for Accounting Professionals
IAS 32/39 Financial Instruments Part 5: EXPLANATIONS OF TERMINOLOGY
2011
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IAS 32/39 Financial Instruments Part 5: EXPLANATIONS OF TERMINOLOGY
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IAS 32/39 Financial Instruments Part 5: EXPLANATIONS OF TERMINOLOGY
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 cost
The 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 price
An expression indicating one's desire to sell a commodity* at a given price; also known as an offer* price.
Assignment
Notice 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-money
An 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*
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 assets
Those 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 point
Measurement 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 premium
When a bond* is issued, the issue price may be at a discount or premium* to the face value (nominal* value) of the bond.
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, bills
Market 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 option
A 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.
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.
Callable
The 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.