arbitrage

• a simultaneous purchase and sale in two separate financial markets in order to profit from a price difference existing between them
• a buying of a large number of shares in a corporation in anticipation of, and with the expectation of making a profit from, a merger or takeover: in full risk arbitrage

asset swap (see notes from 2001.06.29)

• a synthetic structure that enables an investor to buy a fixed-rate bond and hedge out the interest rate risk by swapping the fixed payments to floating. In doing so, the investor retains the credit exposure to the fixed rate bond but earns a floating rate of return. eg,
  • Investor purchases 50M Ford 6.9% 2y priced at par.
  • Investor enters a 2y interest rate swap with GS (investor pays GS the 6.9% coupon and receives LIBOR + 0.2%).
  • Investor has effectively purchased a synthetic Ford floating rate note (FRN) at LIBOR + 0.2%.
  • The market price of the asset swap is the aggregate of the market value of the bond and swap.
  • The investor has credit and basis risk between the fixed rate Ford market and the swaps market. Given the high correlation between swap and general interest rate movements, the asset swap position generally is a market duration neutral position in the credit. For this reason, asset swap market prices can be estimated using FRN discount margin calculations.

basis

• the difference between the spot (invoice) price and the product of the futures price and conversion factor for a given bond; being "long basis" means holding the underlying and shorting the futures contract

basis risk

• unexpected change in the basis when holding a long (short) position in the underlying and short (long) position in the futures contract

capital market

• a market in which medium to long-term capital is raised, including stock and bond markets; businesses use capital markets much less frequently than money markets; the amount of money flowing through money markets is an order of magnitude greater than that of capital markets

commercial paper

• short term (less than nine months) bills written by corporate entities

contango

• The spot price of a commodity (price for immediate delivery) is lower than the future price (price for delivery at a future date), ie the term structure of the futures is upward sloping. Often associated with the current and future price of crude oil. The opposite of contango is backwardation. "Normal backwardation" can occur when participants are willing to pay a premium for immediate supply of consumable commodities, eg oil.

conversion factor

• used to normalize the prices of the basket of deliverable bonds in a futures contract; see this for the mathematical definition and examples. A subtly occurs if the yield is much less or much more than the 6% specified here as of 2010.10.28. See the "converted forward prices" figure by Kuznetsov.

convexity

• curvature (second derivative) of price with respect to yield; increases quadratically with time to maturity; for traders, means asymmetric risk - you stand to gain more in price if the yield goes down than you would lose if the yield goes up by the same amount

debenture

• an interest-bearing bond issued against the general credit of a corporation or governmental unit, with no specific pledge of assets
• a voucher or certificate acknowledging that a debt is owed by the signer
• a customhouse order for payment of a drawback, as to an importer

discount

• the percentage difference between amount returned to the lender (par amount) and the amount lent to the borrower (issuer)

discount bill

• a contract representing a promise by the issuer of a single payment in the (usually near) future

discount rate

• discount divided by the time period to maturity expressed in years; yield (rate of return) is always greater than the discount rate as applied to discount bills

dollar duration

• negative slope (derivative) of the yield curve; -dP / dy

duration

• negative of the logarithmic derivative of price with respect to yield; -dP / P·dy; increases linearly with time to maturity; equals maturity if coupon is zero; always between zero and time to maturity

DV01

• change in price for a 1bp change in yield; derivative of price with respect to yield; dP / dy; increases linearly with time to maturity

fed funds

• money held in reserve accounts; fluctuates due to its dependence on reserve requirements and a given bank's daily total deposits

fed funds rate

• overnight interest rate on fed funds negotiated between banks in order to maintain their reserve requirements; indirectly controlled by The Fed; fed funds rate goes down when The Fed increases the money supply in the banking system by buying securities or vice versa

forward contract

• an over-the-counter agreement to buy or sell an asset at a certain future time for a certain price; at t = 0 the forward price equals the delivery price; as t approaches the future time the forward price approaches the spot price at the future time, which may or may not be the delivery price; neutralizes risk unlike an options contract that is insurance against risk

front contract

• the futures contract for the nearest delivery month

futures contract

• an exchange traded agreement to buy or sell an asset in a future time period for a certain price; the asset may not be limited to a particular thing, ie the 5.25% Feb 15, 2030, but may be a variety of similar things specified in the futures contract, eg any US Treasury bond with a maturity more than 20 years away

futures contract implied yield curve

• the yield curve derived from the yields on a basket of converted deliverable bonds for a given futures contract price

gain from convexity

• the difference between the expected price and the price corresponding to the expected yield

inflation rate

• (CPI today - CPI a year ago) / CPI a year ago

money market

• a market in which money and other liquid assets such as commercial paper and treasury bills can be lent and borrowed; businesses use money markets almost on a daily basis to change the timing of future cash flows and smooth out short term fluctuations in their cash positions; the amount of money flowing through money markets is an order of magnitude greater than that of capital markets

price drop

• difference between the sport price and forward price; bonds usually have positive carry so spot - forward > 0; seller of the bond accrues (daily) interest in the interim between spot date and settle date, which the buyer does not want to also pay!

Sharpe's Ratio

• TODO http://www.lawbizmath.com/?p=296, http://www.excelforum.com/excel-programming/656428-creating-a-sharpe-ratio-function-using-vba.html

reserve requirements

• the percentage of total deposits that commercial banks must keep on hand in a reserve account at the appropriate (regional) federal reserve bank; The Fed does not pay interest on fed funds so banks are highly motivated to keep their reserves at the minimum, which is why the fed funds rate fluctuates daily

spot rate

• the yield at a given maturity on the implied zero coupon bond with that maturity; the discount factor for valuing any cash flow on that date

swap rate

• the fixed rate that makes the present value of the fixed leg equal to the present value of the floating leg based on a snapshot of the yield curve; quarterly rate is compounded in the floating leg since the fixed leg pays semi-annually

The Fed

• The Federal Reserve; charged with guiding monetary policy; its board of governors sets banks' reserve requirements

treasury bills

• short term (less than one year) bills written by governments