjwilmsiBot, Sargdub, ColJenkins, EmausBot, John of Reading, Eorteg01, The quick20, Starcheerspeaksnewslostwars, GoingBatty, Sp33dyphil, Jonathanko1, Ib Ravn,
HACKhalo2, H3llBot, AManWithNoPlan, Dangole81, Gandrewstone, AlexanderHamiltonRulz, ClueBot NG, Magicalife, Dean Turbo,
Danceking5, Hbjames, 23x2, John2019, Bluemars444, MironGainz, Drwagnalls, DPL bot, Robinsrl, Gilgil2, Cyberbot II, Calivaan45,
TheJJJunk, Roozbeh.daneshvar, Whileworth, Mogism, TwoTwoHello, SPECIFICO, Eyesnore, Crow, JaconaFrere, Bookerx3, Whikie,
Artashes Kardashyan, Johnalbertcraig and Anonymous: 450
Long (nance) Source: http://en.wikipedia.org/wiki/Long_(finance)?oldid=630583459 Contributors: R Lowry, Ezhiki, Alan Davies,
CanisRufus, Momotaro, Maurreen, Kappa, Landroni, Boothy443, -oo0(GoldTrader)0oo-, Bluemoose, Quale, Feco, Wragge, YurikBot,
RussBot, RadioKirk, Arthur Rubin, DocendoDiscimus, Sardanaphalus, SmackBot, Vina-iwbot~enwiki, Ulner, Cydebot, Shmulenson,
JohnInDC, Mattisse, Thijs!bot, Istartres, JAnDbot, Avicennasis, Fconaway, Funandtrvl, VolkovBot, Servalo, Lamro, SieBot, Bombastus,
Finnancier, ClueBot, Houyunqing, Addbot, SpBot, Amirobot, KamikazeBot, Shambalala, Obersachsebot, Erik9bot, RouteTurn, Teiresia,
Bluest, rico Jnior Wouters, CanadianBill2010, Kndimov, Whileworth and Anonymous: 24
Risk-free rate Source: http://en.wikipedia.org/wiki/Risk-free_interest_rate?oldid=648992553 Contributors: SimonP, Tzartzam, Olivier,
Edward, Smelialichu, Michael Hardy, Willsmith, Voidvector, Ehn, Mydogategodshat, Pakaran, Sbisolo, Connelly, Derobert, Bnn, Fintor, Blanchette, Saturnight, SKL, Feco, Lmatt, Kdehl, YurikBot, Pseudomonas, DocendoDiscimus, SmackBot, Telestylo, AdamSmithee,
KaiserbBot, Cybercobra, Dreadstar, Park3r, Outriggr, Cydebot, Thijs!bot, RobotG, NBeddoe, Gregalton, VolkovBot, MenasimBot, Lamro,
Phe-bot, Bombastus, Mild Bill Hiccup, Panyd, Physitsky, Anual, Addbot, Diptanshu.D, SatyajitJena, Keithbob, NOrbeck, Dimtsit, Sargdub,
Codehydro, EmausBot, John of Reading, ZroBot, Donner60, EdoBot, BG19bot, Zoe Lindesay, Faizan, Loraof and Anonymous: 41
Basis point Source: http://en.wikipedia.org/wiki/Basis_point?oldid=643125038 Contributors: AxelBoldt, Patrick, Kaihsu, Ehn, Jeq,
Enochlau, Database~enwiki, Superborsuk, MichaelDiederich, Andros 1337, ArnoldReinhold, YUL89YYZ, MeltBanana, MisterSheik,
Spoon!, Maurreen, Jerryseinfeld, AtonX, Egg, Krexwall, Timrichardson, Bluemoose, SDC, DePiep, 121a0012, FrankTobia, RussBot,
Htournyol, Clib, Thoreaulylazy, AB-me, ENeville, Yahya Abdal-Aziz, VAgentZero, Tim Parenti, MathsIsFun, DocendoDiscimus, Eskimbot, IstvanWolf, Betacommand, Bluebot, Nbarth, Rogermw, Uzzo2, Mwtoews, Vina-iwbot~enwiki, The undertow, Njk92, EdC~enwiki,
Edsdet, Buckyboy314, Morgiliath, JustAGal, Greg L, Gregalton, Mack2, TexMurphy, Salgueiro~enwiki, JAnDbot, SHCarter, Rsgoodsp, Stevvers, Darin-0, 4johnny, Gman124, Mufka, STBotD, DorganBot, VolkovBot, Antoni Barau, Klip game, Spaceman21,
AlleborgoBot, Kbrose, EditorInTheRye, Chokoboii, Three-quarter-ten, Cwakley, Addbot, Poco a poco, Ihendy33, Ehrenkater, ,

19.1. TEXT

425

Gail, JEN9841, Tedtoal, Luckas-bot, Newtondominey, Obersachsebot, Laguna CA, GrouchoBot, Suzukitoyoki, Pinethicket, HRoestBot,
Jonkerz, Kmw2700, Sargdub, EmausBot, ZroBot, EdCorr, MelbourneStar, Helpful Pixie Bot, Wromero1978, EuroCarGT, Degenerate
prodigy and Anonymous: 89
LIBOR Source: http://en.wikipedia.org/wiki/Libor?oldid=664659662 Contributors: AxelBoldt, The Anome, Lisiate, Edward, Pcb21,
Glenn, Kaihsu, Dying, RayKiddy, Paranoid, Chrism, Schutz, Diberri, Mattaschen, Christopher Parham, Bnn, Jokestress, Jklamo, MRSC,
Rmgrotkierii, Kdammers, Hyacinth45, Bender235, Fenice, Kwamikagami, Harris000, C S, Viriditas, Veeven, Giraedata, Justinc, PaulHanson, Laug, Wtmitchell, Magicwombat, Davidkazuhiro, SDC, Hughcharlesparker, Paxsimius, Vegaswikian, Feco, Oo64eva, Goclenius, FlaBot, Winhunter, Diza, Roboto de Ajvol, Pinecar, YurikBot, Encyclops, Htournyol, Piet Delport, Tony1, Red Jay, NeilN, DocendoDiscimus, A bit iy, SmackBot, Eskimbot, Mauls, Quidam65, Ohnoitsjamie, Hmains, Jcarroll, Nmacri, Chris the speller, Simon123,
Thumperward, Sadads, Nbarth, Famspear, Volphy, Grover cleveland, Tsop, Cybercobra, Bejnar, SashatoBot, Kuru, , Meco,
Dl2000, JDAWiseman, Hu12, JHP, Tony Fox, JRSpriggs, Typewritten, Jgunaratne, Cydebot, Odie5533, Avashnirvana, JohnClarknew,
SwissConsultant, Thijs!bot, Widefox, Gregalton, Ahq, Daytona2, Deective, Barek, Greensburger, Cloudz679, Flowanda, Gandydancer, Uriel8, R'n'B, PdR, 72Dino, Yonidebot, MoneyRates, 83d40m, VolkovBot, Butwhatdoiknow, McTavidge, A4bot, Crowne, Reibot, VartanM, Naohiro19 revertvandal, Zoogage, Lamro, S.rvarr.S, SieBot, Calabraxthis, Arbor to SJ, Artoasis, GregCampbellUSA,
Kouraloukou, Joe kinincha, Mtaylor848, Certayne, Mrfebruary, Z z zebra, ClueBot, Eciency576os, Ideal gas equation, Icarusgeek, Resoru, Besenok, El bot de la dieta, GFHandel, Wakari07, XLinkBot, Vineetalchemist, Addbot, Download, TheFreeloader, ~enwiki,
Sindinero, Gugustiuci, Gail, Zorrobot, Ettrig, Luckas-bot, Yobot, EdwardLane, Donfbreed, AnomieBOT, Angry bee, Jim1138, LetThemMintPaper, BasilSorbie, Xqbot, NOrbeck, Jeevesandwooster, Smallman12q, LucienBOT, Johnsmith9912, Ionutzmovie, Redrose64,
SynEx, Aquila Huang, DrKiranKalidindi, Agong1, TedderBot, BritishBankers, TexianPolitico, MicioGeremia, RjwilmsiBot, Raellerby,
EmausBot, Neun-x, Fwuensche, Erianna, Rangoon11, Satellizer, Statoman71, Lekrecteurmasque, Laura.rosner, Curb Chain, DBigXray,
Guest2625, BG19bot, Achowat, BattyBot, JYBot, Squid2180, Dv0rsky, Thomas Darcy McGee, TheIrishWarden, Ericm301, Natsailam,
Chanant.hk, Upfrom36chambers, Hairgelmare, Paum89, BeachComber1972, Kind Tennis Fan, Whizz40, Analyst123,
, Monkbot,
Billyshtsang, Studentttt and Anonymous: 184
Compound interest Source: http://en.wikipedia.org/wiki/Compound_interest?oldid=663855581 Contributors: Taral, Patrick, JohnOwens,
Michael Hardy, Ixfd64, Andres, Jengod, Markhurd, Taxman, Donreed, Altenmann, Psychonaut, Meelar, Giftlite, Frencheigh, MrSnow,
Fintor, Karl Dickman, Deebster, D6, Spiy sperry, Corvus~enwiki, Szabo, Notinasnaid, AlphaEtaPi, Bobo192, Wood Thrush, Dpaajones, Mikel Ward, Bawol, Gary, PaulHanson, Yamla, PAR, Versageek, Axeman89, Blaxthos, Akuchling, Brookie, Feezo, Meteoralv,
Woohookitty, Camw, Jhortman, G.hartig, Pdelong, Coemgenus, Salix alba, Algebra, Gurch, Intgr, Preslethe, NevilleDNZ, Bgwhite, Gwernol, The Rambling Man, YurikBot, Lofty, NawlinWiki, Moe Epsilon, Beanyk, Lcmortensen, Silverhill, Modify, GraemeL, CWenger,
Fsiler, Airodyssey, Alynder, SmackBot, Although, Vald, Erkowit, Pandion auk, Teimu.tm, Gilliam, Ohnoitsjamie, Skizzik, Jeretad, Octahedron80, Baronnet, Jxm, Zven, Nicolas.Wu, Darth Panda, Fmalan, Famspear, AussieLegend, Cybercobra, Wizardman, Jna runn,
Vina-iwbot~enwiki, Autopilot, Metric, Kuru, Bssc81, Mr Stephen, Dicklyon, BananaFiend, Brady8, UncleDouggie, Vladimir Baykov,
Lenoxus, AStudent, Lahiru k, SkyWalker, CmdrObot, Leakeyjee, Gravis 23, AndrewHowse, Dancter, Odie5533, Christian75, Teratornis,
Gnfnrf, Ebyabe, Spookpadda, Markber, Neilajh, Topquark170GeV, Slaweks, Dawnseeker2000, Gregalton, Nukemason, Alphachimpbot,
JAnDbot, Barek, Ikanreed, Magioladitis, VoABot II, Billybass, Jason Hommel, Thirlestane, 28421u2232nfenfcenc, User A1, Hbent, Ptrpro,
Retail Investor, Gowish, Tgeairn, Gthm159, UBeR, Uncle Dick, Ginsengbomb, Inking, Ibjoe, Kenkaye, Loanerpers, Compounder~enwiki,
Permarbor0, Bonadea, Postmako, Soliloquial, Philip Trueman, SueHay, Anonymous Dissident, Sintaku, Brunton, Meters, SQL, Aapacleb,
SveinMarvin, RJaguar3, Taggard, Anchor Link Bot, Tiredofscams, ClueBot, Cli, Victorio18, Mild Bill Hiccup, Jim 14159, JJMcVey,
Blanchardb, Cfsenel, Mathstudents, Razorame, Bobbytheonlyone, Kmangold, Fastily, Jurismedia, NellieBly, Fj217, Addbot, DOI bot,
Fieldday-sunday, Stariki, MrOllie, Download, Vivek2020, Jasper Deng, Ehrenkater, Lightbot, , Yobot, THEN WHO
WAS PHONE?, AnomieBOT, DemocraticLuntz, IRP, Chuckiesdad, Materialscientist, ArthurBot, Martnym, Abce2, Shirik, Financialprojections, Mzamora2, Oshoreaccount, Mnmngb, Alweth, Frozenevolution, Dragon741, NorthPark420, Pinethicket, PrincessofLlyr,
MJ94, Calmer Waters, VladimirBaykov, Jelson25, DixonDBot, Dinamik-bot, Duoduoduo, Hankston, Ripchip Bot, J36miles, Boogobooga,
Gfoley4, Thinktwins, Ziva David, PeanutButterBlues, Julienbarlan, Kchowdhary, ClueBot NG, Finnand80, Widr, SerjSagan, Merkelkd,
Oddbodz, Titodutta, DBigXray, Jko831, Monkeytwin, MusikAnimal, Mark Arsten, Snow Blizzard, Manoguru, Achowat, Chris51659,
David in Cincinnati, DonnieSwanson, Alexcurtis2012, Lugia2453, SFK2, Jamesx12345, Epicgenius, Mschmidt224, Shibalagu, RoscoWag,
CyberXRef, Jamalmunshi, Narendrapratap2228, Whikie and Anonymous: 440
Valuation (nance) Source: http://en.wikipedia.org/wiki/Valuation_(finance)?oldid=662121818 Contributors: Enchanter, Edward,
Michael Hardy, Fred Bauder, Ronz, Kaihsu, King brosby, Pfortuny, Dbroadwell, J heisenberg, Cool Hand Luke, Edcolins, Sam Hocevar, Pgreennch, Spizzwink, Xezbeth, Fenice, CanisRufus, Pearle, Poweroid, John Quiggin, Jonathan de Boyne Pollard, SDC, Stefanomione, BD2412, RCSB, Nneonneo, Feco, Lmatt, Bgwhite, RussBot, Tearlach, Zzuuzz, DocendoDiscimus, SmackBot, DWaterson,
Simon123, Ladislav Mecir, Mulder416, Master Scott Hall, RJN, Mion, Waggers, TastyPoutine, Levineps, Eastlaw, Mellery, Cydebot,
Chhajjusandeep, RkuipersNL, T4, JamesAM, BeL1EveR, Gregalton, Mcrain, .anacondabot, Hubbardaie, Accounting instructor, Utc-100,
Flowanda, FactsAndFigures, Largoplazo, DMCer, Bonadea, Squids and Chips, Funandtrvl, Chimpex, Urbanrenewal, Lamro, Dap242, Fredouil, Steven Zhang, LaidO, Busy Stubber, JusticeIvory, Rinconsoleao, HoulihanLokey, Niceguyedc, Boemmels, Physitsky, Doprendek,
SchreiberBike, Chakreshsinghai, DepartedUser4, Good Olfactory, Mergersguy, Addbot, MrOllie, Luckas-bot, Yobot, Nhsmith, Materialscientist, LilHelpa, Xqbot, TheAMmollusc, Erud, Mnmngb, Dbrandon30, Haeinous, Hannibal19, MastiBot, Dinamik-bot, Vukovic2,
EmausBot, HiMyNameIsFrancesca, Listmeister, ZroBot, Investor123, ClueBot NG, Aqeelzam, MerlIwBot, Helpful Pixie Bot, BG19bot,
BendelacBOT, Jeremy112233, Jiminycricket55, Wikiwizard57685 and Anonymous: 96
Valuation of options Source: http://en.wikipedia.org/wiki/Valuation_of_options?oldid=643477775 Contributors: Michael Hardy, Fintor,
MementoVivere, Leifern, Oleg Alexandrov, Ronnotel, Lmatt, RussBot, Kermit2, Crystallina, SmackBot, Bluebot, Sgcook, Hu12, Elchoco,
Cydebot, Alamibayat, VolkovBot, WebScientist, Cibergili, Finnancier, Arjunaraoc, PixelBot, Porphyro, Addbot, Yobot, Ptbotgourou,
Arkachatterjea, Mattias.sander, Erik9bot, Onlymuks, Peedeee, Kpjanes and Anonymous: 10
Black-Scholes Source: http://en.wikipedia.org/wiki/Black%E2%80%93Scholes_model?oldid=661687896 Contributors: The Anome,
Css, Enchanter, William Avery, Roadrunner, Gretchen, Olivier, Edward, Michael Hardy, Willsmith, Kwertii, Nixdorf, Tiles, Pcb21,
Williamv1138, Mydogategodshat, Justin73, Charles Matthews, Nohat, Dino, Viz, Jitse Niesen, Dcsohl, Jerzy, Robbot, Altenmann, Naddy,
Hadal, Pps, Wile E. Heresiarch, Connelly, Giftlite, Pretzelpaws, Leonard G., Tristanreid, Andycjp, Pgreennch, Fintor, TheObtuseAngleOfDoom, Domino~enwiki, Leyanese, H00kwurm, Bender235, Petrus~enwiki, Kimbly, Fenice, Gauge, Kwamikagami, Scrutcheld,
Bobo192, Cretog8, Cyclist, C S, Csl77, Chrisvls, CoolGuy, Leifern, LutzL, Geschichte, Landroni, Etrigan, Reubot, Andrew Gray, EmmetCauleld, Hadlock, Pontus, Wurmli, BDD, Oleg Alexandrov, Ercolev, Guy M, Splintax, SDC, Zzyzx11, Btyner, Marudubshinki,
Ronnotel, A Train, Rjwilmsi, Tangotango, Tawker, Ikelos, Danfuzz, Dudegalea, Feco, Syced, JanSuchy, Mathbot, Mathiastck, Lmatt,
Waagh~enwiki, YurikBot, Michael Slone, RussNelson, Grafen, Rjensen, Gareth Jones, Wlmsears, Schmock, Rajnr, Tony1, Elkman,

426

CHAPTER 19. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

Dan131m, Smaines, Vonfragino, Zophar, JahJah, Shawnc, Spliy, Fsiler, Kungfuadam, A bit iy, SmackBot, Nkojuharov, Tinz, Dpwkbw, IstvanWolf, Vvarkey, Oli Filth, Silly rabbit, CSWarren, Nbarth, Galizur, Smallbones, HLwiKi, Kcordina, Stevenmitchell, Jmnbatista, RJN, -Ozone-, Sgcook, Brianboonstra, Vina-iwbot~enwiki, JzG, John, Ulner, Smartyllama, Mgiganteus1, Goodnightmush, IronGargoyle, Beetstra, Mets501, Hu12, Stephen B Streater, A. Pichler, Aldanor, AdrianTM, CBM, Lithium6, Lehalle, Typewritten, FilipeS,
AndrewHowse, Cydebot, GRBerry, Michael C Price, DavidRF, PeterM~enwiki, Thijs!bot, Aquishix, JustAGal, Makreel, WallStGolfer31,
Gnixon, Sreejithk2000, Quarague, Deective, Yill577, Crocesso~enwiki, Magioladitis, Charlesreid1, EdwardLockhart, Tedickey, Notary137, A3nm, JaGa, Calltech, Daida~enwiki, Mrseacow, Tarotcards, Fish147, EconomistBR, Ontarioboy, HyDeckar, VolkovBot, GoldenPi, Akrouglo, Jameslwoodward, Lxtko2, Dr.007, Coder Dan, Saibod, MBret, WebScientist, Kbrose, Wing gundam, France3470, Ernie
shoemaker, Flyer22, Artoasis, Pls2000, DancingPhilosopher, Cibergili, S2000magician, Melcombe, Finnancier, Kanonkas, Gaschroeder,
WurmWoode, DragonBot, Tomeasy, Echion2, Thrymr, Razorame, Doprendek, Muro Bot, Brachester, Crowsnest, DumZiBoT, Johnbywater, Albambot, Addbot, DOI bot, Jaccard, Cst17, MrOllie, Protonk, LaaknorBot, Favonian, Odont, Ehrenkater, Lightbot, Goliat 43, SPat,
Yobot, Smallbones11, Novolucidus, Arkachatterjea, AnomieBOT, Materialscientist, Citation bot, Xqbot, AbigailAbernathy, Antoniekotze,
Mikc75, Supergrane, Kaslanidi, Alpesh24, Khagansama, FrescoBot, Mfwitten, Prasantapalwiki, Citation bot 1, Roberto.croce, Jigneshkerai89, Sebculture, MastiBot, Curtis23, Mr Ape, Trappist the monk, Avikar1, Gulbenk, Stochastic Financial Model, Islandbay, Taphuri,
RjwilmsiBot, Edouard.darchimbaud, EmausBot, Dewritech, Drusus 0, Alan m, Mewbutton, Zfeinst, Aberdeen01, Sysfx, Yassinemaarou,
Betternance, ClueBot NG, Pameis3, Minhaj.shaik, Kohzy, BarrelProof, Dan Rayn, Snotbot, Statoman71, Bitalgowarrior, Abpai, Indoorworkbench, Helpful Pixie Bot, DudeOnTheStreet, Barely3am, Kirti Khandelwal, BG19bot, BetterToBurnOut, Crougeaux, PleaseKING,
Parsiad.azimzadeh, Chinacat2002, BattyBot, Jlharrington, Artoacts, Adapter9, Enpc, Ogmark, Lemnaminor, Bkm71, Oishi1206, MaxEmilian, Aguo777, Nikolaschou, GiantPeachTime, Peter9002, Monkbot, ICC1812, KurtHeckman and Anonymous: 458
Putcall parity Source: http://en.wikipedia.org/wiki/Put%E2%80%93call_parity?oldid=654367563 Contributors: The Anome, Roadrunner, Pcb21, Justin73, Furrykef, Mike40033, Fintor, Jlang, Flyhighplato, Fenice, Sam Korn, Geschichte, Cburnett, Marudubshinki, Ronnotel, Feco, Ian Pitchford, Mathbot, Lmatt, Chobot, RussBot, Gaius Cornelius, Alias Flood, SmackBot, Nbarth, Smallbones, Alexxandros,
RJN, Sgcook, Ulner, Hu12, Cydebot, Colin Rowat, Nposs, Waltke, R'n'B, Nearaj, Wcspaulding, Solian en, Adrian two, Gerhard Schroeder,
Chimpex, Lamro, Finnancier, ClueBot, Addbot, Zorrobot, Yobot, LilHelpa, Xqbot, Vovchyck, RjwilmsiBot, EmausBot, ZroBot, Drusus
0, Zfeinst, DudeOnTheStreet, Shearyer and Anonymous: 54
Moneyness Source: http://en.wikipedia.org/wiki/Moneyness?oldid=664879768 Contributors: Taral, Enchanter, Graft, Michael Hardy,
Pcb21, Angela, Mydogategodshat, A5, Dmsar, Chris 73, Bbx, Acad Ronin, Fijimf, Fenice, Bhadani, FlaBot, Lmatt, Shell Kinney, GraemeL,
Shawnc, DocendoDiscimus, KnightRider~enwiki, SmackBot, Jphillips, JMSwtlk, Nbarth, A. B., Famspear, Doug Bell, Macrobbie, DiggyG,
Hu12, Korhantoker1, Cydebot, Jpr2000, GeneralBob, Xcalibus, BoogaLouie, EvanCarroll, Artoasis, Finnancier, Erudecorp, Tomeasy,
PixelBot, WikHead, Addbot, Ehrenkater, Luckas-bot, Camiower, Citation bot, Cosmiumiu, Pikiwyn, John of Reading, ZroBot, Scanlin,
Curb Chain, Kndimov, BattyBot, ChrisGualtieri, Ducknish, Joey95es, Vishnu.ACA, Alakzi and Anonymous: 45
Option time value Source: http://en.wikipedia.org/wiki/Option_time_value?oldid=656685108 Contributors: Enchanter, Michael Hardy,
Jay, Wik, Maximus Rex, Fintor, Acad Ronin, Fenice, Leifern, Woohookitty, Grammarbot, Feco, Who, Aaron Brenneman, GraemeL,
A Doon, Sardanaphalus, SmackBot, Jphillips, Smallbones, Sgcook, Hu12, Bkessler, Cydebot, SHCarter, GeneralBob, Adavidb, Ramnarasimhan, Anchor Link Bot, Finnancier, SchreiberBike, Ocdnctx, Download, Chzz, Yobot, Fender0107401, Brad22dir, Mpmchic, Cedjacket, Scanlin, Humanzgnome and Anonymous: 36
Intrinsic value (nance) Source: http://en.wikipedia.org/wiki/Intrinsic_value_(finance)?oldid=625072653 Contributors: Enchanter,
Michael Hardy, Julesd, Pgreennch, Fintor, Shanes, RoyBoy, JIP, Feco, Gurch, Srleer, RussBot, Arthur Rubin, Shawnc, SmackBot, ElectricRay, Vald, Vikramsidhu, Ladislav Mecir, Radagast83, Sgcook, Kuru, Sijo Ripa, Hu12, JHP, NaBUru38, Cydebot, Gogo Dodo, Larry
Lawrence, MER-C, Rumpelstiltskin223, Lamro, Rinconsoleao, JoePonzio, ClueBot, Rduinker, Addbot, MrOllie, Luckas-bot, Yobot, Fraggle81, Pohick2, AnomieBOT, Fender0107401, General agent, Mattis, FrescoBot, Yabanc, LearnK, 10metreh, GoingBatty, Tolly4bolly,
Sailsbystars, Investor123, Chinesefufou, Laterzii, Kcma95, Ugncreative Usergname, Shuvojamal, Rul3rOfW1k1p3d1a, Njasuja, Drstockorg, Travellllar, Watchdogzz and Anonymous: 32
Black model Source: http://en.wikipedia.org/wiki/Black_model?oldid=622005974 Contributors: Roadrunner, Edward, Michael Hardy,
Dori, Pcb21, Renamed user 4, Fintor, Klemen Kocjancic, DanielCD, Oleg Alexandrov, Ronnotel, Captain Disdain, Feco, Mathbot, Lmatt,
YurikBot, RussBot, Oli Filth, Sgcook, Ulner, Hu12, Cydebot, Cfries~enwiki, GeneralBob, PtolemyIV, Jimmycorp, Finnancier, XLinkBot,
Addbot, Yobot, Materialscientist,
, Felix Forgeron, EmausBot, Samcol1492, DudeOnTheStreet and Anonymous: 41
Finite dierence methods for option pricing Source: http://en.wikipedia.org/wiki/Finite_difference_methods_for_option_pricing?
oldid=627652099 Contributors: Michael Hardy, Fintor, Ronnotel, Rjwilmsi, Lmatt, Hmains, Ulner, Cydebot, Demize, Calliopejen1, MrOllie, Citation bot, Citation bot 1, Islandbay, RjwilmsiBot, Helpful Pixie Bot, CitationCleanerBot, Monkbot and Anonymous: 10
Variance gamma process Source: http://en.wikipedia.org/wiki/Variance_gamma_process?oldid=639353066 Contributors: Michael
Hardy, Benwing, Bender235, Arthena, Rjwilmsi, Schmock, Arthur Rubin, Memming, Ulner, Wdevauld, Rlendog, Melcombe, Kmcallenberg, Mwbaxter, Yobot, Angry bee, Mattias.sander, Filof76, RjwilmsiBot, SporkBot, Mathstat, Narkissosarmani, Hcsexton and Anonymous: 9
Heath-Jarrow-Morton framework Source: http://en.wikipedia.org/wiki/Heath%E2%80%93Jarrow%E2%80%93Morton_framework?
oldid=662851939 Contributors: Michael Hardy, Gabbe, Giftlite, Christofurio, Fintor, Bender235, Pontus, Afelton, Schmock, Ms2ger,
Nielses, DocendoDiscimus, RandomProcess, Robma, CmdrObot, Quantyz, Bonjeroo, Adavidb, MatthieuL, Whtsmith, Ernie shoemaker,
Karsten11, Finnancier, MagnusPI, Addbot, Tide rolls, RobertHannah89, Yobot, DARTH SIDIOUS 2, FosterBoondoggle, Dewritech, Helpful Pixie Bot and Anonymous: 25
Heston model Source: http://en.wikipedia.org/wiki/Heston_model?oldid=648234864 Contributors: Michael Hardy, Jitse Niesen, Phil
Boswell, Arthena, Pinball22, Ronnotel, Gareth Jones, Schmock, Terber, SmackBot, Ulner, Chiinners, Hu12, Cydebot, Ttiotsw, Erxnmedia, DavidCBryant, Sebquant, Melcombe, Avenged Eightfold, Yobot, Pit3001, FrescoBot, Citation bot 1, Pinethicket, RjwilmsiBot,
Lechgrzelak, Sgmu, Aberdeen01, FeralOink, Gene.panov, Eric.benhamou.pricingpartners, Monkbot and Anonymous: 34
Monte Carlo methods for option pricing Source: http://en.wikipedia.org/wiki/Monte_Carlo_methods_for_option_pricing?oldid=
649835924 Contributors: Enchanter, Michael Hardy, Charles Matthews, Christofurio, Khalid hassani, Fintor, Rich Farmbrough, Pontus, Woohookitty, Ronnotel, Rjwilmsi, Lmatt, Gdrbot, Encyclops, SmackBot, Bluebot, Ulner, Collect, P199, Hu12, Iridescent, Harej bot,
Nshuks7, JaGa, Ekotkie, Lamro, Finnancier, Dthomsen8, MrOllie, Kalbasa, FrescoBot, Islandbay, Dewritech, Zfeinst, Rocketrod1960,
Astridpowers, Armanschwarz and Anonymous: 23

19.1. TEXT

427

Fuzzy Pay-O Method for Real Option Valuation Source: http://en.wikipedia.org/wiki/Fuzzy_pay-off_method_for_real_option_

valuation?oldid=527539777 Contributors: Michael Hardy, Fintor, Lmatt, Malcolma, Ulner, Dancter, Mild Bill Hiccup, Yobot, Mikc75,
Erik9bot, Hmainsbot1 and Anonymous: 8
Volatility (nance) Source: http://en.wikipedia.org/wiki/Volatility_(finance)?oldid=663172175 Contributors: Taral, Fredbauder, Enchanter, William Avery, Ryguasu, Michael Hardy, Pcb21, Emperorbma, Charles Matthews, Phil Boswell, Brw12, ShaunMacPherson,
Christofurio, Karol Langner, Pgreennch, Bender235, Calair, Andrewpmack~enwiki, BrokenSegue, Jerryseinfeld, John Fader, Landroni,
Orzetto, Eric Kvaalen, Arthena, Walkerma, SKL, Pontus, Oleg Alexandrov, LARS, KKramer~enwiki, Btyner, Ronnotel, Yurik, Rjwilmsi,
Baeksu, FlaBot, Ground Zero, Margosbot~enwiki, Wongm, Tedder, YurikBot, Canadaduane, Gareth Jones, Cleared as led, Lajiri,
GraemeL, Allens, Innity0, That Guy, From That Show!, DocendoDiscimus, KnightRider~enwiki, SmackBot, Jphillips, Rtc, Honza Zruba,
Martinp, Ohnoitsjamie, Chris the speller, Nbarth, Complexnance, RJN, Byelf2007, Kuru, Jimmy Pitt, Babakmd, Hu12, Quaeler, Fvasconcellos, CmdrObot, Innohead, PeterM~enwiki, Volatility Professor, JAnDbot, Barek, A quant, Mtd2006, Ehdr, Pt johnston, Helon, Jewzip,
Showeropera, Nburden, Ask123, UnitedStatesian, Zhenqinli, Lamro, Bdemeshev, Wushi-En, S.rvarr.S, Thobitz, Melcombe, Finnancier,
Denisarona, Cumulant, Eeekster, Qwfp, XLinkBot, Addbot, Catofgrey, Favonian, Tassedethe, Yobot, KamikazeBot, Bearas, Merube 89,
Kingpin13, Kyng, Biem, FrescoBot, Hobsonlane, Tarc87, Time9, UweD, Swerfvalk, DominicConnor, Mayerwin, D15724C710N, AvicAWB, Marishik88, PaulTheOctopus, ClueBot NG, Qarakesek, Statoman71, Helpful Pixie Bot, Volatiller, SteSus85, Pablete85, Alfazagato, IraChestereld, Berklabsci, OccamTheRazor, Rrenicker1, FinancePublisher, Tradedia, EnzaiBot, 3awil, Docirish7, Lawrenceradburn,
Shearyer, Kind Tennis Fan, Mtr98, ChinnarajaC Nithisa and Anonymous: 148
Volatility smile Source: http://en.wikipedia.org/wiki/Volatility_smile?oldid=655466359 Contributors: Enchanter, Roadrunner, SimonP,
Michael Hardy, Zanimum, Dori, Pcb21, JohnH~enwiki, Vespristiano, Rorro, Kasprowicz, Stern~enwiki, Christofurio, Beland, Elroch,
Fintor, Duja, Cretog8, Jerryseinfeld, Zachlipton, Arthena, Brian Merz, GregorB, Ronnotel, Magister Mathematicae, Ian Pitchford, Mathbot, Lmatt, YurikBot, Wknight94, Open2universe, SmackBot, Vald, Nbarth, Sgcook, Ulner, Hu12, JoeBot, Vectro, Cydebot, Brianegge,
EdJohnston, SteloKim, Magioladitis, EdwardLockhart, Pt johnston, Maproom, Finnancier, Mactuary, ProfessorTarantoga, XLinkBot,
Anticipation of a New Lovers Arrival, The, Addbot, Equilibrium007, Yobot, AnomieBOT, Piloter, LucienBOT, Dcshank, Hisabness, Autoreplay, Nikossskantzos, Durn1818, Vergeman, Waynehi, SPECIFICO, Uriah Sheba, Wiki.vbs.redlof, Interzone826, Daniel.roufael and
Anonymous: 81
Implied volatility Source: http://en.wikipedia.org/wiki/Implied_volatility?oldid=631377781 Contributors: Pcb21, Nikai, Jerryseinfeld,
Leifern, Arthena, Ceyockey, Oleg Alexandrov, Ronnotel, Bill37212, Salix alba, Feco, Mathbot, Lmatt, DanMS, Gareth Jones, Crasshopper, GraemeL, Shawnc, Bfair, DocendoDiscimus, SmackBot, Jphillips, RandomProcess, Bluebot, Oli Filth, Ulner, Hu12, Davidryan168,
Highgamma, Cydebot, ST47, Drudru, Magioladitis, CyberSco, Pt johnston, Lars67, Pitilessbronze, Henry Delforn (old), S2000magician,
Behshour, Finnancier, Ustaudinger, Mild Bill Hiccup, Besenok, Qwfp, XLinkBot, Addbot, Favonian, Luckas-bot, AnomieBOT, NOrbeck,
Raotel, Citation bot 1, Skyerise, Jadair10, Skakkle, DerHias, UweD, Freedom2live, Durn1818, Wikiguru2011, Volatiller, SPECIFICO,
Cipherman, Mark viking and Anonymous: 66
Net volatility Source: http://en.wikipedia.org/wiki/Net_volatility?oldid=631436317 Contributors: Ronnotel, Salix alba, Grafen, SmackBot, Cydebot, Finnancier, AlexandrDmitri, Oracleofottawa, John of Reading and Anonymous: 1
Value at risk Source: http://en.wikipedia.org/wiki/Value_at_risk?oldid=664966160 Contributors: Christian List, Ramin Nakisa, Edward,
Michael Hardy, Glinos, Pnm, TakuyaMurata, Mydogategodshat, Charles Matthews, Markhurd, Didickman, Dpbsmith, Juro, Gandalf61,
Ashley Y, Daniel Dickman, Giftlite, Marcika, Bnn, Pgreennch, DomCleal, Fintor, Ukexpat, MementoVivere, Random user, Leibniz,
ArnoldReinhold, Bender235, Elwikipedista~enwiki, Bobo192, Cmdrjameson, Jigen III, Alansohn, DenisHowe, Arthena, Euphrosyne, Oleg
Alexandrov, Woohookitty, Ruziklan, EcoMan, BD2412, Grammarbot, Rjwilmsi, JanSuchy, FlaBot, Mathbot, CarolGray, Gurch, YurikBot, RussBot, Htournyol, Jimmyshek, Knowledge2, Eco, Zwobot, Avraham, InsideNoize333, SmackBot, Stie, KelleyCook, Schmiteye, Chris the speller, Oli Filth, Aimsoft, Sadads, CSWarren, Nbarth, AdamSmithee, Smallbones, RBecks, Kuru, Euchiasmus, Luizabpr,
Nutcracker, MTSbot~enwiki, Hu12, IvanLanin, Pelotas, A. Pichler, Aldanor, AlbertSM, Pete5, ShelfSkewed, Outriggr, Cydebot, PamD,
Thijs!bot, Jafcbs, N5iln, X96lee15, RobotG, Nshuks7, Seaphoto, Dvunkannon, Jcsellak, RDSeabrook, Protip, Wdevauld, R'n'B, Plasticup, SJP, HyDeckar, DMCer, Uaqeel, Broadbot, LeaveSleaves, Zain Ebrahim111, Forlornturtle, Lamro, Riskbooks, Snehalkanakia, Artoasis, Vice regent, Tigergb, ClueBot, Geomatster, Zurich Risk, Aj.nch, Letournp, Sydal~enwiki, DumZiBoT, XLinkBot, Porphyro, Tsancoso, Jgonion, Addbot, Xp54321, Willking1979, MrOllie, Lightbot, Yobot, AnomieBOT, AaCBrown, TheAMmollusc, Barcturus, Alch0,
Doulos Christos, Lprideux, Jeanine Leuckel, Adler.fa, Fortdj33, Scientiae Defensor, Khamgatam, Duoduoduo, 360Portfolios, Etrader,
MithrandirAgain, SporkBot, TheEmanem, Cmathio, Zfeinst, ChuispastonBot, ClueBot NG, Snotbot, Indoorworkbench, Helpful Pixie Bot,
BrassensG, Markadamsbfc, BattyBot, M.daryalal, Makecat-bot, ATomS q, GabeIglesia, Neytchev, Docirish7, Sol1, Thatupiso, Brand39,
Arj.shiv, Monkbot, Sososorry, Novastage and Anonymous: 191
Greeks (nance) Source: http://en.wikipedia.org/wiki/Greeks_(finance)?oldid=664878562 Contributors: The Anome, Enchanter,
Miguel~enwiki, Roadrunner, Edward, Michael Hardy, Pcb21, Glenn, Mydogategodshat, Justin73, Jitse Niesen, Joy, ZimZalaBim, J heisenberg, Bnn, Macrakis, Pgreennch, Fintor, Vivacissamamente, Bender235, Shanes, Cretog8, Gxti, Geschichte, Alfanje~enwiki, Laug,
JordanSamuels, Firsfron, Woohookitty, Josephw, Mandarax, Ronnotel, BD2412, Mtpruitt, 334a, Thoreaulylazy, Gaius Cornelius, Voidxor,
Crasshopper, FF2010, Zophar, GraemeL, A Doon, Fsiler, Selmo, DocendoDiscimus, SmackBot, Eskimbot, Vercalos, Oli Filth, Nbarth,
Jdthood, Smallbones, KaiserbBot, Mkoistinen, Ulner, Bssc81, Slakr, Hu12, 137 0, Yaris678, WallStGolfer31, Kidakaka, Arisofalaska,
Hbent, Philip Maton, STBot, Qatter, Octopus-Hands, WinterSpw, Je G., DavidBrahm, Qxz, BeIsKr, Lamro, SieBot, Psemper~enwiki,
Rr2419, Ernie shoemaker, Jackycwong, Finnancier, ClueBot, The Thing That Should Not Be, Tomeasy, Shabbychef, Razorame, Nairbv,
7, XLinkBot, Avoided, Addbot, Rshiller, Ichase1, Lpele, Northp, Glane23, Ehrenkater, Yobot, AnomieBOT, IDangerMouse, Harryemeric,
Moneyneversleeps, Libbyscooter, Louperibot, Dealer01, Hisabness, Gizbic, Fox Wilson, Kerfue090, RjwilmsiBot, Skamecrazy123,
EmausBot, Dewritech, Freedom2live, , Peralmq, FinancialRisk, ClueBot NG, Jenito, Indoorworkbench, Helpful Pixie Bot, Jhansbo,
Pavelbenesch, BendelacBOT, Kndimov, Fancitron, BattyBot, ChrisGualtieri, Khazar2, Lfdder, Cup of cocoa, Francois-Pier, JWillette,
Bbergero, Fededeo, Wyliechan and Anonymous: 230
Convenience yield Source: http://en.wikipedia.org/wiki/Convenience_yield?oldid=631432527 Contributors: Darkwind, Arthena, Salix
alba, SmackBot, Bluebot, Mitsuhirato, AJR 1978, Chhajjusandeep, Olivcm, Pundit, Ikajo, Addbot, GrouchoBot, Erik9bot, Ripchip Bot,
Snotbot and Anonymous: 14
Monte Carlo method Source: http://en.wikipedia.org/wiki/Monte_Carlo_method?oldid=663165906 Contributors: William Avery, Ramin
Nakisa, Edward, K.lee, JohnOwens, Michael Hardy, Tim Starling, Lexor, Pcb21, Ellywa, Ronz, Nanshu, Snoyes, Mark Foskey, BAxelrod,
Popsracer, Charles Matthews, Jitse Niesen, Zoicon5, Marcofalcioni, Furrykef, Taxman, Dogface, Philopp, EldKatt, Jeq, Pibwl, Altenmann, Aniu~enwiki, Bkell, Moink, Wile E. Heresiarch, Dylanwhs, Giftlite, Gtrmp, Rs2, BenFrantzDale, Tom harrison, Levin, Fastssion,

428

CHAPTER 19. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

Hokanomono, Dratman, Kmote, Bensaccount, Poupoune5, Duncharris, Andrea Parri, Pne, KaHa242, Zuidervled, Karol Langner, AndrewKeenanRichardson, Pinguin.tk~enwiki, Pgreennch, Fintor, DMG413, Andreas Kaufmann, Canterbury Tail, Rich Farmbrough, Misha
Stepanov, Paul August, Bender235, AlfredR, Elwikipedista~enwiki, *drew, Superninja, Rjmccall, Bobo192, Cretog8, Aspuru, John Vandenberg, Blotwell, Flammifer, Boredzo, Zr40, Sam Korn, Nsaa, Storm Rider, Jrme, Nagasaka, Denis.arnaud, Elpincha, Jason Davies, Vipuser, Atlant, ABCD, Here, Tiger Khan, Forderud, Nuno Tavares, Shreevatsa, Broquaint, Pol098, Male1979, Btyner, Stefanomione, Ronnotel, BD2412, Coneslayer, Rjwilmsi, Digemedi, Mathbot, Maxal, Pete.Hurd, Goudzovski, Kri, Chobot, DVdm, Bgwhite, Kummi, YurikBot,
Wavelength, Hawaiian717, KSmrq, SpuriousQ, Jugander, Greenyoda, Aznrocket, EEMIV, Ott2, Masatran, Redgolpe, GraemeL, Nelson50,
Banus, Samratvishaljain, Itub, SmackBot, Apanag, Martinp, Aardvark92, Ddcampayo, Renesis, Stimpy, Gilliam, Ohnoitsjamie, Skizzik,
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Mikael V, Tawkerbot2, ILikeThings, Cm the p, Oneboy, CRGreathouse, Zureks, Frozen sh, Ezrakilty, Andkore, Davnor, Mattj2, Cydebot,
Mblumber, Splash6, TicketMan, Alanbly, Narayanese, Thijs!bot, Richie Rocks, Headbomb, Knordlun, LeoTrottier, Odoncaoa, Urdutext,
Criter, Gkhan, JAnDbot, Maylene, Inrad, Quentar~enwiki, IanOsgood, Kroese, Adfred123, Kibiusa, Magioladitis, VoABot II, Maxentrope, Albmont, Hubbardaie, Avicennasis, Vgarambone, Jackal irl, Boob, David Eppstein, Stevvers, Spellmaster, PaulieG, Theron110,
R'n'B, Pbroks13, Aferistas, Jorgenumata, Thr4wn, Lhynard, ThomasNichols, M-le-mot-dit, Policron, MoonDJ, TXiKiBoT, Qxz, Lambyte,
Lerdthenerd, Bmaddy, Janpedia, Dmcq, Twooars, Kenmckinley, RexJacobus, Tooksteps~enwiki, Darkrider2k6, Dawn Bard, Cython1,
Flyer22, Uwmad, Joey0084, Dhateld, Ddxc, Edstat, PeterBoun, OKBot, Cibergili, BillGosset, Tesi1700, Melcombe, PlantTrees, Rinconsoleao, Agilemolecule, Dundee-scalaer, StewartMH, ClueBot, JavaManAz, Thirteenity, GeneCallahan, Ggia, Jsarratt, LizardJr8, PaulxSA,
Sankyo68, Mathcount, ManchotPi, Kimys, C628, Banano03, ERosa, Qwfp, Jamesscottbrown, BConleyEEPE, Gnowor, SilvonenBot,
Avalcarce, A.Cython, Dsimic, Tayste, SKelly1313, Addbot, TomFitzhenry, Gruntfuterk, BenTrotsky, MrOllie, Download, Nvartaniucsd,
Qadro~enwiki, Lightbot, Luckas-bot, Yobot, OrgasGirl, Ptbotgourou, TaBOT-zerem, Sweetestbilly, Stefanez, AnomieBOT, Ds53, Rubinbot, Duck ears, Grestrepo, Amritkar, RWillwerth, Citation bot, Phluid61, Fritsebits, ArthurBot, MauritsBot, UBJ 43X, VoseSoftware,
P99am, Sdietric, Tyrol5, Mlpearc, Richard.decal, Jacobleonardking, Veszely, Alliance09, AlexBIOSS, Nagualdesign, FrescoBot, MaxHD,
Ironboy11, Mnath, Damistmu, Citation bot 1, ChicagoActuary, Gryllida, Mbryantuk, Drsquirlz, Amkilpatrick, Diannaa, MicioGeremia,
Marie Poise, Mean as custard, RjwilmsiBot, TjBot, Snegtrail, Techhead7890, Spotsaurian, EmausBot, Beatnik8983, Rivanvx, Oceans
and oceans, Martombo, Isthmuses, Rcsprinter123, Glosser.ca, Donner60, Bomazi, Davikrehalt, RockMagnetist, 97, ClueBot NG,
Toughpkh, Gareth Grith-Jones, BeRewt, Lee Sau Dan, Deer*lake, X-men2011, Herath.sanjeewa, Jorgecarleitao, Helpful Pixie Bot, Behinddemlune, J.Dong820, Bibcode Bot, Jayjaybillings, BG19bot, Jwchong, DianeSteele, PhnomPencil, Chafe66, Crougeaux, Rodo82, Seasund, Chip123456, Chrisriche, Pdelmoral, Astridpowers, ChrisGualtieri, Saltwolf, Unknomics, JesseAlanGordon, Compsim, Mbmneuro,
Dexbot, Vividstage, Cerabot~enwiki, Datta research, Rygo796, Sjoemetsa, Hugh.medal, Keith.a.j.lewis, Sinia ubrilo, David.conradie,
, MaxSchumacher, Robinfhill, Mehr86, Monkbot, Retirementplan io, REH7, Michelle Ridomi, Urbanisimo1234, Apeterlein, MrBElbert, Asorsimo, KasparBot and Anonymous: 372
Local volatility Source: http://en.wikipedia.org/wiki/Local_volatility?oldid=664820560 Contributors: Roadrunner, Michael Hardy, Tristanreid, Pontus, Gene Nygaard, Woohookitty, Btyner, Ronnotel, Rjwilmsi, Babakmd, Cydebot, Magioladitis, Jarry1250, Stephennt,
Jluu~enwiki, Lamro, Fragrant, Slowbro, Finnancier, Addbot, LaaknorBot, Yobot, LilHelpa, Piloter, Bin TAN, HeenG, Jigdo and Anonymous: 31
Stochastic volatility Source: http://en.wikipedia.org/wiki/Stochastic_volatility?oldid=662447255 Contributors: Enchanter, Roadrunner,
Michael Hardy, Willsmith, Mu, Leifern, Benna, Firsfron, Woohookitty, Bluegrass, Btyner, Ronnotel, Lmatt, Wavelength, SmackBot, Ulner,
Chiinners, A. Pichler, CmdrObot, Cydebot, Seanhunter, Froufrou07, Hopefully acceptable username, Asperal, Finnancier, Niceguyedc,
Mevalabadie, MystBot, Addbot, Kiril Simeonovski, DominicConnor, ZroBot, Zfeinst, Hulbert88, SteSus85, TheJJJunk, Limit-theorem,
Teich50, Docirish7, Shearyer and Anonymous: 39
SABR Volatility Model Source: http://en.wikipedia.org/wiki/SABR_volatility_model?oldid=660738341 Contributors: Michael Hardy,
Willsmith, LeYaYa, Fintor, Rich Farmbrough, JordanSamuels, Btyner, Ronnotel, Vegaswikian, Schmock, Moe Epsilon, Tony1, Ilmari
Karonen, SmackBot, Cydebot, Hltommy2, PDFbot, ProfessorTarantoga, Ppablo1812, XLinkBot, BetFut, MicioGeremia, John Shandy`,
BG19bot, TheJJJunk, Analyst123 and Anonymous: 29
Foreign exchange option Source: http://en.wikipedia.org/wiki/Foreign-exchange_option?oldid=659807788 Contributors: Edward,
Pcb21, Gadum, Fintor, Poccil, Dominic, Versageek, Jfr26, Chochopk, SDC, Waldir, Lmatt, Dharesign, Tony1, GraemeL, DocendoDiscimus, SmackBot, Vald, Paxse, Ohnoitsjamie, Anwar saadat, Nbarth, Smallbones, KaiserbBot, Sgcook, Igorn, , Hu12,
Cydebot, Tapir Terric, Lfstevens, Severo, Tedickey, GeneralBob, Niwat19, Icecold1, VolkovBot, Je G., Stephennt, Takeiteasyfellow,
Finnancier, Uncle Milty, Auntof6, Mayurun, Dthomsen8, Addbot, Pit3001, CXCV, Erik9bot, DixonDBot, Nikossskantzos, Marrante,
Wikipelli, K6ka, 4blossoms, Yassinemaarou, ClueBot NG, Ramillav, Helpful Pixie Bot, Imwithcow, Andrewelle1 and Anonymous: 64
Chooser option Source: http://en.wikipedia.org/wiki/Chooser_option?oldid=580863991 Contributors: Discospinster, Xezbeth, Lockley,
SmackBot, John, Ulner, Cydebot, Lamro, DoctorKubla, TCMemoire and Anonymous: 2
Basis (options) Source: http://en.wikipedia.org/wiki/Basis_trading?oldid=522388763 Contributors: A i s h2000, SmackBot, Stevage, Cydebot, Jon Mayes, PKT, Severo, Addbot, Eladsinned, Erik9bot, Killian441, Molestash, SPECIFICO and Anonymous: 3
Callable bull/bear contract Source: http://en.wikipedia.org/wiki/Callable_bull/bear_contract?oldid=579148813 Contributors: Oblivia,
RHaworth, Josh Parris, Rjwilmsi, SmackBot, Sadads, Ricky@36, Ulner, Cydebot, R'n'B, Lamro, Addbot, Yobot, AnomieBOT, J04n,
Shadowjams, FrescoBot, Redrose64, Skyerise and Anonymous: 2
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Anonymous: 2
Bond option Source: http://en.wikipedia.org/wiki/Bond_option?oldid=662756040 Contributors: Roadrunner, Michael Hardy, Ringomassa, Icairns, Fintor, Lectonar, RexNL, Lmatt, Stephen Compall, DocendoDiscimus, Crystallina, Sgcook, Cydebot, Road Wizard, Chhajjusandeep, Hypersphere, Severo, R'n'B, Artaxiad, Funandtrvl, Zain Ebrahim111, Vickyadvani, Lamro, Finnancier, ClueBot, PixelBot,
Addbot, Yobot, Deepaknmr, Citation bot, Piloter, Jatinderjit, Zfeinst, Helpful Pixie Bot, Cwagner2011 and Anonymous: 23
Warrant (nance) Source: http://en.wikipedia.org/wiki/Warrant_(finance)?oldid=663407267 Contributors: Enchanter, Edward, Mic,
Ronz, Ehn, Taxman, Nurg, DocWatson42, Kelson, Porges, D6, Notinasnaid, Abelson, Fenice, Kooma, Leifern, HasharBot~enwiki,
Civvi~enwiki, Arthena, RJFJR, Japanese Searobin, Woohookitty, Merlinme, Ronnotel, Sybren~enwiki, Koavf, Feco, Cjusticehk, FlaBot,

19.1. TEXT

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Ground Zero, Gurch, Bigdottawa, YurikBot, RussBot, Clib, Spike Wilbury, A i s h2000, AnaTo, Tjamesjones, DocendoDiscimus, SmackBot, PeterSymonds, KaragouniS, Jdthood, Can't sleep, clown will eat me, Mulder416, Chandrasekhart, DavidSol, Nageshk, A.R., Sgcook,
Vina-iwbot~enwiki, AB, JHunterJ, Fuzzy510, Hu12, The Letter J, Mellery, CmdrObot, Geo8rge, R9tgokunks, Old Guard, Cydebot, Burgwerworldz, Truc Tran, Thijs!bot, NigelR, Dereckson, Gcm, MER-C, Greensburger, Nposs, CliC, Ayonbd2000, MarceloB, Jasonnoguchi,
Wcspaulding, Toon05, Sigmundur, Baronvonmone, Idioma-bot, Tathaeco, Lamro, SieBot, AS, Finnancier, Hesi7, Joaitheamhain, Martarius, ClueBot, EoGuy, Muhandes, Addbot, Mouwen, Plilient, Drkazmer, Chzz, Lightbot, Luckas-bot, Bungofpot, AnomieBOT, Gnomeliberation front, Makks2010, SecondMarket, Inc., RibotBOT, FrescoBot, EBespoke, Oashi, Gulbenk, Sargdub, EmausBot, John of Reading,
AvicBot, White Trillium, FBIMON, Investingterms, Snoeks78, ClueBot NG, Snotbot, Finance1234, Notoriousgorilla, DavidLeighEllis,
WeRegretToInform, Gracelinprathaban and Anonymous: 109
Option screener Source: http://en.wikipedia.org/wiki/Option_screener?oldid=655337368 Contributors: Woohookitty, Ronnotel, RussBot, SmackBot, Hmains, John, Beetstra, Hu12, Cydebot, Glennchan, GeneralBob, Shlomosh, Subodh subu, Lamro, Finnancier, JL-Bot,
SchreiberBike, Bert847, Lightbot, AnomieBOT, FrescoBot, Difu Wu, Sargdub, DorreenR, Scanlin, BG19bot and Anonymous: 14
Reverse convertible securities Source: http://en.wikipedia.org/wiki/Reverse_convertible_securities?oldid=644942029 Contributors: Edward, Bkonrad, Woohookitty, Rjwilmsi, Ground Zero, RussBot, Jaysbro, SmackBot, B3rnd, Lbbzman, Dl2000, StephenBuxton, Alaibot,
Yewlongbow, Fetchcomms, Cander0000, CliC, R'n'B, Lamro, AlleborgoBot, Gbzia, Dan943, Addbot, Ronhjones, Mgmt10uci2008,
MuZemike, Lgrosner, TechBot, OgreBot, Mdavis6890, Blueman01, Riverpa, John of Reading, Ikiwdq55, Makecat-bot and Anonymous:
11
Option style Source: http://en.wikipedia.org/wiki/Option_style?oldid=664412604 Contributors: Enchanter, Roadrunner, Edward, Michael
Hardy, Willsmith, David Martland, Pcb21, Renamed user 4, Marc omorain, Wmahan, MarkSweep, Sam Hocevar, Fintor, Neko-chan, Ignignot, Babomb, Gxti, C S, Cmdrjameson, Leifern, Atlant, RJFJR, JordanSamuels, Woohookitty, Mikedelong, G.W., Marudubshinki, Ronnotel, Grammarbot, Josh Parris, Wragge, Lmatt, Encyclops, RussBot, Bhny, Anomalocaris, Zeno of Elea, Emfraser, Woscafrench, GraemeL,
DocendoDiscimus, SmackBot, Jphillips, Olejasz, Bluebot, Nbarth, Sgcook, JzG, Euchiasmus, Ulner, Hu12, Valoem, Cydebot, WallStGolfer31, EdwardLockhart, GeneralBob, Enivid, ToyotaPanasonic, Lamro, SieBot, Lightmouse, Finnancier, Tigergb, Seeker1900, DumZiBoT, Tjemme, Addbot, MrOllie, Mad scientist03, Yobot, TaBOT-zerem, AnomieBOT, Kshakhna, FrescoBot, Citation bot 1, KBello,
Alpha7248, Ekren, Limit-theorem and Anonymous: 83
American option Source: http://en.wikipedia.org/wiki/Option_style?oldid=664412604 Contributors: Enchanter, Roadrunner, Edward,
Michael Hardy, Willsmith, David Martland, Pcb21, Renamed user 4, Marc omorain, Wmahan, MarkSweep, Sam Hocevar, Fintor,
Neko-chan, Ignignot, Babomb, Gxti, C S, Cmdrjameson, Leifern, Atlant, RJFJR, JordanSamuels, Woohookitty, Mikedelong, G.W.,
Marudubshinki, Ronnotel, Grammarbot, Josh Parris, Wragge, Lmatt, Encyclops, RussBot, Bhny, Anomalocaris, Zeno of Elea, Emfraser,
Woscafrench, GraemeL, DocendoDiscimus, SmackBot, Jphillips, Olejasz, Bluebot, Nbarth, Sgcook, JzG, Euchiasmus, Ulner, Hu12, Valoem, Cydebot, WallStGolfer31, EdwardLockhart, GeneralBob, Enivid, ToyotaPanasonic, Lamro, SieBot, Lightmouse, Finnancier, Tigergb,
Seeker1900, DumZiBoT, Tjemme, Addbot, MrOllie, Mad scientist03, Yobot, TaBOT-zerem, AnomieBOT, Kshakhna, FrescoBot, Citation
bot 1, KBello, Alpha7248, Ekren, Limit-theorem and Anonymous: 83
European option Source: http://en.wikipedia.org/wiki/Option_style?oldid=664412604 Contributors: Enchanter, Roadrunner, Edward,
Michael Hardy, Willsmith, David Martland, Pcb21, Renamed user 4, Marc omorain, Wmahan, MarkSweep, Sam Hocevar, Fintor,
Neko-chan, Ignignot, Babomb, Gxti, C S, Cmdrjameson, Leifern, Atlant, RJFJR, JordanSamuels, Woohookitty, Mikedelong, G.W.,
Marudubshinki, Ronnotel, Grammarbot, Josh Parris, Wragge, Lmatt, Encyclops, RussBot, Bhny, Anomalocaris, Zeno of Elea, Emfraser,
Woscafrench, GraemeL, DocendoDiscimus, SmackBot, Jphillips, Olejasz, Bluebot, Nbarth, Sgcook, JzG, Euchiasmus, Ulner, Hu12, Valoem, Cydebot, WallStGolfer31, EdwardLockhart, GeneralBob, Enivid, ToyotaPanasonic, Lamro, SieBot, Lightmouse, Finnancier, Tigergb,
Seeker1900, DumZiBoT, Tjemme, Addbot, MrOllie, Mad scientist03, Yobot, TaBOT-zerem, AnomieBOT, Kshakhna, FrescoBot, Citation
bot 1, KBello, Alpha7248, Ekren, Limit-theorem and Anonymous: 83
Asian option Source: http://en.wikipedia.org/wiki/Asian_option?oldid=645123322 Contributors: Edward, Pcb21, Rich Farmbrough,
Arthena, Rjwilmsi, Nbarth, Kuru, Ulner, Cydebot, Barek, Oceanynn, Addbot, Adrian 1001, LaaknorBot, Yobot, KamikazeBot, Quebec99, Mattias.sander, Citation bot 1, Hisabness, RjwilmsiBot, ZroBot, Winstoncabra, Bibcode Bot, TheJJJunk and Anonymous: 23
Callable bond Source: http://en.wikipedia.org/wiki/Callable_bond?oldid=580864922 Contributors: The Anome, Choster, Fintor, Art
LaPella, Jerryseinfeld, Wikidea, Isnow, Borgx, RussBot, Filippof, Allens, DocendoDiscimus, Adulteress, Slbrownhk, Ulner, Cydebot,
TheSix, Lamro, Mifter, Addbot, Bunnyhop11, Paine Ellsworth, EmausBot, ZroBot, Factman25, Kilopi, Titodutta, Erathouis, Guptagate
and Anonymous: 19
Puttable bond Source: http://en.wikipedia.org/wiki/Puttable_bond?oldid=647895588 Contributors: Fintor, Courcelles, Cydebot, Technogreek43, Fayenatic london, Lamro, SieBot, Addbot, Luckas-bot and Anonymous: 6
Exchangeable bond Source: http://en.wikipedia.org/wiki/Exchangeable_bond?oldid=578957032 Contributors: Gregbard, Chhajjusandeep, Urbanrenewal, Lamro, Alcatrank, Jimgrantham, Addbot, Luckas-bot, DrilBot and Anonymous: 6
Convertible bond Source: http://en.wikipedia.org/wiki/Convertible_bond?oldid=659031008 Contributors: Edward, Mydogategodshat, Charles Matthews, Taxman, Robbot, UtherSRG, Ludraman, Chowbok, Rdsmith4, Pgreennch, Kevin Rector, Faderrattnerb,
JamesTeterenko, Random contributor, Bender235, Fenice, Art LaPella, C S, Maurreen, Gseebohm, Jerryseinfeld, Lightdarkness, Versageek, Cometopapa, Isnow, Ronnotel, Chobot, YurikBot, RussBot, RJC, Jaysbro, SmackBot, Billyf1, Chris the speller, Bluebot, Thewiikione, Ulner, Hu12, Apterygial, Gregbard, Cydebot, Barticus88, Krookey, Schmassmann, J.delanoy, Rickburnes, Funandtrvl, Swatiquantie, Eliptis, Lambyte, Urbanrenewal, Lamro, SieBot, Finnancier, ImageRemovalBot, Postmortemjapan, Rjd0060, Rosuav, OccamzRazor, Somno, DragonBot, Jimgrantham, Tom Sauce, Sun Creator, Arjayay, Mysmp, Addbot, Poco a poco, Pietrow, Luckas-bot, Vinayaksgcib, Galoubet, Xqbot, Shiju.johns, Resident Mario, Sector001, Fortdj33, Paine Ellsworth, Jonkerz, WikitanvirBot, Leeqin, Dewritech,
RA0808, Ida Shaw, AvicAWB, Jenito, Frietjes, Kwetal1, AllanKristopher, IjonTichyIjonTichy, Jodosma, AlphabetaD and Anonymous:
75
Futures exchange Source: http://en.wikipedia.org/wiki/Futures_exchange?oldid=655230431 Contributors: The Anome, Enchanter, SimonP, BryceHarrington, Edward, Kwertii, Julesd, Renamed user 4, Fuzheado, Jni, Aetheling, Cyrius, Zigger, Gzornenplatz, RayBirks,
Monkeyman, Vsmith, Vapour, Pearle, Gene Nygaard, Conskeptical, Firsfron, -oo0(GoldTrader)0oo-, Chochopk, Privacy, Bluemoose,
Ronnotel, Rjwilmsi, Ryk, Lendorien, Hairy Dude, Retired username, Jpbowen, Amakuha, Open2universe, SMcCandlish, Tiger888, DocendoDiscimus, SmackBot, Septegram, Hmains, Dingar, Patricksewell, Marcushan, Kellyprice, Sgcook, Kuru, Ghw777, MarcButterly, Z
E U S, Hu12, Typelighter, Joseph Solis in Australia, HongQiGong, Menswear, Maslakovic, CmdrObot, Zarex, Cydebot, Chhajjusandeep,
Cricketgirl, Brianegge, Epbr123, Davidhorman, SusanLesch, JAnDbot, Scbomber, Magioladitis, Zewill, Indu Singh, JaGa, Nameweb,

430

CHAPTER 19. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

GeneralBob, VirtualDelight, PCock, Pplata, Oceanynn, Chikinsawsage, Nomi887, Kamanathan, Funandtrvl, Heheman3000, Wordsmith,
Zain Ebrahim111, Dikhatiwada, Devenkshah, Ftindia, Yone Fernandes, Int21h, Usfedavid, Youaresocool, Conant Webb, Evitavired,
Alcatrank, Grazfather, ClueBot, Zippymobile, Afrique, Andyp1847, Noneforall, DumZiBoT, Bobknowitall, Addbot, Thrybe, MrOllie,
Alanscottwalker, LarryJe, Lightbot, Yobot, Arkachatterjea, Ponticalibus, Srich32977, Danapple, Shattered Gnome, Mattis, Mikie
yorkie, Haeinous, HamburgerRadio, Lotje, Eddiequest, Keegscee, Sargdub, Torontokid2006, Tfadams, EmausBot, GoingBatty, JTW4,
KoningToon, ClueBot NG, Mr. Glengarry Glen Ross, Yabyumluckie, Glacialfox, ChrisGualtieri, AbstractIllusions, BeachComber1972,
Monkbot and Anonymous: 136
Margin (nance) Source: http://en.wikipedia.org/wiki/Margin_(finance)?oldid=663081766 Contributors: The Anome, William Avery, Doradus, GreatWhiteNortherner, Centrx, Jackol, Gscshoyru, RickScott, Edave10, V79, Gary, Geraldshields11, OwenX, oo0(GoldTrader)0oo-, Bernburgerin, Wikiklrsc, Holek, Drrngrvy, Mordien, Kevinhksouth, Adam1213, RussBot, Bovineone, Spike
Wilbury, Nirvana2013, Yabbadab, GraemeL, VodkaJazz, Tom Morris, DocendoDiscimus, Sardanaphalus, SmackBot, Jphillips, Chairman S., Gilliam, Chris the speller, Colonies Chris, Mitsuhirato, Stevenmitchell, Get mahim, The PIPE, Tesseran, Gloriamarie, Kuru,
Loadmaster, Bschoeni, Dl2000, Hu12, Lucy-marie, Chris55, Frisbeebomber, Andreas Willow, Codingmasters, Fanscomp, AntiVandalBot, AZard~enwiki, PhilKnight, Mcubebrooklyn, Equitymanager, Joshua Davis, PCock, Donmike10, Idioma-bot, Funandtrvl, Szesetszedziesitsze, Netsumdisc, Klip game, Lamro, Agentq314, Anchor Link Bot, TrGordon, Denisarona, RegentsPark, ClueBot, Dufourspitze, Addbot, Ronhjones, CarsracBot, M sotirov, Luckas-bot, Yobot, Beeswaxcandle, Neptune5000, Obersachsebot, Xqbot, Rjcyer,
Inferno, Lord of Penguins, Bellerophon, Thehelpfulbot, Tangent747, VS6507, Haeinous, DixonDBot, Yunshui, Vovchyck, RjwilmsiBot,
Orphan Wiki, WikitanvirBot, Limninal, Swerfvalk, GoingBatty, GullyFoyle2008, Doris Lethbridge-Stewart, ZroBot, F, Fko, Rcsprinter123, Donner60, Petrb, ClueBot NG, BarrelProof, Joefromrandb, Statoman71, Heidi Wikman, MironGainz, CitationCleanerBot,
Onlymuks, Rndmnss, BattyBot, ChrisGualtieri, K7L, Antunesi, Mustafaokur, Kamal455 and Anonymous: 145
Spread trade Source: http://en.wikipedia.org/wiki/Spread_trade?oldid=663929098 Contributors: Kwertii, Brookie, OwenX, LOL,
SmackBot, Kukini, Iridescent, Mattisse, Potzy, SieBot, Addbot, PatrickFlaherty, Noq, GouZi, Sargdub, Matvey Ezhov, Sepersann, Widr,
Kgm326, Artashes Kardashyan, Edmond8674 and Anonymous: 18
Bid-oer spread Source: http://en.wikipedia.org/wiki/Bid%E2%80%93ask_spread?oldid=631383760 Contributors: The Anome,
Miguel~enwiki, Edward, Earth, Gabbe, Charles Matthews, SEWilco, Robbot, Manuel Anastcio, CharlieZeb, Poccil, R6144, DCEdwards1966, Landroni, Anthony Appleyard, Wdfarmer, Tvh2k, SteinbDJ, Salix alba, Feco, FlaBot, Schandi, YurikBot, Nirvana2013,
Farmanesh, Tony1, GraemeL, LeonardoRob0t, Ogo, DocendoDiscimus, SmackBot, Jphillips, AnOddName, Hectorguinness, Simon123,
AndrewRT, Chrylis, Kuru, Khazar, Robosh, Nagle, Thijs!bot, Createur, Wai Wai, AntiVandalBot, Liquid-aim-bot, Ephery, JAnDbot,
28421u2232nfenfcenc, Sfgiantsbu, Aleksander.adamowski, SueHay, Klip game, Lamro, RoyalFX, Tmcinish, Stepheng3, Addbot, Lightbot, Yobot, Macbao, FFFFFunit, Richbook, Triangle eater, Chepurko, Serious222, WikitanvirBot, Zfeinst, Financestudent, Jomalongo,
Nikos 1993, Badon, Wierzcho and Anonymous: 55
Over-the-counter (nance) Source: http://en.wikipedia.org/wiki/Over-the-counter_(finance)?oldid=656572429 Contributors: Mav, Edward, VeryVerily, T6435bm, Jni, RickBeton, Inkling, RScheiber, MBisanz, Davidruben, Mdkarazim, Jerryseinfeld, Pearle, Hooperbloob,
Yeu Ninje, Mysdaao, BD2412, Sybren~enwiki, Jweiss11, Commando303, FlaBot, Naraht, Ground Zero, Lmatt, Chobot, YurikBot, RussBot, Nirvana2013, Voidxor, Zwobot, GraemeL, NeilN, Rayngwf, DocendoDiscimus, SmackBot, Eskimbot, Gilliam, Ohnoitsjamie, Chris
the speller, DHN-bot~enwiki, Sbharris, A. B., Rlevse, Modest Genius, Monad21, Sgcook, Beetstra, Peterbr~enwiki, Hu12, Iridescent,
Yhager, JHP, CapitalR, Atlantix, Cydebot, Future Perfect at Sunrise, Kozuch, Kubanczyk, Edupedro, Nick Number, TuvicBot, JAnDbot, JamesBWatson, Redboylabs, R'n'B, Oceanynn, VolkovBot, Zain Ebrahim111, Lamro, Why Not A Duck, SieBot, BotMultichill,
Finnancier, ClueBot, Swellsman, Snaeha, Niceguyedc, OccamzRazor, Jbaphna, Do DueDiligence, Excirial, Lizreed61, Mpizzo34, Addbot,
Some jerk on the Internet, MrOllie, Qwertyqwerty999, VP-bot, Luckas-bot, Lolyckan, AnomieBOT, Chelry, Materialscientist, Danno uk,
Obersachsebot, Xqbot, Urbansuperstar~enwiki, Korvin2050, Haeinous, Oashi, Westmorlandia, Blacksabbath4343, TylerFinny, Sargdub,
EmausBot, Kwds, Swayback Maru, Finance C, ZroBot, MRBigdeli, Jack Greenmaven, Emisanle, Binafhmz, Jabaquara, Alderonarino,
Kkumaresan26, Idc209, Meteor sandwich yum, LegalTrivia and Anonymous: 107
Normal backwardation Source: http://en.wikipedia.org/wiki/Normal_backwardation?oldid=652966149 Contributors: Mav, PierreAbbat,
Ellmist, Heron, Braunbaer~enwiki, Jni, Fudoreaper, Bhyde, Dratman, Christofurio, Chameleon, Rworsnop, SURIV, RayBirks, Sotapan,
Rich Farmbrough, Hooperbloob, Keenan Pepper, Splat, Cdc, Bobrayner, Pfalstad, Marudubshinki, Rjwilmsi, Helvetius, Tony1, Qero, DocendoDiscimus, Jsnx, SmackBot, Kevin Ryde, Nbarth, Yanksox, Mitsuhirato, Radagast83, AJR 1978, JohnI, Alexthe5th, Trey, THF,
N2e, Cydebot, Brianegge, Nick Number, Just Chilling, Ssirupa, Jackmass, Sm8900, Andante1234, VolkovBot, LokiClock, Lfstevens.us,
Lamro, Riick, VVVBot, EmanWilm, ImperfectlyInformed, Ignorance is strength, Kevinarpe, DumZiBoT, Pedroecha, Jgonion, Addbot,
Ehrenkater, West Corker, Rubinbot, Robinr22, Bob Burkhardt, LilHelpa, Xqbot, Goallllll1, Full-date unlinking bot, WikitanvirBot, Shadiakiki1986, Skix, AboutSilver, Tango303, Centroidal radius and Anonymous: 54
Credit risk Source: http://en.wikipedia.org/wiki/Credit_risk?oldid=654899406 Contributors: Christian List, Edward, Pnm, Zeno Gantner, Ronz, Charles Matthews, Tempshill, Didickman, Pakaran, Phil Boswell, Fredrik, Altenmann, Justanyone, Rholton, Daniel Dickman,
Akella, Quarl, DomCleal, Mormegil, Wrp103, ArnoldReinhold, Flxmghvgvk, Jerryseinfeld, Arthena, Lightdarkness, Melaen, Bsadowski1,
Woohookitty, Isnow, Sachindole, Intgr, Chobot, WriterHound, YurikBot, Cquan, Paolonalin, GraemeL, SmackBot, Mauls, Winglow, Aimsoft, KaiserbBot, Memming, DinosaursLoveExistence, MikeJAC, Gokmop, DMacks, Lambiam, Kuru, Alfredxz~enwiki, Hu12, LeyteWolfer, Ale jrb, N2e, Outriggr, WeggeBot, Killa2003, Mojo Hand, RobotG, WinBot, Gioto, Gregalton, Fayenatic london, JAnDbot,
Mattpaterson, Pkmilitia, Retail Investor, Athaenara, LinkSpamCop, DMCer, Jaccowiki, Verochio, VolkovBot, Huntingtonjbear, Shals01,
Themcman1, Lamro, Fadiann, Kenpirok, PJGarvey, Dvandeventer, NHRHS2010, Regregex, Leirith, ToePeu.bot, Diazfrancisca, Artoasis,
Finnancier, Savvysoft, ClueBot, Ewawer, Blanchardb, Sun Creator, BOTarate, SoxBot III, Attaboy, Engi08, Jennnyyyp, Mitch Ames,
Addbot, Binary TSO, Cst17, Download, 84user, Luckas-bot, Themfromspace, Rubinbot, Message From Xenu, Citation bot, Piloter,
NigelAshford, GrouchoBot, RibotBOT, Shadowjams, FrescoBot, Ashi7044, Jen Svensson, MicioGeremia, DARTH SIDIOUS 2, Sh zhu,
Kelseyhowarth, Amychenfei, Erianna, ChuispastonBot, Riskrisk, ClueBot NG, Onarposozzem, Redraiders203, Jjw119, Helpful Pixie Bot,
JohnChrysostom, Anindya m 1982, Nerrad eel, Ionutgradinaru, FeralOink, MichaelW01, SjGlMm, Bigbigbigbang, Tahoepark, Frosty,
Riteshmathur, Joei005, Loulougreen, Peter9002, Monkbot, Bankingeditor, Vik2000 and Anonymous: 131
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Edward, Michael Hardy, Pnm, Ronz, Renamed user 4, Grendelkhan, Nurg, Niteowlneils, Christofurio, Fenice, Diomidis Spinellis,
Cmdrjameson, Jerryseinfeld, Arcenciel, Cmprince, Kelly Martin, OwenX, Igny, Ronnotel, Rjwilmsi, Feco, JanSuchy, Ground Zero,
RexNL, Apwhite, Skierpage, Bgwhite, RussBot, Peter, DocendoDiscimus, SmackBot, Vald, Boston2austin, Ben.douglas@btinternet.com,
Spiritia, Ulner, Meinertsen, Cdosoftware, Nutcracker, TastyPoutine, Hu12, Publisher@creditux.com, Neelix, Gaurav2323, Cydebot,
Chhajjusandeep, Hippypink, Alaibot, Legis, Kozuch, JamesAM, Thijs!bot, AntiVandalBot, Yonatan, SummerPhD, Gregalton, Beru7,

19.1. TEXT

431

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Sethop, Leon Byford, Finnancier, Evitavired, Blackwong, The Thing That Should Not Be, Davidovic, Alexbot, PixelBot, Enerelt, XLinkBot,
USmarcomm, Addbot, Badaribi, Buildingsaferproducts, Kiril Simeonovski, Yobot, Ptbotgourou, Synchronism, AnomieBOT, Piper387,
PizzaofDoom, Neurolysis, Xqbot, Shiju.johns, Greghm, X17bc8, Cgersten, Oashi, PigFlu Oink, Hessamnia, RjwilmsiBot, Peaceray,
H3llBot, Erianna, ClueBot NG, CaptainGumby, Princedeb123, Tom Pippens, Fotoriety, ChrisGualtieri, Jfmagana and Anonymous: 158
Credit default swap Source: http://en.wikipedia.org/wiki/Credit_default_swap?oldid=659789453 Contributors: Taral, SimonP, Ramin
Nakisa, Edward, Nealmcb, Michael Hardy, Fred Bauder, Mic, Ronz, JASpencer, Hashar, Charles Matthews, Juxo, Tpbradbury, Taxman,
Jeq, Jni, Phil Boswell, Auric, Mervyn, Sternthinker, Elconde, BenFrantzDale, Timpo, P.T. Aufrette, Dratman, Allstar86, Jabowery,
Tristanreid, Neilc, Alexf, Bolo1729, OldZeb, Beland, CSTAR, Elektron, Rich Farmbrough, Rhobite, ArnoldReinhold, YUL89YYZ, LindsayH, Vhadiant, Diomidis Spinellis, Coolcaesar, Reiska, Giraedata, Jerryseinfeld, Tritium6, Leifern, Spitzl, Polarscribe, L33th4x0rguy,
Uucp, Palea~enwiki, HenryLi, Pulkit, Bobrayner, Jberkes, OwenX, Woohookitty, Guy M, Benbest, Lovingboth, Wikiklrsc, GregorB,
SDC, J M Rice, Igor47, Kbdank71, Mlewan, Rjwilmsi, Koavf, Robotwisdom, Helvetius, MZMcBride, Brighterorange, JanSuchy, Wragge,
FlaBot, Ground Zero, Bondwonk, Czar, Sperxios, Chobot, Wavelength, RussBot, Trondtr, Cartan, Manop, Mavaction, Dysmorodrepanis~enwiki, Cmdrbond, Tinlash, Rjlabs, Pcuk, Zwobot, Ospalh, Vlad, Smaines, Wknight94, 21655, Abune, Shawnc, Smithj, Fsiler, Per
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Peterbr~enwiki, TastyPoutine, Abe.Froman, Hu12, Keisetsu, Andygoneawol, Eastlaw, Amniarix, JForget, Edward Vielmetti, Nunquam
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Klaas1978, Headbomb, Aadal, Nshuks7, SummerPhD, Jim whitson, Dr who1975, Credema, Mikemacman, Yellowdesk, JAnDbot, Barek,
Lan Di, Eurobas, Filnik, GoodDamon, Camerojo, LanceCross, Magioladitis, Jaysweet, VoABot II, Appraiser, Smooth0707, Ling.Nut,
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Madhero88, Zain Ebrahim111, Lamro, Tracerbullet11, Eehellre, AlleborgoBot, Barkeep, Tpb, Swliv, BotMultichill, Quasirandom, Jvs,
Investroll, Lightmouse, Authoress, Sethop, Wyattmj, Leon Byford, Finnancier, WebSurnMurf, Evitavired, Shmiluwill, ClueBot, Rdouglas2007, Catsqueezer, Terets, DragonBot, Campoftheamericas, Deselliers, Alexbot, HHHEB3, Sun Creator, Arjayay, DO56, Jfew, Rutland Square, Muro Bot, Gnickett1, Anual, XLinkBot, Nathan Johnson, Rror, Dthomsen8, MagnusA, RP459, Unvarnishedtruth, MystBot,
Sixtyninefourtyninefourtyfoureleven, BrianDaubach10, Deineka, Addbot, Deepmath, Geitost, MrOllie, Download, CarsracBot, Mikenlesley, Ld100, Tassedethe, 84user, TaxHappy, Luckas-bot, Yobot, TaBOT-zerem, Donfbreed, Nallimbot, QueenCake, Extremepro, FeydHuxtable, AnomieBOT, DerivMan, VanishedUser sdu9aya9fasdsopa, Keithbob, Sz-iwbot, GordonGross, Ulric1313, Flewis, Mervyn Emrys, Jblasdel, JohnnyB256, Geregen2, Ajb2029, ArthurBot, Quebec99, LilHelpa, Amys995, Dataleft, Stewartj76, LegalTech, Obersachsebot, Xqbot, EdWiller, Tripodian, Boothebear, Ytchuan, Capricorn42, Bfrenkel, Jasper50, Ponticalibus, Piloter, J JMesserly, Almabot,
DerryTaylor, Greghm, Omnipaedista, Khaderv, Banquer, 7spinner, X17bc8, Mayank.singhi, Andyyso, PM800, Dan Wylie-Sears 2, FrescoBot, Unstable-equilibrium, Rkjackso, Sanjaykankaria, Smusser, Cronos12, Mboumlouka, Workingsmart, Citation bot 1, CRoetzer, LittleWink, Bidaskspread, Sebculture, Cmlong, Gruntler, Calpass, Corbyboo, Trappist the monk, Blahfasel, Cds casey, Gzorg, WikiTome,
Ammodramus, Skakkle, Jc kortekaas apotheker, RjwilmsiBot, Rwmcm, EmausBot, Hedychium, Marieduville, WikitanvirBot, Peterjleahy,
Quantanew, Dewritech, GoingBatty, Feckler account, Ctk56, Cecody, Aur, ZroBot, John Cline, M colorfu, Bamyers99, Monterey Bay,
Nudecline, Uspastpresentwatch2010, Dsg101, Financestudent, ClueBot NG, Cntras, Rick AUT, Helpful Pixie Bot, Oklahoma3477, Curb
Chain, BG19bot, Penmark, JohnChrysostom, Bill carson, Financial Sense, Cashowtrader, Amacob, Mitchitara, BattyBot, Principesa01,
Con Dailys BL1Y, Dlefcoe, ChrisGualtieri, Calivaan45, LApple2011, Prub79, Nunibad, BeachComber1972, Riteshmathur, I am One of
Many, Ln23nen, Peter9002, Monkbot and Anonymous: 464
Credit linked note Source: http://en.wikipedia.org/wiki/Credit-linked_note?oldid=631824217 Contributors: Edward, Michael Hardy,
Robbot, Yosri, Christofurio, Circeus, Sl, Ethereal, Feco, Mukkakukaku, Smaines, Closedmouth, DocendoDiscimus, Vald, Chris the speller,
KaiserbBot, Hotblaster, TastyPoutine, MrBoo, Gregbard, Barticus88, SummerPhD, Hillgentleman, R'n'B, Tikiwont, Useight, VolkovBot,
Murphy99, Dendodge, Zain Ebrahim111, Lamro, Phe-bot, Evitavired, Alexbot, Addbot, ArthurBot, Thehelpfulbot, NofM, ArmbrustBot
and Anonymous: 19
Collateralized debt obligation Source: http://en.wikipedia.org/wiki/Collateralized_debt_obligation?oldid=663195600 Contributors:
Roadrunner, Edward, Michael Hardy, Earth, Ixfd64, Cherkash, Rl, Choster, Topbanana, Jeq, Nurg, David Gerard, DocWatson42, ShaunMacPherson, Horatio, Tristanreid, Utcursch, ConradPino, Ary29, Pgreennch, Eliazar, Jaberwocky6669, Longhair, Clawson, Giraedata,
Jerryseinfeld, Tritium6, Aphor, Wikidea, LARS, Oblivia, OwenX, Woohookitty, LOL, Chopstickkitty, Puersh101, Imersion, Fleisher,
Rjwilmsi, Bondwonk, Chobot, Porkchop, RussBot, FrenchIsAwesome, Masamunecyrus, Grafen, VinceBowdren, Neumeier, EEMIV,
Superwombatgoddess, Kermit2, Johndburger, Open2universe, Phil Holmes, DocendoDiscimus, SmackBot, Alex1011, Od Mishehu,
Vald, Canthusus, RandomProcess, Ohnoitsjamie, Hmains, JennyRad, Sirex98, Nbarth, Zven, Stevenmitchell, Chrerick, Lambiam, DHR,
Davidt67, Cdosoftware, Saval, Financist, Beetstra, Dicklyon, TastyPoutine, Hu12, Ukgroover, Publisher@creditux.com, Deetdeet, Harold
f, Eastlaw, Seniorreporter, CmdrObot, Bigdaddyedward, Edward Vielmetti, Bezer, N2e, Cumulus Clouds, Neelix, Elambeth, Cydebot,
Gogo Dodo, Jneuenhaus, Quibik, JoshHolloway, Kyle J Moore, Dawnseeker2000, AntiVandalBot, SummerPhD, Ksaliba, Darklilac, Yellowdesk, Puvdaddy, JAnDbot, HillelCaplan, Instinct, GurchBot, Dougbreault, VoABot II, Jem38, Recurring dreams, KConWiki, Mannyishere, M8al, Sm8900, Fiachra10003, SU Linguist, Xdarkrex, Edmunddantes~enwiki, Tsachin, Toanke, Scott Illini, Apophos, Inetpup,
VolkovBot, BoogaLouie, HarrisonScott, Christiantom, Cpdo, UnitedStatesian, Kdsingh98, Zain Ebrahim111, Lamro, Farcaster, JMWester,
Roger Jeurissen, SieBot, Jezzacanread, Gerakibot, Laurasmith76, Jh98105, Jreans, Authoress, Bombastus, Dimorsitanos, S2000magician,
Wyattmj, Finnancier, ClueBot, Avenged Eightfold, Rdouglas2007, Auntof6, Barlie, NJGW, DumZiBoT, XLinkBot, Johnny43d, Avik
pram, Resurchin, Addbot, Flemieux, MrOllie, Egw1119, Lukestarr, Gregweitzner, TaxHappy, Luckas-bot, Yobot, Legobot II, Mknywiki, AnomieBOT, VanishedUser sdu9aya9fasdsopa, 1exec1, Literarycpa, Whjijiwaiwai, Keldomahge, Xqbot, Capricorn42, RibotBOT,
Modailkoshy, Kaslanidi, Dvink, Legion23, Markvisser, Citation bot 1, LittleWink, Olivepickle, RedBot, Trappist the monk, RoadTrain, BeebLee, Shibanz, RjwilmsiBot, EmausBot, John of Reading, Greenback101, Richparisi, Z4ngetsu, KCBrooks, ClueBot NG,
Redraiders203, Lekrecteurmasque, BlackRock CEO, BG19bot, Mcfoster217, Meatsgains, Dewiniaid, Polmandc, BattyBot, Wildfowl, Arttechlaw, ChrisGualtieri, Onepebble, ComfyKem, HaroldvDaalen, Andres Possee, Glins1, Monkbot, Exiguity, TavWiki and Anonymous:
295
Collateralized loan obligation Source: http://en.wikipedia.org/wiki/Collateralized_loan_obligation?oldid=663109771 Contributors:
Nurg, Graeme Bartlett, Christopher Parham, SmackBot, Lohad55, BeenAroundAWhile, Cydebot, DMCer, Funandtrvl, VolkovBot, Ur-

432

CHAPTER 19. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

banrenewal, Clivemacd, Addbot, Luckas-bot, Yobot, Piano non troppo, RjwilmsiBot, Helpful Pixie Bot, BG19bot, Sth48, Holmanoneill
and Anonymous: 15
Single-tranche CDO Source: http://en.wikipedia.org/wiki/Single-tranche_CDO?oldid=663140301 Contributors: Michael Hardy, Topbanana, Phil Boswell, SmackBot, Hmains, Betacommand, Chris the speller, Hu12, Neelix, SummerPhD, Martun, Robina Fox, Magioladitis, Sm8900, SagaciousAWB, Fiachra10003, Oceanynn, Hersfold, JL-Bot, Addbot, Fluernutter, WhyDoIKeepForgetting, Erik9bot and
Anonymous: 10
Total return swap Source: http://en.wikipedia.org/wiki/Total_return_swap?oldid=662118828 Contributors: Edward, Everyking, Christofurio, Fenice, Jerryseinfeld, Leifern, Dexio, Rjwilmsi, FlaBot, Vina-iwbot~enwiki, Ulner, Hu12, Cydebot, Wescbell, Authoress,
Finnancier, Evitavired, Priestman622, Mneisen, PixelBot, Elunah, XLinkBot, Addbot, Ettrig, Gongshow, Kingpin13, ArthurBot, Xqbot,
PigFlu Oink, RjwilmsiBot, EmausBot, Lupkoehl, CitationCleanerBot, Rsoni9 and Anonymous: 46
Constant maturity credit default swap Source: http://en.wikipedia.org/wiki/Constant_maturity_credit_default_swap?oldid=591725770
Contributors: Michael Hardy, Jeodesic, Hjweth, Cydebot, Barticus88, R'n'B, CreditQuant, Piloter and Anonymous: 1
Collateralized mortgage obligation Source: http://en.wikipedia.org/wiki/Collateralized_mortgage_obligation?oldid=656684537 Contributors: Edward, Angela, Nurg, DataSurfer, Daniel Brockman, Tristanreid, Mpearl, Rich Farmbrough, Longhair, PaulHanson,
Pkonigsberg, Alai, Rjwilmsi, Topstar, Wavelength, Porkchop, RussBot, Rodasmith, Anomie, Seanjacksontc, DocendoDiscimus, Simon123, Robosh, Sakuraz, TastyPoutine, CmdrObot, Hebrides, Monger187, Dawnseeker2000, SummerPhD, Epischedda, Gregalton,
Ashvin.chougule, Rich257, Sm8900, R'n'B, PrestonH, Helle55953, Bosoxrock, Lamro, Evil iggy1936, Mightybeancounter, Mujep4,
Alexlimo, Finnancier, ClueBot, Snigbrook, Boing! said Zebedee, Fivesided, Sun Creator, DumZiBoT, Firebat08, Anticipation of a New
Lovers Arrival, The, Addbot, Sdtrams, Kvandersluis, Download, Egw1119, Tassedethe, Frehley, Yobot, Xqbot, Cheesepedia, FrescoBot,
HeatherSmitheld, Ghtaylor, Winstonhyypia, Jacobisq, Khazar2, Glins1 and Anonymous: 63
Interest rate risk Source: http://en.wikipedia.org/wiki/Interest_rate_risk?oldid=632629824 Contributors: Edward, Pnm, Ronz, Samw,
Andrewman327, Bearcat, Poszwa~enwiki, Bobblewik, Absinf, Arthena, Daranz, Woohookitty, SDC, Sachindole, RxS, JanSuchy, RussBot,
Rjlabs, Paolonalin, That Guy, From That Show!, DocendoDiscimus, Teeeim, Bluebot, Jayanta Sen, Smallbones, KaiserbBot, Byelf2007,
Kuru, Highpriority, Hu12, IvanLanin, N2e, Outriggr, Cydebot, Grifmeister, Najro, Chickenhawk32, Escarbot, RobotG, Gregalton,
Flowanda, Pauly04, R'n'B, Katharineamy, VolkovBot, Lamro, Dvandeventer, Regregex, Abortz, Gavotte Grim, Thamilton2, LeadSongDog, Finnancier, Tomeasy, Namruts, Engi08, Addbot, LaaknorBot, Pietrow, Rubinbot, Materialscientist, FrescoBot, IO Device, , MicioGeremia, Sargdub, SharafBot, EmausBot, ZroBot, OlivierMoreau, Pun, Umeraziz, Riskrisk, ClueBot NG, Filing Flunky, Litterbug1,
ChrisGualtieri, Bilorv, Camtheroc and Anonymous: 34
Interest rate derivative Source: http://en.wikipedia.org/wiki/Interest_rate_derivative?oldid=653670102 Contributors: Edward, Michael
Hardy, Pcb21, Charles Matthews, SWAdair, Fintor, Fenice, Bobo192, Pearle, Arthena, Caulds, Woohookitty, Bluemoose, Lfchuang,
Danielfranciscook, Yamamoto Ichiro, YurikBot, Gareth Jones, Arthur Rubin, NYArtsnWords, DocendoDiscimus, SmackBot, Anwar saadat, Smallbones, Meinertsen, Stuarthill, Hu12, Amakuru, Cydebot, Future Perfect at Sunrise, Escarbot, Ex-Nintendo Employee, Losttheory, Feeeshboy, Rich257, CliC, Finnancier, Sumeetakewar, Ratesquant, Addbot, Mortense, Malin Tokyo, Citation bot, LilHelpa, Piloter, 78.26, Amit1law, 478jjjz, Lancastle, Joshnnie, Bamyers99, ClueBot NG, Widr, Helpful Pixie Bot, ChrisGualtieri, Kkumaresan26
and Anonymous: 43
Forward rate agreement Source: http://en.wikipedia.org/wiki/Forward_rate_agreement?oldid=648024847 Contributors: WojPob, Edward, Charles Matthews, Rasmus Faber, Rich Farmbrough, Fenice, R. S. Shaw, .:Ajvol:., Jerryseinfeld, Pearle, Ruziklan, Lfchuang,
Sybren~enwiki, AySz88, FlaBot, YurikBot, Htournyol, ArmadniGeneral, DocendoDiscimus, Sardanaphalus, SmackBot, Stie, Kuru, Ulner, Quaeler, KyraVixen, Cydebot, Thijs!bot, Magioladitis, Njrwilson, Gjgjgj, Jtedor, Vickyadvani, Tpb, SieBot, Simon Watson, Addbot,
Zorrobot, Fraggle81, Xqbot, Shiju.johns, Morten Isaksen, Erik9bot, NoldorinElf, Dinamik-bot, Sargdub, EmausBot, WikitanvirBot, Ajraddatz, Matthiasheymann, Sideburnpete, Gatechjon, ClueBot NG, JoaoPedroNeto and Anonymous: 51
Interest rate future Source: http://en.wikipedia.org/wiki/Interest_rate_future?oldid=664148292 Contributors: Joy, Robert Weemeyer,
Kevin Rector, Fenice, Pearle, SDC, Gareth Jones, EverettColdwell, DocendoDiscimus, SmackBot, Stie, Anwar saadat, , Pelotas,
Cydebot, Colin Rowat, R'n'B, Berean Hunter, Addbot, AnomieBOT, Unstable-equilibrium, Wikiphile1603, Vovchyck, Ripchip Bot, Egg
Centric, ChrisGualtieri, Isarra (HG), JWillette, Brianrisk and Anonymous: 17
Interest rate option Source: http://en.wikipedia.org/wiki/Interest_rate_option?oldid=629146020 Contributors: Edward, Pcb21, Greenrd,
Rich Farmbrough, Fenice, SmackBot, Anwar saadat, Cydebot, Alaibot, Kortaggio, Erik9bot, FrescoBot, QKXM, MVS.VAMSIDHAR,
Colonycat and Anonymous: 5
Interest rate swap Source: http://en.wikipedia.org/wiki/Interest_rate_swap?oldid=664547769 Contributors: SimonP, Maury Markowitz,
Ram-Man, Edward, Michael Hardy, Karada, Pcb21, Rl, Ehn, Renamed user 4, Donreed, Justanyone, Zigger, Dratman, RScheiber,
Vladan~enwiki, Sam Hocevar, Fenice, MBisanz, Cje~enwiki, Jerryseinfeld, Leifern, PaulHanson, Wikidea, Jberkes, Ercolev, Krexwall,
Timrichardson, Wikiklrsc, BD2412, SLi, Gurch, Andrew G Ross, Antiuser, YurikBot, Grafen, GraemeL, Fred2028, ArielGold, DocendoDiscimus, Minnesota1, Veinor, CarbonCopy, OrphanBot, KaiserbBot, Radagast83, Jeremy norbury, TheChieftain, SashatoBot, Korovio, Es330td, JDAWiseman, Hu12, CmdrObot, Cydebot, Peripitus, Future Perfect at Sunrise, KeithWright, AlekseyP, Legis, Thijs!bot,
SvenAERTS, Ste4k, Msankowski, Alphachimpbot, Zidane tribal, Barek, Drdariush, Davidmanheim, Igirisujin, Pauly04, STBot, Tgeairn,
Poddrick, Idioma-bot, Sam Blacketer, Pleasantville, JohnSorrellAu, McTavidge, Dagroup, Purple Aubergine, Altasoul, Gloomy Coder,
Brianga, Gherrington, WRK, Int21h, Pjleahy, Finnancier, Desx2501, EoGuy, Harfo91, Raisaahab, Wp.duan, Wynandbez, Swapsbroker, Sun Creator, Dekisugi, DumZiBoT, Mkipnis, Addbot, Theobaldr, Amkdude2, Kiril Simeonovski, Gail, Xqbot, FrescoBot, Unstableequilibrium, LucienBOT, Diroussel, Haeinous, Anatoly.karpov, VernoWhitney, , Amit1law, Peterjleahy, Dewritech, Lancastle, ZroBot,
Liquidmetalrob, Vega47, Gwen-chan, Peteravel, Ashaykakde, Fancitron, Chinacat2002, BattyBot, Luvoneanother, Quantresearch, Kkumaresan26, Brianrisk and Anonymous: 210
Interest rate cap and oor Source: http://en.wikipedia.org/wiki/Interest_rate_cap_and_floor?oldid=662754791 Contributors: Roadrunner, Edward, Pcb21, Snoyes, Charles Matthews, Niteowlneils, Sam Hocevar, Fintor, Klemen Kocjancic, Poccil, Dreish, Jerryseinfeld,
Gene Nygaard, SDC, Vegaswikian, Feco, Encyclops, RussBot, Crasshopper, Calvin08, GraemeL, DocendoDiscimus, Chris the speller,
CSWarren, Goodnightmush, Hu12, Cydebot, Chhajjusandeep, Adolphus79, AntiVandalBot, Jtedor, Jluu~enwiki, Vickyadvani, Lamro,
Smeyen, Mkipnis, Addbot, Alphawolfer, Kiril Simeonovski, Yobot, Citation bot, Piloter, Shadowjams, Duoduoduo, Dewritech, ClueBot
NG, ThowardLP, Margaux85, TheJJJunk, WyeatesODI and Anonymous: 56
Interest rate basis Source: http://en.wikipedia.org/wiki/Day_count_convention?oldid=664548973 Contributors: Ronz, Reiner Martin,
Tristanreid, Mormegil, Scolebourne, Camw, Oliphaunt, Ground Zero, Thoreaulylazy, Crasshopper, DocendoDiscimus, Bluebot, Jmnbatista,

19.1. TEXT

433

JonathanWakely, Feraudyh, Mets501, Hu12, Ravendarque, Punctum~enwiki, Morgdx, Salgueiro~enwiki, Cyktsui, Rudd73, R'n'B, Jarl
Friis, Butwhatdoiknow, Finnancier, Bhuna71, PixelBot, Addbot, Yobot, Alain tesio, FrescoBot, AngelVel, Rodamaker, Citation bot 1,
Jonesey95, Seek2nd77, Bsoftware, WikitanvirBot, Dewritech, Logexp, Mittgaurav, Boria, Ogmark and Anonymous: 67
Basis swap Source: http://en.wikipedia.org/wiki/Basis_swap?oldid=499963213 Contributors: SimonP, Edward, Matthew Stannard, Jerryseinfeld, Leifern, GraemeL, SmackBot, Ulner, Hu12, Cydebot, Alaibot, Nshuks7, GeneralBob, Lamro, Reagan9000, Finnancier, Standoor,
Malin Tokyo, Erik9bot, Killian441 and Anonymous: 25
Range accrual Source: http://en.wikipedia.org/wiki/Range_accrual?oldid=630936255 Contributors: Michael Hardy, Encyclops, Petiatil,
Chris the speller, Chiao, Cydebot, Fiachra10003, Muhandes, Yobot, LilHelpa, David.champredon, Piloter, Alvin Seville, Erik9bot, ClueBot
NG and Anonymous: 7
Overnight indexed swap Source: http://en.wikipedia.org/wiki/Overnight_indexed_swap?oldid=633295639 Contributors: Tango,
Cherkash, Nurg, Marcika, RayBirks, Bantman, Rjwilmsi, Lmatt, Avraham, SmackBot, NickPenguin, , Fayenatic london, Bongomatic, 72Dino, Kajalsinha, Nastymunky, Lamro, Cp111, Richnewman, Addbot, TheFreeloader, Whiskeydog, LilHelpa, GrouchoBot,
JonathanPoole, Citation bot 1, WildBot, ClueBot NG, Kevin Gorman, Barbicanboy, Ralston83, CommInt'l, BeachComber1972, Tentinator,
Analyst123 and Anonymous: 12
Foreign exchange market Source: http://en.wikipedia.org/wiki/Foreign_exchange_market?oldid=665128019 Contributors: The Anome,
Mark, Ray Van De Walker, Karl Palmen, Edward, Michael Hardy, Kwertii, Mcarling, Julesd, Rl, David Shay, LMB, Francs2000, Jredmond, Postdlf, Yosri, Texture, Hadal, Dinomite, Orangemike, Ianhowlett, Masken, Horatio, Solipsist, Jackol, SonicAD, Utcursch, Antandrus, Quarl, DragonySixtyseven, Elroch, Neutrality, Fintor, Klemen Kocjancic, Cliftonack, Zondor, Mormegil, Monkeyman, Discospinster, Rich Farmbrough, Notinasnaid, Andrew Maiman, Bender235, Kbh3rd, V79, El C, Mwanner, Aude, Grick, Dungodung, Nk,
Alastairgbrown, Pearle, Alansohn, SnowFire, Javier Jelovcan, Arthena, Nealcardwell, Wikidea, Fwb44, Ashlux, Sedimin, Versageek, Gene
Nygaard, Ultramarine, Novacatz, OwenX, Woohookitty, Chochopk, Tabletop, Schzmo, Bbatsell, Bluemoose, GregorB, Dionyziz, Eyreland, Frankie1969, G2010a, Sachindole, Yurik, Mendaliv, Josh Parris, Rjwilmsi, Mgw, Bill37212, Rnolds, Peter Tribe, Dplayonline, Feco,
Sango123, Titoxd, FlaBot, Ground Zero, Gurch, Leslie Mateus, Cyun, Lmatt, Ahunt, Bjoleniacz, Imnotminkus, Michael Denmark, DVdm,
Bgwhite, Roboto de Ajvol, YurikBot, RussBot, Htournyol, Me and, Sasuke Sarutobi, Lemon-s, Bruguiea, Irishguy, Retired username,
RonaldB, Danlaycock, Tachyon01, Wknight94, Searchme, MaNeMeBasat, GraemeL, NFH, Katieh5584, Tiger888, NeilN, White Lightning, SkerHawx, DocendoDiscimus, Veinor, SmackBot, Philipareed, Deon Steyn, Pgk, Lawrencekhoo, Vald, Bobzchemist, Flamarande,
Edgar181, PBS27, Yamaguchi , Gilliam, Jibjibjib, Ohnoitsjamie, Mattrix18, JimS12, Amatulic, Chris the speller, Simon123, Thumperward, Oli Filth, Sheyne, DHN-bot~enwiki, Da Vynci, Zven, Smallbones, Yourika, KevM, Parent5446, Jmlk17, Wapman~enwiki, Jenifan,
MParaz, Rajrajmarley, Shadow1, DavidBoden, DMacks, Pilotguy, Ben Gaskin, Recreator, Igorn, Antifa82, Kuru, Microchip08, Fxman,
Wikiacm, Forex, Stefan2, Cerowyn, Chrisch, Beetstra, MrArt, Alast0r, H, Slyang, Wikixoox, Hu12, Quaeler, Levineps, David Legrand,
Simon12, Iridescent, Joseph Solis in Australia, JoeBot, J Di, Haus, Tony Fox, Billw2, Poweron, Linkspamremover, Mrapple, Tawkerbot2,
Maslakovic, Trade2tradewell, JForget, CmdrObot, Ale jrb, Jackzhp, Dycedarg, Stefanvaduva, Papushin, JohnCD, Ezrakilty, Old Guard,
Neelix, Mcduodonnell01, Pagerank~enwiki, Gogo Dodo, Lgriot, Qtia88, Dancter, Jameboy, DumbBOT, Rdls01, Kozuch, PKT, Epbr123,
Barticus88, Hit bull, win steak, Pajz, Qwyrxian, Andyjsmith, Neil916, James086, FLarsen, ChrisEvans, NERIUM, Nick Number, Wai Wai,
FreeKresge, Dawnseeker2000, Urdutext, Siggis, Escarbot, AntiVandalBot, Davido, Segun1ng, Luna Santin, Drnanotech, Ecocks1229,
Lwcroslow, Pete8, Dylan Lake, Msankowski, OSX, Spouima, Bailmoney27, Jumpinginpuddles, Figma, DOSGuy, JAnDbot, Kigali1,
Barek, MER-C, Kedi the tramp, Vicsar, The Transhumanist, Quentar~enwiki, Ph.eyes, Db099221, Tellmemoreabout, LittleOldMe, Yahel Guhan, Magioladitis, VoABot II, Plain jack, Nyttend, Buchandan, Catgut, Acmforex, Praddy06, SSZ, Rgfolsom, Theluckyjerk, Japo,
Titus999, Seashorewiki, Accesspig, DerHexer, Hdt83, MartinBot, NikNaks, STBot, Als7imy, CliC, Beedi, Rettetast, Notgoogle, Shay
Stewart, Fxdealer, Redboylabs, AlexiusHoratius, Ersuzzi, Jclfx, Stucool34, J.delanoy, Pharaoh of the Wizards, Trusilver, Bongomatic,
Terrynotec, Sherby33, Pumpkin Pie, Drewwiki, Vision3001, Wgibiz, Barts1a, Lovealbatross, McSly, Clerks, KMarie14, Joaquin777,
Daddy32, MoForce, HiEv, Bonadea, Enivid, JLBernstein, Shawncarpenter, Spellcast, Lights, Dxantos, VolkovBot, Indubitably, Lears Fool,
Pparazorback, Ryan032, AllanManangan, GroveGuy, Floshow25, Starnances, Pandacomics, Quizimodo, Anna Lincoln, Leafyplant, Abdullais4u, LeaveSleaves, Dargente, ForexReview, Altasoul, E-mini, Maksdo, Ilyasozgur, Madhero88, Larklight, Tennisnutt92, Greswik,
Martianxo, Erica j, Vpriest, Logan, Kbrose, Pmhoey, SieBot, Mbaluto, Scarian, Euryalus, Takeiteasyfellow, Araignee, Flyer22, Delijaworld, UKFXONLINE, Oxymoron83, Steven Zhang, Lightmouse, Tombomp, KathrynLybarger, Jsxr7, (GD), Fratrep, Abj1, Varange2,
Editor334, James Haughton, Dravecky, Linuzo, Asperal, StaticGull, Chimidan, Finnancier, Pinkadelica, Denisarona, Vivo78, Jvcc~enwiki,
Sfan00 IMG, Manikongo, Isatour, ClueBot, Phoenix-wiki, Jackollie, Yuval613, The Thing That Should Not Be, Twidaleqwerty, PLA y
Grande Covin, Meisterkoch, Plastikspork, Ecmoney, Farolif, Tomas e, Gregdobbs, Kidmercury, Blanchardb, Auntof6, Samuk1000, Rextech, Kitsunegami, Excirial, OracleGD, Erebus Morgaine, Kingjdub, Sun Creator, Pladook, Arjayay, Narnbe2, BusterBluth, Informedtrades, Thingg, Versus22, Zikos750, OscarSebastian, CurrencyMike, DumZiBoT, John0101ddd, XLinkBot, ForexDude, Ninja247, Boyd
Reimer, Tradingdude, Espumadevidrio, Quinjq, WikHead, SilvonenBot, Brandsen, Addbot, Proofreader77, LeeJohnOliver, Quantumres,
Coopeajj, PatrickFlaherty, Tanhabot, Ronhjones, Jncraton, Mohamed Ouda, Leszek Jaczuk, VPISoxFan, Cst17, Djcyanide, MrOllie,
Download, Glane23, Casperdc, Gld.signal, Dijinkv, Miltooon, Shanec90, $1000000000ten0one1, Tide rolls, Ger123~enwiki, Js2008, Fxforex, Gugustiuci, Teles, Doutrax, Yobot, WikiDan61, 2D, Themfromspace, Fraggle81, Washburnmav, THEN WHO WAS PHONE?,
Forexmaster, KamikazeBot, South Bay, Clevercatskin, Rpf 81, Fx-daytrader~enwiki, AnomieBOT, Jim1138, BlazerKnight, Kingpin13,
Materialscientist, Serbancea, ArthurBot, GnawnBot, LilHelpa, Xqbot, Capricorn42, Forexbar, Dina Jones, AlexBraun, SEO Swamee,
Wild lupus, Srich32977, X51xxx, Pmlineditor, GrouchoBot, Mainu30, Mathonius, Amaury, Easy101forex, Msmanikandan, Kog777,
Norelaxation, Smallman12q, Natural Cut, Malayfx, Hmk20009, Sesu Prime, Mautinek, Limecastle, Jcurve100, Vklimko, Fireyhu, Nullnill, Ifxekaterina, Dyingsouls, Spitrebbmf, Jhone01kamil, Jx-10, Nicolebobbin, Intelligentsium, MarquezComelab, I dream of horses,
Sergei Kazantsev, Elockid, Yazdit1, Snesareva, Lupuskus, Rushbugled13, Mdelfs, Nickhorder, Mbahgat3000, Triangle eater, Smileplz,
TraderFX, Merlion444, DiamondJoeQuimby, Bisnisfx, Nyse1982, Blacksabbath4343, Wayne Riddock, Orenburg1, Zahdanrino, Daniel
Renfoh, PiRSquared17, Whufc48, Lotje, Createmilk, Adrie7, Rixs, Jacktzgerald, Davidjholden, Matt2727, Wiki-winky, Real Trade
Group, Nick Bencino, MaxEspinho, EvanHarper, Suusion of Yellow, Tbhotch, MegaSloth, DARTH SIDIOUS 2, Mean as custard,
RjwilmsiBot, Sargdub, FXWM, Berlus, ForexAcionado, Lexxmarzain, EmausBot, John of Reading, Johan888, Acather96, Yca.zuback,
Immunize, Mrmick73, Innocent12345, Grusaj, Dewritech, GoingBatty, RA0808, Eforex, Dfdferer22, Ttmmblogger, Aotf01, TuHanBot, Wikireporter365, KoalaLovesWiki, Ammirajua, Slawekb, John Shandy`, Thecheesykid, John Cline, F, Youngreptile, Kableash,
Maaforex, Elektrik Shoos, MRBigdeli, F.h2010, FinancialExpertise, Vishnu mohanan, Adamforex, Chetannada, Makecat, Mdc-inmueb,
Arakesh999, Gbsrd, Borsaegypt, Obotlig, Vadimurazaev, Jhaprashant, Alberto.a, Mickey what a pity, Deed89, Gsarwa, Donner60, Mamaoyot, ForexGuy, Forex video, MainFrame, ChuispastonBot, Peter681, ClamDip, Irineliul, Jnrmedia, Mjbmrbot, ClueBot NG, Erik
Lnnrot, Cneeds, Haca45, Qarakesek, Vailbrook, Ramillav, Lestatus, Esejoker468, 2010triennialsurvey, Mike3608, Amr.rs, Leewutzke,
O.Koslowski, Liteforex.mx, Statoman71, Rezabot, Laurenrach, Widr, Nakhoa, Swatigoel9, Roeeric51, Lesspaper, Orlydumitrescu, Helpful

434

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Pixie Bot, Dneprolab, Blue rose yy, Bobbyshabangu, Wbm1058, Guest2625, Coventgardenfx, Forextrader2011, Island Monkey, Merikallos,
Pianoje, PTJoshua, Bob walker99, Virtuscience, Kinitex, Fagallos, Cyprianio, EmadIV, Altar, CitationCleanerBot, Fancitron, YantarCoast, Bilalmanzoorrana, Imanizore, Rykerkim, Adamminstry, , Kallios, Alex771, Sumilord, Chi0585, Tutelary, TejaraForex,
Jinex2012, Jonath29, LegacyOfValor, Forex-courses.us, Globalwellnessteam, Deepsnow, Junglecash, Feronnik, Outlawcreations, Juni69,
Chris51659, Lavcom, Assarkareem, Tradinghunter, PurpleLime, Jojo16183, Hamdouch03, JYBot, Largehole, Hassainnawaz, Chrserad,
Precisiontrader, Ujongbakuto, Hjaz, Briantieling, Forexschool, TaylorMarcella, TheBoyEL, Lyonri, Spicyitalianmeatball, Jamesx12345,
Midomss54, Adfx-sa, FXtraderFX, Faizan, GirlTropix, Johnwate, Chillpill1984, Gowthamkumar123, Rich Stevens, Casheymay, Melody
Lavender, Dwdcom, Kind Tennis Fan, Indicontent, Sushant M Tripathi, J.ortho9, Cbluckyus, Jkielty82, Freethinking000, Petervandam, Gracie chan, Smayer97, Notsosoros, Mohcinbahaddou, Aphidelsi, SantiLak, Wcusae, Shayer2014, Dark199102s, Suvidhamhatre,
Forexcurrency, Iano18hf, Scrapeme, Ssanoop123, Tsafrir Attar, Seandouglas1987, Forextread, Gurulines, Imran520, YogiBuddhaTao69,
Dtabber, KH-1, Jamesjohn1102, Pridecolumnist, Scubamaggo, Marcuschenevix, Pierre Cervantes, Muzzamell, Bmaidul, Binarni opce,
Kiara0050, Whalestate, Bratislavgood, Forexchartlive, DavidClarke01, Wasim2288, Cruzer26 and Anonymous: 1154
Exchange rate Source: http://en.wikipedia.org/wiki/Exchange_rate?oldid=664991065 Contributors: AxelBoldt, Bryan Derksen, Roadrunner, SimonP, Edward, Patrick, Fred Bauder, Minesweeper, Pcb21, Ahoerstemeier, Den fjttrade ankan~enwiki, Nikai, Netsnipe,
Andres, Rob Hooft, Mydogategodshat, Dcoetzee, Andy G, Maximus Rex, Thue, M-Henry, Pakaran, Cncs wikipedia, Skyre, Robbot,
Sander123, RedWolf, Lowellian, Rollo, Hadal, Cyrius, Terjepetersen, Christopher Parham, Cokoli, J heisenberg, Seabhcan, Fudoreaper,
Peruvianllama, Gus Polly, Solipsist, Khalid hassani, Mervynl, Thewikipedian, Jossi, Zfr, Imjustmatthew, Sonett72, Thorwald, Random user,
Wareldian, Ularsen, Monkeyman, Discospinster, Rhobite, Vsmith, Andrewferrier, YUL89YYZ, Notinasnaid, Kbh3rd, Mashford, Jarsyl,
Fenice, Freakimus, Rgdboer, Art LaPella, Bobo192, Aml~enwiki, Maurreen, Jerryseinfeld, Blotwell, Ranveig, Jumbuck, Thebeginning,
Apoc2400, Honeydew, DreamGuy, Wtmitchell, DV8 2XL, Palea~enwiki, Preaky, Woohookitty, 2004-12-29T22:45Z, FPAtl, Byped, Chochopk, Dzordzm, Bluemoose, GregorB, Eyreland, Gerbon689, TK-421, Sachindole, NCdave, Deltabeignet, Enzo Aquarius, Buldri, MordredKLB, Peter Tribe, Feco, Sky Harbor, Margosbot~enwiki, RexNL, Mitsukai, Robertrade, LeCire~enwiki, Chobot, Bornhj, Mrnatural,
YurikBot, Wavelength, Borgx, RobotE, RussBot, Pseudomonas, Nirvana2013, Zwobot, DeadEyeArrow, Bota47, Marcelo-Silva, Searchme,
Pulveriser, Zzuuzz, Arthur Rubin, GraemeL, SigmaEpsilon, Cromag, Allens, Teryx, GrinBot~enwiki, YuriyGorlov, DocendoDiscimus, A
bit iy, SmackBot, Bravo-Alpha, JBSmith, Kintetsubualo, PBS27, Ohnoitsjamie, Psiphiorg, RayAYang, Nbarth, Da Vynci, Smallbones,
Yidisheryid, DMacks, Viking880, Letslip, MegaHasher, Igorn, Shlomke, Minna Sora no Shita, Ryanwammons, Dr.K., MTSbot~enwiki,
JDAWiseman, Hu12, Levineps, Joseph Solis in Australia, Linkspamremover, Tawkerbot2, CmdrObot, Jackzhp, Dub8lad1, Mike Christie,
Grant M, Mastertrader, Thijs!bot, Sisalto, Varavour, Dgmaybury, Dawnseeker2000, Porqin, Seaphoto, Fayenatic london, Dylan Lake,
Daytona2, JAnDbot, MER-C, Timur lenk, JamesBWatson, MASROOR, Acmforex, SSZ, SlamDiego, Binh Giang~enwiki, Pikitfense,
Ff2k, Preetam purbia, MartinBot, BetBot~enwiki, Eliko, Fxdealer, TheEgyptian, Nativebreed, J.delanoy, Trusilver, Maurice Carbonaro,
LordAnubisBOT, NewEnglandYankee, Calumbo471, Kraftlos, DorganBot, Gosteve, Mokgen, BigFishy, Je G., Stephennt, Ryan032,
Philip Trueman, TXiKiBoT, DanLRusso, From-cary, UnitedStatesian, Wiki man55, Miwanya, Logan, SieBot, Motorracer, Scarian,
Plinkit, Takeiteasyfellow, Dryfee, Jalanb, Oxymoron83, Ddxc, Lightmouse, StaticGull, Finnancier, Vivo78, Atif.t2, ClueBot, Snigbrook,
The Thing That Should Not Be, Ewawer, Supertouch, Likepeas, CounterVandalismBot, BSAidan, Excirial, Quercus basaseachicensis,
Noneforall, Rhododendrites, Tnxman307, Sh1minh, Aitias, Vikramparsani, Hothead1994, Artur 55, Trader Phil, XLinkBot, Quinjq, Addbot, Cxz111, Mortense, Fieldday-sunday, CarsracBot, Ccacsmss, Casperdc, Codefrog, Sfcardwell, Mjquinn id, Yobot, Themfromspace,
Cm001, Dynamicvn, IMSFX, AnomieBOT, Kermit1818, Angry bee, Floquenbeam, Galoubet, Neptune5000, Materialscientist, StandOrder, Jmundo, Dadur, GrouchoBot, RibotBOT, Smallman12q, IsBroke, Metalindustrien, FrescoBot, Nullnill, Bdmax007, Spitrebbmf,
DrilBot, Snesareva, Chepurko, Bisnisfx, SkyMachine, FoxBot, TobeBot, PiRSquared17, Throwaway85, AHeneen, Duoduoduo, Sarabas,
Jdelatre, DARTH SIDIOUS 2, Mean as custard, Sargdub, EmausBot, Ovzi, Sumsum2010, Iranianson, Fleohau, K6ka, John Shandy`,
SHAXMATH, Shuipzv3, Progers1618, Angelic editor, Nishantkukreja, Donner60, --, Peter681, Irineliul, Garant^ ^, ClueBot NG,
Smtchahal, A1228, Ramillav, Laurenrach, MerlIwBot, Oddbodz, HMSSolent, Calabe1992, Lowercase sigmabot, Wikiped4ik, Bmusician,
BendelacBOT, ChessBOT, Mindmapwiki, ChidemK, CitationCleanerBot, Minsbot, CeraBot, Ankitchkt, Mediran, Jasonwang1981, DaltonCastle, TwoTwoHello, Lyonri, Lugia2453, Midomss54, Finansid, I am One of Many, Interference 541, Shiwoen, LanS26, PhoBo,
Maxbarber, DigitalTeleCom, Ama3hd, Vostori, Joong-suk Kim, Monkbot, Farslaner, Sixtyseventwelve, Bertrandboulle, Hhhhhhr, MTFX,
Jewelpack and Anonymous: 457
Currency risk Source: http://en.wikipedia.org/wiki/Foreign_exchange_risk?oldid=663938238 Contributors: Pnm, Vroman, Fintor, Bobrayner, Rjwilmsi, Shawnc, Biddlesby, SmackBot, Ohnoitsjamie, KaiserbBot, Vina-iwbot~enwiki, Hu12, IvanLanin, Anshal, Outriggr,
Cydebot, Normalsynthesis, RobotG, JAnDbot, Df3gr2003, Leftfoot69, Casperonline, AlleborgoBot, Ewawer, DumZiBoT, Addbot, Andreasmperu, Charybdisz, AnomieBOT, Materialscientist, ArthurBot, DrilBot, Sergei Kazantsev, Trappist the monk, Beyond My Ken,
Dewritech, Wikireporter365, John Shandy`, Riskrisk, Sonicyouth86, BG19bot, BattyBot, Pengyao ma, Southparkfan, Od Altankhuyag,
Monkbot, Jnbird, and Anonymous: 38
Real exchange rate puzzles Source: http://en.wikipedia.org/wiki/Real_exchange-rate_puzzles?oldid=627939238 Contributors: Edward,
Topbanana, Woohookitty, Buldri, Tony1, Reyk, Eastlaw, Citation bot, Citation bot 1, VirginieCB and Anonymous: 2
Interest rate parity Source: http://en.wikipedia.org/wiki/Interest_rate_parity?oldid=657393336 Contributors: Edward, Michael Hardy,
Ixfd64, Tango, Pps, The Land, Fintor, Keenan Pepper, Mandarax, Rjwilmsi, Koavf, SmackBot, McGeddon, Colonel Tom, Larsroe,
Chris the speller, Smallbones, Erweinstein, Radagast83, Nutcracker, Humble2000, Gregbard, Chhajjusandeep, Gnfnrf, TonyTheTiger,
Perrygogas, Just Chilling, Gregalton, Storkk, STBot, Niwat19, Wordsmith, SieBot, StaticGull, RockyAlley, Jan1nad, Mild Bill Hiccup,
1ForTheMoney, MatthewVanitas, Addbot, Fryed-peach, Luckas-bot, Mmxx, FrescoBot, Tetraedycal, Vrenator, RjwilmsiBot, Gf uip, John
Shandy`, Donner60, ClueBot NG, JaymesKeller, Jorgenev, Helpful Pixie Bot, Xjengvyen, Cupco and Anonymous: 80
Foreign exchange derivative Source: http://en.wikipedia.org/wiki/Foreign_exchange_derivative?oldid=594028106 Contributors: Fintor,
Josh Parris, Mitsuhirato, Cydebot, Future Perfect at Sunrise, John of Reading, Fancitron, Kkumaresan26 and Anonymous: 5
Forex swap Source: http://en.wikipedia.org/wiki/Foreign_exchange_swap?oldid=651016662 Contributors: GTBacchus, Dave6,
HorsePunchKid, Fintor, Haxwell, Leifern, Apoc2400, Kmorozov, Lmatt, DVdm, Htournyol, Veinor, A bit iy, Mom2jandk, Jprg1966,
TJJFV, MrArt, Wikixoox, Hu12, Linkspamremover, Shikaga, Cydebot, Coulmullen, Msankowski, Severo, Titus999, Custardninja,
Sherby33, Stephennt, Lampica, Finnancier, Jackollie, Cp111, Jimmychambers, PixelBot, Certes, Firstandgoal, Addbot, Mortense, Fraggle81, Edvc23132, Haeinous, Pinethicket, BlockKin77, F, Mahima.chawla, Fancitron, ChrisGualtieri, I am One of Many, Forexnewbie,
Forexbonus100 and Anonymous: 44
Trade weighted index Source: http://en.wikipedia.org/wiki/Trade-weighted_effective_exchange_rate_index?oldid=621779858 Contributors: Pigsonthewing, Robert Weemeyer, 99of9, John Quiggin, Woohookitty, TheSun, Tony1, BenBildstein, SmackBot, Lsho, Jackzhp,
Eliko, VolkovBot, Thepolitik, Luckas-bot, Capricorn42, EmausBot and Anonymous: 14

19.1. TEXT

435

Covered call Source: http://en.wikipedia.org/wiki/Covered_call?oldid=648994881 Contributors: Enchanter, IRelayer, Michael Devore,

Comatose51, Gxti, Leifern, Pfalstad, Ronnotel, Feco, Itara, Gaius Cornelius, Bovineone, Malcolma, Voidxor, Gtdp, GraemeL, Realkyhick, That Guy, From That Show!, SmackBot, Jphillips, Bilb02, Bluebot, Nbarth, Smallbones, KaiserbBot, Kuru, Ulner, Wikiopt, Hu12,
Trade2tradewell, CmdrObot, Brianbellco, Cydebot, Thijs!bot, Natalie Erin, Seaphoto, Silver seren, MER-C, Magioladitis, GeneralBob,
SJP, DMCer, Blood Oath Bot, Funandtrvl, Sheaton319, Nburden, Dr.007, Ometecuhtli2001, Gtoscano, Optionportfolio, Netsumdisc,
Martin451, Subodh subu, Ramnarasimhan, Brashboy, Lamro, StAnselm, Optionsgroup, ThomasMark, Altzinn, Finnancier, Celique, Deepudec77, PortfConsult, Mild Bill Hiccup, John.templeton, Eeekster, Mkphillips, Goldencub, NJGW, Qwfp, XLinkBot, Nekiko, Sagitarius
d, Albambot, Addbot, Tkeller28, Zorrobot, Yobot, SwisterTwister, LilHelpa, Erik9bot, FrescoBot, U912boiler, RjwilmsiBot, Bornfedslaughter, Freedom2live, Scanlin, SURFThru, Timmybob3349, Helpful Pixie Bot, Rrenicker1, WikiHannibal, Rcunderw, Maxlin8811 and
Anonymous: 94
Naked put Source: http://en.wikipedia.org/wiki/Naked_put?oldid=661307738 Contributors: Enchanter, Kwertii, Gxti, Basilwhite, Leifern,
Nroets, Ronnotel, Shawnc, SmackBot, Hydrogen Iodide, Derek R Bullamore, Disavian, Aaronchall, Hu12, Harej bot, Cydebot, Aliwalla,
Kigali1, GeneralBob, Nburden, Netsumdisc, Subodh subu, Ramnarasimhan, Brashboy, User5910, Finnancier, Franamax, John.templeton,
Eeekster, Addbot, LaaknorBot, Mark Wolnger, AnomieBOT, Joshuwaliu, Knowledgebob, Skyerise, Trappist the monk, SURFThru,
Helpful Pixie Bot, FeralOink and Anonymous: 25
Straddle Source: http://en.wikipedia.org/wiki/Straddle?oldid=663800410 Contributors: Enchanter, Kwertii, Pcb21, Jpatokal, Mydogategodshat, Alkivar, Discospinster, Rich Farmbrough, Grasp, El C, Leifern, Anthony Appleyard, Rlw, Greg~enwiki, Ronnotel, Markkawika,
Pjetter, Feco, FlaBot, Eubot, Carrionluggage, RobotE, Kirill Lokshin, Zagalejo, Closedmouth, GraemeL, Shawnc, DocendoDiscimus,
SmackBot, Jphillips, RandomProcess, Nerd42, Gleb~enwiki, CSWarren, Nbarth, E946, Saturn07, Sgcook, Kuru, Ulner, Airdrake, Hu12,
Travisl, JohnCD, Witaly, Flynnbar, Cydebot, Zalgo, D4g0thur, Crzycheetah, Seaphoto, WallStGolfer31, Lenny Kaufman, GeneralBob,
Commentor, Nburden, Kyle the bot, Finnancier, WebSurnMurf, Escape Orbit, Addbot, Yobot, Macbao, Jim1138, Wesanders, Citation
bot, Akuma6, RjwilmsiBot, Freedom2live, Winner 42, ClueBot NG, Helpful Pixie Bot, Onlymuks, Russell Gold, Reatlas, Baerrus, Mcclured123, Mglukhov and Anonymous: 63
Buttery (options) Source: http://en.wikipedia.org/wiki/Butterfly_(options)?oldid=663801413 Contributors: Gxti, Leifern, SteinbDJ,
Ronnotel, Encyclops, Muchness, Gaius Cornelius, Anomalocaris, ENeville, Grafen, Bluebot, Mitsuhirato, Smallbones, Radagast83, Hu12,
CmdrObot, Cydebot, Clovis Sangrail, Thijs!bot, Crzycheetah, Iron Condor, EvanCarroll, Atomafr, Martin451, Lamro, SieBot, Finnancier,
ClueBot, Rumping, Tired time, WikHead, Addbot, Citation bot, Thehelpfulbot, PigFlu Oink, Freedom2live, Swerfvalk, Winner 42,
Watashinowiki, Hcasir, ClueBot NG, Srangen, Lewisaurus, Baerrus, Mglukhov and Anonymous: 29
Collar (nance) Source: http://en.wikipedia.org/wiki/Collar_(finance)?oldid=664621427 Contributors: Edward, Connelly, DocWatson42,
Vfp15, Mboverload, Salimfadhley, SteinbDJ, Kinema, OwenX, Woohookitty, SDC, Ronnotel, Seidenstud, Dar-Ape, Carrionluggage, RussBot, NawlinWiki, Rayc, SmackBot, Khazar, Watson Ladd, CmdrObot, Cydebot, Mattisse, Epbr123, Gtgrant, KrakatoaKatie, MarshBot,
RobotG, Nshuks7, Ecphora, GeneralBob, Victorgehrke, Finnancier, Ikajo, Arjayay, Anual, Addbot, Rtac5b, Tassedethe, Luckas-bot, Fraggle81, AnomieBOT, LilHelpa, Crookesmoor, Nissimnanach, RedBot, Swerfvalk, Aberdeen01, ChuispastonBot, Gareth Grith-Jones,
Wikirichr, Peteravel, Rrenicker1, WikiHannibal, SkateTier and Anonymous: 32
Iron condor Source: http://en.wikipedia.org/wiki/Iron_condor?oldid=620795624 Contributors: Edward, Michael Devore, GregorB, Ronnotel, Mstroeck, RussBot, Anomalocaris, SmackBot, Mkoistinen, Hu12, Cydebot, MarshBot, Magioladitis, GeneralBob, Xcalibus,
ExarPalantas, Drmurphy, Alefu, S2000magician, Finnancier, ClueBot, Yobot, Mgerity, Materialscientist, FrescoBot, Skyerise, StocksDoc,
Freedom2live, Helpful Pixie Bot, Charliembrodie, Shankeditor, Epoq3 and Anonymous: 28
Strangle (options) Source: http://en.wikipedia.org/wiki/Strangle_(options)?oldid=633627916 Contributors: Gxti, Ronnotel, FlaBot, Warmenhoven, KasugaHuang, SmackBot, Hu12, Cydebot, Witaly84, Tomdinan, Murderbike, Finnancier, U2em, Addbot, GSMR, Yobot,
Thehelpfulbot, Nickucla, DixonDBot, RjwilmsiBot, Aberdeen01, Helpful Pixie Bot, Onlymuks, Russell Gold, Baerrus and Anonymous: 20
Options spread Source: http://en.wikipedia.org/wiki/Options_spread?oldid=656425089 Contributors: Dale Arnett, 2005, Ronnotel,
BD2412, Reedy, Kuru, Ulner, Hu12, Cydebot, Kurl, Mbarbier, Not a dog, GeneralBob, Xcalibus, Wcspaulding, Cbapel, Finnancier,
Jsumma, VQuakr, Erudecorp, Thingg, Porchcorpter, Guyonthesubway, Citation bot, FrescoBot, Andywiki01, KBello, Freedom2live, Onlymuks, Juhuyuta, Dai Pritchard, Kraken347 and Anonymous: 23
Bull spread Source: http://en.wikipedia.org/wiki/Bull_spread?oldid=664363030 Contributors: Fawcett5, Ronnotel, Closedmouth, Mitsuhirato, Cydebot, GeneralBob, Tgeairn, Xcalibus, Finnancier, Citation bot, Oundhakar, Erik9, NoMan 222, KLBot2, Harish7447 and
Anonymous: 40
Box spread Source: http://en.wikipedia.org/wiki/Box_spread?oldid=586888706 Contributors: Enchanter, Kwertii, Dcsohl, Avala,
Aminorex, Fawcett5, Josh Parris, Rjwilmsi, Alex Bakharev, Elkman, SmackBot, Bluebot, Smallbones, Saxbryn, CmdrObot, Cydebot, Don
Watson, MarshBot, QuiteUnusual, Magioladitis, Lamro, ThinkTankTrading, Yobot, FrescoBot, ClueBot NG, Alik.ulmasov and Anonymous: 25
Backspread Source: http://en.wikipedia.org/wiki/Backspread?oldid=653731333 Contributors: Edward, Branddobbe, Mkoistinen, Hu12,
Dgw, Cydebot, GeneralBob, Xcalibus, Finnancier, Citation bot, FrescoBot, John of Reading, Freedom2live, Wikimanoj and Anonymous:
10
Calendar spread Source: http://en.wikipedia.org/wiki/Calendar_spread?oldid=580863972 Contributors: Kwertii, Leifern, Woohookitty,
Ronnotel, Mstroeck, Kstarsinic, Carabinieri, SmackBot, Hu12, Cydebot, MarshBot, GeneralBob, Bissinger, Xcalibus, Timdunfee,
Finnancier, DumZiBoT, WikHead, Addbot, Citation bot, EmausBot, Freedom2live, Aberdeen01 and Anonymous: 10
Ratio spread Source: http://en.wikipedia.org/wiki/Ratio_spread?oldid=633772218 Contributors: Edward, Hu12, Cydebot, GeneralBob,
Xcalibus, Lamro, Citation bot, Baerrus and Anonymous: 6
Vertical spread Source: http://en.wikipedia.org/wiki/Vertical_spread?oldid=657185755 Contributors: Edward, Cretog8, Leifern, Lockley,
Tropylium, SmackBot, Nbarth, Serein (renamed because of SUL), Cydebot, GeneralBob, Xcalibus, Enivid, Finnancier, AnomieBOT,
Citation bot, Hisabness and Anonymous: 4
Credit spread (option) Source: http://en.wikipedia.org/wiki/Credit_spread_(options)?oldid=659353484 Contributors: Wknight94, Heresiarch, Sardanaphalus, SmackBot, Hu12, Cydebot, Skittleys, Severo, Flowanda, Funandtrvl, Finnancier, GFHandel, Cyclingscholar, Skyerise, Vovchyck, Freedom2live, MildInvestor, Adrianw61, Wikiguru2011, BeachComber1972, Mtedesco203 and Anonymous: 16
Debit spread Source: http://en.wikipedia.org/wiki/Debit_spread?oldid=580864042 Contributors: Enchanter, Selket, Leifern, Shawnc,
Bluebot, Hu12, Cydebot, Rayshan, Severo, GeneralBob, Xcalibus, Enviroboy, Finnancier, SchreiberBike, Addbot, Luckas-bot, Yobot,
Citation bot, Freedom2live and Anonymous: 7

436

CHAPTER 19. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

Exotic option Source: http://en.wikipedia.org/wiki/Exotic_option?oldid=656654906 Contributors: Pcb21, Reiner Martin, Ary29, Fintor, Leifern, Arthena, JordanSamuels, Woohookitty, Bluemoose, Encyclops, RussBot, Bhny, Dilaudid~enwiki, Chris. F. Masse, DocendoDiscimus, Betacommand, Chris the speller, Nbarth, Sgcook, Ulner, Robosh, Thisisarun, Hu12, Jackzhp, Cydebot, Hypersphere, MrAWO, BetacommandBot, Nshuks7, Severo, Oceanynn, Trushar, Lamro, Cool Cosmos, BigSwingingSomething, Finnancier,
Obiezyswiat~enwiki, Saddhiyama, Addbot, TaBOT-zerem, Hairhorn, Citation bot, Quebec99, Xqbot, FrescoBot, Shoval55, Vovchyck,
Sargdub, Bento00, Dewritech, Njgdekker, Isoventures73, Pokbot, ChrisGualtieri, Dashm79, Shamoo67, WeRegretToInform, Monkbot,
Rypax and Anonymous: 37
Barrier option Source: http://en.wikipedia.org/wiki/Barrier_option?oldid=603301268 Contributors: SimonP, Edward, Michael Hardy,
Christofurio, Fintor, Bobo192, Leifern, Sade, Cburnett, SteinbDJ, JordanSamuels, Ronnotel, Lmatt, The Rambling Man, YurikBot, SmackBot, Sgcook, Ulner, Hu12, Amniarix, Jackzhp, Dgw, Cydebot, Alaibot, Cyktsui, Lamro, SieBot, Finnancier, Hal8999, Addbot, Bertrc,
Legobot II, Bin TAN, Peter9002 and Anonymous: 44
Compound option Source: http://en.wikipedia.org/wiki/Compound_option?oldid=661353655 Contributors: Robosh, Cydebot, Lamro,
Spinningspark, Brewcrewer, Sargdub, BG19bot, Freedumb123 and Anonymous: 3
Swaption Source: http://en.wikipedia.org/wiki/Swaption?oldid=664114730 Contributors: Enchanter, Edward, Michael Hardy, Pnm,
Pcb21, Nikai, Mydogategodshat, Charles Matthews, Jni, PBS, Justanyone, Hadal, RScheiber, Fintor, Fenice, Jerryseinfeld, Leifern, D32,
Uucp, Borracho, Garylhewitt, Nlsanand, Vegaswikian, FlaBot, Ninel, Encyclops, Bovineone, GraemeL, SmackBot, CarbonCopy, Colonies
Chris, KaiserbBot, Sgcook, Khazar, Ulner, JHunterJ, Hu12, Joseph Solis in Australia, CmdrObot, Cydebot, Thijs!bot, PerfectStorm, Gregalton, R'n'B, Danpak, Dm63, Finnancier, Mkipnis, Paulginz, Addbot, AndersBot, Ginosbot, Citation bot, Xqbot, Piloter, FrescoBot,
Ksb-nances, Berkeley222, Zfeinst, Egg Centric, DudeOnTheStreet, Studentttt and Anonymous: 60
Bond plus option Source: http://en.wikipedia.org/wiki/Bond_plus_option?oldid=605671676 Contributors: Enchanter, Woohookitty,
Lmatt, NawlinWiki, SmackBot, Sadads, Waggers, Cydebot, Hypersphere, Muro Bot, Addbot, Erik9bot, EmausBot, ZroBot and Anonymous: 3
Cliquet Source: http://en.wikipedia.org/wiki/Cliquet?oldid=580863995 Contributors: FlaBot, Hu12, Cydebot, Mariod505, Sm8900,
Lamro, Nsk92, Cpt.schoener, Addbot, Amirobot, Steviegeorge, Pwntato69 and Anonymous: 6
Equity-Linked Note Source: http://en.wikipedia.org/wiki/Equity-linked_note?oldid=626326426 Contributors: Enchanter, Pearle,
Hooperbloob, Plrk, Poltak, Ricky@36, Gregbard, Rkrite, EdJohnston, JMehta, Salad Days, JeM, Shakychan, Lamro, SieBot, Addbot,
Cameron Scott, Lotje, ArmbrustBot and Anonymous: 10
Commodore option Source: http://en.wikipedia.org/wiki/Commodore_option?oldid=649877651 Contributors: SmackBot, Cydebot,
DGG, Funandtrvl, Gbawden, Yobot, Mfuller21, Robstart and Anonymous: 1
Delta neutral Source: http://en.wikipedia.org/wiki/Delta_neutral?oldid=656681536 Contributors: Enchanter, Fintor, Drbreznjev, Ronnotel, Lmatt, Jersey Devil, Skibob1027, Arrive, Yabbadab, DocendoDiscimus, SmackBot, DMS, Smallbones, Altruic, Ulner, Hu12, Cydebot,
Nshuks7, A quant, STBot, Jasonnoguchi, Devlinb, McM.bot, Lamro, SieBot, Colfer2, Finnancier, A1b43789erzsd, Addbot, Yobot, FrescoBot, U912boiler, Satellizer, Furkhaocean, Kunaljvyas and Anonymous: 37
Rainbow option Source: http://en.wikipedia.org/wiki/Rainbow_option?oldid=648806417 Contributors: Edward, Fintor, Lmatt, Brianboonstra, Cydebot, Ironicon, Lamro and Anonymous: 4
Low Exercise Price Option Source: http://en.wikipedia.org/wiki/Low_Exercise_Price_Option?oldid=617881383 Contributors: Michael
Hardy, Coherers, FlaBot, Hu12, Cydebot, CaptinJohn, Wikinista, Addbot, Unscented, Kshakhna, Sargdub, Hmainsbot1 and Anonymous:
3
Forward start option Source: http://en.wikipedia.org/wiki/Forward_start_option?oldid=641401019 Contributors: Rjwilmsi, MZMcBride, Lmatt, Ulner, Cydebot, Fabrictramp, Reedy Bot, ToyotaPanasonic, Lamro, Niceguyedc, Carriearchdale, EastTN, Addbot, Yobot,
Fraggle81, Tb240904, BattyBot, Muskanty, Keepitlucid, Vikram kaurav, Doris90, SwagMaestroSpears, Lovetoreadintexas, Clknows and
Anonymous: 7
Binary option Source: http://en.wikipedia.org/wiki/Binary_option?oldid=663964944 Contributors: Edward, Infrogmation, Michael
Hardy, Willsmith, Pcb21, Mydogategodshat, Quarl, Fintor, Mormegil, Fenice, Sole Soul, Pearle, Leifern, SteinbDJ, Bluemoose, Graham87,
Etairaz, Bgwhite, Gaius Cornelius, Pseudomonas, Dan131m, BiH, SmackBot, C.Fred, Bluebot, Nbarth, Smallbones, Sgcook, Ged UK, ArglebargleIV, Kuru, Ulner, Jas131, Nagle, Hedgestreet, Xyannix, Xionbox, Hu12, HTChief, Edward Vielmetti, Cydebot, Trident13, DumbBOT, Seaphoto, Barek, MER-C, Magioladitis, NetHunter, GeneralBob, Falcor84, Pharaoh of the Wizards, Enivid, Davena, TXiKiBoT,
Someguy1221, Klip game, Billinghurst, Stigin, SieBot, Coee, Jauerback, Rockerdudeman, Smsarmad, Bentogoa, Finnancier, Denisarona,
Ultimatefrisbee92, Fyyer, Yuval613, Farolif, Excirial, PixelBot, Echion2, Aurora2698, XLinkBot, Roxy the dog, WikHead, R10623,
BlackBeast, Fyrael, Fluernutter, MrOllie, Download, Legobot, Luckas-bot, Yobot, WikiDan61, Fraggle81, AnomieBOT, Materialscientist, Tverga, Xqbot, Shouran, TechBot, A.amitkumar, Dav3wil5on, Berek11, Fabien leoch, Haeinous, HJ Mitchell, HamburgerRadio,
Jonesey95, Skyerise, Shoval55, Wikielwikingo, Skakkle, Hobbes Goodyear, RjwilmsiBot, Sargdub, Bento00, Trader.binary, EmausBot,
WikitanvirBot, Wbsteve, L235, Shitehawks, Donner60, Isoventures73, Binaryoptionswiki, Oneneham, ReverendSpikeEButcher, Sepersann, Duyk20, ClueBot NG, Edwardf, Yohiarr, Snotbot, O.Koslowski, Okteriel, Newyorkadam, Katedav19, Chgoe, Helpful Pixie Bot,
Lowercase sigmabot, BG19bot, Sledge 1981, Virtuscience, MrBill3, Altiusfortius, Achowat, Asphasia79, Topdogtrader, Tboptions, ChrisGualtieri, Ducknish, Ukphilosopher, Ellwaky, EagerToddler39, Swmaher, Piyaro, Sallyroman, Rach2012, Jamesmadison2012, Shauljaim,
Classicmilds, Longlane2012, Limit-theorem, Alexnl123, Szury, Epicgenius, Mrsoiza, Rybec, Addz123, Jpbond, Mde.guy, Baconfry, Forexwords, Sydiop36, Jcampbell32, Dashm79, Gareth Leibowitz, LMiller31, Bostrading, Jaaron95, Juhuyuta, Yoavind, Vbillv, JaconaFrere,
Notsosoros, Wiki handel, Binaryex, Adamcooper5, TruthFinderZero, EditMeNowPlease, BinaryOptionFreak, JeppsIsTheBest, 24optioncom, BigEdit34, Midexer, MendicantedBias, BDBJack, Okothben, Entkalker, TerryAlex, BinaryTrader2014, Tarkas64, Malanowski, Martin Nevrela, Mobi007a, Binarni opce, Sinthiashasha, Supdiop, Henrik Rossi, Mayapalm, Arielinteractive, Sylwesterm, Prestigegp, DavidClarke01, Davidclarke0 and Anonymous: 182
Chooser option Source: http://en.wikipedia.org/wiki/Chooser_option?oldid=580863991 Contributors: Discospinster, Xezbeth, Lockley,
SmackBot, John, Ulner, Cydebot, Lamro, DoctorKubla, TCMemoire and Anonymous: 2
Lookback option Source: http://en.wikipedia.org/wiki/Lookback_option?oldid=620798259 Contributors: Edward, Pcb21, Lmatt, Mike
hayes, Brent williams, Cydebot, Barek, Magioladitis, Jmalicki, SoxBot, Addbot, Yobot, Chraemy, Erik9bot, BenzolBot, RjwilmsiBot,
Helpful Pixie Bot and Anonymous: 11

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Mountain range (options) Source: http://en.wikipedia.org/wiki/Mountain_range_(options)?oldid=580864115 Contributors: AlmostSurely, Rich Farmbrough, Leifern, Arthena, Cydebot, Alaibot, Kevinsam, PhDinMS, Finnancier, Erik9bot and Anonymous: 2
Constant proportion portfolio insurance Source: http://en.wikipedia.org/wiki/Constant_proportion_portfolio_insurance?oldid=
651873964 Contributors: Michael Hardy, Fintor, Kjkolb, John Quiggin, Hartjm, Akihabara, Sbrools, Zeycus, Robma, Kotepho, CmdrObot,
Cydebot, Hypersphere, Mickzdaruler, JaGa, Mgarrett6, Ia215, Lamro, Mantis811, Sanya3, Auntof6, Sun Creator, DepartedUser4, Addbot,
Luckas-bot, Xqbot, Haeinous, Ksb-nances, Tristan.Froidure, Skakkle, BG19bot, Yuleikos, ChrisGualtieri, EagerToddler39, Analyst123
and Anonymous: 30
Equity-linked note Source: http://en.wikipedia.org/wiki/Equity-linked_note?oldid=626326426 Contributors: Enchanter, Pearle,
Hooperbloob, Plrk, Poltak, Ricky@36, Gregbard, Rkrite, EdJohnston, JMehta, Salad Days, JeM, Shakychan, Lamro, SieBot, Addbot,
Cameron Scott, Lotje, ArmbrustBot and Anonymous: 10
Equity derivative Source: http://en.wikipedia.org/wiki/Equity_derivative?oldid=650970229 Contributors: Jagged, Enchanter, Cherkash,
Renamed user 4, Gandalf61, David Gerard, Matthew Stannard, Decumanus, MementoVivere, Sortior, Mahanga, Ronnotel, Dpr, Ketiltrout, Cww, Bgwhite, RussBot, JLaTondre, DocendoDiscimus, SmackBot, Thunderboltz, Anwar saadat, Chris the speller, Mulder416,
Meinertsen, Bwpach, JoeBot, Bleechee, CmdrObot, Cydebot, Future Perfect at Sunrise, Steven Russell, Madbehemoth, Ph.eyes, Custardninja, Nono64, DMCer, Finnancier, USmarcomm, Addbot, Equilibrium007, Vrenator, Sargdub, Swerfvalk, Cgt, Rkwestel, Peru Serv,
Kkumaresan26, Wedfghjk123 and Anonymous: 52
Fund derivative Source: http://en.wikipedia.org/wiki/Fund_derivative?oldid=635226178 Contributors: Edward, The wub, Bgwhite,
Albedo, SmackBot, Colonies Chris, Cydebot, John254, Severo, Urbanrenewal, Lamro, Superbeecat, ColinKnight, Addbot, Day000Walker,
Comatmebro and Anonymous: 7
Ination derivatives Source: http://en.wikipedia.org/wiki/Inflation_derivative?oldid=591899556 Contributors: Enochlau, Daf, Guy
M, BD2412, SmackBot, TastyPoutine, Cydebot, Quantyz, DmitTrix, Greensburger, Drdariush, Funandtrvl, Christophenstein, Biebdj,
Finnancier, Lin1, MuedThud, Helpful Pixie Bot, BattyBot, Paul.cabot, Heidmain, JamesBee71 and Anonymous: 15
PRDC Source: http://en.wikipedia.org/wiki/Power_reverse_dual-currency_note?oldid=624623232 Contributors: Edward, Woohookitty,
RHaworth, Sardanaphalus, SmackBot, Cydebot, Dawnseeker2000, Fratrep, Rockfang, Ratesquant, Yobot, Malin Tokyo, PRDC Trader,
R2d2 jp, GoingBatty, Kilopi, Rangoon11, ClueBot NG, Styliann01 and Anonymous: 16
Real estate derivatives Source: http://en.wikipedia.org/wiki/Real_estate_derivative?oldid=611093673 Contributors: Jao, RHaworth,
Lockley, Bhadani, Celendin, Crasshopper, SmackBot, Whpq, Cydebot, Barek, Fabrictramp, R'n'B, Katharineamy, JL-Bot, Epolito,
AnomieBOT, Vovchyck, Polarpanda, Slightsmile, Rangoon11, ClueBot NG and Anonymous: 7
Synthetic option position Source: http://en.wikipedia.org/wiki/Synthetic_position?oldid=647485763 Contributors: Rpyle731, Esrogs,
Dmol, BD2412, SmackBot, Ulner, Hu12, Cydebot, Mojo Hand, AdRock, Beeblebrox, Yobot, Skakkle, Swerfvalk, We hope, Coveredcalls,
Helpful Pixie Bot and Anonymous: 4
Synthetic underlying position Source: http://en.wikipedia.org/wiki/Synthetic_position?oldid=647485763 Contributors: Rpyle731, Esrogs, Dmol, BD2412, SmackBot, Ulner, Hu12, Cydebot, Mojo Hand, AdRock, Beeblebrox, Yobot, Skakkle, Swerfvalk, We hope, Coveredcalls, Helpful Pixie Bot and Anonymous: 4
Swap (nance) Source: http://en.wikipedia.org/wiki/Swap_(finance)?oldid=661874619 Contributors: Derek Ross, Edward, Michael
Hardy, Robbot, Duncharris, Sam Hocevar, Fintor, Miborovsky, Fenice, Beachy, Cmdrjameson, Jerryseinfeld, Leifern, Patsw, Arcenciel, Nealcardwell, Velella, Blaxthos, Levan, Reinoutr, Woohookitty, Krexwall, Lfchuang, Ronnotel, Scaoc, Helvetius, Syced, Cb160,
Nstannik, The Rambling Man, YurikBot, RussBot, Htournyol, NickBush24, Cmcfarland, Arthur Rubin, KGasso, Katieh5584, DocendoDiscimus, SmackBot, Vald, Stie, Gilliam, Bluebot, Mitsuhirato, OrphanBot, Stevenmitchell, Inadarei, Cybercobra, Tesseran, ThurnerRupert, Lambiam, Djmitche, Ulner, 16@r, Interik, Wamiq (usurped), Hu12, Quaeler, Quodfui, Chansunyanzi~enwiki, JohnCD, Cydebot,
Kozuch, Thijs!bot, Movses, MER-C, LeMarsu, Kateshortforbob, Inomyabcs, Idioma-bot, Zhenqinli, Lamro, 970slashx, SieBot, Jojalozzo,
Omarenzi, OKBot, StaticGull, Nakulp, Varni1837, Asocall, Finnancier, Desx2501, The Thing That Should Not Be, Aintneo~enwiki,
Mneisen, Eustress, SchreiberBike, Grkhurana, Addbot, Cwnch, Nataly c, Yobot, Tohd8BohaithuGh1, Fraggle81, AnomieBOT, Dkeditor,
JRB-Europe, Piano non troppo, Fender0107401, Materialscientist, Obersachsebot, Shiju.johns, GrouchoBot, Natural Cut, Oashi, CRoetzer, DrilBot, Jonesey95, Hamtechperson, RedBot, Lars Washington, Tokyoeasywriter, Gizbic, EmausBot, GoingBatty, John Cline, Metaleonid, Benjamin1414141414141414, Benleith, EWikist, Thepractical, ClueBot NG, Cwmhiraeth, Jmreinhart, Mundgan, Dean Turbo,
MerlIwBot, ThowardLP, Titodutta, BattyBot, Tebscasino, Khazar2, Mikeschmidt9119, Analyst123, Thenextneo42, Phleg1, Bold Edits,
Diegodaquilio and Anonymous: 183
Swap rate Source: http://en.wikipedia.org/wiki/Swap_rate?oldid=609671241 Contributors: Cool Hand Luke, Calton, Eddypoon, Whitejay251, SmackBot, Bluebot, TheBlueFlamingo, MarkEdgington, Skapur, Pascal.Tesson, Barek, PhilKnight, Lamro, Finnancier, Floul1,
Addbot, Yobot, BCLH, Helpful Pixie Bot, YFdyh-bot, Hongrusi and Anonymous: 8
Variance swap Source: http://en.wikipedia.org/wiki/Variance_swap?oldid=651648581 Contributors: Edward, Kwertii, Nishball,
Oboulanger, Leifern, TheParanoidOne, Arthena, Btyner, Ronnotel, Stoph, Jaraalbe, Gaius Cornelius, Wiki alf, SmackBot, Rtc, Nbarth,
Wisden17, Ulner, Hu12, Cydebot, VBandal, Ericluk71, Fiachra10003, Swatiquantie, Saber girl08, Lamro, Falcon8765, Sebquant, The
Red Hat of Pat Ferrick, Finnancier, Poleaxe, Yobot, AnomieBOT, Fab10ab, BattyBot, ChrisGualtieri and Anonymous: 41
Forex swap Source: http://en.wikipedia.org/wiki/Foreign_exchange_swap?oldid=651016662 Contributors: GTBacchus, Dave6,
HorsePunchKid, Fintor, Haxwell, Leifern, Apoc2400, Kmorozov, Lmatt, DVdm, Htournyol, Veinor, A bit iy, Mom2jandk, Jprg1966,
TJJFV, MrArt, Wikixoox, Hu12, Linkspamremover, Shikaga, Cydebot, Coulmullen, Msankowski, Severo, Titus999, Custardninja,
Sherby33, Stephennt, Lampica, Finnancier, Jackollie, Cp111, Jimmychambers, PixelBot, Certes, Firstandgoal, Addbot, Mortense, Fraggle81, Edvc23132, Haeinous, Pinethicket, BlockKin77, F, Mahima.chawla, Fancitron, ChrisGualtieri, I am One of Many, Forexnewbie,
Forexbonus100 and Anonymous: 44
Basis swap Source: http://en.wikipedia.org/wiki/Basis_swap?oldid=499963213 Contributors: SimonP, Edward, Matthew Stannard, Jerryseinfeld, Leifern, GraemeL, SmackBot, Ulner, Hu12, Cydebot, Alaibot, Nshuks7, GeneralBob, Lamro, Reagan9000, Finnancier, Standoor,
Malin Tokyo, Erik9bot, Killian441 and Anonymous: 25
Constant maturity swap Source: http://en.wikipedia.org/wiki/Constant_maturity_swap?oldid=601666515 Contributors: Edward, Gui,
Leifern, Babajobu, Cb160, Los688, Chooserr, Zwobot, DocendoDiscimus, Nbarth, Realafella, Berrick, Avg, Cydebot, Onebird~enwiki,
McTavidge, Lamro, Finnancier, Tkaczma, Addbot, Bonewith, Piloter, Bigweeboy, MicioGeremia, Matthiasheymann, Debitoris and Anonymous: 16

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CHAPTER 19. TEXT AND IMAGE SOURCES, CONTRIBUTORS, AND LICENSES

Currency swap Source: http://en.wikipedia.org/wiki/Currency_swap?oldid=636208082 Contributors: Edward, Kwertii, Fred Bauder,

Ixfd64, Pgan002, Fintor, Thorwald, Longhair, Leifern, Woohookitty, SDC, BD2412, John Maynard Friedman, YurikBot, CambridgeBayWeather, Tinlash, Searchme, Pb30, DocendoDiscimus, Veinor, A bit iy, SmackBot, DanSchatz, Wybot, SashatoBot, Kuru, Phil Christs,
Neil916, SvenAERTS, Msankowski, NByz, Tayl1257, Oceanynn, 28bytes, Chris6225, Lamro, Kbrose, Finnancier, Jonathanstray, ClueBot, Clivemacd, Cp111, DumZiBoT, Addbot, ContinentalAve, Luckas-bot, TaBOT-zerem, Wavee, Citation bot, Flyzap, Dinamik-bot,
Ktm1234, RjwilmsiBot, Dewritech, ZroBot, ClueBot NG, MerlIwBot, Frze, Fancitron, SD5bot, Khazar2, Qexigator, Mogism, Lemondetox and Anonymous: 65
Equity swap Source: http://en.wikipedia.org/wiki/Equity_swap?oldid=639055059 Contributors: Edward, Michael Hardy, Jengod, Taxman, Finn-Zoltan, Klemen Kocjancic, Unbehagen, Fenice, Leifern, Arthena, Woohookitty, Lfchuang, Bhadani, DocendoDiscimus,
SmackBot, CWA, CmdrObot, Cydebot, Peripitus, Ameliorate!, Gnfnrf, Thijs!bot, Bahnemann, Abhishekgulati, Smooth0707, DMCer,
Finnancier, Sun Creator, Addbot, Airmark, Download, Kahasabha, Sir Bertie Wooster, Brown motion, Fender0107401, LilHelpa, Helene
descomps, Erik9bot, Unstable-equilibrium, Abhideb1981, YiFeiBot and Anonymous: 34
Ination swap Source: http://en.wikipedia.org/wiki/Inflation_swap?oldid=470643835 Contributors: Jra, Jamesr1ley, AndrewHowse, Cydebot, Misarxist, Lamro, Yobot, Haabla, Smokeyjack2000, MuedThud and Anonymous: 8
Total return swap Source: http://en.wikipedia.org/wiki/Total_return_swap?oldid=662118828 Contributors: Edward, Everyking, Christofurio, Fenice, Jerryseinfeld, Leifern, Dexio, Rjwilmsi, FlaBot, Vina-iwbot~enwiki, Ulner, Hu12, Cydebot, Wescbell, Authoress,
Finnancier, Evitavired, Priestman622, Mneisen, PixelBot, Elunah, XLinkBot, Addbot, Ettrig, Gongshow, Kingpin13, ArthurBot, Xqbot,
PigFlu Oink, RjwilmsiBot, EmausBot, Lupkoehl, CitationCleanerBot, Rsoni9 and Anonymous: 46
Volatility swap Source: http://en.wikipedia.org/wiki/Volatility_swap?oldid=651631345 Contributors: Waldir, SmackBot, Nekohakase,
Cydebot, Epbr123, AlexNewArtBot, Adityachitral, Lamro, Sebquant, Finnancier, Karsten Johannes Martin, Mild Bill Hiccup, Ratesquant
and Anonymous: 1
Correlation swap Source: http://en.wikipedia.org/wiki/Correlation_swap?oldid=429148975 Contributors: Arthena, SmackBot, Brianboonstra, Cydebot, Vovchyck and Anonymous: 3
Conditional variance swap Source: http://en.wikipedia.org/wiki/Conditional_variance_swap?oldid=566932671 Contributors: Edward,
Nishball, Woohookitty, Cydebot, Squids and Chips, Edg2103, UnCatBot, Yobot, Citation bot, Paalappoo, Drilnoth, Vovchyck and Anonymous: 2
Asset-backed security Source: http://en.wikipedia.org/wiki/Asset-backed_security?oldid=664071247 Contributors: Edward, Altenmann,
Stewartadcock, Pgreennch, Clawson, Jerryseinfeld, Eric Kvaalen, Versageek, Tabletop, Ronnotel, Rjwilmsi, JHMM13, JanSuchy, Wragge,
Ground Zero, RussBot, Zwobot, EEMIV, DocendoDiscimus, MaeseLeon, SmackBot, ElectricRay, Ohnoitsjamie, Hmains, Jcoman, Rmonahan, KaiserbBot, Jaedglass, SirIsaacBrock, Langhorner, Dicklyon, Hu12, Eastlaw, Cydebot, Gogo Dodo, Thijs!bot, Dawnseeker2000,
Visik, C4duser, Epeeeche, Magioladitis, Drewwiki, BoogaLouie, DoorsAjar, HarrisonScott, Saber girl08, Zhenqinli, CreditQuant, BotMultichill, Jreans, Authoress, Bombastus, Alexlimo, Finnancier, Alcatrank, DAW0001, Alexbot, Dkgup01, Ejwheeler, Grapeguy, DumZiBoT, XLinkBot, Resurchin, Addbot, Egw1119, IA Finance Type, CountryBot, Luckas-bot, Bunnyhop11, JohnnyCalifornia, Ptbotgourou,
AnomieBOT, Xqbot, Srich32977, GrouchoBot, Modailkoshy, Mnmngb, Dvink, Logomachy, Daniel Damhors, Markvisser, DexDor, Wconerly, John of Reading, Dewritech, Ida Shaw, Dave347, BG19bot, Dwight1234, GabeIglesia, HaroldvDaalen, Wojiushiwo522, Do better,
Jerrywang89320, Laana2, Thomasjames1217 and Anonymous: 69
Mortgage-backed security Source: http://en.wikipedia.org/wiki/Mortgage-backed_security?oldid=660316536 Contributors: Roadrunner, Edward, Fred Bauder, Pnm, Choster, Andrewman327, Tpbradbury, Nurg, Fintor, DMG413, Rich Farmbrough, Amoore, MeltBanana,
LindsayH, RoyBoy, O18, Clawson, Jerryseinfeld, Gary, Ab9~enwiki, PaulHanson, Guy Harris, Lectonar, Lightdarkness, RoySmith,
HenkvD, Jhibschman, JordanSamuels, Bobrayner, Woohookitty, Ronnotel, BD2412, Elvey, Edison, Rjwilmsi, Feco, Wragge, Bondwonk,
Isotope23, FireballDWF2, Srleer, Wasted Time R, RussBot, Anders.Warga, Splette, Kkmurray, GraemeL, DocendoDiscimus, SmackBot, Thomas Ash, Ohnoitsjamie, Hmains, Bluebot, Nbarth, Shalom Yechiel, Frothy, CanDo, Cigar816, ThurnerRupert, Ulner, Loodog,
Williameis, Rjgibb, Dicklyon, TastyPoutine, Hu12, Holmezy, Joseph Solis in Australia, CmdrObot, Svendsgaard, Stebulus, HalJor, Cydebot, Gogo Dodo, Tawkerbot4, Kyle J Moore, Thijs!bot, Radio Guy, Dawnseeker2000, Sherbrooke, Gregalton, MER-C, Hewinsj, Greensburger, 3h3dsfa4, Rich257, Zenomax, Flowanda, R'n'B, Trusilver, Helle55953, Abhijitsathe, ILikeHowMuch, Nwbeeson, DMCer, Useight,
Pleclech, VolkovBot, ABF, BoogaLouie, Indian redi, VivekVish, Atomafr, Food Fighter, Tuneman03, Falcon8765, Physicsbovine,
Rob.philipp, SieBot, StAnselm, Timhowardriley, Nopetro, Faganp, Nuttycoconut, Int21h, JohnSawyer, Wyattmj, Laser813, Finnancier,
ClueBot, Smaglio81, Niceguyedc, Ottawahitech, Gbreen1, Campoftheamericas, Redthoreau, Dlawbailey, Xchange, Greman Knight, Updijp2, Nnnnnnnnn81, Sneelak, Addbot, MrOllie, Egw1119, Lightbot, Bonatto, Yobot, TaBOT-zerem, Taylordw, Rachelmac123456, Nitro
Court, Mahoneylaw, Citation bot, WTBrooks, Xqbot, MarkWarren, Joshvito, Ihodgdhwdh, Natural Cut, Shadowjams, Tophat13, FrescoBot, Dvink, Markvisser, Slessard 79, Tk41, Skyerise, Codwiki, Sivamoturi, Suusion of Yellow, RjwilmsiBot, TheTinyRaccoon, EmausBot, WikitanvirBot, Segenay, Ida Shaw, Metalica23, Laneways, ChuispastonBot, ClueBot NG, Mythicism, Auxilstitute, Helpful Pixie Bot,
Guest2625, Patrug, Macaddictjay, Nsmeshko, Ohyoucare, Polmandc, Sunnyg229, Mlmbs, Kindtony, Jason from nyc, Cupco, Ceraclea,
HaroldvDaalen, Kelly169, Glins1, Djosopolar, Gonzalotudela and Anonymous: 165
Collateralized mortgage obligation Source: http://en.wikipedia.org/wiki/Collateralized_mortgage_obligation?oldid=656684537 Contributors: Edward, Angela, Nurg, DataSurfer, Daniel Brockman, Tristanreid, Mpearl, Rich Farmbrough, Longhair, PaulHanson,
Pkonigsberg, Alai, Rjwilmsi, Topstar, Wavelength, Porkchop, RussBot, Rodasmith, Anomie, Seanjacksontc, DocendoDiscimus, Simon123, Robosh, Sakuraz, TastyPoutine, CmdrObot, Hebrides, Monger187, Dawnseeker2000, SummerPhD, Epischedda, Gregalton,
Ashvin.chougule, Rich257, Sm8900, R'n'B, PrestonH, Helle55953, Bosoxrock, Lamro, Evil iggy1936, Mightybeancounter, Mujep4,
Alexlimo, Finnancier, ClueBot, Snigbrook, Boing! said Zebedee, Fivesided, Sun Creator, DumZiBoT, Firebat08, Anticipation of a New
Lovers Arrival, The, Addbot, Sdtrams, Kvandersluis, Download, Egw1119, Tassedethe, Frehley, Yobot, Xqbot, Cheesepedia, FrescoBot,
HeatherSmitheld, Ghtaylor, Winstonhyypia, Jacobisq, Khazar2, Glins1 and Anonymous: 63
Market Risk Source: http://en.wikipedia.org/wiki/Market_risk?oldid=653145121 Contributors: Pnm, Didickman, Daniel Dickman, Beland, Pgreennch, DomCleal, Trevor MacInnis, Random user, Wrp103, ArnoldReinhold, Jerryseinfeld, Arthena, RJFJR, Bellenion,
Jweiss11, YurikBot, Stephenb, Paolonalin, SmackBot, Eskimbot, Caissas DeathAngel, Kuru, IvanLanin, N2e, Outriggr, Cydebot, Kraky,
Jafcbs, RobotG, Kkjc5824, Nshuks7, Gregalton, Athaenara, VolkovBot, Altruism, Dvandeventer, Gireeshda, SieBot, Leirith, Savvysoft,
Rodhullandemu, PixelBot, Bshravan, Engi08, Ziggy Sawdust, Addbot, MrOllie, IdealWorld, Zorrobot, Themfromspace, Dkeditor, Danno
uk, Citation bot, Jen Svensson, Duoduoduo, MicioGeremia, EmausBot, ZroBot, Zfeinst, ChuispastonBot, Furthermost, Wafa89, Frosty,
JaconaFrere and Anonymous: 42

19.1. TEXT

439

Financial risk Source: http://en.wikipedia.org/wiki/Financial_risk?oldid=663088708 Contributors: Edward, Pnm, Kku, Ronz, Andycjp,
Rich Farmbrough, Chriscf, Hooperbloob, Woohookitty, Prikryl, Piksou, Grafen, DocendoDiscimus, Sardanaphalus, SmackBot, Elonka,
Royalguard11, IstvanWolf, Simon123, NaturalBornKiller, Hu12, IvanLanin, Eastlaw, Outriggr, Cydebot, Josephbrophy, JAnDbot, Krakenies, STBot, Rpclod, Yafool7, Potatoswatter, Idioma-bot, Funandtrvl, Navious, A.Ward, WebScientist, Zhenqinli, Sevela.p, Regregex,
YonaBot, LeadSongDog, Jojalozzo, Dimorsitanos, Enerelt, XLinkBot, Engi08, Addbot, LatitudeBot, MrOllie, Stuartanson, Zorrobot,
Luckas-bot, Yobot, Keithbob, Erik9bot, FrescoBot, Trappist the monk, Duoduoduo, RjwilmsiBot, Afb525, DominicConnor, ZroBot,
John Cline, Zfeinst, Riskrisk, ClueBot NG, Jack Greenmaven, Bped1985, 1991, Noot al-ghoubain, Widr, Helpful Pixie Bot, Titodutta,
Dashdash99, Fordmover334, Fine author, Joancdocyogen, Monkbot, Zach merchant, Craytonconstanceb and Anonymous: 46
Liquidity risk Source: http://en.wikipedia.org/wiki/Liquidity_risk?oldid=662331101 Contributors: Edward, Michael Hardy, Pnm, Daniel
Dickman, DomCleal, D6, ArnoldReinhold, Kimbly, Cretog8, Giraedata, Arthena, Josh Parris, Ketiltrout, Rjwilmsi, Jweiss11, Butros,
Chobot, Skritek, Welsh, Paolonalin, Yabbadab, Avalon, SmackBot, Kuru, IvanLanin, N2e, Outriggr, Cydebot, Edwardx, RobotG, Nshuks7,
Gregalton, Cyktsui, R'n'B, JonMcLoone, TXiKiBoT, Lamro, Aednichols, Dvandeventer, Willisja, Metosa~enwiki, Karsten11, Denisarona,
BOTarate, Engi08, Addbot, Protonk, Zorrobot, Yobot, Weatherg, Treasuryexpert, Karien Pype, AnomieBOT, Killiondude, Citation bot,
LilHelpa, Xqbot, Nipple on my head, NigelAshford, GrouchoBot, AVBOT, BobertTheThird, Benzen, Citation bot 1, Tobo27, Wayne Slam,
Zfeinst, ClueBot NG, Gareth Grith-Jones, MelbourneStar, Helpful Pixie Bot, Kai Ojima, Tarock das, BattyBot, Econstu, Mcc1987,
Sachinidilanka, Wert1980, Sebbo007, Djosopolar, Monkbot and Anonymous: 59
Systemic risk Source: http://en.wikipedia.org/wiki/Systemic_risk?oldid=661809203 Contributors: SimonP, Edward, Pnm, Charles
Matthews, Henrygb, Discospinster, ArnoldReinhold, Bender235, Elipongo, Jerryseinfeld, Pearle, John Quiggin, Boothy443, Rjwilmsi,
Feco, Ground Zero, YurikBot, Htournyol, NawlinWiki, Jpbowen, Rjlabs, Ospalh, 2over0, Madines, SmackBot, Lawrencekhoo, PeterSymonds, Ohnoitsjamie, Prokurator, Nbarth, Darren Wickham, Tchesko, Secretrobotron, Ckatz, Dicklyon, N2e, Thomasmeeks, Outriggr, Cydebot, DumbBOT, RobotG, Nshuks7, Gregalton, Epeeeche, MastCell, Athaenara, Thaurisil, Ryan Postlethwaite, Wkdtr, Andrewaskew, Farcaster, AdRock, Jojalozzo, Le Pied-bot~enwiki, OKBot, Rinconsoleao, ChandlerMapBot, Secret (renamed), Cenarium,
Jkhcanoe, Vivi spil, BigK HeX, Dthomsen8, Good Olfactory, Addbot, Carlos Rosa PT, Verbal, Yobot, Bellemonde, Xqbot, Ron Paul...Ron
Paul..., Rw65, AntonioMustDie, TruthClaries, BulliesForBrains, Angels...Pins...Whatever, Omnipaedista, Albertdavis3, Mmt333, PyramidsOrFood?, FrescoBot, WatchinTheTideRollAway, FranksFannieSmellsLikeHerbs, BucklingUnderTheDebtDeathMarch, FranksCoxInHerbsFannie, DyingSisyphus, ConsumerDebtIsEconomicCancer, Anaskassem, Kwiki, PigFlu Oink, DrilBot, MindlessMaterialism,
Mark"DMW"Patterson, Elockid, Orenburg1, Alph Bot, Sam Solida, Lsevenserve, Dewritech, Cinebio, ZroBot, Richardbbarber,
QE2Innity!, DumbRichSmartPoor, OilyChernobyl, Gaynomics, ArmativeInaction, Esterne, BG19bot, P4Pocket, CitationCleanerBot, Shalapaws, BattyBot, Ajobst, Alevsarc, SPECIFICO, Moneco, Zhengzy, Chris troutman, Robevans123, DebCo, Bjleslie, Monkbot,
Horselover Fats and Anonymous: 61
Systematic risk Source: http://en.wikipedia.org/wiki/Systematic_risk?oldid=632625304 Contributors: Pnm, Jni, Bender235, Jerryseinfeld, John Quiggin, Dar-Ape, Bhny, Lawrencekhoo, Nbarth, Cydebot, DumbBOT, Fconaway, Philip Trueman, Cnilep, Asocall, Rinconsoleao, Gsamdaria, Addbot,
, Yobot, Omnipaedista, Jenks24, MerlIwBot, Rorydurkin, Econdeck, ChrisGualtieri, Dexbot, Vibhorjain100, Moneco and Anonymous: 25
Basis risk Source: http://en.wikipedia.org/wiki/Basis_risk?oldid=663929667 Contributors: Chancemill, Helvetius, Avraham, SmackBot,
Gilliam, KaiserbBot, Robosh, Outriggr, Orlamulligan, Cydebot, RobotG, Apparition11, Yobot, Erik9bot, FrescoBot, Protonx, Zfeinst,
BartThunder, Edmond8674 and Anonymous: 16
Pin risk Source: http://en.wikipedia.org/wiki/Pin_risk_(options)?oldid=597240164 Contributors: Enchanter, Bobo192, Ronnotel, RussBot, Renata3, KaiserbBot, Cydebot, Lamro, Finnancier, Ehrenkater, Miyagawa, Tolly4bolly, Macinsmith and Anonymous: 12
Financial regulation Source: http://en.wikipedia.org/wiki/Financial_regulation?oldid=663215046 Contributors: Olivier, Edward,
Michael Hardy, Pnm, Mic, Docu, Cferrero, Jni, Gidonb, ChicXulub, Sohailstyle, Neutrality, Fintor, Rich Farmbrough, Guanabot, MBisanz,
Jerryseinfeld, 3mta3, Zetawoof, Mdd, Wtmitchell, Woohookitty, Splintax, Ground Zero, Lmatt, Noypi380, Rjlabs, Sschuman, Tiger888,
DocendoDiscimus, Sardanaphalus, SmackBot, RandomProcess, Ohnoitsjamie, Chris the speller, Simon123, Naerhu, Hu12, Dreftymac,
CmdrObot, Insanephantom, Axanumb519, Kozuch, Vladq, Thijs!bot, Bdasgupta@gmail.com, Rabrams20, STBot, Ghileman, J.delanoy,
Shawn in Montreal, Wikipeterproject, Ferdinand Adams, Naive rm, Jhalsey, Claus Ableiter, Heli chapin, SchreiberBike, Addbot, Jncraton,
MrOllie, Luckas-bot, Yobot, Xqbot, Ammubhave, Srich32977, Arnaud.trebaol, Thehelpfulbot, Treasurymarket, Kenfyre, Rodamaker, Intersog, Jem147, Breadnhs99, Muohara1, JaquiB, Mean as custard, Sargdub, FinanceQ, TheSoundAndTheFury, Finance C, DavidMCEddy,
Stikemanforum, Diamondland, ClueBot NG, Widr, JJPicard~enwiki, BG19bot, Pine, Chanewin, Piano1900, Meatsgains, B.Andersohn,
Ujazzz, SERutherford, JYBot, Thaarup, KrisVerde, Jianhui67, Whizz40, Sowndaryab, Charlespeakes, HQcontent, KasparBot and Anonymous: 72
US Federal Reserve Source: http://en.wikipedia.org/wiki/Federal_Reserve_System?oldid=664590778 Contributors: MichaelTinkler, The
Epopt, Derek Ross, LA2, Youssefsan, Shsilver, Sfmontyo, Roadrunner, DavidLevinson, Netesq, Hephaestos, Atlan, Olivier, Octothorn,
Edward, Infrogmation, JohnOwens, Michael Hardy, Fred Bauder, Pnm, BoNoMoJo (old), Jketola, Mic, Ixfd64, Tabrez, Minesweeper,
Looxix~enwiki, Ahoerstemeier, Cyp, Elano, William M. Connolley, Darkwind, Andres, Jiang, Kaihsu, Rl, Csernica, Mydogategodshat,
Jengod, Etherialemperor, Rob.derosa, Choster, Rednblu, Greenrd, DJ Clayworth, Tpbradbury, Saltine, Tempshill, VeryVerily, Wonko,
Nickshanks, Kwantus, Warofdreams, Pstudier, Jason M, Pakaran, Jusjih, Johnleemk, Finlay McWalter, JorgeGG, Chuunen Baka, Gentgeen,
EdwinHJ, Robbot, Icestryke, Josh Cherry, Fredrik, ZimZalaBim, Nurg, Mirv, Postdlf, Rfc1394, Henrygb, Hemanshu, Hadal, Wikibot, Raeky, Cyrius, Dina, Davidcannon, Alan Liefting, Alexwcovington, Centrx, DocWatson42, Awolf002, J heisenberg, BenFrantzDale,
MSGJ, Cool Hand Luke, Everyking, Jacob1207, Hoho~enwiki, Dratman, NeoJustin, DO'Neil, Prodigaldruid, Nkocharh, Remy B, Bobblewik, Poker Player, Stevietheman, Closer71, Chowbok, Pgan002, Rworsnop, Jdevine, Quadell, Antandrus, Beland, OverlordQ, Kaldari,
Jossi, Rdsmith4, DragonySixtyseven, Capnned, RayBirks, Burgundavia, Sam Hocevar, Howardjp, Neutrality, Tmstapf, Trek011~enwiki,
Aknorals, SYSS Mouse, Kmccoy, Dissipate, Haruo, Discospinster, Rich Farmbrough, Jjb, Zombiejesus, Adam850, SocratesJedi, Mani1,
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MPS, Adambro, Causa sui, Bobo192, O18, Hurricane111, Func, John Vandenberg, Dreish, Cappiels, Tobacman, Maurreen, Giraedata, Mdkarazim, Jerryseinfeld, David Gale, Bezbozhnik, Nsaa, Perceval, Stephen G. Brown, Jigen III, Alansohn, PaulHanson, Duman~enwiki, Guy Harris, Eric Kvaalen, Arthena, John Quiggin, Andrew Gray, Mlm42, DonMcNellis, Snowolf, Quaestor~enwiki, RJII,
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DickClarkMises, SNIyer12, Virginia Bell, Javalizard, Diablo-D3, FlaBot, Ian Pitchford, Da'covale, SchuminWeb, RobertG, Ground Zero,

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Quarter-TradeWeightedIndex-EndPeriod-A3533868J.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/fe/ABS-5302.
0-BalancePaymentsInternationalInvestmentPositionAustralia-ExchangeRates_Quarter-TradeWeightedIndex-EndPeriod-A3533868J.
svg License: CC BY-SA 3.0 au Contributors: This image is based on Australian Bureau of Statistics data.
Original artist: Toby Hudson
File:Ambox_globe_content.svg Source: http://upload.wikimedia.org/wikipedia/commons/b/bd/Ambox_globe_content.svg License:
Public domain Contributors: Own work, using File:Information icon3.svg and File:Earth clip art.svg Original artist: penubag
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File:BankingCrises.svg Source: http://upload.wikimedia.org/wikipedia/commons/2/27/BankingCrises.svg License: CC BY-SA 3.0 Contributors: Own work Original artist: DavidMCEddy
File:BilleteiNTER_II.jpg Source: http://upload.wikimedia.org/wikipedia/commons/c/ca/BilleteiNTER_II.jpg License: CC BY-SA 3.0
Contributors: Own work Original artist: Veronidae
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Own work Original artist: Alik.ulmasov
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File:Bull_spread_using_calls.png Source: http://upload.wikimedia.org/wikipedia/commons/0/06/Bull_spread_using_calls.png License:
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File:Butterfly_spread_with_calls.png Source: http://upload.wikimedia.org/wikipedia/commons/5/52/Butterfly_spread_with_calls.png
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IMF_Diagram.png License: Public domain Contributors: Transferred from en.wikipedia by SreeBot Original artist: Farcaster at
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File:CDO_issuances_2004-2012-darker.png Source:
http://upload.wikimedia.org/wikipedia/commons/6/62/CDO_issuances_
2004-2012-darker.png License: CC BY-SA 3.0 Contributors: Own work Original artist: BoogaLouie
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File:CDS-nodefault.PNG Source: http://upload.wikimedia.org/wikipedia/commons/6/64/CDS-nodefault.PNG License: Public domain
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File:CDS_volume_outstanding.png Source: http://upload.wikimedia.org/wikipedia/commons/9/93/CDS_volume_outstanding.png License: CC BY-SA 3.0 Contributors: Own work Original artist: MartinD
File:Cds_cashflows.svg Source: http://upload.wikimedia.org/wikipedia/commons/e/e6/Cds_cashflows.svg License: CC-BY-SA-3.0
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File:Cds_paymentstream_protection_loss_event.svg
Source:
http://upload.wikimedia.org/wikipedia/commons/6/6b/Cds_
paymentstream_protection_loss_event.svg License: CC-BY-SA-3.0 Contributors: Original Image:Cds zahlungsuss ausfall.svg uploaded by User:Gandi79 with summary Andreas Griessner. w:en:User:84user translated it to English and modied it on the English
wikipedia, and then moved it to Commons. Original artist: 84user

19.2. IMAGES

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File:Cds_paymentstream_protection_noloss.svg Source: http://upload.wikimedia.org/wikipedia/commons/c/c4/Cds_paymentstream_

protection_noloss.svg License: CC-BY-SA-3.0 Contributors: Original Image:Cds zahlungsuss ausfall.svg uploaded by User:Gandi79 with
summary Andreas Griessner. w:en:User:84user translated it to English and modied it on the English wikipedia, and then moved it to
Commons. Original artist: 84user
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Obligations.svg License: Public domain Contributors: "Final Report of the National Commission on the Causes of the Financial and
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Crisis in the United States
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artist: User:El T (talk), Analoguni (talk), User:Jklamo (talk)
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self-made
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Mkoistinen (talk)
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org/wikipedia/commons/a/a0/Consolidated_Statement_of_Condition_of_All_Federal_Reserve_Banks-LIABILITIES.png License: Public domain Contributors: Own work Original artist: Analoguni
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wikipedia/commons/c/c6/Consolidated_Statement_of_Condition_of_all_Federal_Reserve_Banks-ASSETS.gif License: Public domain
Contributors: Own work Original artist: Analoguni
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CC BY-SA 3.0 Contributors: Own work Original artist: Suicup
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License: CC BY-SA 3.0 Contributors: Own work Original artist: John Shandy`
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File:Credit_default_swaps_by_quality_size_coloured_sp_percent_years.png Source:
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commons/8/8d/Credit_default_swaps_by_quality_size_coloured_sp_percent_years.png License: CC-BY-SA-3.0 Contributors: Transferred from en.wikipedia
Original artist: User:84user. Original uploader was 84user at en.wikipedia
File:Credit_default_swaps_vs_total_nominals_plus_debt.png Source: http://upload.wikimedia.org/wikipedia/commons/f/f2/Credit_
default_swaps_vs_total_nominals_plus_debt.png License: CC-BY-SA-3.0 Contributors: Transferred from en.wikipedia
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File:Crowd_outside_nyse.jpg Source: http://upload.wikimedia.org/wikipedia/commons/e/e1/Crowd_outside_nyse.jpg License: Public
domain Contributors: ? Original artist: ?
File:Crystal_Clear_app_kchart.png Source: http://upload.wikimedia.org/wikipedia/commons/e/e2/Crystal_Clear_app_kchart.png License: LGPL Contributors: All Crystal Clear icons were posted by the author as LGPL on kde-look; Original artist: Everaldo Coelho and
YellowIcon;
File:Currency_gnp_weighted_comparison_1999_2011.svg Source: http://upload.wikimedia.org/wikipedia/commons/a/a2/Currency_
gnp_weighted_comparison_1999_2011.svg License: CC BY-SA 3.0 Contributors: Own work Original artist: Dominiklenne
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Own work Original artist: Sarang
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? Original artist: ?
File:Dmitry_Medvedev_at_G20_Pittsburgh_summit-1.jpg Source: http://upload.wikimedia.org/wikipedia/commons/6/67/Dmitry_
Medvedev_at_G20_Pittsburgh_summit-1.jpg License: CC BY 3.0 Contributors: http://www.kremlin.ru/news/5576 Original artist: Presidential Press and Information Oce
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Tango! Desktop Project. Original artist:
The people from the Tango! project. And according to the meta-data in the le, specically: Andreas Nilsson, and Jakub Steiner (although
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File:Emblem-money.svg Source: http://upload.wikimedia.org/wikipedia/commons/f/f3/Emblem-money.svg License: GPL Contributors:
http://www.gnome-look.org/content/show.php/GNOME-colors?content=82562 Original artist: perfectska04

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File:Equities_usd.JPG Source: http://upload.wikimedia.org/wikipedia/commons/1/1c/Equities_usd.JPG License: CC BY-SA 3.0 Contributors: Own work on TheGeekKnows.com - Risk aversion in the forex market based on Bloomberg Charts. Original artist:
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File:Euler{}s_formula.svg Source: http://upload.wikimedia.org/wikipedia/commons/7/71/Euler%27s_formula.svg License: CC-BYSA-3.0 Contributors: Drawn by en User:Gunther, modied by others. Original artist: Originally created by gunther using xg, recreated in
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File:Fed_Reserve.JPG Source: http://upload.wikimedia.org/wikipedia/commons/7/7a/Fed_Reserve.JPG License: Public domain Contributors: 1913 US newspaper clipping Original artist: ?
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CC BY-SA 3.0 Contributors: I made this diagram Original artist: Kimse84
File:Federal_Reserve_Bank_bag.jpg Source: http://upload.wikimedia.org/wikipedia/commons/a/a3/Federal_Reserve_Bank_bag.jpg
License: CC BY-SA 4.0 Contributors: Own work Original artist: Olnnu
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Federal_Reserve_Districts_Map_-_Banks_%26_Branches.png License: CC BY-SA 3.0 Contributors: File:Federal Reserve Districts
Map.svg Original artist: ChrisnHouston
File:Federal_funds_effective_rate_1954_to_present.svg Source: http://upload.wikimedia.org/wikipedia/commons/3/31/Federal_
Funds_Rate_1954_thru_2009_effective.svg License: CC BY-SA 3.0 Contributors: Own work using data from the Federal Reserve[1] The
gnuplot source code used to generate the graph is found here Original artist: Kbh3rd
File:Fisher_iris_versicolor_sepalwidth.svg Source: http://upload.wikimedia.org/wikipedia/commons/4/40/Fisher_iris_versicolor_
sepalwidth.svg License: CC BY-SA 3.0 Contributors: en:Image:Fisher iris versicolor sepalwidth.png Original artist: en:User:Qwfp (original); Pbroks13 (talk) (redraw)
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User:Jeltz, User:Dbenbenn, User:Zscout370
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