Glossary Part One Flashcards
(210 cards)
1
Q
Cash Settlement
A
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.
2
Q
Futures Exchange
A
An organized exchange where futures contracts and options on futures contracts are traded.
3
Q
Reference Asset
A
The underlying asset(s) being protected in a credit derivative
4
Q
Locals (Scalpers)
A
Floor traders who trade for their own accounts.
5
Q
Hedge Accounting
A
Hedge accounting should be applied when there is clear evidence that a derivatives transaction is driven by the identification of risk and the effective hedging of such risk. Requires that gains and losses on the hedging instrument (derivatives or otherwise) be recognized at the same time that the effects of related changes in the items being hedged are recognized.
6
Q
Counterparties
A
The buyer and seller of a derivative contract.
7
Q
National Instruments
A
A set of rules and regulations established by the Canadian Securities Administrators that is legally binding in all jurisdictions in Canada.
8
Q
NI 81-104
A
Introduced in 2002, National Instrument 81-104 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.
9
Q
Principal-Protected Note (PPN)
A
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.
10
Q
Bilateral Netting
A
The consolidation of all swap agreements between two counterparties.
11
Q
Convergence
A
The narrowing of the basis as a futures contract nears expiration.
12
Q
Cooling Degree Day (CDD)
A
A day in which the average daily temperature is greater than 65° F (18° C). Therefore, air conditioning is likely to be in demand. If the average daily temperature is 85°, for example, the CDD value for that day is 20.
13
Q
Cost of Carry
A
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.
14
Q
At-the-Money
A
When the exercise price of either a put or a call option is the same as the market price of the underlying asset.
15
Q
Multi-Asset Options
A
Consists of a family of options whose payoffs depend on the prices of more than one asset.
16
Q
Unfunded Swap ETF Structure
A
Under an unfunded swap ETF structure, a swap-based ETF transfers cash equal to a desired notional exposure to the swap provider, which then transfers a basket of collateral assets to the ETF. The total return on this collateral basket is then transferred to the swap provider in exchange for the market return of the index the ETF is trying to replicate.
17
Q
Hedging
A
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.
18
Q
Forward Rate Agreement
A
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.
19
Q
Trading Limits
A
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.
20
Q
Hedge Fund-Linked Notes
A
Principal protected notes in which the return is linked to the performance of an underlying hedge fund, or more commonly, a portfolio of hedge funds.
21
Q
Intercommodity Spread
A
A spread that involves the purchase and sale of futures contracts that have different but related underlying assets. The two contracts may trade on the same or different exchanges.
22
Q
Expiration Date
A
The date on which a derivative contract becomes void.
23
Q
Eurodollar
A
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.
24
Q
Comparative Advantage
A
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.
25
Market-linked GICs
GICs whose interest is linked to the performance of a market index, mutual fund, basket of securities or some other underlying asset.
26
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.
27
Foreign Exchange Agreement
A forward agreement based on a currency.
28
Mutual Fund-Linked Notes
Principal protected notes in which the return is linked to a particular mutual fund or portfolio of mutual funds.
29
Fundamental Analysis
The study of an asset’s current and expected supply and demand situation in order to help forecast future price movements.
30
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.
31
Volatility
A derivative instrument whose value depends on a designated measure of volatility.
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Liquidity Risk
Risk that a derivative cannot be purchased or sold quickly enough or in the required quantity at a fair price.
33
Principle of Substitution
The clearinghouse function of acting as the buyer for every seller and the seller for every buyer.
34
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 of 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.
35
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.
36
Operational Risk
Risk of exposure to loss as a result of inadequate risk management and internal controls by derivative users.
37
Foreign Currency Option
An option on an exchange rate or exchange rate index.
38
Portfolio CDS
A CDS written on a basket of underlying assets but that has a predetermined monetary amount, rather than a number of defaults.
39
Offsetting Transaction
A futures or option transaction that is the exact opposite of a previously established long or short position.
40
Commodity Futures
Futures contracts that are based on a physical or “hard” asset such as gold, soybeans or crude oil.
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Beta
A measure of the responsiveness of a security or portfolio to the market as a whole.
42
Intermarket Spread
A spread that involves the purchase and sale of futures contracts that have the same underlying asset but trade on different exchanges.
43
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.
44
Mini Contracts
Derivative contracts representing a fraction (typically 1/5 or 1/10) of a standard futures or options contract.
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Original Margin
The required deposit when a futures contract is entered into.
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Funded Swap ETF Structure
Under a funded swap ETF structure, a swap-based ETF transfers cash equal to a desired notional exposure to the swap provider, which then provides the market return of the index the ETF is trying to replicate. To offset the counterparty risk exposure, the swap provider has to post collateral that is pledged to the ETF.
47
Single-Name CDS
A plain vanilla single asset CDS, which is basically credit protection (insurance).
48
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.
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Managed Futures Fund
Essentially mutual funds that invest in futures markets.
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Unsystematic Risk
The risk that a particular stock or group of stocks will underperform the market as a whole.
51
Interest Rate Collar
A combination of a cap and a floor created by purchasing a cap, while simultaneously selling a floor.
52
Mark-to-Market Accounting
A method of accounting that applies to speculative and other transactions that do not meet the requirements for hedge accounting. Gains and losses from such trading activities are recorded immediately as income.
53
Spot Price
the price of an asset on the spot market.
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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.
55
Whipsaw
Situation where a speculator is forced to close out a position due to an adverse price movement, only to see the price quickly rebound back in the favoured direction.
56
Index Option
Option contract on a stock index or other financial index.
57
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
58
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.
59
Plain Vanilla Interest Rate Swap
A term used to describe the most basic type of interest rate swap
60
Spreading
Describes a market strategy that attempts to take advantage of relative price changes between two different but similar futures contracts.
61
Amortizing Swap
An interest rate swap in which the notional principal amount is reduced over time until it reaches zero.
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Forward Currency Exchange Agreement
A forward agreement that is based on foreign exchange. The parties to a forward currency agreement are able to fix a foreign exchange rate for a transaction that is going to take place at some point in the future.
63
Caplets
The individual option components of an interest rate cap.
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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.
65
Closed-End Fund
A fund with a fixed number of shares outstanding. The shares are bought and sold on a stock exchange instead of being issued and redeemed the way a typical mutual fund does.
66
Interest Rate Parity
The relationship between the spot and forward foreign exchange rates and the interest rates of two countries. Interest rate parity dictates that the difference between short-term interest rates between two countries should be offset by the forward exchange rate, otherwise an arbitrage opportunity would exist.
67
Contract for Difference (CFD)
A type of cash-settled over-the-counter derivative contract where the parties agree to honour the difference in price between where a position is opened and where it is closed. One major difference between CFDs and other derivatives is that CFDs have no expiration date.
68
Open Outcry Auction System
The auction system used in the trading pits on the floor of a futures exchange. All bids and offers are made openly and loudly by public competitive outcry and hand signals.
69
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.
70
Credit Enhancements
In order to control credit risk, dealers often require credit enhancements such as collateral from their counterparties.
71
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.
72
Forward Agreement
When a forward-based derivative is traded over-the-counter, it is generally referred to as a forward agreement.
73
Reputation Risk
Risk of damage to a company’s reputation if it fails to act honestly and in good faith with counterparties in derivative dealings.
74
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.
75
Synthetic Equity Position
A position that allows an investor to earn equity returns without actually taking a position in equity.
76
Bear Put Spread
The simultaneous purchase of a put option and sale of a put option with a lower exercise price on the same underlying asset and with the same expiration.
77
Time Value
The premium of the option less its intrinsic value.
78
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.
79
Legal Risk
Risk of a loss because a derivative contract cannot be legally enforced.
80
Systemic Risk
Risk that a disruption, at a major firm, or in a market segment, or to a settlement system, causes widespread difficulties in other firms, in other market segments, or in the financial system as a whole.
81
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 the agreed upon equity index.
82
Technical Analysis
The study of past price and volume data in order to anticipate future market movements.
83
Systematic Risk
Risk of overall stock market weakness.
84
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.
85
Net Equity
The net equity in a futures account is defined as the cash deposited plus/minus any open futures positions’ profit/loss.
86
Perfect Hedge
A hedge in which the futures price behaved exactly as expected relative to the cash price.
87
Stress Testing
A technique of measuring risk. Its purpose is to determine what happens to a derivative instrument or a portfolio of derivatives under a variety of unlikely, but not improbable high stress-events.
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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.
89
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.
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American-Style
A type of option that can be exercised at any time up to the expiration of the option.
91
Delivery Price
The price that the purchaser of a forward-based contract agrees to pay to the seller of the contract upon delivery.
92
Delta
Indicates how much the price of an option is expected to change, given a price change in the underlying interest.
93
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.
94
Covered
When an investor writes an option and has an underlying asset position that would satisfy the obligation in case of assignment.
95
Forward Exchange Rate
The rate (or price) associated with the purchase or sale of a currency for a specified future delivery date.
96
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
97
First-To-Default CDS
A CDS that pays upon the first default of any of the referenced assets.
98
Cross-Rate
Rate (or price) associated with the purchase or sale of currencies that are neither traded nor quoted directly against one another.
99
Hedge Fund
A term commonly used to describe lightly regulated pools of capital that have great flexibility in their choice of investment strategies.
100
Clearinghouse
An organization that takes 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.
101
Exchange-traded Derivatives
Forward and option products that trade on an organized exchange.
102
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.
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Leverage
The ability to control large dollar 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.
104
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 fund investments.
105
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.
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Basis
The difference between the current cash price and the futures price.
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Indication Pricing Schedule
A schedule of rates provided by a swap dealer.
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Daily Price Limit
In a futures contract, the maximum amount the price is allowed to rise or fall in one day.
109
Bankers’ Acceptance
A short-term promissory note issued by a corporation that has been backed by a chartered bank.
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Implied Forward Rate
A rate of interest derived from current spot rates that is applicable to a future time period.
111
Cheapest to Deliver (CTD)
The bond or note that can be delivered against a bond or note futures contract that either minimizes the loss on delivery or maximizes the gain.
112
Settlement Risk
Risk of default during the settlement period when one counterparty has fulfilled its obligation under the contract and awaits the payment or delivery of securities from the other counterparty.
113
Sell Program
Refers to reverse cash and carry arbitrage in the stock index futures market. Involves the selling of the stocks that comprise the index underlying the index futures contract and the buying of the futures contract to take advantage of mispricing. Often, instead of selling all the stocks in an index, the arbitrageur will sell a basket of stocks that closely correlate with the index.
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Market Risk
The risk that any market-related factor will change the value of a derivatives position.
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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.
116
Managed Account
Individual accounts where a client gives discretionary authority over to a commodity trading professional.
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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.
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Index-based CDS
Credit default swap (CDS) on an index designed to track the credit risk of a group of corporate entities considered to represent a sector of the economy or a particular geographical region.
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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.
120
Derivative
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.
121
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.
122
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).
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European-Style Option
A type of option that can only be exercised at expiration.
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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.
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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.
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Short Straddle
Writing a call and writing a put with the same exercise price and same underlying asset.
127
Participation Rate
Percentage indicating the portion of the upside growth in a PPN’s underlying asset that will be paid to the PPN’s investors.
128
Weather Derivatives
A financial instrument whose value is derived from the behaviour of weather patterns.
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Futures Contract
A forward-based derivative that trades on an exchange.
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Bull Call Spread
The simultaneous purchase of a call option and sale of a call option with a higher exercise price on the same underlying asset and with the same expiration.
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Callable Convertible Bond
A convertible bond that is also callable.
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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.
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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.
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Exotic Option
Any option that is not traded on an exchange and is not essentially identical to one traded on an exchange.
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Uncovered
When an investor writes an option without having an underlying position that would satisfy the obligation in case of assignment.
136
Position Trader
A type of speculator who is hoping to profit from longer-term price trends.
137
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 has 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 (FIFO).
138
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.
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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.
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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.
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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.
142
Reference Entity
The issuer of the underlying asset(s) being protected in a credit derivative.
143
Long Straddle
Consists of buying a call and buying a put with the same exercise price and same underlying asset.
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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.
145
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.
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Protected Short Sale
A call purchase against the short sale of an underlying security.
147
Commodity Product Spread
A spread that involves the purchase or sale of a commodity futures contract against the opposite position in the products of the commodity.
148
Interbank Market
A network of banks across the world that buy and sell currencies 24 hours a day over telephone lines and computer terminals.
149
Spread Trader
Trader simultaneously taking a long position in one asset and a short position in a related asset.
150
Heating Degree Day (HDD)
A day in which the average daily temperature is less than 65° F (18° C). Therefore, heat is likely to be in demand. If the average daily temperature is 55°, for example, the HDD value for that day is 10.
151
Collateral Basket
A basket of collateral assets pledged to or received by a swap-based ETF, reducing this way the ETF’s counterparty risk exposure to the swap provider.
152
Callable Bond
A regular bond with a provision that allows the firm to repurchase or call the bond at any time, usually after a grace period following issuance, for a specified amount, known as the call price, plus accrued interest since the last coupon date.
153
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.
154
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.
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Long Combination
Consists of buying a call and buying a put with different exercise prices and the same underlying asset.
156
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 automatically terminated upon expiration.
157
Value at Risk (VaR)
A single number that attempts to measure a firm’s total risk exposure from a portfolio of assets. VaR is a statistical measure of estimating the maximum potential loss under normal market conditions, over a certain period of time, for a given confidence level.
158
Stock Index Option
An option that has as its underlying interest a particular stock index.
159
Imperfect Hedge
The result of a 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.
160
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.
161
Covered Call
The purchase of an underlying asset and the sale of a call option on that underlying asset.
162
Buy Program
Cash and carry arbitrage in the stock index futures market. Involves buying the stocks that comprise the index underlying the index futures contract and selling the futures contract to take advantage of mispricing. Often, instead of selling all the stocks in an index, the arbitrageur will sell a basket of stocks that closely correlate with the index.
163
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.
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Futures Option
An option on a particular futures contract.
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Call Option
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.
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Compound Option
An option on an option.
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Separation of Duties
Another crucial principle that should be followed in any effective internal control and monitoring system. An employee or a group of employees should not be given the authority to conduct and approve all risk management activities.
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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.
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Protection Seller
The party wanting to acquire or hold credit risk in the use of credit derivatives.
170
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.
171
Receiver Swaption
Option giving its holder the right but not the obligation to enter into a predetermined swap agreement to pay the floating rate and receive the fixed rate.
172
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.
173
Currency Swap
In its simplest form, a plain fixed-for-fixed currency swap agreement is an 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.
174
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.
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Assignment
When an option holder exercises, the writer is assigned to either buy or sell the underlying asset.
176
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.
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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.
178
Conversion Factor
An adjustment factor that equates all the different bonds that can be delivered against a bond futures contract to the deliverable grade bond underlying the contract.
179
Basket CDS
A CDS that offers protection on the default probabilities of a basket of assets.
180
Basis Swap
An interest rate swap where the interest payments for both counterparties are determined by a floating rate.
181
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
182
Covered Put Sale
The short sale of an underlying asset and the sale of a put option on that underlying asset.
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Basis Risk
The risk of unexpected changes in the basis.
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Convenience Yield
The benefit from owning the physical commodity. The value of the benefit is dependent 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.
185
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.
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Premium
The price of an option.
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Delta Hedging
Adjusting the number of contracts used in an option hedge to reflect the option’s delta.
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Married Put
The purchase of an underlying asset and the purchase of a put option on that underlying asset.
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Expected shortfall
Sometimes referred to as conditional VaR (CVaR), or expected tail loss, expected shortfall is a VaR-based risk measure. It focuses on the potential losses located in the portion of the distribution curve that lies outside the confidence interval used in a specific VaR calculation. It allows risk managers to consider the low probability, but always possible, losses that are larger than VaR.
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Program Trading
The use of computers to execute complicated stock market orders.
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Payer Swaption
Option giving its holder the right but not the obligation to enter into a predetermined swap agreement to pay the fixed rate and receive the floating rate.
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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.
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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.
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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.
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Put Option
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.
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Short Combination
Writing a call and writing a put with different exercise prices and the same underlying asset.
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Financial Futures
Futures contracts that have a financial asset such as a bond, index or currency as their underlying interest.
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Electronic Exchange
An exchange where designated terminals are used to enter orders on listed contracts. As orders are entered, the exchanges’ electronic trading systems will sort, display and, when the rules of auction trading say so, match them (i.e., create a trade).
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Index Swap
A swap where payments of one counterparty are tied to the value of a particular index.
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Day Trader
A type of speculator whose time horizon is a single day.
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Implied Volatility
The volatility implicit in an option’s premium.
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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.
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NI 81-102
A set of rules and regulations that must be complied with by publicly offered investment funds.
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Maintenance Margin
The minimum balance for margin required during the life of a futures contract.
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Floor Brokers
Floor traders who fill orders from customers.
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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.
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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.
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Protection Buyer
The party wanting to reduce credit risk in the use of credit derivatives.
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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 agreed 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 contract 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.
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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.
