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Financial Derivative Terms - I

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IMM Dates
Dates that standardize the expiry date of any contract. Early usage was in the EuroDollar Futures market. An example makes it clearer.
If you buy a 5 year CDS on Ford on 19 October 2006, the contract will expire on 20 December 2011 and not 19 October 2011. If I buy a 5 year CDS on Ford on 3 November 2006, the contract will still expire on 20th December 2011 and not on November 3rd 2011.
Why? The reason is that Credit markets are highly illiquid (or they were for a substantial period). Without IMM dates, the first contract expires on 19 October 2011 and the second contract will expire on 3 November 2011. Now if you want to unwind the original position on 3 November 2006, after the issue date there would be two different CDS in the market that any potential investor could buy. One that expires on 3 November 2011 and one that expires on 19 October 2011. The latter is an off-the-run contract - which would typically be less preferable by a new client. So, there is a glut of these off-the-run contracts.
By standardizing the expiry dates - an illiquid market is forced to become liquid even if different issue dates are set.
Credit markets now operate using IMM date convention.
Implied Black Volatility
An estimate of an underlying asset's market price volatility using the current prices of the derivative, not the historical price changes of the asset. This measure can be determined by using the Black 76 pricing model for the derivative, that is there are no financing costs related to the derivative contract
Implied Forward Rates
Projected future rates that are determined by the differences in the current rates on the same instrument that have different maturities.
Implied Rate
The difference between current (spot) interest rates and the future (forward) rates.
Implied Volatility
An estimate of an underlying asset's market price volatility using the current prices of the derivative, not the historical price changes of the asset. This measure can be determined by using a pricing model for the derivative such as Black-Scholes. Implied volatility can be thought of as the current market consensus of volatility for the underlying instrument assuming that everyone is using the same theoretical option pricing model.
Index
A statistical measure in a securities market that determines a percentage change over a given time period. In financial markets, an index is an imaginary grouping of securities representing a particular market, for example Standard & Poors 500 which is used as the benchmark for the stock market. Each index acts as a benchmark in terms of a change from a base value.
Index Amortizing Swap
An interest rate swap agreement where the notional principal amount declines over the life of the swap according to a level of short-term money rats such as LIBOR or mortgage interest rates.
Index Option
An option contract on a stock index (basket of stocks) such as Standard and Poors 500. Settlement is made via cash payment as delivery of the underlying is not possible.
Index-linked Principal Protected Bond
A structured investment instrument where the bond's principal is protected and its coupon (yield) is linked to the movement of an index, e.g., DJ EuroStoxx Index. The investor pays par at inception and receives at maturity the par value plus a portion of the performance of the index. There may be a ceiling and/or a floor of the variable coupon rate.
Inflation
The rate at which the general level of prices for goods and services is rising, which has an inverse affect on purchasing power.
Inflation Curve
A graphical representation of inflation rates.
Inflation Index-linked Bond
A bond where the coupon and principal payments are adjusted to compensate for changes in inflation. These payments are adjusted in relation to a Consumer Price Index (CPI) value or a Retail Prices Index (RPI) value for a country.
Inflation Swap
A swap where one party pays the other party the inflation rate on each cashflow date and the other party pays the first party a fixed rate. This rate is calculated as a percentage return of the CPI index over the applicable time period.
Inflationary Risk
The possibility that a security will lose its value due to the effects of inflation.
Instantaneous Volatility
The square root of the expected variance of a stock price per unit time, as the time interval approaches zero.
Interbank Rates
Interest rates set daily charged on very large, short-term loans made between banks.
Interest
The price paid by a borrower for a loan and the money received (return) by a lender of a loan. Usually this money is paid periodically over the life of the loan but not always such as the case for savings accounts (no maturity date) or payments made on the maturity date of the loan (e.g. zero coupon bonds) or security.
Interest Rate
An annual percentage of the amount of money borrowed or lent that is paid calculated by dividing the interest amount by the principal amount.
Interest Rate Cap
An agreement between two parties providing the purchaser an interest rate ceiling or 'cap'. This financial instrument is primarily used by borrowers of floating rate debt in situations where short term interest rates are expected to increase. Rate caps can be viewed as insurance ensuring that the maximum borrowing rate never exceeds the specified cap level.
Interest Rate Collar
A combination of a purchase of an interest rate cap and a sale of an interest rate floor to create a range for interest rate fluctuations between the cap and floor strike prices to minimize the risk of a significant rise in the floating rate.
Interest Rate Curve
A graph which plots interest rates over a period of time which forms a curve when the points are connected.
Interest Rate Floor
An interest rate floor guarantees a lower bound for the rate of interest received on an investment. This may be used in conjunction with a floating rate note (FRN) to ensure a minimum return on investment.
Interest Rate Guarantee
An option on a forward rate agreement. The agreement specifies that one party agrees to compensate another party if the reference interest rate is higher than the forward rate over a specified future period. A cap is a form of an interest rate guarantee.
Interest Rate Parity
A principle based on the notion that there should be no arbitrage opportunity between the FX spot market, FX forward market, and the term structure of interest rates in the two countries.
Interest Rate Processes
A method to generate a set of possible future interest rate projections that is arbitrage free.
Interest Rate Risk
The potential that a loss in a value of a security, especially a bond, will occur caused by unanticipated fluctuations in the value of the asset because of changes in interest rates. For example, as interest rates rise, bond prices fall and vice versa.
Interest Rate Swap
A contractual agreement between two counterparties to make periodic payments on particular dates in the future for an agreed period of time based on a notional amount and there is no exchange of principal.
There are two types of cashflow payments called legs. A fixed rate payer always buys a swap and makes a series of fixed payments and at the outset of the swap, these cashflows are known. A floating rate payer, makes a series of payments that depend on the future level of interest rates (a quoted index like LIBOR for example) and at the outset of the swap, most or all of these cashflows are not known. In general, a swap agreement stipulates all of the conditions and definitions required to administer the swap including the notional principal amount, fixed coupon, accrual methods, day count methods, effective date, terminating date, cash flow frequency, compounding frequency, and basis for the floating index.
Interpolation
The mathematical process used to obtain an unknown number whose value is in sequence between two known numbers within a series of numbers. For example, if the prices for 2-, 3-, and 5-year Treasury notes are known, the price for a 4-year Treasury note can be determined. Interpolated values are not always exact, but they are usually accurate enough for most investors. The process is commonly used for interpolating rates, discount factors and volatilities from their respective curves, but can also be used for any application that involves obtaining a continuous set of points from a discrete curve of data. Four methods are in use: linear, cubic spline, exponential and linear spot rate.
Interpolation Methods for Volatility Surface
A mathematical process in the pricing of options used to plot the volatility surface (varying strike prices and expiry dates that assume that the volatility of the underlying fluctuates) from a set of implied volatilities. These methods include:
  • bi-linear: two dimensional (horizontal and vertical),
  • bi-cubic: two dimensional (weighted average of the nearest sixteen pixels in a rectangular grid), and
  • thin plate: produces a smooth continuous surface.
In-the-money Option
Either a call option where the price of the underlying asset is greater that the strike price or a put option where the price of the underlying asset is less that the strike price; therefore the option has intrinsic value.
Intrinsic Value
The amount of any favorable difference between the strike price of an option and the current price of the underlying. For call options, this is the underlying stock's price minus the strike price. For put options, it is the strike price minus the underlying stock's price. In the case of both puts and calls, if the difference between the underlying stock's price and the strike price is negative, the value is zero.
Investment
Something of a certain value now that is given up for something of a possibly uncertain value in the future. Time and risk are the primary attributes of an investment.
Invoice Price
The total payment that a bond buyer must remit to a seller on settlement day. Typically, this is the quoted price plus accrued interest.
Iron Butterfly
An options strategy comprised of a long straddle and a short strangle: a short put, a long call and a long put having the same strike price that is higher than the short put, as well as a short call having the highest strike price.
Iron Condor
An options strategy comprised of a long strangle and a short strangle: a short put, a long put having a higher strike price that the short put, a long call having a higher strike price than the long put as well as a short call having the highest strike price.
Issue Date
The date on which a new security is first offered in the market and is subject to interest accrual.
Issuer
A party or entity that sells a security representing a claim on its assets (an equity security signifying ownership) or its contractual obligation to pay the holder on a future date (a debt security to a lender).
Iterations
Mathematical functions that are repeated.

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