What is an 'Interest Rate Swap'

An interest rate swap is an agreement between two counterparties in which one stream of future
interest payments is exchanged for another based on a specified principal amount. Interest rate
swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to
reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower
interest rate than would have been possible without the swap.

BREAKING DOWN 'Interest Rate Swap'

A swap can also involve the exchange of one type of floating rate for another, which is called a
basis swap.

Interest rate swaps are the exchange of one set of cash flows for another. Because they trade over
the counter (OTC), the contracts are between two or more parties according to their desired
specifications and can be customized in many different ways. Swaps are often utilized if a
company can borrow money easily at one type of interest rate but prefers a different type.

Fixed to Floating
For example, consider a company named TSI that can issue a bond at a very attractive fixed
interest rate to its investors. The company's management feels that it can get a better cash
flow from a floating rate. In this case, TSI can enter into a swap with a counterparty bank in
which the company receives a fixed rate and pays a floating rate. The swap is structured to match
the maturity and cash flow of the fixed-rate bond, and the two fixed-rate payment streams are
netted. TSI and the bank choose the preferred floating-rate index, which is usually LIBOR for a
one-, three- or six-month maturity. TSI then receives LIBOR plus or minus a spread that reflects
both interest rate conditions in the market and its credit rating.

Floating to Fixed
A company that does not have access to a fixed-rate loan may borrow at a floating rate and enter
into a swap to achieve a fixed rate. The floating-rate tenor, reset and payment dates on the loan
are mirrored on the swap and netted. The fixed-rate leg of the swap becomes the company's
borrowing rate.

Float to Float
Companies sometimes enter into a swap to change the type or tenor of the floating rate index that
they pay; this is known as a basis swap. A company can swap from three-month LIBOR to six-
month LIBOR, for example, either because the rate is more attractive or it matches other
payment flows. A company can also switch to a different index, such as the federal funds rate,
commercial paper or the Treasury bill rate.
What is a 'Credit Default Swap - CDS'
A credit default swap is a particular type of swap designed to transfer the credit
exposure of fixed income products between two or more parties. In a credit default swap, the
buyer of the swap makes payments to the swap’s seller up until the maturity date of a contract. In
return, the seller agrees that, in the event that the debt issuer defaults or experiences
another credit event, the seller will pay the buyer the security’s premium as well as
all interest payments that would have been paid between that time and the security’s maturity
date.

A credit default swap is the most common form of credit derivative and may involve municipal
bonds, emerging market bonds, mortgage-backed securities or corporate bonds.

A credit default swap is also often referred to as a credit derivative contract.

BREAKING DOWN 'Credit Default Swap - CDS'

Many bonds and other securities that are sold have a fair amount of risk associated with them.
While institutions that issue these forms of debt may have a relatively high degree of confidence
in the security of their position, they have no way of guaranteeing that they will be able to make
good on their debt. Because these kinds of debt securities will often have lengthy terms to
maturity, like ten years or more, it will often be difficult for the issuer to know with certainty that
in ten years time or more, they will be in a sound financial position. If the security in question is
not well-rated, a default on the part of the issuer may be more likely.

Comparison Chart

BASIS FOR
PLEDGE HYPOTHECATION
COMPARISON

Meaning Bailment of goods as security Hypothecation is the pledging of

against the debt for the goods, against the debt without
performance of the obligation delivering them to the lender.
or the payment thereon, is
known as the pledge.

Defined in Section172 of Indian Section 2 of Securitisation and

Contract Act, 1872 Reconstruction of Financial
 BASIS FOR
PLEDGE HYPOTHECATION
COMPARISON

Assets and Enforcement of

Security Interest Act, 2002

Legal Document Deed of Pledge Hypothecation Agreement

Possession of Remains with the creditor Remains with the debtor

property

Parties Pawnor and Pawnee Hypothecator and Hypothecatee

Rights of lender in To sale out the goods in his To take to possession of the asset
exceptional possession to adjust the debt. first, then it out to recover the
circumstances debt.

Key Differences Between Pledge and Hypothecation

The significant differences between pledge and hypothecation are specified below:

1. The pledge is defined as the form of bailment in which goods are held as security
for the payment of the debt or the performance of an obligation. Hypothecation is
slightly different from the pledge, in which the collateral asset is not delivered to
the lender.
2. The pledge is defined in section 172 of the Indian Contract Act, 1872. On the
other hand, Hypothecation is defined in Section 2 of Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest Act,
2002.
3. In the pledge, the possession of the asset is transferred, but in the case of
hypothecation, possession lies with the debtor only.
 4. Parties to the contract of the pledge are pawnor (borrower) and Pawnee (lender)
whereas in hypothecation the parties are hypothecator (borrower) and
hypothecatee (lender).
5. In the pledge, when the borrower default in payment, the lender can exercise his
right to sell the asset to recover the debt amount. Conversely, in hypothecation, the
lender does not have the possession of goods so he can file a suit to realize his
dues to take the possession first and then disposing off them.

6. Their advantages and disadvantages are outlined below.

Feature Advantage Disadvantage Effect on
Holder/Writer
Cost Options are As a form of Holder may be
an insurance, an disadvantaged
inexpensive option contract due to expiry.
way to gain may expire Writer would
access to the worthless. This be advantaged
underlying risk increases as s/he need not
investment the greater the make delivery
without extent to once the option
having to which the has expired.
buy stock option is out of
the money and
the shorter the
time until
expiration.
Leverage Options Investors Writers of
enable should realize naked calls are
investors to that options\' exposed to
stump up leverage can unlimited risk.
less money impact
and obtain performance
additional on the down
gain. side as well.
Marketability Option terms Regulatory Both parties to
trade on an intervention an options
exchange can prevent transaction
and as such exercise which benefit from
are may not be standardized
standardized. desirable. and enforceable
terms.
Hedging Options may The investor Both the holder
 be used to may end up and the writer
limit losses. being incorrect may be
as to the (dis)advantaged
direction and depending upon
timing of a which side of
stock\'s price the trade they
and may assume and the
implement a ultimate
less than direction of the
perfect hedge. underlying
security.
Return Options may The investor Both the holder
enhancement be used to may end up and the writer
enhance a being incorrect may be
portfolio\'s as to the (dis)advantaged
return. direction and depending upon
timing of a which side of
stock\'s price, the trade they
rendering the assume and the
attempt at ultimate
enhanced direction of the
portfolio underlying
return security.
worthless.
Diversification One can Diversification
replicate an cannot
actual stock eliminate
portfolio systematic
with the risk.
options on
those very
stocks.
Regulation Terms of Restrictions While in some
listed options upon exercise cases necessary,
are may occur by regulatory fiat
regulated. regulatory fiat can disrupt
(OCC, SEC, what may be a
court, other profitable trade,
regulatory affecting holder
agency). and writer
alike.

7. Drivers of option valuation include the volatility of the underlying investment upon which it is
based; the time left until expiration, the level of interest rates and the extent to which the option
is either in- or out-of-the-money.
8. Option holder's choices at expiration-exercise the option, allow it to expire or sell it prior to
the expiration date.

Call Options vs. Put Options

Very simply, an equity option is a derivative security that acquires its value from the underlying
stock it covers. Owning a call option gives you the right to buy a stock at a predetermined price,
known as the option exercise price. A put option gives the owner the right to sell the underlying
stock at the option exercise price. Thus, buying a call option is a bullish bet - you make money
when the stock goes up - while a put option is a bearish bet because if the stock price declines
below the put's exercise price, you can still sell the stock at the higher exercise price.

The exact opposite view is taken when you sell a call or put option. Most important, when you
sell an option you are taking on an obligation not a right. Once you sell an option, you are
committing to honoring your position if indeed the buyer of the option you sold to decides to
exercise. Here's a summary breakdown of buying versus selling options.

 Buying a Call - You have the right to buy a stock at a predetermined price.
 Selling a Call - You have an obligation to deliver the stock at a predetermined price to the
option buyer.
 Buying a Put - You have the right to sell a stock at a predetermined price.
 Selling a Put - You have an obligation to buy the stock at a predetermined price if the
buyer of the put option wants to sell it to you.

What is 'LIBOR'
LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate that some of the
world’s leading banks charge each other for short-term loans. It stands for
IntercontinentalExchange London Interbank Offered Rate and serves as the first step to
calculating interest rates on various loans throughout the world. LIBOR is administered
by the ICE Benchmark Administration (IBA), and is based on five currencies: U.S. dollar
(USD), Euro (EUR), pound sterling (GBP), Japanese yen (JPY) and Swiss franc (CHF),
and serves seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months.
There are a total of 35 different LIBOR rates each business day. The most commonly
quoted rate is the three-month U.S. dollar rate.

BREAKING DOWN 'LIBOR'

LIBOR (or ICE LIBOR) is the world’s most widely-used benchmark for short-term
interest rates. It serves as the primary indicator for the average rate at which banks that
contribute to the determination of LIBOR may obtain short-term loans in the
London interbank market. Currently there are 11 to 18 contributor banks for five
major currencies (US$, EUR, GBP, JPY, CHF), giving rates for seven
different maturities. A total of 35 rates are posted every business day (number of
currencies x number of different maturities) with the 3-month U.S. dollar rate being the
most common one (usually referred to as the “current LIBOR rate”).

LIBOR or ICE LIBOR's primary function is to serve as the benchmark reference

rate for debt instruments, including government and corporate bonds, mortgages, student
loans, credit cards; as well as derivatives such as currency and interest swaps, among
many other financial products.

For example, take a Swiss franc-denominated Floating-Rate Note (or floater) that pays
coupons based on LIBOR plus a margin of 35 basis points (0.35%) annually. In this case,
the LIBOR rate used is the one-year LIBOR plus a 35 basis point spread. Every year,
the coupon rate is reset in order to match the current Swiss franc one-year LIBOR, plus
the predetermined spread.

If, for instance, the one-year LIBOR is 4% at the beginning of the year, the bond will pay
4.35% of its par value at the end of the year. The spread usually increases or decreases
depending on the credit worthiness of the institution issuing debt.

Another prominent trait of LIBOR or ICE LIBOR is that it helps to evaluate the current
state of the world’s banking system as well as to set expectations for future central
bank interest rates.

ICE LIBOR was previously known as BBA LIBOR until February 1, 2014, the date on
which the ICE Benchmark Administration (IBA) took over the Administration of LIBOR.

To learn more about the basics of constructing LIBOR rates, go to the official ICE site.

What is the 'Capital Adequacy Ratio - CAR'

The capital adequacy ratio (CAR) is a measure of a bank's capital. It is expressed as a percentage
of a bank's risk weighted credit exposures.

Also known as capital-to-risk weighted assets ratio (CRAR), it is used to protect depositors and
promote the stability and efficiency of financial systems around the world. Two types of capital
are measured: tier one capital, which can absorb losses without a bank being required to cease
trading, and tier two capital, which can absorb losses in the event of a winding-up and so
provides a lesser degree of protection to depositors.

Also known as "Capital to Risk Weighted Assets Ratio (CRAR)."

BREAKING DOWN 'Capital Adequacy Ratio - CAR'

The reason why minimum capital adequacy ratios are critical is to make sure that banks have
enough cushion to absorb a reasonable amount of losses before they become insolvent and
consequently lose depositors’ funds. Capital adequacy ratios ensure the efficiency and stability
of a nation’s financial system by lowering the risk of banks becoming insolvent. If a bank is
declared insolvent, this shakes the confidence in the financial system and unsettles the
entire financial market system.

During the process of winding-up, funds belonging to depositors are given a higher priority than
the bank’s capital, so depositors can only lose their savings if a bank registers a loss exceeding
the amount of capital it possesses. Thus the higher the bank’s capital adequacy ratio, the higher
the degree of protection of depositor's monies.

Tier One and Tier Two Capital

Tier one capital is the capital that is permanently and easily available to cushion losses suffered
by a bank without it being required to stop operating. A good example of a bank’s tier one
capital is its ordinary share capital.

Tier two capital is the one that cushions losses in case the bank is winding up, so it provides a
lesser degree of protection to depositors and creditors. It is used to absorb losses if a bank loses
all its tier one capital.

When measuring credit exposures, adjustments are made to the value of assets listed on
a lender’s balance sheet. All the loans the bank has issued are weighted based on their degree of
risk. For example, loans issued to the government are weighted at 0 percent, while those given to
individuals are assigned a weighted score of 100 percent.
What is 'Credit Risk'
Credit risk refers to the risk that a borrower may not repay a loan and that the lender may
lose the principal of the loan or the interest associated with it. Credit risk arises because
borrowers expect to use future cash flows to pay current debts; it's almost never possible
to ensure that borrowers will definitely have the funds to repay their debts. Interest
payments from the borrower or issuer of a debt obligation are a lender's or investor's
reward for assuming credit risk.

BREAKING DOWN 'Credit Risk'

When lenders offer borrowers mortgages, credit cards or other types of loans, there is
always an element of risk that the borrower may not repay the loan. Similarly, if a
company offers credit to its client, there is a risk that its clients may not pay their
invoices. Credit risk also describes the risk that a bond issuer may fail to make payment
when requested or that an insurance company won't be able to make a claim.

What is 'Market Risk'

Market risk is the possibility for an investor to experience losses due to factors that affect
the overall performance of the financial markets in which he is involved. Market risk,
also called "systematic risk," cannot be eliminated through diversification, though it can
be hedged against. Sources of market risk include recessions, political turmoil, changes in
interest rates, natural disasters and terrorist attacks.

BREAKING DOWN 'Market Risk'

Companies in the United States are required by the SEC to detail how their productivity
and results may be linked to the performance of the financial markets. This is meant to
provide a reflection of how a company is exposed to financial risk. For example, a
company providing derivative investments or foreign exchange futures may be more
exposed to financial risk than companies who do not provide these types of investments.
This information helps investors and traders make decisions based on their own risk
management rules.
The two major categories of investment risk are market risk and specific risk. Specific
risk, also called "unsystematic risk," is tied directly to the performance of a particular
security and can be protected against through investment diversification. One example
of unsystematic risk is a company declaring bankruptcy, making its stock worthless to
investors.

Under these categories are different classifications that involve unique aspects of
financial markets. The most common types of market risks include interest rate risk,
equity risk, currency risk and commodity risk.

Interest rate risk covers the volatility that happens with changing interest rates due to
fundamental factors, such as Libor and other central bank announcements related to
changes in monetary policies. Equity risk is the risk involved in the changing stock
prices. An investor is exposed to currency risk if he is holding particular currencies
facing volatile movements, because of fundamental factors such as interest rate changes
or unemployment claims. Commodity risk covers the changing prices of commodities
such as crude oil and corn.

What is 'Operational Risk'

Operational risk summarizes the risks a company undertakes when it attempts to operate within a
given field or industry. Operational risk is the risk not inherent in financial, systematic or
market-wide risk. It is the risk remaining after determining financing and systematic risk, and
includes risks resulting from breakdowns in internal procedures, people and systems.

BREAKING DOWN 'Operational Risk'

Operational risk can be summarized as human risk; it is the risk of business operations failing due to
human error. It changes from industry to industry, and is an important consideration to make when
looking at potential investment decisions. Industries with lower human interaction are likely to have
lower operational risk.

Focus of Operational Risk

Operational risk focuses on how things are accomplished within an organization and not
necessarily what is produced or inherent within an industry. These risks are often associated with
active decisions relating to how the organization functions and what it prioritizes. While the risks
are not guaranteed to result in failure, lower production or higher overall costs, they are seen as
higher or lower depending on various internal management decisions.
Examples of Operational Risk
One area that may involve operational risk is the maintenance of necessary systems and
equipment. If two maintenance activities are required, but it is determined only one can be
afforded at the time, making the choice to perform one over the other alters the operational risk
depending on which system is left in disrepair. If a system fails, the negative impact is associated
directly with the operational risk.

Other areas that qualify as operational risk tend to involve the human element within the
organization. If a sales-oriented business chooses to maintain a subpar sales staff, due to its
lower salary costs or any other factor, this is considered an operational risk. The same can be
said for failing to properly staff to avoid certain risks. In manufacturing, choosing not to have a
qualified mechanic on staff, and having to rely on third parties for that work, can be classified as
an operational risk. Not only does this impact a system's operation, it also involves additional
time delays as it relates to the third party.

What is a 'Call Option'

A call option is an agreement that gives an investor the right, but not the obligation, to buy a
stock, bond, commodity or other instrument at a specified price within a specific time period.

It may help you to remember that a call option gives you the right to call in, or buy, an asset. You
profit on a call when the underlying asset increases in price.

BREAKING DOWN 'Call Option'

Call options are typically used by investors for three primary purposes. These are tax
management, income generation and speculation.

What is a 'Put Option'

A put option is an option contract giving the owner the right, but not the obligation, to sell a
specified amount of an underlying security at a specified price within a specified time. This is the
opposite of a call option, which gives the holder the right to buy shares.

BREAKING DOWN 'Put Option'

A put option becomes more valuable as the price of the underlying stock depreciates relative to
the strike price. Conversely, a put option loses its value as the underlying stock increases and the
time to expiration approaches.
A:
The main fundamental difference between options and futures lies in the obligations they
put on their buyers and sellers. An option gives the buyer the right, but not the obligation
to buy (or sell) a certain asset at a specific price at any time during the life of the contract.
A futures contractgives the buyer the obligation to purchase a specific asset, and
the seller to sell and deliver that asset at a specific future date, unless the holder's position
is closed prior to expiration.

[Futures may be great for index and commodities trading, but options are the preferred
securities for equities. Investopedia's Options for Beginners Course provides a great
introduction to options and how they can be used for hedging or speculation.]

Aside from commissions, an investor can enter into a futures contract with no upfront
cost whereas buying an options position does require the payment of a premium.
Compared to the absence of upfront costs of futures, the option premium can be seen as
the fee paid for the privilege of not being obligated to buy the underlying in the event of
an adverse shift in prices. The premium is the maximum that a purchaser of an option can
lose.

Another key difference between options and futures is the size of the underlying position.
Generally, the underlying position is much larger for futures contracts, and the obligation
to buy or sell this certain amount at a given price makes futures more risky for the
inexperienced investor.