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IAS 32/39 Financial Instruments Part 5: EXPLANATIONS OF TERMINOLOGY

2011

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IFRS WORKBOOKS(1 million downloaded)

Welcome to IFRS Workbooks! These are the latest versions of the legendary workbooks in Russian and English produced by 3 TACIS projects, sponsored by the European Union (2003-2009) and led by PricewaterhouseCoopers. They have also appeared on the website of the Ministry of Finance of the Russian Federation.

The workbooks cover various concepts of IFRS based accounting. They are intended to be practical self-instruction aids that professional accountants can use to upgrade their knowledge, understanding and skills.

Each workbook is a self-standing short course designed for approximately of three hours of study. Although the workbooks are part of a series, each one is independent of the others. Each workbook is a combination of Information, Examples, Self-Test Questions and Answers. A basic knowledge of accounting is assumed, but if any additional knowledge is required this is mentioned at the beginning of the section.

Having written the first three editions, we want to update them and provide them to you to download. Please tell your friends and colleagues. Relating to the first three editions and updated texts, the copyright of the material contained in each workbook belongs to the European Union and according to its policy may be used free of charge for any non-commercial purpose. The copyright and responsibility of later books and the updates are ours. Our copyright policy is the same as that of the European Union.

We wish to especially thank Elizabeth Appraxine (European Union) who administered these TACIS projects, Richard J. Gregson (Partner, PricewaterhouseCoopers) who led the projects and all friends at Bankir.Ru for hosting the books.

TACIS project partners included Rosexpertiza (Russia), ACCA (UK), Agriconsulting (Italy), FBK (Russia), and European Savings Bank Group (Brussels). The help of Philip W. Smith (editor of the third edition) and Allan Gamborg, project managers and Ekaterina Nekrasova, Director of PricewaterhouseCoopers, who managed the production of the Russian version (2008-9) is gratefully acknowledged. Glyn R. Phillips, manager of the first two projects conceived the idea, designed the workbooks and edited the first two versions. We are proud to realise his vision. Robin Joyce Professor of the Chair of International Banking and Finance Financial University under the Government of the Russian Federation

Visiting Professor of the Siberian Academy of Finance and Banking Moscow, Russia 2011 Updated

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Glossary of terms used in IAS 32 and IAS 39 (* = defined elsewhere in this book)

This book comprises explanations of terminology used in IAS 32 and IAS 39. It complements the glossaries contained in the 4 workbooks covering those standards.

American Style Option An option* that can be exercised at any time from inception as opposed to a European Style* option which can only be exercised at expiry.

Amortised costThe amount at which the financial asset* or financial liability* is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the effective interest method* of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment* or uncollectability.

The impact is to spread* commissions, charges, discounts and premiums* paid for the instrument over the life of the instrument, and to consider them as extra (or less) interest added to the stated interest amount. For the borrower, this is an expression of cost. For the lender, it is an expression of income, though the term amortised cost continues (confusingly) to be used

Practical Impact of Amortised Cost

1. A bank granting a loan - (in effect this is amortised income, though referred to as amortised cost)

All income generated by the credit grantor relating to a loan, before it is granted and during the term of the loan, is recognised over the term of the loan, regardless of the timing of the cash flows of the income. Fees received at the inception of the loan are recognised in this manner.

Costs and expenses directly attributable to the loan, with the exception of the direct cost of funds, reduce this income.

The net result of the calculation of all the cash flows at the start and during the term of the loan is the effective interest yield*. These cash flows include changes in the original contract loan amount.

2. The purchase of a bond held to maturity - Amortised Cost

All costs related to the bond, including any premium* (in excess of nominal* rate) or discount (less than nominal rate), paid at the inception of the loan are recognised over the term of the bond, regardless of the timing of the cash flows of the expenses.





The net result of the calculation of all the cash flows at the start and during the term of the loan is the effective interest yield. These cash flows include changes in the original contract bond amount such as a premium redeemed at maturity.

Amortising

The notional principal amount of a financial instrument* is decreased over its life. This reflects the repayments of principal by the borrower, normally according to an agreed schedule .Instruments that have been structured in this way include caps*, collars*, floors*, swaps* and swaptions*.

Asking priceAn expression indicating one's desire to sell a commodity* at a given price; also known as an offer* price.

AssignmentNotice to an option* writer*that an option has been exercised. In the swap* market, assignment is the transfer of a swap obligation to another counterparty.

At-the-moneyAn option* with a strike (contract) price that is equal, or approximately equal, to the current market price of the underlying futures* contract. (It offers no profit and no loss.)

Options are often struck (priced) at-the-money forward (the price now of delivery of a futures contract) but can also be struck (priced) at-the-money spot* (the price now of delivery of a current contract).

This is the point at which the strike is equal to the prevailing spot*price of the underlying futures contract.

An interest rate cap* struck at the current LIBOR*level is at-the-money spot; one struck at the current swap* rate for the period of the cap is at-the-money forward.

An option is in-the-money* (profitable) if it has positive intrinsic value*, because the market price of the underlying financial instrument* is above {below} the strike price* of a call* {put}. (You could exercise the option to buy the instrument, and make a profit by selling it for a higher price in the market.)

If an option is not in-the-money*and is not at-the-money then it is said to be out-of-the-money.* (It currently has no intrinsic value.)

At-the-money spot*http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 4




An option* whose strike price* is equal to the current, prevailing price in the underlying cash spot*market.

At-the-money forward An option* whose strike price* is equal to the current, prevailing price in the underlying forward market.

Available-for-sale financial assetsThose financial assets* that are designated as available-for-sale, or are not classified as (i) loans and receivables, (ii) held-to-maturity investments, or (iii) financial assets at fair value through profit or loss* (see Initial Recognition workbook).

Basis pointMeasurement used in financial markets. One basis point is equal to 1/100 of 1%. 100 basis points = 1%

Basis risk

The risk that prices in the underlying cash market are not exactly correlated with prices in the futures* market. Consequently basis risk is used more generally for the risk that hedges* composed of offsetting positions* in the cash and derivatives* markets become unbalanced.

Bear

Someone who thinks market prices will decline.

Bear market

A period of declining market prices.

Beta (see Greek letters at the end of the book)

Bid-ask spread (see spread*)

Bid An expression indicating one's desire to buy a commodity* at a given price; opposite of offer* or asking* price.

Bond discount and premiumWhen a bond* is issued, the issue price may be at a discount or premium* to the face value (nominal* value) of the bond.http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 5




This allows the issuer to adjust the price to the market conditions at the day of issue.

After a bond is issued, it may trade at a discount or a premium. If it has a fixed rate of return, a general rise in interest rates, or a fall in the issuer’s credit rating, would make the bond less attractive and its price may fall.

As the time approaches the date when the bond pays interest, the price will tend to rise to reflect the imminent interest payment that you will receive soon after buying the bond.

Bonds, notes, billsMarket participants normally use bonds for large issues offered to a wide public, and notes for smaller issues originally sold to a limited number of investors. There are no clear demarcations. There are also "bills" which usually denote fixed income securities* with three years or less from the issue date to maturity.

Bonds have the highest risk, notes are the second highest risk, and bills have the least risk. This is due to a statistical measure called duration (time to maturity), where shorter durations have less risk, and are associated with shorter term obligations.

Bonds are issued by public authorities, credit institutions, companies and supranational institutions (such as World Bank) 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.

Bull

Someone who thinks market prices will rise.

Bull Market

A period of rising market prices.

Call optionA call option* is a financial contract giving the owner the right, but not the obligation, to buy a pre-set amount of the underlying financial instrument* at a pre-set price with a pre-set maturity date*.

The buyer of a call option pays a premium* to the writer* of the option. If the option has no value at the time (in the future) when it can be exercised, the buyer loses the premium, but nothing more. The writer*must provide the pre-set amount of the underlying financial instrument at a pre-set price at that time and takes the risk. If the option is not exercised, the writer profits from the premium. http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 6

http://en.wikipedia.org/wiki/Bond_duration



http://en.wikipedia.org/wiki/Primary_market

http://en.wikipedia.org/wiki/Primary_market


The buyer of a call is expressing a bullish* view of the underlying financial instrument and also implicitly, since he is long* (owns) an option, believes either that volatility* will rise or at least that it will not fall.

For example, in EUR/USD, a EUR call is a USD put and vice versa.

Example of a call option showing different market prices, whether or not the buyer will exercise the option at that price, and the profit (or loss) to the buyer and writer.

Note that at each market price the buyer’s profit = the writer’s loss, and vice versa.

The option will only be exercised if the market price is more than the strike price*.

Buy a call: buyer expects that the price may go up. Pays a premium that buyer will never get back. Buyer has the right to exercise the option at the strike price.

Write a call: writer receives the premium. if buyer decides to exercise the option, writer has to sell the share at the strike price.





Call Option- Buyer's Profit

-20

0

20

40

60

80

100

120

140

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Market prices and profits

$

Market price of share

Profit /(loss) to buyer





Call Option - Writer's Profit

-40

-20

0

20

40

60

80

100

120

140

1 2 3 4

Market Prices and Profits

$

Market price of share

Profit /(loss) to w riter

CallableThe financial instrument* can be terminated by the issuer before the maturity date*. Callable bonds* can be redeemed at their pre-set dates and prices by the issuer (the issuer is buying, so has the call option*). Callable swaps* allow the fixed-rate payer to terminate the swap. Where the fixed-rate receiver has the right to terminate, the swap is known as puttable.

Cap {floor - is the opposite of cap}

Cap – a call option* on an interest rate index*. The option allows the holder*to pay no more than the cap interest rate for his floating-rate loan. Floor – a put option* on an interest rate index. The option allows the holder to receive no less than the cap interest rate for his floating-rate loan.

Above {below} the strike the holder of a cap {floor} with a notional principal equal to an underlying liability is hedged against rises {falls} in interest rates.Caps are therefore used as hedges* against rate rise by borrowers and floors as hedges against rate falls by lenders or investors.

In practice, caps and floors are medium-term agreements under which, in exchange for a one-time upfront premium* payment, the seller





agrees to pay the buyer the difference (if positive) between the strike rate and the current rate at preset times over the life of the cap {floor}, thus establishing a maximum {minimum} interest rate for the holder.

The buyer selects the maturity, interest rate strike level, reference floating rate, reset period and notional principal amount. The maturity of standard caps {floors} means that they are actually made up of a series of caplets (small caps) /single period caps {floorlets (small floors)/single period floors}.

A caplet {floorlet} can be viewed either as a call {put} on an interest rate index or a put {call} on an interest futures* contract or zero coupon* bond. Vanilla caps and floors are not a continuous rate guarantee; claims can only be made on specified settlement dates*.

As claims can only be made on specified settlement dates, caps and floors are best-suited to hedging the interest rate on floating-rate instruments that are reset periodically.

Cash flow hedge

A hedge* of the exposure to variations in cash flows that is attributable to a particular risk associated with an asset or liability, or a highly probable forecast transaction* and could affect profit.

Clean-up calls. An undertaking which services transferred assets may hold a clean-up call* (buy) to purchase remaining transferred assets when the amount of outstanding assets falls to a specified level. At such a low level, the cost of servicing those assets becomes burdensome in relation to the benefits of servicing.

A registration agent that provides dividends and information to clients’ shareholders may seek to purchase shares held by small shareholders to reduce the costs of servicing those shareholders.

CollarA combination of cap* and collar* options in which the holder*of the contract has bought one out-of-the money option call* (or put) and sold out-of-the-money*puts (or calls). These actions lock in the minimum and maximum rates that the collar owner will pay for his loan at expiry.

Collateral (US) / security (UK)The right to an asset which is given to a lender in the event that a borrow defaults on payments for a debt.

Commodity http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 11




An article of commerce or a product that can be used for commerce. In a narrow sense, products traded on an authorised commodity exchange. The types of commodities include (but are not limited to) agricultural products, metals, petroleum, foreign currencies, and financial instruments.

Commodity swapA contract in which counterparties agree to exchange payments related to indices, at least one of which (and possibly both of which) is a commodity index*.

Compound instrument Contains liability and equity* elements in a single contact. Instruments, such as bonds* that are convertible into equity shares, either mandatorily or at the option of the holder, must be split into liability and equity components. Each is then accounted for separately. The liability element is determined first by fair valuing the cash flows excluding any equity component, and the residual is assigned to equity.

Contingent rentPortions of lease payments based on a factor that changes from period to period. Examples are sales in a retail shop, amount of future use of a photocopier, future price indices (to account for inflation). The extra (contingent) rent is payable in addition to the basic rent or lease payment.

Covered call option writing A technique used by investors to help fund their underlying positions*, typically used in the equity* markets. An individual who sells a call* (and takes the risk by having to deliver the financial instrument*) is said to "write" the call. If this individual sells a call on a financial instrument* that he has in his inventory, then the written call is said to be "covered" (by his inventory of the underlying financial instrument). If the investor does not have the underlying in inventory, the investor has sold the call "naked" or ‘’uncovered’’.

Convertible bond

A convertible bond gives a bondholder the right to exchange a bond* for a specified a number of shares of the issuer's ordinary shares.

A debt contract that has an embedded derivative*, such as an option* to convert the instrument debt into ordinary shares, must be viewed and accounted for as having an embedded option. When a contract has such a provision, the embedded portion must be separated from the host contract*and be accounted for as a derivative.

Coupon





The interest rate on a debt instrument expressed in terms of a percent on an annualised basis that the issuer guarantees to pay the holder*until maturity.

Credit riskCredit risk is the risk of loss from a counterparty in default or from a pejorative change in the credit status of a counterparty that causes the value of their obligations to decrease.

Critical terms comparisonThis method consists of comparing the critical terms of the hedging instrument* with those of the hedged item*. The hedge relationship is expected to be highly-effective (well-matched) where all the principal terms of the hedging instrument and the hedged item match exactly – for example:

notional and principal amounts,

credit risk* (AA),

term,

pricing,

re-pricing dates (aligned to test date),

timing,

quantum and

currency of cash flows – and there are no features (such as optionality) that would invalidate an assumption of perfect effectiveness. This method does not require any calculations.

This method may only be used in the limited cases described above, but in such cases it is the simplest way to demonstrate that a hedge is expected to be highly effective (prospective effectiveness testing).

A separate assessment is required for the retrospective effectiveness test, as ineffectiveness may arise even when critical terms match; for example, due to a change in the liquidity of a hedging derivative* or in the creditworthiness of the derivative counterparty. Regression analysis is an acceptable method for testing effectiveness retrospectively.

Currency risk





The risk that a given currency cannot be freely exchanged/delivered for another freely exchangeable 'hard' currency. The holder*of a bond is exposed to the risk that the issuer and defaults on a coupon* or principal payment. A party to a swap* is exposed to the risk that the counterparty does not make payments due under the swap agreement. The late arrival of a receipt in a foreign currency may force the recipient to buy foreign currency from someone else to fulfil commitments, with the costs of commission and a risk that the currency costs more on the transaction day than planned.

Currency swap An exchange of interest rate payments in different currencies on a pre-set notional amount and in reference to pre-determined interest rate indices in which the notional amounts are exchanged at inception of the contract and then re-exchanged at the termination of the contract at pre-set exchange rates.

The parties do not exchange the principal amounts, only the interest.

Current yield* The ratio of the coupon* (interest receivable) to the current market price of the debt instrument.

Debt factoringThe sale of accounts receivable in exchange for cash.

Debt security, with interest or principal linked to commodity* or equity* pricesA loan for which the payments of interest and/or repayments of capital are linked to indices, normally to allow for inflation.

Delta (see Greek letters at the end of the book)

Demand depositDeposit repayable on demand of the lender.

Derecognition (see Derecognition workbook)Removal of a financial asset* or financial liability* from the balance sheet. A financial asset (or part of a financial asset) is derecognised when

– The rights to the cash flows from the asset expire

– The rights to the cash flows from the asset and substantially all risks and rewards of ownership of the asset are transferred

– An obligation to transfer the cash flows from the asset is assumed and substantially all risks and rewards are transferred





– Substantially all the risks and rewards are neither transferred nor retained but control of the asset is transferred.

If the undertaking retains control of the asset but does not retain or transfer substantially all the risks and rewards, the asset is recognised to the extent of the undertaking’s continuing involvement.

A financial liability is removed from the balance sheet only when it is extinguished –that is when the obligation specified in the contract is discharged or cancelled, or expires.

A transaction is accounted for as a collateralised* borrowing if the transfer does not satisfy the conditions for derecognition.

IAS 39 sets out the criteria for derecognition of financial assets and liabilities and the consequential accounting treatment.

An undertaking shall derecognise a financial asset only when:

1. the contractual rights to the cash flows from the financial asset expire; or

2. it transfers the financial asset, and the transfer qualifies for derecognition.

DerivativeA financial instrument* with all three of the following characteristics:

(i)Its value changes in response to the change in a specified interest rate, security price, commodity* price, foreign exchange rate, index* of prices or rates, a credit rating or credit index, or other variable (sometimes called the “underlying financial instrument”);

(ii)It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and

(iii)It is settled at a future date.

Discounted cash flowsPresent value of future cash estimated to be generated.

The discount cash flow approach is consistent with the manner in which assets and liabilities with contractually specified cash flows are commonly described (as in “a 12 percent bond”) and it is useful and well accepted for those instruments.





However, because the cash flow approach places the emphasis on determining the interest rate, it is more difficult to apply to complex financial instruments* where cash flows are conditional or optional, and where there are uncertainties, in addition to credit risk*, that affect the amount and timing of future cash flows.

Dollar offset method A computation of the cumulative derivative* hedging gain or loss on the basis of multiple period historical changes in fair value* of the hedging instrument vis-a-vis changes in the fair value of the underlying financial instrument*. The dollar offset period change ratio is the ratio of the dollar gain or loss of the hedging instrument divided by the dollar gain or loss of the hedged item. The cumulative dollar change ratio is the sum of the gains and losses of the hedging instrument divided by the sum of the gains and losses of the hedged item. This is a quantitative method that consists of comparing the change in fair value or cash flows of the hedging instrument with the change in fair value or cash flows of the hedged item attributable to the hedged risk. Depending on the undertaking’s risk management policies, this test can be performed either (1) on a cumulative basis (ie, with the comparison performed from the inception of the hedge), or (2) on a period-by-period basis (ie, with the comparison performed from the last testing date).

A hedge is effective for IFRS purposes if the results are within the range of 80%-125%.

The dollar offset method can be performed using different approaches, including the following:

The hypothetical derivative approach. The hedged risk is modelled as a derivative called a ‘hypothetical derivative’ (as it does not exist). The hypothetical derivative approach compares the change in the fair value or cash flows of the hedging instrument with the change in the fair value or cash flows of the hypothetical derivative.

The benchmark rate approach. This is a variant of the hypothetical derivative approach. The benchmark rate is a ‘target’ rate established for the hedge. In an interest rate hedge of a variable rate debt instrument using an interest rate swap*, the benchmark rate is usually the fixed rate of the swap at the inception of the hedge. The benchmark rate approach first identifies the difference between the actual cash flows of the hedging item and the benchmark rate. It then compares the change in the amount or value of this difference with the change in the cash flow or fair value of the hedging instrument (see Section 2, Q&A 3.8).

The sensitivity analysis approach. This approach is applied to assess the effectiveness of a hedge prospectively. This method consists of measuring the effect of a hypothetical shift in the underlying hedged risk (for example, a 10% shift in the foreign currency exchange rate being hedged) on both the hedging instrument and the hedged item.





When the dollar offset method is used for assessing retrospectively the effectiveness of a hedge, it has the advantage of determining the amount of ineffectiveness that has occurred and of generating the numbers required for the accounting entries.

Dual currency bondsBonds* that pay coupon* interest in one currency, but pay the principal in a different currency.

Effective interest method: a method of calculating the amortised cost*, or yield*, of a financial asset* or financial liability* and of allocating the interest income or interest expense over the relevant period.

Effective interest rate: the rate that exactly discounts future cash payments or receipts through the expected life of the financial instrument* or, when appropriate a shorter period, to the net carrying amount of the financial asset* or financial liability*.

The result is to add all payments and receipts, other than that of the principal, to the interest charge, and divide by the principal.

When calculating the effective interest rate, an undertaking shall consider all terms of the instrument (for example, prepayment, call* and similar options*) but shall not consider future credit losses.

The calculation includes all fees paid or received, transaction costs*, and all other premiums* or discounts. Normally the cash flows and the expected life of a group of similar financial instruments can be estimated reliably.

If not, the undertaking shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).

Embedded derivativeA component of a combined or compound instrument* where some of the cash flows of the combined or compound instrument*vary in a way similar to a stand-alone derivative*.

An embedded derivative causes some or all of the cash flows of the contract to be modified based on a specified interest rate, security price, commodity* price, foreign exchange rate, index* of prices or rates, or other variable.

A derivative that is attached to a financial instrument* but is transferable independently of that instrument, or has a different counterparty from that instrument, is not an embedded derivative but a separate financial instrument.EquityAny instrument that gives a residual interest in the assets of an undertaking after deducting all of its liabilities.




http://www.bloomberg.com/invest/glossary/bfglosp.htm#principal

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Equity conversion or put option in debt instrumentSee also Convertible Bond* and Warrant*. An equity conversion is a convertible bond allowing the holder*to receive shares in exchange for the bond. A put option* enables the holder to sell the instrument back to the issuer (or other party).

Equity swap A contract in which counterparties agree to exchange payments related to indices, at least one of which (and possibly both of which) is an equity index*.

European style option An option* that can be exercised only at expiry, as opposed to an American Style* option that can be exercised at any time from inception of the contract.

Exchange-traded contract

A futures* or option* contract traded on an organised exchange by exchange members. Exchange-traded contracts tend to be short-term, standardised and limited in complexity, though innovation is changing this.

Exercise price The exercise price is the price at which a call's* (put's*) buyer can buy (or sell) the underlying instrument. Also referred to as strike price*.

Expiration date Options* on futures* generally expire on a specific date during the month preceding the futures contract delivery month. For example, an option on a March futures contract expires in February but is referred to as a March option because its exercise would result in a March futures contract position*.

Fair value The price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. (IFRS 13)

Fair value hedge: a hedge* of the exposure to changes in fair value* of a recognised asset or liability or an unrecognised firm commitment*, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit.





Financial instrument: any contract that gives rise to a financial asset* of one undertaking and a financial liability* or equity* instrument of another undertaking. There are two basic types: (1) a debt instrument, which is a loan with an agreement to pay back funds with interest;

(2) an equity security, which is share or stock in a company.

Financial assetAny asset that is:(1) Cash;

(2) An equity* instrument of another undertaking;

(3) A contractual right:

(i) To receive cash or another financial asset from another undertaking; or

(ii)To exchange financial assets or financial liabilities with another undertaking under conditions that are potentially favourable to the undertaking; or

(4)A contract that will or may be settled in the undertaking’s own equity instruments and is:

(i)A non-derivative for which the undertaking is or may be obliged to receive a variable number of the undertaking’s own equity instruments; or

(ii)A derivative* that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the undertaking’s own equity instruments.

Financial asset or financial liability at fair value through profit or lossA financial asset* or financial liability* that meets either of the following conditions:

(1)It is classified as held for trading at fair value through profit or loss (see ‘trading financial assets and financial liabilities’ below)

A financial asset or financial liability is classified as held for trading if it is:(i) acquired or incurred principally for the purpose of selling or repurchasing it in the near term;





(ii) part of a portfolio* of identified financial instruments* that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking; or

(iii) a derivative* (except for a derivative that is a financial guarantee* contract or a designated and effective hedging instrument).

(2) Upon initial recognition, it is designated at fair value through profit or loss.

An undertaking may use this designation only when doing so results in more relevant information, because either:

(i) it eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as ‘an accounting mismatch’) that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases; or

(ii) a group of financial assets, financial liabilities or both is managed and its performance is evaluated on a fair value* basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the undertaking’s key management personnel (IAS 24, Related Party Disclosures), for example the undertaking’s board of directors and chief executive officer.

An undertaking may also designate an entire hybrid (combined) contract as a financial asset or financial liability at fair value through profit or loss if the contract contains one or more embedded derivatives*, unless:

(1) the embedded derivative (s) does not significantly modify the cash flows that otherwise would be required by the contract; or

(2) it is clear with little or no analysis when a similar hybrid (combined) instrument is first considered, that separation of the embedded derivative(s) is prohibited, such as a prepayment option* embedded in a loan that permits the holder*to prepay the loan for approximately its amortised cost*.

Financial liabilityAny liability that is:

(1) A contractual obligation:http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 20




(i) To deliver cash or another financial asset* to another undertaking; or

(ii) To exchange financial assets or financial liabilities with another undertaking under conditions that are potentially unfavourable to the undertaking; or

(2) A contract that will or may be settled in the undertaking’s own equity* instruments and is:

(i) A non-derivative for which the undertaking is, or may be, obliged to deliver a variable number of the undertaking’s own equity instruments; or(ii) A derivative* that will, or may be, settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the undertaking’s own equity instruments.

For this purpose the undertaking’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the undertaking’s own equity instruments.

Financial guaranteeA contract that requires the issuer to make specified payments to reimburse the holder*for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original, or modified, terms of a debt instrument.

Firm commitmentA binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

Floor (see Cap*)

FlooredThe payout of options, warrants* or swaps* is floored if it is guaranteed to be at least a minimum specified amount. The opposite of capped.

Forecast transactionAn uncommitted but anticipated future transaction. As no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an undertaking any present rights to future benefits, nor a present obligation for future sacrifices.





Forced transactionWhen a company has to liquidate assets quickly to meet immediate demands for payment, therefore not necessarily obtaining the full market price.

Foreign exchange riskThe risk of holding assets or owing money in foreign currencies, which may lead to a profit or loss in your own (functional) currency when it is liquidated.

Forward contract

An agreement to buy or sell a given quantity of a particular asset (such as a currency) at a specified future date at a pre-agreed forward price.

A forward is the over-the-counter*(specialised) equivalent of a future.

The difference between the spot*price and the forward price is largely influenced by the cost of carry, for financial assets* that is interest rates.

For example, for currency transactions, the forward rate for a given future point in time is determined from the interest rate differential between the two currencies.

Forward rate agreement (FRA)

An interest rate contract in which buyer and seller agree to exchange the difference between the current interest rate and a pre-agreed fixed rate, struck on the date of execution of the FRA contract.

If rates have risen, then at maturity the purchaser of the FRA receives the difference in rates from the seller.If they have fallen, the seller receives the difference from the buyer.The buyer of an FRA fixes a future borrowing cost; the seller fixes the rate of return on a future deposit.

FRA prices are quoted as interest rates on the basis of the bid* and offer* yield* levels for the period of the FRA.The FRA rate itself is the implied forward rate for the relevant date.





FRAs are labelled on the basis of the number of months to the start and end of the FRA.So a three-month FRA starting one-month forward is a 1 x 4 FRA or 1 v 4 FRA and a 3 v 9 FRA is trading the implied six-month rate in three months' time.So if the 3 v 9 were trading at 6.90% and a hedger or speculator believed that in three months' time six-month LIBOR*would be above 6.90%, then they would buy the FRA on their desired notional principal.

Unlike interest rate futures*, there are no up-front margin payments.FRAs are the building blocks from which swaps* are constructed.

Forward repurchase agreement (see REPO*)

Functional currency (see IAS 21 workbook)

The primary currency in which an undertaking conducts its operation and generates and spends cash. It is usually the currency of the country in which the undertaking is located and the currency in which the books of record are maintained.

Futures contractsTransferable agreement to deliver or receive during a specific future month a standardised amount of a commodity*.

An exchange-traded obligation to buy or sell a financial instrument* or to make a payment at one of the exchange's fixed delivery dates, the details of which are transparent publicly on the trading floor and for which contract settlement takes place through the exchange's clearinghouse.

Like forwards, futures differ from options* in that they represent an obligation to buy or sell the underlying commodity.

Unlike forwards, they have standard delivery dates, trading units and terms and conditions. They are available on a wide range of financial and commodity assets, generally expire quarterly and can be cash or physically settled. Most importantly, they are traded on exchanges which act as counterparties to all transactions and which run margining systems.

Margin is the collateral* that futures traders must set aside against their positions*. First, an initial margin must be deposited with the clearing house on entering a trade. Thereafter futures positions are marked-to-market daily and a variation margin is paid/received to maintain the required level of collateralisation.





The impact of the exchange acting as a clearing house is that, after agreeing a contract, traders are no longer trading with each other, they are trading directly with the exchange. The role of the exchange and the margin system significantly limit credit risk*.

Gamma (see Greek letters at the end of the book)

Hedge A transaction that offsets an exposure to fluctuations in financial prices of some other contract or business risk. It may consist of cash instruments or derivatives*.

Hedge effectivenessThe degree to which offsetting changes in the fair value* or cash flows of the hedged item* are offset by changes in the fair value or cash flows of the hedging instrument*.

Hedged itemAn asset, liability, firm commitment*, highly-probable forecast future transaction, or net investment in a foreign operation that exposes the undertaking to risk of changes in fair value* or future cash flows and is designated as being hedged*. It holds the risk that the hedging instrument* seeks to minimise.

Hedging instrumentA designated derivative*, or non-derivative financial asset* or non-derivative financial liability*, whose fair value* or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item. It is the tool with which to minimise risks in a hedged item*.

A non-derivative financial asset or non-derivative financial liability may be designated as a hedging instrument for hedge accounting purposes only if it hedges the risk of changes in foreign currency exchange rates.

Held-to-maturity investmentsA financial asset* with fixed or determinable payments and fixed maturity that an undertaking has the positive intent and ability to hold to maturity, unless designated as held for trading or available-for-sale*, or that meet the definition of loans and receivables.

Holder The purchaser of either a call* or put* option or other financial instrument*. Holders receive the right, but not the obligation, to assume a futures* position*.

Host security/ Host contracthttp://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 24




The security to which a warrant* is attached.

Hybrid (combined) contractAn instrument whose returns depend on a combination of risk types or which has been built from several different instruments to produce returns which mimic those of another instrument. A common hybrid is the combination of interest rate or currency swaps*.

Impairment (see IAS 36 workbook)is the risk, or certainty, that some of the interest, dividends or capital of a financial instrument* may not be paid in full, and is similar to making a doubtful debt provision for accounts receivable.

A financial asset* or a group of financial assets is impaired, and impairment losses are incurred, only if there is objective evidence of impairment as a result of a past event that occurred after the initial recognition of the asset.

Expected losses as a result of future events, no matter how likely, are not recognised.

In-the-money spotAn option* with positive intrinsic value* with respect to the prevailing market spot*rate. If the option were to mature immediately, the option holder*would exercise it in order to sell the financial instrument* for a profit. For a call* price to have intrinsic value, the strike* must be less than the spot price*. For a put price to have intrinsic value, the strike must be greater than the spot price.

In-the-money forward An option* with positive intrinsic value* with respect to the prevailing market forward rate. If the option were to mature immediately, the option holder*would exercise it in order to capture its economic value. For a call* price to have intrinsic value, the strike must be less than the forward price. For a put price to have intrinsic value, the strike must be greater than the forward price.

Indexis a term used to refer to the underlying measurable base (e.g a commodity* price, LIBOR, or a foreign currency exchange rate) of a derivative* contract.

By "indexed" it is meant that an uncertain economic event that is measured by an economic index (e.g., a credit rating index, commodity price index, convertible debt, equity* index, or inflation index) defined in the contract.

An equity index might be defined as a particular index derived from common stock price movements such as the Dow Industrial Index or the Standard and Poors 500 Index.




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http://www.bloomberg.com/invest/glossary/bfglosw.htm#warrant


Indexed principal paymentThe capital of a loan that is indexed*, probably to adjust for inflation, throughout the life of the loan.

Insurance contract (see IFRS 4 workbook)

Interest rate riskis the risk that a borrower will pay more interest on a floating rate loan, or a lender will receive less interest on a floating rate loan when general interest rates change.

Fixed rate bonds* are subject to interest rate risk, meaning their market price will decrease in value when the generally prevailing interest rate rises. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield*.

When the market's interest rates rise, then the market price for bonds will fall, reflecting investors' improved ability to get a good interest rate for their money elsewhere — perhaps by purchasing a newly issued bond that already features the newly higher interest rate.

This drop in the bond's market price does not affect the interest payments to the bondholder*at all, so long-term investors may not be concerned about price swings in their bonds, if they are being held to maturity.

Interest rate swap An exchange of cash flows based upon different interest rate indices denominated in the same currency on a pre-set notional amount with a pre-determined schedule of payments and calculations. As an example, one counterparty will receivefixed flows in exchange for making floating payments.

An undertaking may transfer to a transferee a fixed rate financial asset* and enter into an interest rate swap with the transferee to receive a fixed interest rate and pay a variable interest rate based on a notional amount that is equal to the principal amount of the transferred financial asset.

The interest rate swap does not preclude derecognition* of the transferred asset provided the payments on the swap are not conditional on payments being made on the transferred asset.

Intrinsic valueThe economic value of a financial contract. Intrinsic value is an expected future value.

Intrinsic (future) value minus current (present) value of the option* is called time value.




http://en.wikipedia.org/wiki/Market_price

http://en.wikipedia.org/wiki/Interest_rate_risk


Hence, intrinsic value has two components. One is the known current value. The other component is time value.

Leverage (US) Gearing (UK)The ability to control or gain exposure to a large nominal* amount of an underlying asset with a relatively small amount of capital. Futures* and options* are leveraged because with relatively small down payments (of margin or premium*) the buyer acquires exposure to large amounts of the underlying commodity* or financial instrument*.

LeveragedThe use of debt financing, for controlling assets. It increases risk, as the debt must be paid in full even if the asset loses its value.

If the asset is worth 100, but you pay 10 of your money and borrow 90, a rise in the asset to 110 will double your money (excluding interest). If the asset falls to 75, then you will have lost your stake and will have to find an additional 15 to repay the interest.

When used for derivatives* or structured notes 'leveraged' indicates that the instruments payoff formula includes a greater than one multiple of some underlying index* or asset price. In the case of leveraged notes, this is generally achieved using embedded swaps* or options* whose notional principal is greater than the nominal* principal of the bond.

The New York Federal Reserve has defined leveraged derivatives transactions (LDTs) much more broadly as a derivative transaction

(i) in which a market move of two standard deviations in the first month would lead to a reduction in value to the counterparty of the lower of 15% of the notional amount or $10 million and

(ii) for notes or transactions with a final exchange of principal, where counterparty principal (rather than coupon*) is at risk at maturity,

and

(iii) for coupon swaps*, where the coupon can drop to zero (or below) or exceed twice the market rate for that market and maturity, and

(iv) for spread* trades that include an explicit leverage* factor, where a spread is defined as the difference in the yield* between two asset classes. This definition bears no strict relevance to the general concept of leverage but means the reclassification of many previously plain vanilla transactions as LDTs.

LIBORLondon Interbank Offer Rate. The rate of interest paid on offshore funds in the Eurodollar markets.The rate is commonly used as an index* in floating rate contracts, interest rate swaps*, and other contracts based upon interest rate fluctuations.http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 27



http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Index%23Index

http://www.bloomberg.com/invest/glossary/bfglosd.htm#debt


Liquidity risk of financial instruments*The risk that a financial market undertaking will not be able to find a price (or a price within a reasonable tolerance in terms of the deviation from prevailing or expected prices) for one or more of its financial contracts in the secondary market. Consider the case of a counterparty who buys a complex option* on European interest rates. He is exposed to liquidity risk because of the possibility that he cannot find any buyer in the secondary market, and because of the possibility that any price he obtains would be very low causing a substantial loss.

Loans and receivables Non-derivative financial assets* with fixed or determinable payments that are not quoted in an active market, other than:

(i)Those that the undertaking intends to sell in the near term, which shall be classified as held for trading, and those that the undertaking upon initial recognition designates as at fair value through profit or loss*;

(ii)Those that the undertaking upon initial recognition designates as Available-for-sale*; or

(iii)Those for which the holder*may not recover substantially all of its initial investment (other than because of credit deterioration) which shall be classified as available-for-sale.

An interest acquired in a pool of assets that are not loans or receivables (for example, an interest in a mutual fund or a similar fund) is not a loan or receivable.

Long positionThe owner’s position*. One who has bought futures* contracts or owns a cash commodity*. Ownership of an investment position, security, or instrument such that rising market prices will benefit the owner. For example, the purchase of a call* option is a long position because the owner of the call option goes in-the-money* with rising prices. Macro hedge The hedging of a portfolio* of items such as loans rather than the hedging of each item within the portfolio. In some cases, the hedge* is a net hedge of the value of the portfolio's asset items less the value of the portfolio's liability items.

Mark to market accountingA method of accounting most suited for financial instruments* in which contracts are revalued at regular intervals using prevailing market prices. This is known as taking a "snapshot" of the market.

Market riskThe exposure to potential loss from fluctuations in market prices (as opposed to changes in credit status).http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 28



http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Option%23Option


Maturity dateThe date on which the issuer agrees to repay the nominal* amount. As long as all payments have been made, the issuer has no more obligations to the bond holders* after the maturity date. The length of time until the maturity date is often referred to as the term 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.

In the market for U.S. Treasury securities, there are three groups of bond maturities:

short term (bills): maturities up to one year;

medium term (notes): maturities between one and ten years;

long term (bonds): maturities greater than ten years.

Monte-Carlo simulationA generic technique involving the generation of random numbers to solve deterministic problems. It is often used by numerical option pricing models* as an alternative to the binomial process as a simulation of the underlying asset price. Using computers, a Monte-Carlo simulation attempts to simulate the process that generates future movements in the price of the underlying commodity* or financial instrument*.

Each simulation results in a terminal asset value and several thousand computer simulations give a distribution of terminal asset values from which the expected asset value at option expiration can be extracted.

Net investment in a foreign operation The amount of the undertaking's interest in the net assets of that operation.

Net present value (NPV)

The value today of a set of cash flows to be made in the future. For example, because there is no initial premium* payable on a standard interest rate swap*, the present value at initiation of the future fixed- and floating-rate payment streams (the cash inflows and cash outflows) due under the swap must be equal, hence the NPV is zero. http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 29




Nominal, Principal or Face AmountThe original amount of a financial instrument* upon which the issuer calculates future interest payments, and which has to be repaid at maturity*.

The nominal value of the remaining principal used to calculate the cashflows on swaps* and other cash-settled derivatives*. In an interest rate swap*, for example, each period's interest rates are multiplied by the notional principal amount and the number of days to determine the actual amount each counterparty must pay. In interest rate swaps, the notional amounts are not exchanged, so any credit risk* is limited to the net amount payable plus a potential future exposure factor. Descriptions of the size of the derivatives* market almost always refer to notional principal amounts when in fact the amount of money at risk is a tiny fraction of the notional amount.

Non-recourse 1 . In the event of default, the lender (or the person to whom the loan has been assigned) must bear the loss. Debt factors buy accounts receivable from traders. If an account is not paid, the factor must bear the loss, although it can use all legal means to collect the debt. 2. A loan for which no partner or related person bears the economic risk of loss. For example, if a partnership fails to repay a nonrecourse loan, the lender has no recourse against any partner except to foreclose on the assets used to secure the loan.

Offer An expression indicating one's desire to sell a commodity* at a given price; opposite of bid*.

Operational riskAny risk that is not market risk*, liquidity risk* or credit risk* related. This includes the risk of loss from events related to technology and infrastructure failure, from business interruptions, from staff-related problems (including fraud) and from external events such as regulatory changes.

Option (see also Vanilla options)A contract giving the holder*the right but not the obligation to buy {call*} or sell {put*} a specified underlying asset at a pre-agreed price, at either a fixed point in the future (European-style*) or at a number of specified times in the future (Bermudan-style), or at a time chosen by the holder up to maturity (American-style*).

Only the seller of the option is obligated to perform.





Options are available in exchange-traded and over-the-counter* (specialised) form and can also be packaged as securities* either separately (where they are known as warrants*) or embedded* in bonds*.

Option pricing modelsOption* pricing models differ in their approach to volatility* which affects the prices they generate.Black-Scholes and other early single-factor models assume constant volatility.Newer models remedy this error by assuming volatility to be stochastic.

Stochastic volatility helps explain the volatility smile effect as it increases the value of out-of-the-money*forward options relative to the At-the-money* forward options.Stochastic volatility models allow a greater probability to large movements in the underlying instrument than the movements used in simpler models.However, as stochastic volatility is a non-traded source of risk, using it as an input into pricing models loses their completeness - that is the ability to hedge* options with the underlying asset.

Other models assume that the continuously-compounded returns of the asset are normally distributed with a variance that is proportional to the time over which the price change takes place. Such models imply that volatility will increase indefinitely with time.In fact, financial assets* tend to exhibit mean reversion - at a given price extreme it is more likely for the price to move back towards the mean than it is for it to move to a new and more extreme price.

Option seller / option writerThe person who sells an option* in return for a premium* and is obligated to perform when the holder*exercises his right under the option contract. This person has the risk.

Out-of-the-money option An option* with no intrinsic value*, i.e., a call* whose strike price* is above the current futures* price or a put* whose strike price is below the current futures price. In either case, there would be no economic benefit to the holder*to exercise the option.

Out-of-the-money spotAn option* with no intrinsic value* with respect to the prevailing market forward rate. If the option were to mature immediately, the option holder*would let it expire. For a call* price to have intrinsic value, the strike price* must be less than the spot*price. For a put price to have intrinsic value, the strike price must be greater than the spot price.





Over-the-counter (OTC)Any transaction that takes place between two counterparties and does not involve an exchange is said to be an over-the-counter transaction.

Perpetual preferred stock -US (share –UK) Type of capital stock that carries certain preferences over common stock, such as a priority claim on dividends and assets, and cannot be redeemed at the option of the holder. Used by financial institutions to boost their capital structures.

Pledged Asset

Asset placed in a trust and used as collateral* for a debt.

Portfolio/ Basket

A selection of stocks, indices, commodities, currencies or interest rates which can either be traded as a unit themselves or which can be used as the underlying instrument for a derivative* product.

Position A market commitment. The ownership or rights within financial instruments* and/or derivatives* create a position for the holder.

Premium (i) The cost associated with a derivative* contract, referring to the combination of intrinsic value* and time value. It usually applies to options* contracts. However, it also applies to off-market forward contracts*. For example, the price paid to enter into a futures* contract, forward contract, interest rate swap*, warrant, or option is called the premium.

In speaking of price relationships between different delivery months of a given commodity*, one commodity is said to be "trading at a premium" over another commodity when its price is greater than that of the other. In financial instruments*, the dollar amount by which a security trades above its principal value. The price of an option the sum of money that the option buyer pays and the option seller receives for the rights granted by the option.

In the case of exchange-traded contracts* (e.g., options, futures*, and futures options), there is generally a premium. In custom-contract derivatives (e.g., forward contracts, forward rate agreements, swaps and some embedded options), however, it is common to not have any premium paid by one party to the other party. There may be legal fees and brokerage costs, but these are not part of the premium and are accounted for separately. http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 32




(ii) For bonds*, a premium is paid when the market price is higher than the nominal* amount. If the price is 112 and the nominal value is 100, the premium is 12.

(iii) In insurance, the cost of specified coverage for a designated period of time.

Prepayment risk (see also surrender risk)The risk taken by a lender when the borrower repays part of a loan before its scheduled time of maturity*.

The lender will receive less interest as the loan has been paid earlier and may not be able to re-lend the money at such a high rate of interest. This is often the case when national interest rates are falling, and borrowers are able to re-finance their borrowings with cheaper loans.

Present Value

Current value of a given future cash flow stream, discounted at a given rate.

ProspectivelyFrom now on. New accounting policies may be applied prospectively, or retrospectively (when they must be applied to earlier periods).

Purchased optionThe purchaser of an option* pays a premium* and then has the choice of whether to exercise the option or not. The risk is limited to the cost of the premium. (In contrast, the writer* of the option receives the premium and takes the risk.)

Put option

A put option* is a financial contract giving the owner the right, but not the obligation, to sell a pre-set amount of the underlying financial instrument* at a pre-set price with a pre-set maturity* date. The buyer of a put is expressing a bearish (pessimistic) view of the underlying financial instrument and also implicitly, since he is long an option, believes either that volatility* will rise or at least that it will not fall.

In a foreign exchange option, since the option is to exchange one currency for another, all options are call* options on one currency and, by definition, put options on the other currency.For example, in EUR/USD, a EUR call is a USD put and vice versa.

Example of a put option http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 33



http://www.bloomberg.com/invest/glossary/bfglosm.htm#maturity

http://www.bloomberg.com/invest/glossary/bfglosl.htm#loan


showing different market prices, whether or not the buyer will exercise the option at that price, and the profit (or loss) to the buyer and writer.

Note that at each market price the buyer’s profit = the writer’s loss, and vice versa.

The option will only be exercised if the market price is less than the strike price*.

Buy a Put : Buyer thinks price of a share will decrease. Pay a premium* which buyer will never get back. The buyer has the right to sell the share at strike price.

Write a put: Writer receives a premium, if buyer exercises the option, writer will buy the share at strike price, If buyer does not exercise the option, writer's profit is premium.





Put option Premium = $8 Strike price= $176

$ $ $ $Market price of share 140 150 170 180

Exercise option Yes Yes Yes No

Income to buyerSale of share = strike price 176 176 176

Costs to buyer:Premium 8 8 8 8Buy share = market price 140 150 170

148 158 178 8

Profit /(loss) to buyer 28 18 -2 -8

Income to writerPremium 8 8 8 8Share = market price 140 150 170

148 158 178 8

Cost of share = strike price 176 176 176

Profit /(loss) to writer -28 -18 2 8





Put Option - Buyer's Profit

-50

0

50

100

150

200

1 2 3 4


$Market price of share

Profit /(loss) to buyer

Put Option - Writer's Profit

-50

0

50

100

150

200

1 2 3 4


$Market price of share

Profit /(loss) to writer





Puttable Bond

A puttable bond contains an embedded put option* that adds to the value of the package deal of the bond*. The put portion of the package allows the bondholder to demand early redemption at a predetermined strike price* at a certain time in the future. The holder* of such a bond has purchased a put option on the bond as well as the bond itself. Since the put option increases the value of the bondholder, bonds with put features provide lower yields* than bonds with no put feature.

Recourse

A type of loan. If a loan is with recourse, the holder*of the loan the ability to claim from the guarantor of the loan if the borrower fails to pay.

For example, Bank A has a loan with Company X. Bank A sells the loan to Bank K with recourse. If Company X defaults, Bank K can demand Bank A fulfil the loan obligation.

The opposite of recourse is non-recourse*.

Redemption amountPrice to be paid by an undertaking to retire its bonds* or preferred stock.

Regression analysisA statistical method used to investigate the strength of the statistical relationship between the hedged item* and the hedging instrument*. Regression analysis involves determining a ‘line of best fit’ (the trend) and then assessing the ‘goodness of fit’ of this line (how well the line represents the relationship). It provides a means of expressing, in a systematic fashion, the extent by which one variable, ‘the dependent’, will vary with changes in another variable, ‘the independent’.

In the context of assessing hedge* effectiveness, regression analysis establishes whether changes in the hedged item and hedging instrument are highly correlated. The independent variable reflects the change in the value of the hedged item, and the dependent variable reflects the change in the value of the hedging instrument.

From an accounting perspective, regression analysis proves whether or not the relationship is sufficiently effective to qualify for hedge accounting. It does not calculate the amount of any ineffectiveness, nor does it provide the numbers necessary for the accounting entries where the analysis demonstrates that the ‘highly effective’ test has been passed.




http://www.bloomberg.com/invest/glossary/bfglosb.htm#borrow



Regular way purchase or sale A contract for the purchase or sale of a financial asset* that requires delivery of the asset within the time frame established by regulation or convention in the marketplace concerned.

REPO / forward repurchase agreement / sale and repurchase agreementAn agreement between a seller and a buyer, for example government securities*, in which the seller receives a loan, gives the securities as collateral* and agrees to buy back the security at a later date, within a certain time period at a certain price.

RetrospectivelyNew accounting policies must be applied to earlier/prior periods.

Risk-free rateA rate of interest that would be charged if there was no risk of default on a loan. This would only apply to the securities* of certain governments. It would not apply to loans to individuals or commercial undertakings, as such loans would have elements of risk, however small.

Sale and repurchase agreement – see REPO*Securities – debt and equityDebt: a bond of a corporation, government, or quasi- government body. Equity*: common or preferred stock (US) or ordinary or preferred shares (UK).

Securities lendingThe loan of securities* between brokers, often to cover a client's short sale*; or a loan secured by marketable securities.

SecuritisationAsset securitisation is the structured process whereby ownership interests in loans and other receivables are packaged, underwritten, and sold in the form of “asset-backed” securities*.

In essence, securitisation is the open market selling of financial instruments* backed by asset cash flow or asset value.

For example, a credit card company can package its loans to clients into an asset that is sold to another financial institution which issues bond to the public. The bondholders receive payments when the credit card clients pay their credit card bills. The credit card company uses this method to receive cash immediately, rather than to wait for money from its clients.

Security (UK) /collateral* (US) Asset pledged, or to be used, as compensation to a lender if a borrow defaults on payments for a debt.http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 38



http://www.bloomberg.com/invest/glossary/bfglosm.htm#marketable_security

http://www.bloomberg.com/invest/glossary/bfgloss.htm#short_sale

http://www.bloomberg.com/invest/glossary/bfglosb.htm#broker

http://www.bloomberg.com/invest/glossary/bfgloss.htm#security



In the context of project financing, additional security pledged to support the project financing.

Settlement dateThe date at which a payable is paid, or a receivable is collected.

Settlement riskThe risk of non-payment of an obligation by a counterparty to a transaction. This includes both late payments and non-payments, as late payments can cause disruption and additional costs.

Share options (see IFRS 2 workbook)Right to purchase or sell a specified number of shares at specified prices and times.

Short positionOwnership of an investment position*, security*, or instrument such that falling market prices will benefit the owner. For example, the purchase of a put (sell) option* is a short position as the owner of the put option goes in-the-money* with falling prices.

Short Sale

Sale of an item before it is purchased. A person entering into a short sale believes the price of the item will decline between the date of the short sale and the date he or she must purchase the item to deliver the item under the terms of the short sale.

Special purpose enterprises (SPE) special purpose vehicles (SPV)Special purpose enterprises / vehicles are companies set up for the sole purpose of containing assets (for example, pooled mortgage loans, or credit card loans created by the SPV’s originator) against which bonds* are issued, often called asset-backed securities* (see securitisation*).

The SPV has no money of its own. To be able to buy the loans from the originator, it issues tradable "securities" to fund the purchase. The performance of these "securities" is directly linked to the performance of the assets and there is normally no recourse* back to the originator.

SpotThe price in the cash market for delivery using the standard market convention. In the foreign exchange market, spot is delivered for value two days from the transaction date, or for the next day in the case of the Canadian dollar exchanged against the US dollar.

Spot MarketMarket for buying and selling commodities or financial instruments* for immediate delivery and payment based on the settlement conventions of the particular market.http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 39



http://en.wikipedia.org/wiki/Securities

http://en.wikipedia.org/wiki/Securities

http://en.wikipedia.org/wiki/Asset-backed_security

http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Option%23Option



Spread(i) The price difference between two related markets or commodities or the difference in price or yield* between two assets that differ

by type of financial instrument*, maturity, strike or some other factor. A credit spread is the difference in yield between a corporate bond and the corresponding government bond. A yield curve spread is the spread between two government bonds* of differing maturity.

(ii) Interest rate spread – interest income from assets less the income expense on liabilities.

Strike priceThe price at which the holder*of a derivative* contract exercises his right, if it is economically reasonable to do so, at the appropriate point in time, as delineated in the financial product's contract.

It is the price at which the futures* contract underlying a call* or put option* can be purchased (if a call) or sold (if a put). Also referred to as exercise price*.

Strip interest-only, principal-only:

-interest only strip

A contract that calls for cash settlement based upon the interest, but not the principal of a note.

-principal only strip A contract that calls for cash settlement for the principal, but not the interest of a note.

Surrender riskThe risk taken by a lender when the borrower repays a loan before its scheduled time of maturity.The lender will receive less interest, as the loan has been paid earlier and may not be able to re-lend the money at the same rate of interest. This is often the case when national interest rates are falling, and borrowers are able to re-finance their borrowings with cheaper loans.

Swap (see also vanilla swaps*)An agreement in which two parties exchange payments over a period of time. The purpose is normally to transform debt payments from one interest rate base to another, for example, from fixed to floating, or from one currency to another.




http://www.bloomberg.com/invest/glossary/bfglosm.htm#maturity



Financial contract in which two parties agree to exchange net streams of payments over a specified period. The payments are usually determined by applying different indices (e.g., interest rates, foreign exchange rates, equity* indices) to a notional amount. The term notional is used because swap contracts generally do not involve exchanges of payments of principal.

SwaptionOptions* on swaps*.The simplest swaption is an option to pay or receive fixed rate in an interest rate swap*.This can be considered an option to buy or sell a fixed-rate bond versus selling or buying a LIBOR* floating-rate note.

A Payer swaption, gives the owner of the swaption the right to enter into a swap where they pay the fixed interest payments, and receive the floating interest payments. A Receiver swaption, gives the owner of the swaption the right to enter into a swap where they will receive the interest payments, and pay the floating interest payments.

A payer('s) swaption also called a put swaption as it is analogous to a put* on a fixed-rate instrument (that is, an option to issue a bond).

Unlike ordinary swaps, a swaption not only hedges the buyer against downside risk, it also lets the buyer take advantage of any upside benefits. Like any other option, if the swaption is not exercised by maturity*, it expires worthless.

The buyer benefits if rates rise as the option will become more valuable.If rates rise above the fixed rate payable under the swaption, then the holder*can exercise it and swap an existing floating rate liability into an advantageous fixed rate.

Swaptions are usually European style though American-style* swaptions, allowing the buyer of the option to enter into a swap at any time after the exercise date, typically on a payment date, are available.

Swaptions are available on most vanilla* and exotic swaps on most underlying assets.

Key terms:-call* swaption - type of swaption giving the owner the right to enter into a swap where he receives fixed and pays floating

-callable swap - type of swaption in which the fixed payer has the right, but not the obligation, to terminate the swap on or before a scheduled maturity date*

-expiration date*- date by which the option must be exercisedhttp://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 41




-extendible swap - type of swaption in which the counterparties have the right to extend the swap beyond its stated maturity date as per an agreed upon schedule

-put swaption - type of swaption giving the owner the right to enter into a swap where he receives floating and pays fixed

-puttable swap - type of swaption in which the variable payer has the right, but not the obligation, to terminate the swap on or before a scheduled maturity date

SyntheticIn financial contexts, used for any instrument constructed from others so that its cashflows and sometimes risk-reward characteristics replicate those of another asset or liability. Such instruments are created either because certain users cannot buy the components separately or because an arbitrage opportunity allows the synthetic to be purchased {sold} more or less cheaply {expensively} than the straightforward product.

TaintingWhere an undertaking sells or transfers more than an “insignificant amount” of its held-to-maturity* investments, it must reclassify all of them as available-for-sale*. It is then prohibited from classifying any assets as held-to-maturity for the next two full annual financial periods, until confidence in its intentions (that such financial instruments* will actually be held to maturity rather than sold early) is restored.

Tick The smallest allowable price movement for a contract.

Total return swaps. An undertaking may sell a financial asset* to a transferee and enter into a total return swap* with the transferee, whereby all of the interest payment cash flows from the underlying asset are remitted to the undertaking in exchange for a fixed payment or variable rate payment and any increases or declines in the fair value* of the underlying asset are absorbed by the undertaking.

In such a case, derecognition* of the asset is prohibited.

Trading financial assets and liabilities (see also financial asset or financial liability at fair value through profit or loss*)A financial asset* or financial liability* is classified as ‘held for trading’ if it is

(i) acquired or incurred for the purpose of selling or repurchasing it in the near term;





(ii) part of a portfolio* of financial instruments* that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking; or

(iii) a derivative* (except for a derivative that is a designated as effective hedging instrument).

Trade dateThe date at which an undertaking commits itself (by contract) to purchase or sell an asset.

Transaction costsIncremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset* or financial liability*. An incremental cost is one that would not have been incurred if the undertaking had not acquired, issued or disposed of the financial instrument*.

Transaction costs include fees and commissions paid to agents, advisers, brokers and dealers, levies by regulatory agencies and securities* exchanges, and transfer taxes and duties. Transaction costs do not include debt premiums* or discounts, financing costs or internal administrative or holding costs.

Transaction riskThe currency risk* incurred by an undertaking with certain or near-certain cashflows in currencies other than the domestic accounting currency of the undertaking.

Treasury bill A Treasury bill is a short-term U.S. government obligation with an original maturity* of one year or less. Unlike a bond or note, a bill does not pay a semi-annual, fixed rate coupon*. A bill is typically issued at a price below its par value and is therefore a discounted instrument. The level of the discount depends on the level of prevailing market interest rates. In general, the higher short-term interest rates are, the greater the discount. The return to an investor in bills is simply the difference between the issue price and par value, which the investor receives at maturity.

Treasury bondsThe U.S. Treasury uses the word bond* only for their issues with a maturity* longer than ten years, and denotes issue obligations with maturities from between one and ten year notes. Elsewhere in the market this distinction has disappeared, and both bonds and notes are used irrespective of the maturity. Government bonds are typically auctioned.

Treasury shares




http://en.wikipedia.org/wiki/United_States_Treasury


If an undertaking reacquires its own equity* instruments, those instruments (‘treasury shares’) shall be deducted from equity. Such treasury shares may be acquired and held by the undertaking or by other members of the consolidated group.

No gain or loss shall be recognised in profit or loss on the purchase, sale, issue or cancellation of an undertaking’s own equity instruments. Consideration paid or received shall be recognised directly in equity.

The transaction represents a transfer between those holders of equity instruments who have given up their equity interest and those who continue to hold an equity instrument.

The amount of treasury shares held is disclosed separately either on the face of the balance sheet or in the notes. An undertaking provides disclosure in accordance with IAS 24 Related Party Disclosures if the undertaking reacquires its own equity instruments from related parties.

TrustLegal practice where one person (the grantor) transfers the legal title to an asset, called the principal or corpus (trust property), to another person (the trustee), with specific instructions about how the corpus is to be managed and disposed. It is primarily used today in tax planning and charities.

Unit-denominated paymentsPayments that are denominated in units of an internal or external investment fund.

Unit-linking feature A contractual term that requires payments denominated in units of an internal or external investment fund.

Unquoted equity* investmentsA security* traded in the over-the-counter market, or privately purchased, that is not listed on an organised exchange.

Vanilla (standard) options

Key Concepts

An option* is a contract, traded over-the-counter*or on an exchange, that grants the buyer the right to buy (call* option) or sell (put* option) a pre-agreed amount (the notional principal) of a specified asset or index* (the underlying financial instrument*) at a pre-determined price or rate (the strike price*) and time specified in the contract.




http://www.bloomberg.com/invest/glossary/bfgloso.htm#organized_exchange

http://www.bloomberg.com/invest/glossary/bfglosl.htm#listed_security

http://www.bloomberg.com/invest/glossary/bfgloso.htm#o.t.c.

http://www.bloomberg.com/invest/glossary/bfglost.htm#trade



The option holder*is said to exercise the option if he exercises his right to buy or sell the underlying financial instrument.

If exercise is allowed only at the option's maturity then the option is said to be European*-style.If exercise is allowed at any point during the life of the option it is said to be American*-style.If it can be exercised on a number of pre-determined dates it is said to be a Bermudan or Atlantic option.

The seller of the option is also known as the option writer*.The underlying asset can be a foreign exchange rate, an interest rate* or swap* rate, a commodity* or commodity index, an individual equity* or an equity index, baskets of any of these assets or spreads* between them.In exchange for this right, the buyer of most types of option makes an upfront payment, the premium*.

The level of this premium is not straightforward to calculate but depends on, among other things, the option's payoff structure and maturity*, the level of interest rates and the volatility* of the underlying financial instrument.

What distinguishes options from other financial instruments is the asymmetric payments they generate.Options allow their holders to profit when the price of the underlying financial instrument moves in their favour while limiting downside risk to the premium paid.This is unlike the symmetrical payoffs associated with forwards and futures* which are fixed contracts with no choices of payment or delivery for either party.

These are financial instruments whose payoffs are continuous, whose strike prices are fixed, which exist in the same form throughout their maturity and for which a standard upfront premium is payable.

Vanilla (standard) swaps

Key facts





Swaps* are the classic over-the-counter*derivative* instruments.Although they are highly liquid, traded instruments, they remain privately-negotiated contracts between counterparties - though these contracts now take the form of standardised master agreements.

They involve the exchange of fixed and/or floating payment streams based on interest rate, currency, equity*, bond, commodity* and real-estate indices.They enable counterparties to exploit different markets' perceptions of their credit to raise cheaper capital, to access new markets by creating synthetic* instruments and to manage currency and interest rate risks*.

The main uses are:

To modify existing or future cash flows from an asset or liability for risk management purposes. To alter an existing cash flow so that it matches a changed set of circumstances. To decrease borrowing costs or increase investment yields*. To access markets synthetically that would otherwise be closed or uneconomical. To modify cash flows for tax and accounting purposes.

Swaps are now used by every kind of user of the financial markets - banks, insurance companies, non-financial corporations and institutional investors.

Standard swaps characterised by the following features: The term of the swap is a whole number, commonly one, two, three, five, seven and 10 years. The fixed and floating coupon* payments take place at regular intervals, for example every six or 12 months. The notional principal of the swap remains constant for the term of the swap. The fixed rate remains constant for the term of the swap. The floating rate is set at the beginning of each interest period and paid in arrears at the end of the interest period. The basic swap structures are the commonest.





However, because swaps are privately-negotiated contracts the terms and conditions of any swap can be altered to suit the exact circumstances of the user.This flexibility has led to the creation of a family of swaps still regarded as vanilla - that is they do not have other derivative instruments combined with them and in particular which do not contain any option*-like characteristics - whose basic form is the same as the standard interest rate and currency swaps* but whose notional principal, coupon payments, period, fixing or final settlement terms are non-standard.

Variable rate loan Loan with interest rate changes over its life in relation to the level of an index*.

Volatility

The measure of a price variation over time.

It is often expressed as a percentage and computed as the annualized standard deviation of the percentage change in daily price.

WarrantsAn option* in the form of a listed security rather than an over-the-counter*contract. Warrants, like options, give the holders' rights into the future but not obligations. Warrants are available on all the financial asset* classes used as the underlying financial instrument* in option contracts. Warrants are also available on a variety of government debt instruments. Both debt and equity* warrants can be attached to public bond issues by corporations and financial institutions. They are often listed on a stock exchange.

Wash sale transaction. The repurchase of a financial asset* shortly after it has been sold is sometimes referred to as a wash sale. (This may be done to record a realised gain or loss for tax purposes.) Such a repurchase may be derecognised provided that the original transaction met the derecognition* requirements.

However, if an agreement to sell a financial asset is entered into concurrently with an agreement to repurchase the same asset at a fixed price or the sale price plus a lender's return, then the asset is not derecognised.

Writer The person who sells an option* in return for a premium* and is obligated to perform when the holder*exercises his right under the option contract. Also referred to as the option seller.

Written optionTo sell an option* and take the risk.http://bankir.ru/technology/vestnik/uchebnye-posobiya-po-msfoeng 47




Yield

A measure of the annual return on an investment.

Yield curveA graph of interest rates versus time. The yield curve is positive when long-term rates are higher than short-term rates; however, the yield curve is negative (‘’inverted’’), when long term rates are lower than short term rates.

Yield to Maturity The rate of return an investor receives if a security is held to maturity.

Greek Letters used in Financial Trading:

Delta (δ) The change in option* value for a given change in the value of the underlying financial instrument*.Gamma (γ) The change in the delta of an option* for a one-unit change in the price of the underlying financial instrument*.Rho (ρ) The change in option* value for a one percentage point change in interest or discount rates.Sigma (σ) The standard deviation or volatility* of the instrument underlying financial instrument* an option*.Theta (θ) The change in option* value over (usually) one day keeping strike, volatility* and discount rate the same.Vega: (V) The change in option* value for a small movement in volatility*.

Lambda (L) The change in option* value for a small change in the dividend rate (equity* options) or foreign interest rate (foreign exchange options)




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