DERIVATIVES CONCEPTS A-Z

Article by Chand Sooran, Principal Victory Risk Management Consulting, Inc.

This article presents a glossary of derivatives-related terminology that will make the other articles in the Financial Pipeline's Derivatives section easier to understand, hopefully. It is not an exhaustive list. It will be updated from time to time. One of the characteristics of new financial products is the proliferation of different terms used to describe the same instrument, as each financial institution tries to brand its product name onto the financial community's awareness.

A

Actuals (see also Cash; Physicals; Underlying)

Financial instruments that exist in one of the four main asset classes: interest rates, foreign exchange, equities or commodities. Typically, derivatives are used to hedge actual exposure or to take positions in actual markets.

All or Nothings (see also Binary; Digital)

An option whose payout is fixed at the inception of the option contract and for which the payout is only made if the strike price is in-the-money at expiry. If the strike price is out-of-the-money at expiry, there is no payout made to the option holder.

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. Early exercise of American options may be warranted by arbitrage. European Style option contracts can be closed out early, mimicking the early exercise property of American style options in most cases.

Accreting Swap (see also Interest Rate Swap)

An exchange of interest rate payments at regular intervals based upon pre-set indices and notional amounts in which the notional amounts decrease over time.

Arbitrage (see also Correlation)

The act of taking advantage of differences in price between markets. For example, if a stock is quoted on two different equity markets, there is the possibility of arbitrage if the quoted price (adjusted for institutional idiosyncrasies) in one market differs from the quoted price in the other. The term has been extended to refer to speculators who take positions on the correlation between two different types of instrument, assuming stability to the correlation patterns. Many funds have discovered that correlation is not as stable as it is assumed to be.

Asset-Liability Management

Closing out exposure to fluctuations in interest rates by matching the timing of cashflows associated with assets and liabilities. This is a technique commonly used by financial institutions and large corporations.

At-the-Market (see also Market Order)

A type of financial transaction in which the order to buy or sell is executed at the current prevailing market price.

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.

Average Rate Options

An option whose payout at expiry is determined by the difference between its strike and a calculated average market rate where the period, frequency and source of observation for the calculation of the average market rate are specified at the inception of the contract. These options are cash settled, typically.

Average Strike Options

An option whose payout at expiry is determined by the difference between the prevailing cash spot rate at expiry and its strike, deemed to be equal to a calculated average market rate where the period, frequency and source of observation for the calculation of the average market rate are specified at the inception of the contract. These options are cash settled, typically.

B

Backwardation (see also Contango)

A term often used in commodities or futures markets to refer to markets where shorter-dated contracts trade at a higher price than longer-dated contracts. Plotting the prices of contracts against time, with time on the x-axis, shows the commodity price curve as sloping downwards as time increases.

Barrier Options (see also Knock-In Options, Knock-Out Options)

An option contract for which the maturity, strike price and underlying are specified at inception in addition to a trigger price. The trigger price determines whether or not the option actually exists. In the case of a knock-in option, the barrier option does not exist until the trigger is touched. For a knock-out option, the option exists until the trigger is touched.

Basis (see also Index)

The difference in price or yield between two different indices.

Benchmarking

A benchmark is a reference point. Benchmarking in financial risk management refers to the practice of comparing the performance of an individual instrument, a portfolio or an approach to risk management to a pre-determined alternative approach.

Black-Scholes

A closed-form solution (i.e. an equation) for valuing plain vanilla options developed by Fischer Black and Myron Scholes in 1973 for which they shared the Nobel Prize in Economics.

C

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.

Cap

A cap is a financial contract giving the owner the right but not the obligation to borrow a pre-set amount of money at a pre-set interest rate with a pre-set maturity date.

Cash Settlement

Some derivatives contracts are settled at maturity (or before maturity at closeout) by an exchange of cash from the party who is out-of-the-money to the party who is in-the-money.

Chooser Option

An option that gives the buyer the right at the choice date (before the option's expiry) to choose if the option is to be a call or a put.

Collar (see also Range Forward; Risk Reversal)

A combination of options in which the holder of the contract has bought one out-of-the money option call (or put) and sold one (or more) out-of-the-money puts (or calls). Doing this locks in the minimum and maximum rates that the collar owner will use to transact in the underlying at expiry.

Commodity Swap

A contract in which counterparties agree to exchange payments related to indices, at least one of which (and possibly both of which) is a commodity index.

Contango (see also Backwardation)

A term often used in commodities or futures markets to refer to markets where shorter-dated contracts trade at a lower price than longer-dated contracts. Plotting the prices of contracts against time, with time on the x-axis, shows the commodity price curve as sloping upwards as time increases.

Convexity

A financial instrument is said to be convex (or to possess convexity) if the financial instrument's price increases (decreases) faster (slower) than corresponding changes in the underlying price.

Correlation (see also Arbitrage)

Correlation is a statistical measure describing the extent to which prices on different instruments move together over time. Correlation can be positive or negative. Instruments that move together in the same direction to the same extent have highly positive correlations. Instruments that move together in opposite direction to the same extent have highly negative correlations. Correlation between instruments is not stable.

Covered Call Option Writing

A technique used by investors to help fund their underlying positions, typically used in the equity markets. An individual who sells a call is said to "write" the call. If this individual sells a call on a notional amount of the underlying that he has in his inventory, then the written call is said to be "covered" (by his inventory of the underlying). If the investor does not have the underlying in inventory, the investor has sold the call "naked".

Credit Risk

Credit risk is the risk of loss from a counterparty in default or from a pejorative change in the credit status of a counterparty that causes the value of their obligations to decrease.

Currency Swap (see also Interest Rate Swap)

An exchange of interest rate payments in different currencies on a pre-set notional amount and in reference to pre-determined interest rate indices in which the notional amounts are exchanged at inception of the contract and then re-exchanged at the termination of the contract at pre-set exchange rates.

D

Delta

The sensitivity of the change in the financial instrument's price to changes in the price of the underlying cash index.

Documentation Risk

The risk of loss due to an inadequacy or other unforeseen aspect of the legal documentation behind the financial contract.

Duration

A weighted average of the cash flows for a fixed income instrument, expressed in terms of time.

E

Embedded Derivatives (see also Structured Notes)

Derivative contracts that exist as part of securities.

Equity Swap (see also Interest Rate Swap)

A contract in which counterparties agree to exchange payments related to indices, at least one of which (and possibly both of which) is an equity index.

European Style Option

An option that can be exercised only at expiry as opposed to an American Style option that can be exercised at any time from inception of the contract. European Style option contracts can be closed out early, mimicking the early exercise property of American style options in most cases.

Exchange Traded Contracts

Financial instruments listed on exchanges such as the Chicago Board of Trade.

Exercise Price (see also Strike Price)

The exercise price is the price at which a call's (put's) buyer can buy (or sell) the underlying instrument.

Exotic Derivatives

Any derivative contract that is not a plain vanilla contract. Examples include barrier options, average rate and average strike options, lookback options, chooser options, etc.

F

Floor (see also Cap; Collar)

A floor is a financial contract giving the owner the right but not the obligation to lend a pre-set amount of money at a pre-set interest rate with a pre-set maturity date.

Forward Contracts

An over-the-counter obligation to buy or sell a financial instrument or to make a payment at some point in the future, the details of which were settled privately between the two counterparties. Forward contracts generally are arranged to have zero mark-to-market value at inception, although they may be off-market. Examples include forward foreign exchange contracts in which one party is obligated to buy foreign exchange from another party at a fixed rate for delivery on a pre-set date. Off-market forward contracts are used often in structured combinations, with the value on the forward contract offsetting the value of the other instrument(s).

Forward or Delayed Start Swap (see also Interest Rate Swap)

Any swap contract with a start that is later than the standard terms. This means that calculation of the cash flows does not begin straightaway but at some pre-determined start date.

Forward Rate Agreements (FRAs) (see also Interest Rate Swap)

A forward rate agreement is a cash-settled obligation on interest rates for a pre-set period on a pre-set interest rate index with a forward start date. A 3x6 FRA on US dollar LIBOR (the London Interbank Offered Rate) is a contract between two parties obliging one to pay the other the difference between the FRA rate and the actual LIBOR rate observed for that period. An Interest Rate Swap is a strip of FRAs.

Futures Contracts

n exchange-traded obligation to buy or sell a financial instrument or to make a payment at one of the exchange's fixed delivery dates, the details of which are transparent publicly on the trading floor and for which contract settlement takes place through the exchange's clearinghouse.

G

Gamma (see also Delta)

Gamma (or convexity) is the degree of curvature in the financial contract's price curve with respect to its underlying price. It is the rate of change of the delta with respect to changes in the underlying price. Positive gamma is favourable. Negative gamma is damaging in a sufficiently volatile market. The price of having positive gamma (or owning gamma) is time decay. Only instruments with time value have gamma.

H

Hedge

A transaction that offsets an exposure to fluctuations in financial prices of some other contract or business risk. It may consist of cash instruments or derivatives.

Historical Volatility

A measure of the actual volatility (a statistical measure of dispersion) observed in the marketplace.

Hybrid Security

Any security that includes more than one component. For example, a hybrid security might be a fixed income note that includes a foreign exchange option or a commodity price option.

I

Implied Volatility

Option pricing models rely upon an assumption of future volatility as well as the spot price, interest rates, the expiry date, the delivery date, the strike, etc. If we are given simultaneously all of the parameters necessary for determining the option price except for volatility and the option price in the marketplace, we can back out mathematically the volatility corresponding to that price and those parameters. This is the implied volatility.

In-The-Money Spot (see also Intrinsic Value; At-The-Money; Out-of-The-Money)

An option with positive intrinsic value with respect to the prevailing market spot rate. If the option were to mature immediately, the option holder would exercise it in order to capture its economic value. For a call price to have intrinsic value, the strike must be less than the spot price. For a put price to have intrinsic value, the strike must be greater than the spot price.

In-The-Money-Forward (see also Intrinsic Value; At-The-Money; Out-of-The-Money)

An option with positive intrinsic value with respect to the prevailing market forward rate. If the option were to mature immediately, the option holder would exercise it in order to capture its economic value. For a call price to have intrinsic value, the strike must be less than the spot price. For a put price to have intrinsic value, the strike must be greater than the spot price.

Index-Amortizing Swaps (see also Interest Rate Swaps; Accreting Swaps)

An interest rate swap in which the notional amount for the purposes of calculating cash flows decreases over the life of the contract in a pre-specified manner.

Interest Rate Swap (see also Forward Rate Agreements; Index-Amortizing Swaps; Accreting Swaps)

An exchange of cash flows based upon different interest rate indices denominated in the same currency on a pre-set notional amount with a pre-determined schedule of payments and calculations. Usually, one counterparty will received fixed flows in exchange for making floating payments.

International Swaps Dealers' Association (ISDA) Agreements (see also Legal Risk)

In order to minimize the legal risks of transacting with one another, counterparties will establish master legal agreements and sidebar product schedules to govern formally all derivatives transactions into which they may enter with one another.

Intrinsic Value

The economic value of a financial contract, as distinct from the contract's time value. One way to think of the intrinsic value of the financial contract is to calculate its value if it were a forward contract with the same delivery date. If the contract is an option, its intrinsic value cannot be less than zero.

K

Knock-in Option (see also Knock-Out Option; Trigger Price)

An option the existence of which is conditional upon a pre-set trigger price trading before the option's designated maturity. If the trigger is not touched before maturity, then the option is deemed not to exist.

Knock-out Option

An option the existence of which is conditional upon a pre-set trigger price trading before the option's designated maturity. The option is deemed to exist unless the trigger price is touched before maturity.

L

Legal Risk (see also International Swap Dealers' Association Agreements)

The general potential for loss due to the legal and regulatory interpretation of contracts relating to financial market transactions.

LIBOR London Interbank Offer Rate

The rate of interest paid on offshore funds in the Eurodollar markets.

Liquidity Risk

The risk that a financial market entity will not be able to find a price (or a price within a reasonable tolerance in terms of the deviation from prevailing or expected prices) for one or more of its financial contracts in the secondary market. Consider the case of a counterparty who buys a complex option on European interest rates. He is exposed to liquidity risk because of the possibility that he cannot find anyone to make him a price in the secondary market and because of the possibility that the price he obtains is very much against him and the theoretical price for the product.

Look-Back Options

An option which gives the owner the right to buy (sell) at the lowest (highest) price that traded in the underlying from the inception of the contract to its maturity, i.e. the most favourable price that traded over the lifetime of the contract.

M

Margin

A credit-enhancement provision to master agreements and individual transactions in which one counterparty agrees to post a deposit of cash or other liquid financial instruments with the entity selling it a financial instrument that places some obligation on the entity posting the margin.

Mark to Market Accounting

A method of accounting most suited for financial instruments in which contracts are revalued at regular intervals using prevailing market prices. This is known as taking a "snapshot" of the market.

Market Risk

The exposure to potential loss from fluctuations in market prices (as opposed to changes in credit status).

Market-Maker

A participant in the financial markets who guarantees to make simultaneously a bid and an offer for a financial contract with a pre-set bid/offer spread (or a schedule of spreads corresponding to different market conditions) up to a pre-determined maximum contract amount..

N

Naked Option Writing

The act of selling options without having any offsetting exposure in the underlying cash instrument.

Netting

When there are cash flows in two directions between two counterparties, they can be consolidated into one net payment from one counterparty to the other thereby reducing the settlement risk involved.

O

OCC

The Office of the Comptroller of the Currency (US).

OSFI

Office of the Superintendent of Financial Institutions (Canada).

Open Interest

Exchanges are required to post the number of outstanding long and short positions in their listed contracts. This constitutes the open interest in each contract.

Operational Risk

The potential for loss attributable to procedural errors or failures in internal control.

Option

The right but not the obligation to buy (sell) some underlying cash instrument at a pre-determined rate on a pre-determined expiration date in a pre-set notional amount.

Out-of-The-Money Spot (see also At-The-Money; In-The-Money)

An option with no intrinsic value with respect to the prevailing market spot rate. If the option were to mature immediately, the option holder would let it expire. For a call price to have intrinsic value, the strike must be less than the spot price. For a put price to have intrinsic value, the strike must be greater than the spot price.

Out-of-The-Money-Forward (see also At-The-Money; In-The-Money)

An option with no intrinsic value with respect to the prevailing market forward rate. If the option were to mature immediately, the option holder would let it expire. For a call price to have intrinsic value, the strike must be less than the spot price. For a put price to have intrinsic value, the strike must be greater than the spot price.

Over-the-Counter

Any transaction that takes place between two counterparties and does not involve an exchange is said to be an over-the-counter transaction.

P

Path-Dependent Options (see also Knock-In Options; Knock-Out Options; Average Rate Options; Average Strike Options; Lookback Options)

Any option whose value depends on the path taken by the underlying cash instrument.

Potential Exposure

An assessment of the future positive intrinsic value in all of the contracts outstanding with an individual counterparty who may choose (or may be unable) to make their obligated payments.

Premium

The cost associated with a derivative contract, referring to the combination of intrinsic value and time value. It usually applies to options contracts. However, it also applies to off-market forward contracts.

Put Option (see also Call Option)

A put option is a financial contract giving the owner the right but not the obligation to sell a pre-set amount of the underlying financial instrument at a pre-set price with a pre-set maturity date.

Put-Call Parity Theorem

A long position in a put combined with a long position in the underlying forward instrument, both of which have the same delivery date has the same behavioral properties as a long position in a call for the same delivery date. This can be varied for short positions, etc.

Q

Quanto Option

An option the payout for which is denominated in an index other than the underlying cash instrument.

R

Regulatory Risk

The potential for loss stemming from changes in the regulatory environment pertaining to derivatives and financial contracts, the utility of these instruments for different counterparties, etc.

Rho

The sensitivity of a financial contract's value to small changes in interest rates.

RiskMetrics (see also Value-at-Risk)

A parametric methodology for calculating Value-at-Risk using data conditioned by JP Morgan's spinoff company RiskMetrics that is most useful for assessing portfolios with linear risks.

S

Settlement Risk

The risk of non-payment of an obligation by a counterparty to a transaction, exacerbated by mismatches in payment timings.

Speculation

Taking positions in financial instruments without having an underlying exposure that offsets the positions taken.

Spot

The price in the cash market for delivery using the standard market convention. In the foreign exchange market, spot is delivered for value two days from the transaction date or for the next day in the case of the Canadian dollar exchanged against the US dollar.

Spread

The difference in price or yield between two assets that differ by type of financial instrument, maturity, strike or some other factor. A credit spread is the difference in yield between a corporate bond and the corresponding government bond. A yield curve spread is the spread between two government bonds of differing maturity.

Standard Deviation (see also Volatility; Implied Volatility)

In finance, a statistical measure of dispersion of a time series around its mean; the expected value of the difference between the time series and its mean; the square root of the variance of the time series.

Stress Testing

The act of simulating different financial market conditions for their potential effects on a portfolio of financial instruments.

Strike Price

The price at which the holder of a derivative contract exercises his right if it is economic to do so at the appropriate point in time as delineated in the financial product's contract.

Structured Notes

Fixed income instruments with embedded derivative products.

Swap Spread (see also Plain Vanilla Interest Rate Swap)

The difference between the swap yield curve and the government yield curve for a particular maturity, referring to the market prices for the fixed rate in a plain vanilla interest rate swap.

Swaptions (see also Plain Vanilla Interest Rate Swap)

Options on swaps.

T

Theta

The sensitivity of a derivative product's value to changes in the date, all other factors staying the same.

Time Value (see also Intrinsic Value; Premium)

For a derivative contract with a non-linear value structure, time value is the difference between the intrinsic value and the premium.

V

Value at Risk or VaR (see also RiskMetrics)

The caculated value of the maximum expected loss for a given portfolio over a defined time horizon (typically one day) and for a pre-set statistical confidence interval, under normal market conditions

Value of a Basis Point

The change in the value of a financial instrument attributable to a change in the relevant interest rate by 1 basis point (i.e. 1/100 of 1%).

Vega

The sensitivity of a derivative product's value to changes in implied volatility, all other factors staying the same.

Volatility (see also Standard Deviation; Implied Volatility)

In finance, a statistical measure of dispersion of a time series around its mean; the expected value of the difference between the time series and its mean; the square root of the variance of the time series.

Y

Yield Curve

For a particular series of fixed income instruments such as government bonds, the graph of the yields to maturity of the series plotted by maturity.

Yield Curve Risk

The potential for loss due to shifts in the position or the shape of the yield curve.

Z

Zero Coupon Instruments

Fixed income instruments that do not pay a coupon but only pay principal at maturity; trade at a discount to 100% of principal before maturity with the difference being the interest accrued.

Zero Coupon Yield Curve

For zero coupon bonds, the graph of the yields to maturity of the series plotted by maturity.