Back office:
the part of a firm that is responsible for post-trade activities. Depending upon the organisational structure of the firm, the back office can be a single department or multiple units (such as documentation, risk management, accounting or settlements). Some firms have combined a portion of these responsibilities, usually found in the back office, particularly those related to risk management, into what they term a middle office function. See front office.

Broker:
a firm that communicates bid and ask levels to potential principals and otherwise arranges transactions as agent for a fee, without acting as counterparty in the transactions.

Clearing House:
a department of an exchange or a separate legal entity that provides a range of services related to the clearance and settlement of trades and the management of risks associated with the resulting contracts. A clearing house is often central counterparty to all trades, that is, the buyer to every seller and the seller to every buyer.

Close-out:
acceleration and termination of a contract prior to its maturity.

Close-out-netting:
an arrangement to settle all contracted but not yet due obligations to and claims on a counterparty by one single payment, immediately upon the occurrence of one of the defined events of default. See netting and payment netting.

Collateral:
an asset that is delivered by the collateral provider to secure an obligation to the collateral taker. Collateral arrangements may take different legal forms; collateral may be obtained using the method of title transfer or pledge. Typically, government securities and cash are used as collateral in the context of OTC derivatives transactions. See pledge and title transfer.

Collateral management service:
a centralised service that may handle any of a variety of collateral-related functions for a client firm, including valuation of collateral, confirmation of valuations with counterparties, optimisation of collateral usage, and transfer of collateral.

Confirmation Process:
the procedure for verifying trade details with a counterparty. This is generally done by exchanging via fax or mail a document (i.e. a confirmation) identifying the trade details and any governing legal documentation and verifying the accuracy of the information provided by the counterparty (i.e. matching).

Credit Risk
the risk that a counterparty will not settle an obligation for full value, either when due or at any time thereafter. Credit risk includes pre-settlement risk (replacement cost risk) and settlement risk (Principal risk).

Current Exposure:
the loss that would be incurred today on a contract or set of contracts if a counterparty failed to perform on its obligations. Also known as replacement cost, current exposure is what it would cost to replace a given contract if the counterparty default now. See potential future exposure.

Custody Risk:
the risk of loss of securities held in custody occasioned by the insolvency, negligence or fraudulent action of the custodian or of a sub-custodian.

Dealer:
a firm that enters into transactions as a counterparty on both sides of the market in one or more products. OTC derivatives dealers are primarily large international financial institutions - mostly commercial banks but also some securities firms and insurance companies - as well as a few affiliates of what are primarily non-financial firms. See end-user.

Default:
generally, failure to satisfy an obligation when due, or the occurrence of one of the defined events of default agreed by the parties under a contract.

Derivative:
a financial contract the value of which depends on the value of one or more underlying reference assets, rates or indices. For analytical purposes, all derivatives contracts can be divided into basis building-blocks of forward contracts, options or

Exchange-traded derivative:
a derivative which is listed and traded at an organised market-place. Derivatives exchanges generally provide standardised contracts and central clearing facilities for participants.

Forward Contract:
a contract in which one party agrees to buy, and the other to sell, a specified product at a specified price on a specified date in the future

Forward Rate Agreement:
a forward contract on interest rates in which the rate to be paid or received on a specific obligation for a set period of time, beginning at some time in the future, is determined at contract initiation.

Front Office:
a firm's trading unit and other areas that are responsible for developing and managing relationships with counterparties. See back office.

Haircut:
the difference between the market value of a security and its value when used as collateral. The haircut is intended to protect a collateral taker from losses due to declines in collateral values.

Legal Risk:
the risk of loss because a law or regulation is applied in an unexpected way or because a contract cannot be enforced.

Liquidity Risk:
the risk that a counterparty will experience demands for funds (or collateral) that are too large to meet when due.

Market Value (replacement value):
the cost that would be incurred or the gain that would be realised if an outstanding contract were replaced at current market prices.

Marking to Market:
the revaluation of open positions in financial instruments at current market prices and the calculation of any gains or losses that have occurred since the last valuation.

Master agreement:
an agreement that sets forth the standard terms and conditions applicable to all or a defined subset of transactions that the parties may enter into from time to time, including the terms and conditions for close-out-netting.

Multilateral Netting:
netting on a multilateral basis is arithmetically achieved by summing each participant's bilateral net positions with the other participants to arrive at a multilateral net position. Such netting is conducted through a central counterparty (such as a clearing house) that is legally substituted as the buyer to every seller and the seller to every buyer. The multilateral net position represents the bilateral net position between each participant and the central counterparty. See netting.

Netting:
an offsetting of positions or obligations by counterparties. See close-out netting and payment netting.

Operational risk:
the risk that deficiencies in information systems or internal controls could result in unexpected losses.

Option Contract:
a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset by (or on) a specific date for a specific price. For this right the purchaser pays a premium.

Out-of-the-Money:
a term used to describe an option contract that would produce a negative cash flow for the holder if it were exercised now.

Over-the-Counter (OTC):
a method of trading that does not involve an exchange. In over-the-counter markets, participants trade directly with each other, typically by telephone or computer links. Payment netting: settling payments due on the same date and in the same currency on a net basis.

Plain Vanilla Transactions:
the most common and generally the simplest types of derivatives transaction. Plain vanilla is a relative concept, and no precise list of plain vanilla transactions exists. Transactions that have unusual or less common features are often called exotic or structured.

Settlement Risk (principal risk):
the risk that the seller of a security or funds delivers its obligation but does not receive payment or that the buyer of a security or funds makes payment but does not receive delivery. In this event, the full principal value of the securities or funds transferred is at risk. See credit risk.

Straight-through Processing:
the capture of trade details directly from front-end trading systems and complete automated processing of confirmation and settlement instructions without the need for rekeying or reformatting data.

Swap:
an agreement for an exchange of payments between two counterparties at some point(s) in the future and according to a specified formula.

Systemic Risk:
the risk that the failure of one participant in a payment or settlement system, or in financial markets generally, to meet its required obligations when due will cause other participants or financial institutions to be unable to meet their obligations (including settlement obligations in a payment and settlement system) when due. Such a failure may cause significant liquidity or credit problems and, as a result, might threaten the stability of financial markets.

Interest Rate Cap
Interest Rate Caps are designed to provide insurance against rising interest rates by payment of a premium to the other party, who promises to make interest payments on specified future dates based on the excess, if any, of interest rates above a certain specified rate.

Interest Rate Floor
Interest Rate Floor is opposite of an interest rate cap agreement. It refers to the purchase of insurance against falling interest rates by payment of a premium to another party who promises to make a payment if a specified floating rate falls below a specified floor rate.

Interest Rate Collar
Collars are the combined purchase and sale of an interest rate cap and an interest rate floor so as to keep interest rate exposure within a defined range. One party agrees to make interest payments to the other party if interest rates exceed a certain rate (i.e. "sells" a cap) and the other party agrees to make interest payments if interest rates drop below a certain rate (i.e. "sells" a floor).

Interest Rate Swaption
Swaptions are options on forward-starting interest rate swaps. A swaption gives the buyer the right, but not the obligation, to enter into an interest rate swap at a specific date in the future, at a particular fixed rate (the strike rate), and for a specified term. The option is called a receiver swaption if the buyer has the right to receive fixed interest in the swap, and is called a payer swaption if the buyer has the right to pay fixed and receive floating interest in the swap.

Call/Put options on Bonds/Interest rates
A bond call/put option is an option to buy or sell a bond for a certain price on a certain date. In an interest rate call/put option, the underlying is a floating interest rate.

Interest Rate Futures
Interest rate futures are forward contracts on a benchmark interest rate traded on a stock exchange. A typical example is the futures contract on 3-month sterling LIBOR traded on the London International Futures & Options Exchange (LIFFE), which is known as a short sterling future.

Option Styles

1. American. "American" means a style of Option Transaction pursuant to which the right or rights granted are exercisable during an Exercise Period that consists of a period of days.

2. Bermuda. "Bermuda" means a style of Option Transaction pursuant to which the right or rights granted are exercisable only during an Exercise Period which consists of a number of specified dates.

3. European. "European" means a style of Option Transaction pursuant to which the right or rights granted are exercisable only on the Expiration Data.

Suppose a corporate has a rupee liability maturing in the next three months. The corporate Treasurer is confident of funding this liability through an issue of 5-year paper around the same time. But the Treasurer wants to hedge the rate of this debt placement now. This rate would be composed of the "Treasury" rate and a "corporate spread" representing the credit risk charge. Suppose for the moment, that the corporate wants to hedge the "Treasury" risk only. Once options are permitted, the corporate could hedge the downside risk of rates moving sharply higher by buying a payer's swaption on 5-year G-Sec rates expiring in 3 months. This product is nothing but a European swaption.

Barrier Option
An option, which is only exercised when the underlying item reaches a predetermined price.

Digital Option
These options are only exercised when the underlying item reaches a pre-determined price and then only pay a fixed amount regardless of how far in-the-money the option settles.

Index Amortizing Caps, Floors
A cap, floor with a notional principal amount that declines as a function of a short term money rate such as Libor. The use of an index protects the client from unanticipated or erratic prepayment risks.

Efficacy of Short Sales - An Illustration

Suppose that a bank offers an option, expiring in 3 months time, on a 5-year swap to a client (having a floating rate liability) where the client has the right to receive the prevailing one year government security yield from the bank on every interest payment date (say, annual) and pay a fixed rate, say, 6% on those dates for a certain notional principal. Also suppose a case where this is the only transaction outstanding in the bank's books. Assuming that the "delta" of this swap is, say, 50%, i.e., the bank needs to hedge 50% of the notional amount of the 5-year received risk immediately. The ideal way, perhaps, would be to short the 5-year G-sec. However, the current regulations do not allow short selling. Therefore, the bank has to find some other way to pay the 5-year fixed rate, which may be done by looking for a counterparty that may want to hedge a fixed rate liability and hence receive a fixed rate from the bank. Alternatively, the bank may decide to hedge by selling some securities in the discretionary portfolio of similar duration to hedge the swap. But this portfolio approach of hedging is fraught with different kind of risks, particularly "basis risks" as "like for like" hedging is not achieved.

For a comprehensive definition of all words(total glossary) please refer to website of Naval Vithalani at URL - http://www.oocities.org/nvithalani/derivatives.html