2
$\begingroup$

What is the difference between funded and unfunded derivative?

Can anyone explain the difference between these two?

$\endgroup$
5
$\begingroup$

This is not a very well defined term, but the usage I most often hear is in the context of structured investments. Suppose an investor pays 100 upfront to a bank and receives over time a coupon, and repays the 100 at maturity. If the entire trade including the principal flows is documented as a derivative , then it is a funded derivative. If, as is more usually the case , the trade is documented as a note issued by the bank ALM, then there is a swap between the bank ALM and the derivatives desk (invisible to the investor) to create the coupon , but this derivative does not contain any principal flows so is unfunded.

$\endgroup$
  • $\begingroup$ This is a valid interpretation. For instance the term funded/unfunded was widely used for CDOs. In a funded CDO the investor would actually invest into a tranche of an underlying bonds pool, and get whatever coupon and principal remaining after losses corresponding to his tranche. In an unfunded CDO the investor would simply receive a coupon in exchange for paying the underlying pool losses corresponding to his tranche. $\endgroup$ – Antoine Conze Dec 23 '17 at 10:43
0
$\begingroup$

I suspect these terms are synonymous with collateralised and uncollateralised. These are properties of derivatives determined from their documentation, i.e. whether a credit-support-annex (CSA) is in place and what are the collateral terms (poorly funded would represent a CSA in place but with weak forms of collateral). This also has the benefit of having a clear definition.

The reason this can be interpreted as 'funding' is because a simple derivative, e.g. an Interest Rate Swap (IRS) has payments that need to be made throughout the life of the swap. For an uncollateralised IRS this often means you will either need to make payments or receive payments without any offset of collateral, i.e. you might need to 'fund' the payments to stay contractual. If the swap was collateralised you do not need to fund outflows because the cash is provided by the counterparty in the collateral they post to you.

However, dm63s answer outlines the notion that funded derivatives essentially contain principal flows, and unfunded do not. This is a valid interpretation. And do not make the mistake of believing everything in finance is well defined and terminology is consistent. It isn't - the same words are often used in multiple contexts.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.