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In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying". Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges.
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.
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 term "swaption" typically refers to options on interest rate swaps.
In finance, a swap is an agreement between two counterparties to exchange financial instruments or cashflows or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount.
In finance, an interest rate derivative (IRD) is a derivative whose payments are determined through calculation techniques where the underlying benchmark product is an interest rate, or set of different interest rates. There are a multitude of different interest rate indices that can be used in this definition.
A quanto is a type of derivative in which the underlying is denominated in one currency, but the instrument itself is settled in another currency at some rate. Such products are attractive for speculators and investors who wish to have exposure to a foreign asset, but without the corresponding exchange rate risk.
In finance, 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.
In finance, a price (premium) is paid or received for purchasing or selling options. This article discusses the calculation of this premium in general. For further detail, see: Mathematical finance § Derivatives pricing: the Q world for discussion of the mathematics; Financial engineering for the implementation; as well as Financial modeling § Quantitative finance generally.
In finance, a lattice model is a technique applied to the valuation of derivatives, where a discrete time model is required. For equity options, a typical example would be pricing an American option, where a decision as to option exercise is required at "all" times before and including maturity. A continuous model, on the other hand, such as Black–Scholes, would only allow for the valuation of European options, where exercise is on the option's maturity date. For interest rate derivatives lattices are additionally useful in that they address many of the issues encountered with continuous models, such as pull to par. The method is also used for valuing certain exotic options, where because of path dependence in the payoff, Monte Carlo methods for option pricing fail to account for optimal decisions to terminate the derivative by early exercise, though methods now exist for solving this problem.
The following outline is provided as an overview of and topical guide to finance:
In finance, inflation derivative refers to an over-the-counter and exchange-traded derivative that is used to transfer inflation risk from one counterparty to another. See Exotic derivatives.
In finance, an option is a contract which conveys to its owner, the holder, 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, depending on the style of the option. Options are typically acquired by purchase, as a form of compensation, or as part of a complex financial transaction. Thus, they are also a form of asset and have a valuation that may depend on a complex relationship between underlying asset value, time until expiration, market volatility, and other factors. Options may be traded between private parties in over-the-counter (OTC) transactions, or they may be exchange-traded in live, orderly markets in the form of standardized contracts.
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 does not makes periodic payments to the protection seller, and in return receives a payoff if an underlying financial instrument defaults. Differently from a standard CDS, the premium leg of a CMCDS does not pay a fixed and pre-agreed amount but a floating spread, using a traded CDS as a reference index. More precisely, given a pre-assigned time-to-maturity, at any payment instant of the premium leg the rate that is offered is indexed at a traded CDS spread on the same reference credit existing in that moment for the pre-assigned time-to-maturity. 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 defined as the ratio between the present value of the premium leg of a standard CDS with the same final 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 offset the default legs and leave only the difference in the premium legs, that are driven by spread risk. Valuation of CMCDS has been explored by Damiano Brigo (2004) and Anlong Li (2006)
In finance, 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. It is one of the most popular non-vanilla financial 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 predefined range.
Damiano Brigo is an applied mathematician and Chair in Mathematical Finance at Imperial College London. He is known for research in filtering theory and mathematical finance.
Credit valuation adjustment (CVA) is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty's default. In other words, CVA is the market value of counterparty credit risk. This price depends on counterparty credit spreads as well as on the market risk factors that drive derivatives' values and, therefore, exposure. CVA is one of a family of related valuation adjustments, collectively xVA; for further context here see Financial economics § Derivative pricing.
In financial mathematics, the Black–Karasinski model is a mathematical model of the term structure of interest rates; see short-rate model. It is a one-factor model as it describes interest rate movements as driven by a single source of randomness. It belongs to the class of no-arbitrage models, i.e. it can fit today's zero-coupon bond prices, and in its most general form, today's prices for a set of caps, floors or European swaptions. The model was introduced by Fischer Black and Piotr Karasinski in 1991.
A bespoke portfolio is a table of reference securities. A bespoke portfolio may serve as the reference portfolio for a synthetic CDO arranged by an investment bank and selected by a particular investor or for that investor by an investment manager.
An X-Value Adjustment is a collective term referring to a number of different “valuation adjustments” that banks must make when assessing the value of derivative contracts that they have entered into. The purpose of these is twofold: primarily to hedge for possible losses due to other parties' failures to pay amounts due on the derivative contracts; but also to determine the amount of capital required under the bank capital adequacy rules. XVA has led to the creation of specialized desks in many banking institutions to manage XVA exposures.
The Merton model, developed by Robert C. Merton in 1974, is a widely used credit risk model. Analysts and investors utilize the Merton model to understand how capable a company is at meeting financial obligations, servicing its debt, and weighing the general possibility that it will go into credit default.
References
- Brigo, Damiano (January 2005). "Market Models for CDS Options and Callable Floaters". Risk Magazine. Related Article at SSRN
- Pedersen, Claus M. (2003). "Valuation of Portfolio Credit Default Swaptions". Lehman Brothers Quantitative Credit Research.
- Brigo, Damiano and Massimo Morini (2008). "Arbitrage-free pricing of Credit Index Options. The no-armageddon pricing measure and the role of correlation after the subprime crisis". Second Conference on the Mathematics of Credit Risk. Princeton University. Archived from the original on 2008-09-25. Related SSRN article at
