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.
Forward
In a forward transaction, two parties agree to terms of a trade which is to be carried out some time in the future. The buyer does not pay the agree upon price right away, nor does the seller deliver the underlying interest. Payment and delivery take place at a specified date in the future, known as the delivery date. The delivery price is agreed upon when the contact is entered into. Forwards that trade on an exchange are typically referred to as futures contracts. Forwards that trade OTC are typically referred to as forward agreements.
Forward Agreement
When a forward-based derivative is traded over-the-counter, it is generally referred to as a forward agreement.
Forward Rate Agreement
A forward agreement that is based on interest rates. The parties to a forward rate agreement are able to fix an interest rate for a transaction that is going to take place at some point in the future.
Fundamental Analysis
The study of an asset’s current and expected supply and demand situation in order to help forecast future price movements.
Futures Contract
A forward-based derivative that trades on an exchange.
Hedge
An attempt to reduce risk by making transactions that reduce exposure to market fluctuations. Hedging with derivatives involves taking an opposite position in the derivative instrument of the asset to be hedged (or one that is very close to it) that is equal in size.
Hedge Funds
A term commonly used to describe lightly regulated pools of capital that have great flexibility in their choice of investment strategies.
Hedge Fund-Linked Notes
Principal protected notes in which the return is linked to the performance of an underlying hedge funds, or more commonly a portfolio of hedge funds.
Historical Volatility
Past or historical volatility of an underlying asset, measured by taking the standard deviation of price changes over a set period of time.
Imperfect Hedge
The result of hedge that does not perform as the hedger expected due to unexpected changes in the basis. A hedge may turn out to be imperfect if there is a difference between the asset underlying the futures contract and the asset being hedged, or if the assets match, but the hedge is lifted early and the basis has changed unexpectedly.
Implied Forward Rate
A rate of interest derived from current spot rates that is applicable to a future time period.
Implied Volatility
The volatility implicit in an option’s premium.
In-the-Money
The amount of intrinsic value an option has. A call option is in-the-money if the market price of the underlying asset is higher than the exercise price. A put option is in-the-money if the market price is lower than the exercise price.
Index-Linked Notes
Principal protected notes in which the return is linked to the performance of an equity index, such as the S&P/TSX 60 Index
Index Option
Option contact on a stock index or other financial index.
Index Swap
A swap where payments of one counterparty are tied to the value of a particular index.
Indication Pricing Schedule
A schedule of rates provided by a swap dealer.
Intercommodity Spread
A spread that involves the purchase and sale of futures contacts that have different but related underlying assets. The two contracts may trade on the same or different exchanges.
Interest Rate Cap
Essentially a series of European call options on interest rates (as opposed to call options on an underlying debt instrument). The holder of the cap gets paid on each settlement date the amount, if any, by which the reference interest rate is above the exercise or strike price.
Interest Rate Collar
A combination of a cap and a floor created by purchasing a cap, while simultaneously selling a floor.
Interest Rate Floor
Essentially a series of European put options on interest rates (as opposed to put options on an underlying debt instrument). The holder o the floor gets paid on each settlement date the amount, if any, by which the reference interest rate is below the exercise or strike price.
Interest Rate Swap
An interest rate swap involves two counterparties, A and B. Under a plain vanilla interest rate swap, counterparty A agrees to pay counterparty B periodic cash flow equal to interest, calculated at a predetermined fixed rate, on a notional principal throughout the life of the swap. Meanwhile, counterparty B agrees to pay interest, calculated at a floating rate, on the same notional principal to counterparty A. Only net cash flows are exchanged.
Intermarket Spread
A spread that involves the purchase and sale of futures contracts that have the same underlying asset but trade on different exchanges.
Intramarket Spread
Also known as a calendar or time spread. Involves buying and selling futures contracts that trade on the same exchange and that have the same underlying interest but different expiry months.
Intrinsic Value
For a call option, intrinsic value is calculated by subtracting the exercise price from the market price. For a put option, intrinsic value is calculated by subtracting the market price from the exercise price. For both calls and puts, intrinsic value cannot be less than zero.
Inverted Market (or Backwardation)
A commodity market where the forward or futures price is lower than the cash or spot price. Also known as backwardation. Inversions occur in commodity futures markets largely due to low near-term supply or high demand of the physical commodity relative to forward supply and demand.
Leverage
The ability to control large dollars amounts of an underlying interest with a comparatively small amount of capital. Leverage can greatly magnify the effect of price changes in an underlying interest.
Liquidity Risk
Risk that a derivative cannot be purchased or sold quickly enough or in the required quantity at a fair price
Locals (Scalpers)
Floor traders who trade for their own accounts.
Long Hedge
A hedge that involves buying the futures contract in anticipation of buying the physical asset at some point in the future. Long hedgers are concerned that the price of the underlying asset will rise in the future, making it more expensive to buy.
Long Position
For forward-based derivatives, the party that agrees to buy the asset has the long position in the contract. For option-based derivatives, the party that pays the premium has the long position in the contract.
Maintenance Margin
The minimum balance for margin required during the life of a futures contract.
Managed Account
Individual accounts where a client gives discretionary authority over to a commodity trading professional.
Managed Futures Fund
Essentially mutual funds that invest in futures markets.
Margin
An amount of money deposited by both buyers and sellers of futures contracts to ensure performance of the terms of the contract (the delivery or taking of delivery of the commodity or offset of the contract). Margin is not a payment of equity, merely a performance bond or good faith deposit.
Market Risk
The risk that any market-related factor will cahnge the value of a derivatives position.
Market Value CDO
In a market value CDO, underlying assets are marked-to-market and payments to tranches are a function of the collateral?s market value.
Marking-to-Market
The process in a futures market in which the daily price changes are paid by the parties incurring losses to the parties earning profits.
Multi-Asset Options
Consists of a family of options whose payoffs depend on the prices of more than one asset.
Mutual Fund-Linked Notes
Principal protected notes in which the return is linked to a particular mutual fund or portfolio of mutual funds.
National Instruments
A set of rules and regulations established by the Canadian Securities Administrators that is legally binding in all jurisdictions in Canada.
NI 81-102
A set of rules and regulations that must be complied with by publicly offered investment funds.
NI 81-104
Introduced in 2002, National Instrument 81104 sets out the rules that govern the operation of commodity pools. It allows them to invest in commodities and use leverage and derivatives in ways not permitted for conventional mutual funds.
Offsetting Transaction
A futures or option transaction that is the exact opposite of a previously established long or short position.
Optimal Hedge Ratio
Represents the ratio used to calculate how many futures contracts should be used in a particular hedge by comparing price volatility of the futures and cash price.
Option
A derivative instrument that gives the purchaser the right, but not the obligation to, buy or sell an underlying asset at a certain price (exercise price) on or before an agreed upon date. For this right the purchaser pays a premium to the seller (writer) of the option. The writer has an obligation, if called upon to do so by the purchaser, to buy, in the case of puts, or sell, in the case of calls, at the exercise price.
Original Margin
The required deposit when a futures contract is entered into.
Out-of-the-Money
A call option is considered out-of-the-money if the market price of the underlying asset is lower than the exercise price. A put option is considered out-of-the-money if the market price is higher than the exercise price.
Over-the-Counter Market
A market that generally consists of a loosely connected network of brokers and dealers who negotiate transactions directly with one another primarily over telephone lines and/or computer terminals.
Perfect Hedge
A hedge in which the futures price behaved exactly as expected relative to the cash price.
Performance Bond
What is often required upon entry into a futures contract is a performance bond or good-faith deposit, which gives the parties to a transaction a higher level of assurance that the terms of the contract will eventually be honored. The performance bond is often referred to as margin.
Plain Vanilla Swap
A term used to describe the most basic type of swap.
Portfolio CDS
A CDS written on a basket of underlying assets but that has a predetermined monetary amount, rather than a number of defaults.
Position Trader
A type of speculator who is hoping to profit from longer-term price trends.
Premium
The price of an option.
Principal-Protected Note (PPN)
A debt-like instrument with a maturity date on which the issuer agrees to repay investors the principal. In addition to the principal, investors may receive interest, the rate of which is tied to the performance of an underlying asset.
Protection Buyer
The party wanting to reduce credit risk in the use of credit derivatives.
Protection Seller
The party wanting to acquire or hold credit risk in the use of credit derivatives.
Put
The right to sell (and lock in a sale price) is referred to as a put option as the put buyer has the right to put the underlying asset to the put writer (seller) during the life of the contract.
Quanto Swap
An interest rate swap where the interest rate payments on the notional principal are determined based on the interest rate of a currency other than the one the notional is denominated in.
Recovery Rate
The realizable rate of recovery of the underlying asset(s), as determined by an independent assessor, if a cash settled CDS is activated.
Reference Asset
The underlying asset(s) being protected in a credit derivative.
Reference Entity
The issuer of the underlying asset(s) being protected in a credit derivative.
Reverse Cash and Carry Arbitrage
Arbitrage that involves buying the futures contract and selling the underlying asset to take advantage of a situation where the futures contract is underpriced relative to fair value.
Segregation of Compensation
A crucial principle that should be followed in any effective internal control and monitoring system. Compensation for back-office personnel should be independent from those who work in the front office. As well, individuals who are responsible for monitoring and controlling derivatives must not receive a bonus or other reward from the profits generated from traders.
Settlement Price
The settlement price is determined at the end of each trading day by the ?Pit Committee? of the Exchange. The price usually represents the average of futures prices for trades made toward the end of the day.
Short Hedge
A hedge that involves selling the futures contract in anticipation of selling the physical asset at some point in the future. Short hedgers are concerned that the price of the underlying asset will decline in the future, meaning they will not receive as high a price when they are ready to sell the underlying asset.
Short Position
For forward-based derivatives, the party that agrees to sell the asset has the short position in the contract. For option-based derivatives, the party that receives the premium has the short position in the contract.
Shout Option
An option that permits the holder at any time during the life of the option to establish a minimum payoff that will occur at expiration.
Single-Name CDS
A plain vanilla single asset CDS, which is basically credit protection (insurance).
Special Purpose Vehicle (SPV)
A legal, independent entity created specifically for each individual CDO. Its role is to take over the loans from the originator and to issue the CDO tranches against these.
Spot Price
The price of an asset on the spot market.
Spreading
Describes a market strategy that attempts to take advantage of relative price changes between two different but similar futures contracts.
Strike Price
See Exercise Price.
Structured Products
Investment instruments that combine at least one derivative with traditional assets such as equity and fixed-income securities. The value of the derivative(s) depend on one or more underlying assets.
Swap
A private, contractual agreement between two parties used to exchange (swap) periodic payments in the future based on an agreed to formula. Swaps are essentially equivalent to a series of forward contracts packaged together.
Swap Dealer
A swap dealer is a financial intermediary who facilitates the entire swap process by finding and bringing together the two sides of a swap agreement and tailoring a product to meet the specific needs of the end-users. The swap dealer simplifies the process by acting as a counterparty for each of the two end-users.
Synthetic CDO
A CDO in which the originator retains ownership of the underlying assets and buys protection from the SPV using a credit default swap, thus swapping the credit risk over to the SPV.
Synthetic Equity Position
A position that allows an investor to earn equity returns without actually taking a position in equity.
Technical Analysis
The study of past price and volume data in order to anticipate future market movements.
Time to Expiration
All derivative contracts have a specific time to expiration. Both parties must honour the contract?s obligations, or, if they plan to, exercise the rights (i.e., the buying or selling of a specified underlying interest) of the contract by expiration. The contract is utomatically terminated upon expiration.
Time Value
The premium of the option less its intrinsic value.
Trading Limits
Exchanges set limits on the amount by which most futures can move, either up or down, during one day?s trading session. If the price moves down by an amount equal to the daily limit, the contract is said to be limit down. If it reaches the upper limit then it is said to be limit up. The limits are designed to calm market panic, and to give market participants time to absorb new information that may have been disseminated.
Trading Unit
The size of the asset underlying the derivative contract. All North American-listed equity options, for example, have a trading unit of 100 shares of the underlying stock.
Triggering Events
A swap contract may call for collateral to be posted or increased if a triggering event takes place such as a downgrade of a counterparty?s credit rating.
Uncovered
When an investor writes an option without having an underlying position that would satisfy the obligation in case of assignment.
Underlying Interest
The value of a derivative instrument is based on 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.
Warehouse Receipt
Even if an individual decides to take delivery, what is received/delivered in the case of most physical commodities is a warehouse receipt which the seller endorses over to the buyer. The receipt is issued by a storage point authorized by the exchange which confirms the presence and ownership of the underlying asset.
Warehousing
When a swap dealer enters into an agreement with one party, it typically takes some time before it finds and arranges an offsetting agreement with another party. In such cases the dealer has to warehouse the swap and hedge its exposure.
Weather Derivatives
A financial instrument whose value is derived from the behaviour of weather patterns.
Writer
An investor who sells an option as an opening transaction. The writer may be obligated to either buy (put writer) or sell (call writer) the underlying asset if called upon to do so by the option buyer.
Zero-Coupon Bond Plus Call Option
The oldest PPN structure and the simplest. When this type of PPN is issued, a large portion of the principal is used to purchase a zero-coupon bond whose maturity date and value matches that of the PPN, thereby guaranteeing the PPN principal is returned. The remaining funds?minus fees?are then used to purchase call options on a risky underlying asset to provide a return.
Zero-Sum Game
Describes the fact that, commission fees and bid-ask spreads aside, the gain from a derivative contract by one counterparty is exactly offset by the loss to the other counterparty.
