Derivatives Flashcards
Limit Move
When a future exceeds its limit and trading does not take place
The price will increase/decrease by the price limit not what people are will to trade it at
Derivative
A security that derives its value from the value or return of another asset or security
Exchange-Traded Derivative
- A physical exchange
- Many options and future contracts trade on it
- Standardized and backed by a clearing house
Over-the-Counter Market
- A dealer market with no central location
- They are largely unregulated markets and each contract is with a counterparty, which may expose the owner of a derivative to default risk
- Forwards and swaps are custom instruments and are traded/created by dealers in OTC markets
- Some options are traded here, notably bond options
A Forward Commitment
- A legally binding promise to perform some action in the future
- Contractual Promise
*- Forward commitments include forward contracts, future contracts, and swaps - Can involve a stock index or portfolio
Forward and Futures Contracts can be Written on …
Equities, indexes, bonds, foreign currencies, physical assets or interest rates
A Contingent Claim
- A claim (to a payoff) that depends on a particular event
- Options are contingent claims that depend on a stock price at some future date
- Credit derivatives are contingent claims because on of the counterparties only has an obligation if certain conditions are met
- Credit default swaps
- Credit spread option
It takes 2 options to replicate ________
the payoff on a futures or forward contract
Forward Contracts
- One party agrees to buy and the counterparty agrees to sell physical or financial asset at a specific price on a specified date in the future
- May enter to speculate on the future price of asset
- Most common is to enter a contract to hedge an existing exposure to the risk of asset price or interest rate changes
- Can be used to reduce or eliminate uncertainty about the future price of an asset it plans to buy or sell at a later date
- Typically neither party to the contract makes a payment at the initiation of a forward contract
If the expected future price of the asset increases over the life of the contract, the right to buy at the forward price will have _____, and the obligation to sell _______
a positive value
will have an equal negative value
If the expected future price of an asset falls below the forward price, the right to sell (at an above-market price) will have a __________?
positive value
If you are long on a forward contract you
Agree to buy the financial or physical asset
What is a cash market (spot market)?
Markets in which assets are traded for immediate delivery
Are ETF & Mutual Funds considered derivatives?
No, they are not derivatives, despite the fact that they derive their value from the values of underlying securities they hold. ETFs & Mutual funds pass through the returns from their underlying securities. Derivatives usually transform the performance of the underlying asset before paying it out in the derivatives transaction. Derivatives provide for the transfer of risk from one party to another.
What is an American-style option?
An option contract which can be exercised at any time up to the expiration date.
As opposed to European options
What is Arbitrage-free pricing?
Determining the price of a derivative based upon the assumption that the market is free of arbitrage opportunities
What does “at the money” mean?
When the underlying asset price is equal to the exercise price of the option contract on that asset
What is a European-style option?
An option contract that can be exercised only on the expiration date
What are Bermuda-style options?
Options contracts that can be exercised on specified dates up to the option’s expiration date,
Call
Option contract that gives the holder the right, not the obligation, to buy an underlying asset at a fixed price over a specified period of time.
Delta
Sensitivity of a derivative’s price to changes in the value of the underlying asset.
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
ESG Investing
Making investment decisions based partially upon considering environmental, social, and governance factors.
Exercise
Utilizing the right to buy or sell the underlying (which is granted by the option contract)
Exercise Value
The value provided by exercising the option
Exercise Price
The price at which the option holder has the right to buy or sell the underlying
Fixed-for floating swap
interest rate swap with one party paying a fixed rate and the other paying a floating rate (in the same currency)
forward contracts
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)
Forward Rate Agreements (FRAs)
Forward contracts where the 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
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
Forward Rate
The interest rate on a fixed-income security traded in a forward market (to be entered into in the future)
Example - agreeing to a rate on a one year bond, to be entered into in one year
Forward Markets
Market in which contracts for the future sale of assets, commodities, or other financial instruments are agreed upon
Forward Price
The fixed price or rate at which the transaction (to occur at the expiration of the forward contract) will take place. Agreed on at the initiation of the contract.
Futures Contract
It is similar to a forward contract but is more standardized and includes things like a clearinghouse guarantee, daily settlement of +/-, and an organized trading facility
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
FX Swap
When offsetting FX S
LIBOR
London Interbank Offered Rate.
The rate offered by banks on Eurocurrency deposits (i.e., the rate at which a bank is willing to lend to other banks)
Delta
Change in option price per dollar increase in underlying asset
Gamma
Change in delta per dollar increase in underlying asset
Vega
Change in option price per 1% increase in volatility (e.g., volatility increases from 20% to 21%)
Rho
Change in option price per 1% increase in interest rate (e.g., interest increases from 5% to 6%)
theta
Change in option price per calendar day passing
DV01
Change in option price per 1-basis-point upward parallel shift in the zero curve
Asset Swap
Exchanges the coupon on a bond for LIBOR plus a spread
LIBOR Curve
LIBOR zero-coupon interest rates as a function of maturity
LIBOR-in-Arrears Swap
Swap where the interest paid on a date is determined by the interest rate observed on that date (not by the interest rate observed on the previous payment date)
LIBOR-OIS Spread
Difference between LIBOR rate and OIS rate for a certain maturity
Limit Move
The maximum price move permitted by the exchange in a single trading session
ABS CDO
Instrument where tranches are created from the tranches of ABSs (Asset Backed Securities)
Asset-or-Nothing Put Option
An Option that provides a payoff equal to the asset price if the asset price is below the strike price and zero otherwise
Asset-or-Nothing Call Option
An option that provides a payoff equal to the asset price if the asset price is above the strike price and zero otherwise
Ask Price
The price that a dealer is offering to sell an asset
Asian Option
An option with a payoff dependent on the average price of the underlying asset during a specified period
Arbitrage
A trading strategy that takes advantage of two or more securities being mispriced relative to each other
A transaction based on the observation of the same or an equivalent asset selling at two different prices. The transaction involves buying the asset at the lower price and selling it at the higher price for a (theoretically) riskless profit
Arbitrageur
An individual engaging in arbitrage
Amortizing Swap
A swap where the notional principal decreases in a predetermined way as time passes
Accrual Swap
An interest rate swap where interest on one side accrues only when a certain condition is met
Accrued Interest
The interest earned on a bond since the last coupon payment date
Adaptive Mesh Model
A model developed by Figlewski and Gao that grafts a high-resolution tree on to a low resolution tree so that there is more detailed modeling of the asset price in critical regions
Analytic Result
Result where the answer is in the form of an equation
Asset-Backed Security (ABS)
Security created from a portfolio of loans, bonds, credit card receivables, or other assets
At-the-Money Option
As applied to an option for which the price of the underlying stock or futures equals the exercise price; an at-the-money option is neither in the money nor out of the money
An option in which the strike price equals the price of the underlying asset
Average Price Call Option
An option giving a payoff equal to the greater of zero and the amount by which the average price of the asset exceeds the strike price
Average Price Put Option
An option giving a payoff equal to the greater of zero and the amount by which the strike price exceeds the average price of the asset
Average Strike Option
An option that provides a payoff dependent on the difference between the final asset price and the average asset price
Backdating
Practice (often illegal) of marking a document with a date that precedes the current date
Back Testing
Testing a value-at-risk or other model using historical data
Backwardation
A condition in financial markets in which the forward or futures price is less than the expected future spot price
Backwards Induction
A procedure for working from the end of a tree to its beginning in order to value an option
Bank Discount Rate
A rate quoted on short-term non-interest-bearing money market securities. The rate represents the annualized percentage discount from face value at the time the security is purchased
Barrier Option
An option whose payoff depends on whether the path of the underlying asset has reached a barrier (i.e., a certain predetermined level)
Base Correlation
Correlation that leads to the price of a 0% to X% CDO tranche being consistent with the market for a particular value of X
Basel Committee
Responsible for regulations of international banks
Basis
The price difference between the underlying asset and the futures contract, generally calculated as the cash price minus the futures price. For some futures, the basis may be calculated as the futures price minus the cash price so that the basis is represented as a positive number
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The difference between the spot price and the futures price of a
commodity
Basis Point
A unit of measure equal to one one-hundredth of 1%. Equivalent
numerical values are 0.01% and 0.0001. Basis points are sometimes verbally referred to as “beps” or written as the acronym “bps.”
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When used to describe an interest rate, a basis point is one hundredth of one percent (=0.01%
Basis Risk
The risk to a hedger arising from uncertainty about the basis at a future time
Basis Swap
A swap where cash flows determined by one floating reference rate are exchanged for cash flows determined by another floating reference rate
Basket Credit Default Swap
Credit default swap where there are several reference entities
Basket Option
An option that provides a payoff dependent on the value of a portfolio of assets
Bear Spread
An option or futures spread designed to profit in a bear market.
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A short position in a put option with strike price K(v1) combined with a long position in a put option with strike price K(V2) where K(V2)
K(v1)A bear spread can also be created with call options
Beta
A measure of the responsiveness of a security or portfolio to the market as a whole. The term is generally used in the context of equity securities.
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A measure of the systematic risk of an asset
Bid-Ask Spread
The amount by which the ask price exceeds the bid price
Binomial Pricing Model
A model based on the assumption that at any point in time, the price of the underlying asset or futures contract can change to one of only two possible variables
Bid Price
The price that a dealer is prepared to pay for an asset
Bilateral Clearing
Arrangement between two parties to handle transactions in the OTC market, often involving an ISDA Master Agreement
International Swaps and Derivatives Association (ISDA)
Trade Association for over-the-counter derivatives and developer of master agreements used in the over-the-counter contracts.
Initial Margin
The cash required from a futures trader at the time of the trade
Index Option
An option contract on a stock index or other index
Instantaneous Forward Rate
Forward rate for a very short period of time in the future
Index Futures
A future contract on a stock index or other index
IMM Dates
Third Wednesday in March, June, September, and December
Implicit Finite Difference Model
A method for valuing a derivative by solving the underlying differential equation. The value of the derivative at time r+▲t is related to three values at t.
Implied Correlation
Correlation number implied from the price of a credit derivative using the Gaussian copula or similar method
Implied Distribution
A distribution for a future asset price implied from option prices
Implied Dividend Yield
Dividend yield estimated using put-call parity from the prices of calls and puts with the same strike price and time to maturity
Implied Tree
A tree describing the movements of an asset price that is constructed to be consistent with observed option prices
Implied Volatility
Volatility implied from an option price using the Black-Scholes or a similar method
implied Volatility Function (IVF) Model
Model designed so that it matches the markets of all European options
Inception Profit
Profit created by selling a derivative for more than its theoretical value
Interest Rate Cap
An option that provides a payoff when a specified interest rate is above a certain level. The interest rate is a floating rate that is reset periodically
Interest Rate Collar
A combination of an interest-rate cap and an interest rate floor
Interest Rate Floor
An option that provides a payoff when an interest rate is below a certain level. The interest rate is a floating rate that is reset periodically
Interest Rate Derivative
A derivative whose payoffs are dependent on future interest rates
Interest Rate Option
An option where the payoff is dependent on the level of interest rates
Interest Rate Swap
An exchange of a fixed rate of interest on a certain notional principal for a floating rate of interest on the same notional principal
In-the-Money Option
Either:
a.) a call option where the asset price is greater than the strike
price; or
b.) a put option where the asset price is less than the strike price
Intrinsic Value
For a call option, this is the greater of the excess of the asset price over the strike price and zero. For a put option, it is the greater of the excess of the strike price over the asset price and zero.
Inverted Markets
A market where futures prices decrease with maturity.
Investment Asset
An asset held by at least some individuals for investment purposes.
IO (Interest Only)
Interest Only. A mortgage-backed security where the holder receives only interest cash flows on the underlying mortgage pool.
Itoˆ Process
A stochastic process where the change in a variable during each short period of time of length t has a normal distribution. The mean and variance of the distribution are proportional to t and are not necessarily constant.
Itoˆ’s Lemma
A result that enables the stochastic process for a function of a variable to be calculated from the stochastic process for the variable itself.
ITraxx Europe
Portfolio of 125 investment-grade European companies
Jump-Diffusion Model
Model where asset price has jumps superimposed on to a diffusion process such as geometric Brownian motion.
Jump Process
Stochastic process for a variable involving jumps in the value of the
variable.
Kurtosis
A measure of the fatness of the tails of a distribution.
LEAPS (Long-term Equity Anticipation Securities)
Long-term equity anticipation securities. These are relatively long-term options on individual stocks or stock indices.
LIBID (London Interbank Bid Rate)
London interbank bid rate. The rate bid by banks on Eurocurrency deposits (i.e., the rate at which a bank is willing to borrow from other banks).
Liquidity Preference Theory
A theory leading to the conclusion that forward interest rates are above expected future spot interest rates.
Liquidity Premium
The amount that forward interest rates exceed expected future
spot interest rates
Liquidity Risk
Risk that it will not be possible to sell a holding of a particular instrument at its theoretical price. Also, the risk that a company will not be able to borrow money to fund its assets.
Lognormal Distribution
A variable has a lognormal distribution when the logarithm
of the variable has a normal distribution
Long Hedge
A hedge involving a long futures position
Long Position
A position involving the purchase of an asset.
Lookback Options
An option whose payoff is dependent on the maximum or min
imum of the asset price achieved during a certain period
Maintenance Margin
When the balance in a trader’s margin account falls below the
maintenance margin level, the trader receives a margin call requiring the account to be topped up to the initial margin level.
Margin
The cash balance (or security deposit) required from a futures or options trader
Margin Call
A request for extra margin when the balance in the margin account falls below the maintenance margin level.
Market-Leveraged Stock Unit (MSU)
A unit entitling the holder to receive shares of a stock at a future time. The number of shares received depends on the stock price.
Market Maker
A trader who is willing to quote both bid and offer prices for an asset
Market Model
A model most commonly used by traders.
Market Price of Risk
A measure of the trade-offs investors make between risk and return.
Market Segmentation Theory
A theory that short interest rates are determined independently of long interest rates by the market.
Marking to Market
The practice of revaluing an instrument to reflect the current values of the relevant market variables
Markov Process
A stochastic process where the behavior of the variable over a short
period of time depends solely on the value of the variable at the beginning of the period, not on its past history.
Martingale
A zero drift stochastic process.
Maturity Date
The end of the life of a contract.
Maximum Likelihood Method
A method for choosing the values of parameters by maximizing the probability of a set of observations occurring.
Mean Reversion
The tendency of a market variable (such as an interest rate) to revert
back to some long-run average level
Measure
Sometimes also called a probability measure, it defines the market price of risk.
Mezzanine Tranche
Tranche which experiences losses after equity tranche but before
senior tranches.
Modified Duration
A modification to the standard duration measure so that it more
accurately describes the relationship between proportional changes in a bond price and actual changes in its yield. The modification takes account of the compounding frequency with which the yield is quoted.
Money Market Account
An investment that is initially equal to $1 and, at time t, increases at the very short-term risk-free interest rate prevailing at that time.
Monte Carlo Simulation
A procedure for randomly sampling changes in market variables in order to value a derivative.
Mortgage-Backed Security
A security that entitles the owner to a share in the cash flows realized from a pool of mortgages.
Naked Position
A short position in a call option that is not combined with a long
position in the underlying asset.
Netting
The ability to offset contracts with positive and negative values in the event of a default by a counterparty or for the purpose ofdetermining collateral requirements.
Newton-Raphson Method
An iterative procedure for solving nonlinear equations.
NINJA
A term used to describe a person with a poor credit risk: no income, no job, no assets.
No-Arbitrage Assumption
The assumption that there are no arbitrage opportunities in market prices.
No-Arbitrage Interest Rate Model
A model for the behavior of interest rates that is exactly consistent with the initial term structure of interest rates.
Nonstationary Model
A model where the volatility parameters are a function of time
Nonsystematic Risk
Risk that can be diversified away.
Normal Backwardation
A situation where the futures price is below the expected future spot price.
Normal Distribution
The standard bell-shaped distribution of statistics
Normal Market
A market where futures prices increase with maturity.
Notional Principal
The principal is used to calculate payments in an interest rate swap. The principal is ‘‘notional’’ because it is neither paid nor received
Numeraire
Defines the units in which security prices are measured. For example, if the price of IBM is the numeraire, all security prices are measured relative to IBM. If IBM is $80 and a particular security price is $50, the security price is 0.625 when IBM is the numeraire
Numerical Procedures
A method of valuing an option when no formula is available.
Open Interest
The total number of long positions outstanding in a futures contract
(equals the total number of short positions)
Open Outcry
System of trading where traders meet on the floor of the exchange
Option
The right to buy or sell an asset.
Option-Adjusted Spread
The spread over the Treasury curve that makes the theoretical price of an interest rate derivative equal to the market price.
Option Class
All options of the same type (call or put) on a particular stock
Option Series
All options of a certain class with the same strike price and expiration
date.
Out-of-the-Money Option
Either
(a) a call option where the asset price is less than
the strike price or
(b) a put option where the asset price is greater than the strike
price
Overnight Indexed Swap
Swap where a fixed rate for a period (e.g., 1 month) is exchanged for the geometric average of the overnight rates during the period
Over-the-Counter Market
A market where traders deal by phone. The traders are usually financial institutions, corporations, and fund managers
Package
A derivative that is a portfolio of standard calls and puts, possibly combined with a position in forward contracts and the asset itself
Par Value
The principal amount5 of a bond
Par Yield
The coupon on a bond that makes its price equal the principal
Parallel Shift
A movement in the yield curve where each point on the curve changes by the same amount
Parisian Option
Barrier option where the asset has to be above or below the barrier for a period of time for the option to be knocked in or out
Path-Dependent Option
An option whose payoff depends on the whole path followed by the underlying variable - not just its final value
Payoff
The cash realized by the holder of an option or other derivative at the end of its life
PD
Probability of Default
Perpetual Derivative
A derivative that lasts forever
Plain Vanillla
A term used to describe a standard deal
P-Measure
Real-World Measure
PO (Principal Only)
A mortgage-backed security where the holder receives only the principal cash flows on the underlying mortgage pool
Poisson Process
A process describing a situation where events happen at random.
Futures trading commenced first on _________?
Who are the participants in the derivative markets?
OTC derivatives are considered risky because ______?
Some of the main variants of derivative markets are____?
Types of options include?
a. Call
b. Put
c. Both a and b
d. None of the above
C Both Call and Put are types of options
Long Call
Consists of buying calls for investors who want a chance to participate in the underlying stock’s expected appreciation during the term off the option.
The potential profit is unlimited, while the potential losses are limited to the premium paid for the call.
Long Put
Consists of buying puts and will profit if the stock price moves lower. It is a candidate for bearish investors who want to participate in an anticipated downturn, but without the risk and inconveniences of selling the stock short.
The potential profit is significant, but the loses are limited to the premium paid
Covered Call
This strategy consists of writing (selling) a call that is covered by an equivalent long stock opo
Anticipatory Hedge
A long anticipatory hedge is initiated by buying futures contracts to protect against a rise in the price of an asset that will need to be purchased at a later date.
A short anticipatory hedge is initiated by selling futures contracts to protect against the decline in price of an asset to be sold at a future date
Model Risk Disclosure
Issued by the members of Exchanges and contains important information on trading in Equities and F&O Segments of exchanges. All prospective participants should read this document before trading on Capital Market/Cash Segment, or F&O segment of the Exchanges
Index
A statistical indicator that measures changes in economy in general or in particular areas
Index Derivatives
Derivatives that have the index as the underlying asset
Essential Features of a Forward:
Forwards are bilateral over the counter (OTC) transactions where the terms of the contract, such as price, quantity, quality, time and place are negotiated between two parties to the contract. Any alteration in the terms of the contract is possible if both parties agree to it. Corporations, traders and investing institutions extensively use OTC transactions to meet their specific requirements.
Major limitations of forwards
Liquidity Risk - Liquidity is nothing but the ability of the market participants to buy or sell the desired quantity of an underlying asset
Counterparty risk - Counterparty risk is the risk of an economic loss from the failure of a counterparty to fulfill its contractual obligation. In addition to the illiquidity and counterparty risks, there are several issues like lack of transparency, and settlement complications as it is to be done directly between the contracting parties
