Term / Definition

Amortising Swap - An interest rate swap contract that has a reducing principal or notional amount over the term of the contract period. The appropriate market swap rate from which to price an amortising swap is the weighted average maturity, not the final maturity date.

Arbitrage - A method or action that allows the securing of a profit (with no market risk) by taking advantage of a mis-pricing of one financial instrument between two market makers.

Asset/Liability Management - The management process a bank uses to ensure its assets (loan made to customers) matches its liabilities (deposits taken from customers).

Average Rate Forward - A series of forward exchange contracts to different dates for the same amount, but at different rates. The series of contracts is re-stated as one contract at the one average rate. Also called a “par forward”.

Balloon Payment - The repayment terms of a loan being the full principal amount due for repayment in one amount on the final maturity date. Also called a “bullet” payment.

Bank Bill - A “bill of exchange” security document issued by a corporate borrower, but guaranteed by a bank, who then in turn sells the security into the bank/investor market to re-liquefy itself with cash. Normally for terms of 30, 60, 90 or 180 days.

Barrier Option - An option that will come into existence or cease to exist if the underlying asset, currency, commodity price trades at a pre-determined price prior to expiration.

Base Rate - Normally a lending bank’s cost of funds/interest rate for a particular funding period. The base or “prime” rate will be changed by the bank from time to time, but not every day like market rates.

Basis Point(s) - In financial markets it is normal market practice to quote interest rates to two decimal places e.g. 6.25% - one basis point is the change from 6.25% to 6.26%, one hundred basis points is the change from 6.25% to 7.25%.

Basis Risk - The risk that the interest rate difference between the current physical debt instrument (say, a bank bill) market interest rate and the interest rate quoted for that debt instrument’s future price (say, a bank bill futures price) changes over the period to the date of the future price.

Basis Swap - A variation of an interest rate swap whereby interest payments are exchanged on a floating to floating basis to change the timing of interest payments on a bank loan i.e. quarterly payments swapped to monthly basis.

Benchmark -An agreed market related yardstick that investor returns, funding costs or average exchange rate achieved are compared against for performance measurement purposes.

Bid–Offer Spread - The exchange points (FX) or basis points (interest rates) difference between the bid and offer rate when quoted by a bank is known as the “bid-offer spread”. Banks make their profits from dealing at their own bid and offer prices, thus earning the spread.

Bid Rate - Exchange rates and interest rate securities/instruments that are traded between banks are always quoted as a two-way price. One rate is where the quoting bank will buy – the bid rate, the second rate or price where the bank will sell at – the offer rate.

Bond - The security instrument that is issued by a borrower whereby they promise to repay the principal and interest on the due dates. A bond’s interest rate is always fixed.

Bond FRA - A tailored contract to buy or sell a bond (Government or Corporate) at a fixed interest rate at some specified future date. The Bond FRA contract rate will differ from the current physical market bond yield, depending on the slope of the interest rate yield curve.

Bond Option - The right, but not the obligation, by the owner/holder of the option to buy or sell bonds (Government or Corporate) at a pre-determined interest rate at a specified future date. The buyer pays a “premium” in cash up-front to reduce risk and have insurance-type protection, the seller of grantor of the bond option receiving the premium for assuming the risk.

Call Option - The owner or buyer of a call option has the right, but not the obligation, to buy the underlying debt security/currency/commodity at the price stated in the option contract.

Cap - A series or string of interest rate put options whereby a borrower can have protection against rising short term interest rates, but participate in the lower rates if market rates remain below the “capped rate.” A cap is normally for more than one 90-day funding period. Also called a “ceiling”.

Caplet – A series of call options (caplets) which exist for each period the cap agreement is in existence.

Certificate of Deposit “CD” - A debt instrument (normally short term) issued by a bank to borrow funds from other banks/investors.

Collateralised Debt Obligations - (CDOs) are a type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets. These assets are divided into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Losses are applied in reverse order of seniority and so junior tranches offer higher coupons (interest rates) to compensate for the added default risk. CDOs serve as an important funding vehicle for fixed-income assets.

Closing-Out - The cancellation/termination of a financial instrument or contract before its maturity date, resulting in a realised gain/loss as the current market rate differs from the contract rate.

Collar - Two option contracts linked together into the one transaction or contract. A borrower’s collar is normally a “cap” above current market rates and a “floor” below current rates. Over the term of the collar contract, if rates go above the cap the borrower is protected and pays an interest cost no more than the cap rate. Likewise, if market rates fall below the floor, the borrower pays the floor rate and does not participate in the lower market rates. Also called a “cylinder”.

Collateral - A legal term, means “security”.

Commercial Paper - The debt security instrument issued by a prime (and normally credit-rated) borrower to raise short-term funds (30, 60, 90 or 180 days). Also called “one-name paper” and “promissory notes” issued by competitive public tender to investors, or by private treaty to one investor.

Commoditised - When a financial market or instrument becomes so popular and “plain vanilla” that there is no longer any difference in the prices quoted by participants in the market.

Compound Option - An option contract on the premium of an option i.e. the right, but not the obligation, to enter an option contract at a pre-determined premium amount.

Convexity - A measure of the degree of curve or slope in an interest rate yield curve.

Convertible Bonds - A debt instrument issued to investors by a borrower that has a fixed interest rate for a period and then converts (under a strict pricing formula) to shares in the issuing company.

Coupon - The interest rate and amount that will be paid on the interest due dates of a bond. The coupon will normally differ from the purchase or issue yield/interest rate on a bond instrument.

Counterparty - The contracting party to a financial transaction or financial instrument.

Covenants - Special conditions and financial ratios required to be met or maintained by a borrower for a lender under the legal security documents.

Cover - A term used to describe any action of entering financial instruments that reduces risk or puts protection in place against adverse future price movements.

Credit Default Swap - A credit default swap (CDS) is a credit derivative between two counterparties, whereby one makes periodic payments to the other and receives the promise of a payoff if a third party defaults. The former party receives credit protection and is said to be the "buyer" while the other party provides credit protection and is said to be the "seller". The third party is known as the "reference entity". CDS resemble an insurance policy, as they can be used by debt owners to hedge, or insure against credit events such as a default on a debt obligation. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can also be used for speculative purposes.

Credit Rating – The credit rating of a Corporation/Council is a financial indicator to potential investors of debt securities such as bonds. These are assigned by credit rating agencies such as Standard & Poor's, Moody's or Fitch Ratings and have letter designations such as AAA, B, CC. A poor credit rating indicates a high risk of defaulting, therefore constitutes a higher level of interest rates.

Credit Risk - The risk that the other party to a financial transaction (bank deposit, interest rate swap contract) will default on or before the maturity date and not be able to fulfil their contractual obligations.

Credit Spread - The interest rate difference (expressed as basis points) between two types of debt securities. The credit spread being a reflection of the difference in credit quality, size and liquidity between the two securities e.g. five year corporate bonds may be at a credit spread of 200 basis points above Government bonds.

Cross Currency Interest Rate Swap - A borrower exchanges (swaps) one set of interest payments. From a loan in one currency for another set of interest payments in a second currency. Interest payments are swapped from fixed to floating and vice verse. See “Interest Rate Swaps”.

Debenture - A debt instrument similar to a bond whereby a borrower (normally a finance company) borrowers for a longer term at a fixed rate. Also a legal instrument provided as security to a lender.

Delta - “Greek” letter that measures how the price of an option (premium) changes given a movement in the price of the underlying asset/instrument.

Derivative(s) - A “paper” contract whose value depends on the value of some “underlying” asset e.g. sharemarket stocks, bank bills, bonds or foreign currency. Also called a “synthetic”. The value of the assets will change as its market price changes, the derivative instrument will correspondingly change its value.

Digital Option - An option contract that provides a predetermined payout based on an agreed and contracted market price path.

Discount - A bond or bank bill is discounted when the interest rate is applied to the face value of the security and the net proceeds after deducting the interest is paid out to the borrower. Investors pay for the discounted (NPV) value at the commencement of the investment and receive the interest coupon payments along the way and the full face value at the maturity date.

Duration - Not the simple average maturity term of a debt or investment portfolio, but a measure of the interest rate risk in a portfolio at a particular point in time. The duration of a portfolio is the term (measured in years and months) if the total portfolio of bonds/fixed interest investments was revalued at market rates and expressed as one single bond. The profit/loss on revaluation of a one basis point movement being the same in both cases.

Earmarking - purchased options on foreign exchange may be entered for short periods, but “earmarked” as cover related to longer periods and reported as such against risk control limits. The options being used as an entry tactic to longer dated forward cover.

Embedded Option - An option arrangement that may be exercised by or on a borrower at a future date, but the determining conditions are buried or “embedded” in a separate debt or financial instrument.

Eurobond - A fixed rate bond issued by a non-resident borrower in a European country.

Eurodollar - The borrowing and depositing of a currency outside its domestic financial markets.

Event Risk - The risk of a major/unforeseen catastrophe e.g. earthquake, Y2K, political elections, adversely affecting a company’s financial position or performance.

Exchange – Traded - A currency, debt or financial instrument that is quoted and traded on a formal exchange with standardised terms, amounts and dates.

Exercise Date/Price - The day and fixed price that an option contract is enforced/actioned or “exercised” because it is in the interests of one of the parties to the contract to do so.

Fair Value - The current market value of an off-balance sheet financial instrument should it be sold or closed-out on the market rates ruling at the balance date.

Federal Reserve - The US Government’s central bank and/or monetary authority.

Fixed Rate - The interest rate on a debt of financial instrument is fixed and does not change from the commencement date to the maturity date.

Floating Rate - The interest rate on a loan or debt instrument is re-set at the ruling market interest rates on the maturity date of the stipulated funding period (usually 90-days).

Floor - The opposite of a “cap”. An investor will buy a floor, or a series/string of call options (the right to buy) to protect against falling interest rates, but be able to invest at higher interest rates if rates move upwards.

Floorlet – A series or string of floor options which exist for each period the floor agreement is in existence.

Forward Exchange Contract - A contract to buy and sell one currency against another at a fixed price for delivery at some specified future date.

Forward Forwards - A forward exchange contract on the forward points for foreign exchange forward contracts i.e. a hedge on the forward points which are determined by the two separate interest rates of the currencies involved.

Forward Points - The difference in interest rates between two currencies expressed as the exchange rate points i.e. 152 forward points is a 0.0152 adjustment to the 0.6500 NZ$/US$ exchange spot rate.

Forward Rate Agreement - A contract (“FRA”) whereby a borrower or investor in Bank Bills agrees to borrow or invest for an agreed term (normally 90-days) at a fixed rate at some specified future date. A FRA is an “over-the-counter” contract as the amount and maturity date is tailored by the bank to the specific requirements of the borrower/investor.

Forward Starting Swap - An interest rate swap contract that commences at a future specified date. The rate for the forward starting swap will differ from the current market rate for swaps by the shape and slope of the yield curve.

Funding Risk - The risk that a borrower cannot re-finance its debt at equal or better terms at some date in the future, in terms of lending margin, bank fees and funding time commitment. Funding risk may increase due the company’s own credit worthiness, industry trends or banking market conditions.

Futures - Exchange-traded financial and commodity markets which provide forward prices for the underlying asset, instrument or commodity. Futures contracts are standardised in amount, term and specifications. Futures markets are cash-based, transacting parties do not take any counter-party credit risk on each other. Deposits and margin-calls are critical requirements of all futures markets.

Gamma - “Greek” letter used in option pricing that measures how rapidly the delta of an option changes given a change in the price of the underlying asset/instrument.

Hedging - The action of reducing the likelihood of financial loss by entering forward and derivative contracts that neutralise the price risk on underlying financial exposures or risks. The gain or loss due to future price movements on the underlying exposure is offset by the equal and opposite loss and gain on the hedge instrument.

High-Yield Bonds - Corporate bonds issued by borrowing companies that are non-prime i.e. have a low or no credit rating. The margin or credit spread above Government bond yields is high (>300 basis points) to compensate the investor into the bond for the higher credit and liquidity risk.

Implied Volatility - Used in option pricing. To estimate the future volatility of the underlying asset or instrument, the option pricing models use historical volatility (expressed as a percentage) as a key variable to calculate the option premium amount. The movement in option prices is therefore a good indicator of future market volatility, as volatility is “implied” in the option price.

Index Linked Bonds - Debt instruments that pay an interest coupon or return that is wholly or partially governed by the performance of another separate index e.g. a sharemarket index, or the gold price.

Indirect FX Risk - A company has indirect foreign exchange risk where their costs, revenues or profits can be adversely affected by exchange rates that they are not directly paying or receiving. The prices they pay or receive in the domestic currency are influenced by the exchange rate movements.

ISDA - International Security Dealers Association: a governing body that determines legal documentation/standards for over-the-counter swaps/options/FRAs and other derivative instruments for interest rates, currencies, commodities etc. Corporate users of such instruments sign an ISDA Master Agreement with banking counterparties that covers all transactions.

Interest Rate Swaps - A binding, paper contract where one party exchanges, or swaps, its interest payment obligations from fixed to floating basis, or floating to fixed basis. The interest payments and receipts under the swap contract being offsetting, equal and opposite to the underlying physical debt.

“In-the-Money” Option - An option contract that has a strike price/rate that is more favourable or valuable than the current market spot or forward rate for the underlying currency/instrument.

Inverse Yield Curve - The slope of the interest rate yield curve (90-days to 10 years) is “inverse” when the short-term rates are higher than the long-term rates. The opposite, when short-term rates are lower than long-term interest rates is a normal curve or “upward sloping”. In theory, a normal curve reflects the fact that there is more time, therefore more time for risk to occur in long term rates, hence they are higher to build in this extra risk premium.

Junk Bonds - High yield bonds at the bottom-end of the credit quality spectrum.

Knock-in/Knock-out Options - Option contracts for currencies or interest rates that are either activated or de-activated on pre-determined market rates being achieved.

Liability Management - The policy, strategy and process of actively managing a portfolio of debt.

LIBOR - London Inter-bank Offered Rate, the average of five to six banks quote for Eurodollar deposits in London at 11:00 am each day. The accepted interest rate-fixing benchmark for most offshore loans.

Limit(s) - The maximum or minimum amount or percentage a price or exposure may move to before some action or limitation is instigated. Also called “risk control limits”.

Liquidity Risk - The risk that a company cannot obtain cash/funds from liquid resources or bank facilities to meet foreseen and unforeseen cash requirements. The management of liquidity risk involves working capital management and external bank/credit facilities.

“Long” Position - Holding an asset or purchased financial instrument in anticipation that the price will increase to sell later at a profit.

Look-back Option - An option structure where the strike price is selected and the premium paid at the end of the option period.

Marked-to-Market - Financial instruments and forward contracts are revalued at current market rates, producing an unrealised gain or loss compared to the book or carrying value.

Margin - The lending bank or institution’s interest margin added to the market base rate, normally expressed as a number of basis points.

Medium Term Notes (MTN) - A continuous program whereby a prime corporate borrower has issuance documentation permanently in place and can issue fixed rate bonds at short notice under standard terms.

Multi-currency Facility - A committed banking facility that allows the borrowing of several alternative currencies to the NZ dollar.

Netting - Method of subtracting currency receivables from currency payables (and vice versa) over the same time period to arrive at a net exposure position.

Open Market Operations - are the means of implementing monetary policy by which a central bank controls its national money supply by buying and selling government securities, or other financial instruments. Monetary targets, such as interest rates or exchange rates, are used to guide this implementation.

Open Position - Where a company has purchased or sold an asset, currency, financial security or instrument unrelated to any physical exposure, and adverse/favourable future price movements will cause direct financial loss/gain.

Option Premium - The value of an option, normally paid in cash at the commencement of the option contract, similar to an insurance premium.

Order - The placement of an instruction to a bank to buy or sell a currency or financial instrument at a pre-set and pre-determined level and to transact the deal if and when the market rates reach this level. Orders are normally placed for a specific time period, or “good till cancelled”. The bank must deal at the first price available to them once the market level is reached. Some banks will only take orders above a minimum dollar amount.

“Out-of-the-Money” Option- An option contract which has a strike price/rate that is unfavourable or has less value than the underlying current spot market rate for the instrument.

Over-the-Counter - Financial and derivative instruments that are tailored and packaged by the bank to meet the very specific needs of the corporate client in terms of amount, term, price and structure. Such financial products are non-standard and not traded on official exchanges.

Path Dependent Options – Are characterised by payoffs that are a function of the particular path that asset prices follow over the life of the relevant option. The path of the underlying asset price is used to determine the payoff or the structure of the option. Path dependent options are driven primarily by the ability to reduce option premiums, increase the probability of gain and match underlying assets and liabilities.

Perpetual Issue - A loan or bond that has no final maturity date.

Pre-Hedging - Entering forward or option contracts in advance of an exposure being officially recognised or booked in the records of the company.

Primary Market - The market for new issues of bonds or MTNs.

Proxy Hedge - Where there is no forward or derivative market to hedge the price risk of a particular currency, instrument or commodity. A proxy instrument or currency is selected and used as the hedging method as a surrogate. There needs to be a high correlation or price movements between the two underlying prices to justify using a proxy hedge.

Put Option - The right, but not the obligation to sell a debt security/currency/commodity at the contract price in the option agreement.

‘Real’ Option - Real option analysis applies put option and call option valuation techniques to capital budgeting decisions. A real option is the right, but not the obligation, to undertake some business decision, typically the option to make a capital investment. For example, the opportunity to invest in the expansion of a firm's factory is a real option. In contrast to financial options, a real option is not often tradeable—e.g. the factory owner cannot sell the right to extend his factory to another party, only he can make this decision; however, some real options can be sold, e.g., ownership of a vacant lot of land is a real option to develop that land in the future. Some real options are proprietary (owned or exercisable by a single individual or a company); others are shared (can be exercised by many parties). Therefore, a project may have a portfolio of embedded real options; some of them can be mutually exclusive.

Revaluation - The re-stating of financial instruments and option/forward contracts at current market values, different from historical book or carrying values. If the contracts were sold/bought back (closed-out) with the counterparty at current market rates, a realised gain or loss is made. A revaluation merely brings the contract/instrument to current market value.

Repurchase Agreement (Repo) – A sale and repurchase agreement has a borrower sell securities for cash to a lender and agrees to repurchase those securities at a later date for more cash. The repo rate is the difference between borrowed and paid back cash expressed as a percentage. For example, the RBNZ in open market operations buys securities from financial institutions who agree to buy them back at a cost of OCR plus margin.

Reverse Repo – The same repurchase agreement from the buyers’ perspective, i.e. the seller executing the transaction would describe it as a ‘repo’, while the buyer in the same transaction would describe it as a ‘reverse repo’.

Roll-over - The maturity date for a funding period, where a new interest rate is reset and the debt re-advanced for another funding period.

Secondary Market - The market for securities or financial instruments that develops after the period of the new issue.

“Short” Position - Selling of an asset or financial instrument in anticipation that the price will decrease or fall in value to buy later at a profit.

Spot Rate - The current market rate for currencies, interest rates for immediate delivery/settlement, normally two business days after the transaction is agreed.

Stop Loss - Bank traders use a “stop-loss order” placed in the market to automatically closeout an open position at a pre-determined maximum loss.

Stop Profit – The opposite of a “stop-loss order” where a “stop-profit order” is placed in the market to automatically closeout an open position at a pre-determined maximum gain/profit.

Strike Price -The rate or price that is selected and agreed as the rate at which an option is exercised.

Strip - A series of short-term interest rate FRAs for a one or two year period, normally expressed as one average rate.

Swap Spread - The interest rate margin (in basis points) that interest rate swap rates trade above Government bond yields.

Swaption - An option on an interest rate swap that if exercised the swap contract is written between the parties. The option is priced and premium paid similar to bank bill and bond interest rate options.

Swaption Collar – The simultaneous position of entering into 2 option contracts on 2 interest rate swaps linked together into one transaction. A swaption collar performs similarly to a ‘collar’ where from a borrower’s perspective a top-side position above current market rates and a bottom-side position below current market rates are entered into. On maturity of the options and depending on current interest rates relative to the strike levels on the swaps will determine if either swap is transacted.

Time Value - Option contracts taken for longer-term periods may still have some time value left even though the market rate is a long way from the strike rate of the option and the option is unlikely to be exercised.

Tranches - A loan may be borrowed in a series of partial drawdowns from the facility, each part borrowing is called a tranche.

Treasury - Generic term to describe the activities of the financial function within a company that is responsible for managing the cash resources, debt, foreign exchange risk, and sometimes the commodity price and energy price risk.

Treasury Bill - A short term (<12 months) financing instrument/security issued by a Government as part of its debt funding program.

Vega - Another “Greek” letter that is the name given to the measure of the sensitivity of the change in option prices to small changes in the implied volatility of the underlying asset or instrument price.

Volatility - The degree of movement or fluctuation (expressed as a percentage) of an asset, currency, commodity or financial instrument price over time. The percentage is calculated using mean and standard deviation mathematical techniques.

Yankee Bond - A non-resident US borrower issuing a corporate bond in the domestic US bond market.

Yield - Interest rate, always expressed as a percentage.

Yield Curve - The plotting of market interest rate levels from short term (90-days) to long term on a graph i.e. the difference in market interest rates from one term (maturity) to another.

Yield to Maturity - The Yield to Maturity (YTM) or redemption yield is the yield promised by the bondholder on the assumption that the bond or other fixed-interest security such as gilts will be held to maturity, that all coupon and principal payments will be made and coupon payments are reinvested at the bond's promised yield at the same rate as invested. It is a measure of the return of the bond.

Zero Coupon Bond - A bond that is issued with the coupon interest rate being zero i.e. no cash payments of interest made during the term of the bond, all interest paid on the final maturity date. In effect the borrower accrues interest on interest during the term, increasing the total interest cost compared to a normal bond of paying interest quarterly, half-yearly or annually.