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Derivative

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Introduction

  • American-Style Option
    An option contract that may be exercised at any time between the date of purchase and the expiration date.
     
  • Arbitrage
    The act of taking advantage of differences in price between markets. For example, if a stock is quoted on two different equity markets, there is the possibility of arbitrage if the quoted price (adjusted for institutional idiosyncrasies) in one market differs from the quoted price in the other.

    The term has been extended to refer to speculators who take positions on the correlation between two different types of instrument, assuming stability to the correlation patterns.
     
  • Assignment
    The receipt of an exercise notice by an option writer (seller) that obligates him to sell (in the case of a call) or purchase (in the case of a put) the underlying security at the specified strike price.
     
  • At-the-Money-Option (ATM)
    At-the-money option is an option that would lead to a zero cash flow if it were exercised immediately. A Call option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price).  
  • Basis
    Basis is usually defined as the spot price minus the futures price.

    There will be a different basis for each delivery month for each contract. In a normal market basis will be negative.

    This reflects that future prices normally exceed spot prices.
     
  • Bear Market
    A market in which prices are declining..
     
  • Benchmarking
    A benchmark is a reference point. Benchmarking in financial risk management refers to the practice of comparing the performance of an individual instrument, a portfolio or an approach to risk management to a pre-determined alternative approach.
     
  • Bid
    The price that the market participants are willing to pay.
     
  • Black-Scholes
    A closed-form solution (i.e. an equation) for valuing plain vanilla options developed by Fischer Black and Myron Scholes in 1973 for which they shared the Nobel Prize in Economics.
     
  • Bull
    One who expects prices to rise.
     
  • Buy On Close
    To buy at the end of a trading session at a price within the closing range.
     
  • Buy On Opening
    To buy at the beginning of a trading session at a price within the opening range.  
  • Call (option)
    An Option contract that gives the holder the right to buy the underlying security at a specified price for a certain fixed period of time.
     
  • 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.
     
  • Class Of Options
    Option contracts of the same type (call or put) and Style (American or European) that cover the same underlying security.
     
  • Close
    The period at the end of the trading session. Sometimes used to refer to the Closing Range (or Range).
     
  • Closing Purchase
    A transaction in which the purchaser's intention is to reduce or eliminate a short position in a given series of options.
     
  • Closing Sale
    A transaction in which the seller's intention is to reduce or eliminate a long position in a given series of options.
     
  • 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.
     
  • Contract Cycle
    The period over which a contract trades. The index futures contracts on the NSE have one-month, two-months and three-months expiry cycles, which expire on the last Thursday of the respective month. Thus a January expiration contract could expire on the last Thursday of January and a February expiration contract would cease trading on the last Thursday of February.

    On the Friday following the last Thursday a new contract having a three-month expiry would be introduced for trading.
     
  • Contract Month
    The month in which futures contracts may be satisfied by making or accepting delivery.
     
  • Contract Size
    The amount of asset that has to be delivered under one contract for instance the contract size of Satyam comprises 1200 shares of Satyam.
     
  • 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 opposite direction to the same extent have highly negative correlations.

    Correlation between instruments is not stable.
     
  • Cost of Carry
    The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.
     
  • Covered Call Option Writing
    A technique used by investors to help fund their underlying positions, typically used in the equity markets. An individual who sells a call is said to "write" the call. If this individual sells a call on a notional amount of the underlying that he has in his inventory, then the written call is said to be "covered" (by his inventory of the underlying). If the investor does not have the underlying in inventory, the investor has sold the call "naked".
     
  • Credit Risk
    Credit risk is the risk of loss from a counter party in default or from a pejorative change in the credit status of a counter party that causes the value of their obligations to decrease.
  • Day Order
    An order that is placed for execution during only one trading session. If the order cannot be executed that day, it is automatically cancelled.
     
  • Delta
    The sensitivity of the change in the financial instrument's price to changes in the price of the underlying cash index.
     
  • Derivative Security
    A financial security whose value is determined in part from the value and characteristics of another security. The other security is referred to as the underlying security.
     
  • Documentation Risk
    The risk of loss due to an inadequacy or other unforeseen aspect of the legal documentation behind the financial contract.
     
  • Embedded Derivatives
    Derivative contracts that exist as part of securities.
     
  • Equity Options
    Options on shares of an individual stock.
     
  • European-Style Options
    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 NSE or BSE
     
  • Exercise Price
    The exercise price is the price at which a call's (put's) buyer can buy (or sell) the underlying instrument.
     
  • Expiry Date
    It is the date specified in the future contract. This is the last day on which the contract will be traded at the end of which it will cease to exist.
     
  • Expiration Time
    It is the date specified in the future contract. This is the last day on which the contract will be traded at the end of which it will cease to exist.
     
  • 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 counter parties.

    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.
     
  • Futures Contracts
    Gamma (or convexity) is the degree of curvature in the financial contract's price curve with respect to its underlying price. It is the rate of change of the delta with respect to changes in the underlying price.
     
  • Gamma
    A financial security whose value is determined in part from the value and characteristics of another security. The other security is referred to as the underlying security.
     
  • 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.
     
  • Holder
    The party who purchases an option.
     
  • Hybrid Security
    Any security 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 Option
    An option with positive intrinsic value with respect to the prevailing market spot rate. A "call" option is in-the-money if the

    strike price is less than the market price of the underlying security. A "put" option is in-the-money if the strike price is greater than the market price of the underlying security This would lead to a positive cash flow to the investor if it were to be exercised immediately.

    A Call option on the index is said to be in the money when the current index stands at a level higher than the strike price. If the index is much higher than the strike price, the call is said to be deep in-the-money. In case of a put, the put is in-the-money if the index is below the strike price.
     
  • Initial Margin
    The amount that must be deposited in the margin account of a customer at the time a futures/options contract is first entered into is known as initial margin
     
  • Limit Order Option
    An order given to a broker by a customer that specifies a price; the order can be executed only if the market reaches or betters that price.
     
  • Liquidation (also known as squaring off)
    Any transaction that offsets or closes out a long or short futures or options position.
     
  • 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 counter party 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.
     
  • Long Position
    An investors position where the number of contracts bought exceeds the number of contracts sold. He is a net holder.
     
  • Maintenance Margin
    This is somewhat lower than the initial margin. This set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.
     
  • Margin
    A credit-enhancement provision to master agreements and individual transactions in which one counter party 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.
     
  • Mark-To-Market
    The daily adjustment of margin accounts to reflect profits and losses.
    In the futures and options market at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures/options closing price. This is called marking-to-market.
     
  • 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.
     
  • Market Order
    An order for immediate execution given to a broker to buy or sell at the best obtainable price.
     
  • Minimum Price Fluctuation
    Smallest increment of price movement possible in trading a given contract, more commonly referred to as a "tick."
     
  • 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 counter parties, they can be consolidated into one net payment from one counter party to the other thereby reducing the settlement risk involved.
     
  • Offer
    The price at which an investor is willing to sell a futures or options contract.
     
  • Open interest
    The number of outstanding option contracts in the exchange market or in a particular class or series. An indicator of the depth or liquidity of a market (the ability to buy or sell at or near a given price)..
     
  • Opening Purchase
    A transaction in which the purchaser's intention is to create or increase a long position in a given series of options.
     
  • Opening Sale
    A transaction in which the seller's intention is to create or increase a short position in a given series of options.
     
  • Out-of-the-Money Option (OTM)
    An option whose exercise price has no intrinsic value. A call option is out-of-the-money if its exercise or strike price is above the current market price of the underlying security. A put option is out-of-the-money if its exercise or strike price is below the current market price of the underlying security. This could lead to negative cash flow it the option was exercised immediately. A Call option on the index is out of the money when the current index stands at a level, which is less than the strike price. If the index is much lower than the strike price, the call is said to be deep out-of-money. In the case of a put option, it is out-of-money if the index is above the strike price.
     
  • 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.
     
  • Over-the-Counter
    Any transaction that takes place between two counter parties and does not involve an exchange is said to be an over-the-counter transaction.
     
  • 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
    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
  • 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.
     
  • Secondary Market
    A market that provides for the purchase or sale of previously sold or bought options through closing transactions.
     
  • Series
    All option contracts of the same class that also have the same unit of trade, expiration date and strike price.
     
  • Settlement Risk
    The risk of non-payment of an obligation by a counter party to a transaction, exacerbated by mismatches in payment timings.
     
  • Short Position
    An investors position where the number of contracts sold exceeds the number of contracts bought. The person is a net seller.
     
  • Speculation
    Taking positions in financial instruments without having an underlying exposure that offsets the positions taken.
     
  • Spread
    The difference in price or yield between two assets that differ by type of financial instrument, maturity, strike or some other factor.
     
  • Stop Order
    An order to buy or sell at the market when and if a specified price is reached.
     
  • Strike price
    The stated price per share for which the underlying security may be purchased in the case of a call, or sold in the case of a put, by the option holder upon exercise of the option contract.
     
  • 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.
     
  • Theta
    The sensitivity of a derivative product's value to changes in the date, all other factors staying the same.
     
  • Time Value of an option
    For a derivative contract with a non-linear value structure, time value is the difference between the intrinsic value and the premium. A call that is out of the money or at the money has only time value. Usually the maximum time value exists when the option is at-the-money. The longer the time to expiration, the greater is a call's time value, all else remaining equal. At expiration a call cannot have a time value.
     
  • Underlying security
    The security subject to being purchased or sold upon exercise of the option contract.
     
  • Volatility
    A measure of the fluctuation in the market price of the underlying security. Mathematically, volatility is the annualized standard deviation of returns.
     
  • 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 pre-set statistical confidence interval, under normal market conditions
     
  • 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.
     
  • Writer
    The seller of an option contract.