Derivatives: Basics of Pricing and Valuation Flashcards
Arbitrage-free pricing
The overall process of pricing derivatives by arbitrage and risk neutrality.
At the money
An option in which the underlying’s price equals the exercise price.
Binomial model
A model for pricing options in which the underlying price can move to only one of two possible new prices.
Carry
The net of the costs and benefits of holding, storing, or “carrying” an asset.
Convenience yield
A non-monetary advantage of holding an asset.
Cost of carry
The net of the costs and benefits of holding, storing, or “carrying” an asset.
Exercise value
The value obtained if an option is exercised based on current conditions.
Fiduciary call
A combination of a European call and a risk-free bond that matures on the option expiration day and has a face value equal to the exercise price of the call.
Forward contract
An agreement between two parties in which one party, the buyer, agrees to buy from the other party, the seller, an underlying asset at a later date for a price established at the start of the contract.
Forward Rate Agreement
A forward contract calling for one party to make a fixed interest payment and the other to make an interest payment at a rate to be determined at the contract expiration.
Futures contract
A variation of a forward contract that has essentially the same basic definition but with some additional features, such as a clearinghouse guarantee against credit losses, a daily settlement of gains and losses, and an organized electronic or floor trading facility.
In the money
Options that, if exercised, would result in the value received being worth more than the payment required to exercise.
Intrinsic value
The value obtained if an option is exercised based on current conditions.
Moneyness
The relationship between the price of the underlying and an option’s exercise price.
Option
A financial instrument that gives one party the right, but not the obligation, to buy or sell an underlying asset from or to another party at a fixed price over a specific period of time.
Out of the money
Options that, if exercised, would require the payment of more money than the value received and therefore would not be currently exercised.
Principle of no arbitrage
The overall process of pricing derivatives by arbitrage and risk neutrality.
Protective put
An option strategy in which a long position in an asset is combined with a long position in a put.
Put–call–forward parity
The relationship among puts, calls, and forward contracts.
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.
Replication
The creation of an asset or portfolio from another asset, portfolio, and/or derivative.
Risk-neutral pricing
Sometimes said of derivatives pricing, uses the fact that arbitrage opportunities guarantee that a risk-free portfolio consisting of the underlying and the derivative must earn the risk-free rate.
Risk-neutral pricing
Weights that are used to compute a binomial option price. They are the probabilities that would apply if a risk-neutral investor valued an option.
Swap contract
An agreement between two parties to exchange a series of future cash flows.
Time Value
The difference between the market price of the option and its intrinsic value.
Time value decay
Said of an option when, at expiration, no time value remains and the option is worth only its exercise value.
