When currency options are not standardized and traded over the counter
Free exchange rate Floating. Fundamental analysis Analysis of basic economic data in a market supply and demand in order to be able to make assertions as to the future price trend of a traded commodity. Fundamental exchange rate analysis is based on the economic and business cycle data of the country in question and leads to longer-term exchange rate forecasts. The contract is valid for a specific amount of a commodity or a fixed amount of a financial instrument.
Some of the legacy currencies are shown until the year when they will be discontinued. Grid Fixed margin within which exchange rates are allowed to fluctuate. G7 Group of 7. Group comprising the major industrialized nations in economic terms, which in view of the global economic importance of the member states have made it their objective to coordinate their respective domestic economic policies.
The coordination of economic, exchange rate and monetary policy aims is achieved both at government, central bank and also on other institutionalized levels. The Group of Ten plays an important role in discussions concerning monetary policy.
Hedge ratio The amount of an underlying instrument or the number of options which are needed to hedge a covered option. The hedge ratio is determined by the size of the delta. Hedging This is the process of establishing protection against loss caused through currency fluctuations by buying a currency from a bank ahead of the time that it is needed or selling a currency to a bank before it is received.
Hedging is achieved by doing forward transactions with a bank. Created as a result of the agreement concluded at Bretton Woods in by the allied forces, the IMF became operational in Washington in Its aim is to maintain orderly exchange practices. The IMF supports countries with balance of payments problems by granting them loans. Switzerland is not a member of the IMF but endeavours to cooperate in specific areas.
Indication Rate When a client requires the rate of exchange between two currencies but does not intend to deal in the currency, the bank will provide an Indication Rate that will be an accurate estimate of the market rate at that moment in time.
Indirectly Quoted Currencies An indirectly quoted currency is one that has its value quoted against a base other than the American dollar. Installments An installment is an amount of money either paid or received at regular intervals in settlement of a debt.
It is customary for these installments to be paid monthly, quarterly, half yearly or annually depending on the nature of the debt. Installment payments as described above are referred to as balloon payments while a single payment in settlement of the entire debt is called a bullet payment. Inflation Loss of purchasing power of money caused by growth of the amount of money in circulation which, if the supply of goods stays the same or only increases at a slower rate loads to an increase in prices.
Interbank dealings Dealings between the banks. Intervention on the foreign exchange market Buying or selling of the domestic currency against foreign currencies normally against US dollars , in order to support or weaken the exchange rate as the monetary authority sees fit.
In-the-money An option is in-the-money in the following cases: For European options , the market price has to be replaced by the forward price of the underlying instrument on the expiry date of the option. Intrinsic value The difference between the strike price of an option and the forward price of the underlying security up to maturity, as long as the option is in-the-money.
The premium of an option is made up of the time value and the intrinsic value. Invisible balance Comprises transportation services; income and expenditure on travel services, insurances, licenses, earnings and interest income from international capital movements. Key currency Small countries, which are highly dependent on exports, orientate their exchange rate to major currencies in the global economy, the so-called key currencies Legacy Currencies These are the currencies that were replaced by the Euro.
They comprise the following. Leverage In options terminology, this expresses the disproportionately large change in the premium in terms of the relative price movement of the underlying instrument.
The interest rate at which banks in London are prepared to accept each other's short-term deposits. This is the interest rate applied by banks in London when lending to each other. A Company's ability to meet its obligations at all times. The availability of liquid funds in an economy.
The possibility of being able to carry out financial transactions without influencing the market. Lombard rate The interest rate applied to loans backed by collateral in the form of movable easily sold assets goods or securities.
Long To be long in a currency means that ones claims in the currency exceeds ones debts in the currency. Spread between bid and offer rates. The good faith deposit which the writer of an option or the buyer of a forward or futures contract has to put up to cover the risk of adverse price movements. Market Rate The market rate is the last accepted bid and offer rate made in the market. Maturity Date The maturity date of a forward exchange contract or other agreement is the date on which funds are transferred from one parties account to the other parties account and the date on which interest charges commences.
This is also referred to as the value date of the contract or agreement. Monetary system The authority of the state in matters of monetary policy. Determining the monetary unit, the monetary authorities and the ways in which money is issued and the money supply can be controlled. Money creation Increase in money supply by the central or commercial banks. Money market Where supply of and demand for short-term funds come together. Money market operations Comprises the acceptance and re-lending of deposits time deposits on the money market.
New Fwd Value See Forward value. Money supply Amount of domestic cash and deposit money available in an economy. Non-resident Account This is the bank account held by a person who resides outside of the country in which the bank account is held. Nostro account Own accounts at another bank.
On the spot A transaction which is concluded in the current time. Option The contractually agreed right to buy call option or sell put option a specific amount of an underlying instrument at a predetermined price on European option or up to a future date American option. Optional Date Contracts At the client's request, the bank will issue a forward exchange contract at a predetermined forward rate at which the client may demand delivery or receipt of funds at his option on any day on or before the maturity date of the contract.
This type of contract differs from a fixed term contract in that the forward rate is valid for the entire period of the contract and not only for the maturity date. Securities trading which is not arranged through exchanges nor tied to a specific place nor time. In contrast to the latter, is not tied to a central set-up in any one place but is conducted mainly by telephone and telex between traders, brokers and customers. An option is out-of-the-money in the following cases: Outright A forward purchase or sale of foreign exchange which is not offset by a corresponding spot transaction, i.
Overnight Swap from settlement date until the following business day, i. Parity Exchange relationship of a currency to a legally binding reference i.
Parity official parity Predetermined exchange rate relationship between two currencies. Period of Grace When entering into a loan transaction, the party making the funds available may choose to allow a period of time to elapse before repayment of the loan commences. This period is referred to as a period of grace. In futures trading the smallest possible price fluctuation upwards or downwards 1 pip is called a tick. Premium markup forward premium or contango of a forward rate against the spot rate.
Corresponds to the price of an option, which the option buyer pays to the option writer. The Premiums and Discounts reflect the interest rate differentials between the centres of two relative currencies. A premium exists for an importer when the interest rate in the home country is higher than the interest rate in the country imported from. A discount exists for an importer when the interest rate in the home country is lower than the interest rate in the country imported from.
A premium exists for an exporter when the interest rate in the home country is lower than the interest rates in the country exported to. A discount exists for an exporter when the interest rate in the home country is higher than the interest rate in the country exported to.
Prime Rate The interest rate charged by banks to their first-class non-banking clients. Public Rate Based on market rates , each morning the bank calculates an exchange rate for small sums. These rates are normally valid for the entire day. They may vary depending on developments in the market. These rates appear in newspapers and are higher than those obtained for large value transactions.
Put option Opposite of call option. Quotation The price quotation of a currency can be made either directly or indirectly. The direct quotation gives the equivalent of a certain amount of foreign currency normally in units of 1OO or 1 in domestic currency. It is less common for the indirect price quotation to be used: Rate of Exchange The value of a currency in relation to other currencies is said to be the rate of exchange between the two currencies.
Market forces of supply and demand determine this rate of exchange. The rate may be influenced by central bank activity as it may trade in the market to influence the rate of exchange. Realignment Simultaneous and mutually coordinated re-and devaluation of the currencies of several countries. The concept was first used in for the exchange rate corrections made in a number of countries within the framework of the Smithsonian Agreement.
Since then, it has mainly been used to describe the exchange rate corrections within the EMS. Revaluation Opposite of devaluation. Risk position An asset or Iiability, which is exposed to fluctuations in value through changes in exchange rates or interest rates.
Extension of a maturing foreign exchange operation through the conclusion of a swap agreement e. Variability at an interest rate according to the appropriate, currently prevailing rates on the Euromarket normally LIBOR for a medium-term loan. Rollover credit Medium-term credit with a variable interest rate, which is governed by the currently prevailing rates on the Euromarket normally LIBOR. Sell In strict financial terms this refers to the currency that the bank sells.
Please see Bid and Offer. In the Forex ToolKit we have looked at it from you the users view point and it refers to you selling the currency. So if you are an exporter click the sell button to see the rate you would sell at. Selling rate Rate at which a bank is willing to sell foreign exchange or to lend money. Short To be short in a currency means that ones debts in that currency exceeds ones claims in that currency.
The value of an SDR is based on a currency basket the last realignment was in January Some countries define the parity of their currencies in SDR. Spot Date When currency is traded "on the spot", the delivery of the funds will only take place in two working days time. This allows for the documentation to be processed and forwarded to the relevant parties. The spot date is therefore two working days after the date on which the transaction is done. Spot operations Foreign exchange dealing in which settlement of the mutual delivery commitments is made at the latest two days normally on the second business day after the transaction was carried out.
Spot Rate The Spot Rate of a currency is that exchange rate at which a transaction takes place "on the spot". That is a transaction with immediate effect. However, the delivery of the funds only takes place two business days later. This is known as the spot date. Spot Value This is the value of the foreign currency converted at the spot rate. Squaring positions Covering an open position securities, foreign exchange or commodities by means of corresponding contra business.
Stop loss order An order to buy on a short position or to sell on a long position foreign exchange if the rate rises above or falls below a specific limit.
As soon as the rate reaches the prescribed limit, the order will be carried out at the next rate. Depending on the market situation, this rate can differ considerably from the limit rate. Strike price Price at which the option buyer obtains the right to purchase call option or sell put option the underlying currency. Striking price Strike price. Swap Swap is the word used to describe a transaction that comprises a spot transaction and a simultaneous forward transaction.
This would occur when doing early utilisation of or extensions to forward exchange contracts. Swap transaction Sale of one currency against another currency at a specific maturity and the simultaneous repurchase from the same counterparty at a different maturity.
Normally, one of the maturity dates will be that of spot operations. Third Currency By convention and because of the Bretton-Wood agreement , all currencies are traded via the American Dollar. The American dollar is a common standard for all currencies. The home currency is referred to as the Base currency. Third Currency currency is any currency that is not the home currency or the American dollar.
Tau Expresses the price change of an option for a 1 percent change in the implied volatility. Technical analysis Is concerned with past price and volume trends - often with the help of chart analysis - in a market, in order to be able to make forecasts about the future price developments of the commodity being traded. Technical exchange rate analysis is often used in professional dealing for short-term exchange rate forecasts. Theta This ratio expresses the price change of an option i.
Mathematically, this corresponds to the 1st derivative of the option premium according to the time factor. Time deposits Funds invested in a bank for a pre-determined time and at a specific interest rate. Maturities in Switzerland range from months. For larger amounts, conditions can be freely negotiable maturity, interest rate. Time value This corresponds to the value of an option , if the intrinsic value is zero.
It merely reflects possible price fluctuations of the underlying instrument, so that at a later point in time the option could achieve an intrinsic value. Trade balance Current balance , balance of payments. In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market:. According to the Bank for International Settlements , who first surveyed OTC derivatives in ,  reported that the " gross market value , which represent the cost of replacing all open contracts at the prevailing market prices, Because OTC derivatives are not traded on an exchange, there is no central counter-party.
Therefore, they are subject to counterparty risk , like an ordinary contract , since each counter-party relies on the other to perform. An "asset-backed security" is used as an umbrella term for a type of security backed by a pool of assets—including collateralized debt obligations and mortgage-backed securities Example: An empirical analysis" PDF.
Retrieved July 13, Asset-backed securities, called ABS, are bonds or notes backed by financial 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.
The CDO is "sliced" into "tranches" , which "catch" the cash flow of interest and principal payments in sequence based on seniority. The last to lose payment from default are the safest, most senior tranches. As an example, a CDO might issue the following tranches in order of safeness: Separate special-purpose entities —rather than the parent investment bank —issue the CDOs and pay interest to investors.
CDO collateral became dominated not by loans, but by lower level BBB or A tranches recycled from other asset-backed securities, whose assets were usually non-prime mortgages. A credit default swap CDS is a financial swap agreement that the seller of the CDS will compensate the buyer the creditor of the reference loan in the event of a loan default by the debtor or other credit event. The buyer of the CDS makes a series of payments the CDS "fee" or "spread" to the seller and, in exchange, receives a payoff if the loan defaults.
In the event of default the buyer of the CDS receives compensation usually the face value of the loan , and the seller of the CDS takes possession of the defaulted loan. 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 than the face value of the loan.
CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. In addition to corporations and governments, the reference entity can include a special-purpose vehicle issuing asset-backed securities. In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today, making it a type of derivative instrument.
The party agreeing to buy the underlying asset in the future assumes a long position , and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price , which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes.
The forward price of such a contract is commonly contrasted with the spot price , which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit , or loss, by the purchasing party.
Forwards, like other derivative securities, can be used to hedge risk typically currency or exchange rate risk , as a means of speculation , or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.
A closely related contract is a futures contract ; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets.
However, being traded over the counter OTC , forward contracts specification can be customized and may include mark-to-market and daily margin calls. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain. In finance , a 'futures contract' more colloquially, futures is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today the futures price with delivery and payment occurring at a specified future date, the delivery date , making it a derivative product i.
The contracts are negotiated at a futures exchange , which acts as an intermediary between buyer and seller. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be " long ", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be " short ".
While the futures contract specifies 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.
Margins, sometimes set as a percentage of the value of the futures contract, need to be proportionally maintained at all times during the life of the contract to underpin this mitigation because the price of the contract will vary in keeping with supply and demand and will change daily and thus one party or the other will theoretically be making or losing money. To mitigate risk and the possibility of default by either party, the product is marked to market on a daily basis whereby the difference between the prior agreed-upon price and the actual daily futures price is settled on a daily basis.
This is sometimes known as the variation margin where the futures exchange will draw money out of the losing party's margin account and put it into the other party's thus ensuring that the correct daily loss or profit is reflected in the respective account. If the margin account goes below a certain value set by the Exchange, then a margin call is made and the account owner must replenish the margin account.
This process is known as "marking to market". Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value i. Upon marketing the strike price is often reached and creates lots of income for the "caller". A closely related contract is a forward contract. A forward is like a futures in that it specifies the exchange of goods for a specified price at a specified future date. However, a forward is not traded on an exchange and thus does not have the interim partial payments due to marking to market.
Nor is the contract standardized, as on the exchange. Unlike an option , both parties of a futures contract must fulfill the contract on the delivery date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit.
To exit the commitment prior to the settlement date, the holder of a futures position can close out its contract obligations by taking the opposite position on another futures contract on the same asset and settlement date. The difference in futures prices is then a profit or loss.. A mortgage-backed security MBS is a asset-backed 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 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.
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 different level of priority in the debt repayment stream, giving them different levels of risk and reward.
The total face value of an MBS decreases over time, because like mortgages, and unlike bonds , and most other fixed-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 MBS's "factor", the percentage of the original "face" that remains to be repaid. In finance , 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 specified strike price on or before a specified date. The seller has the corresponding obligation to fulfill the transaction—that is to sell or buy—if 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 finance. In basic terms, the value of an option is commonly decomposed into two parts:.
Although options valuation has been studied since the 19th century, the contemporary approach is based on the Black—Scholes model , which was first published in Options contracts have been known for many centuries.
However, both trading activity and academic interest increased when, as from , 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 financial instruments known as derivative products or simply derivatives.
A swap is a derivative in which two counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved.
For example, in the case of a swap involving two bonds , the benefits in question can be the periodic interest coupon payments associated with such bonds. Specifically, two counterparties agree to the exchange one stream of cash flows against another stream. These streams are called the swap's "legs".
The swap agreement defines the dates when the cash flows 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 flows is determined by an uncertain variable such as a floating interest rate , foreign exchange rate , equity price, or commodity price.
The cash flows 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 first introduced to the public in when IBM and the World Bank entered into a swap agreement.
In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by derivative market participant. For exchange-traded derivatives, market price is usually transparent often published in real time by the exchange, based on all the current bids and offers placed on that particular contract at any one time.
Complications can arise with OTC or floor-traded contracts though, as trading is handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices. The arbitrage-free price for a derivatives contract can be complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of financial mathematics.
However, for options and more complex derivatives, pricing involves developing a complex pricing model: A key equation for the theoretical valuation of options is the Black—Scholes formula , which is based on the assumption that the cash flows from a European stock option can be replicated by a continuous buying and selling strategy using only the stock.
A simplified 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 model's results are input-dependent meaning the final price depends heavily on how we derive the pricing inputs.
Yet as Chan and others point out, the lessons of summer 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. 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 asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly.
There have been several instances of massive losses in derivative markets, such as the following:. Some derivatives especially swaps expose investors to counterparty risk , or risk arising from the other party in a financial transaction. 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 fixed 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. 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 Buffett in Berkshire Hathaway 's annual report.
Buffett called them 'financial weapons of mass destruction. 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 Report for Under US law and the laws of most other developed countries, derivatives have special legal exemptions that make them a particularly attractive legal form to extend credit. This can contribute to credit booms, and increase systemic risks.
In the context of a 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.
Additionally, the report said, "[t]he Department of Justice is looking into derivatives, too. The department's 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.
For legislators and committees responsible for financial 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 significant" institutions whose default could be large enough to threaten the entire financial system.
At the same time, the legislation should allow for responsible parties to hedge risk without unduly tying up working capital as collateral that firms may better employ elsewhere in their operations and investment. More importantly, the reasonable collateral that secures these different counterparties can be very different.
The distinction between these firms is not always straight forward e. Finally, even financial users must be differentiated, as 'large' banks may classified as "systemically significant" whose derivatives activities must be more tightly monitored and restricted than those of smaller, local and regional banks. The law mandated the clearing of certain swaps at registered exchanges and imposed various restrictions on derivatives. The Commission determines which swaps are subject to mandatory clearing and whether a derivatives exchange is eligible to clear a certain type of swap contract.
Nonetheless, the above and other challenges of the rule-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 financial reform among the nations that comprise the world's major financial markets, a primary responsibility of the Financial Stability Board whose progress is ongoing.
On December 20, the CFTC provided information on its swaps regulation "comparability" determinations. The release addressed the CFTC's cross-border compliance exceptions. Specifically it addressed which entity level and in some cases transaction-level requirements in six jurisdictions Australia, Canada, the European Union, Hong Kong, Japan, and Switzerland it found comparable to its own rules, thus permitting non-US swap dealers, major swap participants, and the foreign branches of US Swap Dealers and major swap participants in these jurisdictions to comply with local rules in lieu of Commission rules.
DTCC , through its "Global Trade Repository" GTR service, manages global trade repositories for interest rates, and commodities, foreign exchange, credit, and equity derivatives. From Wikipedia, the free encyclopedia. Time deposit certificate of deposit.