Derivatives Flashcards
Gain an understanding of derivative markets, instruments, pricing, and valuation.
Define:
American-style Option
An option contract which can be exercised at any time up to the expiration date.
As opposed to Bermuda style and European style
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Arbitrage-free pricing
Determining the price of a derivative based upon the assumption that the market is free of arbitrage opportunities.
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At the money
When the underlying asset price = exercise price of the option contract on that asset.
The option is “at the money”
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Bermuda-style Option
Option contract that can be exercised on specified dates up to the option’s expiration date.
As opposed to American style or European style
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Call
Option contract which gives the holder the right, but not the obligation, to buy an underlying asset at a fixed price over a specific period of time.
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Delta
Sensitivity of a derivative’s price to changes in the value of the underlying asset.
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Derivatives
Financial instruments, or contracts, whose value is derived from (dependent upon) the performance of an underlying asset, index, reference rate, or other financial instrument
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Equity swap
A financial derivative contract between two parties that involves the exchange of cash flows or returns based on the performance of an underlying equity or equity index.
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ESG investing
Making investment decisions based partially upon considerating of environmental, social, and governance factors.
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European-style option
Option contract that can only be exercised on its expiration date.
as opposed to American style and Bermuda style options
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Exercise
Utilizing the right to buy or sell the underlying (which is granted by the option contract).
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Exercise value
The value provided by exercising the option.
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Exercise price
aka strike price
The price at which the option holder has the right to buy or sell the underlying.
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Fixed-for-floating swap
aka plain vanilla swap
Interest rate swap with one party paying a fixed rate and the other paying a floating rate (in the same currency).
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Forward contract
An agreement between two parties to buy/sell an underlying asset at a later date for a price established at the start of the contract. Forwards are typically settled with delivery of the asset, and are highly customizable (as opposed to standardized futures contracts which are often not settled with delivery).
Define:
Forward rate agreements
FRAs
Forward contracts where underlying is an interest rate. Both parties agree to apply a fixed rate to the notional value at a given point in the future. If the floating market reference rate differs at that point then a cash flow (the difference between rates) gets paid to the party that the difference favors.
The party long the FRA benefits if the floating ends above the fixed
Different from interest rate swap, which involves a series of cash flow exchanges.
Define:
Forward curve
A graphic representation of the relationship between expected future interest rates and maturities, each having the same timeframe (ex. 1 year forwards).
“what is the one year forward rate in one year”
Forward curve is above spot curve if spot curve is upward sloping and below if downward sloping.
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Forward rate
The interest rate on a fixed income security traded in a forward market (to be entered into in the future).
ex. agreeing to a rate on a one year bond, to be entered into in one year.
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Forward market
Market in which contracts for the future sale of assets, commodities, or other financial instuments are agreed upon.
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Forward price
The fixed price or rate which the transaction (to occur at the expiration of forward contract) will take place. Agreed on at the initiation of the contract.
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Futures contract
Similar to a forward contract but is more standardized and includes things like clearinghouse guarantee, daily settlement of +/-, and an organized trading facility.
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Futures price
The price of a futures contract, and in essence the price at which the future transaction for the underlying asset will take place.
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FX swap
When offsetting FX spot and forward contract transactions occur. This is done to extend, or roll, a prior FX forward position.
only two settlement dates involved (this differs from a currency swap)
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Gamma
A measure of the how sensitive the option’s delta is to a change in the value of the underlying.
As the relationship that delta captures is not linear, gamma is a measure of that relationships convexity.
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Implied forward rates
Break-even reinvestment rate that links the return on a shorter-term zero-coupon bond to the return on a longer-term zero-coupon bond.
Calculated from spot rates
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Implied volatility
The volatility that option traders use to price an option, often derived using market variables and the Black Scholes formula.
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In the money
ITM
When the option has intrinsic value, and exercising the option would result in a profit for the option holder. For a call, if the price of the underlying > the strike price. For a put, if the price of the underlying < the strike price.
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Interest rate swap
A swap where underlying is an interest rate.
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Inverse floater
A type of leveraged structured financial instrument with cash flows that move in the opposite direction of changes in the reference rate.
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Moneyness
aka intrinsic value of the option
Relationship between the price of the underlying and the option’s exercise price.
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Option
Gives a party the right, but not the obligation, to buy/sell an underlying asset from/to another party (at a fixed price for a specific period of time).
type of contingent claim
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Protective put
Combiing a long position in an asset with a long put position.
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Put
Option giving the holder the right to sell an underlying asset (at a fixed price for specific period of time).
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Put–call parity
An equation expressing the equivalence (parity) of a portfolio of a call and a bond with a portfolio of a put and the underlying, which leads to the relationship between put and call prices.
C + PV(X) = S + P
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Put–call–forward parity
The relationship among puts, calls, and forward contracts.
C + PV(F) = S + P
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Replication
Using another asset, portfolio, and/or derivative in order to create/mimic characteristics of a particular asset.
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Rho
A measure of the sensitivity of an option’s price to the risk-free rate.
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Swap contract
An agreement between two parties to exchange a series of future cash flows.
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Time value
Due to the uncertainty of how the price the underlying may change over the remaining life of the option.
Option premium = intrinsic value + time value
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Theta
Relationship between the time value of an option and the passing of time.
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Total return swap
A swap in which one party agrees to pay the total return on a security in exchange for periodic payments (usually based on fixed or floating rate).
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Vega
A measure of the sensitivity of an option’s price to changes in the underlying’s volatility.
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Volatility
In option pricing: standard deviation of the continuously compounded returns on the underlying asset.
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Basis Risk
Risk that expected value of a derivative is different from the value of the underlying.
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CDS credit spread
Difference in yield between CDS and risk free benchmark.
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Cash flow hedge
When a derivative is designated as a hedge for accounting purposes as it is used to reduce volatility due to variable cash flows related to things like forex, interest rates, commodities).
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Central clearing mandate
Requires OTC derivatives be cleared by a central counterparty.
Came into affect following the great financial crisis of 2008
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Convexity bias
Between interest rate futures and interest rate forwards there is a difference in price sensitivity to changes in yield.
convex for forwards but linear for futures
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Fair value hedge
When a derivative is designated as a hedge for accounting purposes as it is used to reduce fluctuation in fair value of an asset or liability related to things like forex, interest rates.
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Central Counterparty
(CCP)
Intermediary which clears most derivative contracts and assumes counterparty credit risk between the parties involved.
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Futures contract basis point value
BPV
change in price of the contract per 1 basis point change in yield.
similar to bpv with fixed income securities.
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Futures margin account
Money which is held by clearinghouse on behalf of involved counterparties in order to ensure obligations are met.
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Hedge
When a derivative contract is used to mitigate exposure to adverse movements in an underlying (asset, rate, risk).
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Hedge accounting
Accounting standards which allow hedging instruments to offset a transaction or balance sheet item in order to reduce volatility.
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Hedge ratio
Used to determine the number or amount of a hedging instrument required to hedge or offset the risk associated with a specific exposure.
instrument could be futures contracts, options contracts, or other derivatives
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Net investment hedge
Designation when a derivative or foreign bond is used to offset exchange rate risk.
for hedge accounting
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Novation process
Process which substitutes the initial swap execution facility (SEF) contract with identical trades facing the central counterparty (CCP), essentially transfering rights and obligations of the contract to the CCP which then acts as counterparty.
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Par swap rate
The fixed rate that makes the value of the fixed leg equal to the value of the floating leg on a fixed for floating interest rate swap.
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Swap
OTC derivative contract where two parties agree to exchange a series of cash flows.
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Swap execution facility
SEF
Regulated swap trading platform which multiple dealers can access and execute swaps.
Institued following GFC of 2008
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Swap rate
Fixed rate paid by the fixed rate payer in a swap agreement.
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Time Value Decay
aka theta decay
Related to theta sensitivity, the time value declines faster as time passes (as experiation nears).
theta decay is exponential not linear
