Encyclopedia of Investment Terminology

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Derivatives (ABS)

The following are the four types of Interest Rate Derivative Instruments: interest rate options; interest rate futures and forwards; interest rate swaps; and, interest rate caps, floors, and collars. These instruments are principally designed to transfer price, interest rate, and other market risks without involving the actual holding or conveyance of balance sheet assets or liabilities. Some examples of how these vehicles could be used include: using foreign currency swaps to reduce foreign exchange risk, purchasing a call option to lock in the price of a security which the department expects to purchase in the future, purchasing a put option to establish a future selling price, and writing covered call options to enhance the yield of a portfolio.

Some investors use over-the-counter put and call options for accounts as a means of increasing revenue. The writer of put and call options is paid a fee for selling these contracts. The purpose of using exchange traded options would be to take advantage of price fluctuations.

When an investor writes a covered call option on stock held in its accounts, it sells to a third party the right (option) to purchase that stock (call) at a specified price until a specific date. Possession of the stock by the account makes the written option "covered."

Receipt of cash (fee) paid by the third party for the option provides an additional return on the stock if the market price remains the same, and cushions the potential loss if the market value declines. An element of risk is involved if the market value of the stock rises above the strike price, in which case the holder of the option will exercise the right to purchase the stock at the previously agreed upon price. In such instances, by granting of the option, the trust account foregoes any price appreciation over the strike price of the option. If the option contract is written and exercised on a bond, the trust account will receive the cash proceeds resulting from the sale, but reinvestment of these funds in a rising market will likely result in a reduced yield (income) to the account.

Much of the above information is courtesy of the FDIC.

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