Finance

Glossary – Finance

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Accrual Swap
An Interest rate swap where interest on one side accrues only when a certain condition is met.

Accrued Interest
The interest earned on a bond since the last coupon payment date.

Amortizing Swap
A swap where the notional principal decreases in a predetermined way as time passes.

Arbitrageur
An individual engaging in arbitrage.

Asian Option
An option with a payoff dependent on the average price of the underlying asset during a specified period.

Ask Price
The price that a dealer is offering to sell an asset.

Asset-or-Nothing Call Option
An option that provides a payoff equal to the asset price if the asset price is above the strike price and zero otherwise.

Asset-or-Nothing Put Option
An option that provides a payoff equal to the asset price if the asset price is below the strike price and zero otherwise.

At-the-Money Option
An option in which the strike price equals the price of the underlying asset.

Average Price Call Option
An option giving a payoff equal to the greater of zero and the amount by which the average price of the asset exceeds the strike price.

Average Price Put Option
An option giving a payoff equal to the greater of zero and the amount by which the strike price exceeds the average price of the asset.

Average Strike Option
An option that provides a payoff dependent on the difference between the final asset price and the average asset price.

Back Testing
Testing a value-at-risk or other model using historical data.

Backwards Induction
A procedure for working from the end of a tree to its beginning in order to value an option.

Basis Risk
The risk to a hedger arising from uncertainty about the basis at a future time.

Basket Option
An option that provides a payoff dependent on the value of a portfolio of assets.

Bermudan Option
An option that can be exercised on specified dates during its life.

Beta
A measure of the systematic risk of an asset.

Bid-Ask Spread
The amount by which the ask price exceeds the bid price.

Binary Option
An option with a discontinuous payoff: for example, a cash-or-nothing option or an asset-or-nothing option.

Binomial Model
A model where the price of an asset is monitored over successive short periods of time. In each short period it is assumed that only two price movements are possible.

Binomial Tree
A tree that represents how an asset price can evolve under the binomial model.

Black`s Model
An extension of the Black-Scholes model for valuing European options on futures contracts.

Black-Scholes Model
A model for pricing European options on stocks, developed by Fischer Black, Myron Shcoles and Robert Merton.

Bond Option
An option where a bond is the underlying asset.

Calendar Spread
A position that is created by taking a long position in a call option that matures at one time and a short position in a similar call option that matures at a different time (A calendar spread can also be created using put options).

Calibration
A method for implying volatility parameters from the prices of actively traded options.

Call Option
An option to buy an asset at a certain price by a certain date.

Call Settlement
A procedure for settling a futures contract in cash rather than by delivering the underlying asset.

Call-or-Nothing Put Option
An option that provides a fixed predetermined payoff if the final asset price is below the strike price and zero otherwise.

Callable Bond
A bond containing provisions that allow the issuer to buy it back at a predetermined price at certain times during its life.

Capital Asset Pricing Model
A model relating the expected return on an asset to its beta.

Caplet
One component of an interest rate cap.

Cash Flow Mapping
A procedure for representing an instrument as a portfolio of zero-coupon bonds for the purpose of calculating value at risk.

Cash-or-Nothing Call Option
An option that provides a fixed predetermined payoff if the final asset price is above the strike price and zero otherwise.

Clearinghouse
A firm that guarantees the performance of the parties in an exchange-traded derivatives transaction. (Also referred to as a clearing corporation).

Commodity Swap
A swap where cash flows depend on the price of a commodity.

Compound Option
An option on an option.

Constant Maturity Treasury Swap
A swap where the yield on a Treasury bond is exchanged for either a fixed rate or a floating rate on each payment date.

Continuous Compounding
A way of quoting interest rates. It is the limit as the assumed compounding interval is made smaller and smaller.

Convertible Bond
A corporate bond that can be converted into a predetermined amount of the company’s equity at certain times during its life.

Convexity
A measure of the curvature in the relationship between bond prices and bond yields.

Coupon
Interest payment made on a bond.

Covered Call
A short position in a call option on an asset combined with a long position in the asset.

Credit Default Swap
An instrument that gives the holder the right to sell a bond for its face value in the event of a default by the issuer.

Credit Rating
A measure of the creditworthiness of a bond issue.

Credit Transition Matrix
A table showing the probability that a company will move from one credit rating to another during a certain period of time.

Credit Value At Risk
The credit loss that will not be exceeded at some specified confidence level.

Currency Swap
A swap where interest and principal in one currency are exchanged for interest and principal in another currency.

Day Count
A convention for quoting interest rates.

Day Trade
A trade that is entered into and closed out on the same day.

Deferred Payment Option
An option where the price paid is deferred until the end of the option’s life.

Deffered Swap
An agreement to enter into a swap at some time in the future.

Delta Hedging
A hedging scheme that is designed to make the price of a portfolio of derivatives insensitive to small changes in the price of the underlying asset.

Delta-Neutral Portfolio
A portfolio with a delta of zero so that there is no sensitivity to small changes in the price of the underlying asset.

Diagonal Spread
A position in two calls where both the strike prices and times to maturity are different (A diagonal spread can also be created with put options).

Differential Swap
A swap where a floating rate in one currency is exchanged for a floating rate in another currency and both rates are applied to the same principal.

Discount Bond
See zero-coupon bond.

Discount Instrument
An instrument, such as a Treasury bill, that provides no coupons.

Discount Rate
The annualized dollar return on a Treasury bill or similar instrument expressed as a percentage of the final face value.

Dividend Yield
The dividend as a percentage of the stock price.

Down-and-In Option
An option that comes into existence when the price of the underlying asset declines to a prespecified level.

Downgrade Trigger
A clause in a contract that states that the contract will be terminated with a cash settlement if the credit rating of one side falls below a certain level.

Drift Rate
The average increase per unit of time in a stochastic variable.

Duration
A measure of the average life of a bond. It is also an approximation to the ratio of the proportional change in the bond price to the absolute change in its yield.

Duration Matching
A procedure for matching the durations of assets and liabilities in a financial institution.

Dynamic Hedging
A procedure for hedging an option position by periodically changing the position held in the underlying assets. The objective is usually to maintain a delta-neutral position.

Early Exercise
An exercise prior to the maturity date.

Efficient Market Hypothesis
A hypothesis that asset prices reflect relevant information.

Embedded Option
An option that is inseparable part of another instrument.

Equilibrium Model
A model for the behaviour of interest rates derived from a model of the company.

Equity Swap
A swap where the return on an equity portfolio is exchanged for either a fixed or a floating rate of interest.

Eurodollar
A dollar held in a bank outside the United States.

European Option
An option that can be exercised only at the end of its life.

Ex-Dividend Date
When a dividend is declared, an ex-dividend date is specified. Investors who own shares of the stock up to the ex-dividend date receive the dividend.

Exchange Option
An option to exchange one asset for another.

Exercise Price
The price at which the underlying asset may be bought or sold in an option contract. (Also called the strike price).

Exotic Option
A nonstandard option.

Expectactions Theory
The theory that forward interest rates equal expected future spot interest rates.

Expected Value of a Variable
The average value of the variable obtained by weighting the alternative values by their probabilities.

Expiration Date
The end of life of a contract.

Exponentially Weighted Moving Average Model
A model where exponential weighting is used to provide forecasts for a variable from historical data. It is sometimes applied to the variance rate in value at risk calculations.

Exposure
The maximum loss from default by a counterparty.

Extendable Bond
A bond whose life can be extended at the option of the holder.

Extendable Swap
A swap whose life can be extended at the option of one side to the contract.

Financial Intermediary
A bank or other financial institution that facilitates the flow of funds between different entities in the economy.

Flat Volatility
The name given to volatility used to price a cap when the same volatility is used for each caplet.

Flex Option
An option traded on an exchange with terms that are different from the standard options traded by the exchange.

Foreign Currency Option
An option on a foreign exchange rate.

Forward Contract
A contract that obligates the holder to buy or sell an asset for predetermined delivery price at a predetermined future time.

Forward Exchange Rate
The forward price of one unit of a foreign currency.

Forward Price
The delivery price in a forward contract that causes the contract to be worth zero.

Forward Rate Agreement (FRA)
An agreement that a certain interest rate will apply to a certain principal amount for a certain time period in the future.

Forward Risk-Neutral World
A world is forward risk-neutral with respect to a certain asset when the market price of risk equals the volatility of that asset.

Forward Start Option
An option designed so that it will be at-the money at some time in the future.

Forward-Interest Rate
The interest rate for a future period of time implied by the rates prevailing in the market today.

Futures Option
An option on a futures contract.

Futures Price
The delivery price currently applicable to a futures contract.

Gamma
The rate of change of delta with respect to the asset price.

Gamma-Neutral Portofolio
A portfolio with a gamma of zero.

Hedge Ratio
A ratio of the size of a position in a hedging instrument to the size of the position being hedged.

Hedger
An individual who enters into hedging trades.

Historic Volatility
A volatility estimated from historical data.

Historical Simulation
A simulation based on historical data.

Implied Distribution
A distribution for a future asset price implied from option prices.

Implied Repo Rate
The repo rate implied from the price of a Treasury bill and a Treasury bill futures price.

Implied tree
A tree describing the movements of an asset price that is constructed to be consisted with observed option prices.

Implied Volatility
Volatility implied from an option price using the Black-Scholes or a similar model.

In-the-Money Option
Either (a) a call option where the asset price is greater than the strike price or (b) a put option where the asset price is less than the strike price.

Index Arbitrage
An arbitrage involving a position in the stocks comprising a stock index and a position in a futures contract on the stock index.

Index Futures
A futures contract on a stock index or other index.

Index Option
An option contract of a stock index or other index.

Indexed Principal Swap
A swap where the principal declines over time. The reduction in the principal on a payment date depends on the level of interest rates.

Interest-Rate Cap
An option that provides a payoff when a specified interest rate is above a certain level. The interest rate is a floating rate that is reset periodically.

Interest-Rate Collar
A combination of an interest-rate cap and an interest-rate floor.

Interest-Rate Derivative
A derivative whose payoffs are dependent on future interest rates.

Interest-Rate Floor
An option that provides a payoff when an interest rate is below a certain level. The interest rate is a floating rate that is reset periodically.

Interest-Rate Option
An option where the payoff is dependent on the level of interest rates.

Interest-Rate Swap
An exchange of a fixed rate of interest on a certain notional principal for a floating rate of interest on the same notional principal.

Intrinsic Value
For a call option, this is the greater of the excess of the asset price over the strike price and zero. For a put option, it is the greater of the excess of the strike price over the asset price and zero.

Inverted Market
A market where futures prices decrease with maturity.

Libor Curve
Libor zero-coupon interest rates as a function of maturity.

Limit Move
The maximum price move permitted by the exchange in a single trading session.

Limit Order
An order that can be executed only at a specified price or one more favourable to the investor.

Liquidity Premium
The amount that forward interest rates exceed expected future spot interest rates.

Long Hedge
A hedge involving a long futures position.

Maintenance Margin
When the balance in a trader’s margin account falls below the maintenance margin level, the trader receives a margin call requiring the account to be topped up to the initial margin level.

Marking To Market
The practice of revaluing an instrument to reflect the current values of the relevant market variables.

Maturity Date
The end of the life of a contract.

Mortgaged-Backed Security
A security that entitles the owner to a share in the cash flows realized from a pool of mortgages.

Naked Position
A short position in a call option that is not combined with a long position in the underlying asset.

Netting
The ability to offset contracts with positive and negative values in the event of a default counterparty.

Nonsystematic Risk
Risk that can be diversified away.

Normal Distribution
The standard bell shaped distribution of statistics.

Notional Principal
The principal used to calculate payments in an interest rate swap. The principal is ¨notional¨ because it is neither paid nor received.

Open Interest
The total number of long positions outstanding in a futures contract (equals the total number of short positions).

Option Class
All options of the same type (call or put) on a particular stock.

Option Series
All options of a certain class with the same strike price and expiration date.

Option-Adjusted Spread
The spread over the Treasury curve that makes the theoretical price of an interest rate derivative equal to the market price.

Out-of-the-Money Option
Either (a) a call option where the asset price is less than the strike price or (b) a put option where the asset price is greater than the strike price.

Over-the-Counter Market
Market where traders deal by phone. The traders are usually financial institutions , corporations and fund managers.

Par Value
The principal amount of a bond.

Par Yield
The coupon on a bond that makes its price equal the principal.

Path-Dependent Option
An option whose payoff depends on the whole path followed by the underlying variable – not just its final value.

Payoff
The cash realized by the holder of an option or other derivative at the end of its life.

PO (principal only)
A mortgage-backed security where the holder receives only principal cash flows on the underlying mortgage pool.

Portfolio Immunization
Making a portfolio relatively insensitive to interest rates.

Portfolio Insurance
Entering into trades to ensure that the value of a portfolio will not fall below a certain level.

Position Limit
The maximum position a trader (or group of traders acting together) is allowed to hold.

Principal
The par or face value of a debt instrument.

Program Trading
A procedure where trades are automatically generated by a computer and transmitted to the trading floor of an exchange.

Protective Put
A put option combined with a long position in the underlying asset.

Pull-to-Par
The reversion of a bond’s price to its par value at maturity.

Put-Call Parity
The relationship between the price of a European call option and the price of a European put option when they have the same strike price and maturity date.

Puttable Bond
A bond where the holder has the right to sell it back to the issuer at certain predetermined times for a predetermined price.

Puttable Swap
A swap where one side has the right to terminate early.

Rainbow Option
An option whose payoff is dependent on two or more underlying variables.

Range-Forward Contract
The combination of a long call and short put or the combination of a short call and long put.

Rebalancing
The process of adjusting a trading position periodically. Usually the purpose is to maintain delta neutrality.

Repo (Repurchase Agreement)
A procedure for borrowing money by selling securities to a counterparty and agreeing to buy them back later at a slightly higher price.

Repo Rate
The rate of interest in a repo transaction.

Risk-Free Rate
The rate of interest that can be earned without assuming any risks.

Risk-Neutral Valuation
The valuation of an option or other derivative assuming the world is risk neutral. Risk-neutral valuation gives the correct price for a derivative in all worlds, not just in a risk-neutral world.

Scalper
A trader who holds positions for a very short period of time.

Settlement Price
The average of the prices that a contract trades for immediately before the bell signalling the close of trading for a day. It is used in mark-to-market calculations.

Short Hadge
A hedge where a short futures position is taken.

Short Selling
Selling in the market shares that have been borrowed from another investor.

Shout Option
An option where the holder has the right to lock in a minimum value for the payoff at one time during its life.

Spread Option
An option where the payoff is dependent on the difference between two market variables.

Spread Transaction
A position in two or more options of the same type.

Step-up-Swap
A swap where the principal increases over time in a predetermined way.

Stochastic Process
An equation describing the probabilistic behaviour of a stochastic variable.

Stock Dividend
A dividend paid in the form of additional shares.

Stock Index Futures
Futures on a stock index.

Stock Index Option
An option on a stock index.

Stock Option
An option on a stock.

Straddle
A long position in a call and a put with the same strike price.

Strangle
A long position in a call and a put with different strike prices.

Strap
A long position in two call options and one put option with the same strike price.

Stress Testing
Testing of the impact of extreme market moves on the value of a portfolio.

Strip
A long position in one call option and two put options with the same strike price.

Swap Rate
The fixed rate in an interest rate swap that causes the swap to have a value of zero.

Swaption
An option to enter into an interest rate swap where a specified fixed rate is exchanged for floating.

Systematic Risk
Risk that cannot be diversified away.

Tera Structure of Interest Rates
The relationship between interest rates and their maturities.

Terminal Value
The value at maturity.

Theta
The rate of change of the price of an option or other derivative with the passage of time.

Time Value
The value of an option arising from the time left to maturity (equals an option’s price minus its intrinsic value).

Total Return Swap
A swap of the return on one portfolio of assets for the return on another portfolio of assets.

Transactions Costs
The cost of carrying out a trade (commissions plus the difference between the price obtained and the midpoint of the bid-offer spread).

Treasury Bill
A short-term non-coupon-bearing instrument issued by the government to finance its debt.

Treasury Bill Futures
A futures contract on a Treasury bill.

Treasury Bond
A long-term coupon-bearing instrument issued by the government to finance its debt.

Treasury Bond Futures
A futures contract on Treasury bonds.

Treasury Note Futures
A futures contract on Treasury notes.

Underlying Variable
A variable that the price of an option or other derivative depends on.

Up-and-In Option
An option that comes into existence when the price of the underlying asset increases to a prespecified level.

Up-and-Out Option
An option that ceases to exist when the price of the underlying asset increases to a prespecified level.

Value At Risk
A loss that will not be exceeded at some specified confidence level.

Variance Rate
The square of volatility.

Volatility Matrix
A table showing the variation of implied volatilities with strike price and time to maturity.

Volatility Skew
A term used to describe the volatility smile when it is nonsymmetrical.

Volatility Smile
The variation of implied volatility with strike price.

Volatility Term Structure
The variation of implied volatility with time to maturity.

Writing An Option
Selling an option.

Zero-Coupon Interest Rate
The interest rate that would be earned on a bond that provides no coupons.