Glossary of Terms
Actuals – Financial instruments that exist in one of the four main asset classes: interest rates, foreign exchange, equities or commodities.
Accreting Swap – An interest rate swap in which the notional amounts decrease (amortize) over time.
American Style Option – An option that can be exercised at any time from the inception of the financial instrument.
ALCO – The Asset-liability committee for a financial institution.
Asset-Liability Management – The process of matching the timing of cash flows associated with assets and liabilities.
At-the-Money – A financial instrument whose inception price is equal to the current market price.
Backwardation - A term often used in commodities or futures markets to refer to markets where shorter-dated contracts trade at a higher price than longer-dated contracts. Plotting the prices of contracts against time, with time on the x-axis, shows the commodity price curve as sloping downwards as time increases (also called contango.)
Barrier Options - An option contract for which the maturity, strike price and underlying are specified at inception in addition to a trigger price. The trigger price determines whether or not the option actually exists. In the case of a knock-in option, the barrier option does not exist until the trigger is touched. For a knock-out option, the option exists until the trigger is touched.
Basis – The difference in price or yield between two different indices.
Benchmarking – The practice of comparing the performance of one instrument or index, to another instrument or index.
Call Option - A call option is a financial contract giving the owner the right but not the obligation to buy a pre-set amount of the underlying financial instrument at a pre-set price with a pre-set maturity date.
Cap - A cap is a financial contract giving the owner the right but not the obligation to borrow a pre-set amount of money at a pre-set interest rate with a pre-set maturity date.
Cash Settlement - Some derivatives contracts are settled at maturity (or before maturity at closeout) by an exchange of cash from the party who is out-of-the-money to the party who is in-the-money.
Chooser Option - An option that gives the buyer the right at the choice date (before the option’s expiry) to choose if the option is to be a call or a put.
Collar - A combination of options in which the holder of the contract has bought one out-of-the money option call (or put) and sold one (or more) out-of-the-money puts (or calls). Doing this locks in the minimum and maximum rates that the collar owner will use to transact in the underlying at expiry.
Commodity Swap - A contract in which counterparties agree to exchange payments related to indices, at least one of which (and possibly both of which) is a commodity index.
Contango – Same as backwardation.
Convexity - A financial instrument is said to be convex (or to possess convexity) if the financial instrument’s price increases (decreases) faster (slower) than corresponding changes in the underlying price.
Correlation - Correlation is a statistical measure describing the extent to which prices on different instruments move together over time. Correlation can be positive or negative. Instruments that move together in the same direction to the same extent have highly positive correlations. Instruments that move together in opposite direction to the same extent have highly negative correlations. Correlation between instruments is not stable.
Credit Risk - Credit risk is the risk of loss from a counterparty in default or from a pejorative change in the credit status of a counterparty that causes the value of their obligations to decrease.
Currency Swap - An exchange of interest rate payments in different currencies on a pre-set notional amount and in reference to pre-determined interest rate indices in which the notional amounts are exchanged at inception of the contract and then re-exchanged at the termination of the contract at pre-set exchange rates.
Delta - The sensitivity of the change in the financial instrument’s price to changes in the price of the underlying cash index.
Documentation Risk - The risk of loss due to an inadequacy or other unforeseen aspect of the legal documentation behind the financial contract.
Duration - A weighted average of the cash flows for a fixed income instrument, expressed in terms of time.
Embedded Derivatives - Derivative contracts that exist as part of securities.
Equity Swap - A contract in which counterparties agree to exchange payments related to indices, at least one of which (and possibly both of which) is an equity index.
European Style Option - An option that can be exercised only at expiry as opposed to an American Style option that can be exercised at any time from inception of the contract. European Style option contracts can be closed out early, mimicking the early exercise property of American style options in most cases.
Exchange Traded Contracts - Financial instruments listed on exchanges such as the Chicago Board of Trade.
Exercise Price (see also Strike Price) - The exercise price is the price at which a call’s (put’s) buyer can buy (or sell) the underlying instrument.
Exotic Derivatives - Any derivative contract that is not a plain vanilla contract. Examples include barrier options, average rate and average strike options, lookback options, chooser options, etc.
Floor - A floor is a financial contract giving the owner the right but not the obligation to lend a pre-set amount of money at a pre-set interest rate with a pre-set maturity date.
Forward Contracts - An over-the-counter obligation to buy or sell a financial instrument or to make a payment at some point in the future, the details of which were settled privately between the two counterparties. Forward contracts generally are arranged to have zero mark-to-market value at inception, although they may be off-market. Examples include forward foreign exchange contracts in which one party is obligated to buy foreign exchange from another party at a fixed rate for delivery on a pre-set date. Off-market forward contracts are used often in structured combinations, with the value on the forward contract offsetting the value of the other instrument(s).
Forward or Delayed Start Swap - Any swap contract with a start that is later than the standard terms. This means that calculation of the cash flows does not begin straightaway but at some pre-determined start date.
Forward Rate Agreements (FRAs) - A forward rate agreement is a cash-settled obligation on interest rates for a pre-set period on a pre-set interest rate index with a forward start date. A 3×6 FRA on US dollar LIBOR (the London Interbank Offered Rate) is a contract between two parties obliging one to pay the other the difference between the FRA rate and the actual LIBOR rate observed for that period. An Interest Rate Swap is a strip of FRAs.
Futures Contracts - An exchange-traded obligation to buy or sell a financial instrument or to make a payment at one of the exchange’s fixed delivery dates, the details of which are transparent publicly on the trading floor and for which contract settlement takes place through the exchange’s clearinghouse.
Hedge - A transaction that offsets an exposure to fluctuations in financial prices of some other contract or business risk. It may consist of cash instruments or derivatives.
Historical Volatility - A measure of the actual volatility (a statistical measure of dispersion) observed in the marketplace.
Hybrid Security - Any security that includes more than one component. For example, a hybrid security might be a fixed income note that includes more than one component. For example, a hybrid security might be a fixed income note that includes a foreign exchange option or a commodity price option.
Implied Volatility - Option pricing models rely upon an assumption of future volatility as well as the spot price, interest rates, the expiry date, the delivery date, the strike, etc. If we are given simultaneously all of the parameters necessary for determining the option price except for volatility and the option price in the marketplace, we can back out mathematically the volatility corresponding to that price and those parameters. This is the implied volatility.
In-The-Money Spot - An option with positive intrinsic value with respect to the prevailing market spot rate. If the option were to mature immediately, the option holder would exercise it in order to capture its economic value. For a call price to have intrinsic value, the strike must be less than the spot price. For a put price to have intrinsic value, the strike must be greater than the spot price.
In-The-Money-Forward - An option with positive intrinsic value with respect to the prevailing market forward rate. If the option were to mature immediately, the option holder would exercise it in order to capture its economic value. For a call price to have intrinsic value, the strike must be less than the spot price. For a put price to have intrinsic value, the strike must be greater than the spot price.
Index-Amortizing Swaps - An interest rate swap in which the notional amount for the purposes of calculating cash flows decreases over the life of the contract in a pre-specified manner.
Interest Rate Swap - An exchange of cash flows based upon different interest rate indices denominated in the same currency on a pre-set notional amount with a pre-determined schedule of payments and calculations. Usually, one counterparty will received fixed flows in exchange for making floating payments.
International Swaps Dealers’ Association (ISDA) Agreements - In order to minimize the legal risks of transacting with one another, counterparties will establish master legal agreements and sidebar product schedules to govern formally all derivatives transactions into which they may enter with one another.
Intrinsic Value - The economic value of a financial contract, as distinct from the contract’s time value. One way to think of the intrinsic value of the financial contract is to calculate its value if it were a forward contract with the same delivery date. If the contract is an option, its intrinsic value cannot be less than zero.
Knock-in Option - An option the existence of which is conditional upon a pre-set trigger price trading before the option’s designated maturity. If the trigger is not touched before maturity, then the option is deemed not to exist.
Knock-out Option - An option the existence of which is conditional upon a pre-set trigger price trading before the option’s designated maturity. The option is deemed to exist unless the trigger price is touched before maturity.
Legal Risk - The general potential for loss due to the legal and regulatory interpretation of contracts relating to financial market transactions.
LIBOR (London Interbank Offer Rate) - The rate of interest paid on offshore funds in the Eurodollar markets.
Liquidity Risk - The risk that a financial market entity will not be able to find a price (or a price within a reasonable tolerance in terms of the deviation from prevailing or expected prices) for one or more of its financial contracts in the secondary market. Consider the case of a counterparty who buys a complex option on European interest rates. He is exposed to liquidity risk because of the possibility that he cannot find anyone to make him a price in the secondary market and because of the possibility that the price he obtains is very much against him and the theoretical price for the product.
Look-Back Options - An option which gives the owner the right to buy (sell) at the lowest (highest) price that traded in the underlying from the inception of the contract to its maturity, i.e. the most favourable price that traded over the lifetime of the contract.
Margin - A credit-enhancement provision to master agreements and individual transactions in which one counterparty agrees to post a deposit of cash or other liquid financial instruments with the entity selling it a financial instrument that places some obligation on the entity posting the margin.
Market Risk - The exposure to potential loss from fluctuations in market prices (as opposed to changes in credit status).
Market-Maker - A participant in the financial markets who guarantees to make simultaneously a bid and an offer for a financial contract with a pre-set bid/offer spread (or a schedule of spreads corresponding to different market conditions) up to a pre-determined maximum contract amount..
Naked Option Writing - The act of selling options without having any offsetting exposure in the underlying cash instrument.
Netting - When there are cash flows in two directions between two counterparties, they can be consolidated into one net payment from one counterparty to the other thereby reducing the settlement risk involved.
Notional Value – The amount that is used to calculate payments made on a financial instrument such as an interest rate swap.
OCC - The Office of the Comptroller of the Currency (US).
OSFI - Office of the Superintendent of Financial Institutions (Canada).
Open Interest - Exchanges are required to post the number of outstanding long and short positions in their listed contracts. This constitutes the open interest in each contract.
Operational Risk - The potential for loss attributable to procedural errors or failures in internal control.
Option - The right but not the obligation to buy (sell) some underlying cash instrument at a pre-determined rate on a pre-determined expiration date in a pre-set notional amount.
Out-of-The-Money Spot (see also At-The-Money; In-The-Money) -An option with no intrinsic value with respect to the prevailing market spot rate. If the option were to mature immediately, the option holder would let it expire. For a call price to have intrinsic value, the strike must be less than the spot price. For a put price to have intrinsic value, the strike must be greater than the spot price.
Out-of-The-Money-Forward (see also At-The-Money; In-The-Money) - An option with no intrinsic value with respect to the prevailing market forward rate. If the option were to mature immediately, the option holder would let it expire. For a call price to have intrinsic value, the strike must be less than the spot price. For a put price to have intrinsic value, the strike must be greater than the spot price.
Over-the-Counter - Any transaction that takes place between two counterparties and does not involve an exchange is said to be an over-the-counter transaction.
Path-Dependent Options - Any option whose value depends on the path taken by the underlying cash instrument.
Potential Exposure - An assessment of the future positive intrinsic value in all of the contracts outstanding with an individual counterparty who may choose (or may be unable) to make their obligated payments.
Premium - The cost associated with a derivative contract, referring to the combination of intrinsic value and time value. It usually applies to options contracts. However, it also applies to off-market forward contracts.
Put Option - A put option is a financial contract giving the owner the right but not the obligation to sell a pre-set amount of the underlying financial instrument at a pre-set price with a pre-set maturity date.
Put-Call Parity Theorem - A long position in a put combined with a long position in the underlying forward instrument, both of which have the same delivery date has the same behavioral properties as a long position in a call for the same delivery date. This can be varied for short positions, etc.
Quanto Option - An option the payout for which is denominated in an index other than the underlying cash instrument.
Regulatory Risk - The potential for loss stemming from changes in the regulatory environment pertaining to derivatives and financial contracts, the utility of these instruments for different counterparties, etc.
Rho - The sensitivity of a financial contract’s value to small changes in interest rates.
RiskMetrics - A parametric methodology for calculating Value-at-Risk using data conditioned by JP Morgan’s spinoff company RiskMetrics that is most useful for assessing portfolios with linear risks.
Settlement Risk - The risk of non-payment of an obligation by a counterparty to a transaction, exacerbated by mismatches in payment timings.
Speculation - Taking positions in financial instruments without having an underlying exposure that offsets the positions taken.
Spot - The price in the cash market for delivery using the standard market convention. In the foreign exchange market, spot is delivered for value two days from the transaction date or for the next day in the case of the Canadian dollar exchanged against the US dollar.
Spread - The difference in price or yield between two assets that differ by type of financial instrument, maturity, strike or some other factor. A credit spread is the difference in yield between a corporate bond and the corresponding government bond. A yield curve spread is the spread between two government bonds of differing maturity.
Standard Deviation - In finance, a statistical measure of dispersion of a time series around its mean; the expected value of the difference between the time series and its mean; the square root of the variance of the time series.
Stress Testing - The act of simulating different financial market conditions for their potential effects on a portfolio of financial instruments.
Strike Price - The price at which the holder of a derivative contract exercises his right if it is economic to do so at the appropriate point in time as delineated in the financial product’s contract.
Structured Notes - Fixed income instruments with embedded derivative products.
Swap Spread - The difference between the swap yield curve and the government yield curve for a particular maturity, referring to the market prices for the fixed rate in a plain vanilla interest rate swap.
Swaptions - Options on swaps.
Theta - The sensitivity of a derivative product’s value to changes in the date, all other factors staying the same.
Time Value - For a derivative contract with a non-linear value structure, time value is the difference between the intrinsic value and the premium.
Value at Risk or VaR - The calculated value of the maximum expected loss for a given portfolio over a defined time horizon (typically one day) and for a pre-set statistical confidence interval, under normal market conditions.
Value of a Basis Point - The change in the value of a financial instrument attributable to a change in the relevant interest rate by 1 basis point (i.e. 1/100 of 1%).
Vega - The sensitivity of a derivative product’s value to changes in implied volatility, all other factors staying the same.
Volatility - In finance, a statistical measure of dispersion of a time series around its mean; the expected value of the difference between the time series and its mean; the square root of the variance of the time series.
Yield Curve - For a particular series of fixed income instruments such as government bonds, the graph of the yields to maturity of the series plotted by maturity.
Yield Curve Risk - The potential for loss due to shifts in the position or the shape of the yield curve.
Zero Coupon Instruments – Fixed income instruments that do not pay a coupon, but instead only pay principle at maturity.
Zero Coupon Yield Curve – For zero coupon bonds, the graph of the yields to maturity of the series plotted by maturity.