Back Matter

Author(s):
Anne Jansen, Donald Mathieson, Barry Eichengreen, Laura Kodres, Bankim Chadha, and Sunil Sharma
Published Date:
May 1998
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    GlossaryArbitrage.

    Trading strategies designed to profit from price differences for the same or similar goods (assets) in different markets. Historically the term implied little or no risk in the trade, but more recently it has come to include strategies that entail some risk of loss or uncertainty about total profits.

    Broker.

    (1) A person paid a fee or commission for acting as an agent in making contracts, sales, or purchases; (2) a “floor” broker: a person who actually executes someone else’s trading orders on the trading floor of an exchange; and (3) an “account executive”: the person who deals with customers and their orders in commission house offices.

    Carry trade.

    The interest rate arbitrage technique of borrowing in a low-yielding currency and lending in a high-yielding one.

    Counterparty.

    The other party to a contract. For exchange-traded futures and options contracts, the counterparty is usually the exchange itself (an exception is the London International Financial Futures Exchange (LIFFE), where the broker plays this role). For over-the-counter instruments, the counter-party is generally a financial intermediary such as a major money-center bank, an investment or merchant bank, or a securities company.

    Currency swap.

    A transaction in which two counterparties exchange specific amounts of two different currencies at the outset and repay over time according to a predetermined schedule that reflects interest payments and, possibly, amortization of principal. The payment flows in currency swaps (in which payments are based on fixed interest rates in each currency) are generally like those associated with a combination of spot and forward currency transactions.

    Dealer.

    A financial intermediary that makes a market in a financial instrument and hence, as distinct from a broker, participates as a principal in the financial transaction.

    Derivative securities or derivatives.

    Securities whose value is “derived” from the value of other financial securities (called the underlying financial security or instrument).

    Forward contract.

    A cash market transaction in which two parties agree to the purchase and sale of a commodity at some future time under such conditions as the two agree. In contrast to a futures contract, the terms of a forward contract are not standardized; a forward contract is not transferable and usually can be canceled only with the consent of the other party, which often must be obtained for consideration and other penalty. Also, forward contracts are not traded on organized exchanges.

    Futures contract.

    An exchange-traded contract generally calling for delivery of a specified amount of a particular grade of commodity or financial instrument at a fixed date in the future. Contracts are highly standardized and traders need agree only on the price and number of contracts traded. Traders’ positions are maintained at the exchange’s clearing-house, which becomes a counterparty to each trade once it has been cleared at the end of each day’s trading session. Members holding positions at the clearinghouse must post margin, which is marked to market daily. Most trades are unwound before delivery. The interposition of the clearinghouse facilitates the unwinding because a trader need not find his original counterparty, but may arrange an offsetting position with any trader on the exchange.

    Haircut.

    A capital charge representing the fraction of a broker or a dealers’s securities portfolio (or more generally of any portfolio) that cannot be traded but must be held to provide for potential losses.

    Hedging.

    The process of offsetting an existing risk by taking an opposite position on another risk likely to move in the same direction.

    Herding.

    A situation in which traders emulate the actions of other traders.

    Leverage or leverage ratio.

    The proportion of debt to equity.

    Liquidity.

    The ease with which a prospective seller of a financial instrument can find a buyer at the prevailing market price. Liquidity is generally higher in markets in which the volume of trading is larger.

    Long position.

    (1) In the futures market, the position of a trader on the buying side of an open futures contract; and (2) in the options market, the position of a trader who has purchased an option regardless of whether it is a put or a call. A participant with a long call option can profit from a rise in the price of the underlying instrument, while a trader with a long put option can profit from a fall in the price of the underlying instrument.

    Margin.

    An amount of money deposited by both buyers and sellers for futures contracts to ensure performance of the terms of the contract, that is, the delivery or taking of delivery of the commodity or the cancellation of the position by a subsequent offsetting trade at such price as can be attained. Margin in futures markets is not a payment of equity or down-payment on the commodity itself but is rather in the nature of a performance bond or security deposit.

    Off-balance sheet activities.

    Banks’ business, often fee-based, that does not generally involve booking assets and taking deposits (for example, trading of swaps, options, foreign exchange forwards, stand-by commitments, and letters of credit).

    Option.

    The contractual right, but not the obligation, to buy or sell a specified amount of a given financial instrument at a fixed price before or at a designated future date. A call option confers on the holder the right to buy the financial instrument. A put option involves the right to sell the financial instrument.

    Over-the-counter (OTC) trading.

    Trading in financial instruments transacted off organized exchanges. Generally the parties must negotiate all details of the transactions or agree to certain simplifying market conventions. In most cases, OTC market transactions are negotiated over the telephone. OTC trading includes transactions among market-makers and between market-makers and their customers. Firms mutually determine their trading partners on a bilateral basis.

    Position.

    A market commitment. For example, one who has bought futures contracts is said to have a long position, and, conversely, a seller of futures contracts is said to have a short position.

    Repurchase agreements or repos.

    An agreement where the owner of marketable securities agrees to sell them to a financial institution and then buy them back later. The price at which the securities are bought back is slightly higher than the price obtained for their sale. In effect, the financial institution provides a fully collateralized loan to the owner of the securities and the difference between the repurchase price and the sale price is the interest on the loan. Most repos are overnight repos and the agreement is renegotiated the following day. Longer-term agreements are called term-repos.

    Short position.

    (1) In the futures market, the position of a trader on the selling side of an open futures contract; and (2) in the options market, the position of a trader who has sold or written an option regardless of whether it is a put or a call. The writer’s maximum potential profit is the premium received.

    Short sales.

    The sale of assets that a seller does not own.

    Spot.

    Term denoting immediate delivery for cash as distinct from future delivery.

    Swap.

    A financial transaction in which two counterparties agree to exchange streams of payments over time according to a predetermined rule. A swap is normally used to transform the market exposure associated with a loan or bond borrowing from one interest rate base (fixed term or floating rate) or currency of denomination to another.

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