324 Frequently Asked Questions In Quantitative Finance
Straddle is a portfolio consisting of a long call and a long put
with the same strike and expiration. Such a portfolio is for
taking a view on the range of the underlying or volatility.
Strangle is a portfolio of a call and a put, the call having
a higher strike than the put. It is a volatility play like the
straddle but is cheaper. At the same time it requires the
underlying to move further than for a straddle for the holder
to make a profit.
STRIPS stands for Separate Trading of Registered Interest
and Principal of Securities. The coupons and principal of
normal bonds are split up, creating artificial zero-coupon
bonds of longer maturity than would otherwise be available.
Swap is a general term for an over-the-counter contract in
which there are exchanges of cashflows between two parties.
Examples would be an exchange of a fixed interest rate for
a floating rate, or the exchange of equity returns and bond
returns, etc.
Swaption is an option on a swap. It is the option to enter into
the swap at some expiration date, the swap having predefined
characteristics. Such contracts are very common in the fixed-
income world where a typical swaption would be on a swap of
fixed for floating. The contract may be European so that the
swap can only be entered into on a certain date, or American
in which the swap can be entered into before a certain date
or Bermudan in which there are specified dates on which the
option can be exercised.
Total Return Swap (TRS) is the exchange of all the profit or
loss from a security for a fixed or floating interest payment.
Periodically, one party transfers the cashflows plus any posi-
tive value change of a reference asset to the other party,
this includes interest payments, appreciation, coupons, etc.,
while the other party pays a fixed or floating rate, probably
with some spread. The difference between a total return swap
and a default swap is that a default swap simply transfers
credit risk, by reference to some designated asset whereas
a total return swap transfers all the risks of owning the des-
ignated asset. Total return swaps were among the earliest
credit derivatives. TRSs existed before default swaps, but now
