Glossary Flashcards
Alternative Investment-Linked Notes
A category of principal protected notes in which the return may be linked to commodities, managed futures or income-producing notes.
American-Style
A type of option that can be exercised at any time up to the expiration of the option.
Amortizing Swap
An interest rate swap in which the notional principal amount is reduced over time until it reaches zero.
Arbitrage
Academic or pure arbitrage refers to the simultaneous purchase and sale of instruments that are perfect equivalents in the hope of taking advantage of pricing discrepancies between them to earn a risk-free profit. Most real world arbitrage, however, is not pure. There usually is some element of risk.
Arrears Swap
An arrangement where interest payments are made on the day the floating rate is determined (in contrast to the plain vanilla swap where the floating rate is determined prior to the interest payment date.)
Asian Option
An option whose payoff is based on the average price of the underlying asset over time until expiration. Also known as an average price option.
Assignment
When an option holder exercises, the writer is assigned to either buy or sell the underlying asset.
At-the-Money
When the exercise price of either a put or a call option is the same as the market price of the underlying asset.
Bankers’ Acceptance
A short-term promissory note issued by a corporation that has been backed by a chartered bank.
Barrier Option
An option where the payoff depends on whether or not the underlying asset reaches a pre-defined barrier during the life of the option.
Basis
The difference between the current cash price and the futures price.
Basis Risk
The risk of unexpected changes in the basis.
Basis Swap
An interest rate swap where the interest payments for both counterparties are determined by a floating rate.
Basket CDS
A CDS that offers protection on the default probabilities of a basket of assets.
Bilateral Netting
The consolidation of all swap agreements between two counterparties.
Call
The right to buy (and lock in a purchase price) is referred to as a call option as the call buyer has the right to call the underlying asset from the call writer (seller) during the life of the contract.
Canadian Securities Administrators (CSA)
A forum for the 13 securities regulators of Canada’s provinces and territories to coordinate and harmonize regulation of the Canadian capital markets.
Caplets
The individual option components of an interest rate cap.
Cash and Carry Arbitrage
Arbitrage that involves buying the underlying asset and selling the futures contract to take advantage of a situation where futures are priced higher than fair value.
Cash Settlement
A feature of certain types of futures and option contracts that allow delivery or exercise to be conducted with an exchange of cash rather than by delivery of a physical asset in exchange for payment. Stock index futures contracts are the most predominant type of cash-settled contract.
Clearinghouse
An organization that take care of financial settlement and helps ensure that markets operate efficiently. Clearinghouses can be set up either as a separate corporation or as a department of an exchange. The primary functions of a clearinghouse are to guarantee financial performance of each contract, clear all trades and handle deliveries.
Closed-End Fund
A fund with a fixed number of shares outstanding. The shares are brought and sold on a stock exchange instead of being issued and redeemed the way a typical mutual fund does.
Collateral
A form of credit enhancement. Collateral would have to be pledged by the party for which the swap has a negative value. The collateral could be pledged in the form of assets such as securities and real estate or a line of credit provided by another financial institution. Its value should be at least equal to the size of the liability stemming from the swap agreement.
Commodity Futures
Futures contracts that are based on a physical or “hard” asset such as gold, soybeans or crude oil.
Commodity Pool
Mutual funds that are allowed to use derivatives in a leveraged manner for speculation; pay incentive fees based on the total return of the fund since the last fee was paid; and to restrict redemption rights for a period up to six months after the initial purchase.
Commodity Product Spread
A spread that involves the purchase or sale of a commodity futures contract against the opposite position in the products of commodity.
Commodity Swap
A swap in which one counterparty agrees to make fixed periodic payments to a second counterparty for the use of a predetermined amount of a certain commodity. Simultaneously, the second counterparty agrees to make periodic payments to the first counterparty which are based on the same amount of a certain commodity but calculated at a floating unit price.
Comparative Advantage
The mechanism through which the cost of new or existing debt may be reduced by an interest rate or currency swap. Specifically, two companies with complementary relative advantages may come together and design a swap to reduce the financing costs of both companies.
Compound Option
An option on an option.
Constant Proportion Portfolio Insurance (CPPI)
An investment in which the principal is guaranteed by the use of a trading strategy in which allocations to a risky asset and a risk-free position are adjusted periodically. Adjustments to the allocations are based on the market value of the risky exposure and the cost of buying a zero-coupon risk-free bond which can be used to repay the principal of the security at maturity. This technique is often used to create principal-protected notes based on hedge funds investments.
Contango Market
A market where the forward or futures price is higher than the spot price. For commodity futures contracts, contango markets are considered normal as there is typically a cost to carrying or holding a commodity.
Convenience Yield
The benefit from owning the physical commodity. The value of the benefit is dependant upon the probability of shortages of the commodity. If the commodity is currently in short supply and that shortage is expected to continue, the convenience yield will be high.
Convergence
The narrowing of the basis as a futures contract nears expiration.
Cost of Carry
Term associated with the cost of holding a commodity or financial asset until it is sold or delivered. The cost of holding a commodity typically includes financing, storage and insurance charges. The cost of holding a financial asset typically includes financing costs less income received such as dividends for stocks and interest for debt instruments.
Counterparties
The buyer and seller of a derivative contract.
Covered
When an investor writes and option and has an underlying asset position that would satisfy the obligation in case of assignment.
Covered Call
The purchase of an underlying asset and the sale of a call option on that underlying asset.
Credit Enhancements
In order to control credit risk, dealers often require credit enhancements such as collateral from their counterparties.
Credit (or Counterparty) Risk
For a counterparty, credit risk stems from the possibility that the swap dealer may default. For the swap dealer, credit risk stems from the possibility that one of the counterparties may default.
Credit Default Swap (CDS)
The exchange of two cash flows - a fee payment and a conditional payment - which occurs only if certain circumstances are met. A CDS is credit insurance; it transfers credit risk.
Credit Derivatives
Financial instruments that derive their value from an underlying credit asset or pool of credit assets, such as bonds or mortgages, and are designed to transfer and manage credit risk.
Cross-Hedge
A hedge where the futures contract used has an underlying asset which is similar to but not the same as the physical commodity being hedged.
Currency Swap
In its simplest form, a plain fixed-for-fixed currency swap agreement between two counterparties in which the first counterparty agrees to exchange principal and fixed-rate interest payments on a loan denominated in one currency with the second counterparty’s principal and fixed-rate interest payments on a loan denominated in a different currency.
Daily Price Limit
In a futures contract, the maximum amount the price is allowed to rise or fall in one day.
Day Trader
A type of speculator whose time horizon is a single day.
Delivery Notice
When a short futures position holder wants to make delivery he/she notifies his/her broker who in turn tenders a delivery notice to the clearing corporation which then allocates the notice to a broker that had an account who is long that particular futures contract. Allocation by the clearing corporation and the broker is often done on a first-in-first out basis.
Delivery Price
The price that the purchaser of a forward-based contract agrees to pay to the seller of the contract upon delivery.
Delta
Indicates how much the price of an option is expected to change, given a price change in the underlying asset.
Delta Hedging
Adjusting the number of contracts used in an option hedge to reflect the option’s delta.
Derivatives
Financial instruments created by market participants so that they can trade and/or manage more easily the asset upon which these instruments are based. Their values are derived solely from an underlying interest which may be a commodity such as wheat or a financial product such as a bond or stock, a foreign currency, or an economic/stock index.
Equity Swap
An equity swap effectively creates a “synthetic” equity position. In an equity swap, counterparty A will make interest payments to counterparty B calculated at a fixed rate of interest on a notional amount of principal for the duration of the swap. In return, counterparty B will make payments to counterparty A equal to the return (or some fraction thereof) of the same notional amount of agreed upon equity index.
Eurodollar
A U.S. dollar deposited in a bank outside of the U.S. The bank could either be a foreign bank or a branch or a subsidiary of a U.S. bank.
European-Style Option
A type of option that can only be exercised at expiration.
Exchange-traded Derivatives
Forward and option products that trade on an organized exchange.
Exercise Price
The price at which an underlying security can be bought or sold if an option contract is exercised. Also known as the strike price.
Exotic Option
Any option that is not traded on an exchange and is not essentially identical to one traded on an exchange.
Expiration Date
The date on which a derivative contract becomes void.
Fair Value
If a futures contract is trading at a price that reflects full carry, it is said to be trading at fair or theoretical value.
Financial Futures
Futures contract that have a financial asset such as a bond, index or currency as their underlying asset.
First Notice Day
The day that the futures contract delivery process begins. Long position holders who maintain their positions on and after first notice day may have to accept delivery of the underlying asset from the seller of the contract.
First-To-Default CDS
A CDS that pays upon the first default of any of the referenced assets.
Foreign Exchange Agreement
A forward agreement based on a currency.