Derivatives (7%) Flashcards
cash markets
Markets in which specific assets are exchanged at current prices. Cash markets are often referred to as spot markets.
spot markets
Markets in which specific assets are exchanged at current prices. Spot markets are often referred to as cash markets.
cash prices
The current prices prevailing in cash markets.
spot prices
The current prices prevailing in spot markets.
derivative
financial contract that derives its value from the performance of an underlying asset, which may represent a firm commitment or a contingent claim
underlying
The asset referred to in a derivative contract.
forward contract
A derivative contract for the future exchange of an underlying at a fixed price set at contract signing.
counterparty
Legal entities entering a derivative contract.
counterparty credit risk
The likelihood that a counterparty is unable to meet its financial obligations under the contract.
settlement
(context: derivative contract)
The closing date at which the counterparties of a derivative contract exchange payment for the underlying as required by the contract.
contract size
Amount(s) used for calculation to price and value the derivative. The contract size is often referred to as “notional amount or notional principal.
embedded derivative
A derivative within an underlying, such as a callable, putable, or convertible bond.
firm commitment
(context: derivatives)
A pre-determined amount (price and quantity) is agreed to be exchanged at settlement. Examples of firm commitments include forward contracts, futures contracts, and swaps.
swap contract (swaps)
firm commitment to exchange a series of cash flows in the future.
contingent claim
A type of derivative in which one of the counterparties determines whether and when the trade will settle.
An option is a common type of contingent claim.
hedging
The use of a derivative contract to offset or neutralize existing or anticipated exposure to an underlying.
hedge
The derivative contract used in hedging an exposure.
over-the-counter (OTC)
Refers to derivative markets in which derivative contracts are created and traded between derivatives end users and dealers, or financial intermediaries, such as commercial banks or investment banks
OTC markets
formal organizations, such as NASDAQ, or informal networks of parties that buy from and sell to one another, as in the US fixed-income markets
dealers
Financial intermediaries, such as commercial banks or investment banks, who transact as counterparties with derivative end users.
market makers
Over-the-counter (OTC) dealers who typically enter into offsetting bilateral transactions with one another to transfer risk to other parties.
Exchange-Traded Derivative (ETD) Markets
Futures, options, and other financial contracts available on exchanges.
Clearing
An exchange’s process of verifying the execution of a transaction, exchange of payments, and recording of participants.
Central Clearing Mandate
A requirement instituted by global regulatory authorities following the 2008 global financial crisis that most over-the-counter (OTC) derivatives be cleared by a central counterparty (CCP).
Central Counterparty (CCP)
An economic entity that assumes the counterparty credit risk between derivative counterparties, one of which is typically a financial intermediary. CCPs provide clearing and settlement for most derivative contracts.
swap execution facility (SEF)
swap trading platform accessed by multiple dealers
novation process
A process that substitutes the initial swap execution facility(SEF) contract with identical trades facing the central counterparty (CCP).
The CCP serves as counterparty for both financial intermediaries, eliminating bilateral counterparty credit risk and providing clearing and settlement services.
three-step swap process
- company needing swap reaches out to dealers
- dealers access trade platform on behalf of client, share details about trade. trade is started on the “SEF” network.
- “SEF” submits trade to CCP
- “SEF” hands off trade to CCP, which acts as the new counterparty to both dealers.
Index swaps
allow the investor to pay the return on one stock index and receive the return on another index or interest rate.
An investment manager can use index swaps to increase or reduce exposure to an equity market or sector without trading the individual shares.
equity swaps
allow the investor to pay the return on one stock index and receive the return on another index or interest rate.
An investment manager can use index swaps to increase or reduce exposure to an equity market or sector without trading the individual shares.
market reference rate (MRR)
The interest rate underlying used in interest rate swaps.
For example, the Secured Overnight Financing Rate (SOFR) is an overnight cash borrowing rate collateralized by US Treasuries. Other MRRs include the euro short-term rate (€STR) and the Sterling Overnight Index Average (SONIA).
soft commodities
Standardized agricultural products, such as cattle and corn, with markets often involving the physical delivery of the underlying upon settlement.
hard commodities
Traded natural resources, such as crude oil and metals, with markets often involving the physical delivery of the underlying upon settlement.
Credit derivative contracts
A derivative contract based upon the default risk of a single issuer or a group of issuers in an index.
Credit default swaps (CDS) allow an investor to manage the risk of loss from borrower default separately from the bond market. CDS contracts trade on a spread that represents the likelihood of default.
forward price
Represents the price agreed upon in a forward contract to be exchanged at the contract’s maturity date, T. This price is shown in equations as F0(T).
linear derivatives
Firm commitment derivative contracts in which the contract’s payoff/profit function is linear with respect to the price of the underlying.
breakeven point
(derivatives)
Represents the price of the underlying in a derivative contract in which the profit to both counterparties would be zero.
futures contracts
Forward contracts with standardized sizes, dates, and underlyings that trade on futures exchanges.
futures price, f0(T)
The pre-agreed price at which a futures contract buyer (seller) agrees to pay (receive) for the underlying at the maturity date of the futures contract.
mark to market (MTM)
The practice in which a central clearing party assigns profits and losses to counterparties to derivative contracts. In exchange-traded markets, this practice takes place daily and is often referred to as daily settlement.
daily settlement
A specific process of mark-to-market by a central clearing party in which the profits and losses of all counterparties to derivatives contracts are determined using settlement prices for each contract.
settlement price
The price determined by an exchange’s clearinghouse in the daily settlement of the mark-to-market process. The price reflects an average of the final futures trades of the day.
initial margin
The ratio of the price of collateral to the value of cash exchanged in a repo; a value over 1.0 or 100% indicates overcollateralization.
futures margin account
An account held by an exchange clearinghouse for each derivatives counterparty. The funds in such an account are used to ensure that counterparties do not default on their contract obligation.
maintenance margin
Minimum balance set below the initial margin that each contract buyer and seller must hold in the futures margin account from trade initiation until final settlement at maturity.
margin call
Request to a derivatives contract counterparty to immediately deposit funds to return the futures margin account balance to the initial margin.
variation margin
The difference between current margin required and the current collateral price in a repurchase agreement.
price limits
(futures)
Establish a band relative to the previous day’s settlement price within which all trades must occur.
circuit breaker
A pause in intraday trading for a brief period if a price limit is reached.
open interest
The number of outstanding contracts.
floating-rate payer
The counterparty paying the variable cash flows in a swap contract. May also be referred to as the fixed-rate receiver.
fixed-rate payer
The counterparty paying fixed cash flows in a swap contract. May also be referred to as the floating-rate receiver.
swap rate
The fixed rate to be paid by the fixed-rate payer specified in a swap contract.
exercise
The decision to transact the underlying by an option holder.
exercise price
(or strike price)
The pre-agreed execution price specified in an option contract. Sometimes, this price is referred to as the strike price.
option premium
An amount that is paid upfront from the option buyer to the option seller. Reflects the value of the option buyer’s right to exercise in the future.
European options
Options that may be exercised only at contract maturity.
American options
Options that may be exercised at any time from contract inception until maturity.
call option
The right to buy an underlying.
put option
The right to sell an underlying.
option’s intrinsic value
The amount gained (per unit) by an option buyer if an option is exercised at any given point in time. May be referred to as the exercise value of the option.
in-the-money
Describes an option with a positive intrinsic value.
We can say a call option is in-the-money at time t if the spot price, St, exceeds X, with an intrinsic value equal to (St – X).
out-of-the-money
Describes an option with zero intrinsic value because the option buyer would not rationally exercise the option. An example of such would be the case in which the price of the underlying is less than the option’s exercise price for a call option.
St < X
at-the-money
Describes a unique situation in which the price of the underlying is equal to an option’s exercise price. Like an out-of-the-money option, the intrinsic value is zero.
call option value at maturity, cT
cT = max(0, ST – X)
call option buyer’s profit
Π = max(0, ST – X) – c0
non-linear derivatives
Derivatives, such as options or other contingent claims, with payoff/profit profiles that are non-linear (asymmetric) with respect to the price of the underlying
time value of an option
The difference between an option’s premium and its intrinsic value.
This time value of an option is always positive and declines to zero as an option reaches maturity.
long put option value at maturity, pT
pT = max(0, X – ST).
long put option buyer’s profit
Π = max(0, X – ST) – p0.
short put option value at maturity, pT
–pT = –max(0, X – ST).
short put option profit
Π = –max(0, X – ST) + p0.
credit derivative contracts
contracts based on a credit underlying, or the default risk of a single debt issuer or a group of debt issuers in an index.
credit default swap
A credit default swap (CDS) is a financial derivative that allows an investor to swap or offset their credit risk with that of another investor. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse them if the borrower defaults.
Most CDS contracts are maintained via an ongoing premium payment similar to the regular premiums due on an insurance policy. A lender who is worried about a borrower defaulting on a loan often uses a CDS to offset or swap that risk.
cds credit spread
Reflects the credit spread of a credit default swap (CDS) derivative contract.
As with cash bonds, CDS credit spreads depend on the probability of default (POD) and the loss given default (LGD).
high credit spread
higher likelihood of issuer financial distress) corresponds to a lower cash bond price, and vice versa.
credit event
An event that defines a payout in a credit derivative. Events are usually defined as bankruptcy, failure to pay an obligation, or an involuntary debt restructuring.
CDS contract contingent payment
loss given default for the CDS contract notional amount
short credit risk
(CDS)
A credit protection buyer without the corresponding fixed-income exposure who buys a CDS is seeking to gain from higher credit spreads (which correspond to lower cash bond prices) for an underlying issuer
Short forward position
A short forward position is a financial contract in which the holder agrees to sell an asset at a predetermined future date and price.
Long put position
A long put position involves buying a put option, which gives the holder the right, but not the obligation, to sell an underlying asset at a specified price (the strike price) before or at a specified expiration date
Short call position
A short call position involves selling a call option, which obligates the seller (writer) to sell the underlying asset at a specified price (the strike price) if the option is exercised by the buyer.
long cash position
long cash position, often referred to simply as a “long position,” involves owning an asset outright with the expectation that its value will increase over time.
covered call
sold call option
+
long cash position
covered call strategy
The covered call strategy allows investors to generate income from the premium received while providing some downside protection. The potential profit is capped at the strike price plus the premium received, while the risk of loss is reduced by the amount of the premium but still exists if the stock price falls significantly.
derivative benefits:
Information Discovery
Deliver information regarding expected price in the future and information regarding expected risk of underlying
derivative benefits:
Operational Advantages
Reduced cash outlay, lower transaction costs versus the underlying, increased liquidity and ability to “short”
derivative benefits:
Market Efficiency
less costly to exploit arbitrage opportunities or mispricing
derivative benefits:
Risk Allocation, Transfer, Management
Allocate, trade, and/or manage underlying exposure without trading the underlying
derivative benefits:
exposure
Create exposures unavailable in cash markets
structured notes
A broad category of securities that incorporate the features of debt instruments and one or more embedded derivatives designed to achieve a particular issuer or investor objective.
basis risk
(derivatives)
The possibility that the expected value of a derivative differs unexpectedly from that of the underlying.
Basis risk may arise if a derivative instrument references a price or index that is similar to, but does not exactly match, an underlying exposure such as a different market reference rate or an issuer CDS spread versus that of an actual bond. Basis risk is affected by supply and demand dynamics in derivative markets, among other factors.
liquidity risk
(derivatives)
A divergence in the cash flow timing of a derivative versus that of an underlying transaction.
systemic risk
Refers to risks supervisory authorities believe are likely to have broad impact across the financial market infrastructure and affect a wide swath of market participants.
derivative risks:
Greater Potential for Speculative Use
High degree of implicit leverage for some derivative strategies may increase the likelihood of financial distress.
derivative risks:
Lack of Transparency
Derivatives add portfolio complexity and may create an exposure profile that is not well understood by stakeholders.
derivative risks:
Basis Risk
Potential divergence between the expected value of a derivative instrument versus an underlying or hedged transaction
derivative risks:
Liquidity Risk
Potential divergence between the cash flow timing of a derivative instrument versus an underlying or hedged transaction
derivative risks:
Counterparty Credit Risk
Derivative instruments often give rise to counterparty credit exposure, resulting from differences in the current price versus the expected future settlement price.
derivative risks:
Destabilization and Systemic Risk
Excessive risk taking and use of leverage in derivative markets may contribute to market stress, as in the 2008 financial crisis.
hedge accounting
Accounting standard(s) that allow an issuer to offset a hedging instrument (usually a derivative) against a hedged transaction or balance sheet item to reduce financial statement volatility.
cash flow hedges
Absorbs variable cash flow of floating-rate asset or liability (forecasted transaction)
Ex:
Interest rate swap to a fixed rate for floating-rate debt
FX forward to hedge forecasted sales
fair value hedge
Offsets fluctuation in fair value of an asset or liability
Ex:
Interest rate swap to a floating rate for fixed-rate debt
Commodity future to hedge inventory
Net investment hedges
Designated as offsetting the FX risk of the equity of a foreign operation
Ex:
Currency swap
Currency forward
hedge accounting treatment
Hedge accounting allows an issuer to offset a hedging instrument (usually a derivative) against a hedged transaction or balance sheet item to reduce financial statement volatility.
replication
A strategy in which a derivative’s cash flow stream may be recreated using a combination of long or short positions in an underlying asset and borrowing or lending cash.
cost of carry
The net of the costs and benefits related to owning an underlying asset for a specific period.
relationship between the spot and forward prices
(no costs or benefits associated with the underlying asset)
F0(T) = S0*(1 + r)^T.
convenience yield.
A non-cash benefit of holding a physical commodity versus a derivative.
cost of carry for underlying asset:
Asset without cash flows
Benefits: None
Cost: Risk-Free Rate
cost of carry for underlying asset:
Dividend-paying stocks
Benefits: Dividend
Cost: Risk-Free Rate
cost of carry for underlying asset:
Equity indexes
Benefits: Dividend yield
Cost: Risk-Free Rate
cost of carry for underlying asset:
Soft and hard commodities
Benefits: Convenience yield
Cost: Risk-Free Rate; storage costs.
cost of carry for underlying asset:
debt instruments
Benefits: interest income
Cost: risk-free rate
cost of carry for underlying asset:
CDS
Benefits: credit spread
Cost: risk-free rate
initial value of:
forward, futures, or swap contracts
zero.
real-time value of:
forward contract
mark-to-market value of a contract reflects the change in the underlying price and other factors that would result in a gain or loss to a counterparty if the forward contract were to be settled immediately.
settlement:
forward contract
position settled at maturity
settlement:
future
position settled at end of every day
forward contract:
value at maturity
value at maturity is equal to the settlement amount from each counterparty’s perspective
forward contract:
value at time T
The mark-to-market value of a contract at any point in time from inception to maturity, Vt(T), reflects the relationship between the current spot price at time t (St) and the present value of the forward price at time t discounted at the current risk-free rate.
