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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.
In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations with forward rate agreements (FRAs), and with zero coupon swaps (ZCSs).
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments to the seller and, in exchange, may expect to receive a payoff if the asset defaults.
Credit risk is the possibility of losing a lender holds due to a 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.
Over-the-counter (OTC) or off-exchange trading or pink sheet trading is done directly between two parties, without the supervision of an exchange. It is contrasted with exchange trading, which occurs via exchanges. A stock exchange has the benefit of facilitating liquidity, providing transparency, and maintaining the current market price. In an OTC trade, the price is not necessarily publicly disclosed.
The Basel Accords refer to the banking supervision accords issued by the Basel Committee on Banking Supervision (BCBS).
In finance, leverage, also known as gearing, is any technique involving borrowing funds to buy an investment.
Financial risk management is the practice of protecting economic value in a firm by managing exposure to financial risk - principally operational risk, credit risk and market risk, with more specific variants as listed aside. As for risk management more generally, financial risk management requires identifying the sources of risk, measuring these, and crafting plans to mitigate them. See Finance § Risk management for an overview.
Prime brokerage is the generic term for a bundled package of services offered by investment banks, wealth management firms, and securities dealers to hedge funds which need the ability to borrow securities and cash in order to be able to invest on a netted basis and achieve an absolute return. The prime broker provides a centralized securities clearing facility for the hedge fund so the hedge fund's collateral requirements are netted across all deals handled by the prime broker. These two features are advantageous to their clients.
Settlement risk, also known as delivery risk or counterparty risk, is the risk that a counterparty fails to deliver a security or its value in cash as per agreement when the security was traded after the other counterparty or counterparties have already delivered security or cash value as per the trade agreement. The term covers factors incidental to the settlement process which may suspend or prevent a trade from completing, even though the parties themselves are in agreement, are acting in good faith, and otherwise competent to perform.
In the context of operational risk, the standardized approach or standardised approach is a set of operational risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions.
Loss given default or LGD is the share of an asset that is lost if a borrower defaults.
Exposure at default or (EAD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. It can be defined as the gross exposure under a facility upon default of an obligor.
A central clearing counterparty (CCP), also referred to as a central counterparty, is a financial market infrastructure organization that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in foreign exchange, securities, options, and derivative contracts. CCPs are highly regulated institutions that specialize in managing counterparty credit risk.
Collateral has been used for hundreds of years to provide security against the possibility of payment default by the opposing party in a trade. Collateral management began in the 1980s, with Bankers Trust and Salomon Brothers taking collateral against credit exposure. There were no legal standards, and most calculations were performed manually on spreadsheets. Collateralisation of derivatives exposures became widespread in the early 1990s. Standardisation began in 1994 via the first ISDA documentation.
A Credit valuation adjustment (CVA), in financial mathematics, is an "adjustment" to a derivative's price, as charged by a bank to a counterparty to compensate it for taking on the credit risk of that counterparty during the life of the transaction. CVA is one of a family of related valuation adjustments, collectively xVA; for further context here see Financial economics § Derivative pricing. "CVA" can refer more generally to several related concepts, as delineated aside. The most common transactions attracting CVA involve interest rate derivatives, foreign exchange derivatives, and combinations thereof. CVA has a specific capital charge under Basel III, and may also result in earnings volatility under IFRS 13, and is therefore managed by a specialized desk.
Basel III is the third Basel Accord, a framework that sets international standards for bank capital adequacy, stress testing, and liquidity requirements. Augmenting and superseding parts of the Basel II standards, it was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08. It is intended to strengthen bank capital requirements by increasing minimum capital requirements, holdings of high quality liquid assets, and decreasing bank leverage.
Under the Basel II guidelines, banks are allowed to use their own estimated risk parameters for the purpose of calculating regulatory capital. This is known as the internal ratings-based (IRB) approach to capital requirements for credit risk. Only banks meeting certain minimum conditions, disclosure requirements and approval from their national supervisor are allowed to use this approach in estimating capital for various exposures.
An X-Value Adjustment is an umbrella 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.
In finance, a zero coupon swap (ZCS) is an interest rate derivative (IRD). In particular it is a linear IRD, that in its specification is very similar to the much more widely traded interest rate swap (IRS).
References
- ↑ Basel Committee on Banking Supervision (2018). "Counterparty credit risk in Basel III - Executive Summary". www.bis.org
- ↑ Basel Committee on Banking Supervision (2014-03-31). "The standardised approach for measuring counterparty credit risk exposures (BCBS 279)". www.bis.org. Retrieved 3 May 2018.
- ↑ FIS (2017). "Allocating SA-CCR fairly", www.fisglobal.com.