Derivatives

Derivative (finance)
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v·d·e
In finance, a derivative is a financial instrument (or, more simply, an agreement between two parties)
that has a value, based on the expected future price movements of the asset to which it is linked—called
the underlying asset—[1] such as a share or a currency. There are many kinds of derivatives, with the
most common being swaps, futures, and options. Derivatives are a form of alternative investment.
A derivative is not a stand-alone asset, since it has no value of its own. However, more common types of
derivatives have been traded on markets before their expiration date as if they were assets. Among
the oldest of these are rice futures, which have been traded on the Dojima Rice Exchange since the
eighteenth century.[2]
Derivatives are usually broadly categorized by:
• the relationship between the underlying asset and the derivative (e.g., forward, option, swap);
• the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate
derivatives, commodity derivatives or credit derivatives);
• the market in which they trade (e.g., exchange-traded or over-the-counter);
• their pay-off profile.
Another arbitrary distinction is between:[3]
• vanilla derivatives (simple and more common); and

• exotic derivatives (more complicated and specialized).
Contents
[hide]
• 1 Uses
o 1.1 Hedging
o 1.2 Speculation and arbitrage
• 2 Types of derivatives
o 2.1 OTC and exchange-traded
o 2.2 Common derivative contract types
o 2.3 Examples
• 3 Valuation
o 3.1 Market and arbitrage-free prices
o 3.2 Determining the market price
o 3.3 Determining the arbitrage-free price
• 4 Criticism
o 4.1 Possible large losses
o 4.2 Counter-party risk
o 4.3 Large notional value
o 4.4 Leverage of an economy's debt
• 5 Benefits
• 6 Government regulation
• 7 Definitions
• 8 See also
• 9 References
• 10 Further Reading
• 11 External links
[edit] Uses
Derivatives are used by investors to:
• provide leverage (or gearing), such that a small movement in the underlying value can cause a
large difference in the value of the derivative;
• speculate and make a profit if the value of the underlying asset moves the way they expect (e.g.,
moves in a given direction, stays in or out of a specified range, reaches a certain level);
• hedge or mitigate risk in the underlying, by entering into a derivative contract whose value
moves in the opposite direction to their underlying position and cancels part or all of it out;
• obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather
derivatives);
• create option ability where the value of the derivative is linked to a specific condition or event
(e.g., the underlying reaching a specific price level).
[edit] Hedging
This section does not cite any references or sources.

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removed. (October 2010)
Derivatives can be considered as providing a form of insurance in hedging, which is itself a technique
that attempts to reduce risk.
Derivatives allow risk related to the price of the underlying asset to be transferred from one party to
another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified
amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for
the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However,
there is still the risk that no wheat will be available because of events unspecified by the contract, such
as the weather, or that one party will renege on the contract. Although a third party, called a clearing
house, insures a futures contract, not all derivatives are insured against counter-party risk.
From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign
the futures contract: the farmer reduces the risk that the price of wheat will fall below the price specified
in the contract and acquires the risk that the price of wheat will rise above the price specified in the
contract (thereby losing additional income that he could have earned). The miller, on the other hand,
acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying
more in the future than he otherwise would have) and reduces the risk that the price of wheat will rise
above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of
risk, and the counter-party is the insurer (risk taker) for another type of risk.
Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that
has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The
individual or institution has access to the asset for a specified amount of time, and can then sell it in the
future at a specified price according to the futures contract. Of course, this allows the individual or
institution the benefit of holding the asset, while reducing the risk that the future selling price will
deviate unexpectedly from the market's current assessment of the future value of the asset.
Derivatives traders at the Chicago Board of Trade.
Derivatives can serve legitimate business purposes. For example, a corporation borrows a large sum of
money at a specific interest rate.[4] The rate of interest on the loan resets every six months. The
corporation is concerned that the rate of interest may be much higher in six months. The corporation
could buy a forward rate agreement (FRA), which is a contract to pay a fixed rate of interest six months
after purchases on a notional amount of money.[5] If the interest rate after six months is above the
contract rate, the seller will pay the difference to the corporation, or FRA buyer. If the rate is lower, the
corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the
uncertainty concerning the rate increase and stabilize earnings.
[edit] Speculation and arbitrage
Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some
individuals and institutions will enter into a derivative contract to speculate on the value of the
underlying asset, betting that the party seeking insurance will be wrong about the future value of the
underlying asset. Speculators look to buy an asset in the future at a low price according to a derivative
contract when the future market price is high, or to sell an asset in the future at a high price according to
a derivative contract when the future market price is low.
Individuals and institutions may also look for arbitrage opportunities, as when the current buying price
of an asset falls below the price specified in a futures contract to sell the asset.
Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at
Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of
poor judgment, lack of oversight by the bank's management and regulators, and unfortunate events like
the Kobe earthquake, Leeson incurred a US$1.3 billion loss that bankrupted the centuries-old institution.
[6]
[edit] Types of derivatives
[edit] OTC and exchange-traded
In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are
traded in the market:
• Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated)
directly between two parties, without going through an exchange or other intermediary. Products
such as swaps, forward rate agreements, and exotic options are almost always traded in this way.
The OTC derivative market is the largest market for derivatives, and is largely unregulated with
respect to disclosure of information between the parties, since the OTC market is made up of
banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are
difficult because trades can occur in private, without activity being visible on any exchange.
According to the Bank for International Settlements, the total outstanding notional amount is
US$684 trillion (as of June 2008).[7] Of this total notional amount, 67% are interest rate
contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are
commodity contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are
not traded on an exchange, there is no central counter-party. Therefore, they are subject to
counter-party risk, like an ordinary contract, since each counter-party relies on the other to
perform.
• Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded
via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market
where individuals trade standardized contracts that have been defined by the exchange.[8] A
derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin
from both sides of the trade to act as a guarantee. The world's largest[9] derivatives exchanges (by
number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options),
Eurex (which lists a wide range of European products such as interest rate & index products),
and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the
Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange).
According to BIS, the combined turnover in the world's derivatives exchanges totaled USD 344
trillion during Q4 2005. Some types of derivative instruments also may trade on traditional
exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible
preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on
equity exchanges. Performance Rights, Cash xPRTs and various other instruments that
essentially consist of a complex set of options bundled into a simple package are routinely listed
on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors
access to risk/reward and volatility characteristics that, while related to an underlying
commodity, nonetheless are distinctive.
[edit] Common derivative contract types
There are three major classes of derivatives:
1. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price
specified today. A futures contract differs from a forward contract in that the futures contract is a
standardized contract written by a clearing house that operates an exchange where the contract
can be bought and sold, whereas a forward contract is a non-standardized contract written by the
parties themselves.
2. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a
call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is
known as the strike price, and is specified at the time the parties enter into the option. The option
contract also specifies a maturity date. In the case of a European option, the owner has the right
to require the sale to take place on (but not before) the maturity date; in the case of an American
option, the owner can require the sale to take place at any time up to the maturity date. If the
owner of the contract exercises this right, the counter-party has the obligation to carry out the
transaction.
3. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the
underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other
assets.
More complex derivatives can be created by combining the elements of these basic types. For example,
the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified
future date.
[edit] Examples
The overall derivatives market has five major classes of underlying asset:
• interest rate derivatives (the largest)

• foreign exchange derivatives
• credit derivatives
• equity derivatives
• commodity derivatives
Some common examples of these derivatives are:
CONTRACT TYPES
UNDERLYING Exchange- Exchange-traded
OTC swap OTC forward OTC option
traded futures options
DJIA Index Option on DJIA
Back-to-back Stock option
future Index future
Equity Equity swap Repurchase Warrant
Single-stock Single-share
agreement Turbo warrant
future option
Interest rate cap
Option on
and floor
Eurodollar future Eurodollar future Interest rate Forward rate
Interest rate Swaption
Euribor future Option on Euribor swap agreement
Basis swap
future
Bond option
Credit default
Option on Bond swap Repurchase Credit default
Credit Bond future
future Total return agreement option
swap
Foreign Option on Currency
Currency future Currency swap Currency option
exchange currency future forward
WTI crude oil Weather Commodity Iron ore forward
Commodity Gold option
futures derivatives swap contract
Other examples of underlying exchangeables are:
• Property (mortgage) derivatives

• Economic derivatives that pay off according to economic reports[10] as measured and reported by
national statistical agencies
• Freight derivatives
• Inflation derivatives
• Weather derivatives
• Insurance derivatives[citation needed]
• Emissions derivatives[11]
[edit] Valuation
Total world derivatives from 1998-2007[12] compared to total world wealth in the year 2000[13]
[edit] Market and arbitrage-free prices
Two common measures of value are:
• Market price, i.e., the price at which traders are willing to buy or sell the contract;
• Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts;
see rational pricing.
[edit] Determining the market price
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.
[edit] Determining the arbitrage-free price
The arbitrage-free price for a derivatives contract is complex, and there are many different variables to
consider. Arbitrage-free pricing is a central topic of financial mathematics. The stochastic process of the
price of the underlying asset is often crucial. 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. And most of the model's results are input-dependant
(meaning the final price depends heavily on how we derive the pricing inputs).[14] Therefore it is
common that OTC derivatives are priced by Independent Agents that both counterparties involved in the
deal designate upfront (when signing the contract).
[edit] Criticism
Derivatives are often subject to the following criticisms:
[edit] Possible large losses
See also: List of trading losses
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 need to recapitalize insurer American International Group (AIG) with US$85
billion of debt provided by the US federal government.[15] An AIG subsidiary had lost
more than US$18 billion over the preceding three quarters on Credit Default Swaps
(CDS) it had written.[16] It was reported that the recapitalization was necessary because
further losses were foreseeable over the next few quarters.
• The loss of US$7.2 Billion by Société Générale in January 2008 through mis-use
of futures contracts.
• The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long
natural gas in September 2006 when the price plummeted.
• The loss of US$4.6 billion in the failed fund Long-Term Capital Management in
1998.
• The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by
Metallgesellschaft AG.[17]
• The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings
Bank.[18]
Members of President Clinton's Working Group on Financial Markets: Larry Summers, Alan
Greenspan, Arthur Levitt, and Robert Rubin, have been criticized for torpedoing an effort to regulate the
derivatives' markets, and thereby helping to bring down the financial markets in Fall 2008. President
George W. Bush has also been criticized because he was President for 8 years preceding the 2008
meltdown. Bush has stated that deregulation was one of the core tenets of his political philosophy.
[edit] Counter-party risk
Some derivatives (especially swaps) expose investors to counter-party risk.
For example, suppose a person wanting a fixed interest rate loan for his business, but finding that banks
only offer variable rates, swaps payments with another business who wants a variable rate, synthetically
creating a fixed rate for the person. However if the second business goes bankrupt, it can't pay its
variable rate and so the first business will lose its fixed rate and will be paying a variable rate again. If
interest rates have increased, it is possible that the first business may be adversely affected, because it
may not be prepared to pay the higher variable rate.
Different types of derivatives have different levels of counter-party risk. 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.
[edit] Large notional value
Derivatives typically have a large notional value. As such, there is the danger that their use could result
in losses that the investor would be unable to compensate for. The possibility that this could lead to a
chain reaction ensuing in an economic crisis, has been pointed out by famed investor Warren Buffett in
Berkshire Hathaway's 2002 annual report. Buffett called them 'financial weapons of mass destruction.'
The problem with derivatives is that they control an increasingly larger notional amount of assets and
this may lead to distortions in the real capital and equities markets. 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
2002)
[edit] Leverage of an economy's debt
Derivatives massively leverage the debt in an economy, making it ever more difficult for the
underlying real economy to service its debt obligations, thereby curtailing real economic activity, which
can cause a recession or even depression. In the view of Marriner S. Eccles, U.S. Federal Reserve
Chairman from November, 1934 to February, 1948, too high a level of debt was one of the primary
causes of the 1920s-30s Great Depression. (See Berkshire Hathaway Annual Report for 2002)
[edit] Benefits
The use of derivatives also has its benefits:
• Derivatives facilitate the buying and selling of risk, and many people[who?] consider this to have a
positive impact on the economic system. Although someone loses money while someone else
gains money with a derivative, under normal circumstances, trading in derivatives should not
adversely affect the economic system because it is not zero sum in utility.
• Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed
that the use of derivatives has softened the impact of the economic downturn at the beginning of
the 21st century.[citation needed]
[edit] Government regulation

In the context of a 2010 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." More oversight of the banks in this market is needed, he also said. 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."[19]
[edit] Definitions
• Bilateral netting: A legally enforceable arrangement between a bank and a counter-party that
creates a single legal obligation covering all included individual contracts. This means that a
bank’s obligation, in the event of the default or insolvency of one of the parties, would be the net
sum of all positive and negative fair values of contracts included in the bilateral netting
arrangement.
• Credit derivative: A contract that transfers credit risk from a protection buyer to a credit
protection seller. Credit derivative products can take many forms, such as credit default swaps,
credit linked notes and total return swaps.
• Derivative: A financial contract whose value is derived from the performance of assets, interest
rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of
financial contracts including structured debt obligations and deposits, swaps, futures, options,
caps, floors, collars, forwards and various combinations thereof.
• Exchange-traded derivative contracts: Standardized derivative contracts (e.g., futures contracts
and options) that are transacted on an organized futures exchange.
• Gross negative fair value: The sum of the fair values of contracts where the bank owes money to
its counter-parties, without taking into account netting. This represents the maximum losses the
bank’s counter-parties would incur if the bank defaults and there is no netting of contracts, and
no bank collateral was held by the counter-parties.
• Gross positive fair value: The sum total of the fair values of contracts where the bank is owed
money by its counter-parties, without taking into account netting. This represents the maximum
losses a bank could incur if all its counter-parties default and there is no netting of contracts, and
the bank holds no counter-party collateral.
• High-risk mortgage securities: Securities where the price or expected average life is highly
sensitive to interest rate changes, as determined by the FFIEC policy statement on high-risk
mortgage securities.
• Notional amount: The nominal or face amount that is used to calculate payments made on swaps
and other risk management products. This amount generally does not change hands and is thus
referred to as notional.
• Over-the-counter (OTC) derivative contracts: Privately negotiated derivative contracts that are
transacted off organized futures exchanges.
• Structured notes: Non-mortgage-backed debt securities, whose cash flow characteristics depend
on one or more indices and / or have embedded forwards or options.
• Total risk-based capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of common
shareholders equity, perpetual preferred shareholders equity with non-cumulative dividends,
retained earnings, and minority interests in the equity accounts of consolidated subsidiaries. Tier
2 capital consists of subordinated debt, intermediate-term preferred stock, cumulative and long-
term preferred stock, and a portion of a bank’s allowance for loan and lease losses.
Options: Calls and Puts

Options come in two primary forms:
Calls and Puts
A call option gives the holder the right, not the obligation, to buy 100 shares of the underlying
stock at a fixed price and for a fixed period of time.
A put option gives the holder the right, not the obligation, to sell 100 shares of the underlying
stock for a fixed price and for a fixed period of time.
This is why an option is considered to be a "wasting" asset. Since the option only has value for a
fixed period of time, its value decreases, or "wastes" away with the passage of time.
In the case of an index option, the holder can participate in the movement of the index. However,
these options are cash settled and therefore, the holder of the option will never wind up with a
position in the underlying securities.
The Four Components to an Option
There are four components to an option. They are: The underlying security, the type of option (put
or call), the strike price, and the expiration date.
Let"s take an XYZ November 100 call option as an example. XYZ is the underlying security.
November is the expiration month. 100 is the strike price (sometimes referred to as the exercise
price). And the option is a call (the holder has the right, not the obligation, to buy 100 shares of
XYZ at a price of 100).
Types of Expiration
There are two different types of options with respect to expiration. There is a European style option
and an American style option.
The European style option cannot be exercised until the expiration date. Once an investor has
purchased the option, it must be held until expiration. An American style option can be exercised at
any time after it is purchased.
Today, most stock options which are traded are American style options. And many index options
are American style. However, there are many index options which are European style options. An
investor should be aware of this when considering the purchase of an index option.
The Parties to an Option
There are two parties to an option. There is the party who buys the option; and there is the party
who sells the option.
The party who sells the option is the writer. The party who writes the option has the obligation to
fulfill the terms of the contract should it be exercised. This can be done by delivering to the
appropriate broker 100 shares of the underlying security for each option written.
At-the-Money, In-the-Money, Out-of-the-Money
There are three different terms for describing where an option is trading in relation to the price of
the underlying security. These terms are "at-the-money," "in-the-money," and "out-of-the money."
Let's use our XYZ November 100 call as an example. If XYZ stock is trading at a price of 100, the
November 100 call is considered to be trading "at-the-money." If XYZ stock is trading at a price
greater than 100, say 102, the call option is considered to be "in-the-money." And if XYZ is trading
at a price less than 100, say 98, the call option is considered to be trading "out-of-the-money."
Conversely, if it was an XYZ November 100 put option we owned, if the price of XYZ stock was
102, the put option would be considered to be out-of-the-money."
And if XYZ stock were trading at a price of 98, the put option would be considered to be trading
"in-the-money." If XYZ stock were again trading at 100, the put option would be "at-the-money."
Intrinsic Value and Time Value
Intrinsic Value
The price difference between the underlying security and the option's strike price is the intrinsic
value.
For example, let's take that XYZ November 100 call. If XYZ is trading at 102, and the call option is
priced at 2, the intrinsic value is 2. If an XYZ November 100 put is trading at 3, and the price of
XYZ stock is trading at 97, the intrinsic value of the put option is 3.
If XYZ stock were trading at 99, an XYZ November 100 call would have no intrinsic value. And
conversely, if XYZ stock were trading at 101, an XYZ November 100 put option would have no
intrinsic value. An option must be in-the-money to have intrinsic value.
Time Value
Time value is the amount by which the price of the option exceeds its intrinsic value.
For example, that XYZ November 100 call, with XYZ trading at 102, might be selling for 4-1/2.
Thus, there is 2 points in intrinsic value and 2-1/2 points in time value. If XYZ were trading at 99,
and the price of the option was 2, there would be no intrinsic value and 2 points in time value. If
an XYZ November 100 put was priced at 3 and XYZ stock was trading at 99, there would be 1 point
in intrinsic value and 2 points in time value.
If an XYZ November 100 put was trading at 2 and XYZ stock was priced at 101, there would be 2
points in time value and no intrinsic value. The time value premium of an option declines as the
expiration date approaches.
Interest rate swap

A swap is a derivative in which one party exchanges a stream of interest payments for another party's
stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets
and liabilities. They can also be used by speculators to replicate unfunded bond exposures to profit from
changes in interest rates. Interest rate swaps are very popular and highly liquid instruments.
Contents
[hide]
• 1 Structure
• 2 Types
o 2.1 Fixed-for-floating rate swap, same currency
o 2.2 Fixed-for-floating rate swap, different currencies
o 2.3 Floating-for-floating rate swap, same currency
o 2.4 Floating-for-floating rate swap, different currencies
o 2.5 Fixed-for-fixed rate swap, different currencies
o 2.6 Other variations
• 3 Uses
o 3.1 Speculation
o 3.2 LIBOR/Swap zero rate
o 3.3 British local authorities
• 4 Valuation and pricing
• 5 Risks
• 6 Market size
• 7 References
• 8 See also
[edit] Structure
A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay
floating. By entering into an interest rate swap, the net result is that each party can 'swap' their existing
obligation for their desired obligation.
In an interest rate swap, each counterparty agrees to pay either a fixed or floating rate denominated in a
particular currency to the other counterparty. The fixed or floating rate is multiplied by a notional
principal amount (say, USD 1 million). This notional amount is generally not exchanged between
counterparties, but is used only for calculating the size of cashflows to be exchanged.
The most common interest rate swap is one where one counterparty A pays a fixed rate (the swap rate)
to counterparty B, while receiving a floating rate (usually pegged to a reference rate such as LIBOR).
According to usual market convention, the counterparty paying the fixed rate is called the "payer" (while
receiving the floating rate), and the counterparty receiving the fixed rate is called the "receiver" (while
paying the floating rate).
A pays fixed rate to B (A receives variable rate)
B pays variable rate to A (B receives fixed rate).

Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate
payments of 8.65%, in exchange for periodic variable interest rate payments of LIBOR + 70 bps
(0.70%). Note that there is no exchange of the principal amounts and that the interest rates are on a
"notional" (i.e. imaginary) principal amount. Also note that the interest payments are settled in net (e.g.
Party A pays (LIBOR + 1.50%)+8.65% - (LIBOR+0.70%) = 9.45% net). The fixed rate (8.65% in this
example) is referred to as the swap rate.[1]
At the point of initiation of the swap, the swap is priced so that it has a net present value of zero. If one
party wants to pay 50 bps above the par swap rate, the other party has to pay approximately 50 bps over
LIBOR to compensate for this.
[edit] Types
Normally the parties do not swap payments directly, but rather each sets up a separate swap with a
financial intermediary such as a bank. In return for matching the two parties together, the bank takes a
spread from the swap payments (in this case 0.30% compared to the above example)
Being OTC instruments interest rate swaps can come in a huge number of varieties and can be structured
to meet the specific needs of the counterparties. By far the most common are fixed-for-floating, fixed-
for-fixed or floating-for-floating. The legs of the swap can be in the same currency or in different
currencies. (A single-currency fixed-for-fixed rate swap is generally not possible; since the entire cash-
flow stream can be predicted at the outset there would be no reason to maintain a swap contract as the
two parties could just settle for the difference between the present values of the two fixed streams; the
only exceptions would be where the notional amount on one leg is uncertain or other esoteric uncertainty
is introduced).
[edit] Fixed-for-floating rate swap, same currency
Party B pays/receives fixed interest in currency A to receive/pay floating rate in currency A indexed to
X on a notional amount N for a term of T years. For example, you pay fixed 5.32% monthly to receive
USD 1M Libor monthly on a notional USD 1 million for 3 years. The party that pays fixed and receives
floating coupon rates is said to be short the interest swap because it is expressed as a bond convention
(as prices fall, yields rise). Interest rate swaps are simply the exchange of one set of cash flows for
another.
Fixed-for-floating swaps in same currency are used to convert a fixed rate asset/liability to a floating rate
asset/liability or vice versa. For example, if a company has a fixed rate USD 10 million loan at 5.3%
paid monthly and a floating rate investment of USD 10 million that returns USD 1M Libor +25 bps
monthly, it may enter into a fixed-for-floating swap. In this swap, the company would pay a floating rate
of USD 1M Libor+25 bps and receive a 5.5% fixed rate, locking in 20bps profit.
[edit] Fixed-for-floating rate swap, different currencies
Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency B indexed to X
on a notional N at an initial exchange rate of FX for a tenure of T years. For example, you pay fixed
5.32% on the USD notional 10 million quarterly to receive JPY 3M (TIBOR) monthly on a JPY notional
1.2 billion (at an initial exchange rate of USD/JPY 120) for 3 years. For nondeliverable swaps, the USD
equivalent of JPY interest will be paid/received (according to the FX rate on the FX fixing date for the
interest payment day). No initial exchange of the notional amount occurs unless the Fx fixing date and
the swap start date fall in the future.
Fixed-for-floating swaps in different currencies are used to convert a fixed rate asset/liability in one
currency to a floating rate asset/liability in a different currency, or vice versa. For example, if a company
has a fixed rate USD 10 million loan at 5.3% paid monthly and a floating rate investment of JPY 1.2
billion that returns JPY 1M Libor +50 bps monthly, and wants to lock in the profit in USD as they
expect the JPY 1M Libor to go down or USDJPY to go up (JPY depreciate against USD), then they may
enter into a Fixed-Floating swap in different currency where the company pays floating JPY 1M
Libor+50 bps and receives 5.6% fixed rate, locking in 30bps profit against the interest rate and the fx
exposure.
[edit] Floating-for-floating rate swap, same currency
Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating rate in

currency A indexed to Y on a notional N for a tenure of T years. For example, you pay JPY 1M LIBOR
monthly to receive JPY 1M TIBOR monthly on a notional JPY 1 billion for 3 years.
Floating-for-floating rate swaps are used to hedge against or speculate on the spread between the two
indexes widening or narrowing. For example, if a company has a floating rate loan at JPY 1M LIBOR
and the company has an investment that returns JPY 1M TIBOR + 30 bps and currently the JPY 1M
TIBOR = JPY 1M LIBOR + 10bps. At the moment, this company has a net profit of 40 bps. If the
company thinks JPY 1M TIBOR is going to come down (relative to the LIBOR) or JPY 1M LIBOR is
going to increase in the future (relative to the TIBOR) and wants to insulate from this risk, they can
enter into a float-float swap in same currency where they pay, say, JPY TIBOR + 30 bps and receive
JPY LIBOR + 35 bps. With this, they have effectively locked in a 35 bps profit instead of running with a
current 40 bps gain and index risk. The 5 bps difference (w.r.t. the current rate difference) comes from
the swap cost which includes the market expectations of the future rate difference between these two
indices and the bid/offer spread which is the swap commission for the swap dealer.
Floating-for-floating rate swaps are also seen where both sides reference the same index, but on different
payment dates, or use different business day conventions. This can be vital for asset-liability
management. An example would be swapping 3M LIBOR being paid with prior non-business day
convention, quarterly on JAJO (i.e. Jan, Apr, Jul, Oct) 30, into FMAN (i.e. Feb, May, Aug, Nov) 28
modified following・
[edit] Floating-for-floating rate swap, different currencies
Party P pays/receives floating interest in currency A indexed to X to receive/pay floating rate in

currency B indexed to Y on a notional N at an initial exchange rate of FX for a tenure of T years. For
example, you pay floating USD 1M LIBOR on the USD notional 10 million quarterly to receive JPY
3M TIBOR monthly on a JPY notional 1.2 billion (at an initial exchange rate of USDJPY 120) for 4
years.
To explain the use of this type of swap, consider a US company operating in Japan. To fund their
Japanese growth, they need JPY 10 billion. The easiest option for the company is to issue debt in Japan.
As the company might be new in the Japanese market without a well known reputation among the
Japanese investors, this can be an expensive option. Added on top of this, the company might not have
appropriate debt issuance program in Japan and they might lack sophisticated treasury operation in
Japan. To overcome the above problems, it can issue USD debt and convert to JPY in the FX market.
Although this option solves the first problem, it introduces two new risks to the company:
• FX risk. If this USDJPY spot goes up at the maturity of the debt, then when the company
converts the JPY to USD to pay back its matured debt, it receives less USD and suffers a loss.
• USD and JPY interest rate risk. If the JPY rates come down, the return on the investment in
Japan might go down and this introduces an interest rate risk component.
The first exposure in the above can be hedged using long dated FX forward contracts but this introduces
a new risk where the implied rate from the FX spot and the FX forward is a fixed rate but the JPY
investment returns a floating rate. Although there are several alternatives to hedge both the exposures
effectively without introducing new risks, the easiest and the most cost effective alternative would be to
use a floating-for-floating swap in different currencies. In this, the company raises USD by issuing USD
Debt and swaps it to JPY. It receives USD floating rate (so matching the interest payments on the USD
Debt) and pays JPY floating rate matching the returns on the JPY investment.
[edit] Fixed-for-fixed rate swap, different currencies
Party P pays/receives fixed interest in currency A to receive/pay fixed rate in currency B for a term of T
years. For example, you pay JPY 1.6% on a JPY notional of 1.2 billion and receive USD 5.36% on the
USD equivalent notional of 10 million at an initial exchange rate of USDJPY 120.
[edit] Other variations
A number of other variations are possible, although far less common. Mostly tweaks are made to ensure
that a bond is hedged "perfectly", so that all the interest payments received are exactly offset by the
swap. This can lead to swaps where principal is paid on one or more legs, rather than just interest (for
example to hedge a coupon strip), or where the balance of the swap is automatically adjusted to match
that of a prepaying bond (such as RMBS Residential mortgage-backed security)
[edit] Uses
Interest rate swaps were originally created to allow multi-national companies to evade exchange
controls. Today, interest rate swaps are used to hedge against or speculate on changes in interest rates.
[edit] Speculation
Interest rate swaps are also used speculatively by hedge funds or other investors who expect a change in
interest rates or the relationships between them. Traditionally, fixed income investors who expected
rates to fall would purchase cash bonds, whose value increased as rates fell. Today, investors with a
similar view could enter a floating-for-fixed interest rate swap; as rates fall, investors would pay a lower
floating rate in exchange for the same fixed rate.
Interest rate swaps are also very popular due to the arbitrage opportunities they provide. Due to varying
levels of creditworthiness in companies, there is often a positive quality spread differential which allows
both parties to benefit from an interest rate swap.
The interest rate swap market is closely linked to the Eurodollar futures market which trades at the
Chicago Mercantile Exchange.
[edit] LIBOR/Swap zero rate
Since LIBOR only has maturities out to 12 months, and since interest rate swaps often use LIBOR as the
reference rate, interest rate swaps can be used as a proxy to extend the LIBOR yield curve out past 12
months.
[edit] British local authorities
In June 1988 the Audit Commission was tipped off by someone working on the swaps desk of Goldman
Sachs that the London Borough of Hammersmith and Fulham had a massive exposure to interest rate
swaps. When the commission contacted the council, the chief executive told them not to worry as
"everybody knows that interest rates are going to fall"; the treasurer thought the interest rate swaps were
a 'nice little earner'. The controller of the commission, Howard Davies realised that the council had put
all of its positions on interest rates going down; he sent a team in to investigate.
By January 1989 the commission obtained legal opinions from two Queen's Counsel. Although they did
not agree, the commission preferred the opinion which made it ultra vires for councils to engage in
interest rate swaps. Moreover interest rates had gone up from 8% to 15%. The auditor and the
commission then went to court and had the contracts declared illegal (appeals all the way up to the
House of Lords failed); the five banks involved lost millions of pounds. Many other local authorities had
been engaging in interest rate swaps in the 1980s, although Hammersmith was unusual in betting all one
way.[2]
[edit] Valuation and pricing

Further information: Rational_pricing#Swaps
The present value of a plain vanilla (i.e. fixed rate for floating rate) swap can easily be computed using
standard methods of determining the present value (PV) of the fixed leg and the floating leg.
The value of the fixed leg is given by the present value of the fixed coupon payments known at the start
of the swap, i.e.
where C is the swap rate, M is the number of fixed payments, P is the notional amount, ti is the number
of days in period i, Ti is the basis according to the day count convention and dfi is the discount factor.
Similarly, the value of the floating leg is given by the present value of the floating coupon payments
determined at the agreed dates of each payment. However, at the start of the swap, only the actual
payment rates of the fixed leg are known in the future, whereas the forward rates (derived from the yield
curve) are used to approximate the floating rates. Each variable rate payment is calculated based on the
forward rate for each respective payment date. Using these interest rates leads to a series of cash flows.
Each cash flow is discounted by the zero-coupon rate for the date of the payment; this is also sourced
from the yield curve data available from the market. Zero-coupon rates are used because these rates are
for bonds which pay only one cash flow. The interest rate swap is therefore treated like a series of zero-
coupon bonds. Thus, the value of the floating leg is given by the following:
where N is the number of floating payments, fj is the forward rate, P is the notional amount, tj is the
number of days in period j, Tj is the basis according to the day count convention and dfj is the discount
factor. The discount factor always starts with 1. The discount factor is found as follows:
[Discount factor in the previous period]/[1 + (Forward rate of the floating underlying asset in the
previous period × Number of days in period/360)].
(Depending on the currency, the denominator is 365 instead of 360; e.g. for GBP.)
The fixed rate offered in the swap is the rate which values the fixed rates payments at the same PV as
the variable rate payments using today's forward rates, i.e.:
[3]
Therefore, at the time the contract is entered into, there is no advantage to either party, i.e.,
Thus, the swap requires no upfront payment from either party.
During the life of the swap, the same valuation technique is used, but since, over time, the forward rates
change, the PV of the variable-rate part of the swap will deviate from the unchangeable fixed-rate side
of the swap. Therefore, the swap will be an asset to one party and a liability to the other. The way these
changes in value are reported is the subject of IAS 39 for jurisdictions following IFRS, and FAS 133 for
U.S. GAAP. Swaps are marked to market by debt security traders to visualize their inventory at a certain
time.
[edit] Risks
Interest rate swaps expose users to interest rate risk and credit risk.
• Interest rate risk originates from changes in the floating rate. In a plain vanilla fixed-for-floating
swap, the party who pays the floating rate benefits when rates fall. (Note that the party that pays
floating has an interest rate exposure analogous to a long bond position.)
• Credit risk on the swap comes into play if the swap is in the money or not. If one of the parties is
in the money, then that party faces credit risk of possible default by another party.
[edit] Market size

The Bank for International Settlements reports that interest rate swaps are the second largest component
of the global OTC derivative market. The notional amount outstanding as of June 2009 in OTC interest
rate swaps was $342 trillion, up from $310 trillion in Dec 2007. The gross market value was $13.9
trillion in June 2009, up from $6.2 trillion in Dec 2007.
Interest rate swaps can now be traded as an Index through the FTSE MTIRS Index.
Intrinsic Value + Time Value = Option Price
Factors Influencing the Price of an Option
There are four major factors which determine the price of an option. They are:
The price of the underlying stock. The strike price of the option itself. The time remaining until the
option expires. The volatility of the underlying stock.
Two less important factors in determining the price of an option are: 1. The current risk free
interest rate. 2. The dividend rate of the underlying stock.
The primary influence on an options price is the price of the underlying security. On expiration day,
if I own one XYZ November 100 call, and XYZ is trading at 95, my call is worthless. On the other
hand, if I own one XYZ November 100 call, and the price of XYZ on expiration day is 102, my call is
worth at least 2 points.
Part 3
An options price decays each day it is in existence. Further, the closer the option gets to expiration,
the faster it decays. The rate of decay is related to the square root of the time remaining. An
option with two months remaining decays at twice the speed of a four month option etc.
Volatility
The volatility part of the pricing model is a measure of the range the underlying security is
expected to fluctuate over a given period of time. The measurement of volatility is the standard
deviation of the daily price changes in the security. The more volatile the underlying security, the
greater the price of the option.
There are two different kinds of volatility. There is historical volatility; and there is implied
volatility.
Historical volatility estimates volatility based on past prices.
Implied volatility starts with the option price as a given and works backward to ascertain the
theoretical value of volatility equal to the market price minus any intrinsic value.
Option Pricing Models
There are many different option pricing models in practice. However, the original breakthrough was
in the Black-Scholes model. It was a model for pricing options before options were widely traded.
The original Black Scholes model worked primarily for European style options. However, it has been
modified to work with American style expiration.
Since then, several variations have been developed.
The Cox Rubenstein model and Yates models are two widely used models for pricing American style
options. There are other binomial option pricing formulas. And some options are priced according
the cost of the hedge for the specialist/market maker.
Credit default swap

If the reference bond performs without default, the protection buyer pays quarterly payments to the
seller until maturity
If the reference bond defaults, the protection seller pays par value of the bond to the buyer, and the
buyer physically delivers the bond to the seller
This article may be too technical for most readers to understand. Please improve this article to
make it understandable to non-experts, without removing the technical details. (November 2010)
A credit default swap (CDS) is a swap contract and agreement in which the protection buyer of the
CDS makes a series of payments (often referred to as the CDS "fee" or "spread") to the protection seller
and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) experiences a credit
event. It is a form of reverse trading.
In its simplest form, a credit default swap is a bilateral contract between the buyer and seller of
protection. The CDS will refer to a "reference entity" or "reference obligor", usually a corporation or
government. The reference entity is not a party to the contract. The protection buyer makes quarterly
premium payments—the "spread"—to the protection seller. If the reference entity defaults, the
protection seller pays the buyer the par value of the bond in exchange for physical delivery of the bond,
although settlement may also be by cash or auction.[1][2] A default is referred to as a "credit event" and
include such events as failure to pay, restructuring and bankruptcy.[2] Most CDSs are in the $10–
$20 million range with maturities between one and 10 years.[3]
A holder of a bond may “buy protection” to hedge its risk of default. In this way, a CDS is similar to
credit insurance, although CDS are not similar to or subject to regulations governing casualty or life
insurance. Also, investors can buy and sell protection without owning any debt of the reference entity.
These “naked credit default swaps” allow traders to speculate on debt issues and the creditworthiness of
reference entities. Credit default swaps can be used to create synthetic long and short positions in the
reference entity.[4] Naked CDS constitute most of the market in CDS.[5][6] In addition, credit default
swaps can also be used in capital structure arbitrage.
Credit default swaps have existed since the early 1990s, but the market increased tremendously starting
in 2003. By the end of 2007, the outstanding amount was $62.2 trillion, falling to $38.6 trillion by the
end of 2008.[7]
Most CDSs are documented using standard forms promulgated by the International Swaps and
Derivatives Association (ISDA), although some are tailored to meet specific needs. Credit default swaps
have many variations.[2] In addition to the basic, single-name swaps, there are basket default swaps
(BDS), index CDS, funded CDS (also called a credit linked notes), as well as loan only credit default
swaps (LCDS). In addition to corporations or governments, the reference entity can include a special
purpose vehicle issuing asset backed securities.[8]
Credit default swaps are not traded on an exchange and there is no required reporting of transactions to a
government agency.[9] During the 2007-2010 financial crisis the lack of transparency became a concern
to regulators, as was the trillion dollar size of the market, which could pose a systemic risk to the
economy.[2][4][10] In March 2010, the DTCC Trade Information Warehouse (see Sources of Market Data)
announced it would voluntarily give regulators greater access to its credit default swaps database.[11]
Contents
[hide]
• 1 Description
o 1.1 Not insurance
o 1.2 Risk
o 1.3 Sources of market data
• 2 Uses
o 2.1 Speculation
o 2.2 Hedging
o 2.3 Arbitrage
• 3 History
o 3.1 Conception
o 3.2 Market growth
o 3.3 Market as of 2008
 3.3.1 Regulatory concerns over CDS
o 3.4 Market as of 2009
 3.4.1 Government approvals relating to Intercontinental and its competitor CME
 3.4.2 Clearing house member requirements
• 4 Terms of a typical CDS contract
• 5 Settlement
o 5.1 Physical or cash
o 5.2 Auctions
• 6 Pricing and valuation
o 6.1 Probability model
o 6.2 No-arbitrage model
• 7 Criticisms
o 7.1 Systemic risk
• 8 Tax and accounting issues
• 9 LCDS
• 10 See also
• 11 References
o 12.1 In the news
[edit] Description
Buyer purchased a CDS at time t0 and makes regular premium payments at times t1, t2, t3, and t4. If the
associated credit instrument suffers no credit event, then the buyer continues paying premiums at t5, t6
and so on until the end of the contract at time tn.
However, if the associated credit instrument suffered a credit event at t5, then the Protection seller pays
the buyer for the loss, and the buyer would cease paying premiums.
A "credit default swap" (CDS) is a credit derivative contract between two counterparties. The buyer
makes periodic payments to the seller, and in return receives a payoff if an underlying financial
instrument defaults or experiences a similar credit event.[1][2][12] The CDS may refer to a specified loan or
bond obligation of a “reference entity”, usually a corporation or government.[3]
As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is
Risky Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the
seller of protection. If Risky Corp defaults on its debt, the investor will receive a one-time payment from
AAA-Bank, and the CDS contract is terminated. A default is referred to as a "credit event" and include
such events as failure to pay, restructuring and bankruptcy.[2][9] CDS contracts on sovereign obligations
also usually include as credit events repudiation, moratorium and acceleration.[9]
If the investor actually owns Risky Corp debt, the CDS can be thought of as hedging. But investors can
also buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. This
may be done for speculative purposes, to bet against the solvency of Risky Corp in a gamble to make
money if it fails, or to hedge investments in other companies whose fortunes are expected to be similar
to those of Risky (see Uses).
If the reference entity (Risky Corp) defaults, one of two kinds of settlement can occur:
• the investor delivers a defaulted asset to AAA-Bank for payment of the par value, which is
known as physical settlement;
• AAA-Bank pays the investor the difference between the par value and the market price of a
specified debt obligation (even if Risky Corp defaults there is usually some recovery, i.e. not all
your money will be lost), which is known as cash settlement.
The "spread" of a CDS is the annual amount the protection buyer must pay the protection seller over the
length of the contract, expressed as a percentage of the notional amount. For example, if the CDS spread
of Risky Corp is 50 basis points, or 0.5% (1 basis point = 0.01%), then an investor buying $10 million
worth of protection from AAA-Bank must pay the bank $50,000 per year. These payments continue
until either the CDS contract expires or Risky Corp defaults. Payments are usually made on a quarterly
basis, in arrears.
Credit default swaps are not retail transactions. Most CDS’s are in the $10–20 million range with
maturities between one and 10 years.[3] Five years is the most typical maturity.[8]
All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the
CDS associated with a company with a higher CDS spread is considered more likely to default by the
market, since a higher fee is being charged to protect against this happening. However, factors such as
liquidity and estimated loss given default can affect the comparison. Credit spread rates and credit
ratings of the underlying or reference obligations are considered among money managers to be the best
indicators of the likelihood of sellers of CDSs having to perform under these contracts.[2]
[edit] Not insurance
CDS contracts have been compared with insurance, because the buyer pays a premium and, in return,
receives a sum of money if one of the events specified in the contract occurs. However, there are a
number of differences between CDS and insurance, for example:
• The buyer of a CDS does not need to own the underlying security or other form of credit
exposure; in fact the buyer does not even have to suffer a loss from the default event.[13][14][15][16] In
contrast, to purchase insurance, the insured is generally expected to have an insurable interest
such as owning a debt obligation;
• the seller doesn't have to be a regulated entity;
• the seller is not required to maintain any reserves to pay off buyers, although major CDS dealers
are subject to bank capital requirements;
• insurers manage risk primarily by setting loss reserves based on the Law of large numbers, while
dealers in CDS manage risk primarily by means of offsetting CDS (hedging) with other dealers
and transactions in underlying bond markets;
• in the United States CDS contracts are generally subject to mark-to-market accounting,
introducing income statement and balance sheet volatility that would not be present in an
insurance contract;
• Hedge accounting may not be available under US Generally Accepted Accounting Principles
(GAAP) unless the requirements of FAS 133 are met. In practice this rarely happens.
However the most important difference between CDS and insurance is simply that an insurance contract
provides an indemnity against the losses actually suffered by the policy holder, whereas the CDS
provides an equal payout to all holders, calculated using an agreed, market-wide method.
There are also important differences in the approaches used to pricing. The cost of insurance is based on
actuarial analysis. CDSs are derivatives whose cost is determined using financial models and by
arbitrage relationships with other credit market instruments such as loans and bonds from the same
'Reference Entity' to which the CDS contract refers.
Further, to cancel the insurance contract the buyer can simply stop paying premium whereas in case of
CDS the protection buyer may need to unwind the contract which might result in a profit or loss
situation
Insurance contracts require the disclosure of all known risks involved. CDSs have no such requirement.
Most significantly, unlike insurance companies, sellers of CDSs are not required to maintain any capital
reserves to guarantee payment of claims.
[edit] Risk
When entering into a CDS, both the buyer and seller of credit protection take on counterparty risk:[2][8]
• The buyer takes the risk that the seller will default. If AAA-Bank and Risky Corp. default
simultaneously ("double default"), the buyer loses its protection against default by the reference
entity. If AAA-Bank defaults but Risky Corp. does not, the buyer might need to replace the
defaulted CDS at a higher cost.
• The seller takes the risk that the buyer will default on the contract, depriving the seller of the
expected revenue stream. More important, a seller normally limits its risk by buying offsetting
protection from another party — that is, it hedges its exposure. If the original buyer drops out,
the seller squares its position by either unwinding the hedge transaction or by selling a new CDS
to a third party. Depending on market conditions, that may be at a lower price than the original
CDS and may therefore involve a loss to the seller.
In the future, in the event that regulatory reforms require that CDS be traded and settled via a central
exchange/clearing house, such as ICE TCC, there will no longer be 'counterparty risk', as the risk of the
counterparty will be held with the central exchange/clearing house.
As is true with other forms of over-the-counter derivative, CDS might involve liquidity risk. If one or
both parties to a CDS contract must post collateral (which is common), there can be margin calls
requiring the posting of additional collateral. The required collateral is agreed on by the parties when the
CDS is first issued. This margin amount may vary over the life of the CDS contract, if the market price
of the CDS contract changes, or the credit rating of one of the parties changes.
Another kind of risk for the seller of credit default swaps is jump risk or jump-to-default risk.[2] A seller
of a CDS could be collecting monthly premiums with little expectation that the reference entity may
default. A default creates a sudden obligation on the protection sellers to pay millions, if not billions, of
dollars to protection buyers.[17] This risk is not present in other over-the-counter derivatives.[2][17]
[edit] Sources of market data
Data about the credit default swaps market is available from three main sources. Data on an annual and
semiannual basis is available from the International Swaps and Derivatives Association (ISDA) since
2001[18] and from the Bank for International Settlements (BIS) since 2004.[19] The Depository Trust &
Clearing Corporation (DTCC), through its global repository Trade Information Warehouse (TIW),
provides weekly data but publicly available information goes back only one year.[20] The numbers
provided by each source do not always match because each provider uses different sampling methods.[2]
According to DTCC, the Trade Information Warehouse maintains the only "global electronic database
for virtually all CDS contracts outstanding in the marketplace."[21]
The Office of the Comptroller of the Currency publishes quarterly credit derivative data about insured
U.S commercial banks and trust companies.[22]
[edit] Uses
Credit default swaps can be used by investors for speculation, hedging and arbitrage.
[edit] Speculation
Credit default swaps allow investors to speculate on changes in CDS spreads of single names or of
market indices such as the North American CDX index or the European iTraxx index. An investor might
believe that an entity's CDS spreads are too high or too low, relative to the entity's bond yields, and
attempt to profit from that view by entering into a trade, known as a basis trade, that combines a CDS
with a cash bond and an interest-rate swap.
Finally, an investor might speculate on an entity's credit quality, since generally CDS spreads will
increase as credit-worthiness declines, and decline as credit-worthiness increases. The investor might
therefore buy CDS protection on a company to speculate that it is about to default. Alternatively, the
investor might sell protection if it thinks that the company's creditworthiness might improve. The
investor selling the CDS is viewed as being “long” on the CDS and the credit, as if the investor owned
the bond.[4][8] In contrast, the investor who bought protection is “short” on the CDS and the underlying
credit.[4][8] Credit default swaps opened up important new avenues to speculators. Investors could go long
on a bond without any upfront cost of buying a bond; all the investor need do was promise to pay in the
event of default.[23] Shorting a bond faced difficult practical problems, such that shorting was often not
feasible; CDS made shorting credit possible and popular.[8][23] Because the speculator in either case does
not own the bond, its position is said to be a synthetic long or short position.[4]
For example, a hedge fund believes that Risky Corp will soon default on its debt. Therefore, it buys
$10 million worth of CDS protection for two years from AAA-Bank, with Risky Corp as the reference
entity, at a spread of 500 basis points (=5%) per annum.
• If Risky Corp does indeed default after, say, one year, then the hedge fund will have paid
$500,000 to AAA-Bank, but will then receive $10 million (assuming zero recovery rate, and that
AAA-Bank has the liquidity to cover the loss), thereby making a profit. AAA-Bank, and its
investors, will incur a $9.5 million loss minus recovery unless the bank has somehow offset the
position before the default.
• However, if Risky Corp does not default, then the CDS contract will run for two years, and the
hedge fund will have ended up paying $1 million, without any return, thereby making a loss.
AAA-Bank, by selling protection, has made $1 million without any upfront investment.
Note that there is a third possibility in the above scenario; the hedge fund could decide to liquidate its
position after a certain period of time in an attempt to realise its gains or losses. For example:
• After 1 year, the market now considers Risky Corp more likely to default, so its CDS spread has
widened from 500 to 1500 basis points. The hedge fund may choose to sell $10 million worth of
protection for 1 year to AAA-Bank at this higher rate. Therefore over the two years the hedge
fund will pay the bank 2 * 5% * $10 million = $1 million, but will receive 1 * 15% * $10 million
= $1.5 million, giving a total profit of $500,000.
• In another scenario, after one year the market now considers Risky much less likely to default, so
its CDS spread has tightened from 500 to 250 basis points. Again, the hedge fund may choose to
sell $10 million worth of protection for 1 year to AAA-Bank at this lower spread. Therefore over
the two years the hedge fund will pay the bank 2 * 5% * $10 million = $1 million, but will
receive 1 * 2.5% * $10 million = $250,000, giving a total loss of $750,000. This loss is smaller
than the $1 million loss that would have occurred if the second transaction had not been entered
into.
Transactions such as these do not even have to be entered into over the long-term. If Risky Corp's CDS
spread had widened by just a couple of basis points over the course of one day, the hedge fund could
have entered into an offsetting contract immediately and made a small profit over the life of the two
CDS contracts.
Credit default swaps are also used to structure synthetic collateralized debt obligations (CDOs). Instead
of owning bonds or loans, a synthetic CDO gets credit exposure to a portfolio of fixed income assets
without owning those assets through the use of CDS.[24] CDOs are viewed as complex and opaque
financial instruments. An example of a synthetic CDO is Abacus 2007-AC1 which is the subject of the
civil suit for fraud brought by the SEC against Goldman Sachs in April 2010.[25] Abacus is a synthetic
CDO consisting of credit default swaps referencing a variety of mortgage backed securities.
Naked credit default swaps. In the examples above, the hedge fund did not own debt of Risky Corp. A
CDS in which the buyer does not own the underlying debt is referred to as a naked credit default swap,
estimated to be up to 80% of the credit default swap market.[5][6] There is currently a debate in the United
States and Europe about whether speculative uses of credit default swaps should be banned. Legislation
is under consideration by Congress as part of financial reform.[6]
Critics assert that naked CDS should be banned, comparing them to buying fire insurance on your
neighbor’s house, which creates a huge incentive for arson. Analogizing to the concept of insurable
interest, critics say you should not be able to buy a CDS—insurance against default—when you do not
own the bond.[26][27][28] Short selling is also viewed as gambling and the CDS market as a casino.[6][29]
Another concern is the size of CDS market. Because naked credit default swaps are synthetic, there is no
limit to how many can be sold. The gross amount of CDS far exceeds all “real” corporate bonds and
loans outstanding.[9][27] As a result, the risk of default is magnified leading to concerns about systemic
risk.[27]
Financier George Soros called for an outright ban on naked credit default swaps, viewing them as
“toxic” and allowing speculators to bet against and “bear raid” companies or countries.[30] His concerns
were echoed by several European politicians who, during the Greek Financial Crisis, accused naked
CDS buyers as making the crisis worse.[31][32]
Despite these concerns, Secretary of Treasury Geithner[6][31] and Commodity Futures Trading
Commission Chairman Gensler[33] are not in favor of an outright ban of naked credit default swaps. They
prefer greater transparency and better capitalization requirements.[6][17] These officials think that naked
CDS have a place in the market.
Proponents of naked credit default swaps say that short selling in various forms, whether credit default
swaps, options or futures, has the beneficial effect of increasing liquidity in the marketplace.[26] That
benefits hedging activities. Without speculators buying and selling naked CDS, banks wanting to hedge
might not find a ready seller of protection.[6][26] Speculators also create a more competitive marketplace,
keeping prices down for hedgers. A robust market in credit default swaps can also serve as a barometer
to regulators and investors about the credit health of a company or country.[26][34]
Despite politicians' assertions that speculators are making the Greek crisis worse, Germany's market
regulator BaFin found no proof supporting the claim.[32] Some suggest that without credit default swaps,
Greece’s borrowing costs would be higher.[32]
[edit] Hedging
Credit default swaps are often used to manage the risk of default which arises from holding debt. A
bank, for example, may hedge its risk that a borrower may default on a loan by entering into a CDS
contract as the buyer of protection. If the loan goes into default, the proceeds from the CDS contract will
cancel out the losses on the underlying debt.[3]
There are other ways to eliminate or reduce the risk of default. The bank could sell (that is, assign) the
loan outright or bring in other banks as participants. However, these options may not meet the bank’s
needs. Consent of the corporate borrower is often required. The bank may not want to incur the time and
cost to find loan participants. If both the borrower and lender are well-known and the market (or even
worse, the news media) learns that the bank is selling the loan, then the sale may be viewed as signaling
a lack of trust in the borrower, which could severely damage the banker-client relationship. In addition,
the bank simply may not want to sell or share the potential profits from the loan. By buying a credit
default swap, the bank can lay off default risk while still keeping the loan in its portfolio.[24] The
downside to this hedge is that without default risk, a bank may have no motivation to actively monitor
the loan and the counterparty has no relationship to the borrower.[24]
Another kind of hedge is against concentration risk. A bank’s risk management team may advise that the
bank is overly concentrated with a particular borrower or industry. The bank can lay off some of this
risk by buying a CDS. Because the borrower—the reference entity—is not a party to a credit default
swap, entering into a CDS allows the bank to achieve its diversity objectives without impacting its loan
portfolio or customer relations.[2] Similarly, a bank selling a CDS can diversify its portfolio by gaining
exposure to an industry in which the selling bank has no customer base.[3][8][35]
A bank buying protection can also use a CDS to free regulatory capital. By offloading a particular credit
risk, a bank is not required to hold as much capital in reserve against the risk of default (traditionally 8%
of the total loan under Basel I). This frees resources which the bank can use to make other loans to the
same key customer or to other borrowers.[2][36]
Hedging risk is not limited to banks as lenders. Holders of corporate bonds, such as banks, pension
funds or insurance companies, may buy a CDS as a hedge for similar reasons. Pension fund example: A
pension fund owns five-year bonds issued by Risky Corp with par value of $10 million. In order to
manage the risk of losing money if Risky Corp defaults on its debt, the pension fund buys a CDS from
Derivative Bank in a notional amount of $10 million. The CDS trades at 200 basis points (200 basis
points = 2.00 percent). In return for this credit protection, the pension fund pays 2% of $10 million
($200,000) per annum in quarterly installments of $50,000 to Derivative Bank.
• If Risky Corporation does not default on its bond payments, the pension fund makes quarterly
payments to Derivative Bank for 5 years and receives its $10 million back after five years from
Risky Corp. Though the protection payments totaling $1 million reduce investment returns for
the pension fund, its risk of loss due to Risky Corp defaulting on the bond is eliminated.
• If Risky Corporation defaults on its debt three years into the CDS contract, the pension fund
would stop paying the quarterly premium, and Derivative Bank would ensure that the pension
fund is refunded for its loss of $10 million minus recovery (either by physical or cash
settlement — see Settlement below). The pension fund still loses the $600,000 it has paid over
three years, but without the CDS contract it would have lost the entire $10 million minus
recovery.
In addition to financial institutions, large suppliers can use a credit default swap on a public bond issue
or a basket of similar risks as a proxy for its own credit risk exposure on receivables.[6][26][36][37]
Although credit default swaps have been highly criticized for their role in the recent financial crisis,
most observers conclude that using credit default swaps as a hedging device has a useful purpose.[26]
[edit] Arbitrage
Capital Structure Arbitrage is an example of an arbitrage strategy that utilizes CDS transactions.[38] This
technique relies on the fact that a company's stock price and its CDS spread should exhibit negative
correlation; i.e. if the outlook for a company improves then its share price should go up and its CDS
spread should tighten, since it is less likely to default on its debt. However if its outlook worsens then its
CDS spread should widen and its stock price should fall. Techniques reliant on this are known as capital
structure arbitrage because they exploit market inefficiencies between different parts of the same
company's capital structure; i.e. mis-pricings between a company's debt and equity. An arbitrageur will
attempt to exploit the spread between a company's CDS and its equity in certain situations. For example,
if a company has announced some bad news and its share price has dropped by 25%, but its CDS spread
has remained unchanged, then an investor might expect the CDS spread to increase relative to the share
price. Therefore a basic strategy would be to go long on the CDS spread (by buying CDS protection)
while simultaneously hedging oneself by buying the underlying stock. This technique would benefit in
the event of the CDS spread widening relative to the equity price, but would lose money if the
company's CDS spread tightened relative to its equity.
An interesting situation in which the inverse correlation between a company's stock price and CDS
spread breaks down is during a Leveraged buyout (LBO). Frequently this will lead to the company's
CDS spread widening due to the extra debt that will soon be put on the company's books, but also an
increase in its share price, since buyers of a company usually end up paying a premium.
Another common arbitrage strategy aims to exploit the fact that the swap-adjusted spread of a CDS
should trade closely with that of the underlying cash bond issued by the reference entity. Misalignments
in spreads may occur due to technical reasons such as:
• Specific settlement differences

• Shortages in a particular underlying instrument
• Existence of buyers constrained from buying exotic derivatives.
The difference between CDS spreads and asset swap spreads is called the basis and should theoretically
be close to zero. Basis trades can aim to exploit any differences to make risk-free profit.
[edit] History
[edit] Conception
Forms of credit default swaps had been in existence from at least the early 1990s, [39] with early trades
carried out by Bankers Trust in 1991. [40] J.P. Morgan & Co. is widely credited with creating the modern
credit default swap in 1994.[41][42][43] In that instance, J.P. Morgan had extended a $4.8 billion credit line
to Exxon, which faced the threat of $5 billion in punitive damages for the Exxon Valdez oil spill. A
team of J.P. Morgan bankers led by Blythe Masters then sold the credit risk from the credit line to the
European Bank of Reconstruction and Development in order to cut the reserves which J.P. Morgan was
required to hold against Exxon's default, thus improving its own balance sheet.[44] In 1997, JPMorgan
developed a proprietary product called BISTRO (Broad Index Securitized Trust Offering) that used CDS
to clean up a bank’s balance sheet.[41][43] The advantage of BISTRO was that it used securitization to split
up the credit risk into little pieces which smaller investors found more digestible, since most investors
lacked EBRD's capability to accept $4.8 billion in credit risk all at once. BISTRO was the first example
of what later became known as synthetic collateralized debt obligations (CDOs).
Mindful of the concentration of default risk as one of the causes of the S&L crisis , regulators initially
found CDS's ability to disperse default risk attractive. [40] In 2000, credit default swaps became largely
exempt from regulation by both the U.S. Securities and Exchange Commission (SEC) and the
Commodity Futures Trading Commission (CTFC). The Commodity Futures Modernization Act of 2000,
which was also responsible for the Enron loophole , [9] specifically stated that CDSs are neither futures
nor securities and so are outside the remit of the SEC and CTFC. [40]
[edit] Market growth
At first, banks were the dominant players in the market, as CDS were primarily used to hedge risk in
connection with its lending activities. Banks also saw an opportunity to free up regulatory capital. By
march 1998, the global market for CDS was estimated atabout $300 billion, with JP Morgan alone
accounting for about $50billion of this. [40] The high market share enjoyed by the banks was soon eroded
as more and more asset managers and hedge funds saw trading opportunities in credit default swaps. By
2002, investors as speculators, rather than banks as hedgers, dominated the market.[2][8][36][39] National
banks in the USA used credit default swaps as early as 1996.[35] In that year, the Office of the
Comptroller of the Currency measured the size of the market as tens of billions of dollars.[45] Six years
later, by year-end 2002, the outstanding amount was over $2 trillion.[7] Although speculators fueled the
exponential growth, other factors also played a part. An extended market could not emerge until 1999,
when ISDA standardized the documentation for credit default swaps.[46][47][48] Also, the 1997 Asian
Financial Crisis spurred a market for CDS in emerging market sovereign debt.[48] In addition, in 2004,
index trading began on a large scale and grew rapidly.[8]
The market size for Credit Default Swaps more than doubled in size each year from $3.7 trillion in 2003.
[7]
By the end of 2007, the CDS market had a notional value of $62.2 trillion.[7] But notional amount fell
during 2008 as a result of dealer "portfolio compression" efforts (replacing offsetting redundant
contracts), and by the end of 2008 notional amount outstanding had fallen 38 percent to $38.6 trillion.[49]
Explosive growth was not without operational headaches. On September 15, 2005, the New York Fed
summoned 14 banks to it offices. Billions of dollars of CDS were traded daily but the record keeping
was more than two weeks behind.[50] This created severe risk management issues, as counterparties were
in legal and financial limbo.[8][51] U.K. authorities expressed the same concerns.[52]
[edit] Market as of 2008
Composition of the United States 15.5 trillion US dollar CDS market at the end of 2008 Q2. Green tints
show Prime asset CDSs, reddish tints show sub-prime asset CDSs. Numbers followed by "Y" indicate
years until maturity.
Proportion of CDSs nominals (lower left) held by United States banks compared to all derivatives, in
2008Q2. The black disc represents the 2008 public debt.
Since default is a relatively rare occurrence (historically around 0.2% of investment grade companies
will default in any one year),[53] in most CDS contracts the only payments are the premium payments
from buyer to seller. Thus, although the above figures for outstanding notionals are very large, in the
absence of default the net cashflows will only be a small fraction of this total: for a 100 bp = 1% spread,
the annual cash flows are only 1% of the notional amount.
[edit] Regulatory concerns over CDS
The market for Credit Default Swaps attracted considerable concern from regulators after a number of
large scale incidents in 2008, starting with the collapse of Bear Stearns.[54]
In the days and weeks leading up to Bear's collapse, the bank's CDS spread widened dramatically,
indicating a surge of buyers taking out protection on the bank. It has been suggested that this widening
was responsible for the perception that Bear Stearns was vulnerable, and therefore restricted its access to
wholesale capital which eventually led to its forced sale to JP Morgan in March. An alternative,
unsupported view is that this surge in CDS protection buyers was a symptom rather than a cause of
Bear's collapse; i.e., investors saw that Bear was in trouble, and sought to hedge any naked exposure to
the bank, or speculate on its collapse.
In September, the bankruptcy of Lehman Brothers caused a total close to $400 billion to become
payable to the buyers of CDS protection referenced against the insolvent bank. However the net amount
that changed hands was around $7.2 billion[55] This difference is due to the process of 'netting'. Market
participants co-operated so that CDS sellers were allowed to deduct from their payouts the inbound
funds due to them from their hedging positions. Dealers generally attempt to remain risk-neutral so their
losses and gains after big events will on the whole offset each other.
Also in September American International Group (AIG) required a federal bailout because it had been
excessively selling CDS protection without hedging against the possibility that the reference entities
might decline in value, which exposed the insurance giant to potential losses over $100 billion. The CDS
on Lehman were settled smoothly, as was largely the case for the other 11 credit events occurring in
2008 which triggered payouts.[54] And while it is arguable that other incidents would have been as bad or
worse if less efficient instruments than CDS had been used for speculation and insurance purposes, the
closing months of 2008 saw regulators working hard to reduce the risk involved in CDS transactions.
In 2008 there was no centralized exchange or clearing house for CDS transactions; they were all done
over the counter (OTC). This led to recent calls for the market to open up in terms of transparency and
regulation.[56] In November, DTCC, which runs a warehouse for CDS trade confirmations accounting for
around 90% of the total market,[57] announced that it will release market data on the outstanding notional
of CDS trades on a weekly basis.[58] The data can be accessed on the DTCC's website here:[59] The U.S.
Securities and Exchange Commission granted an exemption for IntercontinentalExchange to begin
guaranteeing credit-default swaps.
The SEC exemption represented the last regulatory approval needed by Atlanta-based Intercontinental.
Its larger competitor, CME Group Inc., hasn’t received an SEC exemption, and agency spokesman John
Nester said he didn’t know when a decision would be made.
[edit] Market as of 2009
The early months of 2009 saw several fundamental changes to the way CDSs operate, resulting from
concerns over the instruments' safety after the events of the previous year. According to Deutsche Bank
managing director Athanassios Diplas "the industry pushed through 10 years worth of changes in just a
few months" By late 2008 processes had been introduced allowing CDSs which offset each other to be
cancelled. Along with termination of contracts that have recently paid out such as those based on
Lehmans, this had by March reduced the face value of the market down to an estimated $30 trillion.[60]
The Bank for International Settlements estimates that outstanding derivatives total $592 trillion.[61] U.S.
and European regulators are developing separate plans to stabilize the derivatives market. Additionally
there are some globally agreed standards falling into place in March 2009, administered by International
Swaps and Derivatives Association (ISDA). Two of the key changes are:
1. The introduction of central clearing houses, one for the US and one for Europe. A clearing house acts
as the central counterparty to both sides of a CDS transaction, thereby reducing the counterparty risk
that both buyer and seller face.
2. The international standardization of CDS contracts, to prevent legal disputes in ambiguous cases
where what the payout should be is unclear.
Speaking before the changes went live , Sivan Mahadevan, a derivatives strategist at Morgan Stanley in
New York, stated
A clearinghouse, and changes to the contracts to standardize them, will probably boost
“ activity. ... Trading will be much easier.... We'll see new players come to the market
because they’ll like the idea of this being a better and more traded product. We also feel
”
like over time we'll see the creation of different types of products.
In the U.S., central clearing operations began in March 2009 , operated by InterContinental Exchange
(ICE). A key competitor also interested in entering the CDS clearing sector is CME Group.
In Europe, CDS Index clearing was launched by ICE's European subsidiary ICE Clear Europe on July
31. It launched Single Name clearing in Dec 2009. By the end of 2009, it had cleared CDS contracts
worth EUR 885 billion reducing the open interest down to EUR 75 billion [62]
By the end of 2009, banks had reclaimned much of their market share; hedge funds had largely retreated
from the market after the crises. According to an estimate by the Banque de France, by late 2009 the
bank JP Morgan alone now had about 30% of the global CDS market. [40]
[edit] Government approvals relating to Intercontinental and its competitor CME
The SEC's approval for ICE's request to be exempted from rules that would prevent it clearing CDSs
was the third government action granted to Intercontinental in one week. On March 3, its proposed
acquisition of Clearing Corp., a Chicago clearinghouse owned by eight of the largest dealers in the
credit-default swap market, was approved by the Federal Trade Commission and the Justice Department.
On March 5, the Federal Reserve Board, which oversees the clearinghouse, granted a request for ICE to
begin clearing.
Clearing Corp. shareholders including JPMorgan Chase & Co., Goldman Sachs Group Inc. and UBS
AG, received $39 million in cash from Intercontinental in the acquisition, as well as the Clearing Corp.’s
cash on hand and a 50-50 profit-sharing agreement with Intercontinental on the revenue generated from
processing the swaps.
SEC spokesperson John Nestor stated

For several months the SEC and our fellow regulators have worked closely with all of
“ the firms wishing to establish central counterparties.... We believe that CME should be in
a position soon to provide us with the information necessary to allow the commission to
”
take action on its exemptive requests.
Other proposals to clear credit-default swaps have been made by NYSE Euronext, Eurex AG and
LCH.Clearnet Ltd. Only the NYSE effort is available now for clearing after starting on Dec. 22. As of
Jan. 30, no swaps had been cleared by the NYSE’s London- based derivatives exchange, according to
NYSE Chief Executive Officer Duncan Niederauer.[63]
[edit] Clearing house member requirements
Members of the Intercontinental clearinghouse will have to have a net worth of at least $5 billion and a
credit rating of A or better to clear their credit-default swap trades. Intercontinental said in the statement
today that all market participants such as hedge funds, banks or other institutions are open to become
members of the clearinghouse as long as they meet these requirements.
A clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the risk of a
counterparty defaulting on a transaction. In the over-the-counter market, where credit- default swaps are
currently traded, participants are exposed to each other in case of a default. A clearinghouse also
provides one location for regulators to view traders’ positions and prices.
[edit] Terms of a typical CDS contract

A CDS contract is typically documented under a confirmation referencing the credit derivatives
definitions as published by the International Swaps and Derivatives Association.[64] The confirmation
typically specifies a reference entity, a corporation or sovereign that generally, although not always, has
debt outstanding, and a reference obligation, usually an unsubordinated corporate bond or government
bond. The period over which default protection extends is defined by the contract effective date and
scheduled termination date.
The confirmation also specifies a calculation agent who is responsible for making determinations as to
successors and substitute reference obligations (for example necessary if the original reference
obligation was a loan that is repaid before the expiry of the contract), and for performing various
calculation and administrative functions in connection with the transaction. By market convention, in
contracts between CDS dealers and end-users, the dealer is generally the calculation agent, and in
contracts between CDS dealers, the protection seller is generally the calculation agent. It is not the
responsibility of the calculation agent to determine whether or not a credit event has occurred but rather
a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly available
information delivered along with a credit event notice. Typical CDS contracts do not provide an internal
mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the
matter to the courts if necessary, though actual instances of specific events being disputed are relatively
rare.
CDS confirmations also specify the credit events that will give rise to payment obligations by the
protection seller and delivery obligations by the protection buyer. Typical credit events include
bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed
bond or loan debt. CDS written on North American investment grade corporate reference entities,
European corporate reference entities and sovereigns generally also include restructuring as a credit
event, whereas trades referencing North American high yield corporate reference entities typically do
not. The definition of restructuring is quite technical but is essentially intended to respond to
circumstances where a reference entity, as a result of the deterioration of its credit, negotiates changes in
the terms in its debt with its creditors as an alternative to formal insolvency proceedings (i.e., the debt is
restructured). This practice is far more typical in jurisdictions that do not provide protective status to
insolvent debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code. In
particular, concerns arising out of Conseco's restructuring in 2000 led to the credit event's removal from
North American high yield trades.[65]
Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of
obligations that a protection buyer may deliver upon a credit event. Trading conventions for deliverable
obligation characteristics vary for different markets and CDS contract types. Typical limitations include
that deliverable debt be a bond or loan, that it have a maximum maturity of 30 years, that it not be
subordinated, that it not be subject to transfer restrictions (other than Rule 144A), that it be of a standard
currency and that it not be subject to some contingency before becoming due.
The premium payments are generally quarterly, with maturity dates (and likewise premium payment
dates) falling on March 20, June 20, September 20, and December 20. Due to the proximity to the IMM
dates, which fall on the third Wednesday of these months, these CDS maturity dates are also referred to
as "IMM dates".
[edit] Settlement
[edit] Physical or cash
As described in an earlier section, if a credit event occurs then CDS contracts can either be physically
settled or cash settled.[2]
• Physical settlement: The protection seller pays the buyer par value, and in return takes delivery
of a debt obligation of the reference entity. For example, a hedge fund has bought $5 million
worth of protection from a bank on the senior debt of a company. In the event of a default, the
bank will pay the hedge fund $5 million cash, and the hedge fund must deliver $5 million face
value of senior debt of the company (typically bonds or loans, which will typically be worth very
little given that the company is in default).
• Cash settlement: The protection seller pays the buyer the difference between par value and the
market price of a debt obligation of the reference entity. For example, a hedge fund has bought
$5 million worth of protection from a bank on the senior debt of a company. This company has
now defaulted, and its senior bonds are now trading at 25 (i.e. 25 cents on the dollar) since the
market believes that senior bondholders will receive 25% of the money they are owed once the
company is wound up. Therefore, the bank must pay the hedge fund $5 million * (100%-25%) =
$3.75 million.
The development and growth of the CDS market has meant that on many companies there is now a
much larger outstanding notional of CDS contracts than the outstanding notional value of its debt
obligations. (This is because many parties made CDS contracts for speculative purposes, without
actually owning any debt for which they wanted to insure against default.) For example, at the time it
filed for bankruptcy on September 14, 2008, Lehman Brothers had approximately $155 billion of
outstanding debt[66] but around $400 billion notional value of CDS contracts had been written which
referenced this debt.[67] Clearly not all of these contracts could be physically settled, since there was not
enough outstanding Lehman Brothers debt to fulfill all of the contracts, demonstrating the necessity for
cash settled CDS trades. The trade confirmation produced when a CDS is traded will state whether the
contract is to be physically or cash settled.
[edit] Auctions
When a credit event occurs on a major company on which a lot of CDS contracts are written, an auction
(also known as a credit-fixing event) may be held to facilitate settlement of a large number of contracts
at once, at a fixed cash settlement price. During the auction process participating dealers (e.g., the big
investment banks) submit prices at which they would buy and sell the reference entity's debt obligations,
as well as net requests for physical settlement against par. A second stage Dutch auction is held
following the publication of the initial mid-point of the dealer markets and what is the net open interest
to deliver or be delivered actual bonds or loans. The final clearing point of this auction sets the final
price for cash settlement of all CDS contracts and all physical settlement requests as well as matched
limit offers resulting from the auction are actually settled. According to the International Swaps and
Derivatives Association (ISDA), who organised them, auctions have recently proved an effective way of
settling the very large volume of outstanding CDS contracts written on companies such as Lehman
Brothers and Washington Mutual.[68]
Below is a list of the auctions that have been held since 2005.[69]
Date Name Final price as a percentage of par

2005-06-14 Collins & Aikman - Senior 43.625
2005-06-23 Collins & Aikman - Subordinated 6.375
2005-10-11 Northwest Airlines 28
2005-10-11 Delta Airlines 18
2005-11-04 Delphi Corporation 63.375
2006-01-17 Calpine Corporation 19.125
2006-03-31 Dana Corporation 75
2006-11-28 Dura - Senior 24.125
2006-11-28 Dura - Subordinated 3.5
2007-10-23 Movie Gallery 91.5
2008-02-19 Quebecor World 41.25
2008-10-02 Tembec Inc 83
2008-10-06 Fannie Mae - Senior 91.51
2008-10-06 Fannie Mae - Subordinated 99.9
2008-10-06 Freddie Mac - Senior 94
2008-10-06 Freddie Mac - Subordinated 98
2008-10-10 Lehman Brothers 8.625
2008-10-23 Washington Mutual 57
2008-11-04 Landsbanki - Senior 1.25
2008-11-04 Landsbanki - Subordinated 0.125
2008-11-05 Glitnir - Senior 3
2008-11-05 Glitnir - Subordinated 0.125
2008-11-06 Kaupthing - Senior 6.625
2008-11-06 Kaupthing - Subordinated 2.375
2008-12-09 Masonite [7] - LCDS 52.5
2008-12-17 Hawaiian Telcom - LCDS 40.125
2009-01-06 Tribune - CDS 1.5
2009-01-06 Tribune - LCDS 23.75
2009-01-14 Republic of Ecuador 31.375
2009-02-03 Millennium America Inc 7.125
2009-02-03 Lyondell - CDS 15.5
2009-02-03 Lyondell - LCDS 20.75
2009-02-03 EquiStar 27.5
2009-02-05 Sanitec [8] - 1st Lien 33.5
2009-02-05 Sanitec [9] - 2nd Lien 4.0
2009-02-09 British Vita [10] - 1st Lien 15.5
2009-02-09 British Vita [11] - 2nd Lien 2.875
2009-02-10 Nortel Ltd. 6.5
2009-02-10 Nortel Corporation 12
2009-02-19 Smurfit-Stone CDS 8.875
2009-02-19 Smurfit-Stone LCDS 65.375
2009-02-26 Ferretti 10.875
2009-03-09 Aleris 8
2009-03-31 Station Casinos 32
2009-04-14 Chemtura 15
2009-04-14 Great Lakes 18.25
2009-04-15 Rouse 29.25
2009-04-16 LyondellBasell 2
2009-04-17 Abitibi 3.25
2009-04-21 Charter Communications CDS 2.375
2009-04-21 Charter Communications LCDS 78
2009-04-22 Capmark 23.375
2009-04-23 Idearc CDS 1.75
2009-04-23 Idearc LCDS 38.5
2009-05-12 Bowater 15
2009-05-13 General Growth Properties 44.25
2009-05-27 Syncora 15
2009-05-28 Edshcha 3.75
2009-06-09 HLI Operating Corp LCDS 9.5
2009-06-10 Georgia Gulf LCDS 83
2009-06-11 R.H. Donnelley Corp. CDS 4.875
2009-06-12 General Motors CDS 12.5
2009-06-12 General Motors LCDS 97.5
2009-06-18 JSC Alliance Bank CDS 16.75
2009-06-23 Visteon CDS 3
2009-06-23 Visteon LCDS 39
2009-06-24 RH Donnelley Inc LCDS 78.125
2009-07-09 Six Flags CDS 14
2009-07-09 Six Flags LCDS 96.125
2009-07-21 Lear CDS 38.5
2009-07-21 Lear LCDS 66
2009-11-10 METRO-GOLDWYN-MAYER INC. LCDS 58.5
2009-11-20 CIT Group Inc. 68.125
[edit] Pricing and valuation

There are two competing theories usually advanced for the pricing of credit default swaps. The first,
referred to herein as the 'probability model', takes the present value of a series of cashflows weighted by
their probability of non-default. This method suggests that credit default swaps should trade at a
considerably lower spread than corporate bonds.
The second model, proposed by Darrell Duffie, but also by John Hull and White, uses a no-arbitrage
approach.
[edit] Probability model
Under the probability model, a credit default swap is priced using a model that takes four inputs; this is
similar to the rNPV (risk-adjusted NPV) model used in drug development:
• the "issue premium",

• the recovery rate (percentage of notional repaid in event of default),
• the "credit curve" for the reference entity and
• the "LIBOR curve".
If default events never occurred the price of a CDS would simply be the sum of the discounted premium
payments. So CDS pricing models have to take into account the possibility of a default occurring some
time between the effective date and maturity date of the CDS contract. For the purpose of explanation
we can imagine the case of a one year CDS with effective date t0 with four quarterly premium payments
occurring at times t1, t2, t3, and t4. If the nominal for the CDS is N and the issue premium is c then the
size of the quarterly premium payments is Nc / 4. If we assume for simplicity that defaults can only
occur on one of the payment dates then there are five ways the contract could end:
• either it does not have any default at all, so the four premium payments are made and the
contract survives until the maturity date, or
• a default occurs on the first, second, third or fourth payment date.
To price the CDS we now need to assign probabilities to the five possible outcomes, then calculate the
present value of the payoff for each outcome. The present value of the CDS is then simply the present
value of the five payoffs multiplied by their probability of occurring.
This is illustrated in the following tree diagram where at each payment date either the contract has a
default event, in which case it ends with a payment of N(1 − R) shown in red, where R is the recovery
rate, or it survives without a default being triggered, in which case a premium payment of Nc / 4 is
made, shown in blue. At either side of the diagram are the cashflows up to that point in time with
premium payments in blue and default payments in red. If the contract is terminated the square is shown
with solid shading.
The probability of surviving over the interval ti − 1 to ti without a default payment is pi and the probability
of a default being triggered is 1 − pi. The calculation of present value, given discount factor of δ1 to δ4 is
then
Description Premium Payment PV Default Payment PV Probability

Default at time t1
Default at time t2
Default at time t3
Default at time t4
No defaults
The probabilities p1, p2, p3, p4 can be calculated using the credit spread curve. The probability of no
default occurring over a time period from t to t + Δt decays exponentially with a time-constant
determined by the credit spread, or mathematically p = exp( − s(t)Δt / (1 − R)) where s(t) is the credit
spread zero curve at time t. The riskier the reference entity the greater the spread and the more rapidly
the survival probability decays with time.
To get the total present value of the credit default swap we multiply the probability of each outcome by
its present value to give
[edit] No-arbitrage model
In the 'no-arbitrage' model proposed by both Duffie, and Hull-White, it is assumed that there is no risk
free arbitrage. Duffie uses the LIBOR as the risk free rate, whereas Hull and White use US Treasuries as
the risk free rate. Both analyses make simplifying assumptions (such as the assumption that there is zero
cost of unwinding the fixed leg of the swap on default), which may invalidate the no-arbitrage
assumption. However the Duffie approach is frequently used by the market to determine theoretical
prices. Under the Duffie construct, the price of a credit default swap can also be derived by calculating
the asset swap spread of a bond. If a bond has a spread of 100, and the swap spread is 70 basis points,
then a CDS contract should trade at 30. However there are sometimes technical reasons why this will not
be the case, and this may or may not present an arbitrage opportunity for the canny investor. The
difference between the theoretical model and the actual price of a credit default swap is known as the
basis.
[edit] Criticisms
Critics of the huge credit default swap market have claimed that it has been allowed to become too large
without proper regulation and that, because all contracts are privately negotiated, the market has no
transparency. Furthermore, there have even been claims that CDSs exacerbated the 2008 global financial
crisis by hastening the demise of companies such as Lehman Brothers and AIG.[70]
In the case of Lehman Brothers, it is claimed that the widening of the bank's CDS spread reduced
confidence in the bank and ultimately gave it further problems that it was not able to overcome.
However, proponents of the CDS market argue that this confuses cause and effect; CDS spreads simply
reflected the reality that the company was in serious trouble. Furthermore, they claim that the CDS
market allowed investors who had counterparty risk with Lehman Brothers to reduce their exposure in
the case of their default.
Credit default swaps have also faced criticism that they contributed to a breakdown in negotiations
during the 2009 General Motors Chapter 11 reorganization, because bondholders would benefit from the
credit event of a GM bankruptcy due to their holding of CDSs. Critics speculate that these creditors were
incentivized into pushing for the company to enter bankruptcy protection.[71] Due to a lack of
transparency, there was no way to find out who the protection buyers and protection writers were, and
they were subsequently left out of the negotiation process.[72]
It was also reported after Lehman's bankruptcy that the $400 billion notional of CDS protection which
had been written on the bank could lead to a net payout of $366 billion from protection sellers to buyers
(given the cash-settlement auction settled at a final price of 8.625%) and that these large payouts could
lead to further bankruptcies of firms without enough cash to settle their contracts.[73] However, industry
estimates after the auction suggested that net cashflows would only be in the region of $7 billion.[73] This
is because many parties held offsetting positions; for example if a bank writes CDS protection on a
company it is likely to then enter an offsetting transaction by buying protection on the same company in
order to hedge its risk. Furthermore, CDS deals are marked-to-market frequently. This would have led to
margin calls from buyers to sellers as Lehman's CDS spread widened, meaning that the net cashflows on
the days after the auction are likely to have been even lower.[68]... Senior bankers have argued that not
only has the CDS market functioned remarkably well during the financial crisis, but that CDS contracts
have been acting to distribute risk just as was intended, and that it is not CDSs themselves that need
further regulation, but the parties who trade them.[74]
Some general criticism of financial derivatives is also relevant to credit derivatives. Warren Buffett
famously described derivatives bought speculatively as "financial weapons of mass destruction." In
Berkshire Hathaway's annual report to shareholders in 2002, he said, "Unless derivatives contracts are
collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the
counterparties to them. In the meantime, though, before a contract is settled, the counterparties record
profits and losses—often huge in amount—in their current earnings statements without so much as a
penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or
sometimes, so it seems, madmen)."[75] To hedge the counterparty risk of entering a CDS transaction, one
practice is to buy CDS protection on one's counterparty. The positions are marked-to-market daily and
collateral pass from buyer to seller or vice versa to protect both parties against counterparty default, but
money does not always change hands due to the offset of gains and losses by those who had both bought
and sold protection. Depository Trust & Clearing Corporation, the clearinghouse for the majority of
trades in the US over-the-counter market, stated in October 2008 that once offsetting trades were
considered, only an estimated $6 billion would change hands on October 21, during the settlement of the
CDS contracts issued on Lehman Brothers' debt, which amounted to somewhere between $150 to
$360 billion.[76] Despite Buffett's criticism on derivatives, in October 2008 Berkshire Hathaway revealed
to regulators that it has entered into at least $4.85 billion in derivative transactions.[77] Buffett stated in
his 2008 letter to shareholders that Berkshire Hathaway has no counterparty risk in its derivative
dealings because Berkshire require counterparties to make payments when contracts are inititated, so
that Berkshire always holds the money.[78] Berkshire Hathaway was a large owner of Moody's stock
during the period that it was one of two primary rating agencies for subprime CDOs, a form of mortgage
security derivative dependant on the use of credit default swaps.
The monoline insurance companies got involved with writing credit default swaps on mortgage-backed
CDOs. Some media reports have claimed this was a contributing factor to the downfall of some of the
monolines.[79][80] In 2009 one of the monolines, MBIA, sued Merrill Lynch, claiming that Merill had
misrepresented some of its CDOs to MBIA in order to persuade MBIA to write CDS protection for
those CDOs.[81][82][83]
[edit] Systemic risk
The risk of counterparties defaulting has been amplified during the 2008 financial crisis, particularly
because Lehman Brothers and AIG were counterparties in a very large number of CDS transactions.
This is an example of systemic risk, risk which threatens an entire market, and a number of
commentators have argued that size and deregulation of the CDS market have increased this risk.
For example, imagine if a hypothetical mutual fund had bought some Washington Mutual corporate
bonds in 2005 and decided to hedge their exposure by buying CDS protection from Lehman Brothers.
After Lehman's default, this protection was no longer active, and Washington Mutual's sudden default
only days later would have led to a massive loss on the bonds, a loss that should have been insured by
the CDS. There was also fear that Lehman Brothers and AIG's inability to pay out on CDS contracts
would lead to the unraveling of complex interlinked chain of CDS transactions between financial
institutions.[84] So far this does not appear to have happened, although some commentators[who?] have
noted that because the total CDS exposure of a bank is not public knowledge, the fear that one could
face large losses or possibly even default themselves was a contributing factor to the massive decrease in
lending liquidity during September/October 2008.[85]
Chains of CDS transactions can arise from a practice known as "netting".[86] Here, company B may buy a
CDS from company A with a certain annual "premium", say 2%. If the condition of the reference
company worsens, the risk premium will rise, so company B can sell a CDS to company C with a
premium of say, 5%, and pocket the 3% difference. However, if the reference company defaults,
company B might not have the assets on hand to make good on the contract. It depends on its contract
with company A to provide a large payout, which it then passes along to company C. The problem lies if
one of the companies in the chain fails, creating a "domino effect" of losses. For example, if company A
fails, company B will default on its CDS contract to company C, possibly resulting in bankruptcy, and
company C will potentially experience a large loss due to the failure to receive compensation for the bad
debt it held from the reference company. Even worse, because CDS contracts are private, company C
will not know that its fate is tied to company A; it is only doing business with company B.
As described above, the establishment of a central exchange or clearing house for CDS trades would
help to solve the "domino effect" problem, since it would mean that all trades faced a central
counterparty guaranteed by a consortium of dealers.
[edit] Tax and accounting issues

The U.S federal income tax treatment of credit default swaps is uncertain.[87] Commentators generally
believe that, depending on how they are drafted, they are either notional principal contracts or options
for tax purposes,[88] but this is not certain. There is a risk of having credit default swaps recharacterized
as different types of financial instruments because they resemble put options and credit guarantees. In
particular, the degree of risk depends on the type of settlement (physical/cash and binary/FMV) and
trigger (default only/any credit event).[89] If a credit default swap is a notional principal contract, periodic
and nonperiodic payments on the swap are deductible and included in ordinary income.[90] If a payment
is a termination payment, its tax treatment is even more uncertain.[90] In 2004, the Internal Revenue
Service announced that it was studying the characterization of credit default swaps in response to
taxpayer confusion,[91] but it has not yet issued any guidance on their characterization. A taxpayer must
include income from credit default swaps in ordinary income if the swaps are connected with trade or
business in the United States.[92]
The accounting treatment of Credit Default Swaps used for hedging may not parallel the economic
effects and instead, increase volatility. For example, GAAP generally require that Credit Default Swaps
be reported on a mark to market basis. In contrast, assets that are held for investment, such as a
commercial loan or bonds, are reported at cost, unless a probable and significant loss is expected. Thus,
hedging a commercial loan using a CDS can induce considerable volatility into the income statement
and balance sheet as the CDS changes value over its life due to market conditions and due to the
tendency for shorter dated CDS to sell at lower prices than longer dated CDS. One can try to account for
the CDS as a hedge under FASB 133[93] but in practice that can prove very difficult unless the risky asset
owned by the bank or corporation is exactly the same as the Reference Obligation used for the particular
CDS that was bought.
[edit] LCDS
A new type of default swap is the "loan only" credit default swap (LCDS). This is conceptually very
similar to a standard CDS, but unlike "vanilla" CDS, the underlying protection is sold on syndicated
secured loans of the Reference Entity rather than the broader category of "Bond or Loan". Also, as of
May 22, 2007, for the most widely traded LCDS form, which governs North American single name and
index trades, the default settlement method for LCDS shifted to auction settlement rather than physical
settlement. The auction method is essentially the same that has been used in the various ISDA cash
settlement auction protocols, but does not require parties to take any additional steps following a credit
event (i.e., adherence to a protocol) to elect cash settlement. On October 23, 2007, the first ever LCDS
auction was held for Movie Gallery.[94]
Because LCDS trades are linked to secured obligations with much higher recovery values than the
unsecured bond obligations that are typically assumed to be cheapest to deliver in respect of vanilla
CDS, LCDS spreads are generally much tighter than CDS trades on the same name.
Bond (finance)
Finance
Financial markets[show]
Financial instruments[show]
Corporate finance[show]
Personal finance[show]
Public finance[show]
Banks and banking[show]
Financial regulation[show]
Standards[show]
Economic history[show]
v·d·e
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and,
depending on the terms of the bond, is obliged to pay interest (the coupon) and/or to repay the principal
at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at
fixed intervals.[1]
Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the
coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments,
or, in the case of government bonds, to finance current expenditure. Certificates of deposit (CDs) or
commercial paper are considered to be money market instruments and not bonds. Bonds must be repaid
at fixed intervals over a period of time.
Bonds and stocks are both securities, but the major difference between the two is that (capital)
stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders have a
creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a
defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding
indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity).
Contents
[hide]
• 1 Issuing bonds
• 2 Features of bonds
• 3 Types of Bond
o 3.1 Bonds issued in foreign currencies
• 4 Trading and valuing bonds
• 5 Investing in bonds
o 5.1 Bond indices
• 6 See also
• 7 References
[edit] Issuing bonds

Bonds are issued by public authorities, credit institutions, companies and supranational institutions in
the primary markets. The most common process of issuing bonds is through underwriting. In
underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds
from an issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on
the issue to end investors. Primary issuance is arranged by bookrunners who arrange the bond issue,
have the direct contact with investors and act as advisors to the bond issuer in terms of timing and price
of the bond issue. The bookrunners' willingness to underwrite must be discussed prior to opening books
on a bond issue as there may be limited appetite to do so.
In the case of Government Bonds, these are usually issued by auctions, called a public sale, where both
members of the public and banks may bid for bond. Since the coupon is fixed, but the price is not, the
percent return is a function both of the price paid as well as the coupon.[2] However, because the cost of
issuance for a publicly auctioned bond can be cost prohibitive for a smaller loan, it is also common for
smaller bonds to avoid the underwriting and auction process through the use of a private placement
bond. In the case of a private placement bond, the bond is held by the lender and does not enter the large
bond market.[3]
[edit] Features of bonds

The most important features of a bond are:
• nominal, principal or face amount — the amount on which the issuer pays interest, and which,
most commonly, has to be repaid at the end of the term. Some structured bonds can have a
redemption amount which is different from the face amount and can be linked to performance of
particular assets such as a stock or commodity index, foreign exchange rate or a fund. This can
result in an investor receiving less or more than his original investment at maturity.
• issue price — the price at which investors buy the bonds when they are first issued, which will
typically be approximately equal to the nominal amount. The net proceeds that the issuer
receives are thus the issue price, less issuance fees.
• maturity date — the date on which the issuer has to repay the nominal amount. As long as all
payments have been made, the issuer has no more obligation to the bond holders after the
maturity date. The length of time until the maturity date is often referred to as the term or tenor
or maturity of a bond. The maturity can be any length of time, although debt securities with a
term of less than one year are generally designated money market instruments rather than bonds.
Most bonds have a term of up to thirty years. Some bonds have been issued with maturities of up
to one hundred years, and some even do not mature at all. In early 2005, a market developed in
euros for bonds with a maturity of fifty years[citation needed]. In the market for U.S. Treasury
securities, there are three groups of bond maturities:
o short term (bills): maturities between one to five year; (instruments with maturities less
than one year are called Money Market Instruments)
o medium term (notes): maturities between six to twelve years;
o long term (bonds): maturities greater than twelve years.
• coupon — the interest rate that the issuer pays to the bond holders. Usually this rate is fixed
throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it
can be even more exotic. The name coupon originates from the fact that in the past, physical
bonds were issued which had coupons attached to them. On coupon dates the bond holder would
give the coupon to a bank in exchange for the interest payment.
Bond issued by the Dutch East India Company in 1623
• The "quality" of the issue refers to the probability that the bondholders will receive the amounts
promised at the due dates. This will depend on a wide range of factors.
o Indentures and Covenants — An indenture is a formal debt agreement that establishes the
terms of a bond issue, while covenants are the clauses of such an agreement. Covenants
specify the rights of bondholders and the duties of issuers, such as actions that the issuer
is obligated to perform or is prohibited from performing. In the U.S., federal and state
securities and commercial laws apply to the enforcement of these agreements, which are
construed by courts as contracts between issuers and bondholders. The terms may be
changed only with great difficulty while the bonds are outstanding, with amendments to
the governing document generally requiring approval by a majority (or super-majority)
vote of the bondholders.
o High yield bonds are bonds that are rated below investment grade by the credit rating
agencies. As these bonds are more risky than investment grade bonds, investors expect to
earn a higher yield. These bonds are also called junk bonds.
• coupon dates — the dates on which the issuer pays the coupon to the bond holders. In the U.S.
and also in the U.K. and Europe, most bonds are semi-annual, which means that they pay a
coupon every six months.
• Optionality: Occasionally a bond may contain an embedded option; that is, it grants option-like
features to the holder or the issuer:
o Callability — Some bonds give the issuer the right to repay the bond before the maturity
date on the call dates; see call option. These bonds are referred to as callable bonds. Most
callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has
to pay a premium, the so called call premium. This is mainly the case for high-yield
bonds. These have very strict covenants, restricting the issuer in its operations. To be free
from these covenants, the issuer can repay the bonds early, but only at a high cost.
o Putability — Some bonds give the holder the right to force the issuer to repay the bond
before the maturity date on the put dates; see put option. (Note: "Putable" denotes an
embedded put option; "Puttable" denotes that it may be put.)
o call dates and put dates—the dates on which callable and putable bonds can be redeemed
early. There are four main categories.
 A Bermudan callable has several call dates, usually coinciding with coupon dates.
 A European callable has only one call date. This is a special case of a Bermudan
callable.
 An American callable can be called at any time until the maturity date.
 A death put is an optional redemption feature on a debt instrument allowing the
beneficiary of the estate of the deceased to put (sell) the bond (back to the issuer)
in the event of the beneficiary's death or legal incapacitation. Also known as a
"survivor's option".
• sinking fund provision of the corporate bond indenture requires a certain portion of the issue to
be retired periodically. The entire bond issue can be liquidated by the maturity date. If that is not
the case, then the remainder is called balloon maturity. Issuers may either pay to trustees, which
in turn call randomly selected bonds in the issue, or, alternatively, purchase bonds in open
market, then return them to trustees.
• convertible bond lets a bondholder exchange a bond to a number of shares of the issuer's
common stock.
• exchangeable bond allows for exchange to shares of a corporation other than the issuer.
[edit] Types of Bond
Bond certificate for the state of South Carolina issued in 1873 under the state's Consolidation Act.
The following descriptions are not mutually exclusive, and more than one of them may apply to a
particular bond.
• Fixed rate bonds have a coupon that remains constant throughout the life of the bond.
• Floating rate notes (FRNs) have a variable coupon that is linked to a reference rate of interest,
such as LIBOR or Euribor. For example the coupon may be defined as three month USD LIBOR
+ 0.20%. The coupon rate is recalculated periodically, typically every one or three months.
• Zero-coupon bonds pay no regular interest. They are issued at a substantial discount to par value,
so that the interest is effectively rolled up to maturity (and usually taxed as such). The
bondholder receives the full principal amount on the redemption date. An example of zero
coupon bonds is Series E savings bonds issued by the U.S. government. Zero-coupon bonds may
be created from fixed rate bonds by a financial institution separating ("stripping off") the
coupons from the principal. In other words, the separated coupons and the final principal
payment of the bond may be traded separately. See IO (Interest Only) and PO (Principal Only).
• Inflation linked bonds, in which the principal amount and the interest payments are indexed to
inflation. The interest rate is normally lower than for fixed rate bonds with a comparable
maturity (this position briefly reversed itself for short-term UK bonds in December 2008).
However, as the principal amount grows, the payments increase with inflation. The United
Kingdom was the first sovereign issuer to issue inflation linked Gilts in the 1980s. Treasury
Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued
by the U.S. government.
Receipt for temporary bonds for the state of Kansas issued in 1922
• Other indexed bonds, for example equity-linked notes and bonds indexed on a business indicator
(income, added value) or on a country's GDP.
• Asset-backed securities are bonds whose interest and principal payments are backed by
underlying cash flows from other assets. Examples of asset-backed securities are mortgage-
backed securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized debt
obligations (CDOs).
• Subordinated bonds are those that have a lower priority than other bonds of the issuer in case of
liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid,
then government taxes, etc. The first bond holders in line to be paid are those holding what is
called senior bonds. After they have been paid, the subordinated bond holders are paid. As a
result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than
senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks,
and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid
back first, the subordinated tranches later.
• Perpetual bonds are also often called perpetuities or 'Perps'. They have no maturity date. The
most famous of these are the UK Consols, which are also known as Treasury Annuities or
Undated Treasuries. Some of these were issued back in 1888 and still trade today, although the
amounts are now insignificant. Some ultra-long-term bonds (sometimes a bond can last
centuries: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century)) are
virtually perpetuities from a financial point of view, with the current value of principal near zero.
• Bearer bond is an official certificate issued without a named holder. In other words, the person
who has the paper certificate can claim the value of the bond. Often they are registered by a
number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky
because they can be lost or stolen. Especially after federal income tax began in the United States,
bearer bonds were seen as an opportunity to conceal income or assets.[4] U.S. corporations
stopped issuing bearer bonds in the 1960s, the U.S. Treasury stopped in 1982, and state and local
tax-exempt bearer bonds were prohibited in 1983.[5]
• Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the
issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the
principal upon maturity, are sent to the registered owner.
• Treasury bond, also called government bond, is issued by the Federal government and is not
exposed to default risk. It is characterized as the safest bond, with the lowest interest rate. A
treasury bond is backed by the “full faith and credit” of the federal government. For that reason,
this type of bond is often referred to as risk-free.
Pacific Railroad Bond issued by City and County of San Francisco, CA. May 1, 1865
Municipal bond is a bond issued by a state, U.S. Territory, city, local government, or their
agencies. Interest income received by holders of municipal bonds is often exempt from the
federal income tax and from the income tax of the state in which they are issued, although
municipal bonds issued for certain purposes may not be tax exempt.
• Build America Bonds (BABs) is a new form of municipal bond authorized by the American
Recovery and Reinvestment Act of 2009. Unlike traditional municipal bonds, which are usually
tax exempt, interest received on BABs is subject to federal taxation. However, as with municipal
bonds, the bond is tax-exempt within the state it is issued. Generally, BABs offer significantly
higher yields (over 7 percent) than standard municipal bonds.[6]
• Book-entry bond is a bond that does not have a paper certificate. As physically processing paper
bonds and interest coupons became more expensive, issuers (and banks that used to collect
coupon interest for depositors) have tried to discourage their use. Some book-entry bond issues
do not offer the option of a paper certificate, even to investors who prefer them.[7]
• Lottery bond is a bond issued by a state, usually a European state. Interest is paid like a
traditional fixed rate bond, but the issuer will redeem randomly selected individual bonds within
the issue according to a schedule. Some of these redemptions will be for a higher value than the
face value of the bond.
• War bond is a bond issued by a country to fund a war.
• Serial bond is a bond that matures in installments over a period of time. In effect, a $100,000, 5-
year serial bond would mature in a $20,000 annuity over a 5-year interval.
• Revenue bond is a special type of municipal bond distinguished by its guarantee of repayment
solely from revenues generated by a specified revenue-generating entity associated with the
purpose of the bonds. Revenue bonds are typically "non-recourse," meaning that in the event of
default, the bond holder has no recourse to other governmental assets or revenues.
[edit] Bonds issued in foreign currencies
Some companies, banks, governments, and other sovereign entities may decide to issue bonds in foreign
currencies as it may appear to be more stable and predictable than their domestic currency. Issuing
bonds denominated in foreign currencies also gives issuers the ability to access investment capital
available in foreign markets. The proceeds from the issuance of these bonds can be used by companies
to break into foreign markets, or can be converted into the issuing company's local currency to be used
on existing operations through the use of foreign exchange swap hedges. Foreign issuer bonds can also
be used to hedge foreign exchange rate risk. Some foreign issuer bonds are called by their nicknames,
such as the "samurai bond." These can be issued by foreign issuers looking to diversify their investor
base away from domestic markets. These bond issues are generally governed by the law of the market of
issuance, e.g., a samurai bond, issued by an investor based in Europe, will be governed by Japanese law.
Not all of the following bonds are restricted for purchase by investors in the market of issuance.
• Eurodollar bond, a U.S. dollar-denominated bond issued by a non-U.S. entity outside the U.S[8]
• Yankee bond, a US dollar-denominated bond issued by a non-US entity in the US market
• Kangaroo bond, an Australian dollar-denominated bond issued by a non-Australian entity in the
Australian market
• Maple bond, a Canadian dollar-denominated bond issued by a non-Canadian entity in the
Canadian market
• Samurai bond, a Japanese yen-denominated bond issued by a non-Japanese entity in the Japanese
market
• Uridashi bond, a non-yen-demoninated bond sold to Japanese retail investors.
• Shibosai Bond is a private placement bond in Japanese market with distribution limited to
institutions and banks.
• Shogun bond, a non-yen-denominated bond issued in Japan by a non-Japanese institution or
government[9]
• Bulldog bond, a pound sterling-denominated bond issued in London by a foreign institution or
government
• Matrioshka bond, a Russian rouble-denominated bond issued in the Russian Federation by non-
Russian entities. The name derives from the famous Russian wooden dolls, Matrioshka, popular
among foreign visitors to Russia
• Arirang bond, a Korean won-denominated bond issued by a non-Korean entity in the Korean
market[10]
• Kimchi bond, a non-Korean won-denominated bond issued by a non-Korean entity in the Korean
market[11]
• Formosa bond, a non-New Taiwan Dollar-denominated bond issued by a non-Taiwan entity in
the Taiwan market[12]
• Panda bond, a Chinese renminbi-denominated bond issued by a non-China entity in the People's
Republic of China market[13]
• Dimsum bond, a Chinese renminbi-denominated bond issued by a Chinese entity in Hong Kong.
Enables foreign investors forbidden from investing in Chinese corporate debt in mainland China
to invest in and be exposed to Chinese currency in Hong Kong.[14]
[edit] Trading and valuing bonds

See also: Bond valuation
The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current
market interest rates, the length of the term and the creditworthiness of the issuer.
These factors are likely to change over time, so the market price of a bond will vary after it is issued.
This price is expressed as a percentage of nominal value. Bonds are not necessarily issued at par (100%
of face value, corresponding to a price of 100), but bond prices converge to par when they approach
maturity (if the market expects the maturity payment to be made in full and on time) as this is the price
the issuer will pay to redeem the bond. This is referred to as "Pull to Par". At other times, prices can be
above par (bond is priced at greater than 100), which is called trading at a premium, or below par (bond
is priced at less than 100), which is called trading at a discount. Most government bonds are
denominated in units of $1000 in the United States, or in units of £100 in the United Kingdom. Hence, a
deep discount US bond, selling at a price of 75.26, indicates a selling price of $752.60 per bond sold.
(Often, in the US, bond prices are quoted in points and thirty-seconds of a point, rather than in decimal
form.) Some short-term bonds, such as the U.S. Treasury Bill, are always issued at a discount, and pay
par amount at maturity rather than paying coupons. This is called a discount bond.
The market price of a bond is the present value of all expected future interest and principal payments of
the bond discounted at the bond's redemption yield, or rate of return. That relationship defines the
redemption yield on the bond, which represents the current market interest rate for bonds with similar
characteristics. The yield and price of a bond are inversely related so that when market interest rates rise,
bond prices fall and vice versa. Thus the redemption yield could be considered to be made up of two
parts: the current yield (see below) and the expected capital gain or loss: roughly the current yield plus
the capital gain (negative for loss) per year until redemption.
The market price of a bond may include the accrued interest since the last coupon date. (Some bond
markets include accrued interest in the trading price and others add it on explicitly after trading.) The
price including accrued interest is known as the "full" or "dirty price". (See also Accrual bond.) The
price excluding accrued interest is known as the "flat" or "clean price".
The interest rate adjusted for (divided by) the current price of the bond is called the current yield (this is
the nominal yield multiplied by the par value and divided by the price). There are other yield measures
that exist such as the yield to first call, yield to worst, yield to first par call, yield to put, cash flow yield
and yield to maturity.
The relationship between yield and maturity for otherwise identical bonds is called a yield curve. A
yield curve is essentially a measure of the term structure of bonds.
Bonds markets, unlike stock or share markets, often do not have a centralized exchange or trading
system. Rather, in most developed bond markets such as the U.S., Japan and western Europe, bonds
trade in decentralized, dealer-based over-the-counter markets. In such a market, market liquidity is
provided by dealers and other market participants committing risk capital to trading activity. In the bond
market, when an investor buys or sells a bond, the counterparty to the trade is almost always a bank or
securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer
carries the bond "in inventory." The dealer's position is then subject to risks of price fluctuation. In other
cases, the dealer immediately resells the bond to another investor.
Bond markets can also differ from stock markets in that, in some markets, investors sometimes do not
pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, the dealers earn
revenue by means of the spread, or difference, between the price at which the dealer buys a bond from
one investor—the "bid" price—and the price at which he or she sells the same bond to another investor
—the "ask" or "offer" price. The bid/offer spread represents the total transaction cost associated with
transferring a bond from one investor to another.
[edit] Investing in bonds
Bonds are bought and traded mostly by institutions like central banks, sovereign wealth funds, pension
funds, insurance companies and banks. Most individuals who want to own bonds do so through bond
funds. Still, in the U.S., nearly 10% of all bonds outstanding are held directly by households.
Sometimes, bond markets rise (while yields fall) when stock markets fall. More relevantly, the volatility
of bonds (especially short and medium dated bonds) is lower than that of stocks. Thus bonds are
generally viewed as safer investments than stocks, but this perception is only partially correct. Bonds do
suffer from less day-to-day volatility than stocks, and bonds' interest payments are often higher than the
general level of dividend payments. Bonds are liquid – it is fairly easy to sell one's bond investments,
though not nearly as easy as it is to sell stocks – and the comparative certainty of a fixed interest
payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the
law of most countries, if a company goes bankrupt, its bondholders will often receive some money back
(the recovery amount), whereas the company's stock often ends up valueless. However, bonds can also
be risky but less risky than stocks:
• Fixed rate bonds are subject to interest rate risk, meaning that their market prices will decrease
in value when the generally prevailing interest rates rise. Since the payments are fixed, a
decrease in the market price of the bond means an increase in its yield. When the market interest
rate rises, the market price of bonds will fall, reflecting investors' ability to get a higher interest
rate on their money elsewhere — perhaps by purchasing a newly issued bond that already
features the newly higher interest rate. Note that this drop in the bond's market price does not
affect the interest payments to the bondholder at all, so long-term investors who want a specific
amount at the maturity date need not worry about price swings in their bonds and do not suffer
from interest rate risk.
Bonds are also subject to various other risks such as call and prepayment risk, credit risk, reinvestment
risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk and yield
curve risk.
Price changes in a bond will also immediately affect mutual funds that hold these bonds. If the value of
the bonds held in a trading portfolio has fallen over the day, the value of the portfolio will also have
fallen. This can be damaging for professional investors such as banks, insurance companies, pension
funds and asset managers (irrespective of whether the value is immediately "marked to market" or not).
If there is any chance a holder of individual bonds may need to sell his bonds and "cash out", interest
rate risk could become a real problem (conversely, bonds' market prices would increase if the prevailing
interest rate were to drop, as it did from 2001 through 2003[citation needed]). One way to quantify the interest
rate risk on a bond is in terms of its duration. Efforts to control this risk are called immunization or
hedging.
• Bond prices can become volatile depending on the credit rating of the issuer - for instance if the
credit rating agencies like Standard & Poor's and Moody's upgrade or downgrade the credit
rating of the issuer. A downgrade will cause the market price of the bond to fall. As with interest
rate risk, this risk does not affect the bond's interest payments (provided the issuer does not
actually default), but puts at risk the market price, which affects mutual funds holding these
bonds, and holders of individual bonds who may have to sell them.
• A company's bondholders may lose much or all their money if the company goes bankrupt.
Under the laws of many countries (including the United States and Canada), bondholders are in
line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other
creditors. Bank lenders, deposit holders (in the case of a deposit taking institution such as a bank)
and trade creditors may take precedence.
There is no guarantee of how much money will remain to repay bondholders. As an example, after an
accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications company Worldcom,
in 2004 its bondholders ended up being paid 35.7 cents on the dollar[citation needed]. In a bankruptcy
involving reorganization or recapitalization, as opposed to liquidation, bondholders may end up having
the value of their bonds reduced, often through an exchange for a smaller number of newly issued
bonds.
• Some bonds are callable, meaning that even though the company has agreed to make payments
plus interest towards the debt for a certain period of time, the company can choose to pay off the
bond early. This creates reinvestment risk, meaning the investor is forced to find a new place for
his money, and the investor might not be able to find as good a deal, especially because this
usually happens when interest rates are falling.
[edit] Bond indices
See also: Bond market index
A number of bond indices exist for the purposes of managing portfolios and measuring performance,
similar to the S&P 500 or Russell Indexes for stocks. The most common American benchmarks are the
(ex) Lehman Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. Most indices are parts of
families of broader indices that can be used to measure global bond portfolios, or may be further
subdivided by maturity and/or sector for managing specialized portfolios.
Money market
This article is about the financial market. For the fund type, see Money market fund. For the bank
deposit account, see Money market account.
Finance
Financial markets[show]
Financial instruments[show]
Corporate finance[show]
Personal finance[show]
Public finance[show]
Banks and banking[show]
Financial regulation[show]
Standards[show]
Economic history[show]
v·d·e
The money market is a component of the financial markets for assets involved in short-term borrowing
and lending with original maturities of one year or shorter time frames. Trading in the money markets
involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit, federal funds,
and short-lived mortgage- and asset-backed securities.[1] It provides liquidity funding for the global
financial system.
Contents
[hide]
• 1 Overview
• 2 Common money market instruments
• 3 See also
• 4 References
[edit] Overview
The money market consists of financial institutions and dealers in money or credit who wish to either
borrow or lend. Participants borrow and lend for short periods of time, typically up to thirteen months.
Money market trades in short-term financial instruments commonly called "paper." This contrasts with
the capital market for longer-term funding, which is supplied by bonds and equity.
The core of the money market consists of banks borrowing and lending to each other, using commercial
paper, repurchase agreements and similar instruments. These instruments are often benchmarked to (i.e.
priced by reference to) the London Interbank Offered Rate (LIBOR) for the appropriate term and
currency.
Finance companies, such as GMAC, typically fund themselves by issuing large amounts of asset-backed
commercial paper (ABCP) which is secured by the pledge of eligible assets into an ABCP conduit.
Examples of eligible assets include auto loans, credit card receivables, residential/commercial mortgage
loans, mortgage-backed securities and similar financial assets. Certain large corporations with strong
credit ratings, such as General Electric, issue commercial paper on their own credit. Other large
corporations arrange for banks to issue commercial paper on their behalf via commercial paper lines.
In the United States, federal, state and local governments all issue paper to meet funding needs. States
and local governments issue municipal paper, while the US Treasury issues Treasury bills to fund the
US public debt.
• Trading companies often purchase bankers' acceptances to be tendered for payment to overseas
suppliers.
• Retail and institutional money market funds
• Banks
• Central banks
• Cash management programs
• Arbitrage ABCP conduits, which seek to buy higher yielding paper, while themselves selling
cheaper paper.
• Merchant Banks
[edit] Common money market instruments

• Certificate of deposit - Time deposits, commonly offered to consumers by banks, thrift
institutions, and credit unions.
• Repurchase agreements - Short-term loans—normally for less than two weeks and frequently for
one day—arranged by selling securities to an investor with an agreement to repurchase them at a
fixed price on a fixed date.
• Commercial paper - Unsecured promissory notes with a fixed maturity of one to 270 days;
usually sold at a discount from face value.
• Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch located outside the
United States.
• Federal agency short-term securities - (in the U.S.). Short-term securities issued by government
sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and the
Federal National Mortgage Association.
• Federal funds - (in the U.S.). Interest-bearing deposits held by banks and other depository
institutions at the Federal Reserve; these are immediately available funds that institutions borrow
or lend, usually on an overnight basis. They are lent for the federal funds rate.
• Municipal notes - (in the U.S.). Short-term notes issued by municipalities in anticipation of tax
receipts or other revenues.
• Treasury bills - Short-term debt obligations of a national government that are issued to mature in
three to twelve months. For the U.S., see Treasury bills.
• Money funds - Pooled short maturity, high quality investments which buy money market
securities on behalf of retail or institutional investors.
• Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the reversal of the
exchange of currencies at a predetermined time in the future.
• Short-lived mortgage- and asset-backed securities
Futures contract
Financial markets
Public market
Exchange
Securities
Bond market
Fixed income
Corporate bond
Government bond
Municipal bond
Bond valuation
High-yield debt
Stock market
Stock
Preferred stock
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Registered share
Voting share
Stock exchange
Derivatives market
Securitization
Hybrid security
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OTC, non organized

Spot market
Forwards
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Currency
Other markets
Money market
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Participants
Clearing house
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Finance series
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Public finance
v·d·e
In finance, a futures contract is a standardized contract between two parties to buy or sell a specified
asset (eg.oranges, oil, gold) of standardized quantity and quality at a specified future date at a price
agreed today (the futures price). The contracts are traded on a futures exchange. Futures contracts are
not "direct" securities like stocks, bonds, rights or warrants. They are still securities, however, though
they are a type of derivative contract. 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 is determined by the instantaneous equilibrium between the forces of supply and demand
among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract.
In many cases, the underlying asset to a futures contract may not be traditional "commodities" at all –
that is, for financial futures, the underlying asset or item can be currencies, securities or financial
instruments and intangible assets or referenced items such as stock indexes and interest rates.
The future date is called the delivery date or final settlement date. The official price of the futures
contract at the end of a day's trading session on the exchange is called the settlement price for that day of
business on the exchange.[1]
A closely related contract is a forward contract; they differ in certain respects. Future contracts are very
similar to forward contracts, except they are exchange-traded and defined on standardized assets.[2]
Unlike forwards, futures typically have interim partial settlements or "true-ups" in margin requirements.
For typical forwards, the net gain or loss accrued over the life of the contract is realized on the delivery
date.
A futures contract gives the holder the obligation to make or take delivery under the terms of the
contract, whereas an option grants the buyer the right, but not the obligation, to establish a position
previously held by the seller of the option. In other words, the owner of an options contract may exercise
the contract, but both parties of a "futures contract" must fulfill the contract on the settlement 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 has to offset his/her position by
either selling a long position or buying back (covering) a short position, effectively closing out the
futures position and its contract obligations.
Futures contracts, or simply futures, (but not future or future contract) are exchange-traded derivatives.
The exchange's clearing house acts as counterparty on all contracts, sets margin requirements, and
crucially also provides a mechanism for settlement.[3]
Contents
[hide]
• 1 Origin
• 2 Standardization
• 3 Margin
• 4 Settlement - physical versus cash-settled futures
• 5 Pricing
o 5.1 Arbitrage arguments
o 5.2 Pricing via expectation
o 5.3 Relationship between arbitrage arguments and expectation
o 5.4 Contango and backwardation
• 6 Futures contracts and exchanges
o 6.1 Codes
• 7 Who trades futures?
• 8 Options on futures
• 9 Futures contract regulations
• 10 Definition of futures contract
• 11 Nonconvergence
• 12 Futures versus forwards
o 12.1 Exchange versus OTC
o 12.2 Margining
• 13 See also
• 14 Notes
• 15 References
• 16 U.S. Futures exchanges and regulators
[edit] Origin
Aristotle described the story of Thales, a poor philosopher from Miletus who developed a "financial
device, which involves a principle of universal application". Thales used his skill in forecasting and
predicted that the olive harvest would be exceptionally good the next autumn. Confident in his
prediction, he made agreements with local olive press owners to deposit his money with them to
guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully
negotiated low prices because the harvest was in the future and no one knew whether the harvest would
be plentiful or poor and because the olive press owners were willing to hedge against the possibility of a
poor yield. When the harvest time came, and many presses were wanted concurrently and suddenly, he
let them out at any rate he pleased, and made a large quantity of money.[4]
The first futures exchange market was the Dōjima Rice Exchange in Japan in the 1730s, to meet the
needs of samurai who – being paid in rice, and after a series of bad harvests – needed a stable
conversion to coin.[5]
The Chicago Board of Trade (CBOT) listed the first ever standardized 'exchange traded' forward
contracts in 1864, which were called futures contracts. This contract was based on grain trading and
started a trend that saw contracts created on a number of different commodities as well as a number of
futures exchanges set up in countries around the world.[6] By 1875 cotton futures were being traded in
Mumbai in India and within a few years this had expanded to futures on edible oilseeds complex, raw
jute and jute goods and bullion.[7]
[edit] Standardization
Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
• The underlying asset or instrument. This could be anything from a barrel of crude oil to a short
term interest rate.
• The type of settlement, either cash settlement or physical settlement.
• The amount and units of the underlying asset per contract. This can be the notional amount of
bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the
deposit over which the short term interest rate is traded, etc.
• The currency in which the futures contract is quoted.
• The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered.
In the case of physical commodities, this specifies not only the quality of the underlying goods
but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil
contract specifies the acceptable sulphur content and API specific gravity, as well as the pricing
point -- the location where delivery must be made.
• The delivery month.
• The last trading date.
• Other details such as the commodity tick, the minimum permissible price fluctuation.
[edit] Margin
To minimize credit risk to the exchange, traders must post a margin or a performance bond, typically
5%-15% of the contract's value.
To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed
by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each buyer, so
that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to
transact without performing due diligence on their counterparty.
Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of
the covered commodity or spread traders who have offsetting contracts balancing the position.
Clearing margin are financial safeguards to ensure that companies or corporations perform on their
customers' open futures and options contracts. Clearing margins are distinct from customer margins that
individual buyers and sellers of futures and options contracts are required to deposit with brokers.
Customer margin Within the futures industry, financial guarantees required of both buyers and sellers
of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures
Commission Merchants are responsible for overseeing customer margin accounts. Margins are
determined on the basis of market risk and contract value. Also referred to as performance bond margin.
Initial margin is the equity required to initiate a futures position. This is a type of performance bond.
The maximum exposure is not limited to the amount of the initial margin, however the initial margin
requirement is calculated based on the maximum estimated change in contract value within a trading
day. Initial margin is set by the exchange.
If a position involves an exchange-traded product, the amount or percentage of initial margin is set by
the exchange concerned.
In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in
order to restore the amount of initial margin available. Often referred to as “variation margin”, margin
called for this reason is usually done on a daily basis, however, in times of high volatility a broker can
make a margin call or calls intra-day.
Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the
right to close sufficient positions to meet the amount called by way of margin. After the position is
closed-out the client is liable for any resulting deficit in the client’s account.
Some U.S. exchanges also use the term “maintenance margin”, which in effect defines by how much the
value of the initial margin can reduce before a margin call is made. However, most non-US brokers only
use the term “initial margin” and “variation margin”.
The Initial Margin requirement is established by the Futures exchange, in contrast to other securities
Initial Margin (which is set by the Federal Reserve in the U.S. Markets).
A futures account is marked to market daily. If the margin drops below the margin maintenance
requirement established by the exchange listing the futures, a margin call will be issued to bring the
account back up to the required level.
Maintenance margin A set minimum margin per outstanding futures contract that a customer must
maintain in his margin account.
Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that
is being held as margin at any particular time. The low margin requirements of futures results in
substantial leverage of the investment. However, the exchanges require a minimum amount that varies
depending on the contract and the trader. The broker may set the requirement higher, but may not set it
lower. A trader, of course, can set it above that, if he doesn't want to be subject to margin calls.
Performance bond margin The amount of money deposited by both a buyer and seller of a futures
contract or an options seller to ensure performance of the term of the contract. Margin in commodities is
not a payment of equity or down payment on the commodity itself, but rather it is a security deposit.
Return on margin (ROM) is often used to judge performance because it represents the gain or loss
compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated
(realized return) / (initial margin). The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. For
example if a trader earns 10% on margin in two months, that would be about 77% annualized.
[edit] Settlement - physical versus cash-settled futures

Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per
type of futures contract:
• Physical delivery - the amount specified of the underlying asset of the contract is delivered by
the seller of the contract to the exchange, and by the exchange to the buyers of the contract.
Physical delivery is common with commodities and bonds. In practice, it occurs only on a
minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a
contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier
purchase (covering a long). The Nymex crude futures contract uses this method of settlement
upon expiration
• Cash settlement - a cash payment is made based on the underlying reference rate, such as a
short term interest rate index such as Euribor, or the closing value of a stock market index. The
parties settle by paying/receiving the loss/gain related to the contract in cash when the contract
expires.[8] Cash settled futures are those that, as a practical matter, could not be settled by
delivery of the referenced item - i.e. how would one deliver an index? A futures contract might
also opt to settle against an index based on trade in a related spot market. Ice Brent futures use
this method.
Expiry (or Expiration in the U.S.) is the time and the day that a particular delivery month of a futures
contract stops trading, as well as the final settlement price for that contract. For many equity index and
interest rate futures contracts (as well as for most equity options), this happens on the third Friday of
certain trading months. On this day the t+1 futures contract becomes the t futures contract. For example,
for most CME and CBOT contracts, at the expiration of the December contract, the March futures
become the nearest contract. This is an exciting time for arbitrage desks, which try to make quick profits
during the short period (perhaps 30 minutes) during which the underlying cash price and the futures
price sometimes struggle to converge. At this moment the futures and the underlying assets are
extremely liquid and any disparity between an index and an underlying asset is quickly traded by
arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to
the next contract or, in the case of equity index futures, purchasing underlying components of those
indexes to hedge against current index positions. On the expiry date, a European equity arbitrage trading
desk in London or Frankfurt will see positions expire in as many as eight major markets almost every
half an hour.
[edit] Pricing
When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a futures
contract is determined via arbitrage arguments. This is typical for stock index futures, treasury bond
futures, and futures on physical commodities when they are in supply (e.g. agricultural crops after the
harvest). However, when the deliverable commodity is not in plentiful supply or when it does not yet
exist - for example on crops before the harvest or on Eurodollar Futures or Federal funds rate futures (in
which the supposed underlying instrument is to be created upon the delivery date) - the futures price
cannot be fixed by arbitrage. In this scenario there is only one force setting the price, which is simple
supply and demand for the asset in the future, as expressed by supply and demand for the futures
contract.
[edit] Arbitrage arguments
Arbitrage arguments ("Rational pricing") apply when the deliverable asset exists in plentiful supply, or
may be freely created. Here, the forward price represents the expected future value of the underlying
discounted at the risk free rate—as any deviation from the theoretical price will afford investors a
riskless profit opportunity and should be arbitraged away.
Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t), will be found by
compounding the present value S(t) at time t to maturity T by the rate of risk-free return r.
or, with continuous compounding
This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields.
In a perfect market the relationship between futures and spot prices depends only on the above variables;
in practice there are various market imperfections (transaction costs, differential borrowing and lending
rates, restrictions on short selling) that prevent complete arbitrage. Thus, the futures price in fact varies
within arbitrage boundaries around the theoretical price.
[edit] Pricing via expectation

When the deliverable commodity is not in plentiful supply (or when it does not yet exist) rational pricing
cannot be applied, as the arbitrage mechanism is not applicable. Here the price of the futures is
determined by today's supply and demand for the underlying asset in the futures.
In a deep and liquid market, supply and demand would be expected to balance out at a price which
represents an unbiased expectation of the future price of the actual asset and so be given by the simple
relationship.
By contrast, in a shallow and illiquid market, or in a market in which large quantities of the deliverable
asset have been deliberately withheld from market participants (an illegal action known as cornering the
market), the market clearing price for the futures may still represent the balance between supply and
demand but the relationship between this price and the expected future price of the asset can break
down.
[edit] Relationship between arbitrage arguments and expectation
The expectation based relationship will also hold in a no-arbitrage setting when we take expectations
with respect to the risk-neutral probability. In other words: a futures price is martingale with respect to
the risk-neutral probability. With this pricing rule, a speculator is expected to break even when the
futures market fairly prices the deliverable commodity.
[edit] Contango and backwardation
The situation where the price of a commodity for future delivery is higher than the spot price, or where a
far future delivery price is higher than a nearer future delivery, is known as contango. The reverse,
where the price of a commodity for future delivery is lower than the spot price, or where a far future
delivery price is lower than a nearer future delivery, is known as backwardation.
[edit] Futures contracts and exchanges

Contracts
There are many different kinds of futures contracts, reflecting the many different kinds of "tradable"
assets about which the contract may be based such as commodities, securities (such as single-stock
futures), currencies or intangibles such as interest rates and indexes. For information on futures markets
in specific underlying commodity markets, follow the links. For a list of tradable commodities futures
contracts, see List of traded commodities. See also the futures exchange article.
• Foreign exchange market

• Money market
• Bond market
• Equity market
• Soft Commodities market
Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and
similarly in Holland with tulip bulbs. Trading in the US began in the mid 19th century, when central
grain markets were established and a marketplace was created for farmers to bring their commodities
and sell them either for immediate delivery (also called spot or cash market) or for forward delivery.
These forward contracts were private contracts between buyers and sellers and became the forerunner to
today's exchange-traded futures contracts. Although contract trading began with traditional commodities
such as grains, meat and livestock, exchange trading has expanded to include metals, energy, currency
and currency indexes, equities and equity indexes, government interest rates and private interest rates.
Exchanges
Contracts on financial instruments were introduced in the 1970s by the Chicago Mercantile Exchange
(CME) and these instruments became hugely successful and quickly overtook commodities futures in
terms of trading volume and global accessibility to the markets. This innovation led to the introduction
of many new futures exchanges worldwide, such as the London International Financial Futures
Exchange in 1982 (now Euronext.liffe), Deutsche Terminbörse (now Eurex) and the Tokyo Commodity
Exchange (TOCOM). Today, there are more than 90 futures and futures options exchanges worldwide
trading to include: [9]
• CME Group (formerly CBOT and CME) -- Currencies, Various Interest Rate derivatives
(including US Bonds); Agricultural (Corn, Soybeans, Soy Products, Wheat, Pork, Cattle, Butter,
Milk); Index (Dow Jones Industrial Average); Metals (Gold, Silver), Index (NASDAQ, S&P,
etc.)
• IntercontinentalExchange (ICE Futures Europe) - formerly the International Petroleum Exchange
trades energy including crude oil, heating oil, natural gas and unleaded gas
• NYSE Euronext - which absorbed Euronext into which London International Financial Futures
and Options Exchange or LIFFE (pronounced 'LIFE') was merged. (LIFFE had taken over
London Commodities Exchange ("LCE") in 1996)- softs: grains and meats. Inactive market in
Baltic Exchange shipping. Index futures include EURIBOR, FTSE 100, CAC 40, AEX index.
• South African Futures Exchange - SAFEX
• Sydney Futures Exchange
• Tokyo Stock Exchange TSE (JGB Futures, TOPIX Futures)
• Tokyo Commodity Exchange TOCOM
• Tokyo Financial Exchange - TFX - (Euroyen Futures, OverNight CallRate Futures, SpotNext
RepoRate Futures)
• Osaka Securities Exchange OSE (Nikkei Futures, RNP Futures)
• London Metal Exchange - metals: copper, aluminium, lead, zinc, nickel, tin and steel
• IntercontinentalExchange (ICE Futures U.S.) - formerly New York Board of Trade - softs:
cocoa, coffee, cotton, orange juice, sugar
• New York Mercantile Exchange CME Group- energy and metals: crude oil, gasoline, heating oil,
natural gas, coal, propane, gold, silver, platinum, copper, aluminum and palladium
• Dubai Mercantile Exchange
• Korea Exchange - KRX
• Singapore Exchange - SGX - into which merged Singapore International Monetary Exchange
(SIMEX)
• ROFEX - Rosario (Argentina) Futures Exchange
[edit] Codes
Most Futures contracts codes are four characters. The first two characters identify the contract type, the
third character identifies the month and the last character is the last digit of the year.
Third (month) futures contract codes are
• January = F
• February = G
• March = H
• April = J
• May = K
• June = M
• July = N
• August = Q
• September = U
• October = V
• November = X
• December = Z
Example: CLX0 is a Crude Oil (CL), November (X) 2010 (0) contract.
[edit] Who trades futures?

Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the
underlying asset (which could include an intangible such as an index or interest rate) and are seeking to
hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market
moves and opening a derivative contract related to the asset "on paper", while they have no practical use
for or intent to actually take or make delivery of the underlying asset. In other words, the investor is
seeking exposure to the asset in a long futures or the opposite effect via a short futures contract.
Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets
subject to certain influences such as an interest rate.
For example, in traditional commodity markets, farmers often sell futures contracts for the crops and
livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly,
livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost
for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivative products
will use financial futures or equity index futures to reduce or remove the risk on the swap.
An example that has both hedge and speculative notions involves a mutual fund or separately managed
account whose investment objective is to track the performance of a stock index such as the S&P 500
stock index. The Portfolio manager often "equitizes" cash inflows in an easy and cost effective manner
by investing in (opening long) S&P 500 stock index futures. This gains the portfolio exposure to the
index which is consistent with the fund or account investment objective without having to buy an
appropriate proportion of each of the individual 500 stocks just yet. This also preserves balanced
diversification, maintains a higher degree of the percent of assets invested in the market and helps
reduce tracking error in the performance of the fund/account. When it is economically feasible (an
efficient amount of shares of every individual position within the fund or account can be purchased), the
portfolio manager can close the contract and make purchases of each individual stock.
The social utility of futures markets is considered to be mainly in the transfer of risk, and increased
liquidity between traders with different risk and time preferences, from a hedger to a speculator, for
example.
[edit] Options on futures

In many cases, options are traded on futures, sometimes called simply "futures options". A put is the
option to sell a futures contract, and a call is the option to buy a futures contract. For both, the option
strike price is the specified futures price at which the future is traded if the option is exercised. See the
Black-Scholes model, which is the most popular method for pricing these option contracts. Futures are
often used since they are delta one instruments.
[edit] Futures contract regulations

All futures transactions in the United States are regulated by the Commodity Futures Trading
Commission (CFTC), an independent agency of the United States government. The Commission has the
right to hand out fines and other punishments for an individual or company who breaks any rules.
Although by law the commission regulates all transactions, each exchange can have its own rule, and
under contract can fine companies for different things or extend the fine that the CFTC hands out.
The CFTC publishes weekly reports containing details of the open interest of market participants for
each market-segment that has more than 20 participants. These reports are released every Friday
(including data from the previous Tuesday) and contain data on open interest split by reportable and
non-reportable open interest as well as commercial and non-commercial open interest. This type of
report is referred to as the 'Commitments of Traders Report', COT-Report or simply COTR.
[edit] Definition of futures contract

Following Björk[10] we give a definition of a futures contract. We describe a futures contract with
delivery of item J at the time T:
• There exists in the market a quoted price F(t,T), which is known as the futures price at time t for
delivery of J at time T.
• At time T, the holder pays F(T,T) and is entitled to receive J.
• During any time interval (s,t], the holder receives the amount F(t,T) − F(s,T).
• The spot price of obtaining the futures contract is equal to zero, for all time t such that t < T.
[edit] Nonconvergence
This section may contain original research. Please improve it by verifying the claims made and
adding references. Statements consisting only of original research may be removed. More details
may be available on the talk page. (April 2008)
Some exchanges tolerate 'nonconvergence', the failure of futures contracts and the value of the physical
commodities they represent to reach the same value on 'contract settlement' day at the designated
delivery points. An example of this is the CBOT (Chicago Board of Trade) Soft Red Winter wheat
(SRW) futures. SRW futures have settled more than 20¢ apart on settlement day and as much as $1.00
difference between settlement days. Only a few participants holding CBOT SRW futures contracts are
qualified by the CBOT to make or receive delivery of commodities to settle futures contracts. Therefore,
it's impossible for almost any individual producer to 'hedge' efficiently when relying on the final
settlement of a futures contract for SRW. The trend is for the CBOT to continue to restrict those entities
that can actually participate in settling commodities contracts to those that can ship or receive large
quantities of railroad cars and multiple barges at a few selected sites. The Commodity Futures Trading
Commission, which has oversight of the futures market in the United States, has made no comment as to
why this trend is allowed to continue since economic theory and CBOT publications maintain that
convergence of contracts with the price of the underlying commodity they represent is the basis of
integrity for a futures market. It follows that the function of 'price discovery', the ability of the markets
to discern the appropriate value of a commodity reflecting current conditions, is degraded in relation to
the discrepancy in price and the inability of producers to enforce contracts with the commodities they
represent.[11]
[edit] Futures versus forwards

While futures and forward contracts are both contracts to deliver an asset on a future date at a
prearranged price, they are different in two main respects:
• Futures are exchange-traded, while forwards are traded over-the-counter.
Thus futures are standardized and face an exchange, while forwards are customized and face a
non-exchange counterparty.
• Futures are margined, while forwards are not.
Thus futures have significantly less credit risk, and have different funding.
[edit] Exchange versus OTC
Futures are always traded on an exchange, whereas forwards always trade over-the-counter, or can
simply be a signed contract between two parties.
Thus:
• Futures are highly standardized, being exchange-traded, whereas forwards can be unique, being
over-the-counter.
• In the case of physical delivery, the forward contract specifies to whom to make the delivery.
The counterparty for delivery on a futures contract is chosen by the clearing house.
[edit] Margining
For more details on Margin, see Margin (finance).
Futures are margined daily to the daily spot price of a forward with the same agreed-upon delivery price
and underlying asset (based on mark to market).
Forwards do not have a standard. They may transact only on the settlement date. More typical would be
for the parties to agree to true up, for example, every quarter. The fact that forwards are not margined
daily means that, due to movements in the price of the underlying asset, a large differential can build up
between the forward's delivery price and the settlement price, and in any event, an unrealized gain (loss)
can build up.
Again, this differs from futures which get 'trued-up' typically daily by a comparison of the market value
of the future to the collateral securing the contract to keep it in line with the brokerage margin
requirements. This true-ing up occurs by the "loss" party providing additional collateral; so if the buyer
of the contract incurs a drop in value, the shortfall or variation margin would typically be shored up by
the investor wiring or depositing additional cash in the brokerage account.
In a forward though, the spread in exchange rates is not trued up regularly but, rather, it builds up as
unrealized gain (loss) depending on which side of the trade being discussed. This means that entire
unrealized gain (loss) becomes realized at the time of delivery (or as what typically occurs, the time the
contract is closed prior to expiration) - assuming the parties must transact at the underlying currency's
spot price to facilitate receipt/delivery.
The result is that forwards have higher credit risk than futures, and that funding is charged differently.
In most cases involving institutional investors, the daily variation margin settlement guidelines for
futures call for actual money movement only above some insignificant amount to avoid wiring back and
forth small sums of cash. The threshold amount for daily futures variation margin for institutional
investors is often $1,000.
The situation for forwards, however, where no daily true-up takes place in turn creates credit risk for
forwards, but not so much for futures. Simply put, the risk of a forward contract is that the supplier will
be unable to deliver the referenced asset, or that the buyer will be unable to pay for it on the delivery
date or the date at which the opening party closes the contract.
The margining of futures eliminates much of this credit risk by forcing the holders to update daily to the
price of an equivalent forward purchased that day. This means that there will usually be very little
additional money due on the final day to settle the futures contract: only the final day's gain or loss, not
the gain or loss over the life of the contract.
In addition, the daily futures-settlement failure risk is borne by an exchange, rather than an individual
party, further limiting credit risk in futures.
Example: Consider a futures contract with a $100 price: Let's say that on day 50, a futures contract with
a $100 delivery price (on the same underlying asset as the future) costs $88. On day 51, that futures
contract costs $90. This means that the "mark-to-market" calculation would require the holder of one
side of the future to pay $2 on day 51 to track the changes of the forward price ("post $2 of margin").
This money goes, via margin accounts, to the holder of the other side of the future. That is, the loss party
wires cash to the other party.
A forward-holder, however, may pay nothing until settlement on the final day, potentially building up a
large balance; this may be reflected in the mark by an allowance for credit risk. So, except for tiny
effects of convexity bias (due to earning or paying interest on margin), futures and forwards with equal
delivery prices result in the same total loss or gain, but holders of futures experience that loss/gain in
daily increments which track the forward's daily price changes, while the forward's spot price converges
to the settlement price. Thus, while under mark to market accounting, for both assets the gain or loss
accrues over the holding period; for a futures this gain or loss is realized daily, while for a forward
contract the gain or loss remains unrealized until expiry.
Note that, due to the path dependence of funding, a futures contract is not, strictly speaking, a European
derivative: the total gain or loss of the trade depends not only on the value of the underlying asset at
expiry, but also on the path of prices on the way. This difference is generally quite small though.
With an exchange-traded future, the clearing house interposes itself on every trade. Thus there is no risk
of counterparty default. The only risk is that the clearing house defaults (e.g. become bankrupt), which is
considered very unlikely.
Front Office
1. The front office is responsible for trade capture and execution. This is where the trade originates
and the client relationship is maintained. The front office makes/takes orders and executions.
Traders and sales staff are considered front office staff.
Middle Office
2. The middle office, as the name implies, is a hybrid function between the front and back office.
The middle office handles validations (of stock orders), bookings (orders) and confirmations.
Technically, these are all back office operations, however, they often require the help of front
office staff to resolve.
Back Office
3. The back office exists for three reasons: clearance, settlements and accounting. These three
function interact directly with external agencies like the custodian (actual holder of the security),
the clearing firm (third party) and a commercial bank. The back office maintains external
relationships and control functions and is where the trade ends.
Trade Life Cycle Events

Wednesday, May 26, 2010
By Plaban Roy Bhowmik
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A trade is partially terminated when there is a change in the notional of the trade and it is not pre-fixed
according to the agreement.
Introduction
Every trade has its own life cycle. The entire Life Cycle of a trade can be broken down into pre-trade
and post-trade events. Before going into the details of the trading events, let me explain how a trading
deal is being struck between two entities.
We know that one of the primary usages of derivative contract is to hedge the risk. Let us consider that a
company has got a floating rate liability in LIBOR (London Inter Bank Offered Rate) and it wants to
convert its liability into a fixed rate. The feasible option would be to enter into an Interest Rate Swap.
The company would strike a deal with a bank and enter into a swap where it would pay fixed rate to the
bank and receive floating rate. The company and the bank would enter into a trade and the trade passes
through various stages. The various trade events can be categorized into Front Office, Middle Office and
Back Office activities which are explained below: -
Front Office: The FO forms the stage where the trade gets initiated. Here, the order gets placed and the
entity will price the instrument and give the quote to the counterparty. If the counterparty agrees to the
details of the trade and is willing to enter into the deal, the trade gets executed. The trade is then
captured in the trading desk usually using a deal capture system. The deal capture system validates all
the necessary trade economics before assigning a trade reference number. Subsequent trade events like
amendment, cancellation would refer to the trade with the help of the identifier. An acknowledgement is
being sent to the counterparty with the trade details who confirms it back.
Middle Office: The important function that MO performs is to do the Limits and Risk Management.
The Limits are being calculated at a business hierarchy level. The usual hierarchy would be at a
Portfolio level and subsequently aggregating to a Trader Level, a Desk Level, an Entity Level, and
finally to a Group Level. Validations are being done on the trade captured, and in case of any
discrepancy, an exception is being raised.
The MO plays a vital role in the exception management. The trade gets enriched by static data like the
standard settlement instructions of the counterparty, Custodian details, City holidays, etc.
Such static data details are important for the completion and settlement of the trade. The allocation of
the trade is done in the MO and finally the trade is being pushed to the BO and the trade goes live.
Back Office: The BO is the back bone of the entire life cycle of the trade. The BO mostly deals with the
operational activities like record keeping, confirmation, settlement and regulatory reporting. In most
cases, BO activities are being outsourced to cheaper sources to cut down on costs for the company.
The Life Cycle of such a trade can be categorized into pre-trade events and post-trade events which are
discussed below: -
Pre-Trade Events
Setting up a Master Agreement: It is a standardized contract between the counterparties and should be
there in place before the two parties enter into a deal. For derivative contracts, the Master Agreement is
drafted according to ISDA protocols.
Define Product Characteristics: Every Deal has to be defined by some primary characteristics called
the primary economics of the trade. In case of a Plain Vanilla Interest Rate Swap, the economics of trade
would be as follows: -
Pre-Trade Negotiation: In this stage the client tries to reach a preliminary agreement with the bank.
This stage may include documentation, indication of the interest rate and defines the criteria for
executing a trade which may include the credit support and the bank policies which the counterparty has
to abide by.
Request for Quote: The client will ask for a quote to the bank, say the fixed rate against LIBOR.
Provide Quote: The bank will provide the quote which may be through their traditional channels like
phone, fax and email, or through standardized channel as provided by Swaps wire.
Request Trade Pricing Inputs: The Client will ask inputs which will help to price the product. It may
relate to volatility of the underlying in some cases. The trade is priced after matching every detail of the
trade. For an IRS, both the parties will agree to the rates when the Net Present Value of the swap is zero.
Trade Execution & Immediate Post-Trade Events
Execution of Trade: When both the parties agree to the details of the trade and are willing to enter into
the deal, the trade gets executed.
Confirmation: The bank would draft an inception document capturing all the trade details and send it to
the counterparty to get it confirmed. The counterparty will check the details of the trade and sign it back
confirming the trade on its behalf. The communication of confirmation can be through SWIFT, Telex,
Fax, or through other similar medium of financial information exchange.
Notional
Maturity
Fixed Rate
Floating Rate
Trading Book
Allocation of Trade: Some trades have to be allocated to various sub entities. This is called allocation
of trade and is done for flexibility of Profit & Loss Booking.
Creation of Standard Identifier: Every trade will be stored with the help of a unique Trade ID which is
used to identify the trade.
Post-Trade Changes
Amendment: The trade can be amended by the consent of both the parties. The amendment can be done
in terms of the economics of the trade. If a trade is being booked incorrectly, then the amendments can
be done to the booked trade with the agreed changes and it can be re-booked.
Counterparty Changes:
Assignment / Novation: Novation can be explained by an example. Suppose A and B has entered into a
trade, and then C wants to enter and take A's position, or A wants to exit and let C take its position, then
whoever is at an advantageous position will receive some novation fee. The most important thing is
there should be consent from B for C to come in, through a Consent Letter, and B is called the remaining
party. The assignment of the new counterparty can be done by the bank or the new counterparty can be
assigned by the counterparty himself.
Give Ups: In a Give up Trade, the client will execute a transaction at a price supplied by an executing
broker but then faces the prime broker as the counterparty. The prime broker mirrors the transaction
with the executing broker as the counterparty and effectively intermediates between the two.
Partial Termination: A trade is partially terminated when there is a change in the notional of the trade
and it is not pre-fixed according to the agreement.
Full Termination: This indicates the full termination of the deal before the maturity of the trade. This
may or may not entail a termination fee.
Normal Termination: A trade is normally terminated when it gets matured.
Servicing Events
Rate Fixing: The Floating Rate has to be fixed every period for the cash flow settlement of the floating
rate leg. The fixing rule can be defined and it may differ on a trade to trade basis. The Floating Rate may
be fixed in advance or at the end of the period according to the fixing rule set for the trade.
Payment:
Cash Flow Settlement: Every settlement term, there will be cash flow that the entity will pay and
receive. The cash flow will happen according to the standard settlement instructions. In case of the
Interest Rate Swap, it will be the Pay Flow and Receive Flow.
Fee: A trade may have scheduled and non-scheduled fee event. A payment of brokerage or option
premium might be booked as a fee for the records.
Revaluation: The trade can be revalued at intermediate stage according to the market interest rates at
that point of time. That is, the future cash flows are discounted to find out the present value and then the
NPV is calculated to find out the position of the entity on that particular trade. This is done for
accounting purpose.
Conclusion
The entire Trade Life Cycle is a labyrinth of complex functions where the trade passes through a stream
of different events. There is a lot of manual intervention in all these events and this increases the time
bucket for processing and settlement of the various functions. The answer to this is STP (Straight
through Processing), where the transactions can be conducted electronically without the need of re-
keying or manual intervention. The market today is definitely moving towards such a solution.
Securities Trade Life Cycle

Posted on 11. Apr, 2009 by khader in Finance
It is important to know the big picture of securities trade life cycle. I have been conducting this little
workshop on this topic. This workshop covers the following topics. You can also download
the presentation Securities Trade Processing(PPT/PDF).
CONTENTS:
• Introduction
• Brokerage Firm/Securities Trading Organization
• Trade Life Cycle
• Order Origination / Front Office
• Order Validation / Middle Office
• Settlement / Back Office
• Custodians, Commercial Banks
• References

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Derivative (finance)

From Wikipedia, the free encyclopedia

OTC, non organized

Derivatives are usually broadly categorized by:

Another arbitrary distinction is between:[3]

• vanilla derivatives (simple and more common); and

This section does not cite any references or sources.

Derivatives traders at the Chicago Board of Trade.

[edit] Speculation and arbitrage

[edit] Common derivative contract types

There are three major classes of derivatives:

• interest rate derivatives (the largest)

Some common examples of these derivatives are:

Other examples of underlying exchangeables are:

• Property (mortgage) derivatives

[edit] Market and arbitrage-free prices

Two common measures of value are:

[edit] Determining the market price

[edit] Determining the arbitrage-free price

[edit] Possible large losses

See also: List of trading losses

[edit] Counter-party risk

Some derivatives (especially swaps) expose investors to counter-party risk.

[edit] Large notional value

[edit] Leverage of an economy's debt

[edit] Government regulation

Options: Calls and Puts

Calls and Puts

The Parties to an Option

At-the-Money, In-the-Money, Out-of-the-Money

Intrinsic Value and Time Value

Interest rate swap

A pays fixed rate to B (A receives variable rate)

B pays variable rate to A (B receives fixed rate).

[edit] Fixed-for-floating rate swap, same currency

[edit] Floating-for-floating rate swap, same currency

Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating rate in

[edit] Floating-for-floating rate swap, different currencies

Party P pays/receives floating interest in currency A indexed to X to receive/pay floating rate in

[edit] Fixed-for-fixed rate swap, different currencies

[edit] Other variations

[edit] British local authorities

[edit] Valuation and pricing

Thus, the swap requires no upfront payment from either party.

[edit] Market size

Factors Influencing the Price of an Option

Historical volatility estimates volatility based on past prices.

Option Pricing Models

Since then, several variations have been developed.

Credit default swap

o 12.1 In the news

[edit] Not insurance

[edit] Sources of market data

• Specific settlement differences

[edit] Market as of 2008

[edit] Regulatory concerns over CDS

[edit] Market as of 2009

[edit] Government approvals relating to Intercontinental and its competitor CME

SEC spokesperson John Nestor stated

[edit] Clearing house member requirements

[edit] Terms of a typical CDS contract

Date Name Final price as a percentage of par

[edit] Pricing and valuation