Financial dictionary terms

Dictionary of Financial Terms. Copyright © 2008 Lightbulb Press, Inc. All Rights Reserved.

counterparty risk. The risk that the other party in an agreement will default. In an option contract, the risk to the option buyer that the writer will not buy or sell the underlying as agreed. In general, counterparty risk can be reduced by having an organization with extremely good credit act as an intermediary between the two parties.

Off-the-Run Treasuries. Any set of U.S. Treasury securities of a certain maturity except for the one most recently issued. For example, if the Treasury issues one year notes in May, June, and July, and it is now August, the off-the-run Treasuries are those issued in May and June. Off-the-run Treasuries are less actively traded than on-the-run Treasuries and as a result have a slightly higher yield.

On-the-Run Treasuries. The most recently issued set of U.S. Treasury securities with a certain maturity. For example, if the Treasury issues one year notes in May, June, and July, and it is now August, the on-the-run Treasuries are those issued in July. On-the-run Treasuries are the most actively traded Treasury securities and as a result have a slightly lower yield than off-the-run Treasuries.

Tranche. One of several related securities offered at the same time. Tranches from the same offering usually have different risk, reward, and/or maturity characteristics.
• A class of bonds. Collateralized mortgage obligations are structured with several tranches of bonds that have various maturities.
• A part of an issue. A tranche sometimes refers to a single issue of a security released at different times. For example, a company may announce that is intends to issue $10,000,000 in bonds in two tranches of $5,000,000.
• Tranches are important to collateralized mortgage obligations, which are backed by pools of mortgages. These mortgages are arranged in tranches that mature at different times, for instance in 10 years, 15 years, and 30 years.Certain securities, such as collateralized mortgage obligations (CMOs), are made up of a number of classes, called tranches, that differ from each other because they pay different interest rates, mature on different dates, carry different levels of risk, or differ in some other way.When the security is offered for sale, each of these tranches is sold separately.
• Similarly, a large certificate of deposit (CD) may be subdivided into smaller certificates for sale to individual investors. Each smaller certificate, or tranche, matures on the same date and pays the same rate of interest, but is worth a fraction of the total amount.
• A class of securities. Collateralized mortgage backed securities are usually divided into tranches according to seniority and risk.

Credit Default Swap. A swap in which the buyer makes a series of payments and, in exchange, receives a guarantee against default from the seller on a designated debt security. That is, the buyer transfers the risk that a debt security, such as a bond, will default to the seller, and the seller receives a series of fees for assuming this risk. In some ways, a credit default swap is like insurance, but there are significant differences. Prominently, the buyer of the credit default swap need not own the underlying debt security. Thus, the buyer may be speculating on the potential for default on the designated security. Likewise, the seller is not required to have the cash available to pay the buyer in case the designated security does default. This lack of regulation has raised concern, especially during the late 2000s credit crunch.

The carry of an asset is the return obtained from holding it (if positive), or the cost of holding it (if negative) (see also Cost of carry).
• For instance, commodities are usually negative carry assets, as they incur storage costs or may suffer from depreciation, but in some circumstances, commodities can be positive carry assets if the market is willing to pay a premium for its demand.
• This can also refer to a trade with more than one leg, where you earn the spread between borrowing a low carry asset and lending a high carry one.
• Carry trades are not arbitrages: pure arbitrages make money no matter what; carry trades make money only if nothing changes against the carry's favor.
• Interest rates/ For instance, the traditional income stream from commercial banks is to borrow cheap (at the low overnight rate, i.e., the rate at which they pay depositors) and lend expensive (at the long-term rate, which is usually higher than the short-term rate).This works with an upward-sloping yield curve, but it loses money if the curve becomes inverted. Many investment banks, such as Bear Stearns, have failed because they borrowed cheap short-term money to fund higher interest bearing long-term positions. When the long-term positions default, or the short-term interest rate rises too high (or there are simply no lenders), the bank cannot meet its short-term liabilities and goes under.
• The term carry trade without further modification refers to currency carry trade: investors borrow low-yielding currencies and lend (invest in) high-yielding currencies. It thought to correlate with global financial and exchange rate stability and retracts in use during global liquidity shortages,[2], but the carry trade is often blamed for rapid currency value collapse and appreciation.
- The risk in carry trading is that foreign exchange rates may change to the effect that the investor would have to pay back more expensive currency with less valuable currency.[3] In theory, according to uncovered interest rate parity, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency to rise against the high-interest-rate one. However, carry trades weaken the currency that is borrowed, because investors sell the borrowed money by converting it to other currencies.
- By early year 2007, it was estimated that some US$1 trillion may have been staked on the yen carry trade.[4] Since the mid-90's, the Bank of Japan has set Japanese interest rates at very low levels making it profitable to borrow Japanese yen to fund activities in other currencies.[5] These activities include subprime lending in the USA, and funding of emerging markets, especially BRIC countries and resource rich countries. The trade largely collapsed in 2008 particularly in regards to the yen.
- The 2008–2009 Icelandic financial crisis has among its origins the undisciplined use of the carry trade. Particular attention has been focused on the use of Euro denominated loans to purchase homes and other assets within Iceland. Most of these loans defaulted when the relative value of the Euro appreciated dramatically causing loan payment be unaffordable.