back months Futures contracts with delivery dates in the more distant future. bankruptcy futures The futures contract based on the CME Quarterly Bankruptcy Index. The CME computes the index daily, based on personal and business bankruptcy filings, with personal bankruptcies getting 96% of the weight. (Aaron Luchetti, Commodity Traders May Go for Broke With Novel Contract, WSJ. 4/3/98.) basis point One percent of one percent of a principal amount or Notional Value (q.v. ). Also, known as bp – pronounced bip. For example, the on-the-run Ten-year Treasury might have a coupon of 6.5%, and the 10-year Swap Spread over that might be 22 basis points. basis risk The name attached to the random gains or losses a hedger realizes, when he hedges with something that has an imperfect correlation with his underlying position. benchmark notes Agency notes aimed at filling the partial vacuum in the Treasury note market, now that the deficit appears somewhat under control. Fannie Mae began issuing benchmark notes, and Freddie Mac and other agencies have followed. Apparently, the U.S. Treasury is considering halting its auction of two-, three-,or five-year notes. (Guy Dixon and Ross A. Snel, Bonds Stay Put as Traders Wait for Jobs Report; Fannie Mae to Offer Additional Benchmark Notes, WSJ. 5/5/98.) Bernoulli Option See Introducing: the Bernoulli Option in Derivative Games. Best-of-Two Option A payoff which equals the maximum of two option payoffs, such as the maximum of a call on asset 1 and a put on asset two. Cf. Worst-of-Two Option. Bet Option A Binary Option. (q.v. ) bid The price at which a dealer (market maker) stands ready to buy. Ordinarily the bid is less than the ask (q.v. ), and the bid-ask spread is what the dealer stands to make by quickly turning around one unit of product. big dogs Traders who do large volume. As in You can’t pee like a puppy if you want to run with the big dogs. Binary Call (Put) Option Typically, a Binary Call (Put) Option (q.v. ) that pays off nothing if the underlying risk factor is below (above) the strike, and a constant amount if the risk factor exceeds (is below) the strike. Binary Option An option with a payoff function that has two levels, such as zero dollars or one million dollars. blank check company A public, shell company with few or no assets, income, products, services, activities, business plan, management team, employees, or anything else that an ongoing business ordinarily has — except for registration with the SEC. A private company can use a blank check company to go public via a reverse merger without doing an expensive IPO. An unscrupulous stock promoter can also use a blank check company to defraud sleepy investors. (Schellhardt, Timothy D. As ‘Blank-Check’ Firms Regain Allure, Businessman Lines Up Numerous Suitors. WSJ. 10/29/99.) BISTRO Definition: An acronym for either of the following, depending on who’s talking and who might be listening. 1. Broad Index Secured Trust Offering. J.P.Morgan’s preferred vehicle for transferring a significant amount of diverse credit risk to an SPV.

www.exchange.de/dtb/BOBL-future-option.html ) Boolean trades Definition: Trades based on orders that contain Boolean logic, including the concepts of “if”, “if and only if”, “or”, and “and”.

Example: “I want to sell Microsoft at 75 if and only if I can buy IBM at 110 and buy Intel at 120.”

Source: Hal R. Varian, “Boolean Trades and Hurricane Bonds,” Wall Street Journal. 5/8/00. Bowie Bond A specific, $55 million issue of 10-year Asset-Backed Bonds (q.v. ) that British rock star David Bowie issued and Prudential Insurance Co. bought. The specific collateral consists of royalties from 25 of Mr. Bowie’s albums that he recorded before 1990.

Source: Bloomberg News, 2/20/97 B-Piece Definition: A security from the riskier tranche of a two-tranche ABS (q.v. ) deal. It receives the residual income from the underlying collateral and takes second place in line for the collateral in case of default. In terms of income and collateral, B-pieces are to the ABS’s assets as common shares are to a corporation’s assets. (The analogy breaks down when it comes to taxation and control.) Example: A bank with large credit card operations issues ABS’s backed by credit card receivables. The A-piece has a AAA rating and little credit risk. If the economy heads south, then the B-piece may not pay off in full. Application: Dividing an ABS issue into senior and junior pieces permits the issuer to tap two types of investor. The more (less) risk averse investor that wants to avoid (place) a bet on the performance of the underlying assets can buy the A-Piece (B-Piece). Pricing and Risk Management: This is difficult. The whole point of having a B-piece is to have a place to put the return that is more difficult to price and the risk that is more difficult to manage. Then, people who are more talented at pricing derivatives and managing their risk will buy these pieces. Pricing the A-Pieces is nearly as easy as pricing Treasuries, and their risk is mainly market risk. Comment: Not for the timid or naive. Source: Cecile Gutscher, SEC Is Examining Whether Some Underwriters Are Marketing Bonds at Artificially Low Yields, Wall Street Journal. 5/2/97). 8/28/01 Bulldog bond Definition: A bond, denominated in British pounds sterling, that a company or government that is foreign to the U.K. issues in the U.K. bond market.

Example: A Brazilian company might issue Ј100 million of debt in London.

www.exchange.de/dtb/BUND-future-option.html) Bundle A Strip (q.v.,#2 ) of consecutive, quarterly Eurodollar or Euroyen futures contracts. Markets, such as Simex offer a Bundle as a convenient package of futures contracts, without the execution risk inherent in building up the Strip, contract by contract. A trader can use Bundles and Packs (q.v. ) to implement bets on the change in shape of the Forward Curve. Buy-Write An investment strategy that consists of buying an asset and selling a call on it. Thus, the investor sells upside potential to elevate the rest of his payoff function.

cabinet trade A trade that allows options traders to close out deep out-of-the-money options by trading at a price equal to one-half tick. (Elizabeth Lekan, Chicago Mercantile Exchange) calendar spread A spread trade (q.v. ) involving one long position and one short position. Callable Bond Definition: A (noncallable) Bullet Bond (q.v. ), minus (i.e. short) a Call Option (q.v. ) on the bond. The Call Price as a function of calendar time is the Call Schedule. Example: The U.S. Treasury issued a long sequence of Callable Bonds, callable five years before maturity. Application: A Callable Bond is a way to make a bet about refinancing costs at the Call Date. The issuer is betting that interest rates will drop, the bond price will rise, he will call the bond, and he will refinance at a lower rate. The bondholder takes the other side of that bet. Pricing: The Callable Bond is equivalent to a portfolio, so its value should equal the value of the portfolio, namely, the value of the Bullet Bond minus the value of the Call Option. Risk Management: An issuer could offset the short position in the Bond Option (q.v. ) by buying a corresponding Receiver Swaption on a Swap with the same coupon as the Bond. Comment: For a given coupon rate the Callable Bond will be worth less than the noncallable bond. Hence, for a given price (such as par) the Callable Bond will have a higher coupon rate. Call Option The right, but not the obligation to buy the underlying asset at the previously agreed-upon price on (European) or anytime through (American) the expiration date. Cap A strip of Caplets (q.v. ) — that is, a portfolio of Caplets with sequential accrual periods. Also known as a Ceiling. Caplet An Interest Rate Option to pay fixed in an FRA (q.v. ). Its payoff is proportional to that of a Call Option on a floating rate of interest. Caption An option on a Cap (q.v. ). car The size of one futures contract, based on the idea that some commodity futures contracts historically called for the delivery of one railroad car of the underlying commodity. carry trade Definition: A trade that consists of borrowing and paying interest in order to finance the purchase of an investment that pays a greater interest or a dividend stream.

Example: In a single currency, borrowing short-term and buying bonds leads to a carry that is the coupon minus the interest on the borrowing. The yen carry trade consists of borrowing yen in the Tokyo market and paying the currently (1999) low yen rate, buying dollars in the spot market, and buying dollar bonds paying higher coupons.

Application: The idea is to collect the positive carry, interest and dividends received, minus interest paid.

Pricing: The trade is initially worth about zero, except for small transaction costs.

Risk Management: The major risk is the depreciation in price of the long asset and appreciation in price of the short asset. However, if you get rid of that risk, then you essentially take off the trade.

Comment: The yen carry trade has been a popular trade for hedge funds and others, with the yen rate around one percent and the dollar rate around five percent. However, by 6/12/99 Gretchen Morgenson was able to write, The dollar fell 2.5 percent against the yen in four days of trading. That’s an annualized, continuously compounded rate of about 950%!

Source: Gretchen Morgenson, Once Again, Wall St. Worries About Hedge Funds, New York Times. 6/12/99. Catastrophe Bond Definition: A Bond that promises a coupon (and principal, in some cases) that starts out high, but drops after a suitable catastrophe occurs. A suitable catastrophe might be an earthquake or hurricane of sufficient magnitude and within a particular region. Catastrophe Bonds may be ABS’s (q.v.). The underlying assets may include a pool of Treasury securities. The underlying income stream might be reinsurance premiums. The ABS issue may have two or more classes of securities. Example: A recently proposed (as of 5/30/97) USAA, Inc. Catastrophe issue has a principal protected class (secured by Treasury Zero Strips) and a principal variable class that would become worthless after a hurricane did $1.5 billion of damage anywhere from Maine to Texas. Application: The natural issuer of a Catastrophe Bond is an insurance company or a government agency such as the California Earthquake Authority – any organization exposed to claims resulting from the underlying catastrophe. The Catastrophe Bond is in theory and perhaps even in practice a highly efficient way of paying outside investors (i.e. outside the insurance industry, including the reinsurance market) to share the risk of the catastrophe with the vast general capital market. It is a simple extension of the time-honored concept of securitization. Pricing: Equilibrium of supply and demand. Risk Management: Traditional hedging is impossible. Diversification is possible. Comments: The holder of a Catastrophe Bond is short a Bet, Binary, or Digital Option (all of which q.v.). The Catastrophe Bond is an ideal instrument for an unscrupulous security salesman to present to unsuitably naive retail or even institutional customers, who lack any concept of that game’s odds, or perhaps even its basic rules. Thus, it has excellent potential as a successor to the sometimes abusive or fraudulent sales of poorly understood Florida real estate, securitized receivables, mortgage-backed securities and derivatives, limited partnership interests in real estate and oil exploration, etc.

I predict confidently three things: (1) Competent underwriters of Catastrophe Bonds will not play Russian roulette by holding large positions in them in their investment portfolios for long periods. They will distribute the bonds as soon as possible. (2) Accordingly, almost all of these Catastrophe Bonds will end up in the portfolios of institutional investors, high-rolling individual investors, and retail customers – many of whom will have no idea what they’re getting into. (3) In at least one exceptional case, some manager of a Catastrophe Bond (or Derivatives) desk will convince his naive boss that the market has badly underestimated the real value of certain Catastrophe Bonds (Derivatives), and we should take them into inventory, temporarily. At that point the chips are down and the outcome – heroism or disaster – is up to fate. Comment: Scholars are praising cat bonds and other derivatives for attracting low-cost capital into the industry. (Robert Hunter, Cat Fever, Derivatives Strategy. February 1998, p. 6.) However, it’s not clear that society is better off if the newcomers are paying to much for claims based on catastrophic claims. Catastrophe Futures The ill-fated futures contract that the CBOT introduced in 1993. The underlying risk factor was the Property Claims Service (PCS) index, which was too broad an index for most natural hedgers to use. (Source: Robert Clow, Coping with catastrophe, Institutional Investor. December 1996, pp. 138.) Catastrophe Options The CBOT’s option contracts on several regional indexes of losses. The option on the Eastern Catastrophic contract boomed as Hurricane Fran smashed the Carolinas in the fall of 1996. (Source: Robert Clow, Coping with catastrophe, Institutional Investor. December 1996, pp. 138.) Catastrophe options come in two main varieties: (1) Property Claims Services (PCS) options pay out (European style) based on an index of all claims against property insurance companies. (2)Single-Cat options pay out (American or one-touch style) based on a single, large atmospheric or seismic disaster in a single region (northeast, southeast, east, midwest, or west) or in California, Texas, or Florida. (A New Take on Cat Options, Derivatives Strategy. February 1998, pp. 5-6.) Catastrophe Swaps Contracts similar to standard reinsurance contracts and traded on New York’s Catastrophe Exchange. (Source: Robert Clow, Coping with catastrophe, Institutional Investor. December 1996, pp. 138.) CD Certificate of Deposit (q.v. ). Ceiling A Cap (q.v. ). Certificate of Deposit A sort of bank savings account that ties up the depositor’s money until the certificate matures, and acts more like a bill, note, or bond than a traditional savings account. CFD Contract for Difference (q.v. ). Chase Secured Loan Trust Note (CLST) Definition: Chase Bank’s preferred vehicle for transferring a large amount of diverse credit risk into an SPV. CHIPS C ommon-Linked H igher I ncome P articipation S ecurities (sm). Bear Stearns’ proprietary Equity Linked Debt Security (q.v. ). clean price Definition: The quoted bond price without the accrued interest. (Cf. dirty price.)

www.banque-france.fr/us/finance/regle/3c.htm Common Share A sort of Call Option (q.v. ) on the assets of the corporation, because the common shareholder gets those assets if he pays off everyone else with a claim against the assets. The Common Share represents a fractional ownership interest in the corporation, it has voting rights, and may receive a dividend. Common Stock A collective term for Common Shares (q.v. ). Compound Option An option on an option. Also known as a Split Fee Option (q.v. ). A special case of an Installment Option (q.v. ). concentration risk According to Risk Concentrations Principles, which the BIS released in 12/99, risk concentrations in financial conglomerates come in seven categories of exposures, to: individual counterparties, groups of individual counterparties, counterparties in specified geographical locations, counterparties in industries, counterparties in products, key business services (such as back-office services), and natural disasters. (BIS Examines Concentration Risk. 2/2000, p. 11.) Confirm Confirmation (q.v. ). Confirmation A document that defines a Derivatives contract that a dealer has just entered with a customer. The Confirmation ordinarily incorporates one or more ISDA (q.v. ) documents by reference. The Confirmation comes after the oral agreement – ordinarily over the telephone – which the dealer ordinarily records and saves for months. continuation structure A design for a DPC (q.v. ) that does not liquidate when the related name defaults. Cf. termination structure. Continuous Accrual Currency Option with a One-Touch Knock-out Range A Derivative Product that accrues nominal value at a constant rate for every day that the index exchange rate stays within the accrual range, then loses all value when the index strikes either side of the knock-out barrier range. (Source: Victor Kremer and William Rhode, Dollar Gyrations Lead Investors to Exotics, Derivatives Week. 2/3/97.)

The term, Option, is a misnomer, because no one has a true option, not even one as trivial as for an ordinary European Call Option.

The product’s value is a decreasing function of volatility. Thus, during a period of high anticipated volatility it is possible to buy the product inexpensively. If the index remains within the range, then the percentage payout is relatively large. Contract for Difference Definition: An OTC Currency Forward Contract that settles for a cash amount, perhaps in a third currency, without requiring the exchange of the two underlying currencies. Example: Instead of settling a Forward Contract by having party A deliver 10,000,000 DEM (worth 6,000,000 USD) in Germany and party B deliver 600,000,000 JPY (worth 6,100,000 USD) in Tokyo, party B would deliver the net dollar value of the two payments (100,000 USD) in New York. Application: The CFD would reduce the problem of Herstatt Risk (q.v. ). Pricing: Prices for the two legs of the transaction should be readily visible in the liquid currency markets. Risk Management: This tool is for managing market risk, while managing settlement risk. Comment: Source: Laure Edwards, Chase Manhattan Offers an Answer to BIS Concerns, Financial Trader 4 (June 1997), p. 7. Convertible Bond A Bond that the owner can convert into Common Shares under specific terms. A Convertible Bond is an ordinary Bond, plus the option to exchange the Bond for the Shares. Convexity

1. The sensitivity of a financial instrument’s Modified Duration (q.v. ) to its yield.
2. The second derivative of a financial instrument’s value with respect to its yield.

Corridor Note An Accrual Note (q.v. ). Costless Collar Definition: A Collar (q.v. ) in which the proceeds of the sale of the short Call option exactly finance the purchase of the long Put option. Application: This strategy helps a trader get close to flat. This can be particularly useful for a money manager who is close to having a good measurement period and doesn’t want to screw it up in the last moment. Also, it may be a good tax play for an investor who really wants to sell out, but doesn’t want to pay capital gains taxes. Comment: The term may mislead beginners in Derivatives markets, who might take it at face value. However, of course, the dealer or market maker wouldn’t do the trade at no cost. In fact, the cost is roughly the bid-ask spread of one of the Collar’s component options. Particularly in OTC option markets, the name, Costly Collar, would be more appropriate, because bid-ask spreads require the buyer to give up much upside participation for little downside protection. Credit Default Swap A Swap in which A pays B the periodic fee, and B pays A the floating payment that depends on whether a predefined credit even has occurred, or not. The fee might be quarterly, semiannual, or annual. The floating payment would likely occur only once, and might be proportional to the discount of the reference loan below par. The credit event might be a declaration of bankruptcy or violation of a bond indenture or loan agreement. Credit Derivatives Derivative Products with payoffs that depend on risk factors related to credit quality, such as yield spread over Treasuries, price discount from par, or a credit event. A credit event might be a drop in credit rating or some sort of failure, such as occurrence of default, insolvency or bankruptcy.

One goal of Credit Derivatives is to split credit risk from market risk. The key concept here is that credit risk is an undesirable element, akin to pollution. When you allow a market for pollution, people who don’t want it sell it at at market price to the parties who mind it the least or handle it the best.

Credit Derivatives already come in a variety of flavors, and infinitely many types are possible. However, nearly all current structures are variations on Call or Put Options (q.v. ) on Credit Spreads (q.v. ), Binary Options (q.v. ), or Knockout Options (q.v. ). In the last two cases the trigger is a credit event. Typically, the payoff depends on the state of the world some time – as much as months – after the event. Here are some examples of Credit Derivatives:

1. Notes that Bankers Trust and CSFP issued in 1993, which promised large coupons if the reference asset didn’t suffer a credit event – namely, default or sufficient deterioration in its credit rating – and small coupons if it did. The spread of the large coupon over ordinary debt depended on the reference asset’s credit quality, and was sometimes 80 — 100 b.p. (over LIBOR). This is a sort of Binary Option that is a function of the credit event.
2. A Binary Option that Bankers Trust offered, with a payoff that depended on the credit performance of a basket of bonds. If any of the bonds defaulted, then a counterparty paid Bankers Trust a fee.
3. A Call or Put Option on a credit spread over Treasuries.
4. A One-Touch (q.v. ) Knockin Put (q.v. ) Option on the value of a corporate bond.
5. A One-Touch (q.v. ) Knockin Put Option (q.v. ) on the lowest value of n corporate bonds in a portfolio.

Credit Linked Note Definition: A note that pays interest and repays principal that depends on a credit event, such as bankruptcy and default. Example: Swiss Bank Corporation issued global floating rate notes, which it would redeem for 51% of par value or 100% of the value of a reference security (a similar bond from the same issuer, less the credit exposure), if a particular credit event occurs. Application: The usual, speculation and hedging. Pricing: Risk Management: Comment: Source: Swiss Bank Ready to Offer Big Note Issue, WSJ, 9/7/97. Credit Option Definition: An Option with a payoff that depends on credit quality, without bearing ordinary interest-rate risk. Example: The Option to Exchange private debt for U.S. Treasury debt. Natural Buyers and Sellers: See Credit Derivatives. Pricing: Pricing an Option to Exchange () private and Treasury debt would involve a hybrid option model, having characteristics of equity and debt option pricing. Hedging: One could try to dynamically hedge the delta risks. Comment: Pricing and hedging might be difficult, and market manipulation may be an issue for a thinly traded underlying instrument. Credit Option on Brady Bonds (COBRA) A credit spread option (q.v. ) with a payoff that depends on the yield spread between a Brady bond and another bond – usually, a comparable maturity Treasury. (Gary L. Gastineau and Mark P. Kritzman, Dictionary of Financial Risk Management. Frank J. Fabozzi Associates, 1996.) Credit Risk The risk of loss from not receiving one’s reward for being on the right side of a bet about a market move, due to the losing counterparty’s failure to meet his obligations. Credit Spread 1. An option spread trade – long one option, short another – that generates cash.

2. The excess of the yield on a note with credit risk over a comparable note without credit risk. Credit Spread Option Definition: An Option with a payoff that depends on a Credit Spread (q.v. ). Example: A one-year European Call (q.v. ) on Mexican par bond credit that pays

Max[0, 147 bp — (Mexican Brady Bond Yield — Yield on corresponding U.S. Treasury)]. Application: To spread credit risk associated with lending or assume credit risk without lending. Pricing: Risk management: Comment: Credit Spread Swap Definition: A Swap with a payoff that depends on a Credit Spread (q.v. ). Examples: A Swap with a Floating Leg () that depends on the Credit Spread. Application: A lender who might share its credit exposure to a risky counterparty. Pricing: Requires advanced techniques or SWAG Pricing (q.v. ). Risk management: Dynamic Hedging (q.v. ) based on PV01s (q.v. ), etc. Comment: Not for the cautious. Credit Swap Definition: A Swap whose value depends on underlying credit quality, preferably without bearing ordinary interest-rate risk. Examples: A Total Return Swap (q.v. ) with underlying risky debt might qualify, although this has a heavy dose of interest rate risk. An Outperformance Swap, with a payoff proportional to the excess of the rate of return on the risky debt over the rate of return on a comparable Treasury bond, would be a clearer example. A Total Return Swap plus an ordinary Interest Rate Swap () that offsets the interest rate risk. The exchange of a constant fee per period versus a binary floating payment of either zero or a Credit Event Payment. A Credit Spread Swap. Application: See Credit Derivatives for applications. Pricing and Risk management: See the specific type of Credit Swap. Comment: Pricing and hedging might be difficult, and market manipulation may be an issue for a thinly traded underlying instrument. Cross Currency Option Definition: An option to exchange units of one currency for units of another, as seen from the point of view of a third currency. A Margrabe Option (q.v. ) with underlying currency risk. Example: A New York trader might consider an option to pay 1.5 DEM for 100 JPY as a Cross Currency Option. A trader in Frankfurt might call that a call on yen. A trader in Tokyo might consider it a put on Deutschemarks. Cross Currency Swap A Swap (q.v. ) that involves payments in two currencies. For example, the fixed payment might be in DEM and the floating payment might be proportional to JPY LIBOR. In addition, the swap involves an exchange at maturity of Notional Amounts (q.v. ) in the two currencies at the original exchange rates. crossed market A market where the bid (q.v. ) exceeds the ask (q.v.. also known as asked, offer, offered). In a normal market the bid is less than the ask, and the difference – the bid-ask spread – would be the market maker’s profit on a round trip in the stock. We would not expect to see a crossed market with a single market maker. In a market with more than one market maker, one market maker may show the best bid and another the best offer, and these may cross. However, a crossed market indicates an arbitrage opportunity and cannot last, in equilibrium. CUBS C ustomized U pside B asket S ecurities (q.v. ). Bear Stearns’s proprietary debt securities, with participation in moves in an average over time of the index value of a basket of securities, but with downside protection. The underlying average equals an arithmetic average of the index values on the 24th of each month from issue through maturity. Thus, the underlying price is an average, and any optionality is an option on an arithmetic average. The holder may not redeem CUBS before maturity.

For example, Bear Stearns listed a CUBS issue on 7/25/95 that matures on 7/24/98. The underlying index is a mischmasch of biotech, energy, and other stocks. The CUBS issue price is $3.33. The CUBS gives 90% participation in price moves. The minimum payoff is $3.00. currency swap The exchange of specified amounts of currencies on one (nearby) date, exchange of specified amounts of currencies in opposite directions on a future date, and (possibly) exchange of specified coupons in between. A currency swap is like the exchange of bills, notes, or bonds in different currencies. CUSIP The acronym for the Committee on Uniform Securities Identification Procedures. The CUSIP Service Bureau seeks to assign unique numbers and standardized descriptions [to securities] in a timely and accurate manner, using its best efforts to use primary or reliable sources of information.

Proposed by: Matthew Foss.

www.cusip.com/cusip/cusip/index.html. CUSIP number A unique identifier for securities, consisting of nine alphanumeric characters. The first six uniquely identify the issuer. The next two (alphabetic or numeric) identify the issue. Two numeric digits indicate an equity issue. Two alphabetical characters or a mix of alphabetical and numerical indicate a debt issue. The ninth digit is the check digit.

Standard & Poor’s owns and operates the CUSIP Service Bureau, which maintains the CUSIP system.

Proposed by: Matthew Foss